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IU / Economics / ECON 202 / if there is an increase in capital per hour worked, holding technology

if there is an increase in capital per hour worked, holding technology

if there is an increase in capital per hour worked, holding technology


School: Indiana University
Department: Economics
Course: Intro to Macroeconomics
Professor: Graf p
Term: Fall 2016
Tags: Macroeconomics
Cost: 50
Name: Study Guide for Final
Description: The notes cover all modules from beginning to end. More detailed notes for chapters that covered quizzes 9-12.
Uploaded: 04/27/2016
17 Pages 6 Views 7 Unlocks

Module 1: Unemployment and Inflation

what is Unemployed?

∙ Unemployed: People who are willing and able to work, did not work the previous week, but  were available for work and actively looked for work at some time during the previous 4 weeks ∙ Labor force: Sum of the employed and the unemployed. People who are not looking for work  are not included in the labor force as well as institutionalized people (jail, military, hospitals) ∙ Civilian non-institutional Adult pop: Nonmilitary and non-institutionalized individuals aged 16  years or older who are either in the labor force or not looking for work

o = Labor force + non-labor force

∙ Underemployment rate: Individuals aged 16 years or older who are either unemployed, part time workers, or marginally attached to the labor force =  

o unemployed + part-time + marginally attached / Labor force + marginally attached X 100 ∙ Unemployment rate: Percentage of labor force that is unemployed

what is labor force?

o = number of unemployed / Labor force x 100

∙ Discouraged workers: People who have not actively been looking for a job, same as marginally  attached.  

o Biases the unemployment rate because these people are counted out of the labor force  even though they are still unemployed.  

o As duration of unemployment increases so does the unemployment rate because the  unemployed spend more time looking for jobs due to unemployment benefits

∙ Labor force participation rate: percentage of working age population in the labor force o = Labor force / Working age pop. X 100

o The higher the labor force participation rate the greater the levels of GDP

∙ Employment population ratio: Percentage of the working age population that is employed = o Employment / Non-institutional adult pop. X 100

∙ Frictional Unemployment: Results from the fact that workers must search for appropriate job  offers, but can’t find a job available. Also means in between jobs

what is Underemployment rate?

∙ Structural Unemployment: Results from a poor match of workers’ abilities and skills with  current requirements of employers Don't forget about the age old question of fin 4324 exam 1

o Replacing people with technology

o Industry specific

∙ Cyclical Unemployment: Results from business recessions that occur when aggregate (total)  demand is insufficient to create full employment

o Economy-wide loss of jobs

o Not normally occurring, bad

∙ Seasonal Unemployment: Results from the seasonal pattern of work in specific industries (Ex.  construction, education, holidays) Form of frictional unemployment

∙ Full employment: When cyclical unemployment equals zero and the only remaining  unemployment is structural and frictional (5-6%)

∙ Natural rate of unemployment: Structural + frictional: Long run unemployment once it has fully  adjusted to any changes in the economy and has been seasonally adjusted.

∙ Minimum wage: If the min. wage is set above the market wage determined by supply and  demand of labor, the quantity of labor supplied will be greater than the quantity of labor  demanded and will cause unemployment.Don't forget about the age old question of gaverick matheny

∙ Efficiency wage: Above market wage that a firm pays to motivate workers to be more  productive

∙ Purchasing power: The value of money for buying goods and services

∙ Price level: A measure of the average prices of goods and services in the economy. The cost of  today’s market basket of goods expressed as a percentage of the cost of the same market  basket during a base year. Quantity is fixed for the base year so only the price is changing. o Cost today of market basket / cost of market basket in base year X 100

∙ Inflation rate: Percentage increase in the price level from one year to the next o Price index 2 – Price index 1 / Price index 1 X 100

∙ Consumer price index (CPI): Measure of the average change over time in the prices a typical  urban family of four pay for goods and services they purchase

o = Expenditures in current year / Expenditures in base year * 100

∙ Price index: MB(current year) / MB(base year) * 100

o Market basket = Price * Quantity

o MB Year2 / MB Year1 * 100 = Price index year 2

o Inflation rate = PI Year2 – PI Year1 / PI Year1 * 100

∙ Substitution bias: It’s assumed that each month consumers purchase the same amount of each  product in the market basket while in reality products that increase in price will be purchased  less and vice versa for products that decrease in price Don't forget about the age old question of intro to ethics exam 1

∙ Increase in quality bias: Most products in the CPI improve in quality over time. Increases in  prices of these products partly reflect their improved quality and partly just inflation ∙ New product bias: If the market basket isn’t updated frequently prices of products that were  new then, will likely decrease, but the decrease won’t be included in the CPI ∙ Outlet bias: Statistics are often collected from traditional full price retailers and the CPI did not  reflect the price consumers actually paid. We also discuss several other topics like viewing problems and solutions in rigid either/or terms is known as:

∙ Producer Price Index (PPI): An average of prices received by producers of goods and services at  all stages of the production process

∙ Nominal value: Expressed in today’s dollars

∙ Real value: Value expressed in purchasing power. Nominal value adjusted for inflation. =  nominal variable / price index x 100

∙ Nominal interest rate: Interest rate stated on loan

∙ Real interest rate: Nominal interest rate minus the rate of inflation

∙ Anticipated inflation: Only some individuals will experience a cost, those whose incomes fall  behind the anticipated rate of inflation Don't forget about the age old question of anth 420 class notes

∙ Menu Costs: The costs to firms of changing prices. At high rates of inflation this can cost a lot ∙ Unanticipated inflation: If someone takes out a loan and there is expected to be very little  inflation then the bank will set interest rates low. If unanticipated inflation occurs then the real  interest rates being paid will be low and debtors/borrowers will gain, creditors will lose. ∙ Cost of Living Adjustments (COLAs): Clauses in contracts that allow for increases in specified  nominal values to account of changes in the cost of living. (a pay raise based on inflation)Don't forget about the age old question of uconn biology

Module 2: GDP

∙ Business Cycle: Alternating periods of expansion and recession

∙ Expansion: Period during which total production and total employment are increasing o Inflation rate usually increases

o Spending is strong, businesses find it easier to raise prices

∙ Recession: Total production and total employment are decreasing (opposite above) ∙ Economic growth: Ability of an economy to produce increasing quantities of goods and services ∙ Gross Domestic Product: Market value of all final goods and services produced in a country  during a year. Y = C + I + G + NX

∙ Does not include the value of used goods, only goods in current production ∙ Does not include household production: Goods and services people produce for themselves ∙ Does not include the underground economy: Concealed buying and selling to avoid government  regulations

∙ Does not include the value of leisure: After retirement someone might value their leisure time  more than they value the income they were earning before

∙ GDP is not adjusted for pollution, crime, and other negative externalities

∙ Nominal GDP: The value of final goods and services evaluated at current year prices ∙ Real GDP: Value of final goods and services evaluated at base year prices

o (Base year) real2010 Real GDP : (Q2010 * P2010) = (1000*2.8) + (2*850) = 4500 o 2014 Real GDP : (1500*2.8) + (3*850) = 6750 (Q2014 * P2010)

o = Nominal GDP / Price level(index) * 100

∙ Circular Flow Diagram

o Firms use factors of production to produce goods and services

o Households supply the factors of production in exchange for income

o Transfer of money is always on the outside

∙ Transfer payments: Payments by the government to households for which the government does  not receive a new good or service in return

∙ C = Consumer spending: Spending by the households on goods and services, not including  spending on new houses

∙ I = Investments: Spending by firms on new factories, offices, machinery, inventory, plus  spending by households and firms on new houses

∙ G = Government spending: Spending by federal, state, and local governments on goods and services

∙ Nx = Net Exports: Exports – imports. Exports are goods and services produced in the U.S. and  purchased by foreign firms

∙ Value Added: The additional market value a firm gives to a product and is equal to the  difference between the price for which the firm sells a good and the price it paid other firms for  intermediate goods.

∙ GDP Deflator: Measures the price level = Nominal GDP / Real GDP X 100

∙ Gross National Product: The value of all final goods and services produced by residents of the  US even if the production takes place outside the US

∙ Net Domestic Product (National income) = GDP - Depreciation

∙ Personal income is income received by households before they pay personal income taxes

o Net income - retained earnings – corporate taxes – social security cont. + payments  received by households from the govt (transfer payments or interest on government  bonds)

∙ Disposable Personal income = Personal income – personal taxes

∙ Durables: Goods that are expected to last for 3 or more years. Affected more by the business  cycle than nondurables

∙ Nondurables: Goods that are expected to last for fewer than 3 years (food, clothing) ∙ Economic Growth Rate: The rate of change in real GDP between two time periods o = GDP2 – GDP1 / GDP1 X 100

∙ New GDP = Old GDP * (1 + growth rate)^N (N = number of years)

Module 3: Long-Run Economic Growth

∙ Rule of 70: Calculates how many years it would take for real GDP per capita to double = 70 /  growth rate

∙ Economic growth = rate of growth of capital+ rate of growth of labor + rate of growth in the  productivity of capital and labor

∙ 5 Keys to Economic Growth

o Increase the number of resources

o Increase productivity

o Saving

o New Growth Theory = technology, patents, copyrights

o Human Capital

∙ Capital: Manufactured goods that are used to produce other goods and services. Capital stock is  a country’s total amount of physical capital

∙ Human capital: Accumulated knowledge and skills workers acquire from education or life  experience

∙ Per-worker production function: Relationship between Real GDP per hour and capital per hour  worked, holding the level of technology constant. Explains GDP in the long run

o Continual increases in GDP per capita can only be sustained with technological change o Long run increases in standard of living is due to continuing technological change ∙ New Growth Theory: Model of long run economic growth that emphasizes that technological  change is influenced by economic incentives and so is determined by the working of the market  system

∙ Knowledge capital is subject to increasing returns. It’s non-rival and non-excludable, firms can  free ride on the R&D of other firms

∙ Patent: Exclusive rights to produce a product. Government protects intellectual property to  incentivize R&D of other firms

∙ Trade secret: A product left without a patent so people cannot view the public records and  create a similar product

∙ Foreign Direct Investment (FDI): The purchase or building by a corporation of a facility in a  foreign country. A way a developing country can break out of the cycle of poverty

∙ Foreign Portfolio Investment: The purchase by an individual or firm of stocks or bonds issued in  another country

∙ Globalization: The process of countries becoming more open to foreign trade and investment

Module 4

∙ Wealth effect: Households with more income spend more on GDP. As income decreases,  consumption decreases

o Nominal assets lose value as price level rises, gain value as prices fall

o Real value of household wealth declines when prices rise

∙ Interest rate effect: When prices rise, households and firms need more money to finance buying  and selling, therefore when price level increases, banks charge higher interest rates and people  invest less. Also causes less consumption and govt. spending

∙ International trade effect: If the price level in the US rises relative to other countries, imports  will be relatively less expensive and some US consumers will shift to buying foreign products. US  exports will fall, imports will rise, and this decreases net exports.

Shifts of Aggregate Demand

∙ Monetary Policy: The Federal Reserve can lower the cost to firms and households of borrowing  by taking actions that reduce interest rates. Lower borrowing costs increases consumption and  investment spending, shifting the aggregate demand curve right. Higher interest rates shift left.

∙ Fiscal Policy: Changes in federal taxes and purchases in order to achieve macroeconomic policy  objectives. An increase in govt. spending shifts the aggregate demand curve right, lower  personal income taxes shifts the curve right, as well as decreased business taxes. ∙ Expectations of Households and Firms

o If households are optimistic about the future, they will increase their spending and  consumption, shifting the aggregate demand curve right

o If firms are positive, they increase investment spending and the AD curve shifts right ∙ Changes in Foreign Variables

o If firms and households in other countries buy less US goods or US households and firms  buy more foreign goods, net exports will decrease and cause a shift left of the AD curve. o Net exports will increase if real GDP grows more slowly in the US than other countries or  if the value of the US dollar falls

o A change in net exports that results from a change in price level in the US only creates  movement along the AD curve

LR Aggregate Supply

∙ Determined by the number of workers, the capital stock, and technology

∙ LRAS curve is vertical because changes in price level do not change the level of real GDP ∙ LRAS shifts to the right as number of workers, machinery, and tech. increases ∙ As prices of goods and services rise, prices of inputs rise more slowly leads to higher prices ∙ Prices or wages are sticky when they do not respond quickly to changes in demand or supply.  Contracts can make wages or prices sticky

∙ Menu costs: The costs to firms of changing prices. Make some prices sticky because firms don’t  want to have to pay to change their prices

Short Run Aggregate Supply Curve Shifts

∙ SRAS curve slopes upward because as the price level increases, the quantity of goods and  services firms are willing to supply increases

∙ Increases in the labor force and capital stock will shift the curve right

∙ Technological change increases workers’ productivity so firms can produce more goods and  services at the same price, shifting the AS curve right

∙ If workers and firms believe that the price level is going to increase they will try to adjust their  wages and prices accordingly and SRAS curve will shift left the equivalent amount ∙ Workers and firms sometimes make incorrect predictions about price level. If they adjust the  price level higher than expected, the SRAS curve will shift left.

∙ An unexpected increase in the price of an important natural resource, A “supply shock”, causes  the SRAS curve to shift left.

Module 5

∙ Keynsian Model: Wages and prices are sticky. LRAS is vertical, SRAS is horizontal and GDP is  strongly affected by aggregate demand (closed economy assumed)

∙ New Classical model: The economy will normally be at potential GDP like Keynes did but this  theory said wages and prices react quickly to changes in supply and demand

∙ Aggregate Demand = Consumption + Planned Investment + Government purchases + Net  exports

∙ Actual Investment = planned investment when there are no changes to inventory ∙ Macroeconomic equilibrium: GDP = Aggregate Demand

o AD > GDP, inventories will decline, and GDP and total employment will increase. o AD < GDP, inventories rise, GDP and total employment will decrease

Consumption Determinants

∙ Current Disposable income = Household income – personal income taxes + govt. transfer  payments

∙ Household wealth: Value of assets – liabilities. If wealth increases, consumption increases ∙ Expected future income: higher future income, higher future consumption ∙ Price level: As price level rises, the real value of your wealth declines and so will consumption ∙ Interest rate: high interest rates means the reward for saving is greater and so less people  spend on consumption

∙ Consumption function: Consumption increases as real disposable income increases.  o MPC = Change in consumption / Change in disposable income

∙ Disposable income = National income – net taxes

∙ National income = GDP = Disposable income + net taxes

o = consumption + saving + taxes

∙ Marginal propensity to save = Change in saving / Change in disposable income ∙ MPC + MPS = 1, when taxes are constant

∙ Average propensity to consume = Consumption / Disposable Income

Planned Investment Determinants

∙ Expectations of future profitability: Optimism or pessimism of firms determines if firms  increase spending or decrease it

∙ Interest rate: Higher real Interest rate results in less investment spending, lower interest rates  mean more investment spending

∙ Taxes: Reduction of corporate income taxes increases after tax profitability of investment.  Investment tax incentives increase investment spending because it provides firms with a tax  reduction when they buy new investment goods

∙ Cash flow: Difference between cash revenues received by the firm and their cash spending Net Exports

∙ Price level in the US relative to price levels in other countries: If inflation in the US is lower than  inflation in other countries, the prices of products are relatively lower and this increases  demand for US products in other countries, therefore increases net exports

∙ Growth rate of GDP in the US relative to in other countries: As GDP in the US increases,  household income increases faster than other countries’ household income and US households  spend more on foreign goods than foreigners spend on US goods so net exports decreases.

∙ Exchange rate between the dollar and other currencies: As the value of the US dollar increases,  prices for US goods become relatively more expensive in other countries, while goods become  relatively cheaper in the US so net exports fall.

Autonomous Expenditure

∙ Multiplier effect: Any increase in autonomous expenditure will shift up the aggregate  expenditure function and lead to multiplied increase in GDP

∙ Autonomous expenditure/consumption: spending that does not depend on the level of  GDP/Disposable income

∙ Multiplier: The increase in real GDP / increase in autonomous expenditure o = 1 / 1 – (MPC)

∙ Paradox of thrift: Keynes discovered that in the long run, saving is good for the economy, but in  the short run if households save most of their income and don’t spend it aggregate expenditure  and GDP will decline

∙ Disposable Income (Real GDP) = Consumption + Saving

o DI(Yd) = C + S

∙ Consumption = MPC * Disposable income + autonomous expenditure

o C = b(DI) + a

∙ Saving = (1 – MPC) * Disposable income – autonomous expenditure

o Saving = (1-b)(DI) – a

Module 6

∙ External funds: If firms don’t have retained earnings they need external funds. Rely on the  financial system to transfer money from savers to borrowers

∙ Financial system: System of financial markets and financial intermediaries through which firms  acquire funds from households

o Provides: risk sharing: Chance that the value of the financial security will change relative  to what you expect)

o Liquidity (ease that the security can be exchanged for money)

o Information (facts about borrowers and expectations about returns on financial  securities)

∙ Financial Intermediaries: Firms such as banks, mutual funds, pensions funds borrow funds from  savers and lend them to borrowers

∙ Financial Markets: Markets where financial securities are bought and sold ∙ Indirect finance: A flow of funds from savers to borrowers through financial intermediaries such  as banks. Intermediaries raise funds from savers to lend to firms (Ex: Bank loans) ∙ Direct finance: A flow of funds from savers to firms through financial markets, such as NYSE o Usually borrower selling lender a financial security (bonds and stocks)

∙ Bond: Financial security that represents a promise to repay a fixed amount of funds. Includes  interest payments (coupon payments) and principal (face value)

∙ Interest rate: Cost of borrowing funds, usually percentage of amount borrowed o Higher the default risk, higher interest rate

∙ Stock: Financial security that represents partial ownership of a firm

∙ Mutual funds: Investors save money by not buying stocks directly, but by buying shares of  mutual funds

o Firms use the funds to invest in financial assets such as stocks and bonds o If a firm goes bankrupt it’s not likely to affect the mutual fund

o Mutual funds will buy back shares at any time, investors easy access to their money ∙ Dividends: Payments by a corporation to its shareholders

o Dividend yield = Dividend / Closing price of stock

∙ Capital gain: If a firm uses its retained earnings to grow economic profit, its share price rises,  and provides a capital gain for investors

∙ Over the counter market: Trading stocks and bonds outside of exchanges by securities dealers (NASDAQ)

∙ Stock Market Indexes: Averages of stock prices, value of index set to 100 in the base year ∙ Price Earnings Ratio = Price of firms stock / Earnings per share

∙ Private Saving = GDP + transfer payments – consumption – taxes

o S = Y + TR – C - T

∙ Public Saving = Taxes – government purchases – transfer payments

o S = T – G - TR

∙ Total Saving in the economy = public + private saving

o S = Y – C – G

o S = I

∙ Balanced budget: When the government spends the same amount as it collects in taxes

∙ Budget deficit: T is less than G + TR so public saving is negative (Dissaving)

Market for loanable funds:  

∙ The interaction of borrowers and lenders determines the market interest rate and quantity of  loanable funds exchanged

∙ The equilibrium of the supply and demand for loanable funds determines the real interest rate ∙ Supply determined by willingness of households to save and extent of govt. saving or dissaving.  Higher interest rates mean greater reward for saving so supply curve slopes upward o Wealth (income)

o Taxes

o Government Spending – causes budget deficit, reduces total saving and results in higher  interest rates and lower investment spending. Shifting supply curve right

o Expectations of future income and price levels

∙ Demand determined by willingness of firms to borrow money for investment o Expectations of future profitability

o Productive technology – shifts curve left, firms demand more loanable funds o Business taxes – investment tax credit increases demand for loanable funds shifts  demand curve right

o Cash flow

∙ Crowding out: Decline in investment spending as a result of an increase in government  purchases. Supply of loanable funds is reduced when government is running on a budget deficit.  Normally results from a rise in interest rates

o Change in I = Change in govt spending * crowding out %

∙ Present Value = Future Value / (1 + r)^N (r = interest rate, N = number of years) ∙ Efficient Markets Hypothesis - The theory that asset prices reflect all publicly available  information about the value of an asset.

Module 8 – Fiscal Policy

∙ Discretionary Fiscal Policy: The changes in government expenditures and/or taxes in order to  achieve certain national economic goals (High employment, price stability, economic growth,  improvement of international payments balance)

o Largest component of g expenditures = transfer payments

∙ Automatic Stabilizers: Changes in government spending and taxation that occur automatically  without deliberate action of congress (The tax system, Unemployment compensation, Welfare  spending)

∙ Expansionary fiscal policy: Increase government spending, decrease taxes and AD will increase,  shift to the right, and GDP will increase

∙ Contractionary fiscal policy: Decrease government spending, increase taxes and AD will  decrease, shift to the left, and GDP will decrease

∙ Multiplier = 1 / (1 – MPC)

∙ Tax Multiplier = MPC / (1 – MPC)

Four offsets of Fiscal Policy

∙ Direct Expenditure Offsets: Government spending may compete in the private markets. Any  increase in government spending in an area that competes with the private sector will have  some direct expenditure offset

∙ The Ricardian Equivalence Theorem: The proposition that an increase in the government  budget deficit has no effect on aggregate demand.  

o Complete crowding out, especially in the long run

o People anticipate that a larger deficit today will mean higher taxes in the future and  adjust their spending accordingly

∙ Supply-Side Economics: Expansionary fiscal policy involving the reduction of marginal tax rates  in order to: increase productivity, since individuals will work harder and longer, save more, and  invest more, which will lead to more economic growth (shift LRAS and SRAS right)

∙ Time lags: Recognition Time Lag (not a recession until 6 months of negative economic growth),  Action Time Lag (bill passed through house, senate, president), Effect Time Lag ∙ Laffer Curve: Higher taxes will increase tax revenue until they reach maximum and will continue  to have decreasing profits

∙ Budget deficit: When government spending is greater than tax revenue

o Financed by selling government securities

∙ Balanced Budget: Spending = tax revenue

Module 9 – Monetary Policy

∙ Money: Any medium that people generally accept in exchange for goods and services ∙ Functions of money are:

o Medium of exchange – Any asset that sellers will accept as payment

o Unit of accounting – A measure by which prices are expressed, standard value o Store of value (purchasing power) – Ability to hold value over time, can transfer wealth  into the future

o Standard of deferred payment – Means of settling debts into the future

∙ Liquidity: The degree to which an asset can be acquired or disposed of without much danger of  any intervening loss in nominal value and with small transaction costs. Money is the most liquid  asset

∙ Fiduciary monetary system: Acceptable, predictable, durable, divisible

∙ M1: Currency, Checkable (transaction) deposits, Traveler’s checks not issued by banks ∙ M2: M1 + savings deposits + money market deposit accounts (MMDA) + small denomination  time deposits (ex. CDs) + retail money market mutual funds  

∙ Function of Central banks:  

o Perform banking functions for their nations’ government

o Provide financial services for private banks

o Conduct their nations’ monetary policies

∙ Functions of the Fed:  

o Supplies the economy with fiduciary currency

o Provides a clearing mechanism for checks

o Holds depository institutions reserves

o Acts as the government’s fiscal agent

o Supervises member banks

o Acts as the “lender of last resort”

o Regulates the money supply

o Intervenes in foreign currency markets

∙ Legal (Total) Reserves (TR): Anything that the law permits banks to claim as reserves ∙ Reserve Requirement: Reserve Ratio * Checkable deposits

∙ Excess Reserves: legal reserves – required reserves

∙ Money Multiplier: Gives the maximum potential change in the money supply due to a change in  excess reserves

o 1 / required reserve ratio

o Change in money supply = money multiplier * change in excess reserves ∙ Open Market Operations: Buying & selling of government bonds by the Fed o Most important, largest daily means to control the supply of money

o Buying securities increases bank reserves & thus money supply  

o Selling securities, bank reserves & money supply decreases

∙ Reserve Ratio: Required percentage banks must hold at Fed or in vault

o Raising the reserve ratio increases required reserves, decreases excess reserves, thus  decreasing money supply

o Lowering the reserve ratio increases the money supply

∙ Discount Rate: The interest the Federal Reserve charges for reserves it lends to depository  institutions

o Lowering discount rate, encourages bank borrowing from Fed, increases required &  excess reserves & the money supply

o Increasing discount rate, discourages borrowing, decreases required & excess reserves  & money supply

∙ Expansionary monetary policy: Solve a recessionary gap

o Fed buys bonds

o Lowers the reserve ratio

o Lowers the discount rate

o Increasing the price level, real GDP & employment even more

∙ Contractionary monetary policy: solves an inflationary gap

o Fed sells bonds

o Raises the reserve ratio

o Raises the discount rate

o Decreasing the price level, real GDP & employment  

∙ Quantity theory of Money: Money supply * Velocity of money (avg. number of times each  dollar in the money supply is used to purchase goods and services in GDP) = Price Level * Real  output

o M * V = P * Y

o Growth rate of the money supply + Growth rate of velocity = Growth rate of the price  level (inflation rate) + Growth rate of real GDP

∙ Inflation rate = Growth rate of the money supply – Growth rate of real GDP o If growth rate is constant

Impact of expansionary monetary policy

∙ Net Export Effect:

o Increase the money supply

o interest rates fall

o value of the dollar falls

o net exports increase

o the net export effect complements the effectiveness of monetary policy

∙ Monetary Theory (Milton Friedman): Increase in the money supply increases aggregate demand  directly and can effect real GDP in the short-run

o Based on the quantity theory of money, only the price level will rise in the long-run  when the money supply is increased

o Time lags are too long to use monetary policy effectively

o Monetary policy is seen as a destabilizing force

o Increase in the money supply smoothly at a rate consistent with the economy’s long-run  average growth rate

∙ Federal Funds Rate: The interest rate that depository institutions pay to borrow reserves in the  interbank federal funds market

Module 10 – International Economics

∙ Balance of Trade: The value of goods bought and sold in the world market

∙ Balance of Services: The value of services bought and sold in the world market ∙ Net Exports (NX): The difference between exports and imports of goods and services (Balance of  Trade + Balance of Services)

∙ Balance of Payments: A summary record of a country’s economic transactions with foreign  residents and governments over a year

o CA + FA + capital account + statistical discrepancy

o If Current account is surplus, financial account must be deficit

∙ Current Account: Net exports, Net income on investments, Net transfers

o Exports exceed imports = Current account surplus

o Imports exceed exports = Current account deficit

∙ Financial Account: Foreign Direct Investment (physical capital), Foreign Portfolio Investments  (stocks and bonds), Other investment assets, Reserve assets

o Measure of net capital flows: Capital inflows – capital outflows

∙ Opposite of Net foreign investment: Capital outflows – capital inflows

∙ Capital Account: Migrant transfer of goods and assets: copyrights, trademarks, etc. ∙ Current Account + Financial Account = 0

∙ Current Account = -Financial Account

∙ Current Account = Net Exports

∙ Net Exports = Net foreign Investment

∙ Net foreign Investment = -Financial Account

∙ - Financial Account = - Capital Flows

∙ - Net capital flows = Net Foreign Investment

∙ S = I + NX, S = I + NFI

∙ Every U.S. transaction involving the importation of foreign goods, services, foreign direct and  portfolio investment constitutes a supply of dollars (and a demand for some foreign currency),  and the opposite is true for export transactions

Market determinants of exchange rates

∙ Changes in real interest rates

∙ Perceptions of economic stability

∙ Changes in productivity

∙ Changes in product and asset preferences

∙ Relative price levels

∙ Currency expectations

Exchange Rates

∙ Real exchange rate (XRr): the market exchange rate (nominal exchange rate) adjusted for price  differences between countries

o Price of domestic goods in terms of foreign goods

∙ XRr = (nominal exchange rate) * Domestic price level / Foreign price level

Fiscal Policy

A. Changes in federal taxes and purchases that are intended to achieve macroeconomic policy  goals

B. Automatic Stabilizers: Gov’t spending and taxes that automatically increase of decrease along  with the business cycle

1. Happens without actions by the government

2. Ex. When the economy improves, spending for unemployment insurance decreases  automatically

C. Discretionary Fiscal Policy: the government takes actions to change spending or taxes 1. Ex. Tax cuts and spending increases in the ARRA that Congress and the president enacted in  2009

D. When the economy in a recession, increases in gov’t purchases or decreases in taxes will  increase aggregate demand.

E. Expansionary Fiscal Policy: either an increase in gov’t purchases or a decrease of taxes  1. An increase in gov’t purchases will increase aggregate demand  

2. Cutting taxes can increase disposable income and consumption spending. The cut in taxes  for businesses could increase aggregate demand by increasing business investment 3. The goal of both expansionary monetary and fiscal policy is to increase aggregate demand  relative to what it would have been without the policy.

F. Contractionary Fiscal Policy: decreasing gov’t purchases or increasing taxes 1. Policymakers use contractionary fiscal policy to reduce increases in aggregate demand that  seem likely to lead to inflation

G. Multiplier Effect: the series of induced increases in consumption spending that results from an  initial increase in autonomous expenditures (1/1-MPC) or (1/MPS)

H. Tax Multiplier= Change in equilibrium real GDP / change in taxes

1. The higher the tax rate, the smaller the multiplier effect

2. A cut in the tax rate increases the disposable income of households, which leads them to  increase consumption  

3. A cut in the tax rate increases the size of the multiplier effect

I. Real GDP does not increase by the full amount that the multiplier effect indicates because of the  rise in price level (SRAS is upward sloping not horizontal or constant)

J. Fiscal policy is delayed whereas monetary policy can be implemented almost immediately K. Crowding out: a decline in private expenditures as a result of an increase in gov’t purchases L. When the dollar increases in value, the prices of U.S. products in foreign countries rise which  

causes a reduction in exports and the prices of foreign products in the U.S. to fall M. In the long run, any increase in gov’t spending must come at a decrease of private expenditures  because potential GDP = real GDP in the long run

N. In the long-run, a higher government budget deficit will result in an increase in the gov’t share of  the nation’s economic activity. The deficit also means that foreign investment will increase and  cause a higher trade deficit as exports decrease.

O. Tax simplification will shift the LRAS right because output is higher and at a lower price level.


A. The Functions of Money

1. Medium of Exchange

- Willing to accept for a good or service

- Durable

- Valuable

- Divisible

- Standardized quality

2. Unit of Account

- Measurement of value in the economy in terms of money

3. Store of Value

- Hold value overtime and have liquidity to convert into a medium of exchange 4. Offers a Standard of Deferred payment

- Facilitates exchange over a given point in time

B. Commodity money depends on purity

C. Fiat money: Money authorized by a central bank or gov’t that does not have to be exchanged by  the central bank for gold or some other commodity money

D. The Fed regulates the money supply

E. M1

1. Currency, all paper money and coins held by households and firms

2. The value of all checking account deposits in banks

3. The value of traveler’s checks

F. M2

1. M1 + savings account deposits, small denomination time deposits, balances in money  market deposit accounts in banks, and noninstitutional money market fund shares G. Reserves: deposits that a bank keeps as cash in its vault or on deposit with the Fed H. Required Reserves: reserves that a bank is legally required to hold based on its checking  deposits

I. Required reserve ratio: the minimum fraction of deposits banks are required by law to keep as  reserves

J. Excess reserves: reserves that banks hold over legal requirement

K. Deposits are a bank’s largest liability

L. Monetary policy: the actions the Fed takes to manage the money supply and interest rates to  pursue economic policy objectives through the use of three tools

1. Open market operations- buy and selling of gov’t securities by the Fed in order to control  the money supply

2. Discount rate- the interest rate the Fed charges on discount loans, lower discount rates  means banks are encouraged to take additional loans to increase their reserves 3. Reserve rate- when reduced, it converts required reserves into excess reserves

Monetary Policy

A. Goals

1. Price Stability

2. High Employment

3. Stability of Financial Markets and institutions

4. Economic Growth

B. Policy Tools

1. Buy or sell bonds

2. Increase or decrease the discount rate

3. Increase or decrease the reserve ratio

C. Targets the money supply and the interest rate

D. The demand curve for money in downward sloping

1. The demand curve for money shifts when variables other than interest rate change - Note: a change in interest rate would just be a movement along the curve 2. Real GDP and price level cause the demand curve to shift

- A decrease in real GDP means consumption decreases which decreases the demand for  money as a medium of exchange. Demand curve will shift left.

E. Supply of money is affected when Fed sells or buys bonds

1. Supply increases when the Fed buys bonds because the sellers of these bonds deposit  money into banks which increases the reserves

2. Supply decreases when the Fed sells bonds which decreases the money supply F. The money market model is concerned with the short-term nominal rate of interest G. Aggregate demand is affected by changes in interest rates

- Lower interest rates increase consumption (C), higher interest rates decrease  consumption and lead to more saving

- Lower interest rates encourage more investment projects (I), and higher interest rates  discourage investment projects

- Lower interest rates will discourage foreign investment which increases NX, higher  interest rates encourage foreign investment which decreases NX

H. Expansionary monetary policy: the Fed’s policy of lowering interest rates or increasing the  money supply

I. Contractionary monetary policy: the Fed’s policy of increasing interest rates or decreasing the  money supply

The Effects of Monetary Policy

A. The Current Account

1. A part of balance payments that records a country’s NX, net income on  investments, and net transfers

2. Any payments received by U.S. residents are positive and payments made are  negative

B. The balance of trade is the difference between the value of goods a country exports  versus the value of goods a country imports

C. The Financial Account

1. Deals with foreign physical capital, financial investments, reserve assets 2. Measure of net capital flows which is the opposite of Net Foreign Investment

D. The balance of payments is always zero

1. Current Account+Financial Account= 0

2. What affects the balance of payments

a. Inflation among trading partners

b. Political Stability

c. Interest Rates among trading partners

E. Saving= Investment +Net Exports*

*Net Exports = Net Foreign Investment

F. Market determinants of exchange rates

1. Changes in real interest rate (increase in the rate means demand for U.S. dollar  increases because it is now worth more)

2. Perceptions of economic stability

3. Changes in Productivity

4. Relative Price Levels

5. Current Expectations

G. Real Exchange rates= nominal exchange rate * (domestic price level/ foreign price level)

H. How does a country’s currency depreciate?

1. An increase in supply or a decrease in demand for USD in USD Market 2. Another country’s currency increases in demand or a decrease in that country’s  supply

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