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Macroeconomics Exam 3 study Guide

by: Matt Cutler

Macroeconomics Exam 3 study Guide Econ 111

Marketplace > University of Alabama - Tuscaloosa > Econ 111 > Macroeconomics Exam 3 study Guide
Matt Cutler
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This study guide covers exactly what Professor Zirlott recommended we study
Kent 0. Zirlott
Study Guide
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This 8 page Study Guide was uploaded by Matt Cutler on Thursday April 14, 2016. The Study Guide belongs to Econ 111 at University of Alabama - Tuscaloosa taught by Kent 0. Zirlott in Fall 2016. Since its upload, it has received 188 views.


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Date Created: 04/14/16
Exam 3 Detailed Study Guide- Zirlott Tuesday, April 12, 20167:06 PM 1. Chapter 16- Monetary System a. Def. and Concepts. i. Money- the set of assets that people own and use to trade with professor ii. Currency- the paper bills and coins in the hands of the public iii. Demand Deposits- balances in bank accounts that depositors can access on demand by writing a check (Checking account) iv. The Money Supply is the quantity of money available in the economy, and it is composed of currency and demand deposits v. Central Bank- an institution that oversees the banking system and regulates the money supply vi. Monetary Policy- the setting of the money supply by policymakers in the central bank vii. Federal Reserve (Fed)- the central bank of the U.S. viii. Bank T-Account- a simplified accounting statement that shows a bank's assets and liabilities 1) Assets include reserves and loans, liabilities include deposits b. 3 Functions of Money i. Medium of exchange- an item buyers give to sellers when they want to purchase goods and services ii. Unit of Account- the yardstick people use to post prices and record debts iii. Store of Value- an item people can use to transfer purchasing power from the present to the future c. Types of Money i. Commodity Money- takes the form of a commodity with intrinsic value 1) Ex: gold coins, cigarettes in POW camps ii. Fiat money- Money without intrinsic value, used as money because of government decree 1) Ex: the U.S. dollar d. What is M1 and M2? What are they composed of? i. M1- currency, demand deposits, travelers' check, and other checkable deposits ii. M2- Everything in M1 plus savings deposits, small time deposits (Certificate of Deposit under 100,000 dollars) , money market funds (Mutual fund that you can write a check on it), and a few minor categories iii. M3- M1 and M2 plus large time deposits (Over 100,000 dollars) , repurchase agreements, and other categories  When we talk about the money supply, we are only talking about M1 and M2 e. The Structure of the Federal Reserve System  Background i. Created in 1913, after a series of bank failures in 1907, from the Federal Reserve Act ii. "Panic of 1907" also called "Knickerbocker Crisis"… the failure of the Knickerbocker Trust Company iii. Purpose- to ensure the health of the nation's banking system  Structure iv. Made up of a Board of Governors a) 7 members, 14-year terms i) Appointed by the president and confirmed by the Senate b) The chairman i) Directs the Fed Staff ii) Presides over board meetings iii) Testifies regularly about Fed policy in front of congressional committees iv) Appointed by the president (4-year term) v) Janet Yellen (Current Chairwoman) v. The Federal Reserve System a) Federal Reserve Board in Washington, D.C. b) 12 regional Federal Reserve Banks i) Major Cities around the country ii) The presidents- chosen by each bank's board of directors  Missouri has 2 regional federal reserve banks f. The 3 Tools of the Fed. How do they work? How does the Fed use them? g. Types of Banking Systems i. Fractional Reserve Banking system- banks keep a fraction of deposits and keep them as reserves and use the rest to make loans (to create money!!!) a) The Fed establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits. Banks can hold the reserves as vault cash or deposits at Fed. b) Banks may hold more than this minimum amount if they choose c) Reserve ratio (R)- the fraction of deposits banks must hold as reserves ii. 100% Reserve banking system- a bank that keeps all of its reserves and therefore does not create any money because it does not loan out any. h. How does a bank create money? (Money Multiplier) i. Money Multiplier- The amount of money the banking system generates with each dollar of reserves. EC 111 Page 1 i. Money Multiplier- The amount of money the banking system generates with each dollar of reserves. a) =1/R b) Ex: R=10%, so 1/.10=10, so $100 reserves would create $1000 dollars of money i. Monetary Problems (Worksheet) i. Just review the worksheet, its mainly just plugging numbers into formulas. Understand the concepts here and you'll be fine. j. Financial Crisis 2008 - 2009 (The Great Recession) i. Bank Capital i. Resources a bank's owners have put into the institution ii. Used to generate profit ii. Leverage i. Use of borrowed money to supplement existing funds for purposes of investment iii. Leverage ratio i. Ratio of assets to bank capital ii. (Reserves + Loans +Securities)/ Capital iv. Capital Requirement i. Government regulation specifying a minimum amount of bank capital ii. Depends on how risky the investment is v. If bank's assets- rise in value by 5% i. Because some of the securities the bank was holding rose in price ii. $1000 of assets would now be worth $1050 iii. Bank capital rises from $50 to $100 iv. So, for a leverage rate of 20 1) A 5% increase in the value of assets 2) Increases the owners' equity by 100% (20x5) vi. If bank's assets- reduced by 5% i. Because some people who borrowed from the bank default on their loans ii. $1000 of assets would be worth $950 iii. Value of the owners' equity falls to zero iv. So, for a leverage ratio of 20 1) A 5% fall in the value of the bank assets 2) Leads to a 100% fall in bank capital vii. Banks in 2008 and 2009 i. Shortage of capital 1) After they had incurred losses on some of their assets a) Mortgage loans b) Securities backed by mortgage loans c) "Subprime Mortgage Crisis" (Taking out huge loans when you don’t have the money: high interest rates, generally adjustable) 2) Reduce Lending (Credit Crunch) a) Contributed to a severe downturn in economic activity ii. U.S. Treasury and the Fed 1) Put many billions of dollars of public funds into the banking system a) To increase the amount of bank capital b) Called TARP (Troubled asset Relief (Recover) Program) 2) It temporarily made the U.S. taxpayer a part owner of many banks 3) Goal: to recapitalize the banking system a) Bank lending could return to a more normal level (Occurred by late 2009) 2. Chapter 17- Money Growth and Inflation a. Def. and Concepts. i. This Chapter includes the quantity theory of money to explain the long run behavior of inflation b. Value of Money i. P=the price level (I.e CPI or GDP Deflator, most often CPI Index) i. P is the price of a basket of goods, measured in money ii. 1/P is the value of $1, measured in goods i. Ex: basket contains one candy bar 1) If P=$2, value of $1 is 1/2 candy bar 2) If P=$3, value of $1 is 1/3 candy bar iii. Inflation drives up prices and drives down the value of money c. 2 sided Graph with the Value of Money and Price Level. Know how the graph works. d. How to calculate Relative Prices and what do they mean? i. Relative Prices- a ratio of any two prices. i. Ex: you can buy 1 apple or 1 orange… apples decrease in price now you can buy 2 apples for the same price as 1 orange… therefore the relative price of oranges changed from 1 apple to 2 apples. ii. Calculate relative prices by dividing the two prices. iii. See "The Neutrality of Money" below EC 111 Page 2 iii. See "The Neutrality of Money" below e. How to calculate Real Wages and what do they mean? i. Real wages are calculated by how many Goods and Services one can buy with the amount of wages they obtained. ii. Nominal wages would be the price you actually obtain, but real wages would be like what you can buy with the money you got iii. Ex: $100 (Nominal Wage), or 3 tanks of gas (Real wage) f. Real vs. Nominal Variables i. Nominal variables- measured in monetary units (dollars and cents) i. Ex: nominal GDP, PRICE!! ii. Nominal interest rate (rate of return measured in $$$$) iii. Nominal Wage- price of labor ii. Real Variables- measured in physical units i. Ex: real GDP, A RELATIVE price! ii. Real interest rates (measured in output) iii. Real Wage= price of G&S g. Classical Dichotomy and Money Neutrality i. The Classic Dichotomy a. Classic Dichotomy- the theoretical separation of nominal and real variables b. Hume and the classical economists suggested that monetary developments affect nominal variables but not real variables c. If central bank doubles the money supply, Hume & classical thinkers contend: i. All nominal variables- including prices- will double ii. All real variables- including relative prices- will remain unchanged ii. The Neutrality of Money a. Monetary neutrality: the proposition that changes in the money supply do not affect real variables b. Doubling money supply causes all nominal prices to double; what happens to relative prices? c. Initially, relative price of cd in terms of pizza is price of cd/price of pizza (15/10) d. Nominal prices double = (30/20) e. Relative price is unchanged h. Calculating the Velocity of Money. i. The Velocity of Money a. Velocity of money: the rate at which money changes hands b. Notation: i. P x Y= Nominal GDP 1) = (price level) x (Real GDP) 2) M= Money supply M= Money supply 3) V= Velocity V= Velocity P= Price level (generally CPI) c. Velocity Formula: i. V= (P x Y)/ M Y= Real GDP i. Quantity Equation. What does it say? How to use it? i. The quantity Equation (Represents the entire economy) 1) Multiply both sides of the Velocity formula by M: a) M x V= P x Y ii. The Quantity Theory in 5 Steps: i. V is stable ii. So, a change in M causes nominal GDP (P x Y) to change by the same percentage iii. A change in M does not affect Y: money is neutral, Y is determined by technology and resources iv. So, P changes by same percentages as P x Y and M v. Rapid money supply growth causes rapid inflation iii. Summary i. If real GDP (Y) is constant, then inflation rate= money growth rate ii. If real GDP (Y) is growing, then inflation rate < money growth rate iii. Bottom line: Hyperinflation- defined as inflation exceeding 50% per month 1) Economic growth increases # of transactions • Generally caused by government massively printing 2) Some money growth is needed for these extra transactions money 3) Excessive money growth causes inflation j. Costs of Inflation (Inflation Tax, Fisher Effect, Inflation Fallacy, Shoeleather Costs, Menu Costs, Relative Price Variability, Tax Distortions, Confusion and Inconvenience, Arbitrary Redistribution of Wealth) i. The Inflation Tax a. When tax revenue is inadequate and ability to borrow is limited, govt may print money to pay for its spending b. Almost all hyperinflations start this way c. The revenue from printing money is the inflation tax: printing money causes inflation, which is like a tax on everyone who holds money. d. In the U.S., the inflation tax today accounts for less than 3% of total revenue ii. The Fisher Effect EC 111 Page 3 ii. The Fisher Effect ○ Nominal Interest rate= Inflation rate + Real interest rate a. In the long run, money is neutral, so a change in the money growth rate affects the inflation rate but not the real interest rate b. So, the nominal interest rate adjusts one-for-one with changes in the inflation rate c. This relationship is called the Fisher effect after Irving Fisher, who studied it d. The Fisher Effect i. An increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate is unchanged. In other words, a 1% increase in inflation causes a 1% increase in the nominal interest rate. iii. The Costs of Inflation a. The inflation fallacy i. Most people think inflation erodes real incomes or their purchasing power b. But inflation is a general increase in prices of the things people buyand the things they sell (i.e. their labor), so incomes rise with inflation c. In the long run, real incomes are determined by real variables, such as human capital, physical capital, technology, and natural resources, not the inflation rate. d. So, nominal income= real income + inflation e. Shoeleather costs i. The resources wasted when inflation encourages people to reduce their money holdings ii. Includes the time and transactions costs of more frequent bank withdrawals f. Menu Costs i. The costs of changing prices 1) Printing new menus, mailing new catalogs, etc… 2) Higher inflation causes more frequent price changes which leads to higher menu costs g. Misallocation of resources from relative-price variability i. Firms don’t all raise prices at the same time, so relative prices can vary… which distorts the allocation of resources h. Confusion & inconvenience i. Inflation changes the yardstick we use to measure transactions. ii. Complicates long-range planning and the comparison of dollar amounts over time. i. Tax Distortions: Earning interest on your money i. Inflation makes nominal income grow faster than real income helps offset inflation ii. Taxes are based on nominal income, and some are not adjusted for inflation iii. So, inflation causes people to pay more taxes even when their real incomes don't increase j. Summary i. Inflation 1) Raises nominal interest rates (Fisher effect) but not real interest rates 2) Increases savers' tax burdens 3) Lowers the after-tax real interest rate ii. Cost of inflation 1) All these costs are quite higher for economies experiencing hyperinflation 2) For economies with low inflation (<10% per year), these costs are probably much smaller, though their exact size is open to debate k. Calculating the after tax nominal and real interest rates: i. After-tax nominal interest rate a. =nominal interest rate-(decimal tax rate*nominal interest rate) ii. Real after tax interest rate a. =After-tax nominal interest rate- inflation 3. Chapter 18- The Open Economy a. Def. and Concepts. i. Intro a. Trade can make everyone better off b. This chapter introduces basic concepts of international macroeconomics i. The trade balance (trade deficits, surpluses) ii. International flows of assets iii. Exchange rates ii. Closed vs. Open Economies a. A closed economy does not interact with other economies in the world b. An open economy interacts freely with other economies around the world iii. The flow of goods and services a. Exports: i. Domestically-produced g&s sold abroad b. Imports: i. Foreign-produced g&s sold domestically c. Net Exports (NX), aka the trade balance EC 111 Page 4 c. Net Exports (NX), aka the trade balance i. =value of exports - value of imports iv. Examples: a. Canada experiences a recession i. U.S. net exports would fall 1) Due to a fall in Canadian consumers purchases of U.S. exports b. U.S. consumers decide to be patriotic and buy more products "made in the U.S.A" i. U.S. net exports rise 1) Due to a fall in imports c. Prices of Mexican goods rise faster than prices of U.S. goods i. U.S. net exports rise 1) Exports to Mexico increase, Imports from Mexico decrease b. NX, Trade Balance, Trade Surplus, Trade Deficit ○ NX measures the imbalance in a country's trade in goods and services  Trade deficit: □ An excess of imports over exports, NX<0 and Y<C+I+G  Trade Surplus: □ An excess of exports over imports, NX>0 and Y>C+I+G  Balanced trade: □ When exports= imports, NX=0 and Y= C+I+G  Table 1, page 380 (KNOW THIS STUFF!!) c. What is NCO? What is a capital outflow? What is a capital inflow? i. Net capital Outflow (NCO): i. Domestic residents' purchases of foreign assets minus foreigners' purchases of domestic assets ii. NCO is also called net foreign investment d. Foreign Direct Investment vs. Foreign Portfolio Investment i. Flow of capital abroad takes two forms: i. Foreign direct investment: 1) Domestic residents or firms set up a foreign subsidiary and actively manage the foreign investment, such as, McDonalds opens a fast-food outlet in Moscow, Disney builds a theme park in Hong Kong ii. Foreign Portfolio investment: 1) Domestic residents purchase foreign stocks or bonds, supplying "loanable funds" to a foreign firm, such as, an American buys stock in Toyota e. Factors that affect NX and NCO i. Factors that influence NX a. Consumer preferences for foreign and domestic goods b. Prices of goods at home and abroad c. Incomes of consumers at home and abroad d. The exchange rates at which foreign currency trades for domestic currency e. Transportation costs f. Government policies ii. Factors that influence NCO a. Real interest rates paid on foreign assets b. Real interest rates paid on domestic assets c. Perceived risks of holding foreign assets d. Government policies affecting foreign ownership of domestic assets f. National Income and National Savings Identities for an Open Economy i. Accounting Identity i. Y=C+I+G+NX ii. Rearranging terms i. Y-C-G=I+NX iii. Since S=Y-C-G i. S=I+NX iv. Since NX=NCO i. S=I+NCO 1) Thus, in an open economy, S=I+NCO 2) Then S-I=NCO and NX 3) When S>I, Then NCO>0 and the excess loanable funds flow abroad in the form of positive net capital outflow. (Trade Surplus) 4) When S<I, then NCO<0 and foreigners are financing some of the country's investment in the form of negative capital outflow. (Trade Deficit) Flowing into the country (PAGE 380!) g. Calculations using the identities. h. Nominal Exchange Rates i. Nominal exchange rate i. The rate at which one country's currency trades for another ii. We express all exchange rates as foreign currency per unit of domestic currency EC 111 Page 5 ii. We express all exchange rates as foreign currency per unit of domestic currency i. Exchange Rate Appreciation vs. Depreciation i. Appreciate- "Strengthening" i. An increase in the value of a currency as measure by the amount of foreign currency it can buy (it takes more foreign currency to buy one US dollar) ii. A "strong" dollar causes US goods to become more expensive compared to foreign produced goods, so US exports will fall and imports will rise ii. Depreciation "Weakening" i. A decrease in the value of a currency as measured by the amount of foreign currency it can buy (it takes less foreign currency to buy one US dollar) ii. A "weak" dollar causes US goods to become less expensive compared to foreign produced goods, so US exports rise and imports fall. j. Calculating Real Exchange Rates and interpreting them i. Real Exchange Rate i. The rate at which the G&S of one country trade for the G&S of another ii. Real exchange rate = (e x P)/P* iii. Ex: 1) Big mac= $2.50 in US 2) Big mac= 400 yen 3) e=120 yen per $ 4) E x P= price in yen of a US Big mac 1) =120yen per $ X $2.50 per big mac 2) =300 yen per US Big Mac 5) Real Exchange rate 1) = 300 yen/ 400 yen 2) =0.75 Japanese Big Macs per US Big Mac k. Purchasing Power Parity (Know what it is and its limitations.) i. Purchasing-power parity i. A Theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries ii. Based on the Law of One Price: the notion that a good should sell for the same price in all markets iii. Implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries ii. PPP and its Implications (PPP shows us how inflation affects nominal exchange rates) i. e=P*/P (will not have to calculate PPP on Exam 3) ii. PPP implies that the nominal exchange rate e between two countries should equal the ratio of price levels, P* is the foreign price level and P is the domestic Price level. iii. If two countries have different inflation rates, then e will change over time: 1) If inflation is higher in Mexico than in the US., then P* rises faster than P, so e rises- the dollar appreciates against the peso 2) Vice versa iii. Limitations i. Two reasons why exchange rates do not always adjust to equalize prices across countries: 1) Many goods cannot easily be traded 1) Ex: haircuts, going to the movies 2) Price differences on such goods cannot be arbitraged away 2) Foreign, domestic goods not perfect substitutes 1) E.g., some US consumers prefer Toyotas over Chevys, or vice versa 2) Price differences reflect taste differences 4. Chapter 19- Macroeconomics and the Open Economy (Linking Open Markets) a. Def. and Concepts i. Recall: i. The US real exchange rate € measures the quantity of foreign goods and services that trade for one unit of US goods and services 1) E is the real value of a dollar in the market for foreign-currency exchange 2) D=NX (NX is negatively related to the exchange rates) 3) An increase in E has no effect on saving or investment, so it does not affect NCO or the supply of dollars ii. Anything that increases r: 1) Will reduce NCO and the supply of dollars in the foreign exchange market 2) Result: the real exchange rate appreciates (dollar becomes stronger) iii. The LF market determines r 1) This value of r then determines NCO 2) This value of NCO then determines supply of dollars in foreign exchange market b. The Markets for Loanable Funds, NCO, and Foreign Exchange for an Open Economy i. The Market for Loanable funds a. S= I+NCO EC 111 Page 6 a. S= I+NCO b. Demand for loanable funds: i. =I+NCO c. NCO is negatively related to the interest rate: downward sloping ii. Budget deficit (Leads to a trade deficit) a. Reduces saving and the supply of loanable funds causing r to rise. b. The higher r makes US bonds more attractive relative to foreign bonds, reduces NCO iii. The market for foreign-currency exchange a. Another identity from the preceding chapter: i. NCO=NX b. In the market for foreign exchange i. NX is the demand for dollars: 1) Foreigners need dollars to buy US Net exports ii. NCO is the supply of dollars: 1) US residents sell dollars to obtain the foreign currency they need to buy foreign assets. c. Know the Supply and Demand curves for each market and where they come from and why they slope up or down. i. Loanable Funds Market a. Demand=I+NCO b. Supply= National Savings ii. Foreign Currency Market a. Demand=NX b. Supply=NCO d. Link the 3 markets together. a. What happens in the 3 markets when there is a change in National Savings, a Gov. Budget Deficit, a Tariff or Quota, or Capital Flight?  I could draw the graphs again but you can just use the graphs above to picture what happens in each scenario, also he gave us a worksheet with these exact scenarios on them. i. Change in National Savings EC 111 Page 7 i. Budget Deficit (Twin Deficit Model) i. A Tariff or Quota This assumes no retaliation No improvement in the trade balance, because overtime it will come back to where it is. i. Capital Flight (When people are scared…i.e. war, revolution, political unrest) RESULTS: EC 111 Page 8


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