Study guide for Macroeconomics exam 5
Study guide for Macroeconomics exam 5 ECON 104
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This 16 page Study Guide was uploaded by Morgan Owens on Tuesday April 19, 2016. The Study Guide belongs to ECON 104 at George Mason University taught by Stephen Gillepsie in Summer 2015. Since its upload, it has received 195 views. For similar materials see Macroeconomics in Economcs at George Mason University.
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Date Created: 04/19/16
Exam 5 study guide: Making a household budget: 2 general approaches: 2. Estimate your necessary expenses 1. Estimate your likely income see if your income is large enough Then divide it up Both approaches involve balancing income and expenditures Some expenditures are unavoidable, they must be made: 1. Payments promised for prior spending This can be the biggest part of many households' budgets, ex: monthly payments on a loan 2. Expenses necessary to maintain life: ex: food, clothing, medical care, housing, transportation Spending other than these "unavoidable" is your discretionary spending Note: unavoidable spending generally isn't unavoidable, but is costly to change Making the Federal budget: 1. The President develops a proposed budget Usually in February assisted by staff, OMB, Treasury, Council of Economic Advisors, various govt. agencies 2. The Congress modifies the proposed budget a. Starts in the House Appropriations considers spending, ways and Means considers taxes b. Senate reviews what the House passes c. Differences go to a conference committee d. Both Houses then vote on reconciled bills 3. President signs or vetoes each bill in its entirety if the president vetoes a bill it goes back to congress, where it either is modified or they override the Veto (lineitem veto violates the constitution) 4. Federal agencies actually spend money and collect taxes must either have an approved budges or a continuing resolution in order to operate. Differences between your budget and the Federal budget 1. Only a few people are involved in your budget: yourself, your spouse, perhaps your parents, perhaps important creditors Federal Budget: A huge number of people are involved, congress, president 2. You can make (or change) your budget quickly VS. Federal govt. budget takes all year 3. Your budget is fairly small (in the tens of thousands of $) VS. Federal budget is gargantuan ($3.6 trillion in 2014) 4. Your budget is pretty informal VS. Federal budget is massively documented Similarities between your budget and the Federal budget 1. Both must balance income and expenditures, they both can go into debt. 2. Both have a large "unavoidable" component, obligations to make payments. 3. Both cause headaches, fights, tension, and hard feelings Understand deficit and debt: Budget deficit The Federal government runs a deficit any year that it spends more than it collects in taxes, and a surplus any year that it spends less than it collects in taxes For most of our lives the government has run a deficit, not a surplus Until 1998 we hadn't had a budget surplus since 1969, and we sure don't have one now Government debt differs from household debt in 3 important ways: 1. Household debt must someday be repaid, government debts can be rolled over forever. 2. Household debt is almost exclusively owed to persons outside the household, government is almost exclusively owed to ourselves. 3. Federal debt can be monetized, govt. can reduce real value of debt by causing inflation, and household doesn’t have this option. It's useful to compare the Federal government to a single household If you spend just what you earn, your budget is balanced If you spend more than you earn, you run a deficit How can you spend more than you earn? By borrowing The Federal government also borrows to let it spend more than it has The Treasury issues bills, notes, bonds People buy them (that is, they loan the government money) Impact of deficit on aggregate demand The bigger the deficit, the larger the net increase in aggregate demand * Because disposable income (and consumption) are reduced by taxes a larger Federal budget deficit means a greater increase in AD, there are 2 ways the deficit can get larger: 1. Higher government spending will increase the size of the deficit 2. Lower tax receipts will increase the size of the deficit. However, aggregate demand is unlikely to rise by the size of the deficit More significant impact is called Crowding Out: More government borrowing funds to cover the deficit by selling securities which raises the interest rate which decreases private investment. Effects foreign trade in 2 ways: b. High value of dollarHigh real interest rate increases foreign demand for dollars, this raises price of dollar in terms of foreign currencies, this raises price of our exports, and this decreases our net exports c. Ricardian equivalence Consumers realize that bigger budget deficit now means higher taxes later, so they decrease consumption now in anticipation of higher taxes later. Difference between deficit and debtDeficit happens over a period of one year, Debt is the accumulated deficits over time High employment deficit: how large the deficit would be if the economy were at the level of the potential GDP. the federal budget will vary along with the business cycle deficits will grow during recessions, Deficits will shrink during expansions. This happens because of the activity of automatic stabilizers, most importantly are the Federal income tax and State unemployment insurance programs. Household tax liabilities fall along with income Unemployment insurance automatically fall along with income. To make it easier to compare the deficit from one time period to the next, we can adjust for the effect of automatic result is the high employment deficit. The “high employment” deficit is what the Federal deficit would be if the economy were operating at the level of potential GDP. *when the high employment deficits is small = the current budget imbalance is temporary. *when the high employment deficit is large = fundamental imbalance between govt. spending and tax receipts. (Will not go away on its own) Investment or consumption? There are wise reasons for going into debt, and there are foolish reasons a student loan generally is wise debt you are investing in your future the debt can be repaid out of increased future earnings maxing out numerous credit cards to live beyond your means is generally foolish debt repayment means that you will be poorer in the future The same thing is true for the government it is wise to run a deficit in wartime it is wise to borrow to pay for improvements in infrastructure improved transportation and communications networks are an investment that helps the economy to grow investment in medical research, in basic scientific research can lead to increases in productivity we can pay back the debt from the increased income generated by a growing economy it is foolish to run a deficit to support current consumption if the borrowing isn't for something that will expand our production possibilities in the future, then its repayment will make our children poorer Controlling the budget: Congress and the President struggled mightily over the past 30 years to get the Federal budget under control GrammRudman Act required acrosstheboard cuts in the budgets of Federal agencies it was supposed to eliminate the deficit by 1993 The first President Bush submitted a plan when he took office to eliminate the deficit in 4 years The 1990 tax increase was supposed to eliminate the deficit President Clinton viewed his efforts to reduce the deficit as among the major accomplishments of his first term And yet the deficit remained huge and outofcontrol In 1996 both parties pledged to eliminate the deficit in 7 years based on past experience, a healthy dose of skepticism was not uncalled for And yet, almost overnight, the deficit disappeared! What happened? Simply put, we grew ourselves out of the deficit * Economic growth increased tax revenues * The government resisted the urge to pass large new spending bills And yet, very soon we were back with the biggest deficits ever! In 2012 Congress passed sequestration, new acrosstheboard budget cuts * And the next year they passed exceptions to it Should we balance the Federal budget?* very controversial. Politicians like to spend; they don't like to tax, why? Because voters like to have their benefits increased, but don't like to have their taxes increased Classical: yes, just as it is for house and business, its financially irresponsible for the govt. not to live within its means. Keynesian: no, fiscal policy is the govt. main tool for stabilizing the macro economy. Monetarist: yes in theory but no in practice. Govt is likely to act irresponsibly. There is a builtin bias in government toward increasing net spending but we didn't used to run big deficits Throughout most of American history, we ran deficits during wartime, and then ran surpluses in peacetime to pay off the war debt There was an unwritten agreement among our elected officials that it was their responsibility to balance the budget, failure would result in a betrayal of the public trust. This ended in the 1930's The depression was the critical event Keynesian economic theory provided the justification: he said the only way to recover would be if the govt increase AD by increasing govt. expenditures. (running a deficit) recovery was more important than balance Many would argue that this is good that we shouldn't balance the budget every year Hoover raised taxes at the start of the depression in order to balance the budget, and he vetoed legislation that provided Federal relief funds but it made things worse If we balance the budget every year, we give up our ability to use fiscal policy to stabilize the business cycle, we ought to run a deficit during contractions. The counter argument to this is that we have already given up our ability to use fiscal policy if we run a big deficit every year (as we have done for most of recent history), we are doing nothing to slow down an overheated economy Ideally we should balance the budget over the business cycle run a deficit during contractions run a surplus during expansions No one has been able to come up with an approach that would do this Business cycles vary in length and can't be accurately predicted We would run likely deficits during contractions, but wouldn't run offsetting surpluses during expansions Government budget is a oneyearatatime deal Can’t combine the best of both features of balancing the Federal budget, not every year but over the course of the business cycle? 2 problems: 1. We cannot directly measure the high employment deficit( BC we can’t directly measure potential GDP) 2. Business cycle contractions and expansions are of variable length and can’t be known in advance. The "budget deficit" is simply a very slippery concept Define and measure money Functions of money Define money by what it does: medium of exchange, transactions take place in terms of money, goods and services are sold for money, not for other goods and services *Money is anything you can take into a store and exchange for goods and services The other functions of money are incidental to its use as a medium of exchange * Standard of value * Store of value Types of money Commodity money: the money has intrinsic value (it can be used for something other than money, EX gold or silver coins Fiat money: the money has no (or very little) intrinsic value (good for nothing except use as money): all the currency in your wallets, electronic money Often said that it is money because the government says it is money this is not true: It is money because everybody treats it as money Money must be 5 things: 1. Portable 2. Durable 3. Divisible 4. Standardized 5. Hard to counterfeit Measuring the stock of money Federal Reserve measures the money supply (once a week) M1 corresponds to the stock of money immediately available for the use as a medium of exchange. M2 is a broader measure of money, it includes the medium of exchange money and some “near monies”. Nearmoneies can’t be directly used to make purchases but are relatively easy to convert into money that can be used to make purchases. Demand deposits Other checkable deposits Traveler's checks Savings account Difficulty in measuring money * Financial instruments keep changing why? Partly because of changing technology, partly as response to government regulation Money market: Demand for money is downward sloping on xaxis is the quantity of money on yaxis is the price of money (the interest rate) The intersection of supply and demand determines the equilibrium interest rate. The demand of money is made up of 3 parts: transactions demand, precautionary demand, and speculative demand. Transactions demand: people desire to hold money because they want to buy things. Precautionary demand: tend to hold some extra money because you never know when you’re going to need it. Speculative demand: depends on people’s expectations. If you expect interest rates to rise sharply you might not want to tie up your investments at the low rate. What happens in the money market if the demand for money changes? 1. Inflation: nominal GDP rises: causes the equilibrium interest rate to rise, outward shift in demand. What happens if the Fed Changes the supply of money? The outward shift in the money supply, given a fixed money demand, causes the equilibrium interest rate to fall. Fractional reserve banking: A bank doesn't keep enough money on hand to pay all of its depositors, percent that it keeps is called the reserve ratio Why do depositors allow this to go on? We trust that only a few people will want to withdraw their money at any time, so that the bank will have money for us when we want to withdraw it If we don't trust this, then we withdraw our money, when a lot of people don't trust this, there is a run on the bank The Federal Deposit Insurance Corporation guarantees deposits of up to $250,000 This encourages depositors to trust the bank, and so helps prevent runs What are reserves? Money that the bank keeps on hand to meet any immediate liabilities, like when a depositor wants to withdraw some money The required reserve ratio defines how much money a bank must keep on hand: some % of its deposits, % is defined by the Federal Reserve Required Reserves = Deposits x Required Reserve Ratio For example, if deposits are $10,000 and the reserve ratio is 20%, then required reserves are $10,000 x 20% = $2,000 Excess reserves are reserves above what is required: that is, Reserves Required Reserves = Excess Reserves Bank liabilities: funds that the bank owes to someone else Bank Assets: uses to which the bank puts its funds, bank owns or are owed to the bank by someone else. Banking balance sheet Assets Liabilities Reserves Deposits Loans Borrowing Securities Bank capital Physical capital BANK LOANS: When a bank makes a loan they convert one type of asset (reserves) into another type of asset (loan) Primary income is the interest they make on the loans. a. The balance sheet compares assets and liabilities Assets Liabilities Reserves = 2 Deposits = 10 Loans = 7 Net worth = 1 Govt. securities = 1 Real property = 1 =11 =11 the two sided of the balance sheet must balance Why do banks make loans? To earn interest on the money they loan, the interest earned must be balanced against the risk of default Show effect on balance sheet of a loan default Assets Liabilities Reserves = 2 Deposits = 10 Loans = 7 2 = 5 Net worth = 1 1 = 0 Govt. securities = 1 Property = 1 + 1 = 2 1. Loans decrease by $2 =10 =10 To reduce the risk inherent in making loans, banks generally keep a diversified portfolio usually includes some government securities these are bonds sold by the Federal government they earn a low interest rate, but are very safe and highly liquid: that is, they can be turned into money quickly and at little cost If reserves are low, bank can borrow Federal Funds: these are excess reserves of other banks Money creation when a bank makes a loan, they create money in the form of new demand deposits: the bank credits the checking account of the person taking out the loan For example, a $5 loan: Bank 1 Assets Bank 1 Liabilities Reserves = 20 Deposits = 50 Loans = 30 rise to 55 rise to 35 The bank gains an asset (the loan) equal to the liability of the increased demand deposits The bank creates money and sells it in exchange for the promise to pay the bank the money plus interest on the money But the process does not stop there The person who took out the loan then spends the money The reason he wanted the loan was so that he could spend the money Bank 1 Assets Bank 1 Liabilities Reserves = 20 Deposits = 50 fall to 15 fall back to 50 Loans = 30 rise to 35 That person deposits the money in their own checking account Whatever bank they use now has the money in the form of both a liability (the higher balance in the checking account) and an asset (higher reserves) Bank 2 Assets Bank 2 Liabilities Reserves = 6 Deposits = 30 rise to 11 rise to 35 Loans = 24 :part of the new reserves are required to cover the higher demand deposits, but part can be loaned out to earn interest Bank 2 Assets Bank 2 Liabilities Reserves = 6 Deposits = 30 rise to 11 rise to 35 fall to 7 rise to 39 Loans = 24 fall back to 35 rise to 28 :And around and around and around This is another multiplier the reserve multiplier, a small initial increase in excess reserves can lead to a much larger increase in money supply. Multiplier = 1 ÷ required reserve ratio For example, if reserve ratio = 20%, then multiplier = 1 ÷ 0.2 = 5 What is the Fed, and what does it do? Federal Reserve System regulates the banking sector and implements monetary policy. 3 components: 1. Board of Governors 2. 12 Federal Reserve Banks 3. Federal Open Markey Committee Federal Reserve System: Federal Reserve Banks: 12 of them: They issue currency Board of Governors: Operates out of Washington DC: 7 governors appointed by president to 14year terms Chairperson is Janet Yellen, Set reserve requirements Federal Open Market Committee: Consists of the 7 governors, president of New York FRB, and presidents of 4 other FRB Decides about buying and selling govt. securities Monetary base: Fed does not affect monetary stock directly, but only through the monetary base Definition: Currency in circulation plus total bank reserves Tools to control monetary base: a. Required reserve ratio: This has massive direct effect; not changed very often b. Discount rate: This is the rate at which member banks can borrow from the Fed Used mostly to send signals to banks about direction Fed wants to see the money supply go c. Open market operations: Buying and selling govt. securities Main tool to control money supply; used daily How these tools work: Affect the banks' excess reserves This influences the quantity of loans banks make This affects the money supply Securities market Government securities have their own special set of terminology You have to understand these terms to understand how the Fed influences the money stock and interest rates How securities are priced: face value, discount, interest rate Show how Fed open market operations affect the price of securities and the interest rate Sale of govt. securities increases supply of securities Increase supply lowers the price Lower price means higher interest rate
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