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Exam 3 Study Guide- Chapters 16, 17, 20

by: Rooshna Ali

Exam 3 Study Guide- Chapters 16, 17, 20 Econ 10233

Marketplace > Texas Christian University > Economcs > Econ 10233 > Exam 3 Study Guide Chapters 16 17 20
Rooshna Ali

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About this Document

Study guide includes notes over chapters 16, 17, and 20.
Intro Macroeconomics
Steven Ellis
Study Guide
Econ, Economics, Macro, macroecon, Macroeconomics
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This 19 page Study Guide was uploaded by Rooshna Ali on Sunday May 1, 2016. The Study Guide belongs to Econ 10233 at Texas Christian University taught by Steven Ellis in Winter 2016. Since its upload, it has received 39 views. For similar materials see Intro Macroeconomics in Economcs at Texas Christian University.


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Date Created: 05/01/16
TEST 3- CHAPTER 16, 17, 20 Chapter 16- The Monetary System • What Money Is and Why It’s Important? o Without money § Trade would require barter, the exchange of one good or service for another § Every transaction would require a double coincidence of wants, the unlikely occurrence that two people each have a good or service the other wants § People would have to spend time searching for others to trade with—a huge waste of resources o This search is unnecessary with money, the set of assets in an economy that people regularly use to buy goods and services from other people • The 3 Functions of Money 1) Medium of exchange- an item buyers give to sellers when they want to purchase goods & services 2) Unit of account- yardstick people use to post prices and record debts (measure & record of economic value) 3) Store of value- an item people can use to transfer purchasing power from the present to the future • The 2 Kinds of Money 1) Commodity money- takes the form of a commodity with intrinsic value e.g. gold coins, cigarettes in prisons 2) Fiat money- money w/out intrinsic value value; used as money because of govt. decree e.g. the U.S. Dollar *Intrinsic value- item would have value even If it were not used as money • The Money Supply o The money supply (or money stock): the quantity of money available in the economy = ???????????????????????????????? + ???????????????????????????????? = ???????????????????? ???????????????????????????????????????? ∗ ???????????????? ???????????????????????????????? o What assets should be considered par t of the money supply? § Currency: the paper bills and coins in the hands of the (non-bank) public § Demand deposits: balances in bank accounts that depositors can access on demand by writing a check § Note: credit cards are not money; the credit card company spends money for you • Measures of the U.S. Money Supply o M1: Currency, demand deposits, traveler’s check, and other checkable deposits M1 = $2.6 trillion (Sept. 2013) o M2: everything in M1 plus savings deposits, small time deposits, money market mutual funds and a few minor categories • Central Banks & Monetary Policy o Central bank: an institution that oversees the banking system and regulates the money supply o Monetary policy: the setting of the money supply by policymakers in the central bank o Federal Reserve (Fed): the central bank of the U.S • The Structure of the Fed The Federal Reserve System consists of: o Board of Governors (7 members), located in DC o 12 regional Fed Banks, located around the U.S. o Federal Open Market Committee (FOMC), includes the Board of Governors and presidents of some of the regional Fed banks. § They decide monetary policy § Janet L. Yellen- current Chair of FOMC • Bank Reserves o In a fractional reserve banking system, banks keep a fraction of deposits as reserves and use the rest to make loans § They keep reserves in vaults or let Feds hold it § Lend out excess reserves (usually 10%) o The Fed establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits o Banks may hold more than this minimum amount, if they choose o The reserve ratio, R = fraction of deposits that banks hold as reserves = total reserves as a percentage of total deposits ???????????????????? ???????????????????????????????? = ???????????????????? ???????????????????????????????? • Bank T-Account o T-account: a simplified accounting statement that shows a bank’s assets & liabilities § Liabilities (right) include deposits § Assets (left) include loans & reserves * Fiduciary- proper efforts to protect your money à banks have fiduciary responsibility to protect your money • Banks and the Money Supply: An Example o No banking system § Public holds all the $$ as currency § Money supply = $$ o 100% reserve banking system § Deposits = $$, Reserves= $$, Loans = 0 § Money Supply = 0 + $$ § In a 100% reserve banking system, banks do not affect the size of money supply o Fractional reserve banking system § Deposits = $$, Reserves = .10($$), Loans = .90($$) § Money Supply = currency + deposits = .9($$) + $$ = 1.9$$ § A fractional reserve banking system creates money, but NOT wealth à your net worth did not go up, you owe debt!! • The Money Multiplier o The amount of money the banking system generates w/ each dollar of reserves 1 = ???? e.g. With a R = 10%, $100 of deposit will create $1000 of money • A More Realistic Balance Sheet o Assets: besides reserves and loans, banks also hold securities o Liabilities: besides deposits, banks also obtain funds from issuing debt and equity o Bank capital: the resources a bank obtains by issuing equity (stocks & ownership) to its owners = ???????????????????????? − ???????????????????????????????????????????? o Leverage: the use of borrowed funds to supplement existing funds for investment purposes o Leverage ratio: the ration of assets to bank capital = ???????????????????????? ???????????????????????????? e.g. leverage ratio= 20 Interpretation à for every $20 in assets, $1 is from the bank’s owners $19 is financed w/ borrowed money • Leverage Amplifies Profits and Losses • How the Fed Influences Reserves 1) Open-Market Operations (OMOs): the purchase & sale of U.S. government bonds by the Fed Ø Buy govt. bonds from a bank, it pays by depositing new reserves in that bank’s reserve account With more reserves, the bank can make more loans, increasing the money supply Ø Sell govt. bonds, decrease bank reserves and money supply 2) The Fed makes loans to banks, increasing their reserves v Traditional Method: adjusting the discount rate (the interest rateon loans the Fed makes to banks) to influence the amount of reserves banks borrow v New method: Term Auction Facility—the Fed chooses the quantity of reserves it will loan, then banks bid against each other for these loans Ø The more banks borrow, the more reserves they have for funding new loans and increasing the money supply Chapter 17- Money Growth and Inflation • The Value of Money P = the price level (e.g., the CPI or GDP deflator) P is the price of a basket of goods (measured in money) 1/P is the value of $1 (measured in goods) Ø Inflation drives up prices and drives down the value of money • The Quantity Theory of Money o Asserts that the quantity of money determines the value of money • Money Supply (MS) o In the real world, determined by the Fed, the banking system, and consumers o In this model we assume the Fed precisely controls MS and sets it at some fixed amount • Money Demand (MD) o Refers to how much wealth people want to hold in liquidity form o Depends on P § An increase in P reduces the value of money, so more money is required to buy g&s o Thus, quantity of money demanded is negatively related to the value of money and positively related to P, other things equal (“other things” include real income, interest rates, availability of ATMs) • The Money Supply-Demand Diagram o As the value of money rises, the price level falls o A fall in value of money (or increase in P) increases the quantity of money demanded • The Effects of a Monetary Injection o Suppose the Fed increases the money supply, then the value of money falls & P rises • A Brief Look at the Adjustment Process o Increasing MS causes P to rise. o How does this work? (LONG RUN) § At the initial P, an increase in MS causes an excess supply of money § People get rid of their excess money by spending it on g&s or by loaning it to others, who spend it. § Result: increased demand for goods § But supply of goods does not increase, so prices must rise • Real vs. Nominal Variables o Nominal variables are measured in monetary units (money) e.g. nominal GDP, nominal interest rate (rate of return measured in $), nominal wage ($ per hour) o Real variables are measured in physical units e.g. real GDP, real interest rate (measured in output), real wage (measured in output) o Prices are nominally measured in terms of money § Price of a CD: $15/CD § Price of a pepperoni pizza: $10/pizza o A relative price is the price of one good relative to (divided by) another § Relative price of CDs in terms of pizza- ???????????????????? ???????? ???????? = $15/???????? = 1.5 ???????????????????????? ???????????? ???????? ???????????????????? ???????? ???????????????????? $10/???????????????????? o Relative prices are measured in physical units, so they are real variables o An important relative price is the real wage: W = nominal wage = price of labor, $15/hour P = price level = price of g&s, $5/unit of output Real wage is the price of labor relative to the price of output ???? $15/ℎ???????????? = = 3 ???????????????????? ???????? ???????????????????????? ???????????? ℎ???????????? ???? $5/???????????????? ???????? ???????????????????????? • The Classical Dichotomy o Classical dichotomy: the theoretical separation of nominal & real variables o Hume and the classical economists suggested that monetary developments affect nominal variables but not real variables o If central bank doubles the money supply, § All nominal variables—including prices—will double § All real variables—including relative prices—will remain unchanged • The Neutrality of Money o Monetary neutrality: the proposition that changes in the money supply do not affect real variables e.g. doubling money supply causes all nominal prices to double, however the relative price remains unchanged o Similarly, the real wage W/P remains unchanged, so § Quantity of labor supplied does not change § Quantity of labor demanded does not change § Total employment of labor does not change o The same applies to employment of capital and other resources o Since employment of all resources is unchanged, total output is also unchanged by the money supply o The classical dichotomy and neutrality of money describe the economy in the long run • The Velocity of Money o Velocity of money: the rate at which money changes hands o Notation: P x Y = nominal GDP = (price level) x (real GDP) M = money supply V = velocity ???? ▯ ???? o Velocity formula: ???? = ???? o Interpretation: The average dollar was used in V transactions o Velocity is fairly stable over the long run • The Quantity Equation P x Velocity formula: = M o Multiply both sides of the formula by M: M x V = P x Y o This is called the quantity equation • The Quantity Theory in 5 Steps Start with the quantity equation: M x V = P x Y 1) V is stable 2) So, a change in M causes nominal GDP (P x Y) to change the same percent 3) A change in M doesn’t affect Y: Money is neutral. Y is determined by technology & resources 4) So, P changes by the same percent as P x Y and M 5) Rapid money supply growth causes rapid inflation o If real GDP is constant, then ???????????????????????????????????? ???????????????? = ???????????????????? ????????????????????ℎ ???????????????? o If real GDP is growing, then ???????????????????????????????????? ???????????????? < ???????????????????? ????????????????????ℎ ???????????????? o The bottom line: § Economic growth increases number of transactions § Some money growth is needed for these extra transactions § Excessive money growth causes inflation • Hyperinflation o Hyperinflation is generally defined as inflation exceeding 50% per month o Excessive growth in money supply always causes hyperinflation • The Inflation Tax o When tax revenue is inadequate and ability to borrow is limited, the govt may print money to pay for its spending o Almost all hyperinflations start this way o Inflation Tax: printing money causes inflation, which is like a tax on everyone who holds money o In the U.S., the inflation tax today accounts for less than 3% of total revenue • The Fisher Effect o Rearrange the definition of the real interest rate: ???????????????????????????? ???????????????????????????????? ???????????????? = ???????????????????????????????????? ???????????????? + ???????????????? ???????????????????????????????? ???????????????? o The real interest rate is determined by saving & investment in the loanable funds market o Money supply growth determines inflation rate o So, this equation shows how the nominal interest rate is determined o In the long run, money is neutral: A change in the money growth rate affects the inflation rate but not the real interest rate o So, nominal interest rate adjusts one-for-one w/ changes in the inflation rate o This relationship is called the Fisher effect after Irving Fisher, who studied it • The Fisher Effect & the Inflation Tax o The inflation tax applies to people’s holdings of money, not their holdings of wealth o The Fisher effect: an increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate (on wealth) is unchanged • The Costs of Inflation o The inflation fallacy: most people think inflation erodes real incomes § But inflation is a general increase in prices of the things people buy and the things they sell (e.g. their labor) § In the long run, real incomes are determined by real variables, not the inflation rate o Inflation causes the CPI and nominal wages to rise together over the long run o Shoeleather costs: the resources wasted when inflation encourages people to reduce their money holdings § Includes the time & transactions costs of more frequent bank withdrawals o Menu costs: the cost of changing prices § Printing new menus, mailing new catalogs, etc. o Misallocation of resources from relat ive-price variability: Firms don’t all raise prices at the same time, so relative prices can vary… which distorts the allocation of resources o Confusion & inconvenience: inflation changes the yardstick we use to measure transactions § Complicates long-range planning and the comparison of dollar amounts over time o Tax distortions: Inflation makes nominal income grow faster than real income § Taxes are based on nominal income, and some are not adjusted for inflation § So, inflation causes people to pay more taxes, even when their real incomes don’t increase § Inflation: Ø Raises nominal interest rates (fisher effect) but not real interest rates Ø Increases savers’ tax burdens Ø Lowers the after-tax real interest rate • A Special Cost of Unexpected Inflation o Arbitrary redistributions of wealth Higher-than-expected inflation transfers purchasing power from creditors to debtors Debtors get to repay their debt with dollars that aren’t worth as much Lower-than-expected inflation transfers purchasing power from debtors to creditors High-inflation is more variable and less predictable than low inflation So, these arbitrary redistributions are frequent when inflation is high • The Costs of Inflation o All these costs are quite high for economies experiencing hyperinflation o For economies with low inflation (<10% per year), these costs are probably much smaller, though their exact size is open to debate • Conclusion o Money is neutral in the long run, affecting only nominal variables Chapter 20- Aggregate Demand and Supply • Introduction o Over the long run, real GDP grows about 3% year on average o In the short run, GDP fluctuates around its trend. § Recessions: periods of falling real incomes and rising unemployment Also- negative real GDP for two consecutive quarters § Depressions: severe recessions (very rare) o Short-run economic fluctuations are often called business cycles • Three Facts About Economic Fluctuations 1. Economic fluctuations are irregular and unpredictable 2. Most macroeconomic quantiles fluctuate together 3. As output falls, unemployment rises • Classical economics— A Recap o Classical Dichotomy, the separation of variables into two groups: § Real – quantities, relative prices § Nominal – measured in terms of money o The neutrality of money: changes in the money supply affect nominal but NOT real variables o Most economists believe classical theory describes the world in the long run but not the short run o In the short run, changes in nominal (like the money supply or P) can affect real variables (like Y or the u-rate) • The Model of Aggregate Demand and Aggregate Supply o The model determines the equilibrium price level and equilibrium output (real GDP) • The Aggregate-Demand (AD) Curve o The AD curve shows the quantity of ALL goods & services demanded in the economy at ANY given price level • Why the AD Curve Slopes Downward Y = C + I + G + NX Assume G is fixed by govt. policy To understand the slope of AD, we must determine how a change in P affects C, I, and NX 1. The Wealth Effect (P and C) Suppose P rises Ø The dollars people hold buy fewer goods and services, so real wealth is lower (still have same amount of money though) Ø People feel poorer Result: C falls 2. The Interest-Rate Effect (P and I) Suppose P rises Ø Buying goods and services requires more dollars Ø To get these dollars, people sell bonds or other assets (price of bonds go up) Ø This drives up interest rates Result: I falls (recall I depends negatively on interest rates 3. The Exchange-Rate Effect (P and NX) Suppose P rises Ø U.S. interest rates rise (the interest-rate effect) Ø Foreign investors desire more U.S. bonds Ø Higher demand for money in foreign exchange market Ø U.S. exchange rate appreciates Ø U.S. exports more expensive to people abroad, imports cheaper to U.S. residents Result: NX falls • Why the AD Curve Might Shift o Any event that changes C, I, G, or NX –except a change in P— will shift the AD curve o Changes in C § Stock market boom/crash § Preferences re: consumption/saving tradeoff § Tax hikes/cuts o Changes in I § Firms buy new computers, equipment, factories § Expectations, optimism/pessimism § Interest rates, monetary policy § Investment tax credit or tax incentives o Changes in G § Federal spending e.g., defense § State & local spending e.g., roads, schools o Changes in NX § Booms/recessions in countries that buy our exports § Appreciation/depreciation resulting from international speculation in foreign exchange market • The Aggregate-Supply (AS) Curves o The AS curve shows the total quantity of g&s firms produce and sell at any given price level o AS is § Vertical in the long run § Upward sloping in the short run • The Long-Run Aggregate-Supply Curve (LRAS) o The natural rate of output (YN) is the amount of output the economy produces when unemployment is at its natural rate o (YN ) is also called potential output or full-employment output • Why LRAS is Vertical o (YN ) determined by the economy’s stocks of labor, capital, and natural resources, and on the level of technology o An increase in P does not affect any of these, so it does not affect ( ) N (classical dichotomy) • Why the LRAS Curve Might Shift o Changes in natural resources § Discovery of new mineral deposits § Reduction in supply of imported oil § Changed in weather patterns that affect agricultural production o Changes in technology § Productivity improvements from technological progress • Using AD & AS to Depict Long-Run Growth and Inflation o Over the long run, technological progress shifts LRAS to the right and growth in the money supply shifts AD to the right à Result: ongoing inflation & growth in output


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