Tulane Macroeconomics 1020 with Toni Weiss Final Study Guide
Tulane Macroeconomics 1020 with Toni Weiss Final Study Guide ECON 1020
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Final Study Guide for Macro 1020 with Toni Weiss By Ian Seaman 1/12: The Circular Flow of Wealth: Capital an already produced good that produces more goods (machinery, technology, tools etc.), it is NOT money because it cannot produce other goods 1/14 Production Possibilities Frontier scarcity (limited resources) leads to choices which results in opportunity cost, this is how we measure them: ● more of Good A = less of Good B ● opportunity cost is not constant ● as one goes down the curve, resources are allocated to better suit that good (good A) Law of Increasing Opportunity Cost not all resources are equally well suited to the production of all goods (this is the reason why the curve is bowed out) m = not using all resources or not using them efficiently c = unattainable/ unsustainable Economic Growth when previously unattainable and/or unsustainable levels of production become attainable and sustainable, There are two ways to achieve this: ● new technology ● more resources The Business Cycle: The Study of Macroeconomics: ● attempts to measure a healthy economy such indicators include: ○ steady and sustainable economic growth ○ low levels of unemployment ○ stable prices/inflation ● they measure this through: ○ Gross Domestic Product ○ Unemployment Rate ○ Consumer Price Index Gross Domestic Product the value, in dollars, of all final goods and services that are produced within a country, for the marketplace, within a given time period 1/19 Natural Rate of Unemployment full employment (about 5% unemployment) Intermediate Good produced goods used in the production of final goods Bureau of Economic Analysis branch that calculates GDP every three months Gross National Product value of all final goods and services as produced by that nation’s citizens, regardless of where it’s produced. GDP vs. GNP: ● GDP would be the money made from a Japanese company with factories operating in the USA ● GNP would exclude that ^, but would include an Americanowned business’s profits (take CocaCola for instance) from a factory in Brazil for example ● GDP is also a flow variable, meaning it is calculated quarterly against past GDPs to measure growth Calculating GDP: ● there are three ways of calculating GDP, technically these methods should add up to approximately the same number ○ Expenditure Approach ○ Factor Income Approach ○ Value Added Approach Expenditure Approach: ● idea that money spent on goods and services = value of all final goods and services ● hence, we must add up all that money that was spent on goods and services (C + I + G + Nx) ● there are 4 economic entities that buy/spend money on goods and services: ○ Households C (consumption of goods, durable and nondurable) makes up 70% of GDP ○ Foreign Countries Nx (net exports = exports imports) ○ Government G (all government spending, transfers are not counted) ○ Businesses I Gross Private Domestic Investment (I): ● firms/businesses purchasing capital, residential investment (construction of new houses), nonresidential investment, and changes in inventory levels ● Change in inventory levels means the increase in a business’s product kept in anticipation for sale/demand of them later ● Change in inventory levels can be either positive or negative, if it's positive it is added to GDP, if it is negative, it is subtracted from GDP. ● capital can either increase productive capacity or replace worn out capital =Depreciation *Side note; Gross means depreciation has been included, for example in GDP depreciation is accounted for, but in NDP (National Domestic Product) it is not 1/26 The Expenditure Approach: GDP = C + I + G + Nx Nx = net exports (Ex Im) Factor Income Approach: ● hinges on idea that every time something is produced an equal amount of income is generated ● National Income = wages + rent + interest + profit, synonymous with Net National Product (NNP) ● Gross National Product = National Income + Depreciation ● GDP = GNP + factor income to the rest of the world (payments to the rest of the world) factor income from the rest of the world (receipts from the rest of the world, like coke factories in other countries) ● Personal Income = National Income + Income received but not earned (transfer payments) income earned but not received (payroll taxes and retained earnings) ● 6.2% of what you earn in payroll taxes (you pay half of it and your employer pays another half), income taxes are different, payroll taxes are taken monthly ● Retained Earnings first option for what to do with corporate profits (save the profit to invest in the company) ● Dividends second option for what to do with corporate profits is to pay shareholders in what we call dividends ● Disposable (Personal) Income = personal income taxes Value Added Approach as a product moves through the manufacturing process, each stage of the process adds value to the original base cost, leading up to the retailer placing a final price tag on it, which is then taken as the final good, the value put into GDP Nominal GDP GDP in current dollars Real GDP removes influence of changing price Calculating GDP in Current or Base Year Dollars: ● Fixed Weight Method fixes prices in a certain arbitrary year and then uses these prices to calculate real GDP (now used to calculate CPI) ● Example: prices are fixed at 2009 prices ○ Real GDP(2009) = # of cranes produced in 2009 x Prices in 2009 ○ Real GDP(2010) = # of cranes produced in 2010 x Prices in 2010 ● Economic Growth = Real GDP(2015) Real GDP(2014) / Real GDP(2014) ● The current, ideal method is the chain weighted method (changing weights) Unemployment Rate: ● Underemployment Rate = # of people unemployed / # of people unemployed + # of people employed ● Labor Force = # of people unemployed + # of people employed ● the unemployment rate is calculated by the Bureau of Labor Statistics, on the first friday of every month ● Unemployed have looked for a job within the past 4 weeks or laid off from a job and waiting to be called back ● Employed have to have worked 1 hour during the past week Underemployment Rate workers working parttime involuntarily, creates discouraged workers Labor Force Participation Rate = # of people in the labor force / civilian working age population Civilian Working Age Population (CWAP) = Total Population under 16yearolds military institutionalized Employment to Population Ratio = # of people employed / CWAP Types of Unemployment: ● Frictional Unemployment unemployment by your doing, this could be seeking a job because you want one or you screwed up at your job and got fired and have to get a new job ● Structural Unemployment mismatch between needs of employers and skills of employees (jobs that essentially disappear because they become obsolete etc.) ● Frictional + Structural = Natural Rate of Unemployment ● Cyclical Unemployment unemployment due to ups and downs with the business cycle ● when actual GDP = potential GDP, Cyclical = 0 2/2 *If actual unemployment rate is less than natural then we are producing on the exterior of PPF Consumer Price Index (CPI) a seasonally adjusted measure of how much it costs the typical urban household to purchase a defined bundle of goods compared to a base year. The BLS calculates this monthly, the census bureau creates the bundle, what’s called the Market Basket. Two kinds of CPIs are calculated; the National CPI (National Inflation) and Regional CPIs Market Basket if families on average buy a plane ticket every year, then 1/12th of that price of that ticket goes into the basket. This shows people’s buying habits every 2 years. Tax is not counted CPI = value of the market basket in current prices/value of the market basket in base year prices (19841986) x 100 (no units) Ex. If in 2014, the CPI is 105, then we know prices have increased 5% (105100) from the base year *CPI also calculates the inflation rate and real income Inflation Rate (CPI of 2014 CPI of 2013)/CPI of 2013 x 100 [New Old/Old x 100] = % inflation (REMEMBER UNITS) Ex. Given a CPI of 2013 of 102.7 and a CPI of 2014 of 105, then we know the average price of goods has increased by 2.24% from 2013 to 2014 Core CPI removes constantly fluctuating prices of goods such as foods and utilities (energy) 2/4 Inflation Rate: ● the inflation rate may be positive and falling if prices are increasing at a slower rate than before (and vice versa) ● if prices are falling then the inflation rate MUST be negative (Deflation) and vice versa *The CPI that is used is a fixedweight methodology, meaning we fix the base year and the market basket (although the market basket is updated every two years we still have problems with it) Substitution when price goes up for one good, people may seek other similar products at lower prices *This fixed market basket that we use for CPI does not account for substitution, a major problem with the fixedweight methodology ChainWeighted Method: ● the chainweighted method is used to calculate the CPI and therefore the inflation rate more accurately than the fixedweight method but this has produced some political controversies… ○ the “cost of living” is used to refer, haphazardly, to CPI and because the fixed market basket is not as accurate, meaning it overestimates inflation, payments that are indexed to inflation such as Social Security may be be higher than it actually is ○ thus lobbyist groups such as AARP are not huge fans of the chainweighted method ○ Union wages are also affected by “cost of living”, which is also skewed when we use a fixedweight method to overestimate the inflation rate ● Minimum wage can be indexed to inflation so that we can stop arguing over what it should be Deflation: ● if prices are falling, consumers will stop buying because they can just as easily wait a few months for the price to go down again, and they end up waiting month after month after month ● C (consumption) as a result goes down because of the decline in spending, GDP then goes down, Wages go down which creates the cycle; your income goes down so you have less to spend, and then consumption goes down Real Income accounts for inflation, essentially your purchasing power Nominal Income what’s on the paycheck, does not account for inflation Ex. Real income of 2015 = Nominal Income of 2015/CPI of 2015 x 100 Put more simply; the % change in nominal income is compared to the inflation rate *if % change in nominal income > inflation rate, then purchasing power increases *the fixedweight method for CPI overestimates inflation 3 Problems with High and/or Unexpected Inflation 1) Menu Cost cost of changing prices on items i.e replacing/reprinting menus 2) Shoe Leather Cost cost of tracking changing prices of transactions, like lining up at the bank to take out cash 3) Redistribution of Wealth a) Borrowers and Lenders high/unexpected inflation hurts lenders, and vice versa b) Employers and Employees high/unexpected inflation hurts employers Textbook Notes Microeconomics (Ch.s 2 and 3) Production Possibilities Frontier graphical representation of how much can be produced assuming all resources are used and used efficiently The PPF: ● Scarcity production is limited by limited resources, cause of the bowed out curve ● not all resources are well suited to production of all goods ● because of scarcity, we make choices which creates consequences called… ● Opportunity Cost value of the next best alternative ● if the point of production is on the curve, then it is efficient ● if the point is within the curve, then the economy is not using all the resources ● if the point is outside the curve, then the economy is overproducing at a rate that is not sustainable ● If there is an increase in resources, both axes shift ● if there is a change in technology, typically one axis shifts Demand amount of a good or service a consumer is willing and able to consume at various prices holding everything else constant Determinants of Demand: ● price of the good ● [income, taste, price of related goods, expectations of the future] < what we hold constant demand curves are read from the left shift to right = increase in demand change in quantity is a move along the curve Supply how much of a good or service a supplier is willing and able to produce at various prices, holding everything else constant Determinants of Supply: ● Price ● [technology, prices of related goods, expectations] > held constant supply is also read from the left change in quantity supplied caused only by a change in price (movement along the line) shifts to the right show an increase in supply and vice versa Perfect Competition many buyers and many sellers, no one buyer or seller has any market power, the product being sold is identical, and everyone sells at the exact time Economic Growth when previously unattainable and unsustainable levels of production become attainable and sustainable Theory of Comparative Advantage Ricardo’s theory that specialization and free trade will benefit all trading parties, even those that are “absolutely” more efficient producers Three Markets of the Economy: 1) Goods and Services Market households and the government purchase goods and services from firms 2) Labor Market firms and the government purchase labor from households 3) Money Market also called the financial market, households purchase stocks and bonds from firms. Households may also supply funds to this market in hopes of receiving dividends a) Treasury Bonds, Notes, and Bills promissory notes issued by the federal government when it borrows money b) Corporate Bonds promissory notes issued by firms when they borrow money c) Shares of Stock financial instruments that give to the holder a share in the firm’s ownership and therefore the right to share in the firm’s profits d) Dividends the portion of a firm’s profits that the firm pays out each period to its shareholders The Government’s Role: ● Fiscal Policy government policies that include taxing and spending ● Monetary Policy tools used by the Federal Reserve to control the shortterm interest rate Finetuning refers to the government’s role in regulating inflation and unemployment Stagflation a situation of both high inflation and high unemployment Chapter 6: Calculating Nominal and Real GDP: ● Nominal GDP we know is the current GDP in current prices or dollars ● Real GDP is the current GDP using a base year’s prices ● We will use an example table to show how this works, the table will be the entire economy: Production Production Price per Unit Price per Unit 2014 2015 2014 2015 Quantity in 2014 Quantity in 2015 Price in 2014 Price in 2015 Good A 6 11 $0.50 $0.40 Good B 7 4 0.30 1.00 Good C 10 12 0.70 0.90 ● Let’s calculate Nominal GDP first, taking each year and multiplying the prices and the goods in the current prices of each year; 2014 2015 2014 2015 Nominal Nominal GDP in GDP in 2014 2015 Q in 2014 Q in 2015 P in 2014 P in 2015 Q in 2014 Q in 2015 x P in x P in 2014 2015 Good A 6 11 $0.50 $0.40 $3.00 $4.40 Good B 7 4 0.30 1.00 2.10 4.00 Good C 10 12 0.70 0.90 7.00 10.80 Total $12.10 $19.20 ● So the nominal GDP of 2014 is $12.10, the sum of all the prices and goods multiplied by each other ● And the nominal GDP of 2015 is $19.20, the sum of all its prices and goods ● Now let’s find the Real GDP in 2015, using 2014 as the base year, which means we use 2014 prices times 2015 quantities ● Using a base year (the weight) is called a FixedWeight Procedure ● Since the nominal GDP in 2014 is the same as the Real GDP in 2014, I won’t show those calculations since 2014 is the base year 2014 2015 2014 2015 Real GDP in 2015 using 2014 as the Base Year Q in 2014 Q in 2015 P in 2014 P in 2015 Q in 2015 x P in 2014 Good A 6 11 $0.50 $0.40 $5.50 Good B 7 4 0.30 1.00 1.20 Good C 10 12 0.70 0.90 8.40 Total $15.10 ● So the Real GDP in 2015, using 2014 as the base year, is $1+6945.10 ● So Real GDP in 2015 is $15.10 and Real GDP in 2014 is $12.10, we can calculate the percent increase in Real GDP from 2014 to 2015: ○ (Real GDP in 2015 Real GDP in 2014)/Real GDP in 2014 x 100 ○ [(15.10 12.10)/(12.10)] x 100 = 24.85 ● There was an increase of 24.8% in Real GDP from 2014 to 2015 *Be careful, if we use 2015 as the base year we get an increase in Real GDP of 4.3% from 2014 to 2015, therefore the choice of base year heavily affects our percentage increase Calculating the Inflation Rate: Production Production Price per Unit Price per Unit 2014 2015 2014 2015 Quantity in 2014 Quantity in 2015 Price in 2014 Price in 2015 Good A 6 11 $0.50 $0.40 Good B 7 4 0.30 1.00 Good C 10 12 0.70 0.90 ● We will have to use one of the year’s data as a base year ● However when we calculate the GDP deflator, we are going to use quantities as weights not prices like in Real GDP, so really we just change the base year’s prices to the base year quantities ● Let’s say 2014 is the base year; 2014 2015 2014 2015 Bundle Bundle Price in Price in 2014 2015 Q in 2014 Q in 2015 P in 2014 P in 2015 Q in 2014 Q in 2014 x P in x P in 2014 2015 Good A 6 11 $0.50 $0.40 $3.00 $2.40 Good B 7 4 0.30 1.00 2.10 7.00 Good C 10 12 0.70 0.90 7.00 9.00 Total (We $12.10 $18.40 call this the “bundle price” ● So our “bundle price” for 2014 was $12.10 and the “bundle price” in 2015 was $18.40 ● our change in overall price level, or the inflation rate, would then be... ○ inflation rate = [(18.4012.10)/12.10] x 100 = 52.1% ● if we used 2015 as our base year, then our inflation rate would be 27.2%, again a drastic difference because we used fixed weights Problems with GDP: ● GDP may interpret institutional changes as a real increase in production which is not true ● GDP ignores social ills, such as pollution ● Also GDP does not measure income distribution ● GDP also ignores the informal economy Real Interest Rate = interest rate inflation rate Federal Funds Rate banks can borrow from each other through their excess reserves, this is the rate that banks are charged to borrow reserves from other banks 2/18: Important Preliminary Equations: Yd= disposable income Y = aggregate output (income) (Real GDP) C = Consumption S = Savings T = net taxes 1) LongRun Equation > Y C = S d 2) ShortRun Equation > Y dS = C 3) Y = Y T d 4) T = (total taxes transfer payments) 5) Yd= Y (total taxes transfer payments) Determinants of How Much Households Spend: 1) Expectations (debt and savings) 2) Interest Rates 3) Price Level 4) Wealth 5) Disposable Income (the biggest determinant) Income vs. Wealth: ● Income a rate, a flow variable, what you get ● Wealth a stock variable; net wealth = assets debt *Consumption as a function of disposable income (Consumption Function) Marginal Propensity to Consume (MPC) = change in consumption/change in disposable income Consumption Function → C = a + MPC ×Yd (a = autonomous consumption, i.e consumption when income = 0) The Consumption Function: Marginal Propensity to Save (MPS) = change in savings/change in disposable income (Yd MPS + MPC = 1 > MPS = 1 MPC 1) When interest rates increase, we will have more money to spend later 2) Interest rates go up, consumption goes down 2/23: The Consumption Function: ● The consumption function is a linear function; y = mx + b ○ Y = mx + b ○ C = MPC(Y ) + a d ○ C = MPC(Y T) + a ○ C = MPC(Y) MPC(T) + a ○ C = MPC(Y) + (a MPC(T)) ○ Slope (mx) = MPC(Y) ○ y intercept (b) = (a MPC(T)) ○ The slope is dependent on income ○ The yintercept is not dependent on income ● Y = real income = Real GDP (the factor income approach) When we Graph Consumption (YAxis) vs. Disposable Income (Xaxis): ● The consumption function shifts up if there an increase in a (autonomous consumption) ● The consumption function shifts down if there is a decrease in a ● The consumption function pivots up if MPC increases ● The consumption function pivots down if MPC decreases ● The economy moves along a consumption function if GDP increases Gross Private Investment (I): ● Purchase of new capital ● New home construction ● Changes in inventory levels Planned Investment = I = I changes in inventory levels (I = actual investmen = planned investment) Planned investment is determined today by interest rates and prior GDP 1) I > I, inventory levels are rising P 2) I < I, inventory levels are falling Equilibrium: ● Equilibrium when APE = GDP (APE means Aggregate Planned Expenditures) ● APE = C + I (for now) What Happens When GDP does not equal APE: ● GDP = actual production ● APE = planned expenditures ● GDP = C + I P ● APE = C + I ● GDP > APE, rising inventory levels ● GDP < APE, falling inventory levels ● Therefore, GDP falls when inventory levels increase, and vice versa Equilibrium: ● Formal definition when there is no tendency for change, when quantity demanded = quantity supplied ● When GDP = APE, there is no change in inventory levels, there is shortrun equilibrium ● When GDP (Y) > APE, inventory levels are increasing, actual investment > planned investment, and GDP has to decrease to reach equilibrium (GDP = APE) and so actual GDP is greater than shortrun equilibrium because it has to decrease The Multiplier Effect: Y a MPC C I APE C = a + MPC(Y), APE = C + I P $2,900 $100 0.9 $2,710 $200 $2,910 GDP<APE, inv. levels are falling 3,000 100 0.9 2,800 200 3,000 Equilibrium 3,100 100 0.9 2,890 200 3,090 GDP>APE, inv. levels are rising 2,900 100 0.9 2,710 210 2,920 Change in I P = 10 3,000 100 0.9 2,800 210 3,010 3,100 100 0.9 2,890 210 3,100 Change in Equilibrium = 100 ● A change in I P of 10 leads to a change in Real GDP of 100 ● The Multiplier = 1/(1 MPC) ● The Autonomous Expenditure Multiplier: ΔY/Real GDP = 1/(1 −MPC) • Δplanned investment or Δa Example : P I= $200 a = $100 T = 0 MPC = 0.9 When will the economy be in shortrun equilibrium? I.E when does GDP = APE? P P 1) GDP = Y = C + I , so we need to find when Y = C + I 2) C = a + MPC(Y T) so we can now do the equation Y = a + MPC(Y T) + I P 3) Y = 100 + 0.9(Y 0) + 200 4) Y = 100 + 0.9Y 0 + 200 5) Y = 100 + 0.9Y + 200 6) 1Y 0.9Y = 100 + 200 7) 0.1Y = 300 8) Y = 300/0.1 9) Y = 3,000 10)Short Run Equilibrium will occur when Y/Real GDP = $3,000 Now suppose a increased by $100, therefore a *would be $200, what’s the change in GDP, in other words what is our new shortrun equilibrium? 1) The Autonomous Expenditure Multiplier is ΔY/Real GDP = 1/(1 −MPC) • Δplanned investment or Δa 2) Remember our MPC is 0.9 3) And our Δa is 100 4) So our equations comes to be: 1/(1 0.9) • 100 5) 1/(1 0.9) • 100 6) 1/0.1 • 100 7) 10 • 100 8) $1,000 9) Our change in Y/Real GDP = $1,000 Let’s check it through our equation; 1) Y = 200 + 0.9(Y 0) + 200 2) Y = 200 + 0.9Y + 200 3) 1Y 0.9Y = 400 4) 0.1Y = 400 5) Y = 400/0.1 6) Y = $4,000 7) Our new equilibrium is $4,000, an increase of $1,000 from our previous equilibrium ($3,000) P The same process is used for a change in I Autonomous Expenditures are independent of Real GDP Therefore Government Expenditures (G) and Net Exports (Nx = Ex Im) are autonomous expenditure Autonomous expenditures (like G, Nx, I P, and a) are represented by a horizontal line Government: ● G = government expenditures on goods and services ● Government Outlays = G + transfer payments + net interest ● Government Receipts = total taxes ● When G > T = budget deficit, when G < T = budget surplus (flow variables) ● Government Debt total amount owed at any given point in time (a stock variable) ● Debt = all deficits + all surpluses The Federal Budget: ● Discretionary Spending government expenditures decided Congress every year (National Defense, Education etc.) ● Mandatory and Entitlement Spending what the government spends by law (Medicare, Social Security) ● Net Interest interest on the debt that the government pays ● Net Taxes = total taxes transfer payments net interest increase in interest rate = decrease in planned investment Income taxes are the biggest proponent of receipts (tax revenues) Automatic Stabilizers: ● Automatic Stabilizers structures in the federal budget, while not designed for this purpose, act to stabilize the economy ● During a contraction, GDP falls, income falls, income tax receipts fall, and unemployment rises ● Automatic stabilizers kick in; taxes are lower, giving more money for people to spend, and also more transfer payments flow to the more unemployed ● And vice versa for expansions The Federal Debt: ● Government owns some of its debt (held by the Federal Government Accounts) ● The Fed, owns some, the public owns some (pension plans, retirement plans, Japan, China) ● Our debt has been growing but so has our GDP, therefore we need to look at debt as a percentage of GDP Fiscal Policy the increase or decrease of in government expenditures and/or net taxes designed to manipulate the economy (increase or decrease in GDP) GDP operating at full employment = Potential GDP Should our shortrun equilibrium be different than our potential GDP, the government uses fiscal policy to bring it back to potential Automatic Destabilizers: ● A big automatic destabilizer is the size of the MPC, and therefore the Multiplier ● The larger the MPC, the larger the Multiplier ● Wealth (the value of a household’s assets) is also an automatic destabilizer ● Homes are the most important asset Potential GDP is when the economy is operating at full employment If there is a recessionary gap, it means that our current economy is operating inside the production possibilities curve (we need to increase GDP in order to get back on the production possibilities curve) If there is an inflationary gap, it means that our current economy is operating outside the production possibilities curve Inflationary Gap when actual real GDP (equilibrium) exceeds potential GDP Recessionary Gap when actual real GDP (equilibrium) is below potential GDP In times of inflationary or recessionary gaps, fiscal policy may be enacted in order to bring the economy back to potential GDP, however we don’t just increase government spending by $20 billion if there is a $20 billion dollar recessionary gap, the multiplier effect allows for a smaller stimulus The Tax Multiplier: ● The Tax Multiplier = MPC/(1 MPC), ΔGDP = (−MPC/(1 − MPC)) • ΔT ● So say MPC = 0.9, our multiplier would be 10, but our tax multiplier = 9 ● Therefore we can make a few observations; ○ In absolute value terms, the tax multiplier is one less than the multiplier, therefore as MPC decreases, the magnitude of the tax multiplier decreases ○ Yet the MPC will always have a higher magnitude of 1, therefore the effect of government spending (and other autonomous expenditures) will always be greater than the effect of taxes ○ The tax multiplier is negative because it negatively affects GDP ○ When the Tax Multiplier rises, GDP falls ○ When taxes change, the effect is immediate on households because when taxes increase, consumption goes down 3/10 Money: ● 3 Functions; ○ Medium of Exchange (allows trade of goods outside of a barter system) ○ Store of Value (we can use the value of our labor later on) ○ Unit of Account (allows for relative comparison of prices/values of goods) ● What’s been used before; gold, silver, shells, cigarettes etc. Why? They are… ○ Store value ○ Portable ○ Divisible ○ Not easy to counterfeit ○ Not too common ○ Not too rare ● Commodity Money serves other purposes; has intrinsic value ● Fiat Money has no intrinsic value, like paper ● We value commodities differently per person, therefore we moved to fiat money ● $100 bills are the most prevalent kind of bill (because of illegal activities) Supply of Money: ● M1 all cash in circulation (all cash outside the vaults of banks essentially); value of demand deposits M1 = checking accounts + other checkable accounts + traveler s checks ● M2 all M1 money + value of savings accounts + shortterm certificates of deposits + money market mutual funds (below $1,000) ● Liquidity how easy it is to purchase goods and services ● Say you get $100, put it in savings, then M1 would decrease, but M2 would not change, because you’re taking money out of circulation (M1) and then putting it into M2, which had already included M1 Bank’s Balance Sheets: ● Also called Taccounts (they are divided between assets and liabilities) ● Assets the value of what the bank owns and what is owed to the bank ● Total Assets = cash in the vault + deposits at the Fed + government bonds + property + fixed furniture and equipment + the value of outstanding (persisting) loans ● Liabilities the value of what you owe ● Total Liabilities = value of all deposits + shareholder’s equity ● Shareholder’s Equity amount of money that insures assets and liabilities are equal ● Equity = Total Assets value of deposits ● Goal of balance sheets is for Total Assets = Total Liabilities ● Here is an example: Assets Liabilities $200,000 cash, $100,000 at the Fed, $1,000,000 deposit, $800,000 shareholder’s $1,500,000 are in loans equity Total Assets = $1,800,000 Total Liabilities = $1,800,000 + $100,000 deposit + $100,000 deposit = $100,000 increase + $100,000 deposit = $100,000 increase in cash = $300,000 in cash in deposits = $1,100,000 deposits Total Assets = $1,900,000 Total Liabilities = $1,900,000 + $50,000 in loans + $50,000 in loans = $50,000 decrease in cash = $250,000 in cash + $50,000 in loans = $50,000 increase in loans = $1,550,000 in loans Total Assets = $1,900,000 Total Liabilities = $1,900,000 $100,000 in loans $100,000 in loans = $100,000 decrease in loans = $1,450,000 in loans Total Assets = $1,800,000 Total Liabilities = $1,900,000 Not equal, so we reduce the shareholder’s equity by $100,000 $700,000 in shareholder’s equity Total Assets = $1,800,000 Total Liabilities = $1,800,000 Book Notes: Ch.8: We have pretty much covered everything in Ch. 8 save for a few terms; Planned Investment Vs. Actual Investment: ● Planned Investment planned additions to capital stock and inventory ● Actual Investment the actual investment that took place, includes unplanned changes in inventory ● The relationship between planned investment and the interest rate is a downward sloping demand curve (think of the interest rate as the cost of an investment project) ● Therefore, when the interest rate goes up, planned investment goes down Some Basic Assumptions: 1) When the economy expands, tax payments increase, the economy slows, and the multiplier effect becomes smaller, i.e tax payments affect the multiplier (reduces the multiplier) 2) Fed behavior in manipulating the interest rate can reduce the size of the multiplier 3) Adding price level to analysis reduces the size of the multiplier 4) Since some domestic spending leaks into foreign markets (imports), the multiplier is reduced Ch.9: Fiscal and Monetary Policy: ● Fiscal Policy government spending and taxing policies ○ Policies concerning the government’s purchases of goods and services ○ Taxation ○ Transfer payments ● Monetary Policy the actions of the Fed, mainly manipulating the interest rate ● Discretionary Fiscal Policy changes in taxing and spending that are the result of deliberate changes in government policies The Saving/Investment Approach to Equilibrium: ● In the economy there are leakages and injections ● Leakages are net taxes (T) and savings (S) P ● Injections are government purchases (G) and planned investment (I ) ● So leakages are T + S, and injections are G + I ● If leakages = injections, then we have equilibrium S + T = I + G The Balanced Budget Multiplier: ● Change in level of output (GDP)/change in government spending where the change in government spending is balanced by a change in taxes (to not create a deficit) ● Therefore the multiplier is 1; the change in Y is offset by the change in G by a change in T Fiscal Drag the negative effect on the economy that occurs when average tax rates increase because taxpayers have higher incomes because the economy has expanded FullEmployment Budget what the budget is when the economy is operating at potential GDP; producing at full employment Structural Deficit deficit at full employment Cyclical Deficit deficit during a contraction or recession of the business cycle Ch.10: Special Thanks to Olivia Woo What is Money?: Money is better than barter (direct exchange of goods and services) because it eliminates the need to find someone who wants to find exactly what you sell Money is a medium of exchange, i.e what sellers accept and what buyers use The Liquidity Property of Money what makes money better than barter, it's portable and easily exchanged for goods Money is also a unit of account, meaning we can measure the price of something using a unit; money Commodity Money items used as money that could also serve another purpose, for example, cigarettes or gold Fiat Money items used for money that are intrinsically worthless, they serve no other purpose besides a medium of exchange, for example, paper with ink on it is pretty worthless. Also called token money Legal Tender money the government has required to be accepted in settlements of debt Currency Debasement decrease in the value of a currency when its supply rapidly increases M1 vs. M2: ● M1 = currency held outside banks + demand deposits + traveler’s checks + other checkable deposits ● M1 is a stock measure (measures at a point in time); quantity/year ● M2 = M1 + savings accounts + money market accounts + near money ● M2 is classified as Broad Money near money (close substitutions for transactions, moneysavings accounts, money market accounts) Financial Intermediaries banks + other institutions that act as a link between those who have money to lend + those who want to borrow money Bank Run when many of those who have claims on a bank present them at the same time Accounting: Assets reserves, loans, bank building, holdings of government securities, cash in the vault, bonds, stocks Liabilities deposits, what it owes Net Worth Assets Liabilities = Net Worth or Assets = Liabilities + Net Worth Reserves what the bank deposits at the Fed plus cash on hand Required Reserve Ratio the percentage of total deposits that a bank must keep as reserves at the Fed Excess Reserves = actual reserves required reserves The Money Multiplier: ● Money Multiplier multiple by which deposits can increase for every amount increase in reserves Money Multiplier = 1/required reserve ratio The Federal Reserve: ● There are 12 federal reserve districts ● The Federal Open Market Committee (FOMC) US monetary policy is formally set by the 7 members of the the Fed’s Board of Governors and 5 of the Fed’s presidents ● Open Market Desk the office in New York where government securities are bought and sold by the Fed The Federal Reserve’s Balance Sheet: Assets Liabilities Gold Currency in Circulation U.S Treasury Securities Reserve Balances Federal Agency debt securities U.S treasury deposits Mortgagebacked securities All other liabilities and net worth All other assets Functions of the Fed: ● The Fed has a responsibility for being a lender of last resort; it provides funds to troubled banks that cannot find other sources of funds ● The Fed has three main tools used to manipulate the money supply (monetary policy) 1) Changing the Required Reserve Ratio a) Decreasing the required reserve ratio Increases the money supply i) More reserves (decreasing the ratio (20% > 10%) creates more reserves), leads to more ability to create additional deposits by making more loans ii) If banks don’t have to hold as much as reserves, they have more money to make loans with (deposits) iii) Since the money supply (M1) = currency + deposits, if the deposits go up then the money supply goes up b) Increasing the required reserve ratio Decreases the money supply c) Changing the required reserve ratio does have a lag of about 2 weeks 2) The Discount Rate the interest rate that banks pay the Fed to borrow from it a) Increasing the discount rate Decreases the money supply i) When banks decrease their borrowing from the Fed, the money supply decreases ii) With a higher interest rate on borrowing (loans) from the Fed, banks are discouraged from borrowing, restricting the growth of deposits (reserves) which reduces the growth of the money supply (remember the money supply (M1) = currency + deposits) b) Decreasing the discount rate Increases the money supply c) Moral Suasion historically, the pressure that the Fed has put on banks to discourage them from borrowing from the Fed 3) Open Market Operations a) Open Market Operations purchase and sale by the Fed of government securities in the open market b) The Fed can purchase a security, that when they write a check for it, increases the quantity of reserves in the banking system, therefore increasing the money supply c) How it Works: i) Law requires that should there be deficit, the Treasury department, not the Fed, must borrow money to make that difference ii) The deficit, as you can recall, is G T, the difference between government expenditures and net taxes iii) Should we have a deficit, the treasury must borrow that difference, it cannot print money to make that difference iv) The treasury borrows money by issuing(selling) bills, bonds, and notes that pay interest, IOUs essentially v) These IOUs, bills, bonds, and notes that pay interest, are called Government Securities vi) These government securities can be bought by anyone, U.S citizens and often Foreign Countries buy them vii) The amount of privately held government securities is called the Privately Held Federal Debt viii) The Fed is independent from the treasury ix) The Fed is an agency authorized by congress to buy and sell outstanding (preexisting) government securities on the foreign market x) The Fed’s largest asset is government securities, the bonds, bills, and notes that pay interest issued/sold by the Treasury to finance the deficit xi) So part of our debt is owned by the Fed, owned by the government itself d) An open market purchase of open market securities by the Fed results in an increase in reserves and therefore an increase in the money supply i) This increase in the money supply = the money multiplier times the change in reserves ii) Δmoney supply = 1/(required reserve ratio) • Δreserves e) An open market sale of government securities by the Fed results in adecrease in reserves and therefore a decrease in the supply of money Ch.11 Interest Rates: ● Interest the fee that borrowers pay to lenders for use of their funds ● Firms and governments, when borrowing by issuing bonds, pay interest to the lenders the purchase those bonds ● Loans are simple, you borrow $1,000 at 10% interest for a year, and at the end of the year you pay back $1,100 to the bank Bonds: ● Bonds are complicated loans, they have a lot more conditions ● First, firms and governments borrow by sellin bonds to lenders ● Therefore firms and governments are the borrowers, and the individuals (whether it be citizens or foreign nations) are the lenders ● So bonds are sold to people in the bond market, we can buy a bond, therefore we give money to the firm or government and at a later date we cash that in and they pay us back what we paid them ● However there are three other things that come with that; ○ Bonds are issued with a facevalue; i.e what we would pay to the firm or government (the borrower), typically in denominations of $1,000 ○ They have a maturity date, the date that the borrower pays back the lender (us) the face value of the bond ○ The bonds come with a fixed payment with a specific amount to be paid to the lender (also called bondholder, either way it’s the person who bought the bond, i.e us), this is called Coupon ● Here is an example; ○ a firm (the borrower) in January of 2015, issues a 15year bond with a face value of $1,000 and paid a coupon of $100 per year. ○ On that day, the bond enters the bond market and receives a marketdetermined price (the market determines the price by way of how much the coupon is; typically companies give a coupon that makes it such that the marketdetermined price is similar to the face value of the bond) ○ Say we (the lender) buy that bond. We give that firm (the borrower) $1,000 and every January for the next 15 years, we get a check for $100 from the company as our coupon ○ Then in January of 2030, we (the lender) get back our $1,000 from the firm (the borrower) along with our final coupon of $100 ○ In this example we would say the interest rate that the lender receives each year on their $1,000 investment is 10% (10% of $1,000 is $100) ● Bond prices and the interest rate are inversely related; when interest rates rise, bond prices fall The Equilibrium Interest Rate: ● When quantity of money supplied = the quantity of money demanded, that the equilibrium interest rate An increase of P or Y will shift the demand curve to the right, increasing the equilibrium rate ● Excess supply of money will lead to a fall in the interest rate ● Excess demand for money will lead to a rise in the interest rate ● The Fed can manipulate the equilibrium interest rate by changing the supply of money, increasing it will decrease the interest rate What we need to know about the Federal Reserve: 1) Founded in 1913 by an act of Congress 2) Janet Yellen is the current chair of the Fed 3) There are 12 federal districts 4) New Orleans is in the 6th district, the Federal Reserve Bank of Atlanta 5) Board of Governors the most important group in the Federal Reserve System; 7 members, and the president appoints a chair for a four year term, the Chair is basically independent of the government 6) 7 people sit on the board of the governors 7) The Federal Open Market Committee sets goals concerning the money supply, and interest rates and directs the Open Market desk 8) The FOMC has 12 members, 7 members from the board of governors, the president of the New York Federal Reserve, plus the remaining 4 district bank presidents 9) All of them get to vote 10)The Fed’s functions are a) Clearing interbank payments, b) regulating the banking system, c) assisting banks in desperate financial situation 11)The three ways the Fed control the money supply; a) The required reserve ratio b) The discount rate c) Open market operations 3/29 Supply and Demand for Money ● Demand for Money how much of our wealth we want in cash, “in our pockets” i.e. demand deposits, in technical terms, it refers to how much our relativel liquid assets we want to be converted to cash ● The price we pay for holding cash is the interest foregone by not putting it in the bank ● In the macroeconomy, it looks like this; ● Determinants of Money Demand: ○ Interest rate ○ Income ○ Average price level ○ The last two are held constant ● The Demand Curve for Money: r = interest rate A change in demand = shift of whole demand curve A change in quantity demanded = a movement along the curve Price level increases = demand for money increases Supply of Money: ● Controlled by the Federal Reserve through ○ Open Market Operations buying and selling government bonds (short term) ○ Required Reserve Ratio ○ Discount Rate ○ Interest paid on bank deposits at the Fed (recent, incentivizes banks to increase their reserves at the Fed) ● Open market op
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