Econ 121 Final Exam
Econ 121 Final Exam 36926
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This 13 page Study Guide was uploaded by Lael Wynne on Sunday May 1, 2016. The Study Guide belongs to 36926 at University of Illinois at Chicago taught by Officer in Spring 2016. Since its upload, it has received 46 views. For similar materials see Principles of Macroeconomics in Business at University of Illinois at Chicago.
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Date Created: 05/01/16
Econ Notes (Part 3) All income GDP goes to households Flow-of-Funds equilibrium: o Expenditures on GDP= resource purchases/payments o Sv + T + M = I + G + X LRAS (Long Run Aggregate Supply): 1) Resources ↑ o Labor, physical capital o Human capital 2) Technological change o ↑ productivity of labor o Invention o Innovation- entrepreneur; puts invention to practical use 3) Improvement in institution 4) Work more, less leisure P LRAS1 LRAS2 SRAS1 SRAS2 P1 1 P2 2 Y P1 Yp2 Economic Growth: o LRAS ↑ SRAS ↑ o YP↑ P↓ o Government doesn’t change policies o US & China Economic Growth W/O Cycle: o Slow, steady, outward shift in LRAS o Anticipated/Expected; permanent o Because this economic growth is anticipated, LR equilibrium is never disturbed o Natural rate of unemployment is the same Economic Decline: o LRAS shifts to the left gradually o Everything in reverse Causing the business cycle: 1) Unanticipated shifts in the AD curve & SRAS o Shifts in SRAS: i. Shocks in SRAS- unanticipated and temporary increase in output for any price ii. Negative shock (unfavorable) = decrease in output iii. Positive shock (favorable) = increase; expansion If anticipated (PRES ratio is unchanged and Y remains at YPeven though P varies Expansion (Boom) P AD1 LRAS SRAS AD0 P1 1 YP Y1 Y o Can’t stay at P0 because there’s an excess demand o P↑ = Y↑ ( Point 0 to Point 1) o (P/P ) ↑ Profit ↑ RES o Profitability ↑ LRAS P SRAS0 SRAS1 P1 Y P Y1 Y o At P0, there’s an excess supply o P ↓ = Y↑ o (P/PRES ↑ o Profitability ↑ Contraction (Recession) LRAS AD0 SRAS0 AD1 Y1 YP Y o Inward shift in AD o At P0: excess supply of goods/services o P↓ = Y↓ o (P/PRES ↓ o Profitability ↓ o At Y1: unemployment < natural rate SRAS1 LRAS SRAS0 AD0 Y1 YP Y o Inward shift in SRAS o At P0: excess demand of goods & services o P↑= Y↓ o ↓ in production of resources is greater than ↑ in price o Increase in P is a consequence, not a cause o Profitability ↓ Shifts in AD is caused by change in optimism or pessimism o Business invest a lot ( I↑) (C↑) = AD↑ = Expansion o Pessimism replaces optimism (I↓) (C↓) = AD↓ = Recession Excess supply of labor = unemployment Excess demand of labor = overflow of unemployment Expansion: o W↑ P RES o Pressure in resource labor market o Wages much more flexible upward than downward Recession: o W↓ P RES o Can take a long time (years) for wages to decrease and get back to full employment. Why? o Contracts- set resource prices o Resource suppliers, especially workers, resist reduction of resource price wage Recession is associated with pessimism Cycle caused by shifts in private AD: o I↓ =G↑ o T↓= C↑ Lags in activist fiscal policy (Keynesian): 1) Legislation lag 2) Impact lag (6 mos) 3) Forecasting lag (6-12 mos) Specific problems with K Fiscal Policy: 1) Crowding out o G↑; budget deficit o Demand for loanable funds shifts out (↑) o More expensive for durables to borrow = C↓ investment (I)= ↓ o Increased G has “crowded out” private counterparts of AD; G↑ but C↓ I↓(Physical investment) 2) Foreign exchange market o IR↑ o Net capital inflow ↑ o D for $ increases (currency appreciation) o S of FE increases (currency appreciation) United States services/goods are more expensive for foreigners; foreign goods/services are cheaper to Americans o X↓ M↑= NX↓ (X-M) Recession: o G↑ o IR↑= consumption ↓; investment ↓; NX ↓ o AD doesn’t shift at all or it shifts out but comes right back o All that the fiscal policy has done is changed the composition, real GDP, not the level of GDP Crowding out also occurs all the opposite to inflationary expansion o AD ↑; P↑; Y>P o Expectations of future taxes Reasons why household’s ↑ savings instead of when taxes ↓: 1) T↓ is temporary o Save instead of spend 2) Household (Debt/income) ration is very high o Use reduced taxes to payments to “reduce your debt”; “income savings” 3) Pessimism o Save more not consume more Rent seeking- lobbying of government for T↓ and G↑ o Big business; influence Functions of Banking: 1) Safeguard Functions 2) Pay interest on funds 3) Transfer funds 4) Make loans & buy securities Balance sheet of bank: o Assets: loans, securities, reserves (vault cash; deposits at feds/central bank) o Labilities: deposits Why hold reserves against deposits? 1) Cover withdrawals 2) Cover net check clearing Law- have to have a minimum; minimum reserve requirement o Legal minimum (Reserves/ Deposits) o Way of controlling/determining the money supply o Assumption: 10% Multiple credit creation- banks make loans by creating deposit liabilities upon themselves Excess reserves= (Actual reserves-required reserves) Example: o $100 excess reserves o Only bank in the country (monopoly bank) o No currency o Fully loaned up- excess reserves are 0 ↑Loans= ↑Deposits Excess Reserves Required Reserves $0 100 0 $100 90 10 $90 81 9 $81 72.9 8.1 Change in deposit= (deposit expansion multiplier)*(excess reserves) o Deposit expansion multiplier = (1/req reserve ratio) What can go wrong? 1) Small bank can safely sent out only excess reserves 2) Depositors take out loan partly in currency or cash in some or all deposits they can get from loan o People/firms want currency initially 3) Customers/firms/households don’t want to borrow 4) Banks don’t want to lend o Scared of creating deposit liabilities because they might not be paid back Distinguish theoretical deposit expansion multiplier verses the actual expansion multiplier Central Banking: o Commercial banks o Savings & loans (S & L) o MSB’s o Credit unions Federal Reserve: o 12 federal banks in the United States o Board of governors; 16 year terms o Janet Yellen- chairman o Tries to determine the money supply Suppose that, in the year 2013, when contracts were made, the price level (GDP deflator) was 100 but everyone anticipated that the GDP deflator would be 130 in the year 2016. Here are the AgD and (short-run) AgS schedules for 2016. AgD and AgS are in trillions of constant dollars. GDP Deflator AgD AgS 60 9 2 90 8 3 130 7 4 140 5 5 160 2 9 a. Draw the AgD and AgS curves. Label the curves with the appropriate price level. Label the axes. AD (=130) P SRAS (P =130) exp 140 5 Y b. What is equilibrium price (GDP deflator) and equilibrium GDP in 2016? Explain your answer. (Note: This is short-run equilibrium.) o P equil140 c. Is the equilibrium price level good or bad for business (suppliers of GDP) compared to the anticipated price level? Explain your answer. (Hint: Work with the numbers for the equilibrium price and anticipated price? o P ACTUAl PANTIC o 140>130 o Good for businesses because P RESbased on P ANTIC,ereas price of commodities is 140 d. Why would this level of GDP not also apply in the long run? Explain thoroughly. o GDP=5 so you can’t apply in LR because P ACTdoes not equal P ANTIC e. Revise the above table in a sensible way such that short-run equilibrium GDP (the correct answer in b) would also apply to the long run. Explain why your revision makes that happen. o One way; change the AS column entry from 4 to 7 and the 140 row entry from 5 to 8. Now PACT= PACT= 130, so SR equilibrium = LR equillibrium Reminder: GDP deflator is the price level for GDP, and GDP means real GDP. Money Supply = (money multiplier)*(monetary base) o Money multiplier- related to actual deposit multiplier o Monetary base: o Currency- in hands of non-bank households and firms (potential) o Bank reserves- vault cash and deposits at the FED (actual); “Deposits” Monetary base= actual + potential bank reserves Functions of central bank: o Monetary Policy- monitors banks, determines money supply, and determines interest rate o Purpose: 1) Get economy out of recession or anemic recovery and reduce unemployment 2) Avoid/ get economy out of inflation (inflationary expansion) FED is the most independent central bank in the world Money multiplier: o FED determines reserve requirement; legal minimum reserve ratio o Reduced= multiplier ↑ because potential deposit expansion multiplier ↑ o Increased= multiplier ↓ because potential deposit expansion multiplier ↓ Transaction deposits- “checkable deposits” Millions of $ Min. Reserve Ratio 015.2 0% 15.2110.2 3% >110.2 10% Fed pays interest on bank deposits at FED o .50% o Pay on required reserves and excess reserves Federal Funds Market: o Determines federal funds interest rate o Market for deposits at FED o Short term o FED has target fed funds rate (announced)= .37% Monetary base: 1) Discount window o Lends to banks o “Discount rate” (announced) = 1% o Discount rate > Fed funds rate o Discount rate > interest paid on deposits at fed 2) Open market operations (fed doesn’t issue bonds) o Fed buys/ sells securities usually treasury bonds o Fed buys from bank or from firm/ household o Fed buys securities= monetary base ↑ o Fed sells securities= monetary base ↓ Money supply= (monetary multiplier)*(monetary base) o Fed only influences monetary multiplier Increases base: o Open market purchases of bonds lower, increases, and multiplies interest rate on deposits at FED o Expansionary, loose, easy= monetary policy; MS↑ Reduces base: o Open market sales of bonds reduces multiplier, higher interest rate on bank deposit at FED o Contractionary, restrictive, tight, tough= monetary policy; MS↓ FED can always force banks to contract but cannot ever force banks to expand Expansion (Easy) monetary policy: o As interest ↑= QD of money ↓ o MD=MS o Demand for bonds ↑; PB↑; Interest ↓ Restrictive monetary policy: o Open market sales o MS curve shifts to the left o iST (short term interest) ↓ o Supply of loanable funds shifts up/ to the left What would make it anticipated? o Rational expectations given in short run Equation of exchange: M V=PY S o P: price level o Y: real GDP o M :Smoney supply o V: velocity of circulation (income velocity) Nominal Money GDP: P*Y o Another way is M *S MD = MS; Equilibrium in money market Nominal GDP= $18 trillion M1= $3 trillion V= (Nominal GDP)/ (M )S V1= (GDP)/ (M1) → ($18 trillion)/ ($3 trillion) = $6 trillion V2= (GDP)/ (M2) → ($18 trillion)/ ($12.5 trillion) = $1.5 trillion Relationship between velocity and D for money: o Inversely related o V↑ = D for money ↓ o V↓ = D for money ↑ o V↑ = MS↓ o V↓ = MS↑ Quantity Theory of Money Assumption: 1) Y = YD 2) Velocity (V) is fixed Inflation- too much money chasing too few goods Biggest advantage of expansionary monetary policy over expansionary fiscal policy is: o Fiscal policy has crowding out o G↑ = I ↑R= C↓, I↓, NX↓ o Opposite of crowding out with monetary policy: MS↑= I ↓ = I↑, C↑, R NX↑ “Government prints money”; combined monetary and fiscal policy Disadvantage of Monetary Policy: 1) FED does not determine the MS o MS= (money multiplier)*(monetary base) 2) Federal funds rate: short term rate o MS= i ↓=ST = CLT I↑, NX↑ o Monetarists; money GDP= MS*V o MS↑= Excess supply of money When MS↑ and money GDP is constant, this implies that velocity (V) ↓: o If velocity ↓, then D for money ↑ o Long and variable lags in monetary policy effectiveness In the long run, monetary policy effects on Price (P) inflation Only cause of sustained/larger inflation is MS↑ Why does MS↑? o Because if the central bank is not like the FED (independent), the government is tempted to order the central bank to print money Monetary Rule: o set increase in money supply equal to the economy’s long run growth (Increase in YP, outward shift to LRAS) o Y iPcreases 3% per year o FED should increase MS by 3% per year Derivation: o Objective is a constant price level or a constant low level of inflation o MS*V = P*Y Rule of Inflation = (%↑ in MS) + (%change in Velocity) – (%change in Y ) P % increase in money supply per year = (desired rate of inflation) – (%change in YPper year) FINAL EXAM o 45 questions; 10 graph questions 1) FREE QUESTION: Inflation was anticipated to be 2%. Unexpected inflation is 5%. This benefits _______ and ________. A. Borrowers, Firms B. Lenders, Consumers C. Workers, Resource Suppliers D. Unions, Households 2) FREE QUESTION: Every year, the United States has a goods-and-service deficit with China. Every year, China increases its holding of bonds issued by the US government and by US corporations. What is the explanation for these two phenomena occurring simultaneously? A. No reason; the two phenomena occurring at the same time is poorly accidental B. Equilibrium condition in the US foreign-exchange market; trade deficit (M-X) equals net capital inflow C. Chinese government policy; using the strong form of its authorization government. China makes sure that Chinese investment in the US moves hand and hang with its surplus D. US government policy, the Obama administration refuses China to have surplus works China agrees step-by-step to invest in US. Other subjects covered on exam: 1) Shifts in AD, SRAS, and LRAS curves: o AD: a) Change in real wealth b) The expectation of future economy c) Change in expected inflation d) Change in foreign income e) Change in exchange rate o SRAS: a) Resource price b) Expected inflation c) Supply shocks (unexpected) o LRAS: a) Supply of resources b) Technology and productivity c) Institutional changes 2) Types of unemployment o Frictional- takes time for workers to move from one job to another o Structural- caused by mismatch between skills that workers in economy can offer o Cyclical- cycles of unemployment; occurs during recessions 3) Full Employment o Potential output- means there’s full employment; stable; maximum 4) Deflation of AD and AS 5) Components of Money Supply o M1= currency in circulation + checkable deposits +traveler’s checks o M2= M1+ saving deposits + time deposits+ mutual funds shares 6) Components of Bank Reserves o Vault cash o Federal reserve banks deposit Extras: 1) The 4 keys markets of an economy o Reserve o Goods and Services o Loanable funds o Foreign exchange 2) Unexpected change in AD (AS) and the adjustment of the economy 3) Money Multiplier: o Potential= (1/ reserve ratio) o Actual: less than potential 4) Normative vs Positive Statements: o Normative- “what should be” or “what ought to be” o Positive- “what is…”
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