Study Guide for Exam 3
Study Guide for Exam 3 Econ 253-101
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This 8 page Study Guide was uploaded by Kayla Notetaker on Friday November 27, 2015. The Study Guide belongs to Econ 253-101 at Marshall University taught by Dr. Yuanyuan (Catherine) Chen in Fall 2015. Since its upload, it has received 35 views. For similar materials see Principles of Macroeconomics in Economcs at Marshall University.
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Date Created: 11/27/15
Macroeconomics 253 1 Chapter 14 Money Banks and the Federal Reserve System What IS Money And Why Do We Need It Money assets that people generally accept for goods and services for the payment of a debt Asset anything of value owned by a person or a firm The Barter System and the Invention of Money 0 Economies where goods and services are traded directly for other goods and services are using the barter system 0 Each person involved in an exchange must want what the other person has known as a double coincidence 0 Example Person A Person B Person C Has Apples Grapes Potatoes Wants Potatoes Potatoes Apples Both Person A and B want Apples but only Person A has the ability to barter with Person C because they both have what the other wants 0 Commodity money good used as money but also has value independent from its use as money 0 Has intrinsic independent value 0 Ex Gold and Silver Money makes exchange easier by allowing people to specialize and become more productive while pursuing comparative advantage 0 Five Functions of Money 0 Medium of Exchange when sellers are willing to accept it in exchange for a good or service 0 Unit of account in the barter system a good can have a variety of prices Money however stands for one price in terms of US dollars 0 Store of Value money can be saved and used at another time unlike produce that could be traded in a barter system that may spoil 0 Standard of deferred payment serves as a standard of deferred payment in borrowing or lending Ex buying a refrigerator you can pay a down payment not the full price and take the appliance but you must pay back the remaining amount in a certain time period What can serve as Money Suitable means of exchange The good must be 0 Acceptable usable by most people 0 Standardized quality so any two units are the same 0 Durable value is not lost by spoilage 0 Valuable relative to its weight so large enough amounts would be useful in trade and are easily transported o Divisible used in purchases of low and highpriced goods the US dollar bill meets all this criteria Fiat Money such as paper currency authorized by central bank and government body and that does not have to be exchanged by central bank for commodity money 0 Has no value except as money Macroeconomics 253 2 0 Because US dollars are fiat money the Federal Reserve is NOT required to give you silver or gold for it Federal Reserve currency is legal tender How is money measured in the US Currently the Federal Reserve uses two measures of Money Supply known as monetary aggregates o Ml the narrowest definition of money supply includes 0 Currency which is all paper and coins in circulation held by firms and households not banks 0 Value of checking account deposits in banks 0 Value of traveler s checks smallest compared to other two components 0 M2 broad definition of money 0 Money market mutual fund shares 0 Smalldenomination time deposits 0 M1 0 Savings accounts Credit and Debit cards Credit and debit cards are NOT included in the definitions of money supply In buying with credit you are taking out a loan from whatever bank issued you the credit card The full transaction is complete when you pay the credit card bill Debit cards while they take funds directly from your checking account the card itself does not represent money How the Federal Reserve Manages Money Supply Monetary Policy actions Fed Reserve takes to manage the money supply and interest rates to pursue macroeconomic objectives The Federal Reserve uses three Monetary Policy Tools 0 Open Market Operations divided into two categories 0 Open Market Purchases monetary supply increases 0 Open Market Sales monetary supply decreases 0 Discount Policy if the discount rate increases banks will be less willing to borrow Likewise if discount prices increase banks will be more willing to borrow 0 Reserve Requirements an increase in the requirement ratio leads to a decrease in money supply and a decrease in the requirement ratio leas to an increase in money supply leads into Chapter 15 Chapter 15 Monetary Policy The Fed has four main monetary policy goals 0 Price Stability rising prices erode the value of money as a medium of exchange and a store of value 0 High Employment unemployed workers and underused factories and office buildings reduce GDP below potential also causes financial distress and produces more discouraged workers Employment Act of 1946 helped promote maximum employment 0 Price Stability and High Employment are the two most important of the policy goals and are known as a dual mandate Macroeconomics 253 3 0 Stability of financial markets and institutions firms need access to funds for development production etc while savers look to invest in these firms to increase the value of their savings This provides an efficient ow of funds from savers to borrowers 0 Economic Growth specifically encourages stable economic growth allows households anf firms to engage in needed investment Demand for Money The two monetary policy targets interest rate and unemployment rate are related This relationship is explained by the money market where money supply meets money demand Macroeconomics 253 1 Chapter 15 Cont Monetary Policy Monetary Policy What is it Monetary policy consists of the actions the Federal Reserve takes to manage money supply and interest rates in order to achieve macroeconomic policy goals 0 The goals were eXplained in detail in the previous set of notes but just to recap they were price stability high employment stability of the financial market and economic growth Monetary Policy Targets o The Federal Reserve tries to keep unemployment and in ation low but it does not have the power to affect these goals directly Therefore they use what is called monetary policy targets which they can directly affect o Targets include I Money Supply The purchasing or selling causes the increase or decrease of Money Supply I Interest Rate many different interest rates in the economy but Fed usually targets federal funds rate the interest rate banks charge each other for overnight loans 0 Is meant to encourage banks to make loans instead of holding funds 0 Federal Reserve actually cannot set or affect directly but they have an in uence since they can increase or decrease money supply Shifts and Movements along a Money Market carve Money Market brings together the Money Supply and the Money Demand Money Demand is sloped downward negatively because when interest rates on financial assets are low the opportunity cost of holding money is low and quantity of money demanded will be high and vice versa Shifts in the Money Demand Curve 0 The demand curve for money is drawn holding everything else constant changes in variables besides the interest rate causes a movement along cause the demand curve to shift either right or left Movement Along Interest A decrease in the interest rate causes Rate A an increase in the quantity of money demanded moving along the Money Demand curve from point A to point B Vice Versa an increase in interest rate causes a decrease in the Quantity of MD1 Money Demanded causing a Quantity of movement from point B to A Money Demanded Shift Interest Rate Interest Rate MD2 MD3 MDI Quantity of Money Demanded M81 MD2 MD1 Quantity of Money Demanded Money Supply and Equilibrium in the Money Market Interest Rate E1 E2 M81 M82 MD1 Quantity of Money Demanded Macroeconomics 253 2 An increase in Real GDP or in Price Level will cause MD1 to shift to the right to MD2 A decrease in Real GDP or Price Level will cause MD1 to shift to the left to MD3 From Point A to point B there is a shift in Money Demand to the right being caused by the increase of either price level or Real GDP This graph also shows how the interest rate does NOT affect the Money supplied curve in any way When the Federal Reserve increases Money Supply the Equilibrium interest rate falls A to B E to E2 Vice Versa If Money supply was decreased the Equilibrium interest rate rises B to A E2 to E1 Macroeconomics 253 3 Interest Rates Their E ect on Aggregate Demand As we know from previous chapters interest rate effect Aggregate Demand total level of spending in the economy AD has four components c I NX G three of which are also in uenced by interest rate 0 Consumption a lower interest rate encourages buying on credit which affects the sale of durables positively This also discourages household saving vice versa 0 Investment a lower interest rate encourages capital K investment by firms in a couple ways 0 Lower interest rates make borrowing less expensive 0 It also makes stocks more attractive for households to purchase I Bond vs Stock Market if interest rates increased 0 Investment would increase in bonds 0 But the demand for stocks would decrease 0 Net Exports a high US interest rate attracts foreign funds in other words investing in US financial assets would be beneficial to other countries This raises the US exchange rate and causes net exports to fall Monetary Policies effect on Real GDP and Price Level The Federal Reserve will conduct policies in times of expansion and recession 0 Expansionary monetary policy also known as the loose or easy policy action taken during a recession to reach goal of high employment decreases interest rates and increases money supply consumption investment and net exports This action would be taken when shortrun equilibrium Real GDP was below potential GDP causes a rightward shift in AD 0 Contractionary monetary policy also known as the tight policy action taken when economy produces above the potential GDP Federal Reserve will increase interest rates to decrease in ation AD will shift left to shortrun equilibrium Real GDP Affects when Monetary Policies are Poorly Timed Implementing one of these policies too late can cause disastrous results destabilizing the economy 0 If the Federal Reserve enacts an expansionary policy too late after a recession during the trough the policy is not really needed The added increase will push the economy above the potential GDP The sudden and rapid increase will lead to 0 Rapid rise in in ation 0 Real GDP will increase too quickly as well 0 The next recession will be more severe Macroeconomics 253 1 Chapter 18 Macroeconomics in an Open Economy The Balance of Payments In chapter 7 we learned that a closed economy is an economy that has no interactions in tradefinances with others However economies like that today are rare Most operate in an open economy which is an economy that has interactions in tradefinance with other countries To understand interactions between two different economies we use what is referred to as a Balance of Payments the record of a country s trade with other countries for goods services and assets stocks and bonds This is measured in the form of three accounts 0 Current Account current shortterm ow of funds into and out of a country Records 0 Imports and exports the difference being net exports 0 Income received and paid by US residents from investments in other countries difference between received and paid would be net investments 0 The difference between transfers made to other countries and transfers received by the US net transfers I Any payment received is a positive number any payment made is a negative number 0 Balance of Trade the difference of the value between goods a country exports and goods a country imports Does NOT include services and does NOT equal NX I This is the largest amount on the Current Account I If Exports gt Imports there s a trade surplus If Exports are lt Imports there s a trade deficit If Exports Imports there s a balance 0 Balance of Services the difference of the value between services a country exports and services a country imports Does NOT include goods 0 Financial Account part of the balance sheet for longterm ows of funds into and out of the country It records 0 Capital outflow when an investor in the US buys a bond issued by a foreign company or gov or when a US rm builds a factory in another country 0 Capital inflow when foreign investor buys USissued bond or when a foreign rms builds a factory in the US I The word capital includes both physical assets like factories and financial assets bonds I Net Capital F lows the difference between capital out ows and capital in ows 0 Foreign Direct Investment when firms buildbuy facilities in foreign countries 0 Foreign Portfolio Investment when investors buy stockbond from other countries 0 Net Foreign Investment equal to net Foreign Direct Investment FDI net Foreign Portfolio Investment FPI 0 Net Capital Flows Net Foreign Investment in absolute value the signs are always OPPOSITE 0 Capital Account the smallest amount on the balance of payments Records 0 Minor transactions such as sales and purchases of nonfinancial assets 0 Always is 0 on balance of payments Macroeconomics 253 2 Making it Balance 0 Statistical Discrepancy added to balance of payments to make the current account equal the financial account 0 Changes in foreign holding of dollars are known as o icial reserve transactions 0 A current account deficit must be offset exactly by the financial account surplus Foreign Exchange Market and Exchange Rates Nominal Interest Rate vale of currency in term of other country s currencies determines how many units of a foreign currency can be purchased with 1 Ex 1 100 001 1 Currency Appreciation increase in market value of one currency related to another country s currency Currency Depreciation decrease in market value of one currency related to another country s currency There are 3 Sources of Foreign Currency Demand for US dollars 1 Foreign firms and households that want to buy goods and services produced in US 2 Foreign firms and households that want to invest in US either through foreign direct investment or through FPI 3 Currency traders who believe that value of the US dollar will increase in the near future There are also 3 Sources of Foreign currency Supply for US dollars 1 Demand for goods and services 2 FDI and FPI related to other countries from the US 3 Currency traders believe the value of another currency will increase compared to the US dollar Equilibrium in the Market for Foreign Exchange and Shifts in Supply and Demand Exchange Rate Surplus of Dollars S Market for USD 150 120 100 D Shortage of Dollars Q Speculators currency traders who buy and sell foreign exchange in an attempt to profit from exchange This shifts the demand curve to the right when Japan s income increases and interest rates in the US increased Three factors that greatly in uence shifts in Supply and Demand 1 Changes in Demand for US goods and services and changes in Demand for foreign goods and services 2 Changes in desire to invest in the US and changes in desire to invest in foreign contries 3 Changes in expectations of currency traders about future value of the dollar and likely future value of foreign currencies
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