New User Special Price Expires in

Let's log you in.

Sign in with Facebook


Don't have a StudySoup account? Create one here!


Create a StudySoup account

Be part of our community, it's free to join!

Sign up with Facebook


Create your account
By creating an account you agree to StudySoup's terms and conditions and privacy policy

Already have a StudySoup account? Login here

Final Study Guide

by: Kate Notetaker

Final Study Guide Econ 1012

Kate Notetaker

Preview These Notes for FREE

Get a free preview of these Notes, just enter your email below.

Unlock Preview
Unlock Preview

Preview these materials now for free

Why put in your email? Get access to more of this material and other relevant free materials for your school

View Preview

About this Document

Notes cover Chapters 15 and 16.
Dr. John Volpe
Study Guide
50 ?




Popular in Macroeconomics

Popular in Economcs

This 9 page Study Guide was uploaded by Kate Notetaker on Wednesday April 27, 2016. The Study Guide belongs to Econ 1012 at George Washington University taught by Dr. John Volpe in Spring 2016. Since its upload, it has received 38 views. For similar materials see Macroeconomics in Economcs at George Washington University.


Reviews for Final Study Guide


Report this Material


What is Karma?


Karma is the currency of StudySoup.

You can buy or earn more Karma at anytime and redeem it for class notes, study guides, flashcards, and more!

Date Created: 04/27/16
Chapter 15  Monetary policy  actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy goals  Four main monetary policy goals o Price stability  Rising prices erode the value of money as a medium of exchange and a store of value  Inflation o High employment  Employment Act of 1946 o Stability of financial markets and institutions  Makes funds available to banks in times of crisis, ensuring confidence in those banks  2008  Fed temporarily made these discount loans available to investment banks  Ease their liquidity problems o Economic growth  Encourages long-run investment  Congress and the President may be in a better position to address this goal  Stability and high employment sometimes referred to as dual mandate  Three monetary policy tools o Open market operations o Discount policy o Reserve requirements  Uses the monetary policy tools to try to influence the unemployment and inflation rates o Directly influencing its monetary policy targets  Money supply  Interest rate o Higher interest rate results in a lower quantity of money demanded  Opportunity cost of holding money is higher when the interest rate is high  Shifts in the Money Demand Curve o Change in the need to hold money, to engage in transactions  Higher real GDP or higher price level  demand for money will be higher  Decreases in real GDP or price level  decrease money demand  Fed altering the money supply o Increase the money supply  Fed buys US Treasury securities  Sellers deposit the sale proceeds in a checking account  Money gets loaned out o Decrease the money supply  sell US Treasury securities  Equilibrium in the Money Market o We assume the Fed can completely control the money supply  vertical line o Equilibrium occurs where the money supply and demand cross o When the Fed increases the money supply  short term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money o Fed lowers the money supply  selling securities  Firms and households who bought the securities  have less money than they want  Banks are forced to offer a higher interest rate on interest bearing accounts  The loanable funds model o Concerned with long-term real rate of interest o Relevant for long-term investors  Money market model o Concerned with short-term nominal rate of interest o Most relevant for the Fed  changes in money supply directly affect this interest rate  Fed targets the federal funds rate o The interest rate banks charge each other for overnight loans o Does not set the federal funds rate  affects the supply of bank reserves through open market operations  How interest rates affect Aggregate Demand o Consumption  Lower interest rates encourage buying on credit  affects sale of durables  Discourage saving o Investment  Lower interest rates  encourage capital investment by firms  Makes it cheaper to borrow  Makes stocks more attractive for households to purchase  allows firms to raise funds by selling additional stock  Lower rates  encourage new residential investment o Net exports  High US interest rates attract foreign funds  raises the US exchange rate  causes net exports to fall and vice versa  Expansionary monetary policy  takes actions to decrease interest rates to increase real GDP o Decreases in interest rates raise consumption, investment and net exports o When short run equilibrium real GDP was below potential real GDP o Increase in aggregate demand encourages increased employment  Economy producing above potential GDP o Fed may perform contractionary monetary policy  increases interest rates to reduce inflation  Fed is mostly concerned with long run growth  Completely offsetting a recession is not realistic  can only make recessions milder and shorter o Current economic variables are rarely known  If the Fed keeps interest rates low for too long  encourages real GDP to go far beyong potential GDP o Results in high inflation o The next recession will be more severe  Fed sets policy according to what it forecasts the state of the economy will be in the future  Expansionary policy  “loose” or “easy” monetary policy o FOMC orders an expansionary policy o Money supply increases and interest rates fall o Investment, consumption and net exports all increase o The AD curve shifts to the right o Real GDP and the price level rise  Contractionary policy  “tight” monetary policy o FOMC orders a contractionary policy o Money supply decreases and interest rates rise o Investment, consumption, and net exports all decrease o AD curve shifts to the left o Real GDP and the price level fall  Dynamic aggregate demand and aggregate supply model o Annual increases in long-run aggregate supply (potential GDP) o Typically, larger annual increases in aggregate demand o Typically, smaller annual increases in short-run aggregate supply o Therefore, annual increases in the price level  Expansionary monetary policy  increase aggregate demand o Real GDP at its potential o Higher level of inflation than would otherwise have occurred  Milton Friedman advocated a monetary growth rule o Increases the money supply at about the long-run rate of real GDP growth o An active countercyclical monetary policy  serve to destabilize the economy  Monetary growth rule would provide stability instead o Now  targeting the money supply is not seriously considered  Why not target both the interest rates and the money supply? o It is impossible  the two are linked through the money demand curve o A decrease in the money supply will increase interest rates  Increase in the money supply will increase interest rates  The Taylor Rule  John Taylor o Links the Fed’s target for the federal funds rate to economic variables o Federal funds target rate = current inflation rate + real equilibrium federal funds rate + ((1/2) x Inflation gap) + ((1/2) x Output gap) o Real equilibrium federal funds rate  Estimate of the inflation-adjusted federal funds rate that would be consistent with maintaining real GDP at its potential level in the long run o Inflation gap  Difference between current inflation and the Fed’s target rate of inflation  Could be positive or negative o Output gap  Difference between current real GDP and the potential GDP  Could be positive or negative o Good predictor of the federal funds target rate  Alternative to targeting interest rates or the money supply  target inflation  Inflation targeting  conducting monetary policy so as to commit the central bank to achieving a publicly announce level of inflation o Inflation is lower but unemployment is (temporarily) higher o Arguments for inflation targeting  Clear that the Fed cannot affect real GDP in the long run  Easier for firms and households to form expectations about future inflation  improve their planning  Reduce chance of abrupt changes in monetary policy  Promotes Fed accountability o Arguments against inflation targeting  Reduces the Fed’s flexibility to address other policy goals  Assumes the Fed can correctly forecast inflation rates  may not be true  Fed being less likely to address other beneficial goals  Bubble  refers to a situation in which prices are too high relative to the underlying value of the asset o Form due to:  Herding behavior  failing to correctly evaluate the value of the asset  instead relying on other people’s apparent evaluations  Speculation  believing that prices will rise even higher  buying the asset intending to sell it before prices fall  Housing Market Bubble of the 2000s o High prices resulted in high levels of investment in new home construction o Optimistic sub-prime loans o 2006 and 2007  house prices started to fall, in part because of mortgage defaults  New home construction fell considerably  Banks became less willing to lend  Resulting credit crunch further depressed the housing market  Secondary market in mortgages  made possible by the formation of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation o Government sponsored enterprises sell bonds to investors and use the funds to purchase mortgages from banks o Allowed more funds to flow into mortgage markets  Mortgage-backed securities  investment banks started reselling to investors o Appealing to investors because they paid high interest rates with apparently low default risk o More money flowing into mortgage markets, “worse” loans started to be made  To people with worse credit histories  Without evidence of income  With lower down-payments  Who couldn’t initially afford traditional mortgages  When the housing bubble burst  more lower-quality loans were defaulted on than investors were expecting o Market for securities became very illiquid  few people or firms were willing to buy them, prices fell quickly o Many commercial and investment banks were invested heavily  suffered heavy losses Chapter 16  Fiscal policy  changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives  Automatic stabilizers  some forms of government spending and taxes automatically increase or decrease along with the business cycle  Discretionary fiscal policy  refers to intentional actions the government takes to change spending or taxes  Federal purchases consist of o Defense spending and “everything else”  salaries of FBI agents, operating national parks, and funding scientific research  Federal expenditures o Half are spent on transfer payments  Social Security, Medicare, and unemployment insurance o Rest is spent on grants to the state and local governments  To support their activities (crime prevention and education)  Also on paying interest on the federal debt  Federal Revenues o Majority come from taxes on individual employment  Individual income taxes and “payroll taxes” earmarked to fund Social Security and Medicare o One-seventh  taxes on corporate profits o Remainder comes from excise taxes, tariffs on imports, and other fees from firms and individuals  Expansionary fiscal policy  increasing government purchases or decreasing taxes o Increasing government purchases directly increases aggregate demand o Decreasing taxes indirectly affects aggregate demand  By increasing disposable income  hence consumption spending  If the government believes real GDP will be below potential GDP  can enact expansionary fiscal policy in an attempt to restore long- run equilibrium o Decreases unemployment  Contractionary fiscal policy  decreasing government purchases or increasing taxes o Works just like expansionary fiscal policy  in reverse  If the government believes real GDP will be above potential GDP  can enact contractionary fiscal policy in an attempt to restore long- run equilibrium o Decreases inflation  Countercyclical fiscal policy  federal government’s actions with contractionary and expansionary fiscal policy  Expansionary fiscal policy in the Dynamic Aggregate Demand and Aggregate Supply Model o Initially, economy is in long-run equilibrium o Fed projects that aggregate demand will not rise by enough to maintain full employment o Enacts an expansionary fiscal policy o Price level is higher than it would have been without the expansionary fiscal policy  Contractionary Fiscal Policy in the Dynamic Aggregate Demand and Aggregate Supply Model o Economy starts in long-run equilibrium o Fed projects that aggregate demand will rise so much that employment is beyond the full employment level  causing high inflation o Enacts a contractionary fiscal policy  decrease aggregate demand  Ideally to the full employment level  Autonomous increase in aggregate demand o If the government increases it spending on goods and services, then aggregate demand increases immediately  Induced increase in aggregate demand o People receive this increase spending as increase income and increase their consumption spending accordingly  Multiplier effect  series of induced increases in consumption spending that results from the initial increase in autonomous expenditures  Government purchases multiplier = (change in equilibrium real GDP)/(change in government purchases)  Tax multiplier = (change in equilibrium real GDP)/(change in taxes) o Will be a negative number  increase in taxes will decrease equilibrium real GDP o Expect to be smaller than the government purchases multiplier o Applies to changes in the amount of taxes, without changes in tax rates o Decreases in tax rates have a slightly different effect  Increasing the disposable income of households, leading them to increase their consumption spending  Increasing the size of the multiplier effect, since more of any increase in income becomes disposable income  Increase in aggregate demand  not only increase real GDP but also increase price level o Because the short-run aggregate supply curve is upward sloping  Multipliers work in both directions o Increase in government purchases and a cut in taxes have a positive multiplier effect o Decrease in government purchases and an increase in taxes have a negative multiplier effect  Timing fiscal policy is harder, due to: o Legislative delay  Congress needs to agree on the actions o Implementation delay  Large spending projects may take months or even years to begin, even once approved  Government spending might crowd out private spending o Crowding out  decline in private expenditures as a result of an increase in government purchases  Crowding out in the short run o Temporary increase in government purchases  demand for money and interest rate will rise o Higher interest rate  consumption, investment and net exports all fall o Initial increase in spending  partially offset by the crowding out  Crowding out in the long run o Increase in government purchases  no effect on real GDP  Reduction in consumption, investment and net exports will exactly offset the increase in government purchases  In the long run, economy returns to potential GDP  even without the government’s intervention o Long run effect  increase the size of the government sector within the economy  The intermediate increase in real GDP may be worth the cost  Budget deficit  occurs when the government’s expenditures are greater than its tax revenue o Often occur during war time o Also occur during recessions, as tax receipts fall and automatic stabilizers like increases in transfer payments take effect  Budget surplus  occurs when the government’s expenditures are less than its tax revenue  Cyclically adjusted budget deficit or surplus  deficit or surplus in the federal government’s budget if the economy were at potential GDP  During a recession, tax revenues fall o To balance the budget, spending would have to fall also  making the recession worse  Federal Government Debt o Federal government runs a budget deficit  finances its activities by selling Treasury securities  Total value of those securities outstanding  federal government debt or the national debt  Fed is at no serious risk of defaulting on its obligations because: o Interest rate it can borrow money at is very low o Size of the interest payments on the debt is low relative to the size of the federal budget  Posttax wage  when an individual decides how much to work and bases the decision on how much an hour of work will increase his ability to consume goods and services  Pretax wage  when a firm decides how many people to employ and considers how much it has to pay in total for each worker  Tax wedge  difference between the pretax and posttax return to an economic activity o Large tax wedge distorts the incentives of individuals and firms to take part in economic activities  Results in lower levels of economic activity  lower real GDP  The larger tax rates are, the large the behavioral response to the tax will be o Individual income tax  Affects labor supply decisions and the returns to entrepreneurship o Corporate income tax  Affects the incentives of firms to engage in investment o Tax on dividends and capital gains  Affects the supply of loanable funds from households to firms, and hence the real interest rate  Affects the way firms disburse profits  Simpler taxes o Would lead to economic gains for society o Current tax code is extremely complicated o IRS estimates that taxpayers spend more than 6.4 billion hours each year filling out their tax returns o Simplified tax code would increase economic efficiency by reducing the number of decisions households and firms make solely to reduce their tax payments  Decreasing tax rates would likely result in more economic activity  effect is debatable o Workers may not be able to change their work hours very much o Savings and investment may not be affected much by tax rates o Majority of the effect of tax rate cuts may come through aggregate demand 


Buy Material

Are you sure you want to buy this material for

50 Karma

Buy Material

BOOM! Enjoy Your Free Notes!

We've added these Notes to your profile, click here to view them now.


You're already Subscribed!

Looks like you've already subscribed to StudySoup, you won't need to purchase another subscription to get this material. To access this material simply click 'View Full Document'

Why people love StudySoup

Steve Martinelli UC Los Angeles

"There's no way I would have passed my Organic Chemistry class this semester without the notes and study guides I got from StudySoup."

Janice Dongeun University of Washington

"I used the money I made selling my notes & study guides to pay for spring break in Olympia, Washington...which was Sweet!"

Jim McGreen Ohio University

"Knowing I can count on the Elite Notetaker in my class allows me to focus on what the professor is saying instead of just scribbling notes the whole time and falling behind."


"Their 'Elite Notetakers' are making over $1,200/month in sales by creating high quality content that helps their classmates in a time of need."

Become an Elite Notetaker and start selling your notes online!

Refund Policy


All subscriptions to StudySoup are paid in full at the time of subscribing. To change your credit card information or to cancel your subscription, go to "Edit Settings". All credit card information will be available there. If you should decide to cancel your subscription, it will continue to be valid until the next payment period, as all payments for the current period were made in advance. For special circumstances, please email


StudySoup has more than 1 million course-specific study resources to help students study smarter. If you’re having trouble finding what you’re looking for, our customer support team can help you find what you need! Feel free to contact them here:

Recurring Subscriptions: If you have canceled your recurring subscription on the day of renewal and have not downloaded any documents, you may request a refund by submitting an email to

Satisfaction Guarantee: If you’re not satisfied with your subscription, you can contact us for further help. Contact must be made within 3 business days of your subscription purchase and your refund request will be subject for review.

Please Note: Refunds can never be provided more than 30 days after the initial purchase date regardless of your activity on the site.