Macroeconomics Final Exam Review

Chapter 13 Fiscal Policy * Government funds many programs through tax revenues * Government transfers- payments by the government to households for which no good or service is provided in return * Social insurance programs- gov. programs (transfer payments) intended to protect families against economic hardship * Social security * Medicare * Medicaid * Gov. purchases- national defense and education are the biggest categories * Gov. transfers- social security, Medicare and Medicaid are the biggest programs * GDP= C + I + G+ X – IM * Gov directly controls its spending or G, and indirectly affects Consumer spending and Investment spending…how? * Household incomes are affected by taxes and transfers, and business investment is affected by taxes and regulations * Gov. can shift AD curve * Fiscal Policy- the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve * Expansionary fiscal policy- fiscal policy that increases aggregate demand * An increase in gov. purchases of goods and services * A cut in taxes * An increase in government transfers * Can close a recessionary gap, by stimulating the AD curve and move the economy back toward long run equilibrium * Contractionary fiscal policy- fiscal policy that decreases aggregate demand * A reduction in gov. purchases of goods and services * An increase in taxes * A reduction in government transfers * Can close an inflationary gap, can move the AD curve back toward long run equilibrium * Reasons for caution- significant lags in its use, its takes time to… * Realize the recessionary or inflationary gap by analyzing data * Develop a plan * Implement the action plan (spending the money) * The American Recovery and Reinvestment Act of 2009 * One effect was a sharp drop in revenues at the state and local levels, which in turn forced these lower levels of government to cut spending. Federal aid was sent mitigate these cut * The multiplier effects of an increase in government purchases of goods and services- * Ex: if mpc=.5, the muiltiplier would be 2, so 50billion of new government spending would create 100 billion in real gdp * Will a $50 billion tax cut or increase in transfers have the same effect as a $50 billion increase in government purchases? * No. people save %50 of their extra income, so the same size tax or transfer policy is smaller from the outset * The size of the shift of the aggregate demand curve depends on the type of fiscal policy * Changes in government purchases have a more powerful effect on the economy than equal sized changes in taxes or transfers * Its more complicated because we use simple…. * Lump sum taxes- taxes that don’t depend on the taxpayers income * Types of fiscal policy * Automatic stabilizers- government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically Contractionary when the economy expands (unemployment insurance) * Discretionary fiscal policy- arises from deliberate actions by policy makers rather than rules (the Obama stimulus) * The budget balance measures fiscal policy * Sgovernment= T- G – TR * Government saving (surplus)= tax revenues (t)- government purchases (G) and transfers (TR) * Budget surplus- a positive budget balance * Budget deficit- a negative budget balance * Discretionary expansionary fiscal policies reduce the budget balance for that year * Discretionary Contractionary fiscal policies increase the budget balance for that year * To separate the effects of the business cycle from the effects of discretionary fiscal policy, the government estimate the… * cyclically adjusted budget balance – an estimate of the budget balance if the economy were at potential output * Deficit vs Debt * Deficit- the difference between the amount of money a government spends and the amount it receives in taxes over a given period * Debt- the sum of money a government owes at a particular time * They are linked, gov. debt grows when govs run deficits * Problems by rising government debt. * Public debt may crowd out investment spending, which reduces long run economic growth * Rising debt may lead to government default resulting in economic and financial turmoil * Implicit liabilities- spending promises made by government that are effectively a debt despite the fact that they are not included in the usual debt statistics * Austerity dilemmas- thinking the whole economy is like a family, if we cut back on spending, we can pay our bills, but its more like one person’s spending is another person’s income
Chapter 14 * Currency in circulation- money held by the public * Money supply- is the total value of financial assets in the economy that are considered money * Money must function as: * A medium of exchange – something people accept as payment for goods and services * An asset that individuals acquire for the purpose of trading rather than for their own consumption * A store of value – money is a means of holding purchasing power over time * Saving money for later * A unit of account * Money provides a yardstick for measuring and comparing the values of a wide variety of goods and services * Types of money * Commodity money- a good used for exchange that has intrinsic value in other uses * Commodity-backed money- a medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods * Fiat money (common) – money whose value derives entirely from its official status as a means of payment * Monetary aggregate- an overall measure of money supply * M1 : includes only the most liquid forms of money * M2: includes near-moneys, or financial assets that cant be directly used as a medium of exchange but can readily be converted into cash or checkable bank deposits * Banks * Are financial intermediaries that use liquid assets (in the form of bank deposits) to finance the illiquid investments of borrowers * Act like a bridge between lenders and borrowers * By accepting deposits and making loans, banks are able to create money * Role of banks * T-account- a tool for analyzing a business’s financial position by showing the business’s assets and liabilities * Bank-reserves- the currency that banks hold in their vaults plus their deposits at the federal reserve * The reserve ration- the fraction of bank deposits that a bank holds as reserves * They operate as part of a fractional reserve banking system * When you deposit money in a bank account, the bank is required to hold a part of it in its vault of cash * Problems * They only hold fractions of deposits on reserves, the rest they use to make loans * Bank run: a phenomenon in which many of a banks depositors try to withdraw their funds because they fear a bank failure * Historically, they proven to be contagious * Regulations * Deposit insurance – a guarantee that a banks depositors will be paid even if the bank cant come up with the funds (FDIC currently guarantees the first 250,000 of each account * Capital requirements- requirement that the owners of banks hold substantially more assets than the value of bank deposits * Deposit insurance creates an incentive problem: banks can take more risks, since they are insured * Reserve requirements- rules set by the federal reserve that determine the minimum reserves ration for a bank * Ex: US the min reserve ratio for checkable bank deposits is 10% * The discount window: an arrangement in which the federal reserve stands ready to lend money to banks in trouble * Ex how bank creates money * Guy deposits this cash at the bank. What’s the effect of his 1000? * A)Initial effect before bank makes a new loan * Assets Liabilities * Loans- nochange checkable deposits + 1000 * Reserves +1000 * B)Effect when bank makes a new loan * Assets Liabilities * Loans +900 * Reserves –900 * Banks make their profit from loans, they will make new loans w/ 90% of guys money (the rest in reserve) * Excess reserves: a banks reserves over and above its required reserves * Increase in bank deposits from 1000 in excess reserves = * 1000+[1000x(1-rr^1)]+[1000x(1-rr)^2]+…. * Simplified to 1000/rr * The monetary base- the sum of currency in circulation and bank reserves * Money supply- depends on ratio reserves to bank deposits, but also on the fraction of the money supply that individuals choose to hold in the form of currency * Money multiplier- the ratio of the money supply to the monetary base * Federal Reserve- central bank; oversees and regulates the banking system and controls the monetary base , created in 1913 b/c of panic of 1907 * 1932- the reconstruction finance corporation (RFC)- has authority to make loans to banks in order to stabilize the banking sector * 1932- the glass-steagull act created federal deposit insurance and increased the ability of banks to borrow from the federal reserve system * Separated banks into two * Commercial banks- depository banks that accepted deposits and were covered by deposit insurance * Investment banks- banks which engaged in creating and trading financial assets (stocks and corporate bonds) but were not covered by deposit insurance because their activities were considered riskier * What does it do if a bank cant meet a requirement * Federal funds market- allows banks that fall short of the reserve requirement to borrow funds from banks with excess reserves * Federal funds rate= the interest rate determined in the federal funds market * Discount rate- the rate of interest the fed charges on loans to banks * Open market operations- * When feds buy anything reserves increase * Feds usually buy treasury bills * Federal decisions are independent of the government * Open market operations are the principle tool of monetary policy, the fed can increase or reduce the monetary base by buying or selling government debt to banks * Federal reserve’s: * Assets- government debt (treasury bills) \ * Liabilities- monetary base (currency in circulation +bank reserves) * To increase money supply, fed must inject reserves into the system * Or buy treasury bills: * To decrease money supply, fed must remove reserves from the system * Or sell treasury bills * Ex of an open market purchase of 100 millionL bank gains reserves * Fed reserve * Assets: treasury bills +100million * Liabilities: monetary base +100million * Commercial banks * Assets: treasury bills -100million , reserves + 100million * LTCM (long term capitial management) used lots of leverage to speculate in global financial markets, incurred massive losses and collapsed * Leverage- financing an investment with borrowed funds * Balance sheet effect- the reduction in a firms net worth due to falling asset prices * Vicious circle of deleveraging- asset sales to cover losses forcing creditors to call in their loans, forcing sales of more assets and causing further declines in asset prices * Subprime lending- lending to home buyers who don’t meet the usual criteria for being able to make the payments * Securitization- a pool of loans assembled and shares of it sold to investors * When mid 200s housing bubble burst, massive losses by banks and other financial institutions led to widespread collapse in the financial system
Chapter 15 * The opportunity cost of holding money- we give up the interest income wed collect if that money was in an interest bearing asset like a bond * Short term interest rates- the interest rates on a financial assets that matures within 6 months * Most short term rates tend to move in the same direction * Long term interest rates- interest rates that mature a number of years in the future * The higher the interest rate, the higher the opportunity cost of holding money * Opposite for lower interest rate * The money demand curve- relationship between the quantity of money demanded and the interest rate * At higher interest rates, the cost of holding money id greater so less quantity is demanded * Lower interests rates, the cost of holding money is smaller so higher quantity is demanded ‘ * SHIFTS of the D curve – fall in money demand shifts to the left * Changes in aggregate price level * Higher prices= more money demanded * Changes in real gdp * More goods produced and sold= more money * Changes in technology * The ease of credit card payments reduces need for cash * Changes in institutions * Interest on checking accounts decreases the cost of holding money and money demand increased * How interest rates are set * The liquidity preference model of the interest rate, asserts that the interest rate is determined by the supply and demand for money * The money supply curve- shows how nominal quantity of money supplied varies with the interest rate * If interest rates are high, MS>MD, a surplus of money means a shortage of other assets * If interest rates are low, MD>MS, a shortage of money means a surplus of other assets * The feds sets a target federal funds rate and undertakes the appropriate open- market operations. * Target federal funds rate- feds desired federal funds rate * An increase in money supply lowers the interest rate * Or an open market purchase of treasury bills * Feds giving money to market or purchasing bills * Long term interest rates- don’t move with short term interest rates, they reflect the average expectation for short term rates * Expansionary monetary policy- monetary policy that increase aggregate demand, easy money * Increase money supply, which lower interest rates, which shifts AD to the right * Contractionary monetary policy- monetary policy that reduces aggregate demand, tight money * Decrease money supply, which raises rates, which shifts AD the left * How to decide either Contractionary or expansionary * Policy makers try to fight recessions, as well as to ensure price stability, low inflation * Taylor rule for monetary policy- set the federal funds rate according to the level of the inflation rate and either the output gap or unemployment rate * To address both goals (inflations, recessions) the feds follow * Federal funds target rate= 2.07+1.28x inflation rate – 1.95 x unemployment gap * Rises when output gap is positive and falls when it is negative * Is high when inflation is high and low when inflation is low

Chapter 16 Inflation, Disinflation, and Deflation * Money and Prices * Classical model of the price level- the real quantity of money is always at its long-run equilibrium level * Real quantity of money=M/P * M= nominal money supply * P= price level * If money supply Increase, what Happens? * The increase in AD will increase the price level and output and eventually pull up nominal wages, which moves the SRAS curve leftward * In general, inflation and money supply move together, especially during periods of high inflation * The inflation tax * The inflation tax: the reduction in the real value of money held by the public caused by inflation * Seignorage- The revenue generated by a government’s right to print money (>1% of US govs budget) * Seignorage = Monthly Change in Money Supply (triangleM) * Real Seignorage= monthly Change in Money supply/ P rice level * Or RS=( monthly Change in Money supply/ Money supply)x(money supply/price level) * Or Real Seignorage = rate of growth of the money supply X real money supply * Logic of Hyperinflation * To avoid paying inflation tax, people reduce their real money holdings and force the Gov. to increase inflation to capture the same amount of real inflation tax * If this leads to a circle of shrinking real money supply and rising rate of inflation. * Which turns into hyperinflation and a fiscal crisis * Ex: Hungrys is the highest record, in 1945 1 pengo cost 1.3 septillion pengos at the end of 1946 * Moderate inflation and Disinflation * The govs of wealthy, politically stable countries, like the US and Britain, aren’t forced to print money to pay their bills yet inflation still occurs * In the short run: * policies that produce a booming economy also tends to lead to higher inflation * Policies that reduce inflation tend to depress the economy * The output gap and the unemployment rate * Inflationary gap- the output gap is positive, the unemployment rate is Below the natural rate * Recessionary gap- the output gap is negative, the unemployment rate is above the natural rate. * Changes in the long run trend of potential output correspond to changes in the natural rate of unemployment * On graph they match very similarly * Cyclical unemployment seems to move less than the output gap, * Output reached -8% in 9182 but * cyclical unemployment reached only 4% * Okun’s Law * There is a predictable negative relationship between the output gap and the unemployment rate. A rise in the output gap of 1% reduces the unemployment rate by about .5% * So Natural Rate of Unemployment -.5* Output gat = predicts unemployment rate * Ex: if natural rate of unemployment is 5.2% and the economy is producing at only 98% of potential output, the output gap is -2%, and Okun’s law predicts an unemployment rate of 5.2%-.5*.2%= 6.2% * Short-run Phillips curve: the negative short-run relationship between the unemployment rate and the inflation rate * When unemployment rate is low, Inflation is high * When unemployment rate is high, inflation is low * Aggregate Demand Vs. Aggregate Supply model and the Short-run Phillips curve (SRPC) * An increase in aggregate demand (shift AD curve Right)…. * Leads to both inflation and a fall in unemployment rate. (moves left along line) * The Short-run Phillips curve (SRPC) * Supply Shock * Negative supply shock shifts SRPC UP * Positive Supply Shock shifts SRPC down * Changes in the expected rate of inflation affect the short run tradeoff between unemployment and inflation * Shift up SRPC by the amount of the increase in expected inflation * After 1950s and 60s along came Stagflation- oil shocks and rising inflationary expectations created real problems * Since SRPC shifts whenever inflationary expectations change, attempts to reduce unemployment below the natural rate maybe be effective only in raising prices * The long-run Phillips curve: the relationship between unemployment and inflation after the expectations of inflation have had time to adjust to experience * (NAIRU) Nonaccelerating inflation rate of unemployment- is the unemployment rate at which inflation does not change over time * To avoid accelerating inflation over time, Unemployment rate must be high enough that the actual rate of inflation matches the expected rate of inflation. * Ex. if gov started at 6% unemployment rate and reduce it to 4%, this raises inflation to 2% * the economy reverts to its natural 6% unemployment but SRPC Shirts upward based on 2% inflation * if the gov wants to try to lower the unemployment again, inflation will continue to rise * The natural Rate of Unemployment – the part of unemployment rate unaffected by the swings of the business cycle,( NAIRU is another name for natural rate) now its 5.5% * Disinflation - the process of bringing down inflation that is embedded in expectations * Cost- * Once inflation is embedded in expectations, getting it back down can be hard * Disinflation can require a recession * Debt Deflation: the reduction in aggregate demand arising from the increase in the real burden of outstanding debt caused by deflation. * Effects * There is a “zero bound” on the nominal interest rate: it cannot go below zero * Liquidity trap- inability to use monetary policy because nominal interest rates are too low and cannot fall below the zero bound. * Can occur when there is a sharp reduction in demand for loanable funds
Chapter 19 Open Economy Macroeconomics * Balance of Payments (BoP)- summarize a country’s transactions with the rest of the world * BoP on Current Account- the balance of payments on goods and services plus net international transfer payments and factor income * Bop on goods and services- the difference between exports and imports during a given period * Merchandise trade balance- the difference between a country’s exports and imports of goods, it does not include services * BoP on financial account- the difference between sales of assets to foreigners and purchases of assets from foreigners during a given period * The basic rule- the current account must equal the financial account or the sources of cash must equal the uses of cash (balance out) * Why doesn’t the Gdp equation, Y=C+I+G+X-IM, use current account as a whole instead of X-IM? * Gross Domestic Product (y)- is the value of goods and services produced domestically, * so it shouldn’t include the whole current account balance which has international factor income and transfers * Though Gross National product does include international factor income * Financial account * It’s a measure of capital inflows of foreign savings that are available to finance domestic investment spending * The loanable funds model * Money is mobile, so differences in equilibrium interest rates between two countries matter and will determine investment flows * Ex: USA interest rate is 6%, Britains 2%, * there is an incentive for capital to flow from Britain to the US * If international interest rate is 4%, and US lenders can supply as much as wanted, * so if Britain has more savings then the gap will be filled by the US importing funds from Britain * Moving both interest rates to 4% * What determines the supply and demand for funds internationally? * Main variable- differences in investment opportunities and in savings rate * Higher growth countries tend to have higher returns for investors, which attracts funds from slower-growing countries * Countries with higher savings rates tend to export funds more than those with lower savings rates. * Global savings glut- special factors caused this which pushed down interest rates worldwide * As a result many countries had large capital outflow * Which then flowed to US and fueled the housing bubble * Reasons for capital to flow between countries besides interest rates * Investors seek to diversify against risk by buying stock in a number of countries * Corporations engage in international investment b/c of business strategy * Some are international banking centers, everyone putting money in * The golden Age of Capital flows (1870-1914) * The worlds capital flows were much higher than now * Reason for: more restrictions on migration and political risks have built barriers * Role of Exchange rate * Behavior of the financial account (inflows and outflows of capital) described by equilibrium in the international loanable funds market * The balance of payments on goods and services- determined by decisions in the international markets for goods and services * What ensures that the balance of payments really does balance? * The exchange rate, which is determined in the foreign exchange market * Currencies are traded in the foreign exchange market * Exchange rates- the prices at which currencies trade * Currency appreciation- increasing value of one currency in terms of other currencies * Currency depreciation- the loss of value of one currency in terms of other currencies * The foreign Exchange Market – matches up the demand for a currency from foreigners who buy domestic goods, services and assets with the supply of currency from domestic residents who want to buy foreign goods, services, and assets * The demand for foreign currency slopes downward * b/c when the euro price of the dollar falls (the dollar depreciates) * US goods are cheaper for Europeans, and they need more US money to pay for them * The supply for foreign currency slopes upwards for the same reason * If the US dollar falls against the euro, European products are more expensive to Americans, who demand less. * US will convert fewer dollars into euros * The exchange rate is stable, when the quantity of US dollars Europe wants to buy is equal to the quantity that Americans want to sell * Causes for shifts in Demand * An increase in the demand for US dollars will shift right causing an appreciation of the US Dollar * Any Change in US Balance of payments on financial account generates an equal and opposite reaction in the balance of payments on current account * Real exchange rates- exchange rates adjusted for international differences in aggregate price levels * Real exchange rate= Mexican pesos per US dollar X Price index of US/Price index of Mex * Ex: if peso depreciates from 10 pesos per dollar to 15 per dollar and the Mexican price index rises from 100+150, how has the real exchange rate changed? * Initially * Real exchange rate= 10 (pesos per dollar) X 100(US Price index)/100 (PMex)= 10 * After depreciation * RER= 15 X 100/150= 10 * Purchasing Power Parity- between two countries’ currencies is the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country * Nominal exchange rates are almost always different * Big Mac index- looks at the price of big macs in local currency and computes the following: * The price of a big mac in Us dollars using prevailing exchange rate * The exchange rate at which the price of a Big mac would equal the US price * If Purchasing power parity held true- prices of big macs would be the same * Exchange rate policy * – governments have more power to influence nominal exchange rates than they have to influence ordinary prices * An exchange rate regimen- a rule governing policy for the exchange rate * 2 types * Fixed exchange rate- rate that is held at or near a particular target against some other currency * Floating exchange rate- rate that is allowed to go wherever the market takes it. * To manipulate exchange rate the gov can * Exchange market intervention- gov buys or sells currency in the foreign exchange market * Foreign exchange reserves: gov maintain stocks of foreign currency to buy their own currency on the foreign exchange market * Ex: Genovia has an exchange rate above it equilibrium value, you buy genos and sell dollars, it has a surplus initially so that would move it down * Genovia has an exchange rate below equilibrium value, it must sell genos and buy dollars, it has a shortage initially * Try to shift the supply and demand curves for the geno in the foreign exchange market * Changing interest rates with monetary policy * Reduce the supply of genos to the foreign exchange market * Foreign exchange controls- licensing systems that limit the right of individuals to buy foreign currency. They usually increase the value of a currency. * Exchange rate regime dilemma * There are economic payoffs to stable exchange rates, but policies used to fix it have costs * Stable exchange rates remove uncertainty for businesses * Intervention requires large reserves and distort incentives * If you use Monetary policy to fix the E rate, it then isn’t available to use for domestic policy * Devaluation and revaluation of fixed exchange rates (issue for open economy macro) * Devaluation – a reduction in the value of a currency that previously had a fixed exchange rate * Revaluation- an increase in the value of a currency that previously had a fixed exchange rate * Both can be used to * Eliminate shortages or surpluses in foreign exchange market * Tools of macro policy (change AD) * Monetary policy floating exchange rates (issue for open economy macroeconomics) * Under this, expansionary monetary policy causes the currency to depreciate (increase AD even more) , Contractionary monetary policy has reverse effect * International business cycle (issue for open econ macro) * One country imports are another’s exports creates a link between the business cycles in different countries, floating E rates may weaken that link