Final Exam Study Guide
Table of contents
Table of contents
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Economics is a study based on the idea that there is scarcity (a limited amount) of goods and therefore agents must make decisions about what to produce and how they are distributed. If you want to learn more check out How do dopamine, nitric oxide, and oxytocin influence sexual behavior?
Goods and services are things that meet the wants and needs of consumers. A good tangible, like an apple, while a service is intangible, like advice.
Microeconomics is the study of individuals in particular while macroeconomics is the study of the economy as a whole and patterns like inflation, GDP, and economic growth.
There are four economic resources (or factors of production). These are:
∙ Capital Equipment used in the production of goods
∙ Entrepreneurship The person that figures out how to organize the rest of the resources put them together to produce something
∙ Land Natural resources
∙ Labor Human resources that are paid for their labor
The economic cycle or business cycle is a cycle of ups and downs or expansions and recessions. These will be defined in chapter 8. The trend rate of growth for an economy is its average growth rate over long periods of time, usually measured by GDP.
Outputs are things that an economy produces. They can be either goods or services.
Equity is the overall benefit of something. It can be calculated as assetliability, but can more conceptually be thought of as just benefitcost. If you want to learn more check out Sally, a college student, walks dogs for people in her neighborhood. the going rate is $10 for every walk but she wants to charge $20 because she feels like she does a better job than other dog-walkers. if the market for dog walking services is perfectly
Technology is the processes that an entity uses to produce a good or service.
Every decision in economics has costs. One of these costs that is considered in economics is opportunity cost. Opportunity cost is what the next best alternative was when a decision is made. For example, if you choose to go to class instead of sleep in, the sleep you could’ve had if you skipped class is your opportunity cost for going to class.
Economic models are used to explain the world in a simplified way, only considering certain things, making assumptions about others. These models are based on s few economic principles, such as:
∙ People will make rational decisions based on the information available to them ∙ People make optimal decisions at the margin
∙ People respond to economic incentives
Optimal decisions at the margin means that people understand the benefit and cost of buying or producing one more of a good, and once the marginal cost outweighs the marginal benefit, they will stop buying or producing. For example, if it costs $3 for 1 doughnut and $5 for 2 doughnuts, the marginal cost for increasing your doughnut purchase from 1 to 2 is $2.
The main economic questions that a society must answer are:
∙ What will be produced? We also discuss several other topics like He/she is an architect and a painter, the one who painted mona lisa and last supper, who is he/she?
∙ How will it be produced?
∙ How will it be distributed?
Different types of economies answer these questions in different way. Every economy is somewhere on the spectrum between a market economy and a centrallyplanned economy. A market economy is where the free market determines the answers to the above economic questions while a centrallyplanned economy is where the government answers those questions. Almost every economy in the world is a mixture of these two types and therefore considered a mixed economy. We also discuss several other topics like Who was valentine v chrestensen?
A market is the buyers and sellers of a certain good or service and how they come together to trade. Markets create tradeoffs, where one benefit or cost is traded off for another greater benefit or lesser cost. We also discuss several other topics like What are the recommendations for exercise during pregnancy and post partum?
Adam Smith came up with the idea that if we allow households to decide what to buy and who to work for, firms will decide what to produce and who to hire and this “invisible hand” will determine what is produced and where it goes in an efficient manner. This explains why market economies (capitalistic economies) are more efficient than centrallyplanned economies. They are better at productive efficiency (producing goods at the lowest cost possible) and Allocative efficiency (producing goods consistent with consumer needs).
Market failure is when the free market fails to be efficient. This means goods and services could be allocated in a different way that would be better for some and worse for no one. This can often be caused by externalities. Externalities are costs or benefits that affect people other than the producers or consumers. An example of an externality is pollution. We have pollution laws because without them producers would pollute at a rate very detrimental to society.
Since economics is a social science, it is evaluated through positive analysis (what is) and normative analysis (what should be).
Entrepreneurs are people that bring together the economic resources to produce things. A good entrepreneur will fulfill a consumer need that the consumer never knew it had.
The circular flow diagram is an economic model used to show the relationship between firms and households on the most basic level. It assumes:
∙ Firms produce all goods and services
∙ Households own all factors of production
∙ Firms and Households are the only two types of agents in the economy
To explain the circular flow diagram above, households sell factors of production to firms. Firms produce products and services to sell to the households. The factors of production are sold in markets for factors of production and the products and services are sold in markets for products and services.
The production possibilities frontier is a graph showing maximum output possible for two or more goods and services considering the limited resources available. For example, let’s say a firm that produces cars and motorcycles has 40 units of factors of production available. It takes 5 units to make a car and 4 units to make a motorcycle. Therefore, the production possibilities frontier would look like
Production Possibilities Frontier
0 5 10 Motorcycles Produced
If the firm produces quantities of cars and motorcycles that fall on the line, they are said to be acting on the production possibilities frontier, utilizing all their resources. This is where they are the most efficient (have optimal efficiency). In the above example, the opportunity cost of producing 5 motorcycles is 4 cars.
In the above graph, any point below the production possibilities frontier is attainable for the firm, but inefficient because they’re not utilizing all their resources. For example, if they were to produce 5 motorcycles and 2 cars.
Any point above the production possibilities frontier is unattainable for the firm, because they lack the resources.
If the production possibilities frontier shifts, it usually means economic growth that made production more efficient.
The production possibilities frontier is not always a straight line though. It is often a curve if it becomes cheaper per unit to produce more of a good or if the opportunity cost increases as more of a good is produced.
A firm is said to have absolute advantage over another firm if they can produce every good or service more efficiently. However, a firm can have a comparative advantage on certain goods over a firm that has an absolute advantage over it if the firm with an absolute advantage has a greater marginal opportunity cost than the other firm with certain products. For example, let’s say firm A has the production possibilities frontier of the graph above and frim B has the same
units of factors of production (40) but takes 8 units to make a car and 10 units to make a motorcycle. Below is a table of the cost to produce motorcycles and cars for firm A and firm B.
In this scenario, the economy as a whole is better off if firm A produces only motorcycles and firm B produces cars. In this scenario, firm A has an absolute advantage while firm B has a comparative advantage on cars. This is because for every resource that firm A puts towards building a car, they could’ve put towards building 1.25 motorcycles. However, firm B’s resources are better off put towards building cars so with the same resources the most possible products are produced when firm A makes all the motorcycles and firm B makes all the cars. This concept is what leads to specialization in an economy and increases total efficiency.
Adam Smith’s 1776 book An Inquiry into the Nature and Causes of the Wealth of Nations is where the idea of absolute advantage and specialization was introduced. In David Ricardo’s 1817 book Principles of Political Economy and Taxation, the idea of comparative advantage was introduced. David Ricardo believed in free trade with minimal restrictions.
Supply is the amount of a good or service that is produced for consumption. Demand is how much of a product or service consumers will buy.
Supply and demand can be shown on a graph with price as the y axis and quantity on the x axis 30
1 2 3 4 5 6 7 Quantity
As you can tell, the quantity demanded has a positive relationship with price, while quantity supplied has a negative relationship with price. This is because price increases as demand increases, but price declines as supply increases. The point where these two lines intersect is the equilibrium price and quantity. In theory, a free market will reach its equilibrium price and quantity. Neither the supply nor demand have to be a straight line though: and they are often curves.
A change in price will not move the supply or demand curve unless something else also changes. A change in price only changes the point on the supply and demand curves at a certain time. However, some things do change the location of the supply and demand curves.
A demand curve will move to the right (demand increases) if
∙ Consumers expect an increase in price soon
∙ The price drops of a complimentary good
∙ The price increases of a substitute good
∙ Consumer incomes increase (if it’s a normal or luxury good)
∙ Consumer incomes decrease (if it’s an inferior good)
A demand curve will move to the left (demand decreases) if
∙ Customers expect a decrease in price soon
∙ The price increases of a complimentary good
∙ The price decreases of a substitute good
∙ Consumer incomes decrease (if it’s a normal or luxury good)
∙ Consumer incomes increase (if it’s an inferior good)
A supply curve will move to the right (supply increases) if
∙ Production methods improve
∙ Producers expect an decrease in price soon
∙ Prices of factors of production decrease
∙ Increase in number of sellers
A supply curve will move to the left (supply decrease) if
∙ Producers expect an increase in price soon
∙ Prices of factors of production increase
∙ Number of sellers decreases
Complimentary goods are goods that are often bought together and therefore when the price changes for one complimentary good, the demand of the other complimentary good’s demand is affected as if its own price had been changed. An example would be hot dogs and hot dog buns.
Substitute goods are goods that can be used in place of each other. When the price of a good is increased, the demand of its substitute good will increase. An example would be napkins and paper towels.
Inferior goods are goods that serve the same function as other goods, but aren’t quite as good at them. Inferior goods should be cheaper. Demand of inferior goods goes up during recessions when people have less income. Taco Bell burritos are inferior goods to Chipotle burritos.
Total surplus can be found on a supply and demand graph by calculating the area to the left of the equilibrium price, between the two curves. If you then draw a line straight to the left, from
the equilibrium price point to the y axis, the area of the surplus above this line is the consumer surplus (shaded blue area) while the area below the line is the producer surplus (shaded black area).
One of the functions of macroeconomics is to calculate Gross Domestic Product or GDP.
GDP is the total output from a country over a certain span of time. It is one of the main indicators of a country’s economic success and is reported by the Bureau of Economic Analysis. Real Gross Domestic Product is GDP adjusted for price changes and inflation. GDP is supposed to capture the value of everything produced within a country’s borders over a certain span of time.
Inflation is a sustained increase in the general level of prices for goods and services. GDP includes
∙ Value of final goods produced
∙ Increase in rent value
GDP does not include
∙ Goods produced illegally
∙ Intermediate goods
∙ Secondhand goods
∙ Transfer payments (such as social security or welfare)
∙ Goods produced and used without ever entering the market
A final good is a good that is ready for consumption and sold to consumers. An intermediate good is something that is sold to a producer to produce something. Physical capital is not considered an intermediate good because it is not used up in the production process and can be used for production many times.
GDP can be calculated several ways
∙ Income method =wages +rent +profit +interest
∙ Expenditure method =consumption +government purchases +exports
∙ Output method =total dollar value of output
The Expenditure method is the most important to know and can be expressed as Y=C+I+G+NX
Y is GDP
C is consumption
I is investment
G is government spending
NX is net exports
While Nominal GDP or NGDP calculates total outputs, Real GDP or RGDP is often a better measure of an economy because it accounts for changes in prices.
In developing countries, the underground economy (or informal sector) is usually a larger portion of the economy than the formal sector. However, the production in the informal sector is not recorded in GDP.
When comparing economic wellbeing between different countries using GDP, it’s more useful to use GDP per capita (or GDP per person) than total GDP due to the differences in population in different countries.
GDP per person=GDP/population
GDP per person also tells us the average income, production, and expenditure of each person in an economy.
Real GDP per person is the best single measure of economic wellbeing in a country over time that can be compared between countries.
Sometimes increases in GDP can be misleading. For example, during World War II GDP in the US increased rapidly but the average citizen wasn’t necessarily better off. This is because most of the production was going towards the war effort.
While nominal GDP is the value of all final goods produced at current year prices, real GDP is the value of these final goods at base year prices (the base year is an arbitrary year from the past).
Real GDP is also adjusted for inflation.
Real GDP can more accurately represent the economic growth in a country than nominal GDP because it isn’t as greatly affected by changes in prices.
GDP price deflator=100(nominal GDP/real GDP)
Inflation rate=percent change in GDP price deflator=(100(new price deflatorold price deflator)/ (old price deflator))
Gross National Product (GNP) is a measure of the total market value of all goods and services produced during a given period of time by the nation’s nationals, regardless of where it was produced, while GDP only measures production that takes place within a country.
Gross National Product (GNP)= GDPproduction of goods by nationals outside a country’s border.
So, when a lot of country’s domestic production takes place in foreignowned facilities, GDP will be greater than GNP for that country. If a lot of a country’s production takes place outside of a country’s border, then GNP will be greater than GDP.
Gross National Product can also be called Gross National Income (GNI)
During an economic expansion, real GDP will rise, while during a recession it will fall.
NX is included in the calculation of GDP to account for global trade and is equal to exports imports. If exports are greater than imports there is trade surplus, of exports are less than imports there is a trade deficit.
GDP is generally recorded quarterly while inflation is generally recorded monthly.
Products that are produced but not sold and remain in a firm’s inventory are still counted in GDP because they are still outputs produced in a country.
With the circular flow diagram from before, we can add a few things to better explain a global economy. First, we can add International trade and government
We could also add our banking system to this diagram to show how households put their money in banks and the banks loan some of it out to firms and receive interest from the firms while paying interest to the household, but to avoid clutter that was not included above.
GDP over long periods of time pretty much always increases, however, this increase is not constant or consistent over shorter periods of time.
National Income and Product Accounts (NIPA) is another measure of a country’s economic success. NIPA is calculated in the US by the BEA.
National income is the GDP minus the consumption of fixed capital (loss of value of capital). Personal income is income received by households, including transfer payments. Disposable personal income is personal income minus personal taxes paid. National income must be lower than GDP.
Disposable personal income must be lower than personal income.
Generally, a higher real GDP per person corresponds with longer life expectancies and higher literacy rates.
Countries are broken down into four groups by GDP per person.
Labor force is the sum of employed and unemployed workers in the economy. The US Department of Labor estimates labor force each month and other values related to it, such as unemployment and employment. These numbers can be found at bls.gov.
The unemployment rate is the percent of the labor force seeking employment. This number is one of the most important and closely watched economic statistics of a country.
The Bureau of Labor Statistics estimates these numbers with a household survey conducted every month through the current population by surveying 60,000 randomly selected households. Only people 16 and older are surveyed though.
For someone to be considered employed, they must report that they worked a few hours in the previous week at a paid job. Someone unpaid in a family business is also considered employed.
To be considered unemployed, one must report that they have looked for work during the previous four weeks and are actively seeking and willing to accept a job. This category also includes anyone laid off in the previous four weeks or someone waiting for a job’s start date.
Citizens can also be considered not in labor force (NLF). These people don’t have paid jobs and are not seeking paid jobs. This category is pretty much anyone not in the other two categories.
A discouraged worker is defined as someone not in the labor force and not looking for a job because they are discouraged by their search. Discouraged workers skew the unemployment numbers by making them seem better than they are. This is a weakness of unemployment rates.
Labor force=employment +unemployment
Adult population=Employment +unemployment+ not in labor force
Unemployment rate (UER)= 100(unemployment/labor force)
Labor force participation rate (LFPR)= 100(labor force/adult population)
Employment population ratio= 100(employment/adult population)
The establishment survey is used by the BLS to determine employment by surveying ~300,000 establishments. This method often causes large fluctuations in data and doesn’t include self employed people or new businesses.
The household survey is done to compliment the establishment survey so that people can report themselves what their employment status is.
Every year, tons of jobs are created and destroyed in the US economy.
Unemployment never reaches zero, and the long term average of unemployment is called natural rate of unemployment. Natural unemployment is the US is between 5 and 6 percent.
Natural unemployment is caused by frictional unemployment and structural unemployment. Cyclical unemployment is short term fluctuations in unemployment.
Frictional unemployment is the time is takes to match workers with a job that they’re able and willing to perform. The most common type is the time after graduating before finding a job.
A sectoral shift is when employment drops in one industry and increases in another. Usually due to change in consumer demand or technology.
Structural unemployment is when the number of jobs in a labor market is lower than the number of people seeking jobs in that labor market. Minimum wage laws and unions increase structural unemployment.
Supply and demand curves can be drawn with labor markets just like with any other markets. The x axis is quantity of workers and the y axis is wages. The labor supply curve represents how many people want to work, while the labor demand curve represents how many workers firms would like to hire.
Structural unemployment can theoretically be completely eliminated by lowering minimum wage and increasing education. However, frictional unemployment can never be completely eliminated.
Government often tries to reduce unemployment by subsidizing new hires and offering training. However, they also increase unemployment every time they raise minimum wage laws or tighten up labor laws.
Teenagers and unskilled workers are most likely to receive minimum wage, so every time minimum wage is increased it causes an increase in unemployment, but specifically in teenage unemployment.
Unemployment insurance makes people more likely to turn down a worse job in pursuit of a better one. This can actually increase unemployment.
Unemployment rates in the US are lower than most western European countries, and unemployment benefits are harder to get.
Labor unions are groups of workers that collectively bargain for better wages and working conditions.
Labor unions use tools such as strikes to negotiate. A strike is a formal withdrawal from labor by a group, usually a union, in order to force the employer to do something.
Union members earn 20% more on average than regular workers. They also get better benefits and working conditions. This costs more for employers and forces them to fire people or hire less, thus increasing unemployment.
Efficiency wages are wages above market equilibrium to motivate employees to work harder and be more productive.
Reservation wages are the lowest wage one accepts for a job.
Consumer Price Index=100(current price/base year price)
Consumer Price Index is a measure of the average price of goods in an economy. The base year doesn’t really matter. It tells us the cost of living for consumers in an economy. It is also calculated by the BLS.
While CPI and GDP Price deflator are very similar, CPI includes imports and only counts things that are purchased, while GDP Price deflator doesn’t include imports and does include goods that are produced but never purchased.
A financial intermediary is a financial institution such as a bank, insurance company, or a pension fund.
A junk bond is a high risk, high reward investment.
Bonds are debt, whereas stock is equity. This means that stock is a unit of ownership of a company while a bond is just a stake in a debt.
Term to maturity is the amount of time a bond takes to mature.
A regular economic cycle consists of expansions and recessions.
An expansion is when GDP increases and unemployment decreases and general prosperity and wellbeing is high in a country.
Then, a recession hits and the opposite happens.
While economies alternate between expansions and recessions, the GDP and unemployment and other numbers still fluctuate throughout the expansions and recessions.
Growth rates are the same as percent change and are found with the simple formula 100(new valueold value)/(old value). This formula can be applied to any economic metric.
For short periods of time the growth rate can be taken from each year and then averaged, but for longer periods of time the growth rate g can be found with the equation (old value)(1+g)t=(new value) where t is the amount of time in years.
When an economist says savings, they mean the money left over after income has been spent on the consumption of goods and services. Investments are things purchased that keep value over time and may increase value. Investments turn into capital. While greater investments grow an economy over time, greater savings without investment will hurt an economy.
A healthy, productive economy will see an increase in labor productivity over time. Factors that affect labor productivity growth:
∙ Capital: either physical capital as in physical things used to produce or human capital as in knowledge necessary to produce
∙ Natural resources: resources necessary to produce
∙ Technical knowledge: education and tactics that an economy can employ to increase productivity. Includes advances in technology
∙ Public policy: healthy policies that encourage/discourage trade, education, social stability, technological advances, investment, and globalization
The financial system is made up of financial institutions such as banks and insurance companies.
Financial markets are where people that want to save money lend it directly to people that want to borrow money. Financial markets are made up of
∙ The bond market where debt financing takes place. Bonds pay a fixed interest rate based on the credit risk and term to maturity of the loan.
∙ The stock market is where equity financing takes place. Money is lent to riskier causes and the returns vary based on the performance of the investment.
Financial intermediaries are the middlemen like banks and mutual funds.
Remember that GDP= sum of consumption+ investment+ government purchases+ net exports or Y=C+I+G+NX
This also means that investments= GDP sum of consumption government purchases assuming closed economy with no exports.
Household income= GDP+ transfer payments
Disposable income= household income left over after taxes= Consumption+ private savings Private savings= GDP+ transfer payments taxes consumption
Public savings= taxes government spending transfer payments
Total savings= private savings+ public savings+ GDP consumption government spending= total investments
Total savings of an economy equals total investments because we’re assuming a closed economy where everything that isn’t consumed remains of value within the country.
Firms borrow loanable funds from households. The market for loanable funds has a supply and demand curve similar to any other market, with interest rate on the y axis and demand for loans on the x axis. The demand curve is how much firms demand loans while the supply is how willing households are to loan to them.
Sometimes the government enforces minimum interest rates to encourage investment by firms. The CPI and GDP price deflator are good measures of inflation.
CPI uses a fixed quantity of goods and tracks the price change but GDP price deflator uses a fixed price at the base year but tracks the change in quantity produced.
CPI only tracks consumption goods and services purchased by households while GDP tracks all final goods and services.
CPI includes price of imports while GDP deflator excludes them.
Producer Price Index is the average paid by producers of goods and services at all stages of production.
PPI gives early warnings of changes in consumer prices.
Current value of money=value of old money(new CPI/old CPI).
Budget is the estimation of revenues and expenses over time. When expenses are greater than revenues, there is a budget deficit. When the revenues are greater than the expenses, there is a trade surplus. A balanced budget is when they are equal.
When deficits are accumulated over years, they make debt. The US government runs a deficit pretty much every year, so it has accumulated trillions in debt.
Crowding out is when interest rates are high enough to discourage private investment.
Bonds can be bought to receive a stream of future payments in the form of interest and the principal upon its maturity. The time it takes to reach maturity is called term to maturity and the money originally paid for the bond is called the principal. Riskier bonds have higher interest rates.
Municipal bonds are bonds issued by a local government to fund daytoday government projects.
Real interest rates are interest rates adjusted for inflation.
Shoe leather costs are the increased cost of holding cash due to inflation decreasing its value. Menu costs are the costs of changing prices for businesses and customers.
Investors are taxed on nominal returns rather than real returns, which increases the value of their taxes due.
The market for loanable funds is the market for all forms of credit. It behaves like most other markets, where households are the supply and firms are the demand. These can be graphed with interest rates as the y axis and the quantity of loanable funds as the x axis.
Unexpected inflation redistributes wealth across a population arbitrarily. Unanticipated or miscalculated inflation redistributes wealth from debtors to creditors. Unanticipated or incorrectly anticipated deflation redistributes wealth from creditors to debtors.
Deflation is more dangerous for an economy than inflation because it can create a dangerous downward spiral where no one wants to buy or produce anything because they know it will decrease in price.
The Federal Reserve is the central bank in The United States.
Economists consider money to be any asset that people will accept in exchange for goods and services as a payment. Pretty much anything of value qualifies.
Liquidity is the ease at which an asset can be exchanged for an economy’s main form of money. Commodity money has an intrinsic value even if it isn’t being used as money. Fiat money is money authorized by a government or central bank that has no other uses.
Fiat money has the advantage of being more flexible in its creation than commodity money, but it also only works if people have faith in its value.
Money creates a standard unit of value, which makes comparing prices much easier. Money can also be stored for later use better than most other assets.
Money supply refers to the amount of money circulating in an economy.
The total amount of money in an economy can be calculated differently depending on what you define as money.
As of July 2013, there is more money in checking account deposits in the United States than in physical currency.
Each generation trusts banks more and more.
Debit cards access checking accounts, and the checking balance is money. Credit cards, however, do not represent money because they borrow money on credit. Credit cards represent debt rather than money.
Reserves are the money that banks keep in cash in their vaults or on deposit with the Federal Reserve.
Required reserves are the minimum that banks are legally required to keep in reserves. It’s around 10%.
Sometimes banks also choose to keep excess reserves on top of their required reserves.
When a bank gives out loans the money supply expands. When a bank reduces its loans the money supply decreases.
Change in money supply=increase in checking deposits decrease in money in circulation.
Simple deposit multiplier= 1/required reserves= change in checking account deposits/change in reserves.
M1 is made up of
∙ Currency in circulation
∙ Checking account deposits
∙ Holdings of traveler’s checks
M2 is made up of
∙ Savings account balances
∙ Small denomination time deposits
∙ Money market fund shares
M3 is made up of
∙ Large time deposits
∙ Institutional money market funds
∙ Short term repurchase agreements
∙ Large liquid assets
Money supply is often considered only M1
A T account is a table that accounts for assets and liabilities. For a bank this is usually in terms of reserves and loans as assets and deposits as liabilities.
Banks can choose not to lower their reserves when the required reserves ratio decreases. This makes the Federal Reserve lose the ability to control money supply through required reserves.
Fractional reserve banking system is used by almost all countries and means that not all deposits are held in reserves.
100% reserve banking is when the value of all deposits are held in reserves. These are rare because ya gotta spend money to make money.
A Bank run is when people try to go get their money out of the bank. A bank panic is when everyone does this and banks can’t pay everyone back. The Federal Reserve as a central bank helps prevent this by reassuring people that they’ll get paid eventually.
The banking act of 1933 established the Federal Deposit Insurance Corporation (FDIC).
The FDIC insures deposits in many banks. They insure up to a certain limit for each deposit ownership category ($250,000 currently).
In 1914 the Federal Reserve was created. The Federal Reserve
∙ Regulates banks by setting required reserve and tracking accounts
∙ Acts as a lender of last resort to banks by making discount loans at a lower interest rate ∙ Controls money supply
The Board of Governors oversee the Federal Reserve. They are responsible for overseeing reserve banks and forming monetary policies. They are led by the chair of the board of governors who is currently Janet Yellen. The last chair was Ben Bernanke. The governors of the board of governors serve terms of 14 years and the chair serves a term of 4 years and is appointed by the president.
There are also 12 districts of the Federal Reserve that regulate banks locally.
The Federal Open Market Committee meets in DC every 6 weeks and acts as the main policy maker for the Federal Reserve.
The Federal Reserve has three monetary policy tools at its disposal
∙ It can change the required reserves ratio to change the percent of money that banks must keep in reserves
o Money supply and money multiplier have negative correlations with required reserve ratio
∙ It can change the discount rate, which changes the discounted rate of interest for banks borrowing money from the Federal Reserve
o Money supply has a negative correlation with discount rate because a higher discount rate encourages banks to give less loans
∙ Open market operations: when the Federal Reserve buys and sells treasury securities to control money supply. This is carried out by the trading desk in New York
Treasury bills are short term: 1 year or less.
Treasury notes are medium term: 210 years.
Treasury bonds are long term: more than 10 years.
The inflation fallacy is the common misconception that inflation is bad just because it makes things more expensive over time. This isn’t true because money grows less valuable, products don’t grow more valuable.
The Fisher Effect is the theory that states that nominal interest rates must increase with inflation for real interest rates to remain the same.
Remember, nominal means the actual number, while real means the value compared to a base year.
An open market sale is when the Federal Reserve sells treasury securities, which lowers the money supply.
An open market purchase is when the Federal Reserve buys treasury securities, which raises the money supply.
In the past 20 years, banks have begun to resell their loans instead of keeping them to maturity. Also, financial firms other than commercial banks have become sources of credit to businesses.
Investment banks do not typically accept deposits from or make loans to households. They provide investment advice and engage in crediting and trading securities.
Money market mutual funds are funds that sell shares to investors and then buy a combination of stocks and bonds.
Hedge Funds raise money from wealthy investors and make “sophisticated” investments.
Investment banks, money market mutual funds, and hedge funds are called the shadow banking system. They’re riskier because they’re not regulated as much and they rely more on borrowed money.
The Troubled Asset Relief Program (TARP) allowed the government to provide funds for banks during the 2007 recession when they were having trouble. TARP allowed the government to give funds for stock and provide better discount rates to previously ineligible banks.
Money Supply*velocity of money= price level*real GDP or M*V= P*Y
Velocity of money is the speed at which money circulates in an economy or the average number of times each dollar is used to purchase goods and services. It’s a constant in the above equation.
The classical dichotomy of monetary neutrality is a theory that holds true in the long term but not necessarily over short time increments. It states that a change in money supply causes an equal and proportionate change in price level because velocity of money stays the same. This is also called quantity theory and is shown by the quantity equation:
Growth rate of M+ growth rate of V= growth rate of P+ growth rate of Y
The growth rate of Y in the above equation is inflation.
From the above equation we find that is M grows faster than Y, we have inflation. If Y grows faster than M, we have deflation. If they grow at the same rate then we have a stable price level.
Hyperinflation is really high inflation, often more than 100% a year.
The most recent recession began at the end of 2007 and was caused by banks taking extreme risks, especially on mortgages, and not being able to pay people back as a result.
After the great depression, John Maynard Keynes developed a more shortterm study of economics in his book The General Theory of Employment, Interest, and Money in 1936. He determined that streaks of pessimism and optimism that are largely irrational drive short term economics. Therefore the government should not intervene in shortterm economic problems.
Supply Shock Recessions are when a recession is caused by the steep increase in price of a very important good.
Demand shock recessions are when a recession is caused by the steep increase in demand of an important good.
Fiscal policy refers to changes in government spending and taxation.
The government has to make tradeoffs between saving and spending like any other economic agent. It can save and pay off debt or it can spend to grow the economy.
Monetary policy refers to policies that change money supply.
During a recession, government can reduce the severity by employing expansionary fiscal policies or expansionary monetary policies.
Expansionary fiscal policies are policies either increase government spending or decrease taxes to help end a recession.
Expansionary monetary policies are policies which increase money supply so people will make more investments and spend money to help end a recession.
Keynesian economists believe the government should employ monetary and fiscal policies to stimulate the economy during recessions.
Classical economists believe the government should not employ monetary and fiscal policies to stimulate the economy because it increases inflation and the lag of time for the money and policies to hit the economy could cause them to hit at the wrong time and make the economy worse.
There is debate about whether government spending or cutting taxes is better for an economy in a recession.
1. In the equation Y=C+I+G+NX, what is Y
b. Real GDP
d. Yearly profit
2. Traveler’s checks are part of
3. If GDP is 512 in 2014 and increases by 49 in 2015, what is the growth rate from 2014 to 2015?
4. Processes that an entity uses to produce a good or service is called _______. a. Market
5. Which of the following is NOT a method of calculating GDP?
a. Inflation method
b. Income method
c. Expenditure method
d. Output method
6. GDP includes __________.
a. Secondhand goods
b. Intermediate goods
c. Transfer payments
d. Increase in rent value
7. What does the average consumer spend the largest portion of their income on? a. Food
8. Fiat money is money that
a. Has no intrinsic value
b. Isn’t printed by a central bank
c. Has no physical form
d. Has unknown value
9. The costs of changing prices for businesses and customers are called a. Transition costs
b. Overhead costs
c. Transfer costs
d. Menu costs
10. Who decides required reserve ratio in the US?
b. The president
c. The Federal Reserve
d. Bureau of Labor
11. The speed at which money circulates in an economy is a. Velocity of money
d. Transfer rate
12. What does the Federal Reserve NOT do?
a. Regulates Banks
b. Controls money supply
c. Insures deposits in banks
d. Both B & C