PRIN MACROECONOMICS ECON 2010
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0 Consumer Surplu Measures the difference between the highest price a consumer is willing to pay and the price the consumer actually pays 0 Willing to pay 80 for Macroeconomics textbook but find it online for 40 gt a consumer surplus of 40 a The demand curve can be used to measure the total consumer surplus in a market 0 Demand curves show the willingness of consumers to purchase a product at different prices Marginal Bene t The additional bene t to a consumer from consuming one more unit of a good or service 0 Consumers are willing to purchase a product up to the point where the marginal benefit of consuming a product is equal to its price 0 The total amount of consumer surplus in a market is equal to the area below the demand curve and above the market price This area represents the benefit to Ncr sumers in excess of the price they paid for a product 190 A 22gt 4 a x a quot 62V J an i aquot 0 Producer Surplu The difference between the lowest price a firm would have been willing to accept and the price it actually receives 0 Willing to sell a macroeconomics textbook for 20 but receive 40 gt a producer surplus of 20 0 Supply curves show the willingness of firms to supply a product at different prices 0 Marginal Cos The additional cost to a firm of producing one more unit of a good or service 0 Often the marginal cost of producing a good increases as more of the good is produced during a given time period 0 The total amount of producer surplus in a market is equal to the area above the market supply curve and below the market price we Tarn ml l 90 W an qo 80 40 P 80 PS 93 is Q0 N EQX 21gt 0 Betty 530 39 rmwerowlgagnewemmPaneltarmmseie39eaas i iegr v Mromaetsmte minus the total amount they must pay to buy the good 0 Producer surplus measures the net benefit received by producers from participating in a market Producer surplus in a market is equal to the total amount firms receive from consumers minus the cost of producing the good ll ii i g 639l rj t 39s lgl39 l Y tll i 39l llt gmcieeggrosutcomes 0 When marginal benefit equals marginal cost the market is said to be efficient o Marginal Bene t Equals Marginal Cost in Competitive Equilibrium 0 Given Demand and Supply competitive markets lead to the maximum level of economic surplus 0 Economic Surplu Producer Surplus Consumer Surplus 9 nyPk will Caving or economic aw Deadweight Loss The reduction in economic surplus resulting from a market not being in competitive equilibrium or inefficient 0 When the price of a good is above its equilibrium price economic surplus is less than it would be at the equilibrium price 0 What if price is below the equilibrium price P N KY I K i C ay e DWL 39mm mew r l 0 Price Floor Government controlled price that sets the minimum price that can be charged for a W qosd OY r9168 0 Not effective if set below the equilibrium price level o Inefficient o Leads to a gain in producer surplus at the expense of consumer surplus I Lowers economic surplus I The gain in producer surplus is lower than the loss of consumer surplus Nathan s geeemts KCVoxm cox Me il gmg I JDVILLViX lF w W 0 An example would be Louisiana quotShrimpersquot gathering on the steps of the Capitol in favor of a price floor that would drive up the price of shrimp thereby leading to a greater producer surplus at the expense of consumers I Minimum wage is another example of a price floor P l gt p36 N st r6 given 9 c o mgexsrnment controlled price that sets the maximum price that can be charged 039 donnfllldo39t39elle cgil E if set above equilibrium price 0 inefficient o Leads to a gain in consumer surplus at the expense of producer surplus I Lowers economic surplus I The gain in consumer surplus is lower than the loss of producer surplus 0 Very rare 9102 Cedmg Vrgvemg p x Q 2 31 Libbrzpw 2575K V ltJw5 1 f2 39 V For example rent controls in NYC set the maximum price landlords can charge on apartments this is the only example that l have ever seen of a price ceiling 39 Another example may be the prevention of price gouging after a hurricane or other natural disaster 0 AMJWWMW maswsnammm 39 We a Bamamsnatanssla amegaswica asagicilees asddgsamig twylmaeaearefrom a tax 0 The deadweight loss from a tax is referred to as the excess burden of the tax 0 A tax is ef cient if it imposes a small excess burden relative to the tax revenue that it raises WK 0am A p I Gr K S T 133 v9 raga gtog gizcimc 9 W 3m swd Xaom x e fmdgefax z 733349 axmpg C30 4ui V YquotJ VQ 57 P UAS T Wavx ik w 0 Tax lncidence The actual division of the burden of the tax between buyers and sellers in a market 0 The incidence of a tax does not depend on whether a tax is collected from the buyers of a good or from the sellers Depends on the relative elasticity of Supply and Demand o if Supply has a greater elasticity than demand then consumers will pay the majority of the tax 0 if Demand is more elastic than supply then producers will pay the majority of the tax 12 EIQS E kCH IMF 3 010 A m Q 996 0 08 VCUUVQ a aft g39 z u if EX E VQWCQ xi D mgmg c MK 4232 Egan gi 552 5m 3 O h Wrggct 353 i 5 xz 041 0 6 bm39m am COwQMMfg J Brief Geometry Review 0 Area of a Right Triangle x base x height bh 0 Area of a Rectangle 2 length x width lw Ex E ER lg MG 3 9 4 EDli gtE erx a kit3938quot gorildm 3 bar M arm Pm xz 6 W J f l m 30 9 9 05 m Wm B T w J 7 Z w 139 a XQQOQW v k r U m h Lu W 1 Jr L Q u H k 1 Q Lg 3 0 5 3m a 1 m 3 lt3 i x Q a C v Kquot A be oz P abw 2 t V JQ D Ch 7 SEE Measuring Total Production and Income Definitions I Microeconomics is the study of how households and rms make choices how they interact in markets and how the ovemment attem ts to in uence their choices y g P 7 Erma lt5 Pea JJQ I Macroeconomics is the study of the economy as a whole including topics such as in ation uncm lo men and economic owth P Y L g 7 CourtroLg Business cycle is the alternating periods of ecgglomic expansion and economic recession 13 or urx u 3 arms a Expansion is the period of a busin s cycle during which total production and total employment are increasin g v li m a in GDP I Recession is the period of a business cycle during which total production and total employment are decreasin g A damage A Gm I Economic growth is the ability of an economy to produce increasing quantities of goods and services n low if wt PU li KMiDdogh WWW h VB N U In ation rate is the pet gn age incre 6 Hi the price leveffrom one year t the next to z o rt 2 Leimm 4 MH V Gross Domestic Product GDP Measures Total Production Elisa Gross Domestic Product GDPl the market value of all nal goods and services produced in a country during a period of time typically one year 0 GDP is measured using market values not quantities 0 GDP includes only the market value of nal goods Final Good or Service one that is purchased by its final user and is not included in the production of any other good or service 0 Intermediate Good a good or service that is an input into another good or service such as a tire on a truck GDP includes only current production 0 A Table is a final good wood is an intermediate good fl Courdad lniarwnclisfia DW t J Cordial we 39 Prim 0 iht M 8 Lonnie l quotmgr Holt f ham j J T x W3quot A 397 3 DWI 3 iii b I Y x 391 39 3 B S 1 Em Econom g WW Luff Rm Tram W j m f39i quot39 w mm at a in 1 i A a 39 1 M iii 3 1 A 5 Huic wt u him 2 OVO EVB ZW Ck is I x j 39 E n Hm 0 m Wrm w Ms Muck t 1 WW 5W 3 fgt 3 1 2 g I 39 FX E NW agsAW WI I MEX9845 30w J J gramme W x R NWW F0 iquot DAD L1 Um aw Biob IZP M Sx 9 ii AX x fta Qua A 119k quot 5M QZD zz3amp0 GD and Income When we measure the value of total production in the economy by calculating GDP we are simultaneously measuring the value of total income Firms sell goods and services to three groups domestic households foreign rms and households and the government Who produces goods and services 47 grab o Who receives the profit from production of goods and services 27 Pawn Endo39jue is e J i Edie Tl Woxhjr 0 Transfer Payment payments by the government to individuais for which the government does not receive a new good or service in return 0 Welfare Social Security etc 0 Nothing is produced just a o Look at the diagram on P 217 O of money from one individual to another Components of GDP Consumotion spending by n goods and services not including spending on new houses 0 Spending on new houses is considered investment 0 What about spending on old houses in an old hm Q PWdueiw Niws ringers l 0 M 33 ew 21 investing in lilac geidehonoi no m A investment divided into three categories Cd 39 0 Business xed investment spending by rms on new factories office buildings and c machinery used to produce other goods n v v I 0 Residential investment spending by households on ne housing 0 Changes in business inventories are also included in investment H Sandie en 53 39 1 1 5 sadc N 25 v gt if wii mgt m 0 Government Purchases spending by federal state and local governments on goods and services such as teachers salaries highways and aircraft carriers quotmm51 parental 5 ance s r s TQGdW S amp 91M Lt 1N5 lb n53 g on v is r Vi ta idler lm 39 of mi o W exports minus imports 39 L r v ijt 539 0 Exports domestic goods or services that are sold to foreign markets I Chinese business man buys financial services from American firm 0 imports foreign goods or services that are sold to the domestic market I You buy anything with the inscription Made in China39 unless you re in China A few notes about actual levels of the components of GDP 0 Consumer spending on services is greater than the sum of spending on durable and nondurable goods Business fixed investment is the largest component of investment Purchases made by state and local governments are greater than purchases made by the federal government 0 imports are greater than exports so net exports are negative 00 Measuring GDP 0 Value Added refers to the additional market value a firm gives to a product and is equal to the difference between the price for which the rm sells a good and the price it paid other firms for intermediate goods fem Q r Row A ifi0 100 it loo gm 5 s W 3 Zoo n 00 Ice 02 Roi ZOO new i ZOO iii loo K hll f a qoo f5 600 Shortcomings of GDP 0 Can t measure household production or the underground economy 0 Household Production goods and services people produce for themselves 0 Cooking at home vs eating in a restaurant 0 Washing your own clothes vs a fluff and fold service 0 Underground Market the buying and selling of goods and services that is concealed from the government to avoid taxes or regulations or because the goods and services are often illegal o illegal Drugs 0 Guns 0 Gambling 0 Can39t measure wellbeing Money can39 buy everything Value for leisure not included Pollution is not measured Crime is not accounted for However does provide a tangible measure of how well offa society is doing I Countries with high GDPcapita tend to have low levels of pollution crime and have more leisure O 000 Real vs Nominal GDP 0 Real the value of final goods and services evaluated at base year prices Nominal the value of final goods and services evaluated at currentyear prices GDP de ator 0 Price Level measure of the average prices of goods and services in the economy 0 GDP Deflator a measure of the price level calculated by dividing nominal GDP by real GDP and multiplying by 100 QWJ Q H rt a 1L t A 09 112 424 530001 or a Eakeq bugs 7 7 MO 7 Jo an we 7 7 7 C U comsumer bpujf v 7 3231 lt39 US f mi NJu i 1 3516 315 bULijmi l5 vi3 934D 49 Eiou pwc oagai pkk afriikaf W CO GQJWQTTXQYLquot W b ARWCquotHf mw de Qrcm cama 7 fimva rm w r wcegfw anquot d1 Q R hm m m gg ams Q slt quot e medx i rv Eggwa a 39 r MA c Wkee r wm 3amp3 39 Expnvlv SEMDEELQY 20 A i 239 V5 2in LKJ T CWYYWQ 7 7 f m quotVPY CUMC OnWQE g W 7 5 2mm 9m Ewan wcc semjmmdwq v mjl H b 3 50 D7 A 3432919 f f dm QCnm W s f iuf 4 0 65m aDPz bP 2355 a Sam budge gear P 075306 39 900 7 M0 Wax29000 Gmd P Mimxbm i c3 f 7 quotPquot ZQ ii liiiwg f 77 H Ht mw n Qofra 7 r m 5 V w r 0 A m GDP MUSquot b QO J 3 jr 2 a r ra ar mid FagVow W manyg 4 r r r L 53 r L A I RWCQ WPmdUC Okyiay s 5 f Pkme q MGDPs3 if L DUVWP wii 90 EGO mos r dgcrgc sga XQ inova quotW66 7 nOWvYXO A GD W044 iwrv ms wmm w ox id39JC V 3 1m m cggowx ifg V ri mob 38 E999 M w n fm wad Pf fxampL j Chapter 12 Aggregate Demand and Aggregate Supply Analysis Aggregate Demand To understand what happens during the business cycle we need to explain uctuations in real GDP the unemployment rate and the in ation rate The aggregate demand and aggregate supply model is a model that explains shortrun uctuations in real GDP and the price level The aggregate demand curve AD is a curve showing the relationship between the price level and the quantity of real GDP demanded by households rms and the government The shortrun aggregate supply curve SRAS is a curve showing the relationship in the short run between the price level and the quantity of real GDP supplied by rms In the short run real GDP and the price level are determined by the interaction of the aggregate demand curve and the shortrun aggregate supply curve A Why Is the Aggregate Demand Curve Downward Sloping I The aggregate demand curve is downward sloping because a fall in the price level increases the quantity of real GDP demanded o The wealth effect explains how a change in the price level affects consumption 0 The interestrate e ect explains how a change in the price level affects investment 0 The international trade e ect explains how a change in the price level affects net exports B Shifts of the Aggregate Demand Curve versus Movements Along it The aggregate demand curve tells us the relationship between the price level and the quantity of real GDP demanded holding everything else constant If the price level changes but other variables that affect the willingness of households rms and the government to spend are unchanged the economy will move up or down a stationary aggregate demand curve If any variable changes other than the price level the aggregate demand curve will shift E The Variables That Shift the Aggregate Demand Curve Three variables shift the aggregate demand curve 1 Changes in government policies An increase in interest rates shifts the aggregate demand to the left An increase in government purchases shifts the aggregate demand to the right 2 Changes in the expectations of households and rms An increase in households expectations of their future incomes shifts the aggregate demand to the right An increase in rms expectations of the future profitability of investment spending shifts the aggregate demand to the right 3 Changes in foreign variables An increase in the grth rate of domestic GDP relative to the growth rate of foreign GDP shifts the aggregate demand curve to the left An increase in the value of the dollar relative to foreign currencies shifts the aggregate demand curve to the left Aggregate Supply A The Long Run Aggregate Supply Curve U There are two aggregate supply curves one for the shortrun and one for the long run The longrun aggregate supply curve LRAS is a curve showing the relationship in the long run between the price level and the quantity of real GDP supplied 0 Changes in the price level do not affect the level of aggregate supply in the long run 9 2 mg meg M W B ADPv W Starizg we The Short Run Aggregate Supply Curve The shortrun aggregate supply curve SRAS is upward sloping for two reasons a As the price level increases the quantity of goods and services rms are willing to supply will increase b As prices of nal goods and services rise prices of inputs rise more slowly i Some rms and workers fail to predict accurately changes in the price level ii If rms and workers could predict the future price lcwel exactly the shortrun aggregate supply curve would be the same as the longrun aggregate supply curve The failure of workers and rms to predict the price level accurately results in an upward sloping shortrun aggregate supply curve for the following reasons a Contracts make some wages and prices sticky b Firms are often slow to adjust wages and c Menu costs make some prices sticky Menu costs are the costs to rms of changing prices iriur 920 i 53 WW 2 real Shifts of the ShortRun Aggregate Supply Curve The short run aggregate supply curve states the short run relationship between the price level and the quantity of goods and services rms are willing to supply holding constant all other variables that affect the willingness of rms to supply goods and services If the price level changes but other Variables are unchanged the economy will move up or down a stationary aggregate supply curve If any variable other than the price level changes the aggregate supply curve will shift mv39t mwawf acm Amie 9 or lM mm of QL Pradwggg v L A m 2 ha Fun P 4 1 M J u 3 A w w 7w 391 ir ii 3 1 ma z In fzu1 Jr 5 r H C QDETQ quot 1 H E E dp rK 4L Rb quotro quot mpw s gt r 3235 L935 wwofm JV hmduxci mpu rg cams lnf r OU HDLj r 4 mm gt 5 51 J l M Expem39 A WOf ii r Vg affjggjf 3 Cowper sax45 P x 3 34 QDP 1 x2 m l Ojvs mmr m o Gram bAr you 3 m O Gn quoti W v y 39 x CGH Lr r r23 M22524 39 So who 2 r adjust X r a managed A 39m 2 p 4 Cr Oli gt 2 aoppxg 0 gt Maur 7gt a 499 r 4 552 1 Variables Thar Shift the Sheri Rue Aggregate Suppiy Curve The ve most important variables that cause the short mm aggregate supply curve to shift are a Increases in the labor force and in the capital stock b Technological change c Expected changes in the future price level d Adjustments of workers and rms to errors in past expectations about the price level e Unexpected changes in the price of an important natural resource Supply shock is an unexpected event that causes the shortrun aggregate Supply curve to shift Example To help understand why price and wages may be sticky let s use the example of Bill s Glue Emporium a rm that sells glue and other adhesives to businesses Assume the price level increases by 10 percent in 2007 Bill does not plan to buy new equipment or tools during the year and the wages of Bill s workers are not adjusted until the end of the year Explain why Bill would choose each of the following alternative responses to the price level change f Bill increases the price and the output of his glue during 2007 but reduces the production of glue to its former level in 2008 g Bill does not raise the price of glue during 2007 but does increase the output of glue during 2007 In 2008 he raises glue prices and reduces the production of glue to its former level SOLVING THE PROBLEM Step 1 Step 2 Step 3 Review the chapter material This problem is about the short run aggregate supply curve so you may want to review the section Aggregate Supply To answer question a explain why Bill might increase the price and the output of his glue during 2007 but reduces the production of glue to its former level in 2008 The price level increase means that other output prices have risen Bill believes that he will sell more glue even at a higher price If this price increase sticks pun intended then his pro ts will increase in 2007 because his capital and labor costs will not rise But his workers will probably demand a wage increase in 2008 to compensate for the reduction in real income caused by the price level increase Sellers of capital goods will also want to raise their prices If Bill s input prices rise by the same amount as prices have risen he will decide in 2008 to reduce his output of glue to its former level To answer question b explain why Bill would choose not to raise the price of glue during 2007 but increase the output of glue during 2007 and reduce the production of glue to its former level in 2008 Bill might choose this option if he is not sure if the increase in the price level will be maintained If he raises prices in 2007 he risks losing customers to other glue sellers In addition if he raises his prices only to lower them later in the year he will have incurred menu costs twice costs that he can avoid by not raising his prices in the rst place Because his labor and capital costs will not rise in 2007 he can earn a pro t om selling a higher output of glue even vw39thout raising his prices But in 2008 his workers and capital goods suppliers will likely demand higher wages and prices to compensate for the reduction in real income caused by the price level increase Bill will raise his prices and reduce his output of glue to its former level Macroeconomic Equiiibrium in the Long Run and the Short Run a We can use the aggregate demand and aggregate supply model to illustrate the difference between the shortmm and long run macroeconomic equilibrium 0 In longrun equilibrium the shortrun aggregate supply curve and the aggregate demand curve intersect at a point on the longrun aggregate supply curve Equilibrium occurs at a point along the long run aggregate supply curve and the economy is at potential real GDP 0 Firms are operating at their normal level of capacity and there will be only structural and frictional unemployment rune A Recessions Expansions and Supply Shocks o The economy is often not in longrun macroeconomic equilibrium 0 During a recession there is a shortrun effect of a decline in aggregate demand 0 The aggregate demand curve shifts to the left 0 Adjusmlent back to potential GDP in the long run occurs through an automatic mechanism since the government does not take any actions 0 Workers will be willing to accept lower wages and rms will be willing to accept lower prices As a result the SRAS curve will shift to the right It may take the economy several years to return to potential GDP Alternatively the government can use monetary and scal policy to restore potential GDP more quickly T m 3S ergEva 96a 39 0mm me 665 a be 030 be 59ch 39 W53 41 bra a rww 391 t 000 n X QWLA J gvpeoea 7m 31 Release on gt Uwemzegm 0 During an expansion there is a shortrun increase in aggregate demand The aggregate demand curve shifts to the right Adjustment back to potential GDP in the long run occurs through an automatic mechanism since the government does not take any actions Workers will push for higher wages and rms will charge higher prices As a result the SRAS curve will shift to the le OO O o It may take the economy several years to return to potential GDP 0 Alternatively the government can use frjnkonetary and scal policy to restore potential GDP more quickly La 9 3 5quot quot5 9 3296 r M Q99 1m l Pd 9 232952 Xume On 9 UN ifv gt ma E wb 16 m 1 Farms 1 f 9 W 0 The short run effect of a supply shock is a higher price level I Suppose oil prices increase substantially o This will cause a recession and a higher price level in the short run was 1 a l 0150M 9215 to Sg a worZz r 5 Wat ztw mg Wee we re a9 eJSo re g Hoomgwage gt value at r Stag ation is a combination of in ation and recession usually resulting from a supply 5 oc Ad ustment back to potential GDP in the long run occurs through an automatic mechanism since the government does not take any actions Workers will be willing to accept lower wages and rms will be willing to accept lower prices As a result the SRAS curve will shift to the right It may take the economy several years to return to potential GDP Alternatively the government can use monetary and scal policy to restore potential GDP more quickly but it would result in a permanently higher price level 0 O O O OO Exampie The first graph below illustrates an economy in longrun equilibrium at a price level of 120 and a real GDP of 120 trillion Now assume that an increase in real estate prices raises household wealth h What two assumptions are used when the economy is said to be in an initial long run equilibrium at a price level of 120 and a real GDP equal to 120 trillion i Use graphs to describe the changes in aggregate demand and aggregate supply that result in a short run and a longrun equilibrium that follow from this increase in wealth SOLVING THE PROBLEM Step 1 Step 2 Step 3 Review the chapter material This problem is about the relationship between short run and long run macroeconomic equilibrium so you may want to review the section Macroeconomic Equilibrium in the Long Run and the Short Run To answer question a explain what two assumptions are used when the economy is said to be in an initial longrun equilibrium at a price level of 120 and a real GDP equal to 120 trillion The rst assumption is that the economy has not been experiencing any in ation since the price level is 120 and is expected to remain at this level The second assumption is that potential GDP equals 120 trillion and will remain at this level To answer question b use graphs to describe the changes in aggregate demand and aggregate supply that result in a shortrun and a longrun equilibrium that follow from this increase in wealth The increase in wealth will increase consumption This will cause a shift in aggregate demand to the right see the second graph below from AD to ADZ The economy will reach shortrun equilibrium at a higher real GDP and a higher price level Workers and rms will eventually begin to adjust to the price level being higher than they had expected Workers Will push for higher wages because each dollar of wages is able to buy fewer goods and services and rms will charge higher prices In addition the low levels of unemployment resulting from the expansion will make it easier for workers to negotiate for higher wages and the increase in demand will make it easier for rms to receive higher prices As a result the SRAS curve will shift to the left om SRAS1 to SRASZ At this point the economy will be back in longrun equilibrium The economy s new longrun equilibrium will have a higher price level but the same level of real GDP as the equilibrium before the increase in wealth occurred Price level GDP de ator 2000 100 LRAS 120 Rea GDP trillions of 2000 dollars 0 120 Price level GDP de ator 2000 100 124 122 120 0 120 122 Real GDP trillions of 2000 dollars 9 quotr i xi mu 3 3 ET EiF JJHQEquot Vi f1 hangamtd N quot u x t D 5 lnnTiO TiGl so glygcgo 7 A Dynamic Aggregate Demand and Aggregate Supply Model 0 We can create a dynamic aggregate demand and aggregate supply model by making three changes to the basic model based on the following macroeconomic facts a Potential real GDP increases continually shifting the long run aggregate supply curve LRAS to the right b During most years the aggregate demand curve AD will be shifting to the right c Except during periods when workers and rms expect high rates of in ation the shortrun aggregate supply curve SRAS will be shifting to the right germ c 39 am when Lsmeem ED c OM N3 gang wing What Is the sual Cause of In ation The dynamic aggregate demand and aggregate supply model provides a more accurate explanation than the basic model of the source of most in ation If total spending in the economy grows faster than total production prices rise If aggregate demand increases by the same amount as shortrun and long run aggregate supply the price level will not change RD g nxrc r mor quotifquot 32 as g l l A 9 A35 l 0 QUmva Rmhmw 5 Cm v zm i t av m2 v30 5 955 k4 O w Iv U U u 2 www 4 13 v 5 Tm fj bm k v am w 3 The Slow Recovery from the Recession of 238 0 We can use the dynamic aggregate demand and aggregate supply model to analyze the slow recovery from the recession of 2001 The recession was caused by a decline in aggregate demand Several factors contributed to this decline The end of the stock market bubble In the late 1990s stock prices increased rapidly Stock prices began to fall in the spring of 2000 and by 2002 the total value of stocks had declined by 7 trillion from their peak of two years before Excessive investment in information technology During the late 19905 many rms overestimated the future pro tability of investment in information technology When their Intemet sales proved disappointing the companies had more computers than they needed For these reasons by the spring of 2001 many companies had sharply cut back on their investment spending The terrorist attacks of September 11 2001 The terrorist attacks on New York and Washington DC increased the level of uncertainty in the economy When rms and households face uncertainty they often postpone spending until the uncertainty is resolved The corporate accounting scandals The top managers of some corporations such as WorldCom Tyco and Enron manipulated their nancial statements during the stock market boom to make their corporations appear more pro table than they actually were C The More Rapid Recovery of28032004 O The recovery from the recession of 2001 accelerated in the second half of 2003 and through 2004 Low interest rates spurred spending on new houses and helped increase investment spending by rms Tax cuts increased both consumption and investment spending The value of the dollar also declined against more foreign currencies which helped exports D The Economy in 2007 Continuing Expansion or Looming Recession 0 The business cycle expansion that began with the end of the 2001 recession continued through late 2007 0 By that time the expansion had lasted longer than the average expansion during the period since 1950 The economy in 2007 was also feeling the effects of hard times in the housing market In late 2007 economists were divided over whether the twin blows of higher oil prices and a declining housing sector would be suf cient to push the economy into a recession 0 The majority of economists forecast that growth in real GDP would slow but that the economy would not tip into recession 0 Appendix Macroeconomic Schools of Thought The widespread acceptance during the 19305 and 1940s of John Maynard Keynes s macroeconomic model became known as the Keynesian revolution The aggregate demand and aggregate supply model remains the most widely accepted approach to analyzing macroeconomic issues A signi cant number of economists dispute whether this model is the best way to analyze macroeconomic issues These alternative schools of thought use models that differ signi cantly from the standard aggregate demand and aggregate supply model There are three alternative models 11 Monetarist model 0 New classical model p Real business cycle model A The Monetarist Model The monetarist model also known as the neeQuantity Theory of Money model was developed beginning in the 19405 by Milton Friedman an economist at the University of Chicago who was awarded the Nobel Prize in Economics in 1976 Friedman has argued that the Federal Reserve should change its practices and adopt a monetary growth rule which is a plan for increasing the quantity of money at a xed rate that does not respond to changes in economic conditions Friedman s ideas which are referred to as monetarism attracted signi cant support during the 19703 and early 1980s when the economy experienced high rates of unemployment and in ation B The New Classical Model New classical macroeconomics refers to the macroeconomic theories of Robert Lucas and others particularly the idea that Workers and rms have rational expectations C The Real Business Cycle The real business cycle model refers to a macroeconomic model that focuses on real rather than monetary causes of the business cycle 0er w 04me CL M J w E w WE OWES Q C 26646xv 043 2 waggg 7 9 lavL3 haw DVh s39sw mdx 22963 5Lv 39mw MPG mpg QEJF E mega P 7 r afe hdm J VFW fd 9 may m 39m mm u f in long UVLJEW G Fan ucMw vsrlix f i i Siopihq F 79ZA mo x wv 7 cub V Signvme 7 7777mx Chapter 15 Fiscal Policy Fiscal Policy A o c What Fiscal Policy Is and What It Isn t Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives such as high employment price stability and high rates of economic growth are called scal policy In the United States the federal state and local governments all have responsibility for taxing and spending H a can New 0 am it spending t2 macaw Ab Automatic Stabilizers versus Discretionary Fiscal Policy Some types of government spending and taxes that automatically increase and decrease along with the business cycle are referred to as automatic stabilizers The word automatic means that changes in spending and taxes happen without actions by the government For example when the economy is expanding and employment is increasing government spending on unemployment insurance payments to workers who have lost their jobs will automatically decrease 9 Cxi quotQet tgexoh 395 more U utjmtmg d 153 W533 Mortnne xmogmem msnmnce and u ice 06mm An Overview of Government Spending and Taxes The size of the federal government expanded sigii cantly during the Great Depression As a fraction of GDP the federal government s purchases of goods and services have been declining since the Korean War in the early 19505 Total expenditures by the federal government including transfer payments rose slowly from 1950 through the early 19905 and fell from 1992 to 2001 before rising again Seam JECLJ CCU WWWE mm Mb W ugS m WWSW 0quot WOW9727 60W Wmham y 39ILI jQHLNX M 7 if Ab r CW 2 4 m W WWW 0 6180 mg M Wag Federal government expenditures include purchases plus all other federal government spending eg transfer payments defense spending grants to state and local governments interest payments and other expenditures The Effects of Fiscal Policy on Real GDP and the Price Level A 4 o 5 Expansionary and Contractionary Fiscal Policy An Initial Look Decreasing government purchases or raising taxes can slow the growth of aggregate demand and reduce the in ation rate Expansionary scal policy involves increasing government purchases or decreasing taxes to Moi v m e We An increase in government purchases will increase aggregate demand If the individual income tax is cut household disposable income and consumption spending will rise Tax cuts on business income can increase aggregate demand by increasing business investment The goal of both expansionary monetary policy and expansionary scal policy is to increase aggregate demand relative to what it would have been Without the policy Contractionary scal policy involves decreasing government purchases or increasing taxes Policymakers use contractionary scal policy to reduce increases in aggregate demand that seem likely to lead to in ation Decreasing government purchases or increasing taxes can keep real GDP from moving beyond its potential level Using Fiscal Policy to In uence Aggregate Demand A More Complete Account Fiscal policy affects aggregate demand Increasing government purchases or cutting taxes can shift aggregate demand to the right Contractionary scal policy can keep real GDP from moving beyond its potential level A Summary of How Fiscal Policy Affects Aggregate Demand When there is recession an expansionary scal policy will result in39a higher real GDP and higher price level s G M3 Mb WRDQ m 27 wa AD W3 gom com m ma aq c3004 Pisa m 7 9amp6st W w m 6 1 pame xowmj gm mg 7 A contractionary scal policy causes the price level to rise by less than it would have without the policy Extra Solved Problem 152 Fiscal Policy and Aggregate Demand The graph on the next page illustrates an economy that is in longrun equilibrium in Year 1 at a potential real GDP of 135 trillion and a price level of 120 In Year 2 growth in technology and increases in capital and labor increase potential real GDP to 140 trillion and the longrun aggregate supply curve shifts from LRASI to LRASZ Assume that aggregate demand in Year 2 increases to AD and that there is no change in monetary policy that would increase aggregate demand further For simplicity assume that the short run aggregate supply curve SRAS does not shift In Year 2 the intersection of the shortrun aggregate demand curve and aggregate supply curves occurs at a price level of 122 and a real GDP of 13 8 trillion a How can scal policy be used to allow the economy to reach equilibrium at its new potential real GDP b Draw a graph that illustrates the impact of this scal policy Qaces e wn 7 Crown povcg gum 10016096 m C1 at t M 5 gauge TD ft M Ob 0t KNOWt 10G 2 peopleta a9 mutants on MM WW 39 Wm W15 A 3 m0 R B 9 12 quotis 600 and Am 7 S the th s W2C My 39 quotWt NM Reg B t ccmgass m 2C7 bogmo M M gm w hm 61 19ang CLUTTDnomogg 4 g 1 COW t mom mm mm quotto m Mpg er auraf Price level LHA81 LHA82 GDP price de ator 2005 109 SHAS1 SHASZ 122 W ADz A01 1 0 335 140 Rea GDP trillions of 2000 dollars SOLVlNG THE PROBLEM Step 39I Step 2 Step 3 Review the chapter material 7 This problem is about the use of scal policy so you may want to read the section The Effects of Fiscal Policy on Real GDP and the Price Level which begins on page 934 in the textbook Answer question a by explaining how fiscal policy can be used to allow the economy to reach equilibrium at the new level of potential real GDP Government Spending is a direct increase in aggregate demand while changes in taxes affect spending indirectly through changes in income Therefore the tax reduction would have to be greater than a government spending increase to achieve the same increase in aggregate demand Answer question b by drawing a graph that illustrates the impact of this fiscal policy The graph on the next page shows the impact of a change in spending or taxes that shi s aggregate demand from AD aggregate demand in Year 2 without a change in scal policy to AD3 aggregate demand in Year 2 with a change in scal policy Note the price level is greater 125 as a result of the scal policy than it would have been without it 122 Price level 1 3451 LFt ASZ GDP price de ator 2000 100 SRAS1 SHA52 125 120 W A03 A02 A01 0 135 140 Rea GDP trilions of 2000 dollars The Government Purchases and Tax 39 Economists refer to the series of induced increases in consumption spending that results from an initial increase in autonomous expenditures as the multiplier effect The ratio of the change in equilibrium real GDP to the initial change in government purchases is known as the government purchases multiplier Change in equilibrium real GDP Government purchases multiplier Change 1n government purchases Economists have estimated that the government purchases multiplier has a value of about 2 Cutting taxes increases the disposable income of households and consumption spending and also produces a multiplier effect The tax multiplier is a negative number because changes in taxes and changes in real GDP move in opposite directions An increase in taxes reduces disposable income consumption and real GDP 39 A decrease in taxes raises disposable income consumption and real GDP The expression for the tax multiplier is Change in equilibrium real GDP Tax multiplier Change in taxes A Fiscal Policy in Action The Tax Rebate of 2008 In early 2008 economists advising President Bush believed that the housing crisis the resulting credit crunch and rising oil prices had increased the risk of recession Congress and the president cut taxes through rebates of taxes already paid The rebates were sent as checks during the summer of 2008 Though the effect of the rebates is uncertain a similar rebate was used to combat the recession of 2001 Onetime rebates such as those in 2001 and 2008 increase consumers current income but not their permanent income Therefore a tax rebate is likely to increase consumption spending less than would a permanent tax cut v PQOPM mSUWlWOH OKQCigigl S OW groaning cammgt WW Wme awning th row 0 o B The Effect of Changes in Tax Rates 00 A cut in tax rates affects equilibrium real GDP through two channels 1 A cut in tax rates increases the disposable income of households which leads them to increase their consumption spending 2 A cut in tax rates increases the size of the multiplier effect eoeooie natmtaaet ng Of Ar Nome an autommoos Aimee t CO creme H W m5 UV quot W N C Taking into39giccoZu the Effects of Aggregate Supply The actual change in real GDP resulting from an increase in government purchases or a cut in taxes will be less than indicated by the simple multiplier effect with a constant price level D The Multipliers Work in Both Directions The multipliers can work in two ways t Increases in government purchases and cuts in taxes have a positive multiplier effect on equilibrium real GDP 2 Decreases in government purchases and increases in taxes also have a multiplier effect on equilibrium real GDP only in this case the effect is negative The Limits of Using Fiscal Policy to Stabilize the Economy Ram Wm extnon on M new rs m ammo leg 39 Getting the timing right can be more dif cult with scal policy than with monetary policy for two main reasons 1 Control over monetary policy is concentrated in the hands of the Federal Open Market Committee which can change monetary policy at any of its meetings The president and a majority of the 535 members of Congress have to agree on changes in scal policy Equot A Does Government Spending Reduce Private Spending m namp xmga y pi ngg m 02 355 akeg a 4 9 me a g e x 1 QA apqmw 2 5 3 e P i The size of the multiplier from government spending to increase aggregate demand may be limited if the increase in government purchases causes private components of aggregate expenditures consumption investment or net exports to fall 39 A decline in private expenditures as a result of an increase in government purchases is called crowding out B Crowding Out in the Short Run The greater the sensitivity of consumption investment and net exports to changes in interest rates the more crowding out will occur 39 In a deep recession many rms may be so pessimistic about the future and have so much excess capacity that investment spending falls to very low levels and is unlikely to fall much further even if interest rates rise in this case crowding out is unlikely to be a problem in N5 meg ton t i n 4 must come at no ewbp 39t e 0 whose JarrettWW6 92 Debug atp ndum i 9 36590 0 2W OHM Pix TD 37 50 There N be OK Gianum Km pmcne pcnovtut S or 020 C Crowding Out in the Long Run 0 Most economists agree that the long run effect of a permanent increase in government spending is complete crowding out In the long run the decline in investment consumption and net exports exactly offsets the increase in government purchases and aggregate demand remains unchanged De cits Surpluses and Federal Government Debt The federal government s budget shows the relationship between its expenditures and its tax revenue 39 A budget de cit is the situation in which the government s expenditures are greater than its tax revenue NM 5 Tm mowm vav SWU 1w u mg 67 at gemquotng mmmgw 0 CmW m Wg CWQCW Chi366139s mch meme cmxmg es m 6an m mpg x4 aw w 8me WWW 6 L R 599 m M2396 ggngk C lCW C m cm W hm qwedm quotTm 7 7 Mex lt76 mmw w 3 meme MW ms mm 61 cm m 6 W Chowea quotx n V A budget surplus it the situation in which the government s expenditures are less than its tax revenue How the Federal Budget Can Serve as an Automatic Stabilizer Most of the increase in the federal budget de cit during recessions takes place without Congress and the president taking any action because of the effects of automatic stabilizers De cits occur automatically during recessions for two reasons 1 During a recession wages pro ts and government tax revenues fall 2 The government automatically increases its spending on transfer payments when the economy moves into recession The cyclically adjusted budget de cit or surplus is the de cit or surplus in the federal government s budget if the economy were at potential GDP Economists often look at the cyclically adjusted budget de cit or surplus because budget de cits automatically increase during recessions and decrease during expansions This can provide a more accurate measure of the effects on the economy of the govemment s spending and tax policies than the actual budget de cit or surplus v LECESSlOY r 7 Einc 9 Ewcmg xoh accith screws gt Should the Federal Budget Always Be Balanced Although many economists believe that it is a good idea for the federal government to have a balanced budget when the economy is at potential GDP few believe that the federal government should by to balance its budget every year Dorm we recesskenrms mames mer WCWSM W185 0r tr C7 loom at Nam Wow m Md worsen W recession The Federal Government Debt When the federal government runs a budget de cit the Treasury must borrow funds from investors by selling Treasury securities eg bonds The total value of US Treasury bonds outstanding is referred to as the federal government debt or sometimes as the national debt By the end of May 2008 the federal government debt was 94 trillion but more than half of this debt was held by federal government agencies The impact of the baby boom on the Social Security and Medicare systems has led the Social Securin and Medicare trust fund to acquire more than 41 trillion worth of Treasury debt When baby boomers retire the trust fund will sell those bonds to make payments to retirees ls Government Debt a Problem Debt can be a problem for a government for the same reasons that debt can be a problem for a household or a business In the long run a debt that increases in size relative to GDP can pose a problem because the government may have to raise taxes to high levels or cut back on other spending to make interest payments on the debt The Effects of Fiscal Policy in the Long Run Some scal policy actions are intended to have longrun effects by expanding the productive capacity of the economy and increasing the rate of economic growth These policy actions primarily affect aggregate supply rather than aggregate demand and therefore are referred to as supply side economics 4 utes ea WOLch Saunas map NchQS western hxr x wt more mowers The Long Run Effects of Tax Policy The difference between the pretax and post tax return to an economic activity is known as the tax wedge 39 The tax wedge applies to the marginal tax rate which is the fraction of each additional dollar of income that must be paid in taxes i WNJingNZJM The following are effects on aggregate supply from cutting taxes H Reducing marginal tax rates on individual income will reduce the tax wedge faced by workers thereby increasing the quantity of labor supplied 2 Cutting the marginal corporate income tax rate will encourage investment spending by increasing the return corporations receive from new investments in equipment factories and of ce buildings 3 Lowering tax rates on dividends and capital gains increases the supply of loanable funds from households to rms increasing saving and investment and lowering the equilibrium real interest rate i 30pm tumble OYCK Nr r 7 mwmm Wm Wug 8 WOYWS WOW 5 901M WW6 8 Wm Cius ngoomce UQ N xd 9ampwa NOWU S we ayed MW 3 recewe mm mmgg TOW WObe yams d m 60quot W 5 00 Tb MM quotmem W52 rm can ngrwg MW Twaiep jmmrizexrg CM my Saw CdUm mow Wvgg u Wovmfg 5w Wkng m 96mm quotm we as E ng mg m am WM 003 V090 LUCY MUS g3 th V 39j f NNWQ MMYSUE QVQdMQ39S YLO V CCjfg 90 00 Nka comged 3 06mm R W863 Tax Simpli cation If the tax code were greatly simpli ed the economic resources currently used by the tax preparation industry would be available to produce other goods and services A simpli ed tax code would increase economic ef ciency by reducing the number of decisions made by households and rms solely to reduce their tax payments The Economic Effect of Tax Reform If tax reduction and simpli cation are effective the economy will experience increases in labor supply saving investment and the formation of new rms Economic ef ciency will also be improved Together these factors will result in an increase in the quantity of real GDP supplied at every price level A success il policy of tax reductions and simpli cations will bene t the economy by increasing output and employment and at the same time may result in smaller increases in the price level How Large Are SupplySide Effects Most economists agree that there are supply side effects to reducing taxes decreasing marginal income tax rates will increase the quantity of labor supplied cutting the corporate income tax will increase investment spending and so on The magnitude of the effects is subject to considerable debate The size of the supply side effects of tax policy can be resolved only by careful studies of the effects of differences in tax rates on labor supply and saving and investment decisions Qm n a n F to 3er u 3 OT d a an 50 2 E3 33 47 2 OT 303 03 mm ma u Mmmnpa a ru 58 3f u 336 aw of Ga 93 n 399 00 Jail A D u amppg w g m5 if Chapter 18 The International Financial System Exchange Rate Systems Some countries simply allow the exchange rate to be determined by demand and supply just as other prices are A country that allows demand and supply to determine the value of its currency is said to have a floating currency 39 d61 if r W mad When countries can agree on how exchange rates should be determined economists say that there is an exchange rate system The current exchange rate system under which the value of most currencies is determined by demand and supply with occasional government intervention is known as a managed float exchange rate system SUPPVj 4 d6 W 3lt3t9 63134 ty j t s The two most important alternatives to the managed float exchange rate system were the gold standard and the Bretton Woods System These were both fixed exchange rate systems where exchange rates remained constant for long periods Svppxu at demand wt 0 Eat a rr 397 r r 1839 739 x39 1 39 Under the gold standard a country s currency consisted of gold coins and paper currency that the government was committed to redeem for gold Because of the Great Depression by the mid 19305 most countries including the United States had abandoned the gold standard 150 p39 at 3 goon QM 6 Emma 0a a z 5 2an Gamma r t gt D Cor ucm A 36 i as quot a 30va t 9 0 L5qu a oats 2 gj we avatar Cr3 th w l 3 litre a a The Current Exchange Rate The current exchange rate system has three important aspects H The United States allows the dollar to oat against other major currencies The dollar increases in value when it takes more units of foreign currency to buy one dollar and falls in value when it takes fewer units of foreign currency to buy one dollar 2 Most countries in Western Europe have adopted a single currency the euro 3 Some developing countries have attempted to keep their currencies exchange rates xed against the dollar or another major currency The oating Doiiar The dollar increases in value when it takes more units of foreign currency to buy one dollar and falls in value when it takes fewer units of foreign currency to buy one dollar Since 1973 the value of the US dollar has fluctuated widely against other major currencies From the beginning of 1973 to the end of 2006 the US dollar lost about 60 percent in value against the yen while it increased about 15 percent in value against the Canadian dollar What Determines Exchange Rates in the Long Run The two most important causes of exchange rate movements are changes in interest rates which cause investors to change their views of which countries nancial investments will yield the highest returns and changes in investors expectations about the future values of currencies g5 cuiagrorg The theory that in the long run exchange rates move to equalize the purchasing power of different currencies is referred to as the theory of purchasing power parity Three real world complications though keep purchasing power parity from being a complete explanation of exchange rates even in the long run IQb i Not all products can be traded internationally Products and consumer preferences are different across countries Countries impose barriers to trade such as tariffs and quotas A tariff is a tax imposed by a government on imports A quota is a limit on the quantity of a good that can be imported RAJ PP If mm TAO iiiEma lt7 v5 550 vb Q 22 313 quotma pv f ragawring mam 4 wmem grew C U33 70 r l A r I 4 TAP QC 4 can m mma mr pray Ex hamc38 57353 YWK T 1 r W W i 3 9 333 TW39 Co 6 A 0 gown5 25 ms 6 PP nk PraCC G 3st 1 2 9quot WWW abou k rh lt 93 WK 13530 5 WW g cm 636 men 333 Add acmgg r P Lacyquot1 r WQLQg if L1 fr WCE There are four determinants of exchange rates in the long run 1 Relative price levels 2 Relative rates of productivity growth 3 Preferences for domestic and foreign goods 4 Tariffs and quotas The Euro On January 1 2002 euro coins and paper currency were introduced and as of 2007 13 member countries of the European Union have adopted the euro as their common currency A new European Central Bank ECB was also established to assume responsibility for monetary policy and for issuing currency Economists are divided over whether the creation of the euro will help growth in the EU countries The experiences of the countries using the euro will provide economists with additional information on the costs and bene ts to countries from using the same currency Pegging against the 9o at When a country keeps its currency s exchange rate fixed against another country s currency it is pegging its currency in the 19805 and 19905 the flow of foreign investment funds to developing countries particularly those in East Asia increased substantially Countries attempting to maintain a peg can run into problems By 1997 the Thai Baht was overvalued against the dollar A currency pegged at a value above the market equilibrium exchange rate is said to be overvalued A currency pegged at a value below the market equilibrium exchange rate is said to be undervalued when investors make it more dif cult to maintain a fixed exchange rate it is referred to as destabilizing speculation The number of countries with pegged exchange ratesdeclined sharply therefore the trend has been toward replacing pegged exchange rates with managed floating exchange rates in 1978 China began to move away from central planning and toward a market system which accelerated economic growth Feta r ms International Capital Markets One important reason exchange rates fluctuate is that investors seek out the best investments they can find anywhere in the world For example if Chinese investors increase their demand for US Treasury bills the demand for dollars will increase and the dollar will appreciate If on the other hand interest rates in the United States decline foreign investors may sell us investments and the value ofthe dollar will fall Shares of stock and longterm debt including corporate and government bonds and bank loans are bought and sold on capital markets In the 19805 and 19905 European governments removed many restrictions on foreign investments in financial markets There are large capital markets in Europe and Japan and there are smaller markets in Latin America and East Asia The three most important international financial centers today are New York London and Tokyo Each day the front page of the online version of the Wall Street Journal displays the following stocks Dow Jones Industrial Average and Standard and Poor s 500 stock indexes of US stocks the Nikkei 255 average of Japanese stocks the FTSE 100 index of stocks on the London Stock Exchange and the Euro STOXX 50 index of European stocks By 2007 corporations banks and governments raised more than 1 trillion in funds on global financial markets Beginning in the 19905 the flow of foreign funds into US stocks and bonds or portfolio investments increased dramatically By 2006 foreign investment in these securities was at record levels The globalization of financial markets has helped increase growth and efficiency in the world economy No longer are rms forced to rely only on the savings of domestic households to finance investment Extra Economics in YOUR Life Exchange Rates and Your income Question Suppose that you work for a computer company Because the firm has an office in Germany you are asked to move there and work for a two year period Your employer gives you the option to receive pay either in dollars or in euros Which payment option is better for you What factors should affect your decision Answer Since you will be working in Germany for a twoyear period you need euros in order to pay your bills buy food and cover your living expenses while you are staying in Germany Fluctuations in the foreign exchange market for euros in terms of dollars will affect your income If you choose to get paid in dollars your income wili fluctuate based on the changes in the foreign exchange market An increase in the value of the euro relative to the US dollar means a reduction in your salary in terms of euros A reduction in your salary in terms of euros reduces the purchasing power of your living in Germany So you might be better off if you decide to get paid in euros to avoid fluctuations in your Income 0 A p pe n d IX quotthe Gold Standard Ct d the Bret th Woods System LEARNSNG OBJECTNE Expioin the goid standard and the Station Woods System A The Gold Standard Under the Gold Standard the exchange rate between two currencies was automatically determined by the quantity of good in each currency If there was onefifth of an ounce of gold in a US dollar and one ounce of gold in a British pound the price of gold in the United States would be 5 per ounce and the price of gold in Britain would be 1 per ounce The exchange rate would be 5 E1 B The End of the Gold Standard When the Great Depression began in 1929 governments came under pressure to abandon the gold standard to allow their central banks to pursue active monetary policies In 1931 Great Britain became the first major country to abandon the gold standard The United States remained on the gold standard until 1933 and a few countries including France Italy and Belgium stayed on even longer By the late 19305 the gold standard had collapsed The earlier a country abandoned the gold standard the easier time it had fighting the Depression with expansionary monetary policies C The Bretton Woods System Bretton Woods System is an exchange rate system that lasted from 1944 to 1971 under which countries pledged to buy and sell their currencies at a fixed rate against the dollar International Monetary Fund MP is an international organization that provides foreign currency loans to central banks and oversees the operation of the international monetary system Devaluation refers to a reduction in a fixed exchange rate Revaluation refers to an increase in a xed exchange rate D The Collapse of the Bretton Woods System By the late 19605 the Bretton Woods System faced two severe problems After 1963 the total number of dollars held by foreign central banks was larger than the gold reserves of the United States Some countries with undervalued currencies particularly West Germany were unwilling to revalue their currencies Governments resisted revaluation because it would have increased the prices of their countries exports During the 19605 most European countries including Germany relaxed their capital controls Capital controls are limits on the flow of foreign exchange and financial investment across countries The loosening of capital controls made it easier for investors to speculate on changes in exchange rates Investors actions to make a profit from the expected currency revaluation make it more dif cult to maintain a fixed exchange rate and they are referred to as destabilizing speculation Chapter 9 Economic Growth the Financial System and Business Cycles Long Run Economic Growth A key measure of success of any economy is its ability to increase production of goods and services faster than the growth in population 0 The US economy has experienced periods of expanding production and employment followed by periods of recession during which production and employment decline The business cycle refers to alternating periods of economic expansion and economic recession 0 The business cycle is not uniform Each period of expansion is not the same length nor is each period of recession Most people in the United States Western Europe Japan and other advanced countries expect that over time their standard of living will improve Lon run economic rowth the process by which rising productivity increases the average standard of living The best measure of the standard of living is real GDP per capita o Longrun economic growth is measured by increases in real GDP per capita 0 sin 2295 N 9 ii g gt9 gt39t kfi 06uctl ECOY iGmt R NO 1 1 No4 0 Ni UO Wmcm i 0 Growth Rate the percentage change in real GDP per capita from one year to the next 7quot i n r f 4 i r 2 gt A m 5 f i i n 5 P TM ba r 3 J l 9 we E0 o The Rule of 70 70 Number of years to double Growth rate What Determines the Rate of Long Run Growth 1 C 0 Labor productivity is the quantity of goods and serVIces that can be produced by one worker or by one hour of work 0 Economists usually measure labor productivity as output per hour of work in order to avoid fluctuations in the length of the workday and in the fraction of the population employed Qame mic CCth What Determines Labor Productiv m bait 660mm my g M l o The quantity of capital per hour worked and the level of technology 0 Capital refers to manufactured goods that are used to produce other goods and services 0 Capital is just machines buildings or other manufactured goods that aid in the production of goods and services 0 Examples of capital ELMO m 2de m lam tow r 2 o The total amount of physical capital such as computers factory buildings and trucks available in a country is known as the country s capital stock As the capital stock per hour worked increases worker productivity increases 0 Human capital refers to the accumulated knowledge and skills workers acquire from education and training or from their life experiences I Examples of human capital Ede 19th Exeg Technology refers to the process a firm uses to turn inputs into outputs of goods and services 0 Technological change is an increase in the quantity of output firms can produce using a given quantity of inputs Economic growth depends more on technological change than on increases in capital 0 per hour worked 0 Most technological change is embodied in new machinery equipment or software 0 Potential GDP is the level of GDP attained when all rms are producing at capacity 0 Growth in potential real GDP in the United States39is estimated to be about 35 percent per year Saving A An overview of the Financial System WNQ Sfng gqj39 Pr f g I i 39l 0 Firms can finance their expansion from retained earnings through financial markets and through nancial intermediaries 6quot The financial system is the system of financial markets and nancial intermediaries through which rms acquire funds from households Financial markets are markets where financial securities such as stocks and bonds are bought and sold I Financial intermediaries are firms such as banks mutual funds pension funds and insurance companies that borrow funds from savers and lend them to borrowers There is no country without a weldeveloped financial system that has been able to sustain high levels of economic growth 0 Could it be that countries with really high levels of growth have a need to develop a nancial system The financial system provides three key services for savers and borrowers a Risk sharing Risk is the chance that the value of a financial security will change relative to what you expect b Liquidity ie the ease with which a financial security can be exchanged for money and 0 information ie the facts about borrowers and expectations about returns on financial securities The Macroeconomics of Saving and investment The total value of saving in the economy must equal the total value of investment V There are two categories of saving in the economy private saving by households and public saving by the government When the government spends the same amount that it collects in taxes there is a balanced budget I When the government spends more than it collects in taxes there is a budget deficit I When the government spends less than it collects in taxes there is a budget surplus A budget surplus increases public saving and the total level of saving in the economy 0 Therefore there is a higher level of investment spending in the economy when there is a budget surplus than when there is a balanced budget no39rroclrno Countm gt who J a L vc The Market for Loanable Funds 0 The market for loanable funds refers to interaction of borrowers and lenders that determines the market interest rate and the quantity of loanable funds exchanged A lj K D 1 I f a A V OJ A 1 53quot V Cg ak 3039 1 Wic a v Jo T2 f g 3 1 1 b r K N 1 7 W7 x fix2Msz i3 Coquwxymm rwc re 3 p 590ng f 3 Eli iquot QO J T Eyiyly m A momg smack m man 8 Wfs d N 19 k x n wgw 2 WW m o SwaX vS o dame n Note Got 3205 Shaft An increase in the demand for loanable funds increases the equilibrium interest rate 0 As a result the equilibrium quantity of loanable funds increases When the government begins running a budget deficit the supply of loanable funds shifts to the left 0 The equilibrium interest rate increases 0 As a result the equilibrium quantity of loanable funds decreases Crowding out refers to a decline in private expenditures as a result of an increase in government urchases 39A p mm mquot 113 The Business Cycie gt de ic 9amp9 Hr 5 4 if A E Bush m it r p a 4 M 1574 de 0 During the expansion phase ofa business cycle production employment and income are increasing 0 The period of expansion ends with a business cycle peak Following the business cycle peak production employment and income decline during the recession phase of the cycle 0 The recession comes to an end with a business cycle trough after which another period of expansion begins Consumer dwa bieg 5d ii 1 9amp6 Veluld Q63 During Vece icm D N r What Happens during a Business Cycle 0 Each business cycle is different I A recession will often begin with a decline in spending by rms on capital goods or by households on new houses and consumer durables The inflation rate usually rises nearthe end ofa business cycle expansion and then falls during a recession The unemployment rate declines during the latter part ofan expansion and increases during a recession 0 The unemployment rate often continues to increase even after an expansion has begun Economists have not found a method to predict when recessions will begin and end Recessions are dif cult to predict because they have more than one cause Peop e 0 x T D 70v boos I Recessions have been milder and the economy has been more stable since 1950 Economists have offered three explanations for this The increasing importance of services and the declining importance of goods 21 b The establishment of unemployment insurance and other government transfer programs that provide funds to the unemployed and 0 Active federal government policies to stabilize the economy 9 7 Pa 2305 M lt em a Chapter 16 In ation Unemployment and Federal Reserve Policy The Discovery of the ShortRun Trade off between Unemployment and In ation A Explaining the Phillips Curve with Aggregate Demand and Aggregate Supply Curves 39 There is a shortrun trade019r between unemployment and in ation Higher unemployment is usually accompanied by lower in ation and lower unemployment is usually accompanied by 39 higher in ation The Phillips curve is a curve showing the short run relationship between the unemployment rate and the in ation rate The inverse relationship between unemployment and in ation that Phillips discovered is consistent with the aggregate demand and aggregate supply analysis ngeonenn 3 Sh xtlm up has a exigech V l Cal Vt ab slu q Wu Wtmmoqmaw K Y mg B ls the Phillips Curve a Policy Menu Some economists argued during the 19605 that the Phillips curve represented a structural relationship in the economy PMWS Cuw M M m 00 W 39 A structural relationship depends on the basic behavior of consumers and rms and remains unchanged over long periods 39 Structural relationships are useful in formulating economic policy because the relationships will not change as a result of changes in policy 39 Many economists and policymakers in the 1960s viewed the Phillips curve as a structural relationship and believed it represented a permanent trade0r between unemployment and in ation C Is the ShortRun Phillips Curve Stable 39 In 1968 in his presidential address to the American Economic As39sociation Milton Friedman of the University of Chicago who would go on to win the Nobel Prize in Economics argued that the Phillips curve did not represent a permanent tradeoff between unemployment and in ation D The LongRun Phillips Curve 39 At potential real GDP long run level rms will operate at their normal level of capacity and everyone who wants a job will have one except the structurally and frictionally unemployed 39 Friedman de ned the natural rate of unemployment as the unemployment rate that exists when the economy is at potential GDP 39 The actual unemployment rate will uctuate in the short run but will always come back to the natural rate in the long run If the long run Phillips curve is a vertical line no trade0r exists between unemployment and inflation in the long run P I Lens paga l 9 CL Sh d Wt AD spas C UK P m T OctY 0 m memo Page a m H2 aUlDllWWL WQ CBKW YACKS ill Cmsmg grams to Shi er envioth GLCCUKWQ Nth Dam 61D W W W 0 two Wren mtg 3 12 E The Role of Expectations of Future In ation o A higher in ation rate can lead to lower unemployment if both workers and rms mistakenly expect the in ation rate to be lower than it turns out to bet Expected in ation increases the value of total production and the value of total income by the same amount If actual in ation is higher than expected in ation actual real wages in the economy will be lower than expected real wages and many nns will hire more workers than they had planned to hire causing the unemployment rate to fall An increase in the in ation rate increases employment and decreases unemployment only if the increase in the in ation rate is unexpected Extra Solved Problem 16 1 Determining Real Wage Growth Determine the real wage and the growth rate in the real wage for the years from 2001 to 2004 Nominal wage and price data are given in the table below SOLVING THE PROBLEM Step 1 Review the chapter material EL 0 m f0 QCQM a W wage W L0000 W WA 3 mw mg m be SOHM pewmm 030w TY Wm gamma mme Nm new gt mmm we MOO H QOOO gmwoc HanKOO mm 0 P a I quM mMmlWag W up med lt1 Lammm waga of o V00 3 mm Mimw Kb be 9 10qu Hr g 0mde 5 1 WOW WNCW ESS Ow OD pend DLQ l 606 RSS lt t k Wm dared CLUWCU H63th T mu 3 e We sway 6610 adha m ce m QLW 09m OLWNTV HMO 9W 6 WQWMiW WM Mm mm mm we move WOY W3 7 X Mczmmmx MPim This problem is about calculating real wage rates so you may want to review the section The Discovery of the ShortRun Trade off Between Unemployment and Inflation which begins on page 974 in the textbook Siep 2 Describe how the real wage is calculaled The real wage is calculated as the nominal wage divided by the price level and multiplied by lOO Aom 3 L1 A 3 a new in e WCquot m 6 loco W W 39 52 Y 0 Tml QOOJQQgm C O woeea TV UQ PC when mm is 799 hmmhmcmenl in m 39 ow om Eilmmmmvg WOW M Whog Wait is TY To 600 7 O m g2 womvs Wpeoi n quot 3 39WW memos Cue mow MOWWS 39 0 2 mm l W 9i b y n in bar 330 96 V T novel stf i mm mm LRC POW Coo 0 Step 3 Describe how the growth rate in the real wage rate is calculated The growth rate g in the wage is calculated as wagezom wagezoos wagezom g2004 x100 The calculated values are Percentage rate Percentage change percentage change nominal change real Therefore while the nominal rate increased an average of 31 for this time period the real Wage increased only 07 for the same time period Extra Solved Problem 16 1 The Policy Menu View of the Phillips Curve In 1960 Paul Samuelson and Robert Solow wrote the rst article to use the Phillips curve model to explain the relationship between unemployment and in ation in the United States They concluded that Price stability is seen to involve about 5 12 percent unemployment whereas3 percent unemployment is seen to involve a price rise of about 4 12 percent per annum We rather expect that the tug of war of politics will end us up in the next few years somewhere in between these selected points 39 Source Paul A Samuelson and Robert M Solow Analytical Aspects of AntiIn ation Policy American Economic Review Vol 50 No 2 May 1960 pp 192 193 What did Samuelson and Solow mean by price stability What does the tug of war of politics have to do with what happens to the unemployment and in ation rates SOLVING THE PROBLEM Step 1 Step 2 Step 3 Review the chapter material This problem is about how the Phillips curve was understood in the 19605 so you may want to review the section Is the Phillips Curve a Policy Menu which is on page 976 in the textbook Explain wha39l is meant by price stability When prices are stable the price level does not change So price stability is another term for zero in ation Explain how the tug of war of politicsquot affects the unemployment and inflation rates By the tug of war of politics Samuelson and Solow were referring to the policy menu view of the Phillips curve Some politicians would prefer expansionary policies that would result in very low unemployment at the cost of higher in ation Others would prefer low in ation at the cost of higher unemployment Political compromise would result in the economy ending up somewhere in between The ShortRun and LongRun Phillips Curves o Shifts in the ShortRun Phillips Curve The relationship between the short run and longrun Phillips curves has to do with the economy s equilibrium changes As the US economy s equilibrium moved up the short run Phillips curve during the 19605gt workers and rms were expecting a 15 percent in ation rate However they experienced an in ation rate of 45 percent because of expansionary monetary and scal policies that moved the short run equilibrium up the shortrun Phillips curve The new higher expected in ation rate can become embedded in the economy meaning that workers rms consumers and the government all take the in ation rate into account when making decisions There is a short run Phillips curve for every level of expected in ation Each shortrun Phillips curve intersects the long run Phillips curve at the expected in ation rate B How Does a Vertical LongRun Phillips Curve Affect Monetary Policy By the 19703 economists realized that the common View of the 19605 had been wrong It was not possible to buy a permanently lower unemployment rate at the cost of a permanently higher in ation rate 39 The moral of the vertical longrun Phillips curve is that in the long run there is no tradeoff between unemployment and in ation In the long run the unemployment rate always returns to the natural rate no matter What the in ation rate is In other words in the long run the Federal Reserve can affect the in ation rate but not the unemployment rate Nonaccelera ng in ation rate of unemployment NAIRU refers to the unemployment rate at which the in ation rate has no tendency to increase or decrease m to eat Ecol at meeting pottog on mammogram notwwtmra is a M2 atte r at mobilitde honed on rt 0 Expectations of the In ation Rate and Monetary 39 The economy can remain on the short run Phillips curve depending on how quickly workers and firms adjust ieir expectation of future in ation to changes in current in ation There are three possibilities 1 Low in ation sip VG ao h l Gall 35 2 Moderate but stable in ation g Q Cufng LR C M 30 t g Dk J l5 3 ngh and unstable in ation LR39PC OLA N S 39 Expectations formed by using all available information about an economic variable are called rational expectations Magma wanton 7 adapting to e c O OYltiC gt t0f 39ti after he this future enoecnmon ON on past onewdmOhS A The Eff ct of Rational Expectations on Monetary Policy 39 Robert Lucas and Thomas Sargent pointed out an important consequence of rational expectations An expansionary monetary policy would not Work 39 In other words there might not be a trade off between unemployment and in ation even in the short run SQVC m2 v 1 M WCEK39OWB ok mi Mt39 de w amung mm WM accommng Y Mi mm M Wad fa M m WWW WW Agg adwmwg NM adjung W x xf WWW WW Magech m A MW 14 N OYWg m ecomw mm WWW mmmmm m N mm W w UM QWWM m m WWW Wm wxa 3m Q wwqu C if workers and rms ignore in ation or if they have adaptive expectations in ation will rise and unemployment will fall If workers and rms have rational expectations an expansionary monetary policy will cause the shortrun equilibrium to move up the longrun Phillips curve In ation will still rise but there will be no change in unemployment Is the ShortRun Phillips Curve Really Vertical Many economists have remained skeptical of the argument that the short run Phillips curve is vertical The two main objections raised are that r v O l 39 1 Workers and rms actually may not have rational expectations 2 The rapid adjustment of wages and prices needed for the short run Phillips curve to be vertical will not actually take place Real Business Cycle Models Some economists argued that uctuations in real factors particularly technology shocks explained deviations of real GDP from its potential level Technology shocks are changes to the economy that make it possible to produce either more output or less output with the same amount of workers machines and other inputs Real business cycle models focus on real rather than monetary explanations of uctuations in real GDP Extra Solved Problem 163 Stag otion and the Shortrun Phillips Curve Stag ation is the simultaneous increase in in ation and unemployment or an increase in in ation and slower economic growth Given the negative slope of the shortmn Phillips curve how is it possible for the in ation rate and the unemployment rate to increase at the same time SOLVING THE PROBLEM Step 1 Step 2 Step 3 Review the chapter material This problem is about the role that changing expectations play in shifting the position of the short run Phillips curve so you may want to review the section Expectations of the In ation Rate and VMonetary Policy which begins on page 984 in the textbook illustrate the shortrun tradeoff between the inflation rate and the unemployment rate The shortrun Phillips curve shows the short run tradeoff between in ation and unemployment On any particular short run Phillips curve an increase in in ation will be accompanied by a decrease in unemployment The movement from point A to point B in the graph on the following page shows a decrease in the unemployment and an increase in the in ation rate Inflation Longrun rate Phillips percent curve per year 5 A Shortmn Phillips cuwe 0 Unemp layment rate percent Illustrate how an adverse supply shock can cause both the unemployment rate and the inflation rate to increase Periods of stag ation are often the result of adverse supply shocks caused by rapid increase in the prices of resources such as oil An adverse supply shock that shifts the SRAS curve to i the left will also shift the short run Phillips curve up This is shown in the graph below gt i U m V cm W y K lt r39 af 39 5 A A nr 1 39 8 v Kym a lt3xlttmx Mom 7 C1D MS tmixaci 9 Migr WWWwaWaam xv v Inflaiigtg ongmn percent Phillips Curve per year 8 ShorHun Phillips curve after supply shock 0 Unemployment rate percent Shortrun Phillips curve As the graph shows a shift in the short run Phillips curve creates the possibility of a simultaneous increase in in ation and unemployment Stagflation is shown as a movement from point A to point B in the graph above How the Fed Fights In ation A The Effect of a Supply Shock on the Phillips Curve By the mid 19705 the Fed had to deal with the in ationary impact of the OPEC oil price increases The Organization of Petroleum Exporting Countries OPEC caused the short run aggregate supply curve to shift to the left As a result the economy experienced a higher price level and a lower level of real GDP The in ation rate and unemployment rate both increased The short run Phillips curve was shifted up 0 Paul Volcker and Disin ation The Federal Reserve had gone through a twodecade period of continually increasing the rate of growth of the money supply In August 1979 President Jimmy Carter appointed Paul Volcker as chairman of the Board of Governors of the Federal Reserve System Paul Volcker reduced the annual growth rate of the money supply to reduce in ation which raised interest rates causing a decline in aggregate demand Under Volcker s leadership the Fed had reduced the in ation rate from more than 10 percent to less than 5 percent A signi cant reduction in the in ation rate is called disin ation This episode is often referred to as the Volcker disin ation The disin ation had come at a very high price of unemployment From September 1982 through June 1983 the unemployment rate was above 10 percent Alan Greenspan and the Importance of a Credible Monetary Policy In 1987 President Ronald Reagan appointed Alan Greenspan to succeed Paul Volcker as Fed chairman Beginning in the mid19905 and early 2000s the US economy 1 Experienced an increase in the growth of labor productivity 2 Had a more rapid increase in potential GDP 3 Experienced low rates of in ation De emphasizing the Money Supply Before 1987 the Fed would announce annual targets for how much M1 and M2 would increase during the year In February 1987 the Fed announced that it would no longer set targets for M In July 1993 Alan Greenspan announced that the Fed also would no longer set targets for M2 Instead the Federal Open Market Committee F OMC has relied on setting targets for the federal funds rate to meet its goals of price stability and high employment A KEGme 3 wiw A a A A A A AAAEFTLAOA C AQAAAAAQ r Akr A A A A13 915 x7 A 7 J f OVCMJ EC f czm A L M J x A r rAnx KkLu x i LA lt m QAAAAA 1 gt06 A A A I A AHA AAAAAAAAAmrAAE AAA 7 A AA u s f S lt J 4 a A lt50 71A 3 w A A A A Z M 2 CAch cf 09C AAQm m9 Zcf 2 39 5 A A A AA y 3 AA L A 33 r 3 AU 2 AAAAAAA AAA5 AA A w x AAA AAAh aggmn3w AAAg i mm gip 24 3 g g AAA o The Importance ofFed Credibility The Fed learned an important lesson during the 19703 Workers firms and investors in stock and bond markets have to View Fed announcements as credible if monetary policy is to be effective Monetary Policy Credibility after Greenspan A rules strategy for monetary policy involves the central bank s following speci c and publicly announced guidelines for policy Economists and policymakers who oppose the rules strategy support a discretion strategy for monetary policy The central bank should adjust monetary policy as it sees t to achieve its policy goals such as price stability and high employment According to the Taylor rule the Fed should set the target for the federal funds rate according to an equation that includes the in ation rate the equilibrium real federal funds rate the in ation gap and the output gap A Failure of Credibility at the Bank of apart The in ation rate can be too low if in ation becomes de ation a falling price level De ation can contribute to slow growth by raising real interest rates increasing the real value of debts and causing consumers to postpone purchases in the hope of experiencing even lower prices in the future By 1999 the Bank of Japan had reduced the target interest rate on overnight bank loans the equivalent of the US federal lnds rate t0 zero The Bank of Japan s policies lacked credibility because rms workers and participants in nancial markets doubted the Bank of Japan s willingness to continue an expansionary monetary policy long enough to end the de ation Federal Reserve Policy and Whirlpool s Pricing Powerquot Whirlpool had managed to impose modest price increases at a time its competitors were cutting noes Whirlpool has a double exposure to recession because it may lose direct sales to consumers buying new or replacement appliances and also sales to builders buying appliances to be included in new home construction Consumer demand remained strong throughout 2004 as low interest rates in the United States helped maintain the momentum of new housing starts u m5 Mm 9 m Chapter 13 Money Banks and the Federal Reserve System What is Money and Why Do We Need it A Barter and the invention of Money 0 Money is any asset that people are generally willing to accept in exchange for goods and services or for payment of debts An asset is anything of value owned by a person or rm The invention of money started from barter economies which were economies where people traded goods and services directly for other goods and services 0 For a barter trade to take place between two people each person must want what the other one has known as double coincidence of wants A good used as money that also has value independent of its use as money is called commodity money By making exchange easier money allows for specialization and higher productivity 3 The E nnctions of Money 1 Money should Jl ll four functions Money serves as a medium of exchange when sellers are willing to accept it in exchange for goods or services Money serves as a unit of account when each good has a price in terms of dollars Money serves as a store of value when value is stored such as in stock bonds real estate r and valuable items Sta r bggr y ah C Money serves as a standard of deferred payment in borrowing and lending 0 New 450 gin5 a or Sammie ioziettj y u a5 5 Lt I What Can Serve as Money There are ve criteria that make a good suitable to use as a medium of exchange 1 The good must be acceptable to that is usable by most traders 2 The good should be of standardized quality so that any two units are identical 3 The good should be durable so that value is not lost by spoilage 4 The good should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported PEN 5 The medium of exchange should be divisible because different goods are valued differently I I 339 39 1 Oferi l to i x 4 J I J examplei L760 C2 0 Commodity money eg gold meets the criteria for a medium of exchange but its value depends on its purity gt gold 0an C igm l izgk i Fiat money is a paper currency that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money 1112229 gejgy s afsai 11a thefsslgtal re 2 1739 a9 X How is Money Measured in the United States Today A M1 The Narrowest Be niticn of the Money Supply Economists have developed several different de nitions of the money supply M1 is the narrowest de nition of the money supply and includes 1 All the paper money currency and coins that are in circulation What is not held by banks or government 2 The value of all checking account balances at banks 3 The value of traveler s checks wgwg MCCU39O K show i d so u m M 23quot I v B M2 A Broader Definition of Money M2 is a broader de nition of the money supply and includes Everything that is in M1 Savings account balances Small denomination time deposits eg certi cates of deposit CDs Balances in money market deposit accounts in banks Noninstitutional money market fund shares mg mm V Urhf Nv n M3 is a broader medium of exchange and store value and includes a Everything that is in M2 b Largedenomination time deposits 0 Institutional money market fund shares There are two key points about the money supply The money supply consists of both currency and balances in checking accounts and traveler s checks Because balances in checking accounts are included in the money supply bankskpiay an important role in the process by which the money supply increases and decreases M 5quot 5 What about Credit Lizards and Debit jams 0 Credit cards are not included in the money supply because they are considered a loan from the bank that issued the credit car Beggar Cura twv NOV 3 l1 5 Ex L in Lialoxll l39b Omi lmwg We a 91ng Oils1 Haw Do Banks freate Money A Bank Balance Sheets 0 A bank balance sheet lists a nn s assets on the left and its liabilities and stockholders equity on the right 0 The key assets on a bank s balance sheet are its reserves loans and holdings of securities such as US Treasury bills Reserves are deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve Required reserves are reserves that a bank is legally required to hold based on its checking account deposits A required reserve ratio is the minimum action of deposits banks are required to keep as reserves currently 10 percent 0 Any reserves that banks hold over and above the legal requirement are called excess reserves Banks make consumer loans to households and commercial loans to business 0 A loan is an asset to a bank because it represents a promise by the person taking out the loan to make certain speci ed payments to the bank 0 A bank s reserves and its holding of securities are also assets 3 1 937m 0 t E a x K86 l0 muf e B lising T Aecoiints to Show How a Bank Can reate Marley A T account is a strippeddown version of a balance sheet that shows only how a transaction changes a bank s balance sheet 0 When a bank accepts a deposit it keeps only a fraction of the inds as reserves and loans out the remainder o In making a loan banks increase the checking account balance of the borrower When the borrower uses a check to buy something with the funds the bank has loaned the seller will deposit the check in his bank The seller s bank will keep pan of the deposit as reserves and loan out the remainder This process will continue until no banks have excess reserves In this way the process of banks making new loans increases the volume of checking account balances and the money supply MGWMZWKGWE ca a The Simple Beposit Multiplier 0 The ratio of the amount of deposits created by banks to the amount of new reserves is called the simple jfppsit mul plierl VOW A w heady 2 mic139 d mgzr 3 my gy map yl oetod b 3 D The Simple Eepesit Multiplier versus the Realnif erld Beg30531 Multiplier 0 Whenever banks gain reserves they make new loans and the money supply expands 0 Whenever banks lose reserves they reduce their loans and the money supply contracts 7 bowlf gt169 Y The Federai Reserve System C The fractional reserve banking system is a banking system in which banks keep less than 100 percent of deposits as reserves When many depositors simultaneously decide to withdraw their money from a bank there is a bank run If many banks experience runs at the same time the result is a bank panic It is possible for one bank to handle a run by borrowing from other banks A central bank like the Federal Reserve in the United States can help stop a bank panic by acting as a lender of last resort 0 In this case a central bank makes loans to banks that cannot borrow funds elsewhere The bank can use these loans to pay off depositors When the panic ends and the depositors put their money back in their accounts the bank can repay the loan to the central bank 0 The Organization of the Federal Reserve System With the intention of putting an end to banking panics in 1913 Congress passed the Federal Reserve Act setting up the Federal Reserve System which began operation in 1914 The Fed acts as a lender of last resort to banks and as a bankers bank providing services such as check clearing to banks The Fed also takes actions to control the money supply To aid the Fed in carrying out its responsibilities Congress divided the country into 12 Federal Reserve districts Each district has its own Federal Reserve bank which provides services to banks in that district The real power of the Fed lies in Washington DC with the Board of Governors 0 There are seven members of the Board of Governors who are appointed by the president of the United States to 14year nonrenewable terms 0 One of the seven board members is appointed chairman for a fouryear renewable term B How the Federai Reserve Manages the Money Supply 0 The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives is known as the monetary policy The Federal Open Market Committee FOMC or the Federal Reserve committee is responsible for open market operations and managing the money supply The buying and selling of Treasury securities is called open market operations There are three reasons the Fed conducts monetary policy principally through open market operations 1 The Fed initiates open market operations it completely controls their volume 2 The Fed can make both large and small open market operations 3 The Fed can implement its open market operations quickly with no administrative delay or regired changes in regulations 6 l l the VBECT MOEuth map te dam3 a 7 f 39 z EJVs U v in J 13m 9 w 39 K i J x E3 i A L V M W565ng f z f 0 The loans the Fed makes to banks are called discount loans and the interest rate it charges on the loans is called the discount rate d d scoome rote 3 vquot tacoe game i 1 JAWS 2 d toquot 0 When the Fed reduces the required reserve ratio it converts required reserves into excess reserves 0 The Fed changes reserve requirements much more rarely than it conducts open market operations or changes the discount rate Qi DM m s A r V 63 J a r lj krfCHJtVQCi a b3 v 14 r7 quot3 W5 2 Putting It All Together Decisions of the Nonbank Pubiic Banks and the Fed Using its three tools open market operations the discount rate and reserve requirements the Fed has substantial in uence over the money supply but that influence is not absolute 0 There are two other actors that also in uence the money supply in practice the nonbank public and banks