Econ Exam 2

What shifts the aggregate demand curve?

Study Guide

Word=topic; *Word= valcabulary; Word= important; Word= equation; Word= reasons

AD - AS model

*In AD-AS model, the aggregate supply curve and the aggregate demand curve are used together to analyze economic fluctuations.

The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, business, the government, and the rest of the world.

What is a shock and how does it affect the economy?

-- The curve is downward slope due to the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level. *Wealth effect: Consumer spending falls when the aggregate price level rises. *Interest rate effect: Investment spending falls when the aggregate price level rises. Shift of AD curve:

*An event that shifts the aggregate demand curve is a demand shock. It is positive demand shock if AD shifts to the right.

● Changes in Expectations 

Optimistic, aggregate spending increase, AD shifts rightward

Can a shift in the sras curve shift the ad curve?

● Change in wealth 

Real value household assets increase, purchasing power increase, aggregate spending increase, AD shifts rightward If you want to learn more check out What is the most common tort?

● Size of the existing stocks of physical capital 

Existing stock of physical capital is relatively small, AD shifts rightward ● Fiscal policy 

Government spending increase (directly),or cuts taxes and government transfer (indirectly), AD shifts rightward. → This is Expansionary fiscal policy, to deal with recessionary gap.

*Contractionary fiscal policy is fiscal policy that reduces aggregate demand, to deal with inflationary gap.

● Monetary policy 

Central bank increase the quantity of money (indirectly), AD shifts rightward. → This is expansionary monetary policy, to fight recession.

*Expansionary monetary policy increase MS, lower interest rate, higher investment spending, raises income, higher consumer spending (via multiplier), increase AD *Contractionary monetary policy is monetary policy that decreases aggregate demand, to fight inflation) If you want to learn more check out What do liverworts hornworts and mosses have in common?

The aggregate supply curve shows the relationship between the aggregate price level and quantity of aggregate output supplied in the economy.

The short-run aggregate supply curve shows the relationship between the aggregate price level and quantity of aggregate output supplied that exists in the short run, the time period when many production costs can be taken as fixed.

--The curve is upward sloping because a higher aggregate price level leads to higher profit per unit of output and higher aggregate output given fixed nominal wages. Profit per unit of output = Price per unit of output - Production cost per unit of output . Shifts of SRAS: Don't forget about the age old question of What is the use of newton’s first law of motion?

*An event that shifts the short-run aggregate supply curve is a supply shock. It is positive supply shock if it shifts to the right.

● Changes in commodity prices 

Commodity (oil, fuel) prices decrease, SRAS shifts rightward

● Changes in nominal wages 

Nominal wages falls, SRAS shifts rightward

*Nominal wages is the dollar amount of the wage paid

*Sticky wages are nominal wages that are slow to fall even in the face of high unemployment and slow rise even in face of labor shortages If you want to learn more check out What is the meaning of coercive power?

● Changes in productivity 

Workers become more productive, SRAS shifts rightward

● Changes in natural rate of unemployment 

Natural rate of unemployment increase, SRAS shifts leftward

*Stagflation (negative supply shock) is the combination of inflation and falling aggregate ouput.

*The economy is in short-run macroeconomic equilibrium when the quantity of aggregate output supplied is equal to the quantity demanded.

*The short-run equilibrium aggregate price level is the aggregate price level in the short-run macroeconomic equilibrium. Don't forget about the age old question of What are the three main components of homeostatic regulatory mechanisms?

*Short-run equilibrium aggregate output is the quantity of aggregate output produced in the short-run macroeconomic equilibrium.

*The long-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. We also discuss several other topics like How to calculate employee-paid benefits and taxes?

--The curve is vertical at potential output, YP, because in the long run a change in aggregate price level has no effect on the quantity of aggregate output supplied. *Potential output is the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible.

Shift of LRAS:

● Changes in labor force (Productivity) 

Labor force (Productivity) increase, LRAS shifts rightward

The economy is in long-run macroeconomic equilibrium when the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve. 1.

 2.

*The output gap is the percentage difference between actual aggregate output and potential output. (tends to toward zero because of self-correcting) Output gap = (Actual aggregate potential - Potential output) / Potential output *100% *The economy is self-correcting when shocks to aggregate demand affect aggregate output in the short run, but not the long run.

*Stabilization policy is the use of fiscal or monetary policy to offset demand shocks. There can be drawbacks, however. Such policies may lead to a long-term rise in the budget deficit and lower long-run growth because of crowding-out. And, due to incorrect predictions, a misguided policy can increase economic instability.

Quantity of money

*Short-term (Long-term) interest rate are the interest rates on financial assets that mature within less than a year. (a number of years in the future)

--Long-term interest rates reflect expectations about what is going to happen to short-term rates in the future. Because of risks, long-term interest rates tend to be higher than short-term rates.

*Money demand curve shows the relationship between the interest rate and the quantity of money demanded.

--It is downward sloping because the higher the short-term interest rate, the higher the opportunity cost of holding money.

--It is short-term rates rather than long-term rates that affect money demand, because the decision to hold money involves trading off the convenience of holding cash vs. the payoff from holding assets that mature in the short term. *Money supply curve shows how the quantity of money supplied varies with the interest rate.

--It is vertical at the money supply chosen by the Federal Reserve.

Shifts of MD:

● Changes in Aggregate price level 

Prices increase, MD shifts rightward

● Changes in real GDP 

Real GDP increases, MD shiftes rightward

● Changes in Credit Markets and Banking Technology 

Better credit markets & banking technology, easier to purchase, MD shifts leftward ● Changes in institutions 

allowing banks to pay interest on checking account funds, MD shifts rightward Shifts of MS:

● Making an open-market purchase (sale) of Treasury bills, MS shifts rightward (leftward).

*According to the liquidity preference model of the interest rate, the interest rate is determined by the supply and demand for money.

*Target federal funds rate is the Federal Reseve’s desired federal fund rate. *A Taylor rule for monetary policy is a rule that sets the federal funds rate according to the level of the inflation rate and either the output gap or the unemployment rate. (a background-looking policy rule)

*Inflation targeting occurs when the central bank sets an explicit target for the inflation rate and sets monetary policy in order to hit that target.(a forward policy rule) Although inflation targeting has the benefits of transparency and accountability, some think it is too restrictive.

*The zero lower bound for interest rates means that interest rates cannot fall below zero, limiting the power of monetary policy. Because it is subject to fewer lags than fiscal policy, monetary policy is the main tool for macroeconomic stabilization.

● The short-run and long-run effects of an increase in MS

An increase in the money supply reduces the interest rate and increases aggregate demand, but the eventual rise in nominal wages lead to a fall in short-run aggregate

supply and aggregate output falls back to potential output.

According to the concept of monetary neutrality, changes in the money supply have no real effects on the economy.

An increase in the money supply lower the interest rate in the short run, but in the long run higher prices lead to greater money demand, raising the interest rate to its original level.

 Quantity of Money

In the long run, the equilibrium interest rate in the economy is unaffected by changes in the money supply.

Multiplier

*The marginal propensity to consume (MPC) is the increase in consumer spending when disposable income rises by $1.

MPC = Δconsumer spending / Δdisposable income 

*The marginal propensity to save (MPS) is the increase in the household savings when disposable income rises by $1.

MPS = 1- MPC 

*An autonomous change in aggregate spending is an initial change in the desired level of spending by firms, households, or government at a given level of real GDP. (Investment: ΔAAS)

*The multiplier is the ratio of the total change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous change. ΔY (real GDP) = [1/(1-MPC)] *ΔAAS 

Multiplier = ΔY/ΔAAS = 1/(1- MPC)

*The consumption function is an equation showing how an individual household’s consumer spending varies with the household’s current disposable income. C = a + MPC *yd 

MPC = Δ C / Δyd ; MPC * Δyd = ΔC 

Slope of cf = rise over run = ΔC / Δyd = MPC 

*The aggregate consumption function is the relationship for the economy as a whole between aggregate current disposable income and aggregate consumer spending. C = A + MPC * YD

Shifts of the Aggregate Consumption Function:

● Change in expected future disposable income 

Expected future disposable income increase, CF shifts upward

● Changes in aggregate wealth 

Aggregate wealth increase, CF shift upward

*Planned investment spending is the investment spending that business intend to undertake during a given year. It is negatively related to the interest rate and positively related to expected future real GDP.

*According to the accelerator principle, a higher growth rate of real GDP leads to higher planned investment spending, but a lower growth of real GDP leads to lower planned investment spending.

*Inventories are stocks of goods held to satisfy futrue sales.

*Inventory investment is the value of the change in total inventories held in the economy during a given period. (a form of investment spending can be positive or negative)

*Unplanned inventory investment occurs when actual sales are more or less than business expected, leading to unplanned changes in inventories. *Actual investment spending is the sum of planned investment spending and unplanned inventory investment.

I = Iunplanned + Iplanned 

Multiplier process:

1. Changes in overall lead to changes in aggregate output;

2. The interest rate is fixed;

3. Taxes, government transfers, and governemtn purchases are all zero; 4. Exports and imports are both zero.

(3.&4. are in closed economy)

*Planned aggregate spending is the total amount of planned spending in the economy.

GDP = C + I = C + Iplanned + Iunplanned = AEplanned + Iunplanned 

YD = GDP 

C = A+MPC*YD 

AEplanned = C + Iplanned 

*The economy is in income-expenditure equilibrium when aggregate output, measured by real GDP, is equal to planned aggregate spending. *Income-expenditure equilibrium GDP is the level of real GDP at which real GDP equals planned aggregate spending.

*The Keynesian cross diagram identifies income-expenditure equilibrium as the point where the planned aggregate spending line crosses the 45oline. Because of the multiplier effect, the change in income-expenditure equilibrium GDP is a multiple of the autonomous change in aggregate spending.

Other multipliers:

GDP Mutiplier: 1/(1- MPC) 

G Mutiplier: 1/(1- MPC) 

T Mutiplier:MPC / (1- MPC) 

TR Mutiplier:MPC / (1- MPC)

Money & Banks

*Money is any asset that can easily be used to purchase goods and services. *Currency in circulation is cash held by the public.

*Checkable bank deposits are bank accounts on which people can write checks. *Money supply is the total value of financial assets in the economy that are considered money.

Roles of Money

1. Medium of Exchange 

-is an asset that individuals acquire for the purpose of trading goods and service rather than for their own consumption

2. Store of value 

-is a mean of holding purchasing power overtime

3. Unite of Account 

-is a measure used to set prices and make economic calculations

Types of Money:

1. Commodity money 

- a good used as a medium of exchange that has intrinsic value in other uses. - Gold, silver

- tied up fewer valuable resources.

2. Commodity-backed money 

- a medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods. - Paper currency

3. Flat money 

- a medium of exchange whose value derives entirely from its official status as a means of payment

- creating it doesn’t use up any real resources beyond the paper it’s printed on - the supply of money can be adjusted based on the needs of the economy

*Monetary aggregate is an overall measure of the money supply. *Near-moneys are financial assets that can’t be directly used as a medium of exchange but can be readily converted into cash or checkable bank deposits. (Ex. time deposits: small-denomination CDs)

The money supply is measured by two monetray aggregates: M1 and M2. M1 consists of currency in circulation, checkable bank deposits, and traveler’s checks. 

M2 consists of M1 plus various kinds of near-moneys. 

*Bank revserves are the currency banks hold in their vaults plus their deposits at the Federal Reserve.

*T-account is a tool for analyzing a business’s financial position by showing, in a single table, the business’s assets (on the left) and liabilities (on the right). *Reserve ratio is the fraction of bank deposists that a bank holds as reserves. Bank failure: the bank would be unable to pay off its depositors in full. *Bank run is a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure.

Bank regulation:

1.Deposit insurance 

- *Deposit insurance guarantees that a bank’s depositors will be paid even if the bank can’t come up with the funds, up to maximum amount per account. - eliminates the main reason for bank runs

2.Capital requirements 

- the excess of bank’s asset over its bank deposits and other liabilities is called the bank’s capital. (>/= 7% of assets)

- regulators require that the owners of banks hold substantially more assets than the value of bank deposits.

3.Reserve requirment 

- are rules set by the Federal Reserve that determine the minimum reserve ratio for banks

4.The discount window 

- is an arrangement in which the Federal Reserve stands ready to lend money to banks in trouble.

Banks affect the money supply in two ways:

1. remove some currency from circulation ($ in bank vaults are not money supply)

2. create money by accepting deposits and making loans

*Excess reserves are a bank’s reserves over and above its required reserves. *Monetary base is the sume of currency incirculation and bank reserves.   *Monetary multiplier is the ratio of the money supply to the monetary base. Increase in checkable bank deposits from $1000 in excess reserves = $1000/rr In a checkable-deposits-only system, the money supply would be equal to bank reserves divided by the reserve ratio. In reality, however, the public holds some

funds as cash rather than in checkable deposits, which reduced the size of the multiplier. 

*Central bank is an institution that oversees and regulates the banking system and controls the monetary base.

Ferderal Reserve systerm = Board of Governors + 12 Regional Federal Reserve Banks 

3 main policy tools at Fed’s disposal:

1. Reserve requirments

- set minimum of reserve ratio

- *Federal funds market allows bank that fall short of the reserve requirement to borrow funds from banks with reserves.

- *federal funds rate is the interest determined in the federal funds markets. (Key role in mordern monetary policy)

 2. Discount rate

- is the rate of interest the Fed charges on loans to banks.

 3. Open-Market Operations

- is a purchase or sale of government debt by the Fed.

 (Government debt→ U.S. Treasury bills, via commerical banks) - Increases (purchase) the monetary and therefore the monetary supply.

*Commerical bank accpects deposits and is coverd by deposit insurance *Investment bank trades in financial assets and is not covered by deposit insurance. *Saving and loan (thrift) is another type of deposit-taking bank, usually specialized in issuing home loans.

*A financial institution engages in leverage when it finances its investment with borrowed funds.

*Balance sheet effect is the reduction in a firm’s net worth due to falling asset prices. *Vicious cycle of deleveraging takes place when asset sales to cover losses produce negative balance sheet effects on other firms and force creditors to call in their loans,

forcing sales of more assets and causing further declines in asset prices. *Subprime lending is lending to homebuyers who don’t meet the usual criteria for being able to afford their payments.

*In securitization, a pool of loans is assembled and shares of that pool are sold to investors. (Fed responded by injecting cash into financial institutions and buying private debt).

There is a trade-off between liquidty and yield. Without banks, people would make this trade-off by holding a large fraction of their wealth in idle cash. *Maturity transformation is the conversion of short-term liabilities into long-term assets.

*A shadow bank is a mondepository financial institution that engages in maturity transformation. It depends on short-term borrowing to operate; when short-term lenders won’t lend to a shadow bank, their refusal causes the bank to fail.

*A banking crisis occurs when a large part of the depository banking sector or the shadow banking sector fails or threaten to fail.

Although individual bank failures are common, a banking crisis is a rare event that typically will severely harm the broader economy.

*In an asset bubble, the prices of an asset is pushed to an unreasonably high level due to expectation of further price gains.

*A financial contagion is vicious downward spiral among depository banks or shadow banks: each bank’s failure worsens fears and increases the likelihood that another bank will fail.

*A financial panic is sudden and widespread disruption of the financial markets that occurs when people suddenly lose faith in the liquidity of financial institutions and markets. (Savers cut their spending and investors hoarded their funds, sending the economy into a steep decline.)

Bank crises almost always results in recessions:

1. Credit crunch 

- *In a credit crunch, potential borrowers either can’t get credit at all or must pay very high interest rates.

2. Debt overhang 

- A debt overhang occurs when a vicious circle of deleveraging leaves a borrower with high debt but diminished assets.

3. Loss of monetary policy effectiveness 

- even though the central bank can lower interest rates, financially distressed households and business may still be unwilling to borrow and spend.

Governments step in:

1. They act as the lender of last resort 

- * A lender of last resort is an institution, usually a country’s central bank, that provides funds to financial institutions when they are unable to borrow from the private credit markets.

2. They offer guarantees to depositors and others with claims on banks. - the bank's’ liabilities will be repaid

- In the aftermath of a bank rescue, government sometimes nationalize the bank and then later re-privatize it.

3. Provider of direct financing 

- Central bank provides direct financing to pravite credit markets in an extreme crisis.

*Contractionary fiscal measure such as spending cuts and tax increases aimed at reducing budget deficits are known as fiscal austerity.

Regulation in the wake of the crisis:

1. Consumer protection

2. Derivatives regulation (most derivatives have to be bought and sold in open, transparent markets)

3. Regualtion of shadow banks

4. Resolution authority over nonbank financial institution that face bankruptcy.