Microecon Study Guide Final
Microecon Study Guide Final ECON 200
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This 7 page Study Guide was uploaded by Jonas on Tuesday January 26, 2016. The Study Guide belongs to ECON 200 at University of Washington taught by in Fall 2016. Since its upload, it has received 23 views.
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Date Created: 01/26/16
ECON 201 Finals Guide Lecture 13 – Fiscal Policy - Expansionary fiscal policy increases aggregate demand and closes a recessionary gap. - Contractionary fiscal policy reduced aggregate demand and eliminates inflationary gap. o Difference between potential and actual output is recessionary/inflationary gap. - Caution: there are significant lags in use o Realizing the gap by collecting and analyzing economic data takes time, government development of spending plan takes time, implementation takes time, etc. o Example: C=10+.75(Y-T) ; I planned0 ; G=60 ; T=60 ; NX = 0 - What if 300 is too small for Y* (level of real GDP at which real GDP equals planned aggregate spending) and government wants Y* to be bigger? Increase G by 25. o Increase in spending of 25 leads to rise of output of 100 1 - Spending multiplier is =4 1−.75 o So ∆Y=∆G x Spending Multiplier (100=25*4) - Simply put, multiplier tells us how effective policy will be. o Not actually that simple, since when AD shifts out, equilibrium price level will rise and shift AE down. - If cut taxes by 25 (G remains 60, T falls to 35). o Y = [10 + .75(Y-35)]+ 50 + 60 Y*=375 o Less effective – when given tax cut, people save not spend, whereas government spends all money. Multiplier on tax cut - Multiplier on a tax cut – normally multiplier on dollar is spending multiplier, but with taxes only a fraction of that dollar is spent. o Is negative because increase in taxes decreases spending. o Since multiplier on tax cut is smaller in absolute value than multiplier on spending, government spending is more effective at moving AD than a tax cut. −.75 o =−3 1−.75 o ∆Y=∆T x Tax Multiplier - What happened in the example: economy was in recession, and government closed recession by increasing spending or cutting taxes, which unbalanced the budget! o After increase in spending, budget deficit was -25 Government added to the debt to fight the recession - If we want to keep budget balanced (G rises to 85 but so does T) no multiplier effect at all! Why? o Two effects in the opposite directions; spending increases Y, raising taxes reduces Y o Balanced Budget Multiplier: 1 + −mpc = 1−mpc =1 o 1−mpc (1−mpc ) 1−mpc o So it is very hard to fight recession and balance budget at the same time. Lags in policy - Tough for government to adjust spending promptly in response to recession (time). - Rules governing taxes and transfers acts as automatic stabilizers, reducing size of multiplier and automatically reducing size of fluctuations in business cycle. o Discretionary fiscal policy arises from deliberate actions by policy makers rather than from business cycle. - Automatic stabilizers: spending that occurs automatically when there is a recession o E.g. unemployment insurance, progressive taxation, income redistribution o Recessionary gap will naturally lead to a rise in unemployment claims, and therefore a rise in spending. - Long-run implications of fiscal policy: long-run consequences b/c lead to increase in public debt. Deficits versus Debt - Deficit is the difference between amount of money gov spends and amount it receives in taxes over given period - Debt is sum of money government owes at particular point in time o They are linked because debt grows when gov runs deficits, but they are aren’t the same thing and tell different stories. - Public debt may crowd out investment spending, which reduces long-run economic growth (as evident in market for loanable funds) o In extreme cases, rising debt may lead to government default (economic and financial turmoil) o If government prints money to pay bills, then it would lead to inflation - What to do: deficits and debt are long run problems while recessionary gap is a short run problem. o Keynesian advice: run deficit during recession to stimulate AD o Pay down debt during good times - Budget balance: budget deficit as a percentage of GDP tends to rise during recessions and fall during expansions o Moves closely in tandem with unemployment rate - Budget balance: some fluctuations in budget balance are due to countercyclical spending o To separate effects of business cycle from effects of discretionary fiscal policy, governments estimate the cyclically adjusted budget balance, which is estimate of budget balance if economy was at potential output - Debt-GDP ratio is a widely used measure of fiscal health; GDP is what we have to pay off debt, so… o Can change in in face of moderate budget deficits if GDP rises over time - Implicit liabilities: spending promises made by governments that are effectively a debt despite fact that they are not included in usual debt statistics - Argentina’s haircut – in 1990s Argentina experienced economic boom and borrowed lots of money from abroad, then slid into slump. However, had to pay off loans and borrowed at much higher interest rates. o Forced creditors to trade sovereign bonds for new bonds not worth that much o Reduction in value of debt is known as “haircut” Austerity Dilemmas - Austerity means implementing a contractionary fiscal policy (reduce G, increase T) o Short-run analysis continues to apply – if economy is already depressed, contractionary fiscal policy will make it even more depressed. Worsened state of economy can undermine investor confidence that austerity supposed to produce. - The Sequester: the austerity dilemma in Argentina is the reason many economists oppose the sequester. - With US, no one is worried we can’t pay off our debt. o Interest rates are at all time low; people begging us to borrow their money o It is entirely a needless self-inflicted wound. Lecture 14: Money Money and Banking - Monetary policy is shifting AD around by manipulating the money supply - We need to understand the role money play in AD and AE, the role banks play, and the Federal Reserve - Money is any asset that can easily be used to purchase goods and services o By definition is most liquid asset (easiest to turn into cash without loss of value) - Currency in circulation: cash held by public (cash in bank vaults don’t count) - Checkable bank deposits: bank accounts on which people can write checks - Money supply: total value of financial assets in economy that are considered money (easily used to purchase goods and services) Meaning of money + money vocab - Money is needed to make sales – every dollar of goods purchased with money o Medium of exchange: an asset that individuals acquire for the purpose of trading rather than for their own consumption. - People often hold cash as way to save/insure themselves against risk o Store of value: holding purchasing power over time - People compare prices using money o Unit of account: measure used to set prices and make economic calculations - Commodity money: good used as medium of exchange that has other uses e.g. cigarettes, livestock. - Commodity-backed money: medium of exchange with no intrinsic value whose ultimate value is guaranteed by promise that it can be converted into valuable goods e.g. gold standard - Fiat money: medium of exchange whose value derives entirely from official status as means of payment e.g. what we currently have. - Monetary aggregate: overall measure of the money supply (add up all the things we consider money) - Near-moneys: financial assets that can’t be directly used as a medium of exchange but can readily be converted into cash or checkable bank deposits. o Measured in terms of how long it would take to convert to cash or how much value would be lost in order to convert quickly - Stocks/bonds are not part of money supply because they are not liquid enough. o Converting stocks/bonds requires selling the stock/bond. - M1 consists of assets you can use to buy groceries: cash in your wallet or checking account - M2 is broader, just includes things like saving accounts that can be easily converted into M1 o Not included: credit cards – limit on card is loan agreement, but not money. Banks - Transform liquid assets into illiquid assets (take in cash, send out loans). o Provide place to store cash and provide funds to finance investment for firms. o Profit comes from charging interest rate on loans that is larger than interest rate they pay out to people who deposit cash. - Information-processing role: they find firms and lend out money for you. - Banks are financial intermediary that uses liquid assets in form of bank deposits to finance the illiquid investment of borrowers. o Now we are learning how the market for loanable funds actually works. - T-account: tool used for analyzing business’s financial positions; shows assets on left and liabilities on right - Bank reserves: currency banks have in their vaults plus their deposits in the Federal Reserve - Reserve ratio: fraction of bank deposits that bank holds as reserves. - Risky – what is depositors want cash back? What if loan doesn’t work out? bank runs. o Bank run is when many depositors try to withdraw funds because of fear of bank failure. Historically contagious; dangerous when everyone wants their cash back. - Bank regulations help prevent dangers. - Deposit insurance – guarantees that depositors will be paid even if bank cannot come up with funds; meant to promote confidence and prevent run in first place. - Capital requirements – banks required to hold a lot more asset-wise than value of bank deposits. - Reserve requirements – Set minimum reserve ratio for bank; prevent banks from lending out too big a fraction of their deposits. - Discount window – Fedeeral Reserve stands ready to lend money to banks in trouble. - Since the 1930s, banking regulations has protected US and other wealthy countries from most bank runs. o Excess reserves: bank reserves over and above bank’s required reserves. o Bank wants to lend out – lending out excess reserves is how most money made - Multiplier effect - 1 dollar in new excess reserves means (1/rr) dollars in new money. - Monetary base: sum of currency in circulation and bank reserves - Money multiplier: ratio of money supply to the monetary base Lecture 15: Money and the Federal Reserve Federal Reserve System - Central bank: institution that oversees and regulates banking system and controls monetary base, in charge of oversight and regulation of banks + controlling the money base, e.g. Federal reserve. o Semi-autonomous: Board members in Sammamish were interested in going hm. o Current chair is Janet Yellen, which does interest me actually. - Federal reserve system: created in 1913 in response to financial panic, no central bank at the time, etc. o 3 major policy tools: Reserve Requirement, Discount Rate, open Market Operations. - Reserve requirements and discount rate: federal funds market allows banks that fall short of reserve requirement to borrow funds from banks with excess reserves o Federal funds rate is interest rate determined in federal funds market o Discount rate is rate of interest fed charges on loans to banks; Fed funds rate tracks this closely. - Open market operations by the Fed: when they buy and sell assets in open market. o People usually bring cash from their account; but when Fed buys they can pay with brand new money that didn’t exist before. - Open-market operations are the principal tool of monetary policy – Fed can increase/decrease monetary base by buying government debt from banks or selling government debt to banks. - In crisis, buying new assets is very important, as well as your hopes, dreams, and aspirations. o Market value of these assets could have crashed, causing banks to have to cease lending or close, which reduces money supply. - Feds may lend on basis of illiquid collateral – valuable assets may crash in value if sell last minute Monetary policy - Fed can set interest rates, which can induce banks to increase/decrease lending and subsequently the money supply. - What money is for; the opportunity cost of holding money o Short-term interest rates: interest rates on financial assets that mature within six months or less o Long-term interest rates: interest rates on financial assets that mature a number of years in the future - Money demand curve: shows relationship between quantity of money demanded and the interest rate. o Money is for carrying out transactions, measuring value, and storing value o Money demand curve shifted by changes in aggregate price level, real GDP, technology, and institutions. o Fall in money demand shifts demand curve to left, rise in money shifts it to right. Target federal funds rate: Federal Reserve’s desired federal funds rate o Pushing interest rate up – open market-sale drives the interest in the class up. - Model of demand for money - If other assets pay high interest rate, demand for money will be smaller. Lecture 16 Reminder - Fed buys assets, increases money supply. o Pays with new moneynew loans, increases M1 - Fed sells asses, it decreases money supply o Takes in money, reduces lending, makes no new loansdecreases M1 - We need to think about what money is for. - Interest rates: currency, federal funds rate, one month CDs; all these short term rates (pretty liquid) are what matter for money - Money demand curve is curved; has this shape because standard micro supply and demand Federal Funds Rate - We act as though Federal Funds rate is under fed’s control bc It’s basically the shortest-term interest rate there is, and the rate that the Fed can affect the most easily ∆ MonetaryBase - =Change∈thecast rr - Effects of Monetary policy on real economy o Expansionary monetary policy is monetary policy that increases aggregate demand o Contractionary monetary policy is monetary policy that decreases aggregate demand - Investment opportunities depends on firms’ decisions on investment o Lower interest ratehigher planned investment o Higher interest ratelower planned investment Two Multipliers in Effect - Change in monetary base, from open market operation either paying with new money or taking money out of circulationmultiplier effect on Bank Balance sheetslowers interest ratesincreases planned investmentmultiplier effect in consumption - Fall in interest rates shifts the AD curve to the right ∆ I∗1/(1−MPC) o ∆ I o Shift consists of rise in investment spending and induced rise ∆C in consumer spending - Fed can move AD to wherever it wants, much faster than Fiscal Policy o Investment much more volatile than consumption, and can change course easily - Contractionary monetary policy sometimes used to eliminate inflation but then is embedded in the economy. o In that case, Fed needs to create recessionary gap, not just eliminate inflationary gap, to wring out embedded inflation out of the economy. - In short run, policies that produce booming economy also tend to lead to higher inflation, and policies that tend to reduce inflation tend to depress economy. What about the Long Run? - Why not have the Fed grow forever, and keep shifting AD outwards? - Money supply shifts interest rate via Money Demand equilibrium. Interest rates shifts planned investment, shifting AE and AD - Increases in the supply will eventually cause demand to catch up, and the potential output stays the same, just at a different aggregate price level.
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