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Eco 2013, last week of notes

by: Lauren Carstens

Eco 2013, last week of notes Eco2013

Marketplace > Florida State University > Economcs > Eco2013 > Eco 2013 last week of notes
Lauren Carstens
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We finished chapter 12 and chapter 13 this week. Our final is on Friday, good luck!
Principles of Macroeconomics
Joan Corey
Class Notes
Macroeconomics, Chapter, 12, 13, LAST, week
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This 9 page Class Notes was uploaded by Lauren Carstens on Saturday April 23, 2016. The Class Notes belongs to Eco2013 at Florida State University taught by Joan Corey in Spring 2016. Since its upload, it has received 26 views. For similar materials see Principles of Macroeconomics in Economcs at Florida State University.


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Date Created: 04/23/16
Macroeconomics Chapter 12: Fiscal Policy: Incentives and Secondary Effects Keynesian vs. Classical  Keynesian Economist: expansionary fiscal policy during a recession will stimulate AD and pull us out of a recession  Classical: Possibly, but maybe not because of crowding out o Crowding out: A reduction in private spending due to higher interest rates generated by budget deficits financed through government borrowing  There’s no such thing as a free lunch  The crowding out process  1. When we are in a recession  the government conducts expansionary fiscal policy to bring the economy out o Government spending increases while taxes decrease  2. This increases the budget deficit (which must be financed through borrowing)  government borrowing increases  3. Government borrowing more  Demand for loanable funds increases  interest rates (r) increase  4. Increase in interest rate  consumption and investment decrease  Capital inflow increases  5. The dollar appreciates  Net exports decline (fiscal policy fails to bring the economy out of a recession  According to Classical economists, when real interest rates are going up  Consumption and investment goes down  Capital inflow increases  Dollar appreciates  Net exports decrease New Classical View of Fiscal Policy  Keynesians: use expansionary fiscal policy in a recession  Classical: Crowding out  New classical: Ricardian Equivalence o Don’t believe that budget deficits will stimulate additional consumption and AD o Because people will save for the expected future tax increase (permanent income hypothesis)  The government jacks up their deficits  People realize that their taxes will increase in future so they save o Ricardian Equivalence: belief that a tax reduction financed with government debt will exert no effect on aggregate demand because people will know that higher future taxes are coming Keynesian’s Paradox of Thrift  When many people drastically increase their savings and reduce consumption, total savings may decrease o If someone puts all their money in the bank, the company will need to produce less and will lay off employees  they now have less money to save and spend Problems with Fiscal Policy  Politicians have a tendency to overuse expansionary policy (even when it is not called for) o Especially around election time (giving us stuff and charging less to get votes) o Everyone wants to decrease government spending, but not decrease the spending on them o  DEBT The Great Debate  The US is currently undergoing an experiment which has already been run by two other countries  I don’t know why this is significant Keynesian AND Classical  Most macroeconomics, both Keynesian and Classical believe o 1. Proper timing is crucial and hard to achieve  Using the counter-cyclical method to steer the economy o 2. Automatic stabilizers do help redirect the economy  Makes the timing even more difficult o 3. Fiscal policy is less potent than originally thought Taxes and Growth  High taxes retard growth because o 1. High tax rates discourage work effort and productivity  You will be receiving less of the money you’re working for o 2. High tax rates reduce capital formation  People may stop buying more expensive material even if it is much more efficient just because the taxes increase  Less production o 3. High tax rates encourage people to purchase goods that are less desired, just because they are tax deductible  Businesses may spend extra money on things they don’t need (business trip to Hawaii) just to write off more costs (less profit) and get taxed less Fiscal Policy and Supply Side Economics  Supply-side Economics: The belief that changes in the marginal tax rate will exert important effects on aggregate supply o A lower marginal tax rate will give people more incentive to work more o If the lower marginal rate is believed to be long-term, it will shift both SRAS and LRAS  As SRAS and LRAS shift right, AD will also shift right because people will spend more with lower taxes o Supply side economics is a long-run, growth oriented strategy, not a short-run stabilization tool o  Low taxes for everyone will help the economy grow Review 1. Know what crowding out is and how it occurs 2. Know the new classical view of fiscal policy 3. Understand what is meant by the paradox of thrift a. Increasing savings may decrease savings in the long run 4. Know they perverse political incentives of discretionary fiscal policy 5. Know the Classical vs. Keynesian debate 6. Understand what goes into the relationship between low taxes and economic growth 7. Know the idea behind supply side economics Macroeconomics Chapter 13: Money and the Banking System  To stimulate the economy o Fiscal policy  Done by the government  Expansionary (government spending increase, taxes decrease  Restrictive (government spending decreases, taxes increase) o Monetary policy  Done by the Federal Reserve  Expansionary (money supply increases)  Restrictive (money supply decreases) The Three Functions of Money  1. Money is used as a medium of exchange o Used to buy goods and services o Double coincidence of life: finding someone who wants what you have and has what you want o It is more efficient to use money than to barter good o Fiat money: Money that has no intrinsic value  No longer backed by gold  2. A store of value o An asset that will allow people to transfer purchasing power from one period to the next o Liquid assets: Asset that can be easily and quickly converted to purchasing power  Not chairs  3. Money serves as a unit of account (measurement) o A unit of measurement used by most people to post prices and keep track of revenues and costs Value of Money  The value of money is determined by the demand relative to supply  M1: currency + checkable deposits + traveler’s checks o Currency: dollar bills in your pocket o Checkable deposits: anything in your checking account o Traveler’s checks o M1 is the more liquid form of money  M2: M1 + savings deposits + time deposits (less than $100,000) + money market mutual funds o Savings account: Interest bearing holding account at a bank o Small denomination time deposits: Any financial account with a minimum time requirement (CD) o Money market mutual funds: interest earning accounts that pool depositor’s funds and invest them in highly liquid short term securities  Diversify your investments  Poor people can engage in mutual funds because they can combine their small amount of money with others to invest in a lot of different companies o M2 is a broader, less liquid definition of money o Economists who stress the store value of money prefer M2  If you take money from your savings account and put it in your checking account, M1 will increase and M2 will not change because both are included in M2 The Central Bank  An institution that regulates the banking system and controls the money supply  The Federal Reserve System (The Fed): The central bank in the US o Carries out regulatory policies o Conduct monetary policy (changing the monetary supply)  Definitions o Bank reserves: Vault cash + the deposits of banks with the Fed o Fractional reserve banking system: A system that permits banks to hold reserves of less than 100% against depositors  The bank doesn’t just save your money for you, they loan it out to other people and charge them an interest rate higher than what they are giving you for having your money there o Required reserves: the minimum amount of reserves (your money) that a bank is required by law to keep on hand to back up its deposits (ratio: 0.20) o Federal Deposit Insurance Corporation (FDIC): A federal corporation that insures deposits up to $250,000  If the bank closes, you’re guaranteed to get your money back from the government who will pull it from taxes How Banks Create Money  Required Reserve Ratio (RRR): percentage of deposits that banks are required to hold as reserves (percentage: 20%)  Excess reserves: actual reserves that exceed the legal requirement o Usually, the bank will loan out as much as they are allowed to because that is how they make money  Potential deposit expansion (money multiplier): The maximum potential increase in the money supply as a ratio of new reserves injected into the banking system o 1/ RRR o Inverse of the required reserve ratio o If the RRR is 20%, the MM is 5, meaning banks can increase the money supply up to 5 x as much as was put in the bank  Decreasing the RRR allows banks to loan out more, which increases the money supply  Note: The lower the required reserve ratio, the more money supply will expand o The higher the required reserve ratio, the less money supply will expand The Actual Deposit Multiplier  New currency reserves will NOT expand money supply by as much as the potential multiplier indicates for 2 reasons: o The effect of the deposit multiplier will be reduced if  1. Some people decide to hold onto their currency rather than deposit it into the bank  2. Banks fail to use all of the new excess reserves to extend loans (excess reserves) The Federal Reserve System  The Fed is instructed by congress to conduct monetary policy in a manner that promotes o 1. Full Employment  Recession: The Fed could use the expansionary monetary policy to increase the money supply which will increase aggregate demand and stimulate the economy  Expansion: The Fed may use the restrictive monetary policy to make the money supply go down o 2. Price Stability  Inflation causes a lot of problems so the Fed is instructed to promote monetary stability and stable business cycles  Inflation: Increasing the money supply too much too fast o These goals must be timed correctly in order to work efficiently and promote monetary stability  Recognition Lag: We need to know that the economy is in a recession/expansion in order to use the expansionary/ restrictive monetary policy  We’re bad at this  Administrative Lag  Impact Lag  These cause the policies to not take hold until we are actually in a recession/ expansion which does not help much  Federal Open Market committee o Made up of 5(out of 12) bank presidents and 7 Board of Governors members o Determines the feds policy with respect to the purchase and sale of government bonds  Open Market operations: the buying and selling of bonds in the open market by the Fed  Number one way they control open market supply  How the Fed controls the money supply o 1. Open market operations  When the Fed wants to increase the money supply, it buys bonds  When the Fed wants to decrease the money supply, it sells bonds o 2. Reserve Requirements  Lower reserve requirements will increase the money supply  When the bank is required to hold onto less money, more money can be lent out  Higher reserve requirements will decrease the money supply  When the bank is required to hold onto more money, less money is available to be lent out o 3. Extension of loans  Banks borrow money from the Fed and the Fed will charge interest on those loans  The discount rate: The interest rate that the Fed charges banking institutions to borrow funds  Federal funds rate: The interest rate that commercial banks charge each other when borrowing from each other  Banks want to borrow money from other banks before the Fed because the Fed is basically the “boss”  When the Fed extends more loans, money supply increases  To do this, they lower the discount rate to make banks more eager to borrow  When the Fed extends less loans by raising the discount rate, money supply decreases o 4. Changing the interest paid on excess bank reserves (New since 2012)  We get paid interest for putting money in the bank   Banks also earn interest on their deposits with the Fed  If they want to increase the money supply, they reduce the interest rate paid on excess reserves o The bank holds less money at the Fed  If they want to decrease the money supply, they increase the interest rate paid on excess reserves o They encourage banks to hold deposits at the Fed instead of loaning them out  When the AD increases unanticipated: the LRAS will increase, but then the SRAS will decrease and the output will stay the same and price index will increase o In the short-run, you have higher output and then in the long run, only prices increase  When the expected inflation is expected to go up: We will buy more now (AD increase), SRAS decreases because they want to sell more at higher prices o AD increases at the same time that SRAS will decrease  PI increases without the output increases (higher inflation) o No increase in output in the short run Review: 1. What are the 3 functions of money? 2. What is contained in M1? 3. What is contained in M2? 4. What is the required reserve ration and how does it affect the money multiplier and, thus, the money supply? 5. Know the economic goals of the Fed. 6. Know the 4 ways the Fed conducts monetary policy.


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