Macro Final Exam Study Guide
Macro Final Exam Study Guide Eco2013
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Final Exam Study Guide Chapter 1: Life is getting better, not worse (Look at the positive changes) o Life expectancy o Health o Income o Education o Entertainment What is Economics? o The study of how individuals make choices under scarcity Scarcity: The concept that there is less of a good freely available from nature than people would like (Time, money, textbooks) Necessitates rationing, or allocating goods to those who want them most (first come/first serve, price) Leads to competitive behavior Resources o An input used to produce an economic good Human Resources (Human Capital) Intelligence, endurance, kindness Physical Resources (Physical Capital) Pencils, paper, laptop Natural Resources (NOT Natural CapitalNot man-made) Gold, iron 8 Guideposts to the Economic Way of Thinking o 1. Resources are scarce so decision makers must make trade-offs No such thing as a free lunch Opportunity Cost When you make a decision to do one thing, everything needed for that decision can not now be used for any other alternative Ex: An hour of your time, where to spend money o 2. Individuals are rational; they try to get the most from their limited resources Try to get the greatest benefit from the least possible cost What is rational for one person may not be rational for everybody o 3. Incentives Matter; Choice is influenced in a predictable way by changing incentives Ex: As price goes up, producers are willing to make more, but customers are less willing to buy o 4. Individuals make decisions at the margin Marginal Benefits vs. marginal costs Perform a cost-benefit analysis (examples in notes) o 5. Information helps us make better choices, but it is costly to acquire We sometimes make decisions without perfect information The bigger the decision, the more information we are likely to acquire Buying a new pencil vs. buying a new car o 6. Beware of secondary effects Indirect impacts of an event or policy that may not be easily and/ or immediately observable Pitbull on the subway in a shoulder bag o 7. The value of a good or service is subjective Whoever owns an item creates the value for it Voluntary trade creates value o 8. The test of a theory is its ability to predict If real world events are consistent with a theory, then the theory is valid Positive vs. Normative Economics o Positive: The scientific study of what is; testable “It’s 45 degrees outside” o Normative: Judgments about what people think “ought to be”; not testable “It’s too cold outside” 4 Pitfalls to Avoid in Economic Thinking o 1. Violation of the ceteris paribus principle Ceteris Paribus: All other things constant Ex: “If the price of eggs goes up, people will buy less… ceteris paribus.” NOT during Easter o 2. Good intentions do not guarantee desirable outcomes Ex: suicide warnings on antidepressant medicine o 3. Association is not causation Just because two things happen together does not mean one causes the other Often an unseen third variable o 4. Fallacy of composition False belief that what is true for one might be true for all If one person stands at a football game, they will see better; but if everyone stands, not everyone will see better Microeconomics vs. Macroeconomics o Micro: Focuses on how human behavior affects the conduct of affairs within individually defined units o Macro: Focuses on how human behavior affects outcomes in larger markets Chapter 2: Trade Creates Value (only with voluntary trade) o Ex: The Candy Trading Game o Both parties are better off when they engage in voluntary trade Creation of Wealth o If people become rich through voluntary exchange (creating something that everyone wants to buy), it makes everyone richer Don’t hate the rich. Private Property Rights o 1. The right to exclusive use of the property and the right to deny people from using it o 2. Legal protection against invasion from other individuals o 3. The right to sell, transfer, exchange or mortgage the property o Incentives of private property rights 1. Incentive to use resources in ways that are considered beneficial to others You will make more money by using your property for what the majority wants 2. Private owners have an incentive to care for and manage what they own People take better care of what they own than what they share with others 3. Private owners have an incentive to conserve for the future When you share, you want to use everything so the other person can’t. When it’s only yours, you will save it for when you really need it. 4. Private owners have an incentive to make sure their property does not damage other’s property They don’t want to be responsible for any damage. o Lack of property rights lack of economic progress Production Possibilities Curve (PPC) o Outlines all possible combinations of total output that could be produced within an economy The amount of productive resources must be fixed The amount of technical knowledge must be given to us The use of resources must be full and efficient o Efficient points: on the curve o Inefficient points: below the curve o Unobtainable points: above the curve *Graphs are in notes* o Factors that shift the PPC 1. A change in the economy’s resource base Changing how an economy invests (investing now is more efficient for the future) 2. Changes in technology Determines the amount of output we can generate with our limited resources 3. A change in the rules under which an economy functions Ex: Imposing trade barriers reduces economic growth and shifts the PPC inward 4. Changes in work habits Ex: Working harder shifts the curve out Law of Comparative Advantage o The total output of a group of individuals, an entire economy or a group of nations will be greatest when the output of each good is produced by whoever has the lowest opportunity cost Ex: Bill Gates should not do his own dishes because he can hire someone to do it for much cheaper while he does something that makes him more money Economic Organization o Every economy asks: What will be produced? How will it be produced? For whom will it be produced? o Capitalism: A system of economic organization where productive resources are owned privately and the goods and resources are allocated through market process Market Organization: private parties make their own decisions and plans with the guidance of market prices Private individuals making decisions for themselves o Socialism: A system of economic organization where ownership and control of the means of production rest with the state/governor and resource allocation is determined by centralized planning Collective Decision Making: Relies on public sector decision making to resolve basic economic questions Economic Freedom o Economic Freedom of the World Scale Determines how free each country is based on how likely they are to make their own decisions Bluer countries are more free Redder countries are less free Shows a strong relationship between economic freedom and quality of life o Capitalism is similar to natural selection: when individuals make decisions for themselves regarding use of resources, they are more likely to make decisions that will create economic growth and keep customers happy in order to maximize their success More Freedom o Socialism: suffers from an information problem as in the government does not know everyone’s preferences at every point so it is hard for them to determine who will get the most benefit from resources Less Freedom Chapter 3: The Demand Curve and the Law of Demand o There is an inverse/ negative relationship between the price of a good and the quantity that buyers are willing to purchase Downward sloping curve Consumer Surplus o The difference between the maximum amount of money consumers would be willing to pay and the amount that they actually pay Area below the demand curve but above price (1/2bxh) There will never be negative consumer surplus Demand vs. Quantity Demand o Quantity demanded Changes move ALONG the curve (right/left) Buying a different quantity because the price changes o Demand Changes shift the WHOLE curve Caused by a change in anything that affects demand other than the price Ask yourself why you are buying more/less? Shifters of demand Change in consumer income o If you have more money, you will buy more normal goods (goods you tend to like) and less inferior goods (goods you only buy because they are cheap and you are poor). Change in number of consumers o When there are more people, demand is higher Change in the price of a related good o When the price of a substitute increases, demand of the actual good increases (Chicken vs. beef) o When the price of a compliment good goes up, demand goes down (cereal and milk) Change in expectations o If the future price is expected to increase, current demand increases and also the opposite Expected change in income o If you expect your future income to increase, your current demand will increase because you know you’ll be able to pay it off Change in consumer tastes and preferences (popularity) o When a media star is popular, the demand for their tickets and merchandise increases The Supply Curve and the Law of Supply o There is a direct relationship between the price of a good or service and the amount that suppliers are willing to produce If the price goes up, sellers are willing to sell more (quantity supplied increases) Upward sloping curve Producer Surplus o The difference between the minimum price suppliers are willing to accept and the price they actually receive o Producer surplus will never be lower than zero o Area above the supply curve but below price (1/2b x h) Supply vs. Quantity Supplied o Quantity Supplied Changes move ALONG the curve Caused by a change in the price of the good o Supply Changes SHIFT the whole curve Caused by a change in anything that affects supply other than the price of the good Shifters of supply 1. A change in resource price o If the price of a resource increases, supply decreases 2. A change in technology o If technology increases, supply/production increases 3. A change in nature and politics o Depends on what the change is Bad weather decreases supply Good weather increases supply 4. A change in taxes o As taxes increase, supply decreases Elasticity o Inelastic: Changes in quantity are not sensitive to changes in price Steep curve If price changes, quantity of demand does not change Perfectly inelastic: you buy the same amount of the item no matter how much the price changes Vertical line o Elastic: changes in quantity are sensitive to changes in price Flatter curve If the price changes, the quantity of demand changes more drastically Perfectly elastic: If the price goes up at all, you will buy none; if the price goes down at all, you will buy an infinite amount Horizontal line Market Equilibrium o When the conflicting forces of supply and demand are in balance Where the demand curve and supply curve intersect o Economically efficient because there is no excess demand or supply Excess supply: Quantity supplied > quantity demanded Excess demand: Quantity demanded> Quantity supplied Move the price to eventually reach equilibrium Changes in Demand: o Demand increases when price increases o Demand increases when quantity increases Changes in Supply o Supply increases when price decreases o Supply increases when quantity increases Changes in Both Demand and Supply o 1. Take it one statement at a time A. Does it affect demand or supply? B. Is demand/ supply increasing or decreasing C. Does it affect price nd quantity? o 2. Repeat steps A-C for the 2 statement o 3. Add effects together o *Apply the rules from supply/ demand individually in order to solve the statements Invisible Hand Principle o The tendency for people, while pursuing their own interests, to promote the economic well-being of society Ex: Waitresses Chapter 6: Role of Government o 1. Protect individuals and their property rights o 2. Provide goods that cannot be easily provided by the market Debate among economists regarding this role because, just because the government gets involved, does not mean things will get better When the government takes over, it can lead to a government failure. Size and Growth of the U.S. Government o Indicated by government expenditures as a percentage of U.S. GDP Has been steadily increasing o Where is the government spending our money? Federal Spending Medicare and Health Social Security National Defense State and Local Spending Education Public Welfare and Health Administrative Expenses Transfer Payments: Transfers of income from some individuals to others Giving money to another group of people just because they are in that group o Ex: Taking money from young people and giving it to older people About 50% of total government spending Economics of Voting o 1. Rational Ignorance Effect: a rational individual can have little or no incentive to acquire the information needed to cast an informed vote For most people, the marginal cost of voting outweighs the marginal benefit of voting o 2. Median Voter Theory: The idea that a vote maximizing politician in a two party system will be close to the middle so that there is little difference between candidates and the preference of the median voter will be represented Politicians want to be closer to the middle of conservative and liberal to maximize voters o When the Political Process Works When voters pay in proportion to the benefits they receive from a particular policy, productive projects will be passed and unproductive projects will not be passed When benefits outweigh the costs for most, the plan will be passed o When the Political Process Does Not Work Special Interest Effect Special Interest Groups forming to lobby the government for benefits Benefits a small group with minimal costs to a larger group Logrolling o Politicians trading votes in order to get their legislation passed (Offering to vote for someone else’s policy in order for them to vote for yours) Pork-Barrel Legislation o State representatives adding their own stipulations to national bills that will benefit them locally through the finances of the federal government The president can not take out their additions without vetoing the whole bill that he initially proposed Shortsightedness Effect Politicians favor policies that generate immediate benefits with long-term and not immediate costs Everyone keeps letting the next guy worry about debt Rent Seeking Individuals and groups spend their time lobbying and trying to gain political favors instead of bettering their production methods or working on their job. Lack of Profit Move Unlike private firms, the public sector/ government lacks the incentive to produce efficiently o Private firms see their benefits and personally get hurt if they act inefficiently o The government could loose funding if they act efficiently or gain funding if they say they can not work with what they have (acting inefficiently) Chapter 7: Taking the Nation’s Economic Pulse Gross Domestic Product: The market value of all final goods and services produced within a country during a specific time o Market Value: Goods and services are weighted according to the purchase price Total spending is added to get the annual GDP o Final Goods and Services: purchased by the ultimate (last) user Intermediate goods/services: purchased for resale or to produce something else Intermediate goods are not counted in GDP because their value is included once it’s a final good o Production: Only produced goods/services are included in GDP (not transfers of money) o Within a country: GDP only counts what is produced in the country o During a specific period: GDP only counts what is produced in 2016, not what is sold How to measure GDP o Expenditure approach (Y=C+I+G+NX) GDP= consumption+ private investment+ Government consumption and investment+ Net exports (exports- imports) o Resource cost-income approach Employee compensation (54.6%) Proprietors’ income (7.7%) Rent (3%) Corporate Profits (12.4%) Interest Income (3.2%) Indirect Business Taxes (7.4%) Depreciation (13.3%) Net income of foreigners (-1.6%) Gross National Product: Total market value of all goods and services produced by the citizens of a country o Includes production done by citizens abroad Adjusting for Price Changes o Nominal values: values expressed in current dollars o Real values: Values that have been adjusted for the effects of inflation Calculating real values Real= Nominal x (PI base year/ PI current year) Price Index: Measures the cost of purchasing a market basket at one time in relation to the cost of purchasing the same basket during an earlier time o PI= Cost of the bundle in the current year/ cost in the base year Consumer Price Index: Indicator of general level of prices; designed to measure the impact of price changes on a typical bundle purchased by households GDP Inflator: Reveals the cost during the current period of purchasing the items included in GDP; broader than CPI because it includes goods purchased by government and businesses Limitations of GDP o Excludes non-market production (domestic) o Excludes the underground economy o Excludes leisure and human costs (physical risk and time) o Difficulties measuring quality variation and introduction of new goods o Excludes the cost of harmful side effects Per Capita GDP o GDP/Population o General indicator of living standards (high economic freedom often correlates to high Per Capita GDP) Chapter 8: Economic Fluctuations, Unemployment and Inflation Business Cycle: Fluctuations in the general level of economic activity (Graph of Real GDP vs. Time) o Moves in cycles and is measured by changes in real GDP and unemployment rate o Expansion: growing GDP and declining unemployment o Peak (boom): the height of the expansion phase o Contraction: characterized by falling GDP and rising unemployment o Trough: The lowest point of the contraction phase o Recession: A decline in GDP for 6 months (2 quarters) Extended recession o Depression: A prolonged and severe recession Labor Market o Employed: If someone has worked full-time or part-time in the past week or is on vacation or sick leave o Unemployed: A person who is not currently employed but is actively seeking employment or waiting to start or return to a job If neither of these, they are not in the labor market (or under 16 or institutionalized) o Civilian Labor Force: Number of people age 16 or older who are employed or unemployed Unemployed + Employed o Labor Force Participation Rate: Percent of population age 16 or older who is in the civilian labor force Civilian labor force/ population 16 and older o Unemployment rate: Percentage of people in the labor force who are unemployed Unemployed/ Civilian labor force o Employment/ population ratio: Percent of population age 16 and over who are employed Employed/ population 16 and older Unemployment o Frictional Unemployment: Unemployment from changes in the economy and imperfect information that prevent workers from being immediately matched with existing jobs They will find a job but it may take a little while o Structural Unemployment: Unemployment due to structural characteristics of the economy that prevent the matching of available jobs to available workers There are people that want to work and jobs available, but the potential workers lack the necessary skills o Cyclical Unemployment: Unemployment due to recessions and inadequate labor demand People have the skills and want to work, but there are no jobs High during recessions Negative during expansions o Places with higher worker benefits have higher unemployment because they don’t want to hire new people (it’s too costly) Natural Rate of Unemployment: The normal rate when the economy is operating at a sustainable rate of output o What the economy can maintain for a long time, not the highest output o Natural = Frictional + Structural unemployment o Affected by structure of the labor force and public policy Actual Rate of Unemployment o Actual= Frictional +Structural+ Cyclical Unemployment o During expansion: Natural >Actual o During recession: Natural < Actual Affected by Cyclical Unemployment Full Employment: Occurs when the economy is experiencing the highest rate of output that it can sustain o Exists when the economy is operating at the natural rate of unemployment Potential Output: The level of output that can be achieved and sustained in the future given that we are operating at the natural rate of unemployment (full) o Expansion: Actual Output> Potential output o Recession: Actual output< Potential output Inflation: An increase in the general level of prices (percent change in prices) o Causes the value of the dollar to decrease o High and variable inflation causes Reduced investment Distorted information delivered by prices Less productive use of resources o Caused by: Demand rising faster than supply Rapid increase in the money stock Hyperinflation Chapter 9: An introduction to Basic Macroeconomic Markets The Labor Market o Price= wage (w) o Quantity= employment (E) o Labor Demand Businesses demand labor Downward sloping because as wage decreases, employers want to hire more As demand increases, the employment and wage increase As demand decreases, the employment and wage decrease o Labor Supply Workers supply labor Upward sloping because as wage increases, people are more likely to work As supply increases, employment increases and wage decreases As supply decreases, employment decreases and wage increases Loanable funds market o Market that coordinates the borrowing and lending decisions of business firms and households Borrowing money from the bank is demanding money Putting money in the bank is supplying money o Price= real interest rate (r) o Quantity= amount saved or invested (Q ) s,I o Demand for Loanable Funds (investment) Downward sloping because as the interest rate decreases, firms will want to borrow more money Increase in investment: demand curve shifts right Decrease in investment: demand curve will shift left o Supply of loanable funds (savings) Upward sloping because, as the interest rate increases, people will want to save more and spend less Increase in savings: supply curve shifts right Decrease in savings: supply curve shifts left Interest Rate o Nominal interest rate: the percentage of the amount borrowed that must be paid to the lender in addition to the repayment of the principle o Real interest rate: The interest rate for inflation (real cost of borrowing and lending money) R= i – pi (inflation) o Interest rate and inflation When the actual rate of inflation is greater than anticipated, borrowers gain and the lenders lose When the actual rate of inflation is less than anticipated, the lenders gain and the borrowers lose o Interest rate and bond prices Inversely related The foreign exchange market: market in which the currencies of different countries are bought and sold o Appreciation: An increase in the value of a currency relative to foreign currencies o Depreciation: A reduction in the value of a currency relative to foreign currencies o Price= price of foreign currency o Quantity= the amount of foreign currency o Demand for foreign currency Imports+ Capital outflows (domestic money invested abroad) Downward sloping because as the dollar appreciates, people can import more and invest more in other countries o Supply of foreign currency Exports + capital inflows (foreign money that is invested domestically) Upward sloping because, as the dollar depreciates, foreign countries will demand more domestic exports and will invest more domestically o Equilibrium When supply of foreign currency equals demand Trade deficit: imports> exports Trade surplus: exports > imports Aggregate goods/ Services market: includes all final goods (goods that enter GDP) o Price= Price index (PI) o Quantity= real GDP (Y) o Aggregate Demand Relationship between the price level and the quantity of domestically produced goods and services people are willing to purchase Downward sloping because, as price level goes gown, quantity demanded goes up A lower price increases the purchasing power of your money A lower price will lead to a lower real interest rate, which increases consumption and investment A lower price will make domestically produced goods less expensive relative to foreign goods o Aggregate Supply Relationship between a nations price level and the quantity of goods supplied by its producers Short Run Aggregate Supply Curve (SRAS) Some things are fixed Upward sloping because an increase in the price level will improve the profitability of the firms and increase profit Profit= revenue-cost o In the short run, many costs are fixed Long-run Aggregate Curve (LRAS) Everything can change Vertical because, in the long run, people have time to adjust so a higher price level will increase costs just as much as it increases revenue Profit won’t change in the long run because, as you increase price, producers will increase your costs Where SRAS = LRAS: actual price level = expected price level o Short-run equilibrium When the aggregate demand (AD) and the SRAS intersect o Long-Run equilibrium When the aggregate demand, SRAS and LRAS intersect When we correctly anticipate price level No expansion or recession o When real GDP> potential output, we are at expansion o When real GDP < potential output, we are in recession Chapter 10: Working with Our Best Aggregate Demand and Aggregate Supply Model Anticipated changes are foreseen early enough to adjust and unanticipated changes are not Shifters of Aggregate Demand o 1. Changes in Real Wealth Increase in real wealth: shifts AD curve right (increases) Decrease in real wealth: shifts AD curve left (decreases) o 2. Changes in the real interest rate Interest rate rises: AD curve shifts left Interest rate falls: AD curve shifts right o 3. Changes in the expectations of businesses and households about the future Optimism: Shifts AD curve right Pessimism: Shifts AD curve left o 4. Changes in the expected rate of inflation Expected to increase: AD curve shifts right Expected to decreases: AD curve shifts left This makes sense because people will buy more now if it is EXPECTED to increase and buy more later if it is EXPECTED to decreases o 5. Changes in income abroad Foreign income increases: AD curve shifts right Foreign income decreases: AD curve shifts left o 6. Changes in exchange rates Dollar appreciates: AD curve shifts left Dollar depreciates: AD curve shifts right Shifters of Aggregate Supply o Permanent Changes (shifters of LRAS and SRAS) 1. Change in resource base Resource base increases, LRAS increases Resource base decreases, LRAS decreases 2. Change in the level of technology Technology increases, LRAS increases Technology decreases, LRAS decreases 3. Change in institutional arrangements that affect productivity Positive: LRAS increases Negative: LRAS decreases o Temporary changes (shifters of only the SRAS) Change in resource prices Resource price increases, SRAS shifts left (recession) Resource price decreases, SRAS shifts right (expansion) Change in the expected rate of inflation Expected inflation increases, SRAS shifts left Expected inflation decreases, SRAS shifts right Supply Shocks (an unexpected event that temporarily affects aggregate supply) Negative: SRAS decreases Positive: SRAS increases Anticipated changes in long-run aggregate supply o Causes both the LRAS and SRAS to shift in the same direction Unanticipated changes in aggregate demand o Causes both the AD and the SRAS to shift in opposite directions o Know how to recognize what the short term and long term affects of a situation will be on the graphs Unanticipated changes in short-run aggregate supply o Only shifts the SRAS curve and it shifts back to its original position These are always temporary changes Chapter 11: The Keynesian View and Historical Perspective Classical vs. Keynesian Economics o Classical: belief that the market and resource prices are flexible and allow the economy to self-correct fairly quickly (F.A. Havek) Says Law: supply creates demand so production matters o Keynesian: belief that market and resource prices are inflexible so the market is unable to quickly correct itself (John Maynard Keynes) Demand creates supply so spending matters People do things for reasons we may not understand sometimes (animal spirits) Why prices and wages are inflexible Wages: Trade unions and large corporations enter into long-term contracts Bosses would rather fire people than lower wages during a recession Prices: It takes work for the prices to change o Menu Costs: The costs of changing prices Marginal Propensity to Consume (MPC) o MPC= additional consumption/ additional income The Expenditure Multiplier (M) o M= 1/(1-MPC) o A change in expenditures will have a greater impact than the initial change o For the multiplier to be effective, it must come from resources that otherwise would not have been used Ex: The economy is poorer from paying people to break windows Budget Deficits and Surpluses o Increasing the budget deficit increases the debt faster o Decreasing our budget deficit increases our debt slower o Balanced budget: government revenues (taxes) are equal to the government expenditures (T=G) Budget Deficit: Government expenditures are greater than taxes (T<G) Budget Surplus: Taxes are greater than government spending (T>G) o Causes that change the size of the deficit or surplus 1. A reflection of the state of the economy Recession: Taxes go down because people are making less money; government spending goes up because more people are collecting unemployment benefits budget deficit Expansion: Taxes go up because income increase, government spending goes down because less people are unemployed Budget surplus 2. Discretionary Fiscal Policy Deliberate changes in the tax policy and/ or government spending designed to affect the budget deficit or surplus Keynesian view: o Expansionary Fiscal Policy: Increase government spending or reduce taxes to bring the economy out of a recession by increasing AD Unfortunately, this Increases the size of the budget deficit o Restrictive Fiscal Policy: Decrease government spending or increase taxes to bring the economy down from an expansion by decreasing AD Reduces the size of the budget deficit Keynesians believe in the counter cyclical policy (not balancing the budget) o A policy that moves the economy in the opposite direction from the forces of the business cycle Recession: Expansionary policy We’ll be able to pay back deficits when we have surplus Expansion: Restrictive Policy Use surplus in the good times to pay back the deficits to balance over a long time period o Timing Problems of Fiscal Policy 1. Recognition lag: Our ability to forecast a recession/ expansion is extremely limited 2. Administrative lag: Change in fiscal policy requires legislative action, which takes time 3. Impact lag: Change in fiscal policy will not have an immediate impact in the economy When timed incorrectly, fiscal policy will increase economic instability Automatic Stabilizers o Built in features that automatically promote a budget deficit during a recession and a budget surplus during an expansion without a change in policy 1. Unemployment Compensation Recession: When unemployment goes up, taxes decrease and government spending increases Budget deficit Expansion: When unemployment goes down, taxes increase and government spending decreases Budget surplus 2. Corporate Profit Tax Recession: Corporate profits decrease so taxes decrease Expansion: Corporate profits increase so taxes increase 3. Progressive Income Tax Recession: Everyone’s income decreases so their taxes decrease Expansion: Everyone’s income increases so their taxes increase Chapter 12: Fiscal Policy: Incentives and Secondary Effects Classical Economists believe in crowding-out o A reduction in private spending due to higher interest rates generated by budget deficits financed through government borrowing Recession Expansionary fiscal policy (government spending increases and taxes decreases) Higher budget deficit Financed through higher government borrowing Demand for loanable funds increases Higher real interest rate Decrease in consumption and investment Increase in capital inflows The dollar appreciates Net exports decline Fiscal policy fails to bring the economy out of a recession New Classical View of Fiscal Policy: Ricardian Equivalence o Belief that a tax reduction financed with government debt will exert no effect on aggregate demand because people will know that higher future taxes are coming and decide to save their money Based on the permanent income hypothesis Keynesian’s Paradox of Thrift o When many people drastically increase their savings and reduce consumption, total savings will actually decrease Savings increase Spending decreases Production decreases People get laid off They have less money to save o Problem with fiscal policy Politicians have a tendency to overuse expansionary policy especially during election time higher debt What Keynesians and Classicals agree on o 1. Proper timing is crucial and hard to achieve o 2. Automatic stabilizers do help redirect the economy o 3. Fiscal policy is less potent than originally thought Taxes and Economic Growth o High taxes decrease growth High tax rates discourage work effort and productivity High tax rates reduce capital formation People stop buying the more efficient products because they are more expensive High tax rates encourage people to purchase goods that are less desired, just because they are tax deductible (they get taxed less because their “profit” is less) Supply Side Economics o The belief that changes in the marginal tax rate will exert important effects on aggregate supply A lower tax rate will give people incentive to work more If the lower tax rate is believed to belong term, both the LRAS and the SRAS will shift Supply side economics is a long-term growth oriented strategy, not a short-run stabilization tool Chapter 13: Money and the Banking System Three functions of money o 1. Medium of exchange Used to buy goods and services It is more efficient to use money than to search for a trade Fiat money: Money that has no intrinsic value o 2. A store of value An asset that will allow people to transfer purchasing power from one period to the next Liquid assets: Assets than can be easily and quickly converted to purchasing power o 3. A unit of amount A measurement used by most people to post prices and keep track of revenues and costs The value of money o Determined by the demand relative to supply o M1: currency + checkable deposits + traveler’s checks Most liquid form of money o M2: M1+ savings deposits + time deposits (less than $100,000) + money market mutual funds Broader, less liquid definition of money Economists who stress the store value of money prefer M2 The Central Bank o An institution that regulates the banking system and controls the money supply o The Federal Reserve system is the Central Bank in the US Carries out regulatory policies and conducts monetary policies o Definitions Bank reserves: vault cash + deposits from the banks into the Fed Fractional reserve banking system: A system that permits banks to hold reserves of less than 100% against deposits Banks loan out fractions of your money and charge an interest rate higher than what you are getting for keeping your money there Required reserves: the minimum amount of your money that a bank is required by law to keep on hand to back up its deposits (decimal) Different than RRR Federal Deposit Insurance Corporation (FDIC): A federal corporation that insures deposits up to $250,000 How banks create money o Required Reserve Ratio: percentage of deposits that banks are required to hold as reserves (percentage) o Excess reserves: When the bank holds on to more than the RRR instead of loaning out the maximum they are allowed to o Potential Deposit Expansion (money multiplier): The maximum potential increase in the money supply as a ratio of new reserves injected into the banking system 1/RRR (inverse) o Actual Deposit Multiplier: New currency will not expand money supply by as much as the potential multiplier indicates because the effects of the deposit multiplier will be reduced if 1. People decide to hold onto some of their money instead of depositing it into a bank 2. Banks fail to use all of the new excess reserves to extend loans The Federal Reserve System o Instructed by congress to conduct monetary policy in a manner that promotes 1. Full Employment Recession: The Fed uses the expansionary monetary policy to increase the money supply to stimulate the economy Expansion: The Fed uses the restrictive monetary policy to make the money supply decrease 2. Price Stability Inflation causes a lot of problems so the Fed is instructed to promote monetary stability These goals are difficult to time correctly Recognition Lag Administrative Lag Impact Lag o Federal Open Market Committee 5 out of the 12 bank presidents and the 7 Board of Governors members Determines the Fed’s policy with respect to the purchase and sale of government bonds o How the Fed controls the money supply 1. Open market operations When the Fed wants to increase the money supply, it buys bonds When the Fed wants to decrease the money supply, it sells bonds 2. Reserve Requirements When the Fed wants to increase the money supply, it lowers reserve requirements When the Fed wants to decrease the money supply, it raises reserve requirements 3. Extension of loans Discount rate: interest rate that the Fed charges banks to borrow funds Federal Funds rate: interest rate that banks charge each other to borrow from each other When the Fed wants to increase the money supply, it extends more loans by lowering the discount rate When the Fed wants to decrease the money supply, it extends less loans by raising the discount rate 4. Changing the interest paid on excess bank reserves When the Fed wants to increase the money supply, it reduces the interest rate paid on excess reserves held in the Fed When the Fed wants to decrease the money supply, it increases the interest rate paid on excess reserves held in the Fed
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