Week 14 Notes
Week 14 Notes ECN 222 - 005
Popular in Macroeconomics
Popular in Economcs
This 9 page Class Notes was uploaded by Abigail Johnson on Wednesday April 20, 2016. The Class Notes belongs to ECN 222 - 005 at University of North Carolina - Wilmington taught by Adam Talbot Jones in Spring 2016. Since its upload, it has received 19 views. For similar materials see Macroeconomics in Economcs at University of North Carolina - Wilmington.
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Date Created: 04/20/16
4/20/16 10:34 PM MONDAY APRIL 18 Last week • How does the Fed control the money supply? (4 Tools) 1) Open-Market Operations (OMOs): the purchase and sale of U.S. govn’t bonds by the Fed. § To increase money supply, the Fed buys govn’t bonds, paying with new dollars. (HINT: Janet Yellen BUYS bonds) ú …which are deposited in banks, increasing reserves ú …which banks loan, causing MS to expand § To decrease money supply, the Fed sells govn’t bonds, reversing the process (and Janet Yellen SELLS bonds) § OMOs are easy to buy/sell § Fed’s monetary policy tool of choice 2) Fed Pays Interest on Excess Reserves: affects banks desire to make loans influencing money supply (pay off the banks to hold back from loaning) § To increase money supply, the Fed lowers interest paid on excess reserves. § Lower opportunity cost of making loans; more loans are made. § To decrease money supply, the Fed increases interest paid on excess reserves. § Increases the opportunity cost of making loans; fewer loans are made. Now… 3) The Discount Rate (penalty for over-lending) • the interest rate on loans the Fed makes to banks o If a bank is short on reserves, can borrow from Fed § “Lender of Last Resort” o To increase money supply, Fed lowers discount rate, reducing penalty for not keeping enough reserves § …Banks make more loans, increasing the money supply o To decrease money supply, Fed can raise discount rate 4) Reserve Requirement (RR): may affect reserve ratio (~10%) • To increase money supply, Fed reduces RR. o More loans from each dollar of reserves, which increases money multiplier and money supply. • To reduce money supply, Fed increases RR. • Not effective at increasing money supply and is super disruptive when reducing money supply: RARELY used by Fed as it is very disruptive to the market economy. Ex: • ] A) R=.25; 1/R=1/25=4 • Reserves increase from $50 to $125 • Money Supply=Reserves * 1/R o 125*1/.25= 125*4= $500 • The MS grew from $200 to $500, by $300 B) Reserve Ratio falls to .1 (10%) • MS=Reserves * 1/R = $50*1/R= $50*10= $500 • MS grew from $200 to $500, by $300 If the Fed is increasing/decreasing the key interest rate… The Federal Funds Rate: • Banks can borrow reserves from banks with excess reserves o Interest rate on these loans is the Federal Funds Rate. • The FOMC uses OMOs to target the Federal Funds Rate • Interest rates are highly correlated, so changes in Fed Funds Rate lead to changes in other rates. **Note: • Discount Rate is the rate that Fed lends to banksàserves as a penalty to banks for falling low on reserves • Federal Funds Rate is the rate at which banks lend to each other o NOT the rate from the Fed; NOT the rate on federal govn’t loans Bank Vault -Required Reserves -Bonds, extra cash = Excess Reserves (loanable) • If Fed buys bonds, bonds decrease and cash increases Federal Funds Market Loans between banks 1. Supply 2. Supply shifts right 3. FF decreases (E 0rops) Nominal Variables are measured in monetary units. • Nominal wage = $10/hr Real Variables are measured in physical units or output • Relative prices • Real wage = 1 pizza / hr Monetary Neutrality: the proposition that changes in the money supply do not affect real variables • Doubling money supply causes all nominal prices to double; what happens to relative price? (nothing changes) • $10 = 40 Quarters (i.e., monetary neutrality) Velocity of Money Equation Velocity of Money: the rate at which money changes hands (www.wheresgeorge.com) • V- the velocity of money • P- Price level (price of goods) • Y-Output/Real GDP • P*Y-Nominal GDP/”total spending” • M- Money Supply • V=(P*Y)/M [Velocity Formula] Velocity is relatively stable. The Quantity Equation Rearranged V equation • M*V=P*Y • V and Y are relatively stable variables • M and P are directly correlated WEDNESDAY 4/20 GOLD STANDARD HW on APLIA TONIGHT APLIA under unemployment due tonight as well Quantity Equation –where the money supply determines inflation Qequation M*V=P*Y • V is relatively stable o Plug in a constant (1) • %change in M * 1=%change(P*Y) • Y is RGDP o Y=Af(L,K,H,N) § No M, No P à Y is not dependent upon prices and money supply • Recall: %changeM*1= %change(P*Y) o V and Y are both relatively constant o Because %changeM doesn’t affect Y… Y=1 § %changeM*1 = %change(P*1) § %changeM=%changeP • Rapidly increasing the M (money supply), rapidly increases P(prices) o Money supply dictates inflation levels Vequation V=(P*Y)/M V is relatively stable The inflation fallacy: most people think inflation erodes real incomes. • Inflation is a general increase in prices of the things people buy and sell (labor) • In the long run real incomes are determined by real variables, not the inflation rate. The costs of inflation • Changing prices requires adjustments o Menus reprinted o Difficult to compare across time o Budget forecast inaccurate (very difficult)… The inflation Tax • Government spending funded by: o Taxes o Borrowing o Printing Money § Not US Gov., Fed handles MS • Almost all hyperinflations start this way • Referred to as the inflation tax: printing money causes inflation, which is like a tax on everyone who holds money Unexpected Inflation, Wealth to Debtors Arbitrary redistribution of wealth: higher-than-expected inflation transfers purchasing power from creditors to debtors (lender to borrower) • Debtors repay debts with dollars that aren’t worth as much The cost of inflation: costs are quite high for economies experiencing hyperinflation, but the costs with low inflation (<10%/yr) are probably much smaller *** Important that Central Bank be independent of politics Aggregate Supply and Aggregate Demand -short-run economic fluctuations are often called business cycles -Most economists believe classical theory- monetary neutrality- describes the world in the long run, but not the short run • In the short run, changes in nominal variables (like the money supply or P) can affect real variables (like Y or the u-rate) Model of Agg.Demand and Agg.Supply Long-run Agg.Supply (Y =An(L,K,H,N)) SRAS (short-run agg.supply) ADcurve: the quantity of all goods and services demanded at any given price level. AD=C+I+G+NX Assume G is fixed by govn’t policy Slope of AD: the Wealth Effect • Suppose price level increases • Real value o money falls • Consumers are poorer, purchase less (C) The Interest Rate Effect • Increased price level requires more liquid money (dollars) • Less saved, interest rate increased • Encourages less investment (declines) Exchange Rate Effect Why the Agg.Demand curve might shift • Changes in C o Stock market boom/crash o Tax hikes/cuts • Changes in I o Expectations, optimism/pessimism o Interest rates, monetary policy • Changes in G o Wars o Stimulus spending on new roads (“Fiscal Policy”) • Changes in NX o Booms/recessions in countries that buy our exports 4/20/16 10:34 PM 4/20/16 10:34 PM
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