Economics 1051 Final Study Guide
Economics 1051 Final Study Guide Economics 1051
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This 10 page Study Guide was uploaded by Ashley Albers on Sunday May 1, 2016. The Study Guide belongs to Economics 1051 at University of Missouri - Columbia taught by George Chikhladze,Martha Steffens in Spring 2016. Since its upload, it has received 178 views. For similar materials see General Economics in Economcs at University of Missouri - Columbia.
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Date Created: 05/01/16
Study Guide: Exam 3 Chapter 12: Aggregate Demand and Aggregate Supply Aggregate Demand Definition: Real GDP demanded/desired at each price level (aggregate demand) Inverse Relationship o Households o Firms o Foreigners o Spend less at higher price Determinants of Aggregate Demand o Changes in Consumer Spending (C) Consumer wealth (wealth effect) Stock market, real estate market Household borrowing or spending Consumer expectations (about future income or inflation) If you think recession you’ll start saving Personal taxes (tax hikes, tax cuts, and rebates) determined by fiscal policy o Change in investment spending (I) Real interest rates (costs of borrowing) monetary policy Expected returns (or current investment) Expectations about future business conditions Business taxes (investment tax credit) fiscal policy Investment spending is more volatile than consumer spending All else equal a decrease in real rate of interest will increase level of investment o Change in Government spending (G) Government spending increases (fiscal policy) Aggregate demand increases (as long as interest rates and tax rates do not change) i.e. more highways Government spending decreases Aggregate demand decrease I.e. cut military spending o Change in export spending (NX) National income abroad Exchange rates Dollar depreciation: NX Increases Weaker dollar is good for people who sell overseas Foreigners buy more Dollar appreciation: NX Decreases How does depreciation effect exports? Stimulates exports, because our goods and services are cheaper to foreigners. Makes US business happy Weaker dollar means more expensive to US, so imports decline Tourism: foreign nationals visiting US is our export, Weaker dollar promotes our country to foreign tourists, makes them happy, Weaker dollar makes you (US) less likely to travel Lately the US dollar has been appreciating Aggregate Supply Definition: total real output produced at each possible price level Relationship depends on time horizon o Short run versus long run Short run aggregate supply is upward sloping. Positive relationship between aggregate price level and quantity produced o Increase in price level increases output o Rationale: as aggregate price level increases it allows businesses to increase output prices without paying more for inputs o Sticky prices: input prices are inflexible they are fixed in short run by contracts Long run Aggregate Supply is vertical o All prices are flexible o Change in price level do not affect our productive capabilities Chapter 14: Money, Banking, and Financial Institutions Functions of Money Medium of Exchange o Used to buy/sell goods Unit account o Goods valued in dollars Store of Value o Hold some wealth in money form Money Definition M1 o M1 (cash in your pocket) Currency (Checkable deposits) o M2 M1 plus near-monies (Savings deposits) Federal Reserve – Banking System Board of Governors Appointed by the President and confirmed by the senate for 14 year non-renewable term Headquartered in DC 7 governors, one of them is appointed as a chair 12 federal reserve banks o Serve as the central bank, Quasi-public banks, Bankers Bank, NY Fed is the most important Federal Open Market Committee (FOMC) o 12 voting members, 7 governors plus 5 presidents of district banks Presidents rotate each year on who votes but NY President ALWAYS votes o Makes important monetary policy decisions, Meets about 8 times a year Commercial banks and thrifts o 6,800 commercial banks o 8,700 thrifts Thrifts – (credit unions/ loan associations) o Big Four: BOA – Acquired Merrill Lynch JP Morgan Chase – Acquired Bear Sterns Citi Group Wells Fargo – Acquired Wachovia Bank Federal Reserve Functions o Issues currency Regulating money supply in the US Fed is independent institution that is created by gov’t but separated from the gov’t o Set reserve requirements Fed mandates every commercial bank to keep fraction of total deposits in reserves (10%) o Lend money to banks (Fed operates discount window), Collect checks o Act as fiscal agent for US government o Supervise Banks (Control the money supply and influence interest) Federal Reserve Independence o Established by Congress as an independent agency o Feds policies cannot be reversed, Fed is given a freedom to pursue its own objectives and choose monetary policy tools to do so o Feds objectives Dual mandate: price stability (2% inflation rate) and maximum and sustainable economic growth o Enables the fed to take actions to increase interest rates in order to stem inflation as needed (can be politically unpopular move) The Financial Crisis of 2007-09 Mortgage default crisis Subprime mortgage loans Mortgage-backed securities Government programs that encouraged home ownership o Bad incentives provided by mortgage lenders (no credit checks) o Declining real estate values Securitization – the process of slicing up and bundling groups of loans into new securities These securities (MBS) ended up everywhere Insurance companies insured those securities Sever conflict of interest Credit Rating Agencies o Moody’s, S&P, Fitch o Ratings vary from D – AAA. Credit rating agencies assigned AAA rating to lots of the MBS. Why? Because SP, Moody, and Fitch get paid by the same corporations who issue those securities When interest rates increased, and real estate values fell, lots of homeowners defaulted on mortgage loans Failures and near-failures of financial firms o Countrywide to BOA: second largest lender o Washington Mutual to JPMorgan Chase: largest lender o Wachovia (fourth largest bank) to Wells Fargo Other firms filed for bankruptcy (Lehman Brothers) Sep. 18, 2008 Troubled Asset Relief Program (TARP) o Allocated $700 billion to make emergency loans o Instead treasury ended up buying stock o Saved several institutions from failure Fed extensively lent money to financial institutions If corporation knows that it will always get bailed out by the government, then it has very strong incentives to be reckless Consolidation in the industry Need to know words o Mutual funds: sell shares to large number of small investors and invest funds in diversified portfolio of securities (stocks, bonds, commercial paper) o Security: financial asset (something that promises future stream of income) that’s traded on the financial markets o Stocks: pay dividends, not guaranteed. Varies with company profitability o Bonds: make fixed payments, guaranteed, does not vary o Derivative: promise to deliver certain asset at a specified price at some future date. For example: Futures -> promise to deliver one gallon of gas at $3 on April 7, 2017 o Investment Bank: financial institutions that provide various services: Wealth management Securities trading Underwriting: helping private start ups go public or helping already established corporations to sell new issues of stock Guarantee a certain price for a stock and later resell to investors on NYSE or NASDAQ (tech stocks) Connection between Wall Street and Main Street o Wall street or financial institutions provide necessary funding to al kinds of firms (small, medium-sized, and large corporations) for long-run and day to day operations) o equipment and pay employee salaries o Therefore, if Wall Street is unable to make loans to or buy commercial paper from main street the main street cant stock inventories or pay salaries Credit Crunch o Commercial banks used to be just banks in the past, before 1999 Glass Steagall Act of 1933: separated commercial banking from investment banking and insurance Some people want to bring Glass Steagall back o Wall Street Reform and Consumer Protection Act (Dodd- Frank Act of 2010) Passed to help prevent many of the practices that led to the crisis Major provisions: Financial stability oversight council o Collection of Fed, FDIC, SEC, Treasury, Comptroller of currency, others) Living will of SIFIs (Systematically important financial institution) More securities traded on public exchanges Retaining credit risk Critics say it adds heavy regulatory costs Chapter 15: Interest Rates and Monetary Policy Interest Rates The price paid for the use of money It represents two things: o Cost of borrowing o Reward for lending Many different interest rates Speak as if only one interest rate Determined by the money supply and money demand Demand for money o Why hold money? o Asset demand, Da Money as a store of value Varies inversely with the interest rate o Total money demand, Dm Equilibrium Interest Rates o Changes with shifts in money supply and money demand o We will focus on changes of money supply because that’s all the FED has control over o FED can influence supply of money by using tools of monetary policy o Tools of monetary policy Open market operations (conducted by NY FED) Open market purchase: FED buying treasury bonds from banks o FED pays for securities by giving reserves to banks (excess reserves). Banks make loans with these reserves. Multiple deposits will be created (multiple deposit expansion through money multiplier) and money supply increases Open market sale: FED sells securities to banks o Banks pay with reserves. Effectively FED takes out reserves from the banking system. Leads to multiple deposit contraction, money supply shrinks The reserve ratio Changes the money multiplier (1/r) Lowering reserve ratio, increases money multiplier, increases money supply Increasing reserve ration, decreases money multiplier, decreases money supply The discount rate The FED acts as lender of last resort Interest rates on short-term loans granted by FED Increasing discount rate, discourages banks from borrowing; money supply shrinks Open market operations are most important (could sell/buy little or a lot) most common Reserve ratio last changed 1992 Discount rate is a passive tool Monetary Policy o Expansionary monetary policy (easy money) Economy faces recession Fed buys securities Lowers reserve ratio Lowers discount rate o Restrictive monetary policy (tight money) Slow down/ periods of rising inflation Fed sells securities Increases reserve ratio Raises discount rate Monetary policy, GDP, and price level o Effect on real GDP and price level o Cause-effect chain Money supply changes interest rates Which in turn changes investment and consumption spending Real GDP and price level respond Monetary Policy in Action o Advantages over fiscal policy (taxes and government spending) Speed and flexibility Isolation from political pressure Monetary policy is more subtle than fiscal policy o Fiscal policy is conducted by congress over the president. Fed is responsible over monetary Federal funds rate o To lower federal funds rate, fed increases bank reserves by conducting open market purchase o To raise federal funds rates, fed decreases bank reserves by conducting open market sale Recent U.S. monetary policy o Highly active in recent decades o Responded with quick and innovative actions during the recent financial crisis and the severe recession o Quantitative Easing (QE) or asset purchase program Fed bought trillions worth of securities from the banks o Critics contend the fed contributed to the crisis by keeping the federal funds rate too low for too long Problems and complications o Lags Recognition and operational Price level is reported monthly GDP data is reported quarterly (and often revised) It takes 3-6 months for interest rates to affect investment spending and economy activity Liquidity Trap Pumping reserves may not solve the problem if banks are not willing to lend and households/businesses are not willing to borrow Despite historical low interest rates (real interest rates are actually negative) investment spending still remained low Fed’s “Exit Strategy": how exactly doe the fed plan to drain the banking system of reserves in case it needs to slow down the economy or in case inflation picks up Chapter 16: international Trade and Exchange Rates Trade Facts US trade deficit in goods (imports>exports) o $738 billion in2011 US trade surplus in services (exports>imports) o $178 billion in 2011 Overall trade balance: overall US has trade deficit or negative net exports US has been running a trade deficit for 3 decades Canada is US’s biggest trade partner Trade deficit in goods with China (DUH!) o $290 billion in 2011 Main reason it’s possible we buy more stuff from foreigners than we sell to them is that we sell domestic assets to foreigners or we borrow money from them o Selling domestic assets to foreigners is call foreign investment Investing in our own country Foreign Direct Investment (FDI): InBev purchasing Anheuser Busch Foreign Portfolio Investment: Japanese pension fund buying Facebook stock o US borrowing takes two forms Public borrowing (national): US government selling debt securities (bonds) to foreigners Private borrowing: Microsoft selling bond to Chinese bank or taking out loan from French Bank o Government borrowing over time adds to our public debt Currently at $20 trillion (public debt) US total debt is at $64 trillion Principle US exports include o Chemicals o Agricultural products o Consumer durables o Semiconductors (computer software stuff) o Aircraft United states provides about 8.5% of worlds total exports (largest exporter China) Principle US imports include o Oil o Cars o Metals o Household appliances o Computers Largest exporters: China Germany USA Largest exports as % of their GDP: Belgium Netherlands South Korea th o USA is 12 o Means other countries rely on exports more heavily than we do US leads the world in total dollar volume of exports and imports Exchange Rates Foreign exchange market determines foreign exchange rates Big participants are banks that trade deposits denominated in different currencies on behalf of multinational corporations For example o If a bank in the US exchanges $1million for 800,000 euros with a bank in Germany, than that sets the exchange rate at $1 per 0.8 euro o Alternatively $1.25 = 1 euro o Always say euro per $1 How to use exchange rates o You travel to Mexico and a bottle of tequila costs 20,000 pesos. Exchange rate is at $.01 per peso. How much will a bottle of tequila cost in dollars? 20,000(.01)= $200 o A glass of sake costs 500 yen if the exchange rate is 150/dollar, how much would you have for sake in dollars 500/150= $3.3 o In Ireland you pa 2 pounds for a beer and you know its equivalent to $5 the exchange rate is: 2pounds = $5 1pound= $2.50 $1 =0.4 pounds When dollar value gains its called appreciation When dollar loses value its called depreciation When the dollar appreciates against some other currency the other currency must depreciate o on December 4, 2014 exchange rate as $.6 per pound now it is $1.4 per pound so dollar appreciated/ pound depreciated
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