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Macro Exam 3 Study Guide

by: Carter Cox

Macro Exam 3 Study Guide EC 111

Carter Cox

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Notes cover chapters 16 through 19
Principles of Macroeconomics
Study Guide
Macroeconomics, Economics, 16, 17, 18, 19
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This 13 page Study Guide was uploaded by Carter Cox on Friday April 15, 2016. The Study Guide belongs to EC 111 at University of Alabama - Tuscaloosa taught by Zirlott in Spring 2015. Since its upload, it has received 129 views. For similar materials see Principles of Macroeconomics in Economcs at University of Alabama - Tuscaloosa.


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Date Created: 04/15/16
Macro Exam 3 Study Guide Chapter 16 3 Functions of Money - Medium of Exchange o Item buyers give to sellers when they want to purchase goods and services o Picking up and buying - Unit of account o The yardstick people use to post prices and record debts (dollars and cents) o Prices are recorded - Store of value (save) o Item people can use to transfer purchasing power from the present to the future o Investing and checking accounts are examples Types Of Money - Commodity money o Takes the form of a commodity with intrinsic value o Gold coin, diamonds, cigarettes in POW camps are examples o Has uses other than just money - Fiat Money o Money because the government says so o No intrinsic value o The US dollar is an example M1, M2, and M3 - M1- o Currency, demand deposits, travelers checks, and other checkable deposits - M2- o Everything in M1 plus savings deposits, small time deposits (CD under $100,000), money market mutual funds (write a check on it), and a few minor categories - M3- o M1 and M2 plus a large time deposit (over $100,000), repurchase agreements (repo), and other categories - The distinction between M1 and M2 will usually not matter when we talk about “ the money supply” in this course Structure of the Federal Reserve System - Purpose of the FED is to ensure the health of the nations banking system - Board of governors o 7 member with 14 year terms  appointed by the president and confirmed by the senate o The chairman  Directs the FED staf  Presides over board meeting  Testifies regularly about FED policy in front of congressional committees and nations  Appointed by the president (4 year term)  Janet Yellen is the current chairwoman o The FED system  Federal reserve board is in Washington, DC  12 regional Federal Reserve Banks  Closest one to T-Town is in Atlanta  Major cities around the country  The presidents- chosen by each banks board of directors  Which state has two banks  Missouri  The FED’s Jobs  Regulate banks and ensure the health of the banking system o Regional Federal Reserve Banks o Monitors each banks financial condition o Facilitates bank transactions- clearing checks o Acts as a banks bank  Banks put their money into the FED o The FED- lender of last resort  FED can bail out o Control the money supply  Quantity of money available in the economy  Monetary policy- their biggest job  By Federal Open Market Committee (FOMC  - FOMC o 7 members of the board of governors o 5 of the twelve regional bank presidents  All twelve regional presidents attend each FOMC meeting, but only five vote  New York regional president always votes o Meets about every 6 weeks in Washington, DC  Discusses the condition of the economy  Consider changes in monetary policy - The structure of the FED o Board of governors  7 members o 12 regional FED banks  Located in the US o FOMC  Includes the 7 board of governors and 5 presidents of the regional FED banks 3 Tools of the Fed, how they work and how they are used - Open Market Operations (OMO’s) o The purchase and sale of US government bonds by the FED o Buying and selling of government bonds o Increase money supply, FED buys government bonds, which are deposited in banks, increasing reserves o Which banks use to make loans, causing the money to expand o To reduce money supply, FED sells government Bonds, taking dollars out of circulation, and the process works in reverse o OMO’s are easy to conduct and are the FEDs monetary policy tool of choice - Reserve Requirements (RR) o Afect how much money banks can create by making loans o To increase money supply, FED reduces RR  Banks make more loans from each dollar of reserves, which increases money multiplier and money supply o To reduce money supply, FED raises RR, and the process works in reverse o Fed rarely uses RR to control money supply  Frequent changes would disrupt banking - Discount rate (don’t make loans to consumers) o Interest rate on loans the FED makes to banks o When banks are running low on reserves, they may borrow reserves from the FED o To increase money supply, FED can lower discount rate, which encourages banks to borrow more reserves from FED o Banks can then make more loans, which increases the money supply o To reduce the money supply FED can raise discount rate Types of Banking Systems Central Bank o Institution that oversees the banking system and regulates the money supply - Monetary Policy o Setting of the money supply by policymakers in the central bank - Federal Reserve (FED) o The central bank of the US Commercial bank - Depository banks that accepted deposits and are covered by deposit insurance Investment Bank - Banks engaged in creating and trading financial assets such as stocks and corporate bonds but were not covered by deposit insurance because of their riskiness of their activities How does a bank create money? - The money Multiplier o The amount of money the banking system generates with each dollar of reserves o Money multiplier equal 1/ Reserve ration Financial Crisis 2008-2009 - Banks capital o Resources a banks owners have out into the institution o Used to generate profit - Leverage o Use of borrowed money to supplement existing funds for purposes of investment - Leverage ration o (Reserves + Loans + securities)/ Capital - Capital requirement o Gov. regulation specifying a minimum amount of bank capital o Depends on the type of assets a bank holds o The safer the assets the lower the requirement - Safe asset- bonds - Risky asset- stocks - Shortage of capital o After they had incurred losses on some of their assets  Mortgage loans  Securities o Reduce lending (credit crunch)  Contributed to a severe downturn in economic activity - US Treasury and the FED o Put many billions of dollars of public funds into the banking system  To increase the amount of bank capital  Called TARP o Temporarily made the US taxpayer a part owner of many banks o Goal: to recapitalize the banking system  Bank lending could return to a more normal level Chapter 17 Value of Money ­ P is equal to Price Level (CPI or GDP Deflator) o P is the price of a basket of goods, measured in money  ­ 1/P is the value of $1 measured in goods o Example: basket contains one candy bar  P= $2, value of $1 is ½ candy bars ­ Inflation drives up prices and drives down the value of money Graphs ­ Money Supply o MS is determined by Federal Reserve, the banking system, and consumers in the real world o We assume the FED precisely controls MS and sets it at some fixed  amount  ­ Money Demand – how much cash you hold o Refers to how much wealth people want to hold in liquid for   Most liquid form is cash o Depends on P  An increase in price level reduces the value of money, so more  money is required to buy goods and services o The quantity of money demanded is negatively related to the value of  money and positively related to P, other things equal  o If prices levels rise you have to pay more  Money Supply Diagram  ­ FED sets MS at some fixed value  o 1 – perfectly inelastic  ­ If Fed precisely fix the MS then it is perfectly inelastic  ­ As the price level falls the value of money rises ­ Demand for money is like the traditional demand curve, which is downward sloping  ­ P adjusts to equate quantity of money demanded with money supply Calculating Relative Price ­ Relative Price o Price of one good relative to (divided by) another  Example  Price of a CD is $15  Price of a pizza $10  CD in terms of Pizza  15/10= 1.5 pizzas per cd o Measured in physical units, so they are real variables  Calculating Real Wage  ­ W= nominal wage= price of labor  ­ P= price level= price of goods and services ­ Real wage is the price of labor relative to the price of output  o W/P Real Vs. Nominal Variables ­ Nominal Variables­ measured in monetary units o Examples:  Nominal GDP, nominal interest rate (rate of return measured in $),  nominal wage ($ per hour worked), minimum wage  ­ Real Variables – measured in physical units o Examples:  Real GDP, real interest rate (measured in output), real wage  (measured in output)  What can you buy with wage Classical Dichotomy and Money Neutrality ­ Classical dichotomy­ nominal and real don’t interact o Theoretical separation of nominal and real variables  ­ Hume and the classical economists suggested that monetary developments affect  nominal variables but not real  ­ If the central bank double the MS, Hume and classical thinkers contend o All nominal variables­ including prices­ will double  o All real variables­ including relative prices­ will remain unchanged ­ Monetary Neutrality  o The proposition that changes in the money supply do not affect real  variables ­ Doubling the MS causes all nominal prices to double  ­ Most economists believe the classical dichotomy and neutrality of money describe the economy in the long run Calculating Velocity of Money The Velocity of Money ­ the rate at which money changes hands  ­ V= (P x Y)/ M ­ (P x Y) is nominal GDP  ­ M is the money supply ­ V is velocity Quantity Equation  ­ M x V = P x Y o Represents entire economy ­ The quantity theory in 5 steps  o V is stable o So, change in M causes nominal GDP to change by the same percentage   M goes up 10% then GDP goes up 10% o A change in M does not affect Y  Money is neutral when it comes to real output   Y is determined by technology and resources  o So, P changes by the same percentage as P x Y and M  o Rapid money supply growth cause rapid inflation Costs of Inflation ­ Hyperinflation o Defined as inflation exceeding 50% per month  o Prices rise when the government massively prints too much money o Excessive growth in the money supply always causes hyperinflation ­ The Inflation Tax o when tax revenue is inadequate and ability to borrow is limited,  government may print money to pay for its spending  o the revenue from printing money is called inflation tax ­ The Fisher Effect o Nominal interest rate = inflation rate + real interest rate o In long run money is neutral, so a change in the money growth rate affects  the inflation rate but not the real interest rate  o The nominal interest rate adjusts one for one with changes in the inflation  rate ­ Inflation fallacy­ most people think inflation erodes real incomes or their  purchasing power ­ Shoe leather Costs­ the resources wasted when inflation encourages people to  reduce their money holdings­ how much cash you hold o Includes the time and transactions costs of more frequent bank  withdrawals  ­ Menu Costs o Costs of changing prices o Printing new menus, mailing new catalogs ­ Higher inflation causes more frequent price changes which leads to higher menu  costs ­ Misallocation of Resources from Relative price variability   Firms don’t all raise prices at the same time, so relative prices can  vary.. Which distorts the allocation of resources ­ Confusion and Convenience   Inflation changes the yardstick we use to measure transactions ­ Tax Distortions  o Inflation makes nominal income grow faster than real income  o Taxes are based on nominal income and some are not adjusted for  inflation  o So inflation causes people to pay more taxes even when their real incomes don’t increase ­ Arbitrary redistributions of wealth  o Higher than expected inflation transfers purchasing power from creditors  to debtors; Debtors get to repay their debt with dollars that aren’t worth as  much  o Lower than expected inflation transfers purchasing power from debtors to  creditors o High inflation is more variable and less predictable than low inflation o These arbitrary redistributions are frequent when inflation is high  After Tax Nominal and Real Interest Rates ­  Chapter 18 Net Export, Trade Balance, Trade Surplus, Trade Deficit - Trade Surpluses and Deficits o Net Exports measures the imbalance in a countries trade in goods and services  Trade Deficit  Excess of imports over exports, NX < 0 and Y < C + I + G  Trade Surplus  Excess of exports over imports, NX > 0 and Y> C + I + G  Balance Trade  Exports = imports, NX = 0 and Y = C + I + G - Exports o Domestically produced goods and services sold abroad - Imports o Foreign produced goods and services sold domestically - Net Exports or the Trade balance o Exports – imports What are NCO, capital outflow, and capital inflow? - NCO measures the imbalance in a country’s trade in assets o When NCO is positive “capital outflow  Domestic purchases of foreign assets exceed foreign purchases of domestic assets o When NCO is negative = to “capital inflow”  Foreign purchases of domestic assets exceed domestic purchases of foreign assets Foreign Direct Investment VS Foreign Portfolio Investment - Net capital outflow (NCO)- Flow of assets o Domesic residents purchases of foreign assets o Foreigners purchases of domestic assets - NCO is also called net foreign investment - Two Forms o Foreign direct investment  Set up foreign subsidiary and actively manage the foreign investment o Foreign Portfolio investment  Purchase foreign stocks or bonds, supplying “loanable funds” to a foreign firm, such as an American buys stock in Toyota Factors that afect NX and NCO - NCO = NX - Variable that influence NCO o Real interest rates paid on foreign assets o Real interest rates paid on domestic assets o Perceived risks of holding foreign assets o Government policies afecting foreign ownership of domestic assets National Income and National Savings Identities for an Open Economy - National Income Identity o Y= C+ I+ G+ NX - In an open economy o S= I+ NCO  Saving = Investment + NCO - NX= NCO - S-I = NCO o Positive, and capital will flow out of the country - When S>I then NCO>0 and the excess loanable funds flow abroad in the form of positive net capital outflow o Trade Surplus - The opposite, foreigners are financing some of the country’s investment in the form of negative net capital outflow o Trade Deficit Nominal Exchange Rate - Nominal Exchange Rate; o Rate at which one country’s currency trades for another - We express all exchange rates as foreign currency per unit of domestic currency Exchange Rate Appreciation VS Depreciation - Appreciation o Strengthening o Increase in the value of a currency as measured by the amount of foreign currency it can buy o Takes more foreign currency to buy one US dollar o Strong dollar causes US goods to become more expensive compared to foreign goods, so US exports will fall and imports to the US will rise - Depreciation o Weakening o Decrease in the value of a currency as measured by the amount of foreign currency it can buy o Takes less foreign currency to buy one US dollar o Weak dollar causes US goods to become less expensive compared to foreign produced goods, US exports will rise and imports will fall Calculating and Interpreting Real Exchange Rate - Real Exchange Rate o Rate at which the goods and services of one country trade for the goods and service of another o e x P/ P*  e= nominal exchange rate  P*= foreign price  P= domestic price - Interpreting Real Exchange Rate o .75 Japanese Big macs per US Big Mac o Correct  US big mac can be exchanged/ traded for .75 Japanese big mac o This is called terms of trade Purchasing Power Parity - Purchasing Power Parity o Theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries o Law of One price  Notion that a good should sell for the same price in all markets  Implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries - PPP an its implications o Implies that the nominal exchange rate (e) between two countries should equal the ratio of price levels o If two countries have diferent inflation rates, then (e) will change over time - Limitations to PPP o Many goods cannot easily be traded  Haircuts, going to the movies  Price diferences on such goods cannot be arbitraged away o Foreign, domestic goods not perfect substitutes  Some US consumers prefer Toyotas over Chevys  Price diferences reflect taste Chapter 19 The Market for Loanable Funds - An identity from the preceding chapter o S= I+ NCO  S= saving, I= domestic investment, NCO = net capital outflow - Supply of loanable funds is equal to saving - A dollar of saving can be used to finance o The purchase of domestic capital o Purchases of a foreign asset - Demand of loanable funds are equal to I + NCO - Recall o S depends positively on the real interest rate (r) o I depends negatively on (r) How NCO depends on the Real Interest Rate - Real interest rate is the real return on domestic assets - Fall in real interest rate makes domestic assets less attractive relative to foreign assets o People in US purchase more foreign assets o People abroad purchases fewer US assets o NCO rises Loanable Funds Diagram - Real interest rate adjusts to balance supply - Loanable funds is demand - Both I and NCO depend negatively on real interest rate, so demand curve is downward sloping Market for Foreign Currency Exchange - NCO = NX o NCO = Net capital outflow o NX = Net exports - NX is the demand for dollars o Foreigners need dollars to buy US net exports - NCO is the supply of dollars o US residents sell dollars to obtain the foreign currency they need to buy foreign assets - US real exchange rate (E) measures the quantity of foreign goods and service that trade for one unit of US goods and service o E is the real value of a dollar in the market for foreign currency exchange - An Increase in E has no efect on saving or investment, so it does not afect NCO or the supply of dollars Disentangled Supply and Demand - When a US resident buy imported goods does the transaction afect supply or demand in the foreign exchange market o The supply of dollars increase  Person needs to sell her dollars to obtain the foreign currency she needs to buy the imports o Demand for dollars decrease  Increase in imports reduce NX which we think of as the demand for dollars - When a foreigner buys a US asset, does the transaction afect supply o Demand in the foreign exchange market  Demand for dollars in order to purchase the US asset o The supply of dollar falls  Transaction reduces NCO which we think of as the supply of dollars o IN both of these the second is what we will use


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