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CU / Economics / ECON 2020 / What do you call the total number of people currently employed for pay

What do you call the total number of people currently employed for pay

What do you call the total number of people currently employed for pay

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School: University of Colorado
Department: Economics
Course: Principles of Macroeconomics
Professor: Fevzi iyigun
Term: Spring 2017
Tags: Macro, Economics, and Macroeconomics
Cost: 50
Name: MACROECONOMICS FINAL EXAM STUDY GUIDE
Description: This study guide covers everything that is going to be on the final. The final will be 50 multiple choice questions coming from chapters 8, 9, 10, 11, 12, 13, 14, 15, & 19.
Uploaded: 05/03/2017
61 Pages 233 Views 0 Unlocks
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MACROECONOMICS FINAL STUDY GUIDE Chapter 8: Unemployment & Inflation 1. Employment: The total number of people currently  employed for pay in the economy either full time or part  time  2. Unemployment: The total number of people who are  actively looking for work but aren’t currently employed  3. Labor force: all workers, employed or unemployed – the  sum of employment and unemployment  4. Labor force participation rate: percentage of the  working-age population that is in the labor force  a. legal working age is 16+ -- only counts those who are  above 16 and a part of the labor force  b. take a small random sample that would closely  represent the US  Labor force participation rate = (Labor force / Population  age 16 and older)x 100  5. Unemployment rate: The percentage of the total number  of people in the labor force who are unemployed  a. The unemployment rate is a good indicator of how easy or difficult it is to find a job given the current state of  the economy  Unemployment rate = (Number of unemployed workers /  Labor Force) x 100 6. Discouraged Workers: Individuals who want to work but  who have state to government researches that they aren’t  currently searching for a job because they see little prospect  of finding one given the state of the job market  a. The unemployment rate does not count  discouraged workers 7. Marginally Attached Workers: Non-working individuals  who say they would like a job and have looked for work in  the recent past but are not currently looking for work  a. The unemployment rate does not count  marginally attached workers  8. Underemployed Workers : Workers who would like to find  full-time jobs but are currently working part time for  “economic reasons” – that is, they can’t find a full-time job  a. The unemployment rate does not count  underemployed workers   Adult population 200 million Labor force 150 million Employed 138.75 million Discouraged workers 10.5 million


According to the table, what is the unemployment rate and what is the labor force participation rate?



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According to the table, what is the unemployment rate and what  is the labor force participation rate?  Unemployment = ((150-138.75)/150) x 100 Labor force participation rate = (150/200) x 100 = 75% 9. Jobless Recovery: A period in which real GDP growth rate  is positive but the unemployment rate is still rising  10. Job Search: Workers who spend time looking for  employment  a. Frictional Unemployment: Unemployment due to the time workers spend in job search  i. A certain amount of frictional unemployment is  inevitable due to the constant process of economic change  ii. The economy is more productive if workers take  the time to find jobs that are well matched to their skills iii. When there is a low unemployment rate, periods  of unemployment tend to be quite short, suggesting that much of the unemployment is  frictional  iv. In periods of higher unemployment, workers tend  to be jobless for longer periods of time, suggesting that a smaller share of unemployment is frictional  b. Structural Unemployment: Unemployment that  results when there are more people seeking jobs in  particular labor markets than there are jobs available at the current wage rate, even when the economy is at  the peak of the business cycle  Minimum Wage – each person should get an honest  hours worth of work  Labor Unions – Creating unemployment? Labor unions  are not good if you’re not working because they have  bargaining power (an organized association of workers,  often in a trade or profession, formed to protect and  further their rights and interests  Efficiency Wages – Wages that employers set above the equilibrium rate as an incentive for better employee  performance  *** Frictional and Structural employment are considered long term unemployment  Frictional & Structural unemployment are always present; they  are NATURAL c. Short Run Unemployment – Cyclical: When workers  lose their jobs during downturns in the business cycle.  Cyclical unemployment results from a large drop-off in  demand. When consumer demand for goods and  services drops, business revenues decline, and  eventually companies have to lay off workers to  maintain profit margins.  For example… 100 people are in the labor force  1 person was unemployed for 12 months  12 others were unemployed for 1 non-overlapping month each  What is the unemployment rate?GDP % = (2/100) x 100 = 2%  because 1 person contributed 50% to the unemployment rate and the others produced the other 50%. The one person that was  unemployed for 12 months contributes more to unemployment. Actual  Unemployment Natural 5% unemployme nt Cyclical  Unemployment 11. Nominal vs. Real Wages  a. Nominal: Rate of pay employees are compensated  ($15/hr)  b. Real: Wages adjusted for inflation or wages in terms of  the amount of goods and services that can be bought  12. Okun’s Law: change in GDP % = 3% - 2(change in  unemployment %)  3%1.5% Because 3% - 2(1.5) = 0% 13. Phillips Curve (unemployment % & inflation %)  a. If inflation is high, then unemployment is low (and vice  versa)  Inflation %Unemployment  %14. Costs of Inflation: (a general increase in prices  and fall in the purchasing value of money) a. Shoe Leather Costs: The increased costs of  transactions caused by inflation  i. Since cash loses its value quickly during high  inflation, people waste more time running around  to spend it as fast as they can  b. Menu Costs: The real cost of changing a listed price  c. Unit of Account Costs (inconveniences): Costs  arising from the way inflation makes money a less  reliable unit of measurement  i. Calculations are hard when inflation is high  Expected inflation is not bad!  Unexpected inflation is a big problem!  Inflation rate = ((price level yr 2 – price level yr 1)/price  level yr 1) x 100  15. Interest Rate: the proportion of a loan that is charged as interest to the borrower, typically expressed as a  percentage of the loan outstanding a. Real interest: the rate of interest an investor, saver,  or lender receives after allowing for inflation  b. Nominal interest: the interest rate before taking  inflation into account  __________________________________________________________________ _ Chapter 9: Economic Growth and Development 1. Facts a. World income distribution is very unequal, but this is a  recent phenomenon  2. The rule of 70: the magic of compounding  a. Even small differences in growth rate get magnified  over time  b. Doubling time = (70 / percent growth rate)  i. Example: If real GDP per capita is growing at an  annual growth rate of 3.5%, it will double in:  = 70/3.5 = 20 YEARS c. The moral? Small improvements in growth add up fast  (the power of compounding)  3. Sources of Economic Growth  a. Factor accumulation  i. Capital  ii. Human capital (health, education, experience)  iii. Technology  iv. Rule of law, “institutions”  *** technology and rule of law are unobservable  that combine to determine total productivity 4. Aggregate Production Function  Y = T x F (K,H,L,N)  T = total factor productivity  ∙ Technology  ∙ Rule of law  ∙ Institutions  ∙ Property rights  ∙ Social contracts  K = physical capital  ∙ In order to have more capital, you need to invest  ∙ Encourage investment ∙ Investing in a poorer country gives you more return  H = human capital  ∙ Health, experience, and education  L = labor force  N = natural resources  *** all of your inputs are compliments and that is why you  multiply (when you add, they are substitutes)  Y = T (2K + 3H + 5L) inputs are perfect substitutes Y = T (K)^0.3 (H)^0.4(L)^0.4 inputs are perfect compliments  5. In per capita terms:  (Y/L) = T ((K)^0.3(H)^0.4(L)0.4) //// L) divide everything  by labor force  6. Sources of economic growth  a. Factor accumulation (more k & h)  b. Technological change (grow your technology) Chapter 10: Savings, Investment, and the Financial  System 1. Refreshing our National Income Account Knowledge… a. Closed Economy (no trade, self sufficient)  GDP = C + I + G  Total Income = Total Spending  Now, what can be done with income? It can either be  spent on consumption – consumer spending (C) plus  government spending (G) – or saved (S).  SO, it must be true that… GDP = C + G + S  Total spending consists of either consumption spending  (C+G) or investment spending (I) GPD = C + G + I  Total income = consumption spending + investment  spending  Putting the equations together, we get: C + G + S = C + G + I  Consumption spending + savings = consumption  spending + investment spending  Subtract consumption spending (C+G) from both sides  and we get:  S = I Savings = Investment spending  Budget Surplus: The difference between tax revenue and  government spending when tax revenue exceeds government  spending (positive contribution to national savings)  Budget Deficit: The difference between tax revenue and  government spending when government spending exceeds tax  revenue (negative contribution to national savings) Budget Balance: The difference between tax revenue and  government spending. A positive budget balance is referred  to as a budget surplus; a negative budget balance is  referred to as a budget deficit  National Savings: The sum of private savings and the  government’s budget balance; the total amount of savings  generated within the economy  Total income = Consumption spending + savings  b. Open Economy  NCI = IM – X  Net capital inflow = Imports – Exports  Rearranging the equation, we get:  I = Y – C – G + NX  Using both of the equations, we know that GDP – C – G  is equal to National Savings that:   (I – S) + NX = 0  Investment spending is equal to savings, where savings is equal to national savings plus net capital inflow  Net Capital Inflow: The total inflow of funds into a country  minus the total outflow of funds out of a country  2. The Market for Loanable Funds A hypothetical market that brings together those who want  to lend money (savers) and those who want to borrow (firms  with investment spending projects)  We assume that the price of loans is the nominal  interest rate  a. The Demand for Loanable Funds i. The demand curve for loanable funds slopes  downward: the lower the interest rate, the greater  the quantity of loanable funds demanded. Here.  Reducing the interest rate from 12% to 4%  increases the quantity of loanable funds  demanded from $150 billion to $450 billion.  ii. The higher the interest rate, the higher the  opportunity cost of investment spending  iii. The higher the opportunity cost of investment  spending, the lower the number of investment  spending projects firms want to carry out, and  therefore the lower quantity of loanable funds  demanded  iv. To evaluate whether a particular investment  spending project iw worth undertaking, a business  must compare the present value of the future  payoff with the current cost of that project  1. If the present value > current cost =  profitable and worth investing in  2. If the interest rate falls, then the present  value of any given project rises, so more  projects pass that test (and vice versa)  Present Value: (of X) The amount of money needed today in  order to receive X at a future date given the interest rate  Ex.) A firm has two potential investment projects in mind, each of  which will yield $1000 a year from now  Each project has different initial costs:One requires that the firm borrow $900 right now  The other requires that the firm borrow $950  Which of these projects is worth borrowing money to finance  and undertake? Depends on the interest rate… A 10% interest rate means $1000  is worth $909 now, so only the first project is worth it, since its  initial cost ($900) is l less that the present value  b. The Supply of Loanable Funds  i. The supply curve for loanable funds slopes  upward: the higher the interest rate, the greater  the quantity of loanable funds supplied. Here,  increasing the interest rate from 4% to 12%  increases the quantity of loanable funds supplied  from $150 billion to $450 billion  ii. Loanable funds are supplied by savers, and savers  incur an opportunity cost when they lend to a  business: the funds could instead be spent on  consumption  iii. By saving your money today and earning interest  on it, you are rewarded with higher consumption in the future when the loan you made is repaid with  interest iv. It is a good assumption that more people are  willing to forgo current consumption and make a  loan to a borrower when the interest rate is higher  3. The Equilibrium Interest Rate  A situation where the interest rate at which the quantity of  loanable funds supplied equals the quantity of loanable  funds demanded  a. At the equilibrium interest rate, the quantity of loanable funds supplied equals the quantity of loanable funds  demanded. Here, the equilibrium interest rate is 8%  with $300 billion of funds lent and borrowed. Lenders  who demand an interest rate of 8% or lower have their  offers of loans accepted; those who demand a higher  interest rate do not. Projects that are profitable at an  interest rate of 8% or higher are funded; those that are  profitable only when the interest rate falls below 8% are not.  4. Shifts of the Demand for Loanable Funds  a. Changes in perceived business opportunities  b. Changes in government borrowing Crowding Out: The negative effect of budget deficits on private  investment, which occurs because government borrowing drives  up interest rates  5. Shifts of the Supply of Loanable Funds  a. Changes in private savings behavior b. Changes in net capital inflows  6. Inflation and Interest Rates a. Anything that shifts either the supply of loanable funds  curve of the demand for loanable funds curve changes  the interest rate  Major Changes in Interest rates due to… ∙ Changes in government policy  ∙ Technological innovations that create new investment  opportunities  The true cost of borrowing is the real interest rate, not the nominal interest rate. Real interest rate = Nominal interest rate – Inflation rate  SO, why do we use the nominal interest rate rather than the real  interest rate? ∙ In the real world, neither borrowers nor lenders know what  the future inflation rate will be when they make a deal  ∙ Actual loan contracts specify a nominal interest rate rather  than a real interest rate  Fisher Effect: The principle by which an increase in expected  future inflation drives up the nominal interest rate, leaving the  expected real interest rate unchanged  i = r + pi  Real interest rate = Nominal interest rate – Inflation rate  ∙ An increase in expected future inflation drives up the  nominal interest rate, where each additional percentage  point of expected future inflation drives up the nominal  interest rate by 1 percentage point  ∙ The central point is that both lenders and borrowers base  their decisions on the expected real interest rate  ∙ As a result, a change in the expected rate of inflation does  not affect the equilibrium quantity of loanable funds or the  expected real interest rate; all it affects is the equilibrium  and nominal interest rate 7. The Financial System  Wealth: (of a household) the value of accumulated savings  Financial Asset: A paper claim that entitles the buyer to  future income from the seller. Loan, stocks, bonds, and bank  deposits are types of financial assets  Physical Asset: A claim on a tangible object that can be  used to generate future income  Liability: A requirement to pay income in the future  A well-functioning financial system is a critical  ingredient in achieving long-run growth because it  encourages greater savings and investment spending. It also ensures that savings and investment spending  are undertaken efficiently. a. Three Tasks of a Financial System: ∙ Reducing Transaction Costs  o Transaction Costs: The expenses of  negotiating and executing a deal ∙ Reducing Risk  o Financial Risk: Uncertainty about future  outcomes that involved financial losses or gains  o Risk-averse: a person who is more sensitive to a loss than to a gain of an equal dollar amount  o Diversification: Investment in several different assets with unrelated, or independent, risks, so  that the possible losses are independent events  ∙ Proving Liquidity o Liquid: Describes an asset that can be quickly  converted into cash with relatively little loss of  value   An asset is liquid if it can be quickly  converted into cash with relatively little  loss of value  o Illiquid: Describes an asset that cannot be  quickly converted into cash with relatively little  loss of value  b. Types of Financial Assets  ∙ Loans: A lending agreement between an individual  lender and an individual borrower. Loans are usually  tailored to the individual borrower’s needs and ability to pay but carry relatively high transaction costs  ∙ Bond: An IOU issued by the borrower  ∙ Loan-Back Securities: Assets created by pooling  individual loans and selling shared in that pool  ∙ Stocks: A share in the ownership of a company  ∙ Financial Intermediaries: An institution, such as a  mutual fund, pension fund, life insurance company, or  bank that transforms the funds it gathers from many  individuals into financial assets ∙ Mutual Fund: A financial intermediary that creates a  stock portfolio by buying and holding shared in  companies then selling shares of this portfolio to  individual investors  ∙ Pension Fund: A type of mutual fund that holds  assets in order to provide retirement income to its  members  ∙ Life Insurance Companies: A financial  intermediary that sells policies guaranteeing a  payment to a policyholder’s beneficiaries when the  policyholder dies  ∙ Bank: A financial intermediary that provides liquid  assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investments  or investment spending needs of borrowers *** REMEMBER  C = GDP – G – I  NS = Y – C – G  PS = Y – C – T  BB = T – G  Chapter 11: Income & Expenditure Marginal Propensity to Consume: The increase in consumer  spending when disposable income rises by $1. Because  consumers normal spend part but not all of an additional dollar of  disposable income, MPC is between 0 and 1 MPC = (change in consumer spending) / (change in  disposable income)  For example, if consumer spending goes up by $6 billion when  disposable income goes up by $10 billion, MPC = 6/10 = 0.6 Marginal Propensity to Save: The fraction of an additional  dollar of disposable income that is saved  MPS = 1 – MPC  Because we assumed that there are no taxes and no international  trade, each $1 increase in aggregate spending raises both real  GDP and disposable income by $1. So the $100 billion increase in  investment spending initially raises real GDP by $100 billion. This  leads to a second-round increase in consumer spending, which  raises real GDP by a further MPC × $100 billion. It is followed by a third-round increase in consumer spending of MPC × MPC × $100  billion, and so on. After an infinite number of rounds, the total  effect on real GDP is: Total increase in real GDP = (1 + MPC + MPC^2 + MPC ^3  + …) x $100 billion So the $100 billion increase in investment spending sets off a  chain reaction in the economy. The net result of this chain  reaction is that a $100 billion increase in investment spending  leads to a change in real GDP that is a multiple of the size of that  initial change in spending. How large is this multiple? It’s a mathematical fact that an infinite series of the form 1 + x + x^2 + x^3+ …, where x is between 0  and 1, is equal to 1/(1 − x). So the total effect of a $100 billion  increase in investment spending, I, taking into account all the  subsequent increases in consumer spending (and assuming no  taxes and no international trade), is given by: Total increase in real GDP from $100 billion rise in I = (1/1  – MPC) x $100 billion  Autonomous change in Aggregate Spending: An initial rise  or fall in aggregate spending at a given level of real GDP. It’s  autonomous – which means “self governing” – because it’s the  cause, not the result, of the chain reaction we just described  Multiplier: The ratio of total change in real GDP caused by an  autonomous change in aggregate spending to the size of that  autonomous change Assuming no taxes and no trade, the change in real GDP caused  by an autonomous change in spending is:  Change in GDP = (1 / 1 – MPC) x change in AAS  So the multiplier is:  Multiplier = (change in GDP / change in AAS) = (1 / 1 –  MPC)  Notice that the size of the multiplier depends on MPC. If the MPC  is high, so is the multiplier. This is true because the size of the  MPC determines how large each round of expansions is compared  with the previous round. The higher the MPC is, the less  disposable income “leaks out” into savings at each round of  expansion.  Consumption Function: An equation showing how an individual  household’s consumer spending varies with the households  current disposable income c = a + MPC x yd  lower case letters indicate variables measured for individual  household  c = individual household consumer spending  yd = individual household current disposable income  a = constant term – individual household autonomous consumer  spending, the amount of spending a household would do if it had  zero disposable income  Aggregate Consumption Function: The relationship for the  economy as a whole between aggregate current disposable  income and aggregate consumer spending  C = A + MPC x YD  C = consumer spending  YD = disposable income  A = aggregate autonomous consumer spending, the amount of  consumer spending when YD equals zero  Shifts in the Aggregate Consumption Function:  Changes in Expected Future Disposable Income: consumers will  now spend more at any given level of current disposable income,  YD, corresponding to an increase in A  Changes in Aggregate Wealth: A rise in aggregate wealth  increases the vertical intercept A, which shifts the aggregate  consumption function up  Investment Spending:  Although consumer spending is much larger than investment  spending, booms and busts in investment spending tend to drive  the business cycle  Planned Investment Spending: The investment spending that  firms intend to undertake during a given period. Planned  investment spending may differ from actual investment spending  due to unplanned inventory investment  Planned investment spending is negatively related to the  interest rate  A higher interest rate leads to a lower level of planned  investment spending What drives planned investment? ∙ Interest rate  ∙ Expected future real GDP  ∙ Current level of production capacity  Accelerator Principle: The proposition that a higher rate of growth  in real GDP results in higher level of planned investment  spending, and a lower growth rate in real GDP leads to lower  planned investment spending  Inventories: Stocks of goods and raw materials held to facilitate  business operations  Inventory Investment: The value of the change in total inventories held in the economy during a given period. Unlike other types of  investment spending, inventory investment can be negative if  inventories fall  Unplanned Inventory Investment: Unplanned changes in  inventories, which occur when actual sales are more or less than  businesses expected  Actual Investment Spending: The sum of planned investment  spending and unplanned inventory investment  I = I unplanned + I planned  Planned Aggregate Spending: The total amount of planned  spending in the economy; includes consumer spending and  planned investment spending  AE planned = C + I planned  Planned aggregate spending = total amount of planned spending  in the economy The general relationship among real GDP, planned aggregate  spending, and unplanned inventory investment follows:  GDP = C + I  = C + I planned + I unplanned  = AE panned + I unplanned  SO, whenever real GDP exceeds AE planned, I unplanned is  positive; whenever real GDP is less that AE planned, I unplanned  is negative Income expenditure: A situation in which aggregate output,  measured by real GDP, is equal to planned aggregate spending  and firms have no incentive to change output  Income expenditure equilibrium GDP: The level of real GDP at  which real GDP equals planned aggregate spending  Keynesian Cross: A diagram that identifies income expenditure  equilibrium as the point where the planned aggregate spending  line crosses the 45-degree line  Chapter 12: Aggregate Demand and Aggregate Supply In chapter 3, we explained that when economists talk about a fall  in the demand for a particular good or service, they’re referring to a leftward shift of the demand curve.  SIMILARLY, when economists talk about a negative demand shock  to the economy as a whole, they’re referring to a leftward shift of  the aggregate demand curve. Aggregate Demand Curve: A graphical representation that  shows the relationships between the aggregate price level and  the quantity of aggregate output demanded by households, firms, the government, and the rest of the world. The aggregate  demand curve has a negative 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. A higher aggregate price level, other things equal, reduces the  quantity of aggregate output demanded; a lower aggregate price  level, other things equal, increases the quantity of aggregate  output demanded.  Why is the Aggregate Demand Curve Downward Sloping? Wealth Effect: The effect on consumer spending caused by the  change in the purchasing power of consumers’ assets when the  aggregate price level changes. A rise in the aggregate price level  decreases the purchasing power of consumers’ assets, so  consumers decrease their consumption; a fall in the aggregate  price level increases the purchasing power of consumers’ assets,  so consumers increase their consumption.  Consumer spending falls when the aggregate price level rises,  leading to a downward sloping aggregate demand curve. Interest Rate Effect: The effect on consumer spending and  investment spending caused by a change in the purchasing power of consumers’ money holdings when the aggregate price level  changes. A rise (fall) in the aggregate price level decreases  (increases) the purchasing power of consumers’ money holdings.  In response, consumers try to increase (decrease) their money  holdings, which drives up (down) interest rates, thereby  decreasing (increasing) consumption and investment. A higher interest rate indirectly tends to reduce exports and  increase imports The Aggregate Demand Curve and the Income Expenditure Model: In the last chapter, we introduced the income expenditure  model: Consumption is largely determined by income. The more  money people make, the more money they will use to purchase  goods and services  How does the aggregate demand curve and the income  expenditure model fit together? The aggregate demand curve is derived from the income expenditure model  Planned aggregate spending (C + I planned) rises with real GDP.  This is illustrated by the upward-sloping lines AEplanned 1 and  AEplanned 2.  Income expenditure equilibrium is at the point where the line  representing planned aggregate spending crosses the 45-degree  line. A fall in the aggregate price level caused the AE planned  curve to shift from AEplanned 1 to AEplanned 2, leading to a rise  in income-expenditure equilibrium GDP from Y1 to Y2.  Shifts of the Aggregate Demand Curve: A rightward shift occurs when the quantity of aggregate output  demanded increases at any given aggregate price level   A decrease in aggregate demand means that the AD curve shifts  to the left. A leftward shift implies that the quantity of aggregate  output demanded falls at any given aggregate price level  Panel (a) shows the effect of events that increase the quantity of  aggregate output demanded at any given aggregate price level,  such as improvements in business and consumer expectations or  increased government spending.  Such changes shift the aggregate demand curve to the right, from AD1 to AD2.  Panel (b) shows the effect of events that decrease the quantity of  aggregate output demanded at any given aggregate price level,  such as a fall in wealth caused by a stock market decline. This  shifts the aggregate demand curve leftward from AD1 to AD2.  

When this  happens … Aggregat e  Demand  INCREASE S But when  this  happens… Changes  in  Expectati ons When  consumers  and firms  become more Shift to  the right When  consumers  and firms  come more


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Don't forget about the age old question of Identify the critical components of economis.

Aggregate  demand  DECREASES  Shift to the  left

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pessimistic Changes  in Wealth When the real value of  household  assets rises Shift to  the right When the  real value of  household  assets fall Size of  the  existing  stock of  physical  capital When the  existing stock of physical  capital is  small Shift to  the right When the  existing sock of physical  capital is  large Fiscal  Policy When the  government  increases  spending or  cuts taxes Shift to  the right When the  government  reduces  spending or  raises taxes Monetary  Policy When the  central bank  increase the  quantity of  money Shift to  the right When the  central bank  reduces the  quantity of  money


Now, what can be done with income?



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Don't forget about the age old question of abrigation

Shift to the  left  Shift to the  left  Shift to the  left  Shift to the  left  Changes in Expectations: Consumers base their spending not  only on the income they have now but also on the income they  expect to have in the future. Firms base their planned investment  spending not only on current conditions but also on the sales they expect to make in the future  Changes in Wealth: When the value of household assets rises,  the purchasing power they embody also rises, leading to an  increase in aggregate spending  Size of the Existing Stock of Physical Capital: Firms engage  in planned investment spending to add to their stock of physical  capital. Their incentive to spend depends in part on how much physical capital they already have: the more they have, the less  they will feel a need to add more  Fiscal Policy: The use of either government spending or tax  policy to stabilize the economy. An increase in government  purchases shifts the aggregate demand curve to the right and a  decreases shifts it to the left  Monetary Policy: The use of changes in the quantity of money  or the interest rate to stabilize the economy. When the central  bank increases the quantity of money in circulation, households  and firms have more money, which they are willing to lend out.  Increasing the quantity of money shifts the aggregate curve to  the right (and vice versa) __________________________________________________________________ _ Aggregate Supply Curve: A graphical representation that  shows the relationship between the aggregate price level and the  total quantity of aggregate output supplied  The Short Run Aggregate Supply Curve: There is a positive  relationship in the short run between the aggregate price level  and the quantity of aggregate output supplied.  A rise in the aggregate price level is associated with a rise in the  quantity of aggregate output supplied.  A fall in the aggregate price level is associated with a fall in the  quantity of aggregate output supplied. A graphical representation that shows the positive relationship  between the aggregate price level and the quantity of aggregate  output supplied that exists in the short run, the time period when  many production costs, particularly nominal wages, can be taken  as fixed. The short-run aggregate supply curve has a positive  slope because a rise in the aggregate price level leads to a rise in  profits, and therefore output, when production costs are fixed.  Wages are typically an inflexible production cost because the  dollar amount of any given wage paid, called the nominal wage,  is often determined by contracts that were signed some time ago. As a result of both formal and informal agreements, then, the  economy is characterized by sticky wages: nominal wages that  are slow to fall even in the face of high unemployment and slow  to rise even in the face of labor shortages  Shifts of the Short-Run Aggregate Supply Curve  Panel (a) shows a decrease in short-run aggregate supply: the  short-run aggregate supply curve shifts leftward from SRAS1 to  SRAS2, and the quantity of aggregate output supplied at any  given aggregate price level falls.  Panel (b) shows an increase in short-run aggregate supply: the  short run aggregate supply curve shifts rightward from SRAS1 to  SRAS2, and the quantity of aggregate output supplied at any given aggregate price level rises. Changes in Commodity Prices: An increase in the price of a  commodity (oil) raised production costs across the economy and  reduced the quantity of aggregate output supplied at any given  aggregate price level, shifting the curve to the left and vice versa  Changes in Nominal Wages: A rise in nominal wages increases  production costs and shifts the short-run aggregate supply curve  to the left  Changes in Productivity: An increase in productivity means  that a worker can product more units of output with the same  quantity of inputs. So a rise in productivity increases producers’  profits and shifts the short-run aggregate supply curve to the right The Long-Run Aggregate Supply Curve  In the long run, nominal wages are flexible, not sticky  A graphical representation that 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. The long-run aggregate supply curve is vertical because the aggregate price level has no effect on aggregate  output in the long run – in the long run, aggregate output is determined by the economy’s potential output Potential Output: The level of real GDP the economy would  produce if all prices, including nominal wages, were fully flexible  This is where the LRAS touches the horizontal axis We generally think of the long-run aggregate supply curve as  shifting to the right over time as an economy experiences long run growth  From the Short Run to the Long Run In panel (a), the initial short run aggregate supply curve is SRAS1. At the aggregate price level P1, the quantity of aggregate output  supplied Y1 exceeds potential output, Yp. Eventually, low  unemployment will cause nominal wages to rise, leading to a  leftward shift of the short run aggregate supply curve from SRAS1  to SRAS2.  In panel (b), the reverse happens: at the aggregate price level P1, the quantity of aggregate output supplied is less than potential  output. High unemployment eventually leads to a fall in nominal  wages over time and a rightward shift of the short run aggregate  supply curve The AD – AS Model: The basic model used to understand  fluctuations in aggregate output and the aggregate price level. It  uses the aggregate supply curve and the aggregate demand  curve together to analyze behavior of the economy in response to shocks or government policy  This model is good for:  ∙ Understanding macro fluctuations in the short run  ∙ Transitions from short run to longer run ∙ Roles of monetary and fiscal policies in the short run  Transactions velocity of money  VT = P * T / M  T = 60 laptops produced  P = $1000 M = $10000VT = 6 Income velocity of money  V = P * Y / M  “T” is not observable  Y = $16,000,000 P = 100  M = 320,000,000 P*Y = 1,600,000,000 V = 5  The money that is in circulation  Rearrange to write quantity equation:  V = P*Y / M  P*Y = M*V  Side note: if M,V,P,Y don’t change too fast then  %change in P + % change in Y = %change in M + %change in V  Deriving the AD curve: If V is constant an if M (money supplied) is fixed, then aggregate demand is downward sloping  If price goes down, then real GDP goes up  Short Run Macroeconomic Equilibrium: The point at which  the quantity of aggregate output supplied is equal to the quantity  demanded  Short Run Equilibrium Aggregate Price Level: The aggregate price level in short-run macroeconomic equilibrium  Short Run Equilibrium Aggregate Output: The quantity of  aggregate output produced in short-run macroeconomic  equilibrium The AD-AS model combines the aggregate demand curve and the  short-run aggregate supply curve. Their point of intersection, Esr,  is the point of short-run macroeconomic equilibrium where the  quantity of aggregate output demanded is equal to the quantity  of aggregate output supplied. Pe is the short-run equilibrium  aggregate price level. And Ye is the short-run equilibrium level of  aggregate output.  Shifts of Aggregate Demand: Short Run Effects  Demand Shock: An event that shifts the aggregate demand  curve.  A positive demand shock is associated with higher demand for  aggregate output at any price level and shifts the curve to the  right.  A negative demand shock is associated with lower demand for  aggregate output at any price level and shifts the curve to the  left. A demand shock shifts the aggregate demand curve, moving the  aggregate price level and aggregate output in the same direction. In panel (a), a negative demand shock shifts the aggregate  demand curve leftward fro AD1 to AD2, reducing the aggregate  price level from P1 to P2 and aggregate output from Y1 to Y2.  In panel (b), a positive demand shock shifts the aggregate  demand curve rightward, increasing the aggregate price level  from P1 to P2 and aggregate output from Y1 to Y2.  Shifts of the SRAS Curve  Supply Shock: An event that shifts the short-run aggregate  supply curve. A negative supply shock raises production costs and reduces the quantity supplied at any aggregate price level,  shifting the curve leftward. A positive supply shock decreases  production costs and increases the quantity supplied at any  aggregate price level, shifting the curve rightward.A supply shock shifts the short-run aggregate supply curve,  moving the aggregate price level and aggregate output in  opposite directions. Panel (a) shows a negative supply shock,  which shifts the short-run aggregate supply curve leftward and  causes stagflation—lower aggregate output and a higher  aggregate price level. Here the short-run aggregate supply curve  shifts from SRAS1 to SRAS2 , and the economy moves from E1 to  E2 . The aggregate price level rises from P1 to P2 , and aggregate  output falls from Y1 to Y2.  Panel (b) shows a positive supply shock, which shifts the short-run aggregate supply curve rightward, generating higher aggregate  output and a lower aggregate price level. The short-run aggregate supply curve shifts from SRAS1 to SRAS2, and the economy  moves from E1 to E2. The aggregate price level falls from P1  to P2, and aggregate output rises from Y1 to Y2. Long Run Macroeconomic Equilibrium: The point at which the short-run macroeconomic equilibrium is on the long-run  aggregate supply curve; so short-run equilibrium aggregate  output is equal to potential output.  __________________________________________________________________ _ Chapter 13: Fiscal Policy 1. Central question for chapters 13-15… “can government  policies stabilize an economy?” ie.) fighting, unemployment,  inflation, or both  a. Expansionary fiscal policy can close a recessionary gap: instead of waiting for the long run correction mechanism, policy makers could choose to stimulate  AD and move the economy back towards long-run  equilibrium  2. Fiscal Policy: Changing taxes or government spending in  order to stabilize the economy  a. Only moves the AD curve  b. Expansionary Fiscal Policy: Increased government  spending, decreased taxation in order to stabilize the  economy c. Contractionary Fiscal Policy: Decreased government spending, increased taxation in order to stabilize the  economy  3. Lags in Fiscal Policy  a. Inside Lags: The amount of time it takes for a  government or central bank to respond to a shock in  the economy  b. Outside Lags: The amount of time it takes for a  government or central banks actions to have a  noticeable effect on the economy  4. Fiscal Multipliers  a. Autonomous Spending Multiplier (G)  1 / (1 – MPC)  b. Tax Multiplier (T) MPC / (1 – MPC)  Higher T is going to shrink your demand  Lump-sum Taxes: A tax that is the same for everyone,  regardless of any actions people take  Automatic Stabilizers: Government spending and taxation rules that cause fiscal policy to be automatically expansionary when  the economy contracts and automatically contractionary when  the economy expands  Discretionary Fiscal Policy: Fiscal policy that is the direct result of deliberate actions by policy makers rather than automatic  adjustments or rules  Cyclically Adjusted Budget Balance: An estimate of what the  budget balance would be if real GDP were exactly equal to  potential output  Public Debt: Government debt held by individuals and  institutions outside the government  Implicit Liabilities: Spending promises made by governments  that are effectively a debt despite the fact that they are not  included in the usual debt statistics. In the United States, the  largest implicit liabilities arise from Social Security and Medicare,  which promise transfer payments to current and future retirees  and to the elderly.  __________________________________________________________________ _ Chapter 14: Money, Banking, and the FED 1. Functions of Money  ∙ Medium of exchange: an asset that individuals  acquire for the purpose of trading for goods and  services rather than for their own consumption  ∙ Store of value: An asset that is a means of holding  purchasing power over time  ∙ Unit of account: A measure used to set prices and  make economic calculations 2. Types of Money  ∙ Commodity Money: A medium of exchange that is a  good, normally gold or silver, that has intrinsic values in other uses  ∙ Commodity-backed Money: A medium of exchange  that has no intrinsic value whose ultimate value is  guaranteed by a promise that it can be converted into  valuable goods on demand  ∙ Fiat Money: A medium of exchange whose value  derives entirely from its official status as a means of  payment  3. Measuring the Money Supply  ∙ Monetary Aggregates: An overall measure of the  money supply. The most common monetary aggregates in the US are: ∙ M1, which involves currency in circulation,  traveler’s checks, and checkable banks deposits  ∙ M2, which includes M1 as well as near moneys ∙ Near Moneys: Financial assets that can’t be directly  used as a medium of exchange but can be readily  converted into cash or checkable bank deposits  4. What do Banks do? ∙ A bank is a financial intermediary that uses liquid  assets in the form of bank deposits to finance the  illiquid investments of borrowers  ∙ Banks can create liquidity because it isn’t necessary for a bank to keep all of the funds deposited with it in the  form of highly liquid assets  ∙ Banks can’t lend out all the funds placed in their hands  by depositors because they have to satisfy any  depositor who wants to withdraw his or her funds, and  in order to meet these demands, a bank must keep  substantial quantities of liquid assets on hand  ∙ Bank Reserves: Currency held by banks in their vaults plus their deposits at the Federal Reserve ∙ T-account: A simple too that summarizes a business’s  financial position by showing, in a single table, the  business’s assets and liabilities, with assets on the left  and liabilities on the right  ∙ Reserve Ratio: The fraction of bank deposits that a  bank holds as reserves. In the US, the minimum  required reserve ratio is set by the FED  ∙ Bank Run: A phenomenon in which many of a bank’s  depositors try to withdraw their funds because of fears  of bank failure  5. Bank Regulation  ∙ Deposit Insurance: A guarantee that a bank’s  depositors will be paid even if the bank can’t come up  with the funds, up to a maximum amount per account ∙ Capital Requirements: To reduce the incentive for  excessive risk taking, regulators require that the owners of banks hold substantially more assets that the value  of bank deposits  ∙ Reserve Requirements: Rules set by the FED that set the minimum reserve ratio for banks (US 10%)  ∙ Discount Window: A protection against bank runs in  which the FED stands ready to lend money to banks in  trouble  6. Reserves, Bank Deposits, and the Money Multiplier  ∙ Excess Reserves: A bank’s reserves over and above  the reserves required by law or regulation  ∙ Money Multiplier = 1/reserved requirement  ∙ or (money supply / money base)  ∙ The ratio of money supply to the monetary base  ∙ Monetary Base: the sum of currency in circulation and bank reserves  ∙ Monetary Supply: money available for spending  (checkable bank deposits)  7. Structure of the FED ∙ Board of Governors: oversees the entire system from its offices in D.C.  o Constituted like a government agency: its seven  members are appointed by the president and must be approved by the senate  o Appointed for 14 year terms to insulate them from  political pressure  ∙ 12 Federal Reserve Banks: each serve a region of the  country, providing various banking and supervisory  services  ∙ Federal Open Market Committee: make decisions about  monetary policy  o Consists of the Board of Governors plus 5 of the  regional bank presidents  8. What the FED does: A central bank that oversees and  regulates the banking system ad controls the monetary base ∙ Federal Funds Market: a financial market that allows  banks that fall short of reserve requirements to borrow  funds from banks with excess reserves  ∙ Federal Funds Rate: The interest rate at which funds  are borrowed and lent in the federal funds market  ∙ Discount Rate: the rate of interest the FED charges on loans to banks that fall short of reserve requirements  9. Open Market Operations ∙ Like the banks it oversees, the FED has assets and  liabilities. The FED’s assets normally consist of holdings  of debt issued by the US government, mainly short term US government bonds with a maturity of less than  one year, known as US Treasury bills. The Fed isn’t  exactly part of the US government, so the US Treasury  bills held by the FED are a liability of the government  but an asset of the FED  ∙ The FEDS liabilities consist of currency in  circulation and bank reserves ∙ Open Market Operation: A purchase or sale of US  Treasury bills by the FED, normally through a  transaction with a commercial bank  10. Respond the the Banking Crisis: The Creation of the  Fed  ∙ In 1913, the national banking system was eliminated  and the Fed was created as a way to compel all deposit  taking instituions to hold adequate reserves and to  open their accounts to inspection by regulators  ∙ But, this did not eliminate the potential for bank  runs so the potential for more bank runs became  a reality during the Great Depression  ∙ After of a failure of a large bank in 1930, federal official  realized that the economy-wide effects compelled them to take a less hands-off approach and to intervene more vigorously  ∙ In 1932, the Reconstruction Finance Corporation (RFC)  was established and given the authority to make loans  to banks in order to stabilize the banking sector  ∙ In 1933, FDR immediately declared a “bank holiday”  closing all banks until regulators could get a handle on  the problem  ∙ Although the RFC stabilized the banking industry, they  still needed to do more, so the Glass-Steagall Act of  1933 separated banks into two categories: ∙ Commercial banks: a bank that accepts  deposits and is covered by deposit insurance  ∙ Investment banks: A bank that trades in  financial assets and is not covered by deposit  insurance  Leverage: The degree to which a financial institution is financing  its investments with borrowed funds  Balance Sheet Effect: The reduction in a firm’s net worth from  falling asset prices  Vicious Cycle of Deleveraging: Describes the sequence of  events that takes place when a firm’s 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: Lending to home-buyers who don’t meet the usual criteria for borrowing  Securitization: The pooling of loans and mortgages made by a  financial institution and the sale of shares in such a pool to other  investors  Open market operations are the principal tool of monetary policy:  The Fed can increase or reduce the monetary base by buying or  selling government debts to banks  If the Fed wants to increase the money supply, it will buy T-bills  If the Fed wants to decrease the money supply, it will sell T-bills  __________________________________________________________________ _ Chapter 15: Monetary Policy 1. Demand for money  What determines how much M the public holds? ∙ Price of things we buy (P)  M goes up  ∙ Wealth and income (Y)  M goes up  ∙ Opportunity cost of M (r)  M goes down  2. The Money Demand Curve  ∙ A graphical representation of the relationship between the interest rate and the quantity of money demanded ∙ The money demanded curve slopes downward because,  other things equal, a higher interest rate increases the  opportunity cost of holding money  ∙ By contrast, if the interest rate is high, the opportunity  cost of holding money is high  people will respond by  keeping only small amounts in cash and deposits,  converting assets into money only when needed  ∙ When prices increase, you’ll want to hold more money  ∙ If prices grow or if income grows, shift to the right 3. Shifts in the Money Demand Curve  The demand curve for money shifts when non-interest rate  factors that affect the demand for money change. An  increase in money demand shifts money demand curve to  the right, from MD1 to MD2, and the quantity of money  demanded rises at any given interest rate. A decrease in  money demand shifts the money demand curve to the left,  from MD1 to MD3, and the quantity of money demanded falls at any given interest rate. Shifts:  ∙ Changes in the Aggregate Price Level: Higher prices  increase the demand for money (right) and lower prices decrease the demand for money (left)  o The demand for money is proportional to the price  level  If the aggregate price level rises by 20%  the quantity of money demanded at any given  interest rate also rises by 20%  ∙ Changes in Real GDP: The large the quantity of goods  and services they buy, the larger the quantity of money they will want to hold at any given interest rate  o An increase in real GDP  rightward o A decrease in real GPD  leftward  ∙ Changes in Credit Market and Banking Technology: The  invention of a revolving-balance credit card allowed  people to hold less money in order to fund their  purchases and decreased the demand for money  4. The Equilibrium Interest Rate  ∙ Liquidity Preference Model of the Interest Rate: A model of the market for money in which the interest rate is  determined by the supply and demand for money The money supply curve, MS, is vertical at the money supply chosen by the Fed, M. The money market is in equilibrium at  the interest rate rE: the quantity of money demanded by the  public is equal to M, the quantity of money supplied.  At a point such as L, the interest rate, rL, s below rE and the  corresponding quantity of money demanded, ML, exceeds  the money supply, M. In an attempt to shift their wealth out  of non-money interest-bearing financial assets and raise  their money holdings, investors drive the interest rate up to  rE. At a point such as H, the interest rate rH exceeds rE and  the corresponding quantity of money demanded, MH, is less  than the money supply, M. In an attempt to shift out of  money holdings into non money interest-bearing financial  assets, investors drive the interest rate down to rE.  5. Monetary Policy and the Interest Rate  The Fed can lower the interest rate by increasing the money  supply. Here, the equilibrium interest rate falls from r1 to r2  in response to an increase in the money supply from M1 to  M2. In order to induce people to hold the large quantity of  money, the interest rate must fall from r1 to r2. So an increase in the money supply drives the interest rate  down. Similarly, a reduction in the money supply drives the  interest rate up. By adjusting the money supply up or down,  the Fed can set the interest rate.  Target Federal Funds Rate: The Fed’s desired level for the  federal funds rate. The Fed adjusts the money supply  through the purchase and sale of Treasury bills until the  actual rate equals the desired rate.  The Federal Reserve sets a target for the federal funds rate  and uses open market operations to achieve that target. In both panels the  target rate is rT. In panel (a) the initial equilibrium interest  rate, r1, is above the target rate. The Fed increases the  money supply by making an open-market purchase of  Treasury bills, pushing the money supply curve rightward,  from MS1 to MS2, and driving the interest rate down to rT. In  panel (b) the initial equilibrium interest rate, r1, is below the  target rate. The Fed reduces the money supply by making an open-market sale of Treasury bills, pushing the money supply curve leftward, from MS1 to MS2, and driving the interest  rate up to rT.Panel (b) shows the opposite case. Again, the initial money  supply curve is MS1 with money supply M1. But this time the equilibrium interest rate, r1, is below the target federal funds rate, rT. In this case, the Fed will make an open-market sale  of Treasury bills, leading to a fall in the money supply  to M2 via the money multiplier. The money supply curve  shifts leftward from MS1 to MS2, driving the equilibrium  interest rate up to the target federal funds rate, rT. 6. Expansionary and Contractionary Monetary Policy  ∙ In chapter 12, we learned that monetary policy shifts the  aggregate demand curve. We can now explain how that  works: through the effect of monetary policy on the  interest rate  ∙ Expansionary Monetary Policy: Monetary policy, that,  through the lowering of the interest rate, increases  aggregate demand and therefore output (shift to the right) ∙ Contractionary Monetary Policy: Monetary policy, that  through the raising of the interest rate, reduces aggregate demand and therefore output 7. Taylor Rule Method of Setting Monetary Policy: 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  8. Inflation Targeting: An approach to monetary policy that  require that the central bank try to keep the inflation rate  near a predetermined target rate  ∙ One major difference between inflation targeting and the  Taylor rule method is that inflation targeting is forward looking rather than backward-looking.  o The Taylor rule method adjusts monetary policy in  response to past inflation  o Inflation targeting is based on a forecast of future  inflation  ∙ Advocates of inflation targeting argue that it has two key  advantages over the Taylor Rule: o Economic uncertainty is reduced because the central bank’s plan is transparent: the public knows the  objective of an inflation-targeting central bank  o The central bank’s success can be judged by seeing  how closely actual inflation rates have matched the  inflation target, making central banks accountable  9. Zero Lower Bound for Interest Rates: statement of the fact  that interest rates cannot fall below zero  10. Short-Run and Long-Run Effects of an Increase in the  Money Supply When the economy is already at potential output, an  increase in the money supply generates a positive short-run  effect, but no long-run effect, on real GDP. Here, the economy begins at E1, a point of short-run and  long-run macroeconomic equilibrium. An increase in the  money supply shifts the AD curve rightward, and the  economy moves to a new short-run macroeconomic  equilibrium at E2 and a new real GDP of Y2. But E2 is not a  long-run equilibrium: Y2 exceeds potential output, Y1,  leading over time to an increase in nominal wages. In the  long run, the increase in nominal wages shifts the short-run  aggregate supply curve leftward, to a new position at SRAS2. The economy reaches a new short-run and long-run  macroeconomic equilibrium at E3 on the LRAS curve, and  output falls back to potential output, Y1. When the economy  is already at potential output, the only long-run effect of an  increase in the money supply is an increase in the aggregate price level from P1 to P3.11. Monetary Neutrality: The concept that changes in the  money supply have no real effects on the economy in the  long run and only result in a proportional change in the price  level  12. The Long-Run Determination of the Interest Rate  In the short run, an increase in the money supply  from M1 to M2 pushes the interest rate down  from r1 to r2 and the economy moves to E2, a short-run  equilibrium. In the long run, however, the aggregate price  level rises in proportion to the increase in the money supply,  leading to an increase in money demand at any given  interest rate in proportion to the increase in the aggregate  price level, as shown by the shift from MD1 to MD2. The  result is that the quantity of money demanded at any given  interest rate rises by the same amount as the quantity of  money supplied. The economy moves to long-run equilibrium at E3 and the interest rate returns to r1.Now suppose the money supply increases from M1 to M2. In the  short run, the economy moves from E1 to E2 and the interest rate falls from r1 to r2. Over time, however, the aggregate price level  rises, and this raises money demand, shifting the money demand  curve rightward from MD1 to MD2. The economy moves to a new  long-run equilibrium at E3, and the interest rate rises to its  original level at r1. __________________________________________________________________ _ Chapter 19: The Open Economy 1. Balance of Payments Accounts: Summary of the country’s  transactions with other countries for a give year  ∙ Balance of Payments on Current Account:  Transactions that don’t create liabilities; a country’s  balance of payments on goods and services plus net  international transfer payments and factor income  ∙ Current Account: Transactions that don’t create  liabilities; a country’s balance of payments on goods and  services plus net international transfer payments and  factor income ∙ Balance of Payments on Goods and Services: The  difference between the value of exports and the value of  imports during a given period  ∙ Merchandise Trade Balance/Trade Balance: The  difference between a country’s exports and imports of  goods alone – not including services  ∙ Balance of Payments on Financial Account/Financial Account: International transactions that involved the sale or purchase of assets, and therefore create future  liabilities  The yellow arrow represents payments that are counted in the  current account. The green arrow represents payments that are  counted in the financial account. Because the total flow into the  US must equal the total flow out of the US, the sum of the current  account plus the financial account is zero.  2. Modeling the Financial Account ∙ A country’s financial account measures its net sales of  assets to foreigners. There is, however, another way to  think about the financial account: it’s a measure of capital inflows, of foreign savings that are available to finance  domestic investment spendingThe Loanable Funds Model  According to the loanable funds model of the interest rate, the  equilibrium interest rate is determined by the intersection of the  supply of loanable funds curve, S, and the demand for loanable  funds curve, D. At point E, the equilibrium interest rate is 4%.  Loanable Funds Markets in a Two-Country World  Here we show two countries, the US and Britain, each with its own loanable funds market. The equilibrium interest rate is 6% in the  US but only 2% in the British market. This creates an incentive for capital to flow from Britain to the US. Panel a shows the loanable funds market in the US, where the  equilibrium in the absence of international capital flows is at point Eus with an interest rate of 6%.  Panel b shows the loanable funds market in Britain, where the  equilibrium in the absence of international capital flows is at point Eb with an interest rate of 2%.  Will the actual interest rate in the US remain at 6% and that in  Britain at 2%? No… not if it is easy for British residents to make  loans to Americans. In that case, British lenders, attracted by high US interest rates, will send some of their loanable funds to the US. This capital inflow will increase the quantity of loanable funds  supplied to American borrowers, pushing the US interest rate  down. At the same time, it will reduce the quantity of loanable  funds supplied to British borrowers, pushing the British interest  rate up.  SO, international capital flows will narrow the gap between US  and British interest rates.  This figure shows an international equilibrium in the loanable  funds markets where the equilibrium interest rate is 4% in both  the US and Britain. At this interest rate, the quantity of loanable  funds exceeds the quantity of loanable funds supplied by  American lenders. This gap is filled by “imported” funds – a  capital inflow from Britain. At the same time, the quantity of  loanable funds supplied by British lenders is greater than the quantity of loanable funds demanded by British borrowers. This  excess is “exported” in the form of a capital outflow to the US.  And the two markets are in equilibrium at a common interest rate  of 4% -- at that interest rate, the total quantity of loans demanded by borrowers across the two markets is equal to the total quantity of loans supplied by lenders across the two markets.  In short, international flows of capital are like international flows  of goods and services. Capital moves from places where it would  be cheap in the absence of international capital flows to places  where it would be expensive in the absence of such flows.  3. Understanding Exchange Rates  ∙ Foreign Exchange Market: The market in which  currencies can be exchanged for each other  ∙ Exchange Rates: The price at which currencies trade,  determined by the foreign exchange market  ∙ Appreciates: A rise in the value of one currency in terms  of other currencies  ∙ Depreciates: A fall in the value of one currency in terms  of other currencies  Movements in exchange rates, other things equal, affect the  relative prices of goods, services, and assets in different  countries.  4. Equilibrium Exchange Rate: the exchange rate at which the  quantity of a currency demanded in the foreign exchange  market is equal to the quantity supplied The Foreign Exchange Market  The foreign exchange market matches up the demand for a  currency from foreigners who want to buy domestic goods,  services, and assets with the supply of a currency from domestic  residents who want to buy foreign goods, services, and assets.  The figure shows two curves, the demand curve for US dollars and the supply curve for US dollars. The key to understanding the  slopes of these curves is that the level of the exchange rate  affects exports and imports. When a country’s currency  appreciates (becomes more valuable), exports fall and  imports rise. When a country’s currency depreciates  (becomes less valuable) exports rise and imports fall.  If the US dollar rises against the euro (the dollar appreciates),  America products will become more expensive to Europeans  relative to European produces. SO, Europeans will buy less from  the US and will acquire fewer dollars in the foreign exchange  market: the quantity of US dollars demanded falls as the number  of euros needed to buy a US dollar rises.  If the US dollar falls against the euro (the dollar depreciates),  American products will become relatively cheaper for Europeans.  Europeans will respond buy buying ore from the US and acquiring  more dollars in the foreign exchange market: the quantity of US  dollars demanded rises as the number of euros needed to buy a  US dollar falls.  An Increase in the Demand for US Dollars Suppose that for some reason capital flows from Europe to the US  increase. The demand for US dollars in the foreign exchange  market increases as European investors convert euros into dollars to fund their new investments in the US. This is shown by the shift of the demand curve from D1 to D2. As a result, the US dollar  appreciates against the euro: the number of euros per US dollar at the equilibrium exchange rate rises from XR1 to XR2. 5. Inflation and Real Exchange Rates  ∙ To take account of the effect of difference in inflation  rates, economists calculate real exchange rates:  (sigma) the ratio of the price level abroad and the  domestic price level, where the foreign price level is  converted into domestic currency units via the current  nominal exchange rate  o As the exchange rate falls, they should be able to sell more  Real exchange rate = Mexican pesos per US dollar x (Pus / Pmex)  ∙ Nominal Exchange Rate: (e) the number of units of the  domestic currency that can purchase a unit of a given  foreign currency  (Foreign Currency / Home Currency) ie.) euro / $ , pesos / $  ∙ Purchasing Power Parity: A theory that states that  exchange rates between currencies are in equilibrium  when their purchasing power is the same in each of the  two countries  when real exchange rates = 1 o Lose the incentive to have foreign trade  o Goods would cost the same amount of money in  each country  6. Exchange Rate Regimes  ∙ Exchange Rate Regime: A rule governing policy toward  the exchange rate  ∙ Fixed Exchange Rate: An exchange rate regime in  which the government keeps the exchange rate against  some other currency at or near a particular target.  ∙ Floating Exchange Rate: An exchange rate regime in  which the government lets market forces determine the  exchange rates  7. Exchange Market Intervention  Panel a shows the case in which the equilibrium value of the  geno is below the target exchange rate.  Panel b shows the case in which the equilibrium value of the  geno above the target exchange rate  In both panels, the imaginary country of Genovia is trying to keep  the exchange rate of the geno fixed at US$1.50 per geno. In panel (a), the equilibrium exchange rate is below $1.50, leading to a  surplus of genos on the foreign exchange market. To keep the  geno from falling below $1.50, the Genovian government can buy  genos and sell U.S. dollars. In panel (b), the equilibrium exchange  rate is above $1.50, leading to a shortage of genos on the foreign  exchange market. To keep the geno from rising above $1.50, the  Genovian government can sell genos and buy U.S. dollars.As panel a shows, at the target exchange rate of $1.50 per geno,  there is a surplus of genos in the foreign exchange market, which  would normally push the value of the geno down.  One way the Genovian government can support the geno is to  “soak up” the surplus of genos by buying its own currency in the  foreign exchange market.  ∙ A government purchase or sale of currency in the foreign  exchange market is called an exchange market  intervention  ∙ To buy genos in the foreign exchange market, the Genovian  government must have US dollar to exchange for genos. In  fact, most countries maintain foreign exchange reserves:  stocks of foreign currency that they can use to buy their own currency to support its price  They can also raise the interest rate, which will increase capital  flows, increasing the demand for genos  an increase in a  country’s interest rate will increase the value of its currency  They can also reduce the supply of genos to the foreign exchange market by requiring domestic residents who want to buy foreign  currency to get a license  foreign exchange controls:  licensing systems that limit the right of individuals to buy foreign  currency  8. Devaluation and Revaluation  ∙ Devaluation: A reduction in the value of a currency that  is set under a fixed exchange rate regime  o Makes domestic goods cheaper in terms of foreign  currency which leads to higher exports o Also makes foreign goods more expensive in terms of domestic currency which reduces imports  ∙ Revaluation: An increase in the value of a currency that  is set under a fixed exchange rate regime  o Makes domestic goods more expensive in terms of  foreign currency which reduces exports  o Makes foreign goods more cheaper in domestic  currency, which increases imports  9. Monetary Policy and the Exchange Rate  This shows the effect of an interest rate reduction on the  foreign exchange market. The demand curve for genos shifts leftward, from D1 to D2, and the supply curve shifts  rightward, from S1 to S2. The equilibrium exchange rate, as  measured in U.S. dollars per geno, falls from XR1 to XR2.  That is, a reduction in the Genovian interest rate causes the  geno to depreciate. Here we show what happens in the foreign exchange market if  Genovia cuts its interest rate. Residents of Genovia have a  reduced incentive to keep their funds at home, so they invest  more abroad. As a result, the supply of genos shifts rightward,  from S1 to S2. Meanwhile, foreigners have less incentive to put  funds into Genovia, so the demand for genos shifts leftward,  from D1 to D2. The geno depreciates: the equilibrium exchange  rate falls from XR1 to XR2. The depreciation of the geno affects aggregate demand. A depreciation that  is the result of a change in a fixed exchange rate increases exports and  reduces imports, thereby increasing aggregate demand. A depreciation that results from an interest rate cut has the same effect: it increases exports and reduces imports, increasing aggregate demand.
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