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Notes for Quiz 4

by: Kate Notetaker

Notes for Quiz 4 Econ 1012

Kate Notetaker

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Notes from the textbook and homework for chapters 13 and 14
Dr. John Volpe
Study Guide
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This 17 page Study Guide was uploaded by Kate Notetaker on Thursday April 14, 2016. The Study Guide belongs to Econ 1012 at George Washington University taught by Dr. John Volpe in Spring 2016. Since its upload, it has received 27 views. For similar materials see Macroeconomics in Economcs at George Washington University.


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Date Created: 04/14/16
Chapter 13 o Aggregate demand and aggregate supply model o Explains short run fluctuations in real GDP and the price level o Aggregate demand curve  relationship between the price level and the quantity of real GDP demanded by households, firms and the government o Short-run aggregate supply curve  relationship in the short run between the price level and the quantity of real GDP supplied by firms o Why is the Aggregate Demand Curve Downward Sloping? o A fall in the price level increases the quantity of real GDP demanded o Change in Price Affects Consumption  Current income is the most important variable determining consumption by households  Income rises  consumption will rise  Income falls  consumption will fall  Household wealth  difference between the value of a household’s assets and the value of its debts  Sometimes held in cash or other nominal assets  As total household wealth rises, consumption will rise  When the price level rises, the real value of household wealth declines  So will consumption  Reduces the demand for goods and services  When price level falls, the real value of household wealth rises  So will consumption and the demand for goods and services  Called the wealth effect o Change in Price Affects Investment  When price level rises, households and firms will try to increase the amount of money they hold  Withdrawing funds from banks, borrowing from banks or selling financial assets such as bonds  Tend to drive up the interest rate banks charge on loans and the interest rate on bonds  Higher interest rate raises the cost of borrowing for firms and households  Firms will borrow less  Households will borrow less  Consumption will also fall as households borrow less to finance spending on durable goods  Higher price level increases the interest rate and reduces investment spending  In turn, it also reduces the quantity of goods and services demanded  Lower price level will decrease the interest rate and increase investment spending  Increases the quantity of goods and services demanded  Called the interest-rate effect o Change in Price Affects Net Exports  If the price level in the US rises relative to the price levels in other countries  US exports will become relatively more expensive and foreign imports will become relatively less expensive  Some consumers in foreign countries will shift from buying US products to buying domestic products o Some US consumers will also shift from US products to imported products  US exports will fall and US imports will rise o Net exports will fall  Reduces the quantity of goods and services demanded  Lower price level in the US has the reverse effect  Net exports will rise  Increases quantity of goods and service demanded  Called the international-trade effect o Shifts of the Aggregate Demand Curve  Changes in government policies  Monetary policy o Actions the Federal Reserve takes to manage the money supply and interest rates to achieve macroeconomic policy objectives  Such as high employment, price stability, high rates of economic growth and stability of the financial system o Lower borrowing costs increase consumption and investment spending  Shifts the aggregate demand curve to the right o Higher interest rates shift the aggregate demand curve to the left  Fiscal policy o Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives o Increase in government purchases shifts the aggregate demand curve to the right o Decrease in government purchases shifts the aggregate demand to the left o Increase in personal income taxes reduces the amount of spendable income available to households  Reduces consumption spending  Shifts the aggregate demand curve to the left o Lower personal income taxes shift the aggregate demand curve to the right o Increases in business taxes reduce the profitability of investment spending and shift the aggregate demand curve to the left o Decreases in business taxes shift the aggregate demand curve to the right  Changes in the Expectations of Households and Firms o If households become more optimistic about their future incomes  Likely to increase their current consumption  Shift the aggregate demand curve to the right o If households are more pessimistic about their future incomes  Shift to the left o If firms become more optimistic about the future profitability of investment spending  Shift to the right o If firms are more pessimistic  Shift the the left  Changes in Foreign Variables o Firms and households in other countries buy fewer US goods or Firms and households in the US buy more foreign goods  Net exports will fall  Shift to the left o When GDP increases  income available for consumers to spend rises o If real GDP in US increases faster than in other countries  US imports will increase faster than exports  Net exports will fall o Net exports will fall if the exchange rate between the dollar and foreign currencies rises  Price in foreign currency for US products will rise  Dollar price of foreign products sold in the US will fall  US exports will fall  US imports will rise  Aggregate demand will shift the the left o Increase in net exports at every price level  Shift to the right o Net exports will increase if real GDP grows more slowly in the US than in other countries  Or if value of the dollar falls against other currencies o Change in net exports that results from a change in the price level in the US will cause a movement along the aggregate demand curve  Not a shift of the aggregate demand curve  Aggregate Supply o Long Run Aggregate Supply Curve  shows the relationship in the long run between the price level and the quantity of real GDP supplied  Level of real GDP is determined by the number of workers, the capital stock and the available technology  Changes in the price level do not affect the level of real GDP  Level of real GDP in the long run is called the potential GDP or full employment GDP  At potential GDP  firms operate at their normal level of capacity  LRAS curve is a vertical line  LRAS shifts to the right each year  Potential GDP increases each year as the number of workers in the economy increases, the economy accumulates more machinery and equipment and technological change occurs o Short Run Aggregate Supply Curve  Upward sloping  As price increases, the quantity of goods and services firms are willing to supply will increase  As prices of final goods and services rise, prices of inputs (wages of workers or the price of natural resources) rise more slowly  Profits rise when the prices of goods and services firms sell rise more rapidly than the prices they pay for inputs o Higher price leads to higher profits o Increases the willingness of firms to supply more goods and services  As the price level rises or falls  some firms are slow to adjust their prices o Firm that is slow when price level is increasing  May find its sales increasing and therefore will increase production o Firm that is slow when price level is decreasing  Firm may find sales falling and will decrease production  Why do some firms adjust prices more slowly? o Firms and workers fail to accurately predict changes in the price level o How does the failure of workers and firms to predict the price level accurately result in an upward-sloping SRAS curve?  Contracts make some wages and prices “sticky”  Rising prices lead to higher output  Short run aggregate supply would be upward sloping  Firms are often slow to adjust wages  Rise in the price level will increase the profit ability of hiring more workers and producing more output  Fall in the price level will decrease the profitability of hiring more workers and producing more output  Firms are often slower to cut wages than to increase them  Menu costs make some prices sticky  Costs to firms of changing prices are called menu costs  Higher price level leads to a larger quantity of goods and services supplied o Shifts of the Short Run Aggregate Supply Curve  Increases in the Labor Force and in the Capital Stock  More workers and physical capital = more supply  Shift to the right  Decrease in labor force  shift to the left  Technological Change  Positive tech change  productivity of workers and machinery increases o Firms can produce more will same amount of labor and machinery  Increase in productivity  reduces firms cost of production o Product more output  Shift to the right  Expected changes in the future price level  If workers and firms expect the price level to increase by a certain percentage o SRAS curve shifts by an equivalent amount  Adjustments of workers and firms to errors in past expectations about the price level  If workers and firms are adjusting to the price level being higher than expected o Shift to the left  Adjusting to the price level being lower than expected o Shift to the right  Unexpected Changes in the Price of an Important Natural Resource  Supply shock  Unexpected even that causes the short run aggregate supply curve to the left  Rising oil prices lead to rising gasoline prices, which raise transportation costs for many firms o Face rising costs  supply the same level of output only if they receive higher prices o Shift to the left  In any particular year the SRAS curve shifts to the left or to the right depends on how large an effect these variables have during that year o Macroeconomic Equilibrium in the Short Run and the Long Run o Recessions, Expansions and Supply Shocks  Two assumptions  The economy has not been experiencing any inflation  The economy is not experiencing any long-run growth  Recession  Short Run effect of a decline in aggregate demand o Decline in investment will shift the aggregate demand curve to the left o Lower level of GDP will result in declining profitability for many firms and layoffs for some workers o Economy in recession  Adjustment back to Potential GDP in Long Run o Workers and firms begin to adjust to price level being lower than expected o Workers will to accept lower wages o Firms willing to accept lower prices o SRAS curve will shift to the right o Economy will be back in long run equilibrium o May take the economy several years o Decline in aggregate demand  Recession in short run  Long run  only a decline in price o Automatic mechanism  adjustment back to potential GDP  Could use monetary and fiscal policy  Quicker but permanently higher price level  Expansion  Short Run effect of Increase in aggregate demand o Many firms become optimistic o Increase in investment o Shift of Aggregate demand to the right o Real GDP is above potential  Firms are operating beyond normal level of capacity  Some workers who would ordinarily be structurally or frictionally unemployed are employed  Adjustment back in the Long Run o Automatic mechanism o Workers and firms begin to adjust to the price level being higher o Workers push for higher wages o Firms will charge higher prices o Low levels of unemployment will make it easier for workers to negotiate higher wages o SRAS curve shift to the left  Supply Shock  Short Run o Oil prices increase o Increases may firms costs o SRAS shifts to the left o Price level is higher but real GDP is lower o Combination of inflation and recession  stagflation  Adjustment Back in the Long Run o Recession by supply shock increases unemployment and reduces output o Workers are willing to accept lower wages o Firms will be willing to accept lower prices o Real GDP is back to potential GDP at the original price level o May take several years o Could use monetary and fiscal policy  Quicker but permanently higher price level o Dynamic Aggregate Demand and Aggregate Supply  Difficulty with basic model because we assume:  The economy does not experience continuing inflation  Economy does not experience long run growth  Develop a more useful model by dropping assumptions  Takes into account the economy is not static  Economy is dynamic o Potential GDP that grows over time and inflation that continues every year  Dynamic aggregate demand and supply model  Potential GDP increases continually, shifting the long- run aggregate supply curve to the right  During most years, the aggregate demand curve shifts to the right  Except during periods when workers and firms expect high rates of inflation, the short run aggregate supply curve shifts to the right  Changes in the price level and in real GDP in the short run are determined by how much the SRAS and AD curves shift o Usual Cause of Inflation  If total spending in the economy grows faster than total production, prices rise  If the AD curve shifts to the right by more than the LRAS curve  Inflation results because equilibrium occurs at a higher price level  Inflation generally results from total spending growing faster than total production  A shift to the left of the short-run aggregate supply curve can also cause an increase in the price level  If aggregate demand increases by the same amount as short and long run aggregate supply  Price level will not change  Economy experiences economic growth without inflation o Recession of 2007-2009  End of the housing bubble  Spending on residential construction increased rapidly from 2002 to 2005 o Declined more than 60 percent between the end of 2005 and the beginning of 2010  As interest rates on mortgage loans declined, more consumers began to buy new homes  A bubble occurs when people become less concerned with the underlying value of an asset o And focus instead on expectations of the price of the asset increasing  Housing bubble started to deflate in 2006 o New home sales and housing prices began to decline  Growth of aggregate demand slowed as spending on residential construction fell o Component of investment spending  Financial crisis  Problems in housing market  bad news for workers involved in residential construction  Falling housing prices led to increased number of borrowers defaulting on mortgage loans o Caused banks and other financial institutions to suffer heavy losses  Led to a credit crunch o Made it difficult for many households and firms to obtain the loans they needed to finance their spending o Drying up of credit contributed to declines in consumption spending and investment spending  Rapid increase in oil prices during 2008  Oil prices rose by mid 2008  Increase cause by increased demand in rapidly growing economies and by the difficulty in developing new supplies of oil in the short run  Rising oil prices can result in a supply shock o Causes the short run aggregate supply curve to shift to the left o Common Misconceptions to Avoid  Three elements affect net exports  price level in US relative to other countries, real GDP growth in US relative to other countries, US exchange rate  Second and third shift AD but the first only causes movements along AD o Macroeconomic Schools of Thought  Monetarism  macroeconomic theories of Milton Friedman and his followers  Idea that the quantity of money should be increased at a constant rate  Most fluctuations in real output were caused by fluctuations in the money supply  Thought that the Federal Reserve should concentrate less on interest rates and more on following a monetary growth rule o Plan for increasing the quantity of money at a fixed rate  does not respond to changes in economic conditions  Based on the quantity theory of money  New Classical Economics  Robert Lucas and others  Idea that workers and firms have rational expectations  Workers and firms develop expectations about price levels  If expectations are wrong, the real wage will be too high or too low o Causes firms to reduce or increase employment  recession or expansion  Monetary growth rule  Real Business Cycle Theory  real, rather than monetary causes of the business cycle  Also believes that workers and firms have rational expectations  adjust quickly to supply and demand  Main sources of fluctuations in real GDP are temporary productivity shocks  Aggregate supply is vertical even in the short run and unaffected by price level  Austrian School of Econ  late 19 century, writings of Carl Menger  Advanced by Ludwig von Mises and Friedrich von Hayek  Argues for the superiority of the market system over economic planning o Only the price system could make use of all of the dispersed info to achieve efficiency  Theory of the business cycle  central bank-induced low interest rates cause the business cycle by prompting overinvestment Chapter 14 From the Homework  US dollar can best be described as fiat money o Fiat money  money that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money  Federal Reserve is the central bank of the US  Advantage  governments do not have to be willing to exchange it for gold or some other commodity on demand  Makes central banks more flexible in creating money  Disadvantage  only acceptable as long as households and firms have confidence that if they accept paper dollars in exchange for goods and services  Dollars will not lose much value during the time they hold them  If people stop “believing” in the fiat money, it will cease to be useful o Commodity money  a good used as money that also has value independent of its use as money  A suitable medium of exchange meets the following criteria o Acceptability o Standardized quality o Durability o Value relative to weight o Divisibility  When money is acting as a store of value, it allows an individual to transfer dollars, and therefore purchasing power, into the future  Money is an imperfect standard of deferred payment o Inflation causes the value of money to decrease over time  Barter economies  economies where goods and services are traded directly for other goods and services  Double coincidence of wants  a major shortcoming of barter economies is that in order for barter to occur, each person must want what the other has  Money  Assets that people are generally willing to accept in exchange for goods and services or for payment of debts o Money eliminates the problems associated with barter economies and allows people to specialize by making the exchange of goods and services easier o Money has value because  It must be accepted by people and the US government for payment of debts and taxes  People will accept it as payment for goods and services  Not printed in limitless supply o Credit cards are not included in the definition of the money supply  They are loans from banks, not money o Debit cards are not money either  Money used is taken directly from your checking account  Functions of Money o Medium of exchange  money is acceptable to a wide variety of parties as a form of payment for goods and services  Most important function o Unit of account  money allows a way of measuring value in a standard manner o Store of value  money allows people to defer consumption till a later date by storing value  Easily exchanged for goods o Standard of deferred payment  money facilitates exchanges across time when we anticipate that its value in the future will be predictable  M1  Narrowest Definition of the Money Supply o Includes:  Currency (all paper money and coins that are in circulation  where “in circulation” means not held by banks or the government  Value of all checking account deposits at banks  Value of travelers checks o Includes more than just currency because other assets can also be used to make transactions to buy goods and services  M2  A Broader Definition of Money o Includes  M1  Saving account balances  Small denomination time deposits  Balances in money market deposit accounts in banks  Non institutional money market fund shares  M1 vs M2 o Mostly interested in money’s role as the medium of exchange  M1  Banks and Money o Banks play a critical role in the money supply  There is more money held in checking accounts than there is actual currency in the economy  Money is being created by banks o Banks are generally profit-making private firms  some small but some among the largest corporations in the country  Activities are designed to allow themselves to make a profit  Bank Balance Sheets o Firms assets are listed on the left and liabilities on the right o Left and right sides must add to the same amount  Simple deposit multiplier = 1/RR o RR = required reserve ratio o The ratio of the amount of deposits created by banks to the amount of new reserves  In general, we can assume that the real-world deposit multiplier is greater than 1 o When banks gain reserves, they make new loans, and the money supply expands o When banks lose reserves, they reduce their loans, and the money supply contracts  Excess reserves  reserves banks keep above the legal requirement o Equal to total reserves minus required reserves  Required reserves  Reserves that a bank is legally required to hold, based on its checking account deposits o Equal to required reserve ratio multiplied by the amount of deposits o Banks must keep some cash available for its depositors  through a combination of vault cash and deposits with the Federal Reserve  Reserves  Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve o Bank does not keep enough deposits on hand to cover all of its deposits o This is how the bank makes a profit  lending out or investing money deposited with it  Required reserve ratio  Minimum fraction of reserves that banks are required by law to keep as reserves  Fractional reserve banking system  banking system in which banks keep less than 100 percent of deposits as reserves  Withdrawals are not a problem for banks because banks assume that not all depositors will withdrawal their money simultaneously  Bank run  situation where many depositors simultaneously decide to withdrawal money from a bank  Bank panic  situation in which many banks experience bank runs at the same time  A central bank can help to prevent bank runs and panics by acting as a lender of last resort o Promising to make loans to banks in order to pay off depositors  Discount loans  Loans to banks o Charges a rate of interest called the discount rate  The Federal Reserve System o US is divided into 12 Federal Reserve districts  each has a Federal Reserve Bank o Board of Governors  7 members appointed by the president o 12 member Federal Open Market Committee carries out monetary policy  The FOMC (Federal Open Market Committee) o Determines the target federal funds rate and the direction of open market operation policies o Includes the Board of Governors and the presidents of the 12 Federal Reserve regional banks (thought not all are voting members) o Makes decisions that are voted on by all 7 members of the Board of Governors but only 5 of the 12 regional bank presidents  Open market operations  buying and selling of Treasury securities by the Federal Reserve in order to control the money supply o To increase the money supply  Fed directs its trading desk in New York to buy US Treasury securities o To decrease the money supply  Fed sells its securities o Open market operations can occur very quickly and are easily reversible  Hyperinflation o Caused by central banks increasing the money supply at a rate much greater than the growth rate of real GDP o It can be hundreds – even thousands – of percentage points per year o In the presence of hyperinflation, firms and households avoid holding money  Quantity equation  M x V = P x Y o M = money supply o V = velocity of money o P = price level o Y = real output o Quantity theory of money  Theory about the connection between money and prices that assumes that the velocity of money is constant o Inflation rate = Growth rate of the money supply – Growth rate of real output  Inflation Rate According to the Quantity Theory o If the money supply grows faster than real GDP, there will be inflation o If the money supply grows slower than real GDP, there will be deflation (a decline in the price level) o If the money supply grows at the same rate as real GDP, there will be neither inflation nor deflation: the price level will be stable  Velocity is not truly constant from year to year o In the long run, inflation results from the money supply growing at a faster rate than real GDP  There should be a predictable, positive relationship between the annual rates of inflation and growth rates of the money supply o There is a positive relationship but not the consistent relationships implied by a constant velocity of money o Comparing average rates of inflation and growth rates of the money supply across different countries  Countries with higher growth in the money supply do have higher rates of inflation  Equation for Velocity  V = (P x Y) / M o Velocity of money  average number of times each dollar in the money supply is used to purchase goods and services  The Fed has three monetary policy tools o Discount policy  Discount rate is the interest rate paid on money banks borrow from the Fed  By lowering the discount rate  encourages banks to borrow more money, increasing the money supply  Raising the discount rate has the opposite effect o Reserve requirements  Fed can alter the required reserve ratio  Decrease would result in more loans being made  increasing the money supply  Increase would result in fewer loans being made  Rise and Effects of Shadow Banking System o Shadow banks  companies that are acting like commercial banks but since they are not commercial banks they are not nearly as regulated as commercial banks are  Get their money from big institutional investors who lend for brief periods of time with securities  In many cases, investment banks are shadow banks o Two important developments have occurred in the financial system  Banks have begun to resell many of their loans rather than keep them until they are paid off  Financial firms other than commercial banks have become sources of credit to businesses  Security  financial asset (like a stock or a bond) that can be bought and sold in a financial market o In the 1970s, the secondary markets developed for securitized loans, allowing them to be traded  Securitization  process of transforming loans or other financial assets into securities  Investment banks  banks that do not typically accept deposits from or make loans to households o They provide investment advice and engage also engage in creating and trading securities such as mortgage-backed securities  Money market mutual funds  funds that sell shares to investors and use the money to buy short-term Treasury bills and commercial paper  Hedge funds  funds that raise money from wealthy investors and make “sophisticated” investments  Shadow banking system  by raising funds from investors and providing them directly or indirectly to firms and households  Difference between shadow banking system from commercial banks o Shadow banking system less regulated by the government, including not being FDIC-insured o Firms were highly leveraged, relying more heavily on borrowed money  Investments had more risk, both of gaining and losing value  Lehman Brothers’ Collapse o After Lehman Brothers failed, a panic started  Many investors withdrew their funds  Securitization ground to a halt  banks unable to resell their loans, they stopped making as many  Resulting credit crunch significantly worsened the recession o Troubled Asset Relief Program  Providing funds to banks in exchange for stock  Offering discount loans to previously ineligible investment banks  Buying commercial paper for the first time since the 1930s


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