Macro Exam 3 Study Guide
Macro Exam 3 Study Guide EC 111
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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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