Principles of Macroeconomics Final Exam Study Guide
What is Money
∙ Money is any commodity or token that is generally acceptable as a means of payment.
∙ A means of payment is a method of settling a debt.
∙ Money has three other functions:
o Medium of exchange
A medium of exchange is an object that is generally accepted in exchange for goods and services.
In the absence of money, people would need to exchange goods and services directly, which is called barter.
Barter requires a double coincidence of wants, which is rare, so barter is costly
o Unit of account
A unit of account is an agreed measure for stating the prices of goods and services
o Store of value
As a store of value, money can be held for a time and later
exchanged for goods and services
o Money in the United States consists of
Deposits at banks and other depository institutions
Currency is the notes and coins held by individuals and
Deposits are money because the owners can use the deposit to make payments We also discuss several other topics like What are the three most important things to consider in terms of language choices in a speech?
o The two main official measures of money in the United States are M1 and M2.
M1 consists of currency and traveler’s checks and checking
deposits owned by individuals and businesses.
M2 consists of M1 plus time deposits, saving deposits, money market mutual funds, and other deposits
o Are M1 and M2 Really Money?
All the items in M1 are means of payment, so they are money. Some saving deposits in M2 are not means of payments—they are called liquid
Liquidity is the property of being instantly convertible into a means of payment with little loss of value.
o Deposits are Money but Checks Are Not
In defining money, we include, along with currency, deposits at banks and other depository institutions.
A check is an instruction to a bank to transfer money.
A check is not money, but the deposit on which it is written is money.
o Credit Cards Are Not Money?
A credit card enables the holder to obtain a loan, but it must be repaid with money. Credit cards are not money We also discuss several other topics like How do you know if variances are equal?
∙ A depository institution is a firm that takes deposits from households and firms and makes loans to other households and firms.
∙ Types of Depository Institutions
o Deposits at three institutions make up the nation’s money. They are o Commercial Banks
A commercial bank is a private firm that is licensed by the We also discuss several other topics like What is the turbulent flow inside a pipe?
Comptroller of the Currency or by a state agency to receive
deposits and make loans.
o Thrift Institutions
Savings and loan associations, savings banks, and credit unions are called thrift institutions.
o Money Market Mutual Funds
A money market mutual fund is a fund operated by a financial institution that sells shares in the fund and holds assets such as U.S. Treasury bills. (You can write checks on these accounts.
o The goal of any bank is to maximize the wealth of its owners. o To achieve this objective, the interest rate at which it lends exceeds the interest rate it pays on deposits.
o But the banks must balance profit and prudence:
Loans generate profit.
Depositors must be able to obtain their funds when they want them
o A commercial bank puts the depositors’ funds into three types of assets:
o Cash assets—notes and coins in its vault or its deposit at the Federal Reserve Don't forget about the age old question of What is the meaning of mercantilism?
o Securities—U.S. government Treasury bills and commercial bills and longer-term U.S. government bonds and other bonds such as
o Loans—commitments of fixed amounts of money for agreed-upon periods of time.
o Key point. Deposits at banks become loans, holdings of bonds, or reserve deposts at the central bank
The Federal Reserve System
∙ The Federal Reserve System (the Fed) is the central bank of the United States.
∙ A central bank is the public authority that regulates a nation’s depository institutions and controls the quantity of money.
∙ The Fed’s goals are to keep inflation in check, maintain full employment, moderate the business cycle, and contribute toward achieving long-term growth.
∙ In pursuit of its goals, the Fed pays close attention to the federal funds rate— the interest rate that banks charge each other on overnight loans of reserves. ∙ The key elements in the structure of the Fed are
o The Board of Governors
o The regional Federal Reserve banks
o The Federal Open Market Committee
∙ The Federal Open Market Committee (FOMC) is the main policy-making group in the Federal Reserve System.
∙ It consists of the members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the 11 presidents of other regional Federal Reserve banks of whom, on a rotating basis, 4 are voting members. ∙ The FOMC meets every six weeks to formulate monetary policy. We also discuss several other topics like What is the systematic study of society?
The Conduct of Monetary Policy
∙ An open market operation is the purchase or sale of government securities by the Fed from or to a commercial bank or the public.
∙ When the Fed buys securities, it pays for them with newly created reserves held by the banks.
∙ When the Fed sells securities, they are paid for with reserves held by banks. ∙ So open market operations influence banks’ reserves
The Federal Reserve System
∙ Last Resort Loans
o The Fed is the lender of last resort, which means the Fed stands ready to lend reserves to depository institutions that are short of reserves. The Federal Reserve essentially purchases assets from banks in exchange for increasing the banks’ reserves. This if often called discount window lending.
∙ Required Reserve Ratio
o The Fed sets the required reserve ratio, which is the minimum percentage of deposits that a depository institution must hold as reserves.
o The Fed rarely changes the required reserve ratio We also discuss several other topics like How tributary-based societies differ from kinship-based societies?
How Banks Create Money
∙ Banks create deposits when they make loans and the new deposits created are new money.
∙ The quantity of deposits that banks can create is limited by three factors: o The monetary base
The monetary base is the sum of Federal Reserve notes, coins, and banks’ deposits at the Fed.
The size of the monetary base limits the total quantity of money that the banking system can create because
Banks have desired reserves.
Households and firms have desired currency holdings.
And both these desired holdings of monetary base depend on the quantity of money.
o Desired reserves
A bank’s actual reserves consists of notes and coins in its vault and its deposit at the Fed.
The desired reserve ratio is the ratio of the bank’s reserves to total deposits that a bank plans to hold.
The desired reserve ratio exceeds the required reserve ratio by the amount that the bank determines to be prudent for its daily business.
o Desired currency holding
People hold some fraction of their money as currency.
So when the total quantity of money increases, so does the
quantity of currency that people plan to hold.
Because desired currency holding increases when deposits
increase, currency leaves the banks when they make loans and increase deposits.
This leakage of reserves into currency is called the currency drain.
The ratio of currency to deposits is the currency drain ratio.
o The money creation process begins with an increase in the monetary base.
o The Fed conducts an open market operation in which it buys securities from banks.
o The Fed pays for the securities with newly created bank reserves. o Banks now have more reserves but the same amount of deposits, so they have excess reserves.
o Excess reserves = Actual reserves – desired reserves.
o The Money Multiplier
The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base.
For example, if the Fed increases the monetary base by
$100,000 and the quantity of money increases by $250,000, the money multiplier is 2.5.
The quantity of money created depends on the desired reserve ratio and the currency drain ratio.
The smaller these ratios, the larger is the money multiplier.
The Money Market
∙ The Influences on Money Holding
∙ The quantity of money that people plan to hold depends on four main factors: o The price level
A rise in the price level increases the quantity of nominal money but doesn’t change the quantity of real money that people plan to hold.
Nominal money is the amount of money measured in dollars. Real money equals nominal money ÷ price level.
The quantity of nominal money demanded is proportional to the price level—a 10 percent rise in the price level increases the
quantity of nominal money demanded by 10 percent
o The nominal interest rate
The nominal interest rate is the opportunity cost of holding
wealth in the form of money rather than an interest-bearing
A rise in the nominal interest rate on other assets decreases the quantity of real money that people plan to hold.
o Real GDP
An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to
o Financial innovation
Financial innovation that lowers the cost of switching between money and interest-bearing assets decreases the quantity of
real money that people plan to hold.
o The demand for money is the relationship between the quantity of real money demanded and the nominal interest rate when all other
influences on the amount of money that people wish to hold remain the same
The Quantity Theory of Money
The quantity theory of money is the proposition that, in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.
The quantity theory of money is based on the velocity of circulation and the equation of exchange.
The velocity of circulation is the average number of times in a year a dollar is used to purchase goods and services in GDP.
∙ The quantity of real GDP supplied is the total quantity that firms plan to produce during a given period
∙ Aggregate supply is the relationship between the quantity of real GDP supplied and the price level
∙ We distinguish two line frames associated with different states of the labor market
o Long-run aggregate supply
The relationship between the quantity of real GDP equals
Potential GDP is independent of price level
LAS- vertical at Potential GDP
o Short-run aggregate supply
Relationship between the quantity of real GDP supplied and the price level when the money wage rate, the prices increases the quantity of real GDP supplied
The short-run aggregate supply curve SAS is upward sloping ∙ Changes in Aggregate Supply
o Aggregate supply changes if an influence on production plans other than the price level changes
o These influences include
Changes in potential GDP
Changes in money wage rate and other factor prices
o Changes in potential GDP
When Potential GDP increases, both LAS and SAS curves shift upward
Potential GDP changes for three reasons
∙ An increase in the full-employment quantity of labor
∙ An increase in the quantity of capital (physical or human)
∙ An advance in technology
∙ The quantity of real GDP demanded, Y, is the total amount of final goods and services produced in US that people, businesses, governments, and foreigners plan to buy.
∙ This quantity is the sum of consumption expenditures, C, investment, I, government expenditure, G, and net exports, X-M
∙ Y = C + I + G + X – M
∙ Buying plans depend on many factors and some of the main ones are o The price level
o Fiscal policy and monetary policy
o The world economy
∙ Aggregate Demand Curve
o Aggregate demand is the relationship between the quantity of real GDP demanded and the price level
o The aggregate demand curve AD plots the quantity of real GDP demanded against the price level
o Slopes downward because of the wealth effect and substitution effect o Wealth effect
A rise in the price level, other things remaining the same,
decreases the quantity of real wealth (money, stocks, etc.).
To restore their real wealth, people increase saving and decrease spending.
The quantity of real GDP demanded decreases.
Similarly, a fall in the price level, other things remaining the same, increases the quantity of real wealth, which increases the quantity of real GDP demanded.
Monetary wealth (MW/P)
Nonmonetary wealth (NMW/P)
o Substitution Effect
Intertemporal Substitution effect
A rise in the price level, other things remain the same, decreases the real value of money and raises the interest rate When the interest rate rises, people borrow and spend less, so the quantity of real GDP demanded decreases
Similarly, a fall in the price level increase the real value of money and lowers the interest rate
When the interest rate falls, people borrow and spend more so the quantity of real GDP demand increases
International Substitution Effect
A rise in the price level, other things remaining the same, increases the price of domestic goods relative to foreign goods So imports increase and exports decrease, which decreases the quantity of real GDP demanded
Similarly, a fall in the price level, other things remaining the same, increases the quantity of real GDP demanded
o Changes in Aggregate Demand
A change in any influence on buying plans other than the price level changes aggregate demand
o Expectations about future income, future inflation
and future profits change aggregate demand
o Increases in expected future income increase
people’s consumption today and increases
o A rise in the expected inflation rate makes buying
goods cheaper today and increases aggregate
o An increase in expected future profits boosts firms’
investment, which increases aggregate demand.
∙ Fiscal policy and monetary policy
o Fiscal policy is the government’s attempt to
influence the economy by setting and changing
taxes, making transfer payments, and purchasing
goods and services
o A tax cut or an increase in transfer payments
increase household’s disposable income- aggregate
income minus taxes plus transfer payments
o An increase in disposable income increases
consumption expenditure and increases aggregate
∙ The world economy
o The world economy influences aggregate demand
in two ways:
o A fall in the foreign exchange rate lowers the price
of domestic goods and services relative to foreign
goods and services, which increases exports,
decreases imports, and increases aggregate
o An increase in foreign income increases the
demand for U.S. exports and increases aggregate
∙ Explaining Macroeconomic Trends and Fluctuations
o Short Run Macroeconomic equilibrium- occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the SAS curve
Explaining Macroeconomic Trends and Fluctuations
∙ In short run equilibrium, real GDP can be greater than or less than potential GDP
∙ Long-Run Macroeconomic equilibrium
o Occurs when real GDP equals potential GDP—when the economy is on its LAS curve, occurs an intersection of the AD and LAS curves
∙ ** Consider studying the graphs they are super useful**
Explaining Macroeconomic Trends and Fluctuations
∙ Business Cycle in the AS-AD Model
o The business cycle occurs because aggregate demand and the short run aggregate supply fluctuate, but the money wage does not change rapidly enough to keep real GDP at potential GDP.
o An above full-employment equilibrium is an equilibrium in which real GDP exceeds potential GDP.
o A full-employment equilibrium is an equilibrium in which real GDP equals potential GDP.
o A below full-employment equilibrium is an equilibrium in which potential GDP exceeds real GDP.
o Graph of above full-employment equilibrium
Amount by which real GDP exceeds potential GDP is called an inflationary gap
o Graph of below full-employment equilibrium
The amount by which real GDP is less than potential GDP is
called a recessionary gap
o At the short run equilibrium, there is an inflationary gap
The money wage rate begins to rise and the SAS curve starts to shift leftward
The price level continues to rise and real GDP continues to
decrease until it equals potential GDP
Macroeconomic Schools of Thought
∙ 3 broad schools of thought
o CLASSICAL VIEW
A classical macroeconomist believes that the economy is self regulating and always at full employment.
The term “classical” derives from the name of the founding
school of economics that includes Adam Smith, David Ricardo,
and John Stuart Mill.
A new classical view is that business cycle fluctuations are the efficient responses of a well-functioning market economy that is bombarded by shocks that arise from the uneven pace of
A Keynesian macroeconomist believes that left alone, the
economy would rarely operate at full employment and that to
achieve and maintain full employment, active help from fiscal
policy and monetary policy is required.
The term “Keynesian” derives from the name of one of the
twentieth century’s most famous economists, John Maynard
A new Keynesian view holds that not only is the money wage rate sticky but also are the prices of goods
A monetarist is a macroeconomist who believes that the
economy is self-regulating and that it will normally operate at
full employment, provided that monetary policy is not erratic
and that the pace of money growth is kept steady.
The term “monetarist” was coined by an outstanding twentieth century economist, Karl Brunner, to describe his own views and those of Milton Friedman
Fixed Prices and Expenditure Plans
∙ The Keynesian model describes the economy in the very short run when prices are fixed.
∙ Because each firm’s price is fixed, for the economy as a whole o The price level is fixed
o Aggregate demand determines real GDP
∙ Expenditure Plans
o Components of aggregate expenditure sum to real GDP
o Y = C + I + G + X – M
o 2 of the components of aggregate expenditure, consumption and imports, are influenced by real GDP.
o there is a two-way link between aggregate expenditure and real GDP ∙ Two-way link between Aggregate Expenditure and Real GDP
o Other things remaining the same
An increase in real GDP increases aggregate expenditure.
An increase in aggregate expenditure increases real GDP
∙ Consumption and Saving Plans
o Consumption expenditure is influenced by many factors but the most direct one is disposable income.
o Disposable income is aggregate income or real GDP, Y, minus net taxes, T.
o Call disposable income YD.
o The equation for disposable income is
YD = Y – T
o Disposable income, YD, is either spent on consumption goods and services, C, or saved, S.
o That is, YD = C + S.
o The relationship between consumption expenditure and disposable income, other things remaining the same, is the consumption function. o The relationship between saving and disposable income, other things remaining the same, is the saving function
o On Graphs
When consumption expenditure exceeds disposable income, saving is negative (dissaving).
When consumption expenditure is less than disposable income, there is saving
∙ Marginal Propensities to Consume and Save
o The marginal propensity to consume (MPC) is the fraction of a change in disposable income spent on consumption.
o It is calculated as the change in consumption expenditure, ∆C, divided by the change in disposable income, ∆YD, that brought it about. o That is, MPC = ∆C/ ∆YD
o The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved.
o It is calculated as the change in saving, DS, divided by the change in disposable income, DYD, that brought it about.
o MPS = ∆S/ ∆YD.
o Disposable income changes when either real GDP changes or net taxes change.
o If tax rates don’t change, real GDP is the only influence on disposable income, so consumption expenditure is a function of real GDP.
o We use this relationship to determine real GDP when the price level is fixed.
o In the short run, U.S. imports are influenced primarily by U.S. real GDP. o The marginal propensity to import is the fraction of an increase in real GDP spent on imports.
Real GDDP with a Fixed Price Level
∙ When the price level is fixed, aggregate demand is determined by aggregate expenditure plans.
∙ Aggregate planned expenditure is planned consumption expenditure plus planned investment plus planned government expenditure plus planned exports minus planned imports
∙ Planned consumption expenditure and planned imports are influenced by real GDP.
∙ When real GDP increases, planned consumption expenditure and planned imports increase.
∙ Planned investment plus planned government expenditure plus planned exports are not influenced by real GDP.
∙ The relationship between aggregate planned expenditure and real GDP can be described by an aggregate expenditure schedule, which lists the level of aggregate expenditure planned at each level of real GDP
Real GDP with a Fixed Price Level
∙ Actual aggregate expenditure is always equal to real GDP.
∙ Aggregate planned expenditure may differ from actual aggregate expenditure because firms can have unplanned changes in inventories
∙ Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP
∙ From Below Equilibrium
o If aggregate planned expenditure exceeds real GDP,
o there is an unplanned decrease in inventories.
o To restore inventories, firms hire workers and increase production. o Real GDP increases.
∙ From Above Equilibrium
o If real GDP exceeds aggregate planned expenditure, …
o there is an unplanned increase in inventories.
o To reduce inventories, firms lay off workers and decrease production. o Real GDP decreases
∙ When autonomous expenditure changes, so does equilibrium expenditure and real GDP.
∙ But the change in equilibrium expenditure is larger than the change in autonomous expenditure.
∙ The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP.
∙ An increase in investment (or any other component of autonomous expenditure) increases aggregate expenditure and real GDP.
∙ The increase in real GDP leads to an increase in induced expenditure. ∙ The increase in induced expenditure leads to a further increase in aggregate expenditure and real GDP.
∙ real GDP increases by more than the initial increase in autonomous expenditure
∙ Why Is the Multiplier Greater than 1?
o The multiplier is greater than 1 because an increase in autonomous expenditure induces further increases in aggregate expenditure. ∙ The Size of the Multiplier
o The size of the multiplier is the change in equilibrium expenditure divided by the change in autonomous expenditure.
∙ The slope of the AE curve determines the magnitude of the multiplier: o Multiplier = 1 ÷ (1 – Slope of AE curve).
∙ If the change in real GDP is DY, the change in autonomous expenditure is DA, and the change in induced expenditure is DN, then
o Multiplier = ∆Y/∆A
∙ Turning points in the business cycle—peaks and troughs—occur when autonomous expenditure changes.
∙ An increase in autonomous expenditure brings an unplanned decrease in inventories, which triggers an expansion.
∙ A decrease in autonomous expenditure brings an unplanned increase in inventories, which triggers a recession
The Multiplier and the Price Level
∙ Real firms don’t hold their prices constant for long.
∙ When firms have an unplanned change in inventories, they change production and prices.
∙ And the price level changes when firms change prices.
∙ The AS-AD model explains the simultaneous determination of real GDP and the price level.
∙ The two models are related
∙ The aggregate expenditure curve is the relationship between aggregate planned expenditure and real GDP, with all other influences on aggregate planned expenditure remaining the same.
∙ The aggregate demand curve is the relationship between the quantity of real GDP demanded and the price level, with all other influences on aggregate demand remaining the same
∙ When the price level changes, a wealth effect and substitution effects change aggregate planned expenditure and change the quantity of real GDP demanded.
The Business Cycle
∙ Two approaches to understanding business cycles are
o Mainstream business cycle theory
Because potential GDP grows at a steady pace while aggregate demand grows at a fluctuating rate, real GDP fluctuates around potential GDP
o Real business cycle theory
Regards random fluctuations in productivity as the main source of economic fluctuations
These productivity fluctuations are assumed to result mainly from fluctuations in the pace of technological change
But other sources might be international disturbances, climate fluctuations, or natural disasters
We will explore RBC theory by looking first at its impulse and then at the mechanism that converts that impulse into a cycle in real GDP
∙ The RBC Impulse
o The impulse is the productivity growth rate that results from technological change.
o Most of the time, technological change is steady and productivity grows at a moderate pace.
o But sometimes productivity growth speeds up, and occasionally it decreases—labor becomes less productive, on average.
o A period of rapid productivity growth brings an expansion, and a decrease in productivity triggers a recession.
o Two effects follow from a change in productivity that gets an expansion or a contraction going
Investment demand changes
The demand for labor changes
∙ The Key Decision: When to work
o To decide when to work, people compare the return from working in the current period with the expected return from working in a later period. o The when-to-work decision depends on the real interest rate. The lower the real interest rate, the smaller is the supply of labor today.
o Many economists believe that this intertemporal substitution effect is small, but RBC theorists believe that it is large and the key feature of the RBC mechanism
∙ Criticisms and Defense of RBC Theory
o The three main criticisms of RBC theory are that
The money wage rate is sticky, and to assume otherwise is at odds with a clear fact
Intertemporal substitution is too weak a force to account for large fluctuations in labor supply and employment with small
real wage rate changes
Productivity shocks are as likely to be caused by changes in aggregate demand as by technological change
∙ Defenders of RBC theory claim that
o RBC theory explains the macroeconomic facts about business cycles and is consistent with the facts about economic growth. RBC theory is a single theory that explains both growth and cycles.
o RBC theory is consistent with a wide range of microeconomic evidence about labor supply decisions, labor demand and investment demand decisions, and information on the distribution of income between labor and capital
∙ In the long run, inflation occurs if the quantity of money grows faster than potential GDP.
∙ In the short run, many factors can start an inflation, and real GDP and the price level interact.
∙ To study these interactions, we distinguish between two sources of inflation: o Demand-pull inflation
An inflation that starts because aggregate demand increases is called demand-pull inflation.
Demand-pull inflation can begin with any factor that increases aggregate demand.
Examples are a cut in the interest rate, an increase in the
quantity of money, an increase in government expenditure, a
tax cut, an increase in exports, or an increase in investment
stimulated by an increase in expected future profits.
o Cost-push inflation
An inflation that starts with an increase in costs is called cost push inflation.
There are two main sources of increased costs:
∙ An increase in the money wage rate
∙ An increase in the money price of raw materials, such
∙ Aggregate Demand Response
o The initial increase in costs creates a one-time rise in the price level, not inflation.
o To create inflation, aggregate demand must increase.
o That is, the Fed must increase the quantity of money persistently ∙ Forecasting inflation
o To expect inflation, people must forecast it.
o The best forecast available is one that is based on all the relevant information and is called a rational expectation.
o A rational expectation is not necessarily correct, but it is the best available
∙ Inflation and the Business Cycle
o When the inflation forecast is correct, the economy operates at full employment.
o If aggregate demand grows faster than expected, real GDP moves above potential GDP, the inflation rate exceeds its expected rate, and the economy behaves like it does in a demand-pull inflation.
o If aggregate demand grows more slowly than expected, real GDP falls below potential GDP, the inflation rate slows, and the economy behaves like it does in a cost-push inflation.
∙ An economy experiences deflation when it has a persistently falling price level.
∙ What causes deflation?
o The price level falls persistently if aggregate demand increases at a persistently slower rate than aggregate supply.
o The Quantity Theory and Deflation
Inflation rate = Money growth rate + Rate of velocity change – Real GDP growth rate
Deflation occurs if
Money growth rate < Real GDP growth rate – Rate of velocity change.
∙ What are the consequences of deflation?
o Unanticipated deflation redistributes income and wealth, lowers real GDP and employment, and diverts resources from production
∙ How can deflation be ended?
o By increasing the growth rate of money.
o Make the money growth rate exceed the growth rate of real GDP minus the rate of velocity change.
The Phillips Curve
∙ A Phillips curve is a curve that shows the relationship between the inflation rate and the unemployment rate.
∙ There are two time frames for Phillips curves:
o The short-run Phillips curve
The short-run Phillips curve shows the trade off between the inflation rate and unemployment rate, holding constant
∙ The expected inflation rate
∙ The natural unemployment rate
o The long-run Phillips curve
The long-run Phillips curve shows the relationship between
inflation and unemployment when the actual inflation rate
equals the expected inflation rate
The Federal Budget
∙ The federal budget is the annual statement of the federal government’s outlays and tax revenues.
∙ The federal budget has two purposes:
o To finance federal government programs and activities
o To achieve macroeconomic objectives
∙ Fiscal policy is the use of the federal budget to achieve macroeconomic objectives, such as full employment, sustained economic growth, and price level stability.
∙ Fiscal policy operates within the framework of the Employment Act of 1946 in which Congress declared that
o it is the continuing policy and responsibility of the Federal Government to use all practicable means
o to coordinate and utilize all its plans, functions, and resources . . . to promote maximum employment, production, and purchasing power o Surplus or Deficit
The federal government’s budget balance equals receipts minus outlays.
If receipts exceed outlays, the government has a
If outlays exceed receipts, the government has a
If receipts equal outlays, the government has a
The projected budget deficit in fiscal 2015 is $644 billion.
o State and Local Budgets
The total government sector includes state and local
governments as well as the federal government.
In Fiscal 2015, when federal government outlays were about $4,158 billion, state and local outlays were a further $2,700
Most of state expenditures were on public schools, colleges, and universities ($550 billion); local police and fire services; and
∙ A fiscal stimulus is the use of fiscal policy to increase production and employment.
∙ Fiscal stimulus can be either
∙ Automatic fiscal policy is a fiscal policy action triggered by the state of the economy with no government action.
∙ Discretionary fiscal policy is a policy action that is initiated by an act of Congress.
∙ Automatic Changes in Tax Revenues
o Congress sets the tax rates that people must pay.
o The tax dollars people pay depend on tax rates and incomes. o But incomes vary with real GDP, so tax revenues depend on real GDP. o When real GDP increases in an expansion, tax revenues increase. o When real GDP decreases in a recession, tax revenues decrease ∙ Needs-Tested Spending
o The government creates programs that pay benefits to qualified people and businesses.
o These transfer payments depend on the economic state of the economy.
o When the economy is in an expansion, unemployment falls, so needs tested spending decreases.
o When the economy is in a recession, unemployment rises, so needs tested spending increases.
∙ Automatic Stimulus
o In a recession, receipts decrease and outlays increase.
o So the budget provides an automatic stimulus that helps shrink the recessionary gap.
o In a boom, receipts increase and outlays decrease.
o So the budget provides automatic restraint that helps shrink the inflationary gap.
∙ Cyclical and Structural Balances
o The structural surplus or deficit is the budget balance that would occur if the economy were at full employment and real GDP were equal to potential GDP.
o The cyclical surplus or deficit is the actual surplus or deficit minus the structural surplus or deficit.
o That is, a cyclical surplus or deficit is the surplus or deficit that occurs purely because real GDP does not equal potential GDP.
∙ Discretionary Fiscal Stimulus
o Most discretionary fiscal stimulus focuses on its effects on aggregate demand.
∙ Fiscal Stimulus and Aggregate Demand
o Changes in government expenditure and taxes change aggregate demand and have multiplier effects.
o Two main fiscal multipliers are
o Government expenditure multiplier
o Tax multiplier
∙ The government expenditure multiplier is the quantitative effect of a change in government expenditure on real GDP.
∙ Because government expenditure is a component of aggregate expenditure, an increase in government expenditure increases real GDP.
∙ When real GDP increases, incomes rise and consumption expenditure increases. Aggregate demand increases.
∙ If this were the only consequence of the increase in government expenditure, the multiplier would be >1.
∙ But an increase in government expenditure increases government borrowing and raises the real interest rate.
∙ With the higher cost of borrowing, investment decreases, which partly offsets the increase in government expenditure.
∙ If this were the only consequence of the increase in government expenditure, the multiplier would be < 1.
∙ Which effect is stronger?
∙ The consensus is that the crowding-out effect dominates and the multiplier is <1.
∙ The tax multiplier is the quantitative effect of a change in taxes on aggregate demand.
∙ The demand-side effects of a tax cut are likely to be smaller than an equivalent increase in government expenditure.
∙ Monetary Policy Objectives
o Monetary policy objectives stem from the mandate of the Board of Governors of the Federal Reserve System as set out in the Federal Reserve Act of 1913 and its amendments. The law states:
o The Fed and the FOMC shall maintain long-term growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, ...
o so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
Monetary Policy Objectives and Framework
∙ Goals and Means
o The Fed’s monetary policy objective has two distinct parts:
A statement of the goals or ultimate objectives
A prescription of the means by which the Fed should pursue its goals
o Goals of Monetary Policy
Goals are maximum employment, stable prices, and moderate long-term interest rates.
In the long run, these goals are in harmony and reinforce each other.
But in the short run, they might be in conflict.
The key goal is price stability.
Price stability is the source of maximum employment and
moderate long-term interest rates.
∙ Operational Stables Prices Goal
o The Fed pays attention to two measures of inflation: the CPI and the personal consumption expenditure (PCE) deflator.
o The Fed’s operational guide is PCE deflator excluding fuel and food— the core PCE deflator.
o The rate of increase in the core PCE deflator is the core inflation rate.
o The Fed believes that the core inflation rate is less volatile than the CPI inflation rate and provides a better measure of the underlying inflation trend.
∙ Operational Maximum Employment Goal
o Stable prices is the primary goal, but the Fed pays attention to the business cycle.
o To gauge the overall state of the economy, the Fed uses the output gap —the percentage deviation of real GDP from potential GDP.
o A positive output gap indicates increasing inflation.
o A negative output gap indicates unemployment above the natural rate. o The Fed tries to minimize the output gap
∙ Responsibility for Monetary Policy
o What is the role of the Fed, the Congress, and the President? o The Fed’s FOMC makes monetary policy decisions.
o The Congress plays no role in making monetary policy decisions. The Fed makes two reports a year and the Chairman testifies before Congress (February and June).
o The formal role of the President is limited to appointing the members and Chairman of the Board of Governors
The Conduct of Monetary Policy
∙ How does the Fed conduct monetary policy?
∙ This question has two parts:
o What is the Fed’s monetary policy instrument?
o How does the Fed make its policy decision?
∙ The Monetary Policy Instrument
o The monetary policy instrument is a variable that the Fed can directly control or closely target.
∙ The Fed has two possible instruments:
o Monetary base
o Federal funds rate—the interest rate at which banks borrow and lend overnight from other banks.
∙ The Fed’s choice of policy instrument (which is the same choice as that made by most other major central banks) is the federal funds rate.
∙ The Fed sets a target for the federal funds rate and then takes actions to keep it close to its target.
∙ The Fed’s Decision-Making Strategy
o The Fed’s decision begins with an intensive assessment of the current state of the economy.
o Then the Fed forecasts three variables
∙ Is the inflation rate inside the Fed’s comfort zone?
∙ If the inflation rate is above the comfort zone or expected
to move above it, the Fed considers raising the federal
funds rate target.
∙ If the inflation rate is below the comfort zone or expected
to move below it, the Fed considers lowering the federal
funds rate target.
∙ If the unemployment rate is below the natural
unemployment rate, a labor shortage might put pressure
on wage rates to rise, which might feed into inflation.
∙ The Fed might consider raising the federal funds rate.
∙ If the unemployment rate is above the natural
unemployment rate, a lower inflation rate is expected.
∙ The Fed might consider lowering the federal funds rate
∙ If the output gap is positive, it is an inflationary gap and
the inflation rate will most likely accelerate.
∙ The Fed might consider raising the federal funds rate.
∙ If the output gap is negative, it is a recessionary gap and
inflation might ease.
∙ The Fed might consider lowering the federal funds rate
Monetary Policy Transmission
∙ When the Fed lowers the federal funds rate, it buys securities in an open market:
o Other short-term interest rates and the exchange rate fall.
o The quantity of money and the supply of loanable funds increase. o The long-term real interest rate falls.
o Consumption expenditure, investment, and net exports increase o Aggregate demand increases
o Real GDP growth and the inflation rate increase
∙ When the Fed raises the federal funds rate, it sells securities in an open market and the ripple effects go in the opposite direction.
∙ Exchange Rate Fluctuations
o The exchange rate responds to changes in the interest rate in the United States relative to the interest rates in other countries—the U.S. interest rate differential.
o But other factors are also at work, which make the exchange rate hard to predict
∙ Money and Bank Loans
o When the Fed lowers the federal funds rate, the quantity of money and the quantity of bank loans increase.
o Consumption and investment plans change.
∙ Long-Term Real Interest Rate
o Equilibrium in the market for loanable funds determines the long-term real interest rate, which equals the nominal interest rate minus the expected inflation rate.
o The long-term real interest rate influences expenditure plans ∙ Expenditure Plans
o The ripple effects that follow a change in the federal funds rate change three components of aggregate expenditure:
o A change in the federal funds rate changes aggregate expenditure plans, which in turn change aggregate demand, real GDP, and the price level
o So the Fed influences the inflation rate and the output gap
∙ Loose Links and Long and Variable Lags
o Long-term interest rates that influence spending plans are linked loosely to the federal funds rate.
o The response of the real long-term interest rate to a change in the nominal interest rate depends on how inflation expectations change. o The response of expenditure plans to changes in the real interest rate depends on many factors that make the response hard to predict.
o The monetary policy transmission process is long and drawn out and doesn’t always respond in the same way.
∙ The Key Elements of the Crisis
o The three main events that put banks under stress were:
Widespread fall in asset prices (loans worth less)
A significant currency drain
A run on the bank
∙ The Policy Actions
o Policy actions dribbled out for more than a year.
Massive open market operations were used to increase bank reserves.
Deposit insurance was expanded.
The Fed bought troubled assets from banks.
o These actions provided banks with more reserves, more secure depositors, and safe liquid assets in place of troubled assets
∙ Interest Rate Targeting
o a monetary policy strategy in which the central bank makes a public commitment
To achieve an explicit inflation target
To explain how its policy actions will achieve that target
o Several central banks practice inflation targeting and have done so since the mid-1990s.
o Inflation targeting is a strategy that avoids serious inflation and persistent deflation.
∙ THE TAYLOR RULE?
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