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UF / OTHER / ECO / what is Macroeconomics?

what is Macroeconomics?

what is Macroeconomics?


Macroeconomics Exam 3 Study Guide  

what is Macroeconomics?

Lecture 19 

All Concepts On Exam 3 

- Fiscal policy is the economic policy conducted by Congress, President, or government Change in taxes or government spending, or both

- Monetary policy is conducted by the central bank of any country. It looks at the changes of  money and interest rates in the economy to pursue some macroeconomic objective Central bank in US = Federal Reserve

- Exchange rate policy

Fiscal Policy 

- Fiscal policy – the use of the Federal budget to pursue a macroeconomic objective Relies on changes to taxes and/or government spending

o For this class, focus on the Federal fiscal policy (not on state level)

o Uses budgets (why it relies on government spending and taxes) We also discuss several other topics like how much is the first salary of lebron james?

Receipts – forms and channels where the government collects money  


Outlays – forms and channels where the government spends money

What is the definition of Barter?

- Who controls/decides on the budget of the US?

Congress and President

- Core objective of fiscal policy should affect production and employment

- Congress and the President work back and forth to decide how they are going to spend and  collect taxes during the year

Fiscal year IS NOT the same as a calendar year (October 1st – September 30th)

o The fiscal budget is attached to a fiscal year, and it involves a negotiation, between  Congress and the President on how much money/funds will be allocated over the  year.  

o Congress will craft the actual budget for the fiscal year before October 1st 

Federal Budget 



Personal Income Tax (Largest)

Transfer Payment

Social Security Tax (Capped benefit)

Payment for Goods/Services

Corporate Income Tax

Interest Payments on National Debts

What are the types of Types of Depository Institutions?

Indirect Taxes and Other Receipts

*Social Security Tax – capped benefit; other payroll tax; small increases to this tax and cutting benefits  would make program viable for much longer Don't forget about the age old question of - Which atoms can hydrogen bond and how many of those atoms do you have?

*Indirect Tax refer to excise tax, or quantity tax (federal gas tax – put into trust fund for building  highways)

*Other receipts refer to small ways the Federal government collects money (ex. Passports) *Personal income tax is low, but corporate income tax can be high

*Largest portion of transfer payment is social security

- When receipts are greater than outlays – budget surplus (debt decreases)

- When receipts are less than outlays – budget deficit (debt increases) We also discuss several other topics like What is beta of XYZ?

- Expansionary fiscal policy aims to increase production and employment in the economy Recession

Increase government spending or decrease taxes

- Contractionary fiscal policy aims to decrease production and employment in the economy Expansionary/inflationary gap

Decrease government spending or increase taxes

Automatic Fiscal Policy vs. Discretionary Fiscal Policy 

Discretionary requires a deliberate act of the government, Congress, or President Automatic stabilizers help economy automatically move back to long-run equilibrium 1. Need-Tested Spending – spending increases during recessionary gap (expansionary fiscal  

policy) or spending decreases during inflationary gap (contractionary fiscal policy) 2. Changes to tax receipts – tax decreases during recessionary gap (expansionary fiscal policy)  or taxes increase during expansionary gap (contractionary fiscal policy)

- These stabilizers force economy back to potential GDP

Does not require a deliberate act of government, Congress, or President

Marginal Tax Rates 


Tax Rates







If a person earns $100,000, how much do they owe in taxes?

*Note: It is NOT ($100,000*0.40) = $40,000!

Here is the formula layout for this question:

0.10($10,000) + 0.25($50,000-$10,000) + 0.40($100,000 - $50,000)

Simplify: 0.10($10,000) + 0.25($40,000) + 0.40($50,000)

$1,000 + $10,000 + $20,000 = $31,000 If you want to learn more check out What is Realized Returns?

*Much lower than $50,000

Lecture 20 

- Supply-side economic policies are focused on or targeted towards the production side of the  economy

Related to Reaganomics – lower taxes to promote economic growth

- Fiscal policy multipliers determine how much to change government spending or taxes to make  Real GDP move back to Potential GDP

Reduction (Changes) to the Labor Income Tax 

Market for Labor Macroeconomic Reduction Function If you want to learn more check out What do we know about this function?



15k 18kHours  

Worked15k 18k

Hours  Worked

If we reduce tax on labor income, people want to work more

Determines how much the economy should produce  based on equilibrium quantity in market for labor

Supply shifts right; equilibrium quantity increases to 18k

Potential GDP goes from $40B to $45B

Wage Types – ones that companies pay and workers receive

When supply shift right, wage rate falls

Employers pay workers less because these people are taxed less

Take home pay for workers increase, so workers are more productive

o Expansionary fiscal policy (increased production and employment)



Reduction (Changes) to the Capital Gains Tax 


Funds Quan.

- Tax based on income earned from assets  becoming more valuable when sold

Tax on savings

- When real interest rate falls, consumer spending,  investment, and net exports increase

Expansionary fiscal policy

- Reduce tax on saving income will increase supply  (savers

- Interest rate falls and quantity increases - If tax is reduced, it will promote productive  activity and income so much that it will  If you want to learn more check out what do liver glycogen contributed to?

essentially pay for itself

Assumption is made by Laffer $40B $45B Laffer Curve (not incorrect, but not applicable) 

If tax rate = 0%, tax receipt = 0. If tax = 100%, tax receipt = 0.

Irrelevant because most societies are on left side of the  

curve (tax receipts decrease when tax rate decreases)

If we reduce tax rate, tax receipt increases if the country is  

on the right left of the curve Tax Rate

0% 95%


Government Spending Multiplier  Real GDP

 Government Spending

This multiplier is always positive. When Real GDP increases (decreases),  govt. spending increases (decreases). Positive over positive or negative  over negative.

Usually over 1 because Real GDP increases more than govt. spending

Tax Multiplier  Real GDP  Tax

This multiplier is always negative. When Real GDP increases (decreases), taxes  decrease (increase). Positive over negative or negative over positive.

Balanced Budget Multiplier 

If government changes government spending and taxes by the same amount.

 Real GDP   (G+T)  

This equals balanced budget multiplier (G + T)Lecture 21 

Barter: A system in which goods and services are traded for other goods and services Three Functions of Money 

1. Medium of exchange (solves “double coincidence of wants” – wanting what each other has;  money exchanged for good/service)

2. Unit of account (has specific value and less complicated than barter system) 3. Store of value (save income in the past and spend it when not working)

Money – perfectly and near-perfectly liquid (“spendable”) asset

Two Definitions of Money 

M1: Perfectly definition of money

Currency and coins

Checking account balances

Travelers’ checks (secure way to take out money in foreign countries before ATMs) *Strictest definition of money

M2: Perfectly/Near-Perfectly Spendable

Everything in M1

Savings Account Deposit

Time Deposit

Money Market Mutual Funds

*Less strict than M1

Lecture 22 

- Depository institutions are private institutions that accept deposits from households, firms, and  the government to make loans

Serves as financial intermediaries for the marker for loanable funds’ market

- If the total amount of money in the economy in the strictest way possible were measures, we  would look at M1

Not just the total amount of cash and coins

- The institutions where we deposit money and hold our balances will play a big role in monetary  policy because money is not just cash

Types of Depository Institutions 

1. Commercial banks are large banks that are engaged in taking deposits/giving loans from/to a  large number of institutions

Represents most prominent and largest portion of depository institutions

2. Thrift institutions

These institutions tend to be more limited in their scope and their operations because they  service only individuals and households

Savings Bank (take deposits, which are used to make loans)

o Largely only accept deposits from households and individuals

Many are there to offer you the function of having a saving account  

(where you go to deposit funds that you don’t touch until retirement)

o On the loan side, savings banks try to service individuals and households alone as  well

They are not making small or huge business loans (they mainly make  

mortgage and auto loans or smaller loans

Credit Union take deposits and make loans as well

o Tends to be member-owned (account-holders)

Commercial banks are owned by stockholders

o Credit Union’s responsibility is to benefit its owners (the account holders), so  fees are less likely to be high

Commercial banks’ responsibility is to benefit its owners (stockholders),  

so fees are more likely to be high

o Unlike commercial banks, credit unions have a social goal or purpose

Ex. Supporting veterans

3. Money Market Mutual Funds


o Social minded funds – funds that do or do not invest in particular companies (funds that  don’t invest in animal products or those that doesn’t pay workers a fair wage; funds that are  focused on exclusively American companies)

*What you earn from fund is subject to capital gains tax

Low-risk, low-reward fund

Fund manager is investing in monetary instruments only (no stocks or bonds) for less risk There is no concern that your money/value in the fund will not be there on any particular day  (checks can be written out of your ownership of the fund)

There is a minimum of how much you can write in the check

*All balances in these depository institutions can count as money

Roles of Depository Institutions 

1. Create Liquidity (Money)

Depository institutions create money, but not cash (if they created cash, it would be counterfeit) Fractional reserve system involves having the deposit and lending side

o You deposit money into the institution, and then they take a fraction and put it into  their reserves. The rest becomes available to borrowers through loans

Money is growing through this money multiplier process with the lending/relending  system

o Ex. Deposit $100 in commercial bank, then bank lends out $50 out of that $100.  Technically now, there is $150 in the economy.

Banks are critical in determining the total money in the economy because of their loans 2. Pool Risk

With depository institutions, if someone cannot pay back their loan, they default on their loan.  The bank then pools the risk among all the depositors (take $2 from each depositor while keep  their balance the same until the loan is paid off)

3. Reduce Cost of Borrowing Money

Depository institutions allow you to just walk in and fill out loan application (to see if you are  eligible)

4. Reduce Cost of Monitoring Borrowers

The banks have expertise in evaluating the likelihood of success in the loan and seeing if you  are able to pay it back

- Depository institutions play an important role in transmission of monetary policy - Federal Reserve System is a decentralized central bank that has branch locations around the US Structure of Federal Reserve 

“The Fed” is the headquarters in Washington D.C.

There is a Board of Governors (7 Members)

o “Chair” (only 4 years – also chair of FOMC)

o 6 other governors

o All serve a 14-Year, non-renewable term as Governor

12 Regional Federal Reserve Banks

Federal Open-Market Committee (12 Members) (Conducts largest portion of monetary policy) o Members included in FOMC:

7 Governors

President of NY Fed

4 Other Regional Fed Banks (alternate between the 11 regional Federal Reserve  banks that aren’t the NY Fed)

Rotate on 6-month terms

*Nonrenewable terms are used to avoid corruption (no need to please someone to be reappointed) *14 Years is used so governors can serve multiple presidents

Roles of a Central Bank 

1. Conduct monetary policy (changing money supply in economy and interest rates to pursue some  macroeconomic objective (reduce recessionary gap by increasing real GDP or reduce  expansionary gap by decreasing real GDP)

2. Serve as the bankers’ bank

- All depository institutions in the United States have an account at the Federal Reserve  (specifically at one of the 12 regional Federal Reserve banks)

3. Serve as “lender of last resort”

- Provides loans to depository institutions who cannot get loans on the private market

*In countries that use a different country’s currency, they cannot conduct monetary policy because they  do not own that currency

o Cannot change the amount of money

Lecture 23 

- Monetary policy enacted by the central bank (Federal Reserve) relies on the changes to the  money supply and interest rate

- Expansionary monetary policy increases Real GDP through a reduction in interest rates - Contractionary fiscal policy decreases Real GDP through an increase in interest rates

- Overnight loans are short-term loans between two commercial banks.  

Low interest rates because it is short term and the borrower is creditworthy

- A bank who cannot get these overnight loans (on the private market) can go to the Federal  Reserve for a discount loan

Where the Federal Reserve / central bank serve as lender of last resort

- Banks try to get the overnight loans because the interest rate is one of the lowest compared to  what the Federal Reserve charges

Commercial Bank Balanced Sheet 



Loans & Reserves


- Deposit is liability because it is the bank’s responsibility to give their customers their money back - Loans are assets because they have rights to get funds in the future

- Reserves are an asset because a fraction is held as reserves while the rest is used to make loans Reserves are held in either vaults or Federal Reserve

- Positive valuation is when assets are greater than the liabilities - solvent

- Negative valuation is when liabilities are greater than the assets - insolvent - Liquidity relates to cash on hand

Do you have enough reserves to allow people to withdraw their funds?

o Yes – liquid No – illiquid

Monetary Policy Tools:

1. Open Market Operations – largest chunk of monetary policy

Transactions that changed the total reserves in the banking system (monetary base) Involves the Federal Reserve engaging in a transaction with a private commercial bank  related to non-monetary assets (bills and notes which allow govt. to borrow money) What the Federal Open Market Committee is responsible for taking care of

o Monetary base – total reserves in the banking systems

Banks must have enough reserves to service calls on deposits

o This factor determines how much a bank can loan out

o The total amount of money in the economy depends on the total money in reserves Account balances are the largest chunk of money in the economy

o Money is in the financial system as these balances

- If a bank increases the amount of reserves, it can increase the amount of lending Banks rely on the increase in reserves to make loans

o An increase in the monetary base will directly increase the total amount of money in  the economy by even more

However, banks hold more than just reserves and loans (equities)

o Government securities – similar to bonds (IOUs from the federal government of the  United States – issuing debt)

Purchases – when the Federal Reserve buys government securities (non-monetary) from  a commercial bank, they add reserves to the monetary base because they pay with  reserves

o This allows the commercial bank to engage in more lending, growing the total  amount of money in the economy

Grows monetary base; expansionary  

Sales – when the Federal Reserve sells government securities to commercial banks o The Federal Reserve sells an asset that is non-monetary to a commercial bank in  reserves, which shrinks the total amount of reserves because they are selling an  asset and the banking system is paying with reserves

Shrinks monetary base; contractionary

2. Reserve Requirement

- Minimum fraction (percentage) of deposits that banks must hold as reserves The total amount of reserves in the banking system determines the total amount of lending  BECAUSE banks have to hold on to a certain fraction of their deposits as reserves This requirement prevents banks from situations where they cannot services calls on  deposits

o Promotes stability of financial system

o Requirement should not be too high because banks should be able to make loans 3. Discount Policy

Policy approach of the Federal Reserve to giving out emergency loans

o Eligibility criteria – who would the Federal Reserve give the emergency loan to, and  who would they reject?

Lecture 24 

- Federal Funds Rate is the single interest rate that the Federal Reserve targets. It is on overnight  loans between commercial banks

Interest rate on borrowing reserves between two commercial banks

- Federal Funds Rate is really low because of secure borrowers and short periods of time Interest payments depend on the likelihood of repayment

o The longer the loan, the higher that the loan and interest rate will be

- Open market policy – after buying all the government securities available, they bought troubled  housing loans

Extraordinary monetary policy

The mortgages were backed by houses

- Open market purchases are expansionary monetary policy because it increased the money  supply

- Open market sales are contractionary monetary policy because it decreases the money supply - Increasing the reserve requirement decreases the money supply (contractionary)

- Decreasing the reserve requirement increases the money supply (expansionary) - Money supply is all the money in the economy while the monetary base is just all the money in  reserves

o Money supply is bigger than monetary base

Money Multiplier Process 

- Suppose commercial banks held 10% of deposits as reserves, and the Federal Reserve increases  the monetary base by $50B…

Money Supply:

+ $50B Initial increase in the monetary base

+ $45B (90% of 50B)

+ $40.5B (90% of 45B)

(Continue the process) 

= $500B Overall increase in the money supply

- Increase/decrease in the monetary base < increase/decrease in the money supply

*Money Multiplier = Money Supply = 1  

Monetary Base Fraction of deposits held as reserves

*If commercial banks hold no excess reserves, then the money multiplier equals 1 Reserve Requirement

*(Less lending) If commercial banks hold excess reserves, money multiplier is < 1 Less Lending Reserve Requirement Open Market Purchase 



Quantity of  

Reserves Market Monetary Base

Money Market



Quantity of  


5% 4%

Market for Loanable  Funds


Quantity of  Loanable Funds

Money Supply

Real Economy *Recessionary Gap

Money Real GDP

1. An open market purchase increases the monetary base, so supply in the reserves market will  shift right (Federal Funds rate decreases)

2. The money supply grows by even more (supply in money market shifts more than reserve)  (lower interest rate)

3. When the monetary base increases, more lending can happen (supply for loanable funds shifts  right) (real interest rate decreases)

4. When real interest rate decreases, consumer spending, investment, and net exports increase  (AE Line) (AD line shifts right, increasing Real GDP back to potential GDP - expansionary).

Open Market Sale 


Reserves Market



Quantity of  


Money Market



Quantity of  



Market for Loanable  

Funds Real Economy



Quantity of  

Loanable Funds

Expansionary Gap

1. With open market sales, the monetary base shrinks (supply reserve market shifts left – Federal  Funds rate increases)

2. Money supply decreases by more than monetary base because of money multiplier (supply for  money market shifts left - interest rate rises)

3. With less money in the economy, there is less to lend (loanable funds supply shifts left – real  interest rises)

4. When real interest rises, AD shifts left (Real GDP decreased back to Potential GDP – contractionary)

Another way to conduct expansionary or contractionary monetary policy: change the reserve  requirement

Dropping the reserve requirement would increase the amount of money in the economy  because there would be more lending

o Expansionary monetary policy

o With this, the monetary base would never change, so there is no shift in the supply  of the Reserves Market

Raising the reserve requirement would decrease the amount of money in the economy  because there would be less lending

o Contractionary monetary policy

Lecture 25 

- Exchange rate – value of one unit of a particular currency… denominated in units of some other  currency

How Represent Exchange Rates: 

If 1 US dollar = 0.85 Euros, then…

€1 = $1.18

To find out how much €1 equals in US dollars, you simply divide $1 / €0.85

o The exchange rates are reciprocals of each other

1 / 0.85 = 1.18 1 / 1.18 = 0.85

- Without currency, you have no control over monetary policy

- Purchasing power parity (PPP) allows you to compare countries’ currencies (what one currency  could buy in different countries)

If a bottle of water in the United States is $1, then it should be €0.85 in Europe Transportation cost, trade costs, tariffs, & movement of productive capital allows price  differences to exist – problem with PPP

Appreciation vs. Depreciation 

Example: Currently, $1 USD = $1.25 CAD. Then, it changes to $1 USD = $1.40 CAD. This means that the US dollar has appreciated against the Canadian dollar

o $1 CAD = $0.8 USD (1/1.25)

o $1 CAD = $0.71 USD (1/1.40)

This means that the Canadian dollar has depreciated against the US dollar

o If a country’s currency appreciates against another, the other currency will depreciate

Where Do These Exchange Rates Come From? 

- The currency exchange rates are just prices, which are determined by supply and demand Currency exchange rates are determined by the supply and demand of these currencies - Foreign exchange markets are markets for currency exchange

Supply of dollars is a small portion of the overall amount of the US dollars because it is the US  dollars that are being made available for exchange

o Only involves money immediately available for exchange

0.065  Yuan

Market for Yen Market for Yuan




of Yen

1 Yuan / 15.38 Yen = 0.065 Yuan

1 Yen = 0.065 Yuan

1 Yen / 0.065 Yuan = 15.38 Yen

1 Yuan = 15.38 Yen

Market for Yen is the market for those who want  to purchase yen with yuan

Market for Yuan is the market for those who  want to purchase yuan with yen

Demand of Market for Yen = Supply of Market for Yuan

Supply of Market for Yen = Demand of Market for Yuan

Reasons to Exchange: 

1. To buy goods/services from another country

2. When a country’s currency depreciates

If the United States currency is speculated to depreciate, you could buy euros. Then, you can  trade it back once the United States currency appreciates to get a higher return. o These two reasons are the sources of demand

Why is Demand Downward Sloping? 

1. When the currency exchange rate is lower, importing goods from that country is more  affordable

2. When currency exchange rate is lower, there could be a higher likelihood of probability that it  will appreciate

- The demand for one country’s currency is specifically the supply of the other country’s currency Supply: holders of the currency that is being exchanged

o In the graph above, the supply of yen for yuan is the demand for yuan relative to yen Mirror images of each other

Why is Supply Upward Sloping? 

- When the US dollar is more valuable, the US dollar will appreciate, meaning that the US dollar  can buy more goods/services from abroad

Holders of the more valuable currency are interested in buying other goods/services and making  more imports

o Holders of less valuable currency are less interested in buying other goods/services and  making less imports

When the US dollars are higher, there is a bigger chance it will depreciate. There will be more  selling of the currency to buy something else that’s cheap.

Quantity  of Yuan

Lecture 26 

Foreign Exchange Market 








*(2) When real interest rate rises, net exports fall because the United States produces less physical  capital. This allows foreign companies to build factories (physical capital) in the United States When the US real interest rate rises, demand for US dollars increase

When the US real interest rate falls, demand for US dollars fall

*(3) When incomes in different country rise, demand for US dollars increase because the different  country’s households want to buy more American goods (America will export)

When incomes in America increase, American dollars are supplied for different currency to buy a  different country’s goods or services (America will import)

Example 1: Suppose that Professor Knight (from US) purchases a large quantity of olive oil from Italy. 

Market for Dollars



Quantity of Dollars


Market for Euros

Quantity of Euros

Supply increases because there is an increase in  demand for US imports

Demand increases because euros are being  demanded for the purchase

Equilibrium price falls to €0.60

Equilibrium price rises to $1.67 ($1/€0.60)

US dollar depreciated against euro because the  exchange rate has fallen

Euro appreciates against US dollar because the  exchange rate is higher

Each US dollar is worth less euros

Each euro is worth more dollars

Example 2: Suppose that the real interest rate in the US rises, relative to interest rates in Japan. 

Market for Dollars ¥25


Quantity of Dollars


Market for Yen

Quantity of Yen

When the real interest rate in the US rises, Japan will want to invest more in the United States. Demand for Dollars shift right because there is a demand for US dollars

o US Dollar appreciates to ¥25

Supply of Yen shifts right because more yen is being supplied for trade for US dollars o Yen depreciates to $0.04 ($1/¥25)

Reasons Why People Want to Change Exchange Rate: 

1. A lot of countries promote depreciation to promote exports

2. A lot of countries promote appreciation to promote imports (to be able to pay off debts easier) 3. A lot of countries peg their currency to that of another country to avoid the risk of money not  being worth as much as a result of appreciation or depreciation

Exchange Rate Policies:

1. Floating Exchange Rate

Determined by demand and supply for the currency; no intervention – leave it to the markets 2. Managed Float

Allowing supply and demand to determine the exchange rate for the currency. However, the  country will allow demand and supply to determine this exchange rate as long as it stays in a  predetermined band

o If it appreciates above or depreciates below some level, the country intervenes 3. Crawling Peg

The country allows demand and supply to work, but they slow the readjustment process (don’t  let the exchange rate to change immediately)

o Makes the exchange rate change slower, thus smoother

4. Peg/Fixed Exchange Rate

Bahamas has this with US dollar

- Whenever a central bank intervenes (Policies 2-4), they are either buying or selling units of their  own currency

When a central bank wants to appreciate its currency because the market-determined rate is  below the target rate, the central bank will then buy its own currency of foreign exchange  markets from their reserves

When a central bank wants to depreciate its currency because the market-determined rate is  above the target rate, the central bank will then sell its own currency of foreign exchange  markets from their reserves

Balance of Payments 

An account mechanism that countries use to record international transactions

*Positive means flowing into country Negative means flowing out of country 1. Exports are positive because they result in money flowing into the country (countries sell  goods/services)

2. Imports are negative because they result in money flowing out of the country (countries buy  goods/services)

3. Net interest income deals with money that flows in or out of a country as a return to physical  capital investments abroad

Ex. Ford (US) own company in Canada and GVA Lightning (Canadian) owns company in the US o Net Interest Income = Money Ford Makes in Canada minus Money GVA Lightning makes  in the US

o If this is positive, then the US earns more abroad than lost domestically

o If this is negative, then the US earns less abroad than lost domestically

4. Net transfers is the transfer of money without goods/services in exchange

- Remittance refers to a huge chunk of transfer payments that people who work abroad send to  family members back home

When money is earned in US and sent back home to different country, then the net transfer is  negative

When the money earned in a different country is sent back home to the US, then the net  transfer is positive

*Add all four of these, and you will get the currency account balance

Capital and Financial Account 

- Production of physical capital across borders or investment in other countries - When foreign firm builds new physical capital in the US, that is money coming into the US Foreign investment in US

o Note: Initial building of physical capital from foreign firms is positive in this account, but  the transfer payment in current account is negative

*Foreign investment in US minus US investment abroad plus statistical discrepancy Official Settlements Account 

- What is happening to the cash called “official reserves” in different countries Positive means it is shrinking Negative means it is growing

*All these accounts have to add up to zero

- Statistical discrepancy (refer to capital and financial account) means measurement error Ex. If statistical discrepancy is $30B, then $30B is unaccounted for in these accounts Without this $30B, the total of all these accounts would be -$30B

o This is just there to say that it is known that the accounts must add up to 0, but it  doesn’t. So, $30B is the missing about needed to force it to equal 0.

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