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Econ 121 Week 16 Notes

by: Lael Wynne

Econ 121 Week 16 Notes 36926

Lael Wynne

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These notes cover past weeks and include updated notes from the week of April 18
Principles of Macroeconomics
Class Notes
Econ, Economics, business, businesseconomics, econ121
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This 10 page Class Notes was uploaded by Lael Wynne on Wednesday April 20, 2016. The Class Notes belongs to 36926 at University of Illinois at Chicago taught by Officer in Spring 2016. Since its upload, it has received 20 views. For similar materials see Principles of Macroeconomics in Business at University of Illinois at Chicago.


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Date Created: 04/20/16
Econ Notes (Part 3) All income GDP goes to households Flow-of-Funds equilibrium: o Expenditures on GDP= resource purchases/payments o Sv + T + M = I + G + X LRAS (Long Run Aggregate Supply): 1) Resources ↑ o Labor, physical capital o Human capital 2) Technological change o ↑ productivity of labor o Invention o Innovation- entrepreneur; puts invention to practical use 3) Improvement in institution 4) Work more, less leisure P LRAS1 LRAS2 SRAS1 SRAS2 P1 1 P2 2 Y P1 Yp2 Economic Growth: o LRAS ↑ SRAS ↑ o YP↑ P↓ o Government doesn’t change policies o US & China Economic Growth W/O Cycle: o Slow, steady, outward shift in LRAS o Anticipated/Expected; permanent o Because this economic growth is anticipated, LR equilibrium is never disturbed o Natural rate of unemployment is the same Economic Decline: o LRAS shifts to the left gradually o Everything in reverse Causing the business cycle: 1) Unanticipated shifts in the AD curve & SRAS o Shifts in SRAS: i. Shocks in SRAS- unanticipated and temporary increase in output for any price ii. Negative shock (unfavorable) = decrease in output iii. Positive shock (favorable) = increase; expansion If anticipated (PRES ratio is unchanged and Y remains at YPeven though P varies Expansion (Boom) P AD1 LRAS SRAS AD0 P1 1 YP Y1 Y o Can’t stay at P0 because there’s an excess demand o P↑ = Y↑ ( Point 0 to Point 1) o (P/P ) ↑ Profit ↑ RES o Profitability ↑ LRAS P SRAS0 SRAS1 P1 Y P Y1 Y o At P0, there’s an excess supply o P ↓ = Y↑ o (P/PRES ↑ o Profitability ↑ Contraction (Recession) LRAS AD0 SRAS0 AD1 Y1 YP Y o Inward shift in AD o At P0: excess supply of goods/services o P↓ = Y↓ o (P/PRES ↓ o Profitability ↓ o At Y1: unemployment < natural rate SRAS1 LRAS SRAS0 AD0 Y1 YP Y o Inward shift in SRAS o At P0: excess demand of goods & services o P↑= Y↓ o ↓ in production of resources is greater than ↑ in price o Increase in P is a consequence, not a cause o Profitability ↓ Shifts in AD is caused by change in optimism or pessimism o Business invest a lot ( I↑) (C↑) = AD↑ = Expansion o Pessimism replaces optimism (I↓) (C↓) = AD↓ = Recession Excess supply of labor = unemployment Excess demand of labor = overflow of unemployment Expansion: o W↑ P RES o Pressure in resource labor market o Wages much more flexible upward than downward Recession: o W↓ P RES o Can take a long time (years) for wages to decrease and get back to full employment. Why? o Contracts- set resource prices o Resource suppliers, especially workers, resist reduction of resource price wage Recession is associated with pessimism Cycle caused by shifts in private AD: o I↓ =G↑ o T↓= C↑ Lags in activist fiscal policy (Keynesian): 1) Legislation lag 2) Impact lag (6 mos) 3) Forecasting lag (6-12 mos) Specific problems with K Fiscal Policy: 1) Crowding out o G↑; budget deficit o Demand for loanable funds shifts out (↑) o More expensive for durables to borrow = C↓ investment (I)= ↓ o Increased G has “crowded out” private counterparts of AD; G↑ but C↓ I↓(Physical investment) 2) Foreign exchange market o IR↑ o Net capital inflow ↑ o D for $ increases (currency appreciation) o S of FE increases (currency appreciation) United States services/goods are more expensive for foreigners; foreign goods/services are cheaper to Americans o X↓ M↑= NX↓ (X-M) Recession: o G↑ o IR↑= consumption ↓; investment ↓; NX ↓ o AD doesn’t shift at all or it shifts out but comes right back o All that the fiscal policy has done is changed the composition, real GDP, not the level of GDP Crowding out also occurs all the opposite to inflationary expansion o AD ↑; P↑; Y>P o Expectations of future taxes Reasons why household’s ↑ savings instead of when taxes ↓: 1) T↓ is temporary o Save instead of spend 2) Household (Debt/income) ration is very high o Use reduced taxes to payments to “reduce your debt”; “income savings” 3) Pessimism o Save more not consume more Rent seeking- lobbying of government for T↓ and G↑ o Big business; influence Functions of Banking: 1) Safeguard Functions 2) Pay interest on funds 3) Transfer funds 4) Make loans & buy securities Balance sheet of bank: o Assets: loans, securities, reserves (vault cash; deposits at feds/central bank) o Labilities: deposits Why hold reserves against deposits? 1) Cover withdrawals 2) Cover net check clearing Law- have to have a minimum; minimum reserve requirement o Legal minimum (Reserves/ Deposits) o Way of controlling/determining the money supply o Assumption: 10% Multiple credit creation- banks make loans by creating deposit liabilities upon themselves Excess reserves= (Actual reserves-required reserves) Example: o $100 excess reserves o Only bank in the country (monopoly bank) o No currency o Fully loaned up- excess reserves are 0 ↑Loans= ↑Deposits Excess Reserves Required Reserves $0 100 0 $100 90 10 $90 81 9 $81 72.9 8.1 Change in deposit= (deposit expansion multiplier)*(excess reserves) o Deposit expansion multiplier = (1/req reserve ratio) What can go wrong? 1) Small bank can safely sent out only excess reserves 2) Depositors take out loan partly in currency or cash in some or all deposits they can get from loan o People/firms want currency initially 3) Customers/firms/households don’t want to borrow 4) Banks don’t want to lend o Scared of creating deposit liabilities because they might not be paid back Distinguish theoretical deposit expansion multiplier verses the actual expansion multiplier Central Banking: o Commercial banks o Savings & loans (S & L) o MSB’s o Credit unions Federal Reserve: o 12 federal banks in the United States o Board of governors; 16 year terms o Janet Yellen- chairman o Tries to determine the money supply Suppose that, in the year 2013, when contracts were made, the price level (GDP deflator) was 100 but everyone anticipated that the GDP deflator would be 130 in the year 2016. Here are the AgD and (short-run) AgS schedules for 2016. AgD and AgS are in trillions of constant dollars. GDP Deflator AgD AgS 60 9 2 90 8 3 130 7 4 140 5 5 160 2 9 a. Draw the AgD and AgS curves. Label the curves with the appropriate price level. Label the axes. AD (=130) P SRAS (P =130) exp 140 5 Y b. What is equilibrium price (GDP deflator) and equilibrium GDP in 2016? Explain your answer. (Note: This is short-run equilibrium.) o P equil140 c. Is the equilibrium price level good or bad for business (suppliers of GDP) compared to the anticipated price level? Explain your answer. (Hint: Work with the numbers for the equilibrium price and anticipated price? o P ACTUAl PANTIC o 140>130 o Good for businesses because P RESbased on P ANTIC,ereas price of commodities is 140 d. Why would this level of GDP not also apply in the long run? Explain thoroughly. o GDP=5 so you can’t apply in LR because P ACTdoes not equal P ANTIC e. Revise the above table in a sensible way such that short-run equilibrium GDP (the correct answer in b) would also apply to the long run. Explain why your revision makes that happen. o One way; change the AS column entry from 4 to 7 and the 140 row entry from 5 to 8. Now PACT= PACT= 130, so SR equilibrium = LR equillibrium Reminder: GDP deflator is the price level for GDP, and GDP means real GDP. Money Supply = (money multiplier)*(monetary base) o Money multiplier- related to actual deposit multiplier o Monetary base: o Currency- in hands of non-bank households and firms (potential) o Bank reserves- vault cash and deposits at the FED (actual); “Deposits” Monetary base= actual + potential bank reserves Functions of central bank: o Monetary Policy- monitors banks, determines money supply, and determines interest rate o Purpose: 1) Get economy out of recession or anemic recovery and reduce unemployment 2) Avoid/ get economy out of inflation (inflationary expansion) FED is the most independent central bank in the world Money multiplier: o FED determines reserve requirement; legal minimum reserve ratio o Reduced= multiplier ↑ because potential deposit expansion multiplier ↑ o Increased= multiplier ↓ because potential deposit expansion multiplier ↓ Transaction deposits- “checkable deposits” Millions of $ Min. Reserve Ratio 0­15.2 0% 15.2­110.2 3% >110.2 10% Fed pays interest on bank deposits at FED o .50% o Pay on required reserves and excess reserves Federal Funds Market: o Determines federal funds interest rate o Market for deposits at FED o Short term o FED has target fed funds rate (announced)= .37% Monetary base: 1) Discount window o Lends to banks o “Discount rate” (announced) = 1% o Discount rate > Fed funds rate o Discount rate > interest paid on deposits at fed 2) Open market operations (fed doesn’t issue bonds) o Fed buys/ sells securities usually treasury bonds o Fed buys from bank or from firm/ household o Fed buys securities= monetary base ↑ o Fed sells securities= monetary base ↓ Money supply= (monetary multiplier)*(monetary base) o Fed only influences monetary multiplier Increases base: o Open market purchases of bonds lower, increases, and multiplies interest rate on deposits at FED o Expansionary, loose, easy= monetary policy; MS↑ Reduces base: o Open market sales of bonds reduces multiplier, higher interest rate on bank deposit at FED o Contractionary, restrictive, tight, tough= monetary policy; MS↓ FED can always force banks to contract but cannot ever force banks to expand Expansion (Easy) monetary policy: o As interest ↑= QD of money ↓ o MD=MS o Demand for bonds ↑; PB↑; Interest ↓ Restrictive monetary policy: o Open market sales o MS curve shifts to the left o iST (short term interest) ↓ o Supply of loanable funds shifts up/ to the left


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