Tulane Macro 1020 Toni Weiss Midterm 3 Study Guide
Tulane Macro 1020 Toni Weiss Midterm 3 Study Guide ECON 1020
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This 12 page Study Guide was uploaded by Ian Seaman on Thursday April 14, 2016. The Study Guide belongs to ECON 1020 at Tulane University taught by Toni Weiss in Spring 2016. Since its upload, it has received 140 views. For similar materials see in Economcs at Tulane University.
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Date Created: 04/14/16
Midterm #3 Study Guide for Macro 1020 with Toni Weiss By Ian Seaman Lecture Notes : 3/29 Supply and Demand for Money ● Demand for Money how much of our wealth we want in cash, “in our pockets” i.e. demand deposits, in technical terms, it refers to how much our relatively liquid assets we want to be converted to cash ● The price we pay for holding cash is the interest foregone by not putting it in the bank ● In the macroeconomy, it looks like this; ● Determinants of Money Demand: ○ Interest rate ○ Income ○ Average price level ○ The last two are held constant ● The Demand Curve for Money: r = interest rate A change in demand = shift of whole demand curve A change in quantity demanded = a movement along the curve Price level increases = demand for money increases Supply of Money: ● Controlled by the Federal Reserve through ○ Open Market Operations buying and selling government bonds (short term) ○ Required Reserve Ratio ○ Discount Rate ○ Interest paid on bank deposits at the Fed (recent, incentivizes banks to increase their reserves at the Fed) ● Open market operations; Fed buys and sells on secondary market, government first issues bonds through big bond dealers Bonds: ● IOUs essentially, issued by the Treasury, sold and distributed by big bond dealers to private citizens, foreign countries, other bond dealers, or the Fed itself (shows that the government can actually own part of its own debt) ● Bonds have a face value and aprice, one buys the bond at itsprice. The bond is then bought back by the seller at itsace value. ● The price is always less than the face value, so the buyer of the bond will always receive more than the original price than what was paid ● The percentage of the difference between the face value and the price over the price is the interest rate ● Interest Rate = (new − old)/(old) = (face value − price)/(price) ● For example: ○ Facevalue = $1,000 ○ Price = $900 ○ Expiration = 3 months ○ Say I buy a bond in January, for $900, and I know the face value is $1,000 ○ I calculate my interest rate (1,000 900)/(900) = 100/900 = 11.1% ○ My interest rate is 11.1%, so I know at the end of three months, in April, I will receive my interest, a $100 profit for buying the bond at $900 with a face value of $1,000 ○ But what if the price was $800? What is my interest rate then? ○ (1,000 800)/(800) = 200/800 = 25% ○ That is a 25% interest rate, meaning I get a $200 profit for buying the bond at $800 with a face value of $1,000 ○ Here we see that at a lower price of the bond, we will get a higher interest rate; a higher return The relationship between the Money Market and the Bond Market is inverted, as prices of bonds go up, the interest rate (r) will go down, we will show this in the example below; Example: Say the Fed buys bonds, supply of bonds goes down, money supply goes up, price of bonds goes up, demand for bonds goes down (shifts left) So we can see that if the Fed buys bonds, that reduces the supply of bonds, increases the money supply, which results in an increase in the price of bonds but a decrease in the interest rate Fed buys bonds > Supply of bonds goes down > Money Supply goes up > Price of bonds goes up. And vice versa: Fed sells bonds > Supply of bonds goes up > Money Supply goes down > Price of bonds goes down Why would they do this? If the interest rate decreases, investment that needed bank loans will increase because the interest rate (the cost of that money) goes down, so planned investment goes up. This shifts our C + I P+ G + N curve shift up, and GDP has grown, X making people’s incomes bigger, and so Consumption (C) goes up as well However, the economy may be stimulated, but that does not mean it will stay that way Originally, the Fed bought bonds and the supply of bonds decreased (shifted to the left) S goes down > M goes up > interest rates (r) go down > IPand C go up > Real GDP = B S Income goes up Demand for Money (M D will also go up because there is a lower interest rate, meaning there is a lower opportunity cost of holding cash, so we want more cash in our pockets When M D goes up, the contrary happens in the bond market, since we want more cash, we will want less bonds, so Demand for Bonds will go down (Shift left As we can see, in reaction to more demand for money (M D shifting to the right), the interest rate has risen P Interest Rates (r) go up > I and C go down > Real GDP = Income goes down The Fed will often respond to these increases in the Demand for Money by buying bonds which leads to MSgoes up > r goes down > Real GDP = Income goes up and we are back where we started This is Monetary Policy the buying and selling of government bonds in order to increase or decrease the money supply in order to decrease or increase the interest rate in order to manipulate the economy. BounceBack Effects: ● So we saw how the money market can push GDP back and forth through actions of the Fed P ○ Fed buys bonds > S dBondses > M S ncreases > r decreases > C and I crease > Inventory levels decrease > APE increases > Real GDP = Income increases > P MD increases > r increases > C and I decreases > Real GDP = Income decreases ● The Fed is not the only agent that pushes GDP back and forth, we can see that several actions can propel these markets to bounce back and forth (think of the things that we use for the autonomous expenditure multiplier, changes in G for example) Thus, GDP will not change by the full effect of the multiplier effect because of BounceBack Effects We can also see how just an increase in G, caused C and IP to decrease and then GDP to decrease, this is called Crowding Out Crowding Out when increases in public expenditures (G) come at the expense of private expenditures (businesses and consumers), part of justification that government healthcare will take away from the private sector Fiscal and Monetary Policy: ● We have seen now that both the Fed and the Government can manipulate GDP and set the two markets on a bounceback cycle ● This shows how both fiscal and monetary policy can work; ○ Monetary Policy actions by the Fed to manipulate the economy by changing the money supply through buying and selling bonds, heavily depends on if people react to the interest rate ○ Fiscal Policy actions by the Government to manipulate the economy by changing G or C (consumption) through changing taxes (taxes increase, C decreases) Quantitative Easing: ● Put simply, it is just the buying of bonds by the Fed to increase the money supply and decrease the interest rate ● It used to be that the Fed could raise and lower interest rates from the bottom of the interest rate pile (think of the hydraulic machine, all the interest rates rest on a machine to raise and lower them, with the shortterm interest rates on the bottom of the pile and the longterm interest rates on the top) ● The Fed only needed to raise or lower shortterm interest rates and nearly all interest rates would follow suit ● However, a break occurred between longterm rates and shortterm rates, the Fed could no longer manipulate all of them Aggregate Demand: Aggregate Demand is NOT a demand curve, it is an equilibrium curve It answers the question “What level of GDP will create equilibrium in the money market and APE at various price levels?” So we can see from the graph that certain price levels support certain levels of GDP At these certain price levels, each of them correspond to the price level of that equilibrium GDP Movement Along the Aggregate Demand Curve: ● Movement along the curve = changes in the average price level ● If the price level changes, equilibrium GDP will only move to another point along the curve ● So if P (average price level/inflation rate) increases; ○ Money Demand increases because money is worth less so we need more of it, that increases the interest rate, which causes C and I P to decrease ○ C and I P will also decrease independently because the our dollars are worth less, hence we will hold onto them and not spend or invest as much ● These two events will cause APE, and hence GDP. to decrease ● A change in the YAxis (P) will cause a change in the XAxis (Real GDP = Y) Shift of the Aggregate Demand Curve: ● Shift of the curve = changes in P M S M D Taxes, G, I ● The Aggregate Demand Curve will shift when something that shifts GDP occurs without a change in price level ● You can see in the graph that if GDP changes without a change in price level, the entire curve must shift ● Emphasis on NO change in price level Example: we start with the Fed selling bonds, so M shifts left S MS ecreases > r increases > C and I P decrease > APE decreases > GDP decreases GDP has decreased because of the Fed decreasing the money supply by selling bonds GDP has decreased without a change in price level, so the Aggregate Demand curve has shifted to the left Due to bounceback effects, the new equilibrium GDP is between Y* and Y, finally resting at Y** because initially MS ifted to the left Aggregate Supply: ● This is the ShortRun Aggregate Supply Curve ● Answers the question; “What price level is necessary to support any given amount of GDP?” ● So we read the graph from the xaxis to the yaxis; At this level of GDP, what is our price level to support it? ● Segment 1: little demand, underproduction, abundant resources, operating on the interior of our PPF ● Segment 3: resources limited, producing at maximum capacity, operating on the exterior of the PPF ● Segment 2: equilibrium GDP, operating on the PPF, this segment is sloped because as production increases, cost of production increases, price level needs to increase needs to increase to support cost, and as we use lesssuited resources, the cost will increase even further ● The curve is upward sloping because ○ 1) (quantity) as production increases, lesssuited resources will be used, cost of resources increases, price needs to rise to cover the cost and ○ 2) (quality) resources are scarce, so when demand goes up, price also goes up ● The only resource whose price is held constant along the SRAS curve is labor (i.e wages) ● A movement along the SRAS curve a change in GDP ● A shift of the SRAS curve change in technology, price in resources NOT caused by a change in GDP (price of oil for example) Differences between Long Run and Short Run: ● In the short run, there is not enough time to enter or exit the industry ● In the short run, one or more items are constant (in this case the labor market wage) ● In the long run, the economy is producing its potential level of GDP ● In the long run, the economy operates at its natural level of unemployment ● In the long run, all markets clear (equilibrium has been reached) ● The only way to reach this long run equilibrium is if prices change Equilibrium: ● Equilibrium is different for the short run than it is for the long run ● In the short run, we do not take into account the labor market, where wages are sticky ● In the short run, we take the price of commodities where prices are relatively flexible and react quickly ● Long run takes into account wages, and once wages have changed due to changes in price level, we have reached Long Run equilibrium Putting the SRAS curve and the AD curve together: ● We are always operating on our SRAS curve, but we are only on our AD curve when we have equilibrium in Money Market and APE ● For this reason, all the marked P I and P IIand Y I and Y I are on the SRAS curve ● At Y I, inventory levels are falling because production is very low Examples:
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