Final Study Guide
Final Study Guide EC 202
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Chapter 8: The Price Level and Inflation Inflation- growth in the overall level of prices in an economy o Hyperinflation- extremely high rate of inflation, rule of thumb: when the overall price level is increasing 50 percent or more per month ex. Inflation in Zimbabwe reached 80 billion percent per month in 2009 Deflation- occurs when overall prices fall o often coincides with periods of recession, but not always Disinflation- decrease in the rate of inflation There are two difficulties with measuring inflation o 1) prices all move together o 2) some prices affect consumers more than others Bureau of Labor Statistics (BLS) measures and reports inflation. Their goals are: o 1) determine the prices of all goods and services that a typical consumer buys o 2) identify how much of a typical consumer’s budget is spent on these items Price level- index of the average prices of goods and services throughout an economy Consumer Price Index (CPI)- measure of the price level based on the consumption patterns of a typical consumer (includes things like groceries, housing, medical care) Price Index= (Basket Price/Basket Price in Base Year) x 100 Inflation Rate= x 100 Use to compare the prices of goods over time: When employers adjust for inflation, they generally use the CPI The most common concern is that CPI overstates true inflation b/c o 1) Substitution of different goods and services When the price of a good rises, consumers look to substitute less expensive alternatives Without taking into account substitution, CPI would exaggerate the effects of a price increase leading to upward bias o 2) Changes in quality Over time, the quality of goods generally increases. If the CPI did not account for this, it would have an upward bias o 3) Availability of new goods, services, and locations Traditionally, the BLS updated the CPI goods basket after long time delays which biased CPI in an upward direction because: Prices of new products typically drop in the first few years after their introduction (The price drop is lost) Internet and outlet prices are typically lower priced than traditional retail stores Chained CPI- measure of the CPI in which a typical consumer’s “basket of goods” is updated monthly (lower than traditional CPI, distance between them grows over time) Problems with Inflation: 2 Shoeleather costs- resources that are wasted when people change their behavior to avoid holding money (ex. Fuel costs to get to the bank) Money illusion- occurs when people interpret nominal changes in wages or prices as real changes (ex. When inflation occurs, we think the real price has changed and change our behavior, like seeing fewer movies) Menu costs- costs of changing prices (ex. Printing new menus or losing regular business) Uncertainty About Future Price Levels- inflation can confuse workers and lenders and make necessary long-term agreements for businesses to produce output difficult Wealth Redistribution- From lenders to borrowers because high inflation has devalued borrowers’ payments Price Confusion- Firms taking rising prices as a signal to increase output can lead to resources being misdirected Tax Distortions- capital gains taxes: are on gains realized by selling an asset for more than its purchase price ex. When you sell a house you are taxed for capital gains, but inflation is NOT taken into account Cause of Inflation: Inflation is consistently caused by increases in a nation’s money supply relative to the quantity of real goods and services in an economy Inflation is still a macroeconomic problem because: 1) large government debts and 2) short-term gains Also review the present-value formula 3 Chapter 9: Savings, Interest Rates, and the Market for Loanable Funds Most interest rates in the US economy are determined privately- through the interaction between the market forces of supply and demand Loanable funds market- market where savers supply funds to borrowers as loans Firms (primary borrowers) and governments obtain financing for their operation from financial markets who get their funds primarily through household savings (but also foreign entities as well) Firms are primary borrowers of loanable funds because they borrow to invest Every dollar borrowed requires a dollar saved Interest rate- price of loanable funds, quoted as a percentage of the original loan amount For the saver, the interest rate is the return they get and thus, the higher the interest rate, the greater the incentive to save For the borrower, the interest rate is the cost of borrowing o Profit-maximizing firms borrow to fund an investment only if the expected return of the investment is greater than the interest rate of the loan A larger quantity of loans is demanded as the interest rate drops (inverse relationship) Fisher equation 4 o Real interest rate= nominal interest rate – inflation rate Nominal interest rates are the stated interest rate Three factors determine the supply level for loanable funds: o 1) Income and Wealth Increases in income generally produce increases in savings Foreign funds often find their way into the US market because historically they have offered relatively greater returns than markets in other countries (good because domestic savings began falling in the 1980s) o 2) Time Preferences- refers to the fact that people prefer to receive goods and services sooner rather than later o 3) Consumption Smoothing- occurs when people borrow and save in order to smooth consumption over their lifetime Investor Confidence- measure of what firms expect for future economic activity Chapter 10: Financial Markets and Securities Financial intermediaries- firms that help to channel funds from savers to borrowers (ex. Banks) Bank- private firms that accept deposits and extend loans There are two different types of funding in the loanable funds market: 5 o Indirect finance- occurs when savers deposit funds into banks, which then loan these funds to borrowers o Direct finance- occurs when borrowers go directly to savers for funds To undertake direct finance, firms need a contract that specifies the terms and conditions of t he loan, usually in the form of a security o Security- tradable contract that entitles its owner to certain rights ex. Bond Bond- security that represents a debt to paid Key Financial Tools for the Macroeconomy 1) Bonds-essentially an IOU contract w/ the name of the borrower, repayment date, and the amount due at the repayment (face value) o maturity date- date on which the loan repayment is due o face value or par value- value of the bond at maturity Some bonds have coupons that specify periodic interest payments to the bond owner o = o the dollar price, not the face value, determines the interest rate of the bond (lower the price, the higher the interest rate, an inverse relationship) o The primary factor in determining the interest rate on bonds is the default risk of the borrower 6 Default risk- risk that the borrower will not pay the face value of a bond on the maturity date The greater the default risk, the higher bond interest rate and the lower the price of the bond 2) Stocks- are ownership shares in firms o Stocks allow firms to move forward without the burden of debt o Shareholders are owners of the firm and have some influence in the operations of firms 3) Secondary Markets- where securities are traded after their first sale (ex. New York Stock Exchange) o The ease of resale is valuable and therefore worth a higher price (secondary markets increase the demand which lowers the interest rate for the firm) 4) Treasury Securities- bonds sold by the US government to pay for the national debt o Sold through auctions to large financial firms (auction price determines the interest rate) and then to the large secondary market o Considered less risky than any other bond o Foreign savings keep interest rates lower in the US than they would be otherwise 5) Home Mortgages- essentially a variation used on basic bond security 6) Securization- creation of new security by combining other separate loan agreements o Lower interest rates for borrowers and gives lenders more opportunity 7 Stocks are riskier but have higher potential yields than bonds Chapter 11: Economic Growth and the Wealth of Nations Economic growth- percentage change in real per capita GDP Indicators between poor and rich countries: 1) Life Expectancy (including infant and under-five mortality) o residents of wealthy nation are expected to live longer because we have more doctors per person and better access to clean water and sanitation 2) Nonessential Conveniences o Rich countries have more personal computers, internet users, motor vehicles, and cellular subscriptions than rich countries 3) Education o Poorer countries have lower literacy rates, fewer educational opportunities, and a larger gap between women and men in education Living standards did not change significantly from the time of Jesus to the time of Thomas Jefferson. There was a dramatic change around 1800 because of the Industrial Revolution, where economies shifted away from agriculture and toward manufacturing The modern differences in wealth that we see today began to emerge before 1900, but the US and western 8 Europe saw unprecedented wealth growth in the 20 th century Small difference in growth rates lead to large differences in wealth levels over time o Economics growth is approximately equal to… % nominal GDP - % price level - % population Since 1950, average economic growth in the US has been about 2.1% In the US, per capita real GDP more than doubled in the 40 years between 1970 and 2010 Rule of 70- if the annual growth rate of a variable is x%, the size of the variable doubles every x/ 70 years (approximation) Over the past 20 years, China has grown at nearly 10% a year There are three significant factors in economic growth: resources, technology, and institutions Resources or factors of production- inputs used to produce goods and services o Resources fall into three major categories: natural resources, physical capital, and human capital Natural resources include physical land and input that occur naturally in/over the land (ex. Coal, lumber, weather patterns, beaches, geography) Physical capital is the tools and equipment used in the production of goods and services (ex. Factories, roads, shovels) 9 As the quantity of physical capital per worker rises, so does the output per worker Human capital- represents the quantity, knowledge, and skills of the workers in an economy Can increase human capital by increasing the number of workers in the labor force or by educating existing workers Technology- knowledge that is available for use in production Technological advancement- introduces new techniques or methods so that firms can produce more valuable outputs per unit of input (ex. Assembly line) Institution- significant practice, relationship, or organization in society o Essentially, conditions that shape the environment Institutions that affect production are below: o 1) Private Property Rights-encompass the rights of individuals to own property, to use it in production, and to own the resulting input o 2) Political Stability and Rule of the Law- Political stability is a disincentive for investment o 3) Competitive and Open Markets- Competitive markets: monopolies inhibit competition and innovation International trade: ability to specialize makes nations better off Flow of funds across borders: expands opportunities for investment 10 o 4) Efficient Taxes High taxes can reduce the incentive for production o 5) Stable Money and Prices Chapter 6: Introduction to Macroeconomics and Gross Domestic Product Identify whether a statement is positive or normative o Positive statements are descriptive, scientific, devoid of value judgments, and can be true or false facts ex. The U.S. has a larger GDP than any other country o Normative statements are opinions about values, judgments, public policy ex. Billionaires should be taxed at a higher rate than those in poverty Explain the difference between microeconomics and macroeconomics o Macroeconomics: study of the entire economy of a nation or society o Microeconomics: study of an individual person, firm, industry, etc. Explain how economists gauge the health of the economy o Economists use Gross Domestic Product because it measures both output (productivity) and income Explain what Gross Domestic Product is o The summation of the market value of all final goods and services produced within a country during a specific time period, measures income and output Describe the three uses of GDP o 1) To estimate living standards (Calculate per capita GDP: divide GDP by population) 2) To measure 11 economic growth (Measured as a percentage change in real per capita GDP) 3) To determine the economy’s point in the business cycle (Expansions are from trough to peak on GDP graph, contractions are from peak to trough on GDP graph) Identify the difference between nominal and real GDP o Real GDP is data adjusted for changes in price over time, adjusted for inflation o Nominal GDP is data measured in current prices, not adjusted for inflation Explain what a market value is o Market values are the product of quantity and price information (which is why we must adjust for inflation by using the real GDP) Describe final goods and services and how they make up GDP o A service is an output that provides benefits w/o the production of a tangible product ex. Doctor’s visit o A final good is a good sold to the final user ex. Gallon of milk o Intermediate goods are goods that a firm repackages or bundles with other goods for sale at later stage. These are NOT counted in GDP. o The composition of the U.S. economy has shifted from being dominated by manufactured goods to being dominated by services (now about 70%). This is partly because it is cheaper to manufacture goods in other countries. Identify the difference between gross domestic product and gross national product o Gross national product (GNP) is the output produced by workers and resources owned by the residents of the nation o GDP only includes goods produced domestically, within the nation’s borders 12 o Example: All Nike shoes produced in Thailand counted toward Thailand’s GDP, but Nike shoes counted toward United States’ GNP Explain the four categories that make up GDP o Consumption-purchase of final goods and services by households, excluding new housing example: groceries, automobiles, services Consumption is the largest component in GDP Two different types of goods: non-durable (consumed over short period) and durable (consumed over long period) Sale of durable goods are subject to the cyclical fluctuations of the business cycle while non-durables must be purchased regardless of economic condition o Investment-private spending on tools and equipment used to produce future output example: firm buying a sewing machine to make clothes When a family purchases a new home it goes in this category Stores purchasing inventory are counted in this category as well Stocks, bonds, and land do not count o Government Spending- spending by all levels of government on final goods and services Transfer payments (welfare, unemployment) that the government gives to households does NOT count o Net Exports- exports minus imports of final goods and services Typically negative for the U.S. Describe price level and GDP deflator o Price level is an index of the average prices of goods and services included in the GDP (measure of inflation) 13 o GDP deflator is a measure of the price level that includes prices of final goods and services included in the GDP (way to adjust GDP for inflation) Compute real GDP o x 100 Compute the nominal GDP growth o x 100 Explain the four shortcomings of GDP o GDP does not count non-market goods, which are produced and not sold, even though they create value for society example: mowing your grass o GDP also does not count the underground (shadow) economy which includes transactions that are not reported to the government and not taxed example: tipping waiters and the drug trade Typically, the underground economy is smaller depending on how developed the country is o GDP does not take into account how goods and services are produced (affects quality of life) example: environmental impact of production o GDP does not capture how much time workers work to produce goods quality of life) example: environmental impact of production o GDP does not capture how much time workers work to produce goods Explain a recession and an expansion in technical terms o A recession is a contraction period where output and unemployment fall. An expansion is where output and unemployment rise (also called a boom) o Depression is a deep and prolonged recession, but this is not a technical term 14 Know the theoretical and practical relationship between income and output o Theoretically, output and income are equal o Practically, income is lower than output because people have an incentive to lie about their income Explain the relationship between total production and total sales o GDP= final sales + change in business inventories Calculate real GDP o Explain why GDP is not a perfect measure o Countries with high prices, high wages, or relatively strong currencies will have their currencies overstated. This problem is fixed with purchasing power parity. Chapter 7: Unemployment Explain what happens to unemployment during a recession o Unemployment spikes quickly and then comes down gradually Identity who an unemployed person is o An unemployed person is at least 16 years old, not working, available for work, and has made specific efforts to look for work in the last four weeks Describe the difference between unemployment level and unemployment rate o The unemployment level is the number of people who are technically unemployed o The unemployment rate is the percentage of the labor force that is unemployed Know that unemployment can never be completely eliminated 15 Explain the three different types of unemployment o Structural unemployment- caused by changes in the industrial makeup (structure) of an economy Component of natural unemployment Creative destruction- when the introduction of new products or technologies leads to the end of other industries and jobs Governments can help relieve structural unemployment with job training programs and relocation subsidizes o Frictional unemployment- caused by delays in matching available jobs and workers Causes: information availability and government policies about hiring/ firing (i.e. unemployment insurance) Component of natural unemployment o Cyclical unemployment- caused by economics downturns (i.e. recessions) NOT a component of natural unemployment Most concerning type of unemployment because jobs are not available for those who want to work and the duration is open-ended Explain the natural rate of unemployment o The natural rate of unemployment (u*) is the typical rate of unemployment that occurs when the economy is growing normally. We do not know the exact answer, but estimates are about 5% Calculate the unemployment rate o Unemployment rate = u = x 100 o The labor force only includes people who are employed or are actively seeking employment within last four weeks Discuss the shortcoming of the unemployment rate o Discouraged workers (those who are not working, have looked for a job in the past 12 months and are 16 willing to work, but have not sought employment in the last four weeks) and underemployed (people who work full-time, but would rather work part-time) are not included o Unemployment does not include whether people are short-term or long-term unemployed Explain and calculate the labor force participation rate o Percentage of population that is in the labor force (labor force divided by population) multiplied by 100 Chapter 13: The Aggregate Demand- Aggregate Supply Model Business cycle theory typically focuses on time horizons of five years or less During recessions, real GDP growth slows and unemployment rises During expansions, real GDP growth expands and the unemployment rate falls The model used to study business cycles is the aggregate demand-aggregate supply model o Aggregate demand- total demand for final goods and services in an economy To determine aggregate demand, we sum up spending from different sources in an economy… AD= C + I + G +NX o Aggregate supply- total supply of final goods and services in an economy 17 The downward-sloping aggregate demand curve shows an inverse relationship between price level and real GDP. There are three reasons for this: o 1. The Wealth Effect wealth- value of one’s accumulated assets wealth effect- change in the quantity of aggregate demand that results from wealth changes due to price level changes If prices increase, then a person’s wealth falls and they demand less (aggregate demand decreases) o 2. The Interest Rate Effect interest rate effect- when a change in the price level leads to a change in interest rate and therefore in the quantity of aggregate demand When savings declines, investment declines as well (AD goes down) o 3. The International Trade Effect international trade effect- when a change in price level leads to a change in the quantity of net exports demanded When US products are more expensive, foreign countries demand less Shifts in Aggregate Demand o 1. Real Wealth When national wealth increases, aggregate demand increases If wealth falls, aggregate demand declines 18 o 2. Expected Income If people expect higher income in the future, they spend more today which increases aggregate demand o 3. Expected Prices When people expect higher prices in the future, they are more likely to spend today, so current aggregate demand increases (and vice versa) o 4. Foreign Income When the income of people in foreign nations grows, their demand for US goods increases and this increases aggregate demand o 5. Value of the Dollar When the value of the dollar rises relative to the currency of other nations, Americans find that imports are less expensive and it becomes more expensive for other nations to buy our exports, so aggregate demand declines Input prices determine a firm’s costs while output prices determine a firm’s revenue Shifts in long-run aggregate supply (vertical line) happen because of the same factors that determine economic growth: resources, technology, and institutions When the LRAS shifts, unemployment always remains at the natural rate In the short-run, there is a positive relationship between the price level and the quantity of aggregate supply. There are three reasons for this: o 1. Inflexible Input Prices 19 When the price level increases, a business owner can often increase output prices, but the input prices are sticky. Because costs don’t rise, but revenues do, it makes sense for a firm to increase output o 2. Menu Costs If the general price level is increasing, but a firm decides not to adjust its prices because of menu costs, customers will want more of its output which means that aggregate supply increases o Money Illusion See Chapter 8 notes Shifts in the Short-Run Aggregate Supply o The short-run always moves when the long-run aggregate supply shifts, but three other factors only affect the short-run o 1. Supply Shocks- surprise events that change a firm’s production costs negative supply shocks lead to higher production costs, positive supply shocks reduce production costs o 2. Expected Future Prices Higher expected future prices lead to a lower quantity of aggregate supply because workers bargain for higher wages which reduces the firm’s profitability and makes them less willing to produce at any price level o 3. Corrections of Past Errors in Expectations 20 When workers renegotiate their wages upward, this action reduces short-run aggregate supply (and vice versa) Market forces automatically push the economy to the price level at which aggregate demand is equal to aggregate supply Chapter 15: Federal Budgets- The T ool of Fiscal Policy There are two sides to a budget: the source of funds (income or revenue) and the uses of funds (spending or outlays) Government spending contains goods and services (roads, government employees), but it also includes transfer payments as well o Transfer payments- payments made to groups or individuals when no good or service is received in return ex. Welfare, Social Security payments to retired or disabled Government Outlays- part of the government budget that includes both spending and transfer payments. Divided into three groups: o 1) mandatory outlays: spending on entitlement programs, mandatory because laws mandate funding, largest portion of spending o 2) discretionary spending- spending that can be altered, less than 40% of the total budget o 3) interest payments- payments made to owners of Treasury bonds. Essentially mandatory. 21 Discretionary Outlays- comprise of spending that can be altered when the government is setting its annual budget (ex. Monies for roads, payment to government workers, defense spending) Much of the growth in government spending has been in mandatory spending o 50 years ago, mandatory spending was less than 1/3 of the US federal budget, but the growth has been because of politics (adding programs like unemployment, welfare, food stamps, etc.) In 1935, as a part of the New Deal and during the Great Depression, US Congress and FDR created- o Social security- government administered retirement funding program How it works: workers are required to contribute part of their income into the Social Security Trust Fund and they get some back upon retirement (w/ a modest growth rate) Goal: Ensure every American has at least some retirement income Problem: As more and more workers become eligible for Social Security, the Social Security tax rate has had to rise (2% to 12.4%) to supply the Trust Fund Medicare- mandated federal program that funds healthcare for retired people o How it works: Similar to Social Security o Goal: Provide medical insurance for all retired workers Both of the above programs are affected greatly as population demographics shift. Three reasons why these 22 programs take up an increasing portion of the federal budget. o 1) People are living longer today which means they draw post-retirement benefits for longer periods o 2) Those who paid into the programs for many years are now retired and drawing benefits (at first no one was eligible) o 3) Baby boomers are now retiring Going forward, the US will have fewer and fewer workers paying into the system and more and more retirees drawing out. Potential solutions: o Increasing retirement age from 67 to 70 o Adjusting the benefits computation to the consumer price index o Means-testing for Medicare and Social Security benefits Three Major Factors in Increased Spending o 1. Increased spending on Social Security and Medicare o 2. Defense spending in the wake of 9/11 o 3. Government responses to the Great Recession, beginning with fiscal policy in 2008 (Government outlays increased by 25% in two years) Fees for government services contribute small amounts of revenue, but most comes from taxes o Two largest tax sources are Social Security and Medicare taxes (individual income and social insurance). These are payroll taxes that make up 81% of income. 23 Half of payroll taxes are paid by the employee, half by the employer o Other sources are: corporate income tax (10%), estate and gift taxes, excise taxes on a particular commodity, custom taxes on imports The US uses a progressive income tax system where people with higher incomes pay a larger portion of their income in taxes than people with lower incomes do o Marginal tax rate- tax rate paid on an individual’s next dollar of income o Average tax rate- total tax paid divided by the amount of total taxable income, typically less than the marginal rate in the progressive system o Wealthiest 20% of Americans paid 94% of all income taxes in 2009. Top 1% of all households alone paid about 40% of income taxes in 2009. o Poorest 40% actually pay negative taxes with tax credits and income assistance Budget deficit- when government outlays exceed revenue Budget surplus- when government revenue exceeds outlays To control for both population and economic growth, we divide budget data by GDP When recessions hit, tax revenue declines and government outlays increase When the budget is in deficit, the government must borrow funds to cover the difference and the government sells Treasury bonds Deficit- shortfall in revenue of a particular year’s budget 24 Debt- sum total of accumulated budget deficits o Portion of the US Debt that is held publically is all the debt that the government does not own o Foreign lending increases the supply of loanable funds which keeps interest low o In 2011, 70% of US national debt was held domestically while only 30% was held nationally Chapter 16: Fiscal Policy The government affects the economy with two different types of policy: monetary policy and fiscal policy o Monetary policy- Use of the money supply to influence the economy o Fiscal policy- Use of government spending and taxes to influence the economy, utilizes the federal budget Expansionary fiscal policy- when the government increases spending or decreases taxes to stimulate the economy towards expansion o Goal: shift aggregate demand back up to original position so the economy returns to full employment without waiting for long-term adjustments Government spending is a component of aggregate demand (increases in G directly increase aggregate demand) Decreases in taxes can also increase aggregate demand because people have more of their income left to spend after paying taxes (affects consumption) 25 The government pays for economic stimulus through borrowing o In a recession, the government’s tax revenue will fall because 80% of tax revenue is from payroll taxes and unemployment will increase Expansionary fiscal policy inevitably leads to increases in budget deficits and the national debt during economic downturns Contractionary fiscal policy-when the government decreases spending or increases taxes to slow economic expansion o Goal: To reduce aggregate demand o Why? There are two possible reasons: 1. An increase in taxes or a decrease in spending during an economic expansion can work to eliminate the budget deficit and pay off some government debt 2. If the government believes that the economy is expanding beyond its long-run capabilities Analysts worry the economy will overheat from too much spending, which leads to inflation o When aggregate demand is high enough to drive unemployment below the natural rate, there is upward pressure on price level Countercyclical fiscal policy- fiscal policy that seeks to counteract business-cycle fluctuations o Expansionary policy during downturns, contractionary during expansions 26 The initial effects of fiscal policy can snowball into further effects because: o 1. What one person spends becomes income to another o 2. Increases in income generally lead to increases in consumption marginal propensity to consume (MPC)- portion of additional income that is spent on consumption o MPC= ( in consumption) / ( in income) Spending multiplier (aka Keynesian or fiscal multiplier)- formula to determine the the total impact on spending from an initial change of a given amount o Spending multiplier= 1/ (1-MPC) Summary of Fiscal Policy Shortcomings Time Lags o The effects of fiscal policy may be delayed by lags in recognition, implementation, and effectiveness o If lags are significant, fiscal policy can be destabilizing and magnify business cycles Crowding Out- when private spending falls in response to increases in government spending o Government spending can serve as a substitute for private spending o Even partial crowding-out reduces the impact of fiscal stimulus Savings shift o In response to government spending or lower taxes, people may increase their current savings to help pay for inevitably higher taxes later on 27 o If current savings increases by the whole amount of the Fed stimulus, the effects are negated One possible possible of getting rid of the lag problem is through the uses of automatic stabilizers- government programs that automatically implement countercyclical fiscal policy in response to economic conditions. Examples: o Progressive income taxes- guarantee that tax bills rise/fall w/ incomes o Taxes on corporate profits- raise/lower taxes when profits are higher/lower o Unemployment compensation- increases government spending when more people are unemployed o Welfare programs- increase/decrease government spending during downturns/booms New classical critique- asserts that increases in government spending and decreases in taxes are largely offset by increases in savings because people know they will pay higher taxes later Supply-side fiscal policy- involves the use of government spending and taxes to affect the production (supply) side of the economy o Research and development tax credits- reduced taxes for firms who work to develop new technology o Policies that focus on education- example Pell Grant o Lower marginal income tax rates- create incentives for individuals to work harder and produce more o All these initiatives: 1) increase incentives for productive activities and 2) take time to affect aggregate supply 28 The Laffer curve show that there is a rate at which tax revenue is maximized and incentives are still in place to encourage the production of output Chapter 17: Money and the Federal Reserve Currency- paper bills and coins that are used to buy goods and services Money has three functions: medium of exchange, unit of account, and store of value Medium of exchange- what people trade for goods and services ex. US government provides the dollar currency that we use today, tobacco was used in colonial Virginia Medium of exchange will evolve in any economy because of the inefficiency of bartering- trading a good or service without a commonly accepted medium of exchange because you need a double coincidence of wants- where each party in an exchange transaction happens to have what the other desires (pretty unusual) Historically, the first medium of exchange to evolve has been commodity money- use of an actual good in the place of money ex. Gold, tobacco in colonial Virginia Commodity-backed money- money that can be exchanged for a commodity at a fixed rate (ex. Until 1971, the US currency was backed by silver and gold. The quarters were made of silver until 1964. o Modern economies use fiat money- money that has no value except as a medium of exchange; there is no inherent or intrinsic value to the currency 29 o With commodity-backed money, the government is limited on the number of dollars it can print which limits inflation, but commodity-backed money is dangerous because it ties the value of a nation’s currency to a commodity that fluctuates (ex. finding more gold could lead to inflation with gold-backed currency) Unit of account- measure in which prices are counted o Allows consumers to make comparisons between items Store of value- means for holding wealth o Bank and investment accounts have caused this function’s importance to lessen Because people buy things with stuff other than currency, to measure the quantity of money in an economy, we must find the sum of these alternatives o Checkable deposits- deposits in the bank accounts from which depositors may make withdrawals by writing checks o These deposits have purchasing power very similar to currency o M1- money supply measure that is essentially composed of currency and checkable deposits (and traveler’s checks, but that’s a very small portion of M1) o M2- money supply measure that includes everything in M1 plus savings deposits, money market mutual funds, and small-denomination time deposits (CDs) Money supply= currency + deposits 30 Credit cards are NOT part of the money supply because they involve the use of borrowed funds Until the 70s, M1 more closely monitored the money supply because it reliably estimated the medium of exchange, but ATMs rendered M1 obsolete because both checking and savings accounts are readily accessible Banks have two important roles in the Macroeconomy: o 1) Crucial participants in the market of loanable funds o 2) Play a role in the money success process Banks can be profitable if they charge a higher rate on the loans than they make on the interest rates they pay out on deposits Reserves- portion of bank deposits that are set aside and not lent out ex. currency in the bank’s own vault and the Federal Reserve Our modern system uses fractional reserve banking- where banks only hold a fraction of deposits on reserve o US Banks only hold about 10% on deposits on reserve because every dollar on reserve costs the bank potential income (reserves only get 0.25% interest) The cost of a firm holding money = loan interest rate – reserve interest rate The bank holds reserves to o 1. Accommodate withdrawal requests from depositors (to avoid a bank run) Bank Run- when many depositors attempt to withdraw their funds at the same time 31 o 2. Banks are legally required to hold the required reserve ratio Required reserve ratio (rr)- portion of deposits that banks are required to keep on reserve (about 10%) Required reserves= rr x deposits Excess reserves- any reserves held in excess of those required In 1933, the US government created federal deposit insurance through the Federal Deposit Insurance (FDIC) which guarantees up to $250,000 will be given back to depositors (even if the bank goes bankrupt) o This created a moral hazard when a party that is protected from risk behaves differently from the way it would behave if it were fully exposed to risk Banks nor depositors have an incentive to monitor their risk o The more deposit insurance offered by a government, the less likely a bank run is Banks create money because they create new deposits, which are part of the money supply o Banks create new money when they loan out part of a deposit o Simple money multiplier- rate at which banks multiply money when all currency is deposited into banks and they hold no excess reserves Simple money multiplier = 1/rr Because of the unrealistic assumptions, the simple money multiplier represents the maximum size of the money multiplier 32 Jobs of the Federal Reserve (aka The Fed) o 1. Monetary policy- The Fed controls the US money supply and is charged with regulating it to offset macroeconomic fluctuations o 2. Central banking- The Fed serves as a bank for banks, holding their deposits, and extending loans to them o 3. Bank Regulation- The Fed is one of the primary entities charged with ensuring the financial stability of the banks, including the determination of the reserve requirements As the central bank, the Fed holds federal funds- deposits that private banks hold on reserve at the Federal Reserve Banks keep federal funds partly because the Fed clears loans between private banks (often short-term) o Federal funds rate- interest rate on loans between private banks o Discount loans- loans from the federal reserve to private banks o Discount rate- interest rate on the discount loans made by the Federal Reserve to private banks Open market operations- involve the purchase or sale of bonds by a central bank o When the Fed wants to increase the money supply, it buys securities o When the Fed wants to decrease the money supply, it sells securities The Fed buys/sells Treasury Securities because 1) the goal is to get the funds directly into the market for loanable funds and 2) a typical day of open market 33 operations might entail 20 billion dollars worth of purchasing from the Fed (which would be difficult to do with bagels) Quantitative easing- targeted use of open market operations in which the central bank buys securities specifically targeted in certain markets Open market operations typically are buying shorter term bonds that mature in a year or less, but in 2008 the Fed also bought long-term bonds as well as mortgage- backed securities and securities from government- sponsored enterprises When the Fed buys securities in a particular market, the action leads to lower interest rates in that market The reserve requirement and the discount rate are other tools the Fed has in its administration of monetary policy o If the Fed lowers the reserve ratio, the money multiplier increases (vice versa) o The Fed can increase the discount rate to discourage borrowing by banks and to decrease the money supply (vice versa) After the Great Recession, banks began to hold on to more excess reserves because they were more risk averse and the Fed began paying interest on reserves to reduce opportunity cost Chapter 18: Monetary Policy Monetary policy is most effective in the short-run (because in the short-run, prices are inflexible) 34 Central banks use monetary policy to reduce interest rates which makes it easier to borrow which generates new economic activity to get the economy moving again o In the short-run, new money expands the amount of loanable funds available and paves the way for economic expansion Expansionary monetary policy- when a central bank acts to increase the money supply in an effort to stimulate the economy (usually through open market purchases o In the short-run, expansionary monetary policy leads to increases in real GDP and employment and somewhat of an increase in price level as the flexible prices adjust in the short-run o While there is a short-run incentive to increase the money supply, these effects wear off in the long-run as prices adjust and then drive down the value of money o Unexpected inflation hurts workers with sticky wages, suppliers with sticky prices, and lenders Contractionary monetary policy- when a central bank acts to decrease the money supply o This action would be taken when the economy is expanding rapidly and the bank fears inflation o The central bank sells bonds in the loanable funds market to reduce the money supply, which raises the interest rate and causes investment to fall (therefore aggregate demand falls which results in a reduction in real GDP, employment, and a decrease in price level) Private individuals can affect the money supply through the money multiplier 35 A bank run can cause a reduction in the money supply which leads to an economic contraction o This was a great contributor to the Great Depression There are three major limitations to Monetary Policy 1) Long-Run Adjustments o Input prices (ex. workers’ wages) take longer to adjust than output prices (ex. cup of coffee). So, in the long run, as prices adjust throughout the Macroeconomy, the stimulating effects of expansionary monetary policy wear off o In the long-run, expansionary monetary policy results in no change in real GDP or unemployment and an increase in price level (inflation) o Money neutrality- idea that the money supply does not affect real economic variables 2) Adjustments in Expectations o Workers have an incentive to expect a certain level of inflation and negotiate their contracts accordingly because when inflation is expected, the real effects on the economy are limited o Short-run aggregate supply shifts back (left) when workers and resource suppliers expect higher prices, since they do not want their real prices to fall (SRAS and AD shift together and go directly to equilibrium) o Monetary policy has real effects only when some prices are sticky 3) Aggregate Supply Shifts and the Great Recession o Monetary policy affects the economy by shifting aggregate demand, but downturns are not all results of aggregate demand shifts. Declines in 36 aggregate supply can also lead to a recession and then monetary policy will have little or no effect. The Phillips curve indicates short-run inverse relationship between inflation and unemployment rates o Higher inflation can lead to lower levels of unemployment in the short run o The curve implies that a central bank can choose higher or lower unemployment rates simply by adjusting the rate of inflation When inflation is expected, long-term contractions can reflect inflation and mitigate its effects When inflation is unexpected, wages and other prices don’t adjust immediately, and this leads to economic expansion Adaptive expectations theory- holds that people’s expectations of future inflation are based on their most recent experience o When inflation accelerates, people underestimate inflation o Expansionary monetary policy can stimulate the economy and reduce unemployment—but only if it is unexpected Stagflation- combination if high unemployment rates and high inflation (ex. 1970s) o Disproves the Phillips curve Under adaptive expectations theory, expectations are always a step behind reality and errors are predictable which led economists to develop… o Rational expectations theory- holds that people form expectations on the basis of all available information (people notice trends) 37 Prediction errors are random, some positive, some negative The short-run Phillips curve is built on the assumption that inflation expectations never adjust Phillips curve relationship only holds true in the short- run, modern economist believe that there are many factors that influence the unemployment rate in an economy, and inflation is just one Active monetary policy- strategic use of monetary policy to counteract macroeconomic expansions and contractions o If people anticipate the strategies of the central bank, the power of monetary policy erodes Passive monetary policy- occurs when central banks purposefully choose to only stabilize money and price levels through monetary policy o Does not try to affect unemployment and GDP o Fed has leaned this way since the early 1980s 38 39
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