Econ exam 3
The Fed has three major methods to control the supply of money:
1. ***Open market operations*** 2. Change reserve requirements. 3. Change its discount rate. o Of these three tools, the open market operations are the most important and the most frequently use .
A central bank has many functions:
1. A central bank is a "banker's bank." It serves as a bank where commercial banks maintain their own reserves. 2. It performs service functions for commercial banks- Transferring funds and checks between various commercial banks in the banking system. 3. It typically serves as the major bank for the central government. 4. It buys and sells foreign currencies and generally assists in the completion of financial transactions with other countries. 5. It serves as a "lender of last resort" that helps banking institutions in financial distress. 6. It is concerned with the stability of the banking system and the money supply, which we know results from loan decisions of a bank.
M2:
1. Includes M1, plus 2. Savings deposits -Earn interest, but have no specific maturity date 3. Time deposits called certificates of deposit, or CDs, specific maturity date 4. Money market mutual funds - Has additional restrictions
How does a change in taxes primarily affect aggregate demand?
A tax change alters disposable income and consumption spending.
During a recession, total public assistance payments and unemployment compensation payments automatically increase while income taxes automatically decrease. Which of the following best describes the effect of these changes on aggregate demand?
Aggregate demand will be more than it would be without these automatic stabilizers.
Assume that the government is considering plans to increase aggregate demand in order to reduce unemployment. Which of the following would be effective?
Any of the above
Money
Anything that is generally accepted in exchange for goods or services
Currency
Coins and/or paper money that some institution or government has created to be uses in the trading of goods and services and th payment of debts
Banking Institutions:
Commercial banks, Savings and loan associations and Credit unions.
Fiscal policy are made by
Congress and the president
The Fed can do three things if it wants to reduce the money supply to prevent inflationary periods, it is known as
Contractionary monetary policy. 1. Sell bonds 2. Raise reserve requirements; 3. Raise the discount rate.
Credit Card
Convenient Tool
If government policy makers were worried about the inflationary potential of the economy, which of the following would be a correct fiscal policy change?
Decrease government purchases of goods and services.
John Maynard Keynes (1883-1946)
Father of discretionary fiscal policy
Legal tender
Fiat Money
Precautionary reasons
If unexpected medical or other expenses require an unusual outlay of cash, people want to be prepared
After legislation is signed into law, the time it takes before actual fiscal stimulus law goes into effect
Implementation lag.
If the Fed sells a U.S. government bond to a bank, what is the effect on the money supply?
It will shrink.
The term marginal propensity to consume has two parts:
Marginal and Propensity
Definitions of the Money Supply
Money aggregates: measures of the economy's money supply - M1, M2,
Most important method the Fed uses to change the supply of money.
Open market operations
Which of the following is most frequently used when the Fed is attempting to adjust the money supply?
Open market operations
Federal Reserve Notes (Fiat Money)
Our paper money
Gresham's Law:
People tend to trade away inferior money and hoard the best. Over time, the quality of money in circulation becomes less acceptable, so money should be of uniform quality
The Fed limits the loan issuance of banks by imposing
RESERVE REQUIRMENTS o Banks are required to keep on hand a quantity of cash or reserve accounts with the Federal Reserve equal to a prescribed proportion of their checkable deposits
You are a member of Congress when the economy is in a recession. If your goal is to achieve a fully employed labor force, which of the following fiscal policy scenarios should you follow?
Raise government purchases, reduce taxes, and/or increase transfer payments.
Supply-siders would encourage government
Reduce individual and business taxes • Deregulate • Increase spending on research and development.
Velocity of money
The "turnover" rate (speed), or the intensity with which money is used. o Velocity of money represents the average number of times that a dollar is used in purchasing final goods or services in a one-year period.
If the Fed is concerned about unemployment, recession, or a slowing/contracting economy it would increase
The money supply. This is known as expansionary monetary policy. 1. Buy bonds; 2. Lower reserve requirements; 3. Lower or decrease the discount rate;
Required reserve ratio
The percentage of deposits that a bank must hold at the Federal Reserve Bank or in the banks vaults
Marginal propensity to consume (MPC).
The percentage of your extra disposable income that you decide to spend on consumption
Effectiveness Lag
The time needed for changes in monetary and fiscal policy to change the economy o Did the changes work
Decision-making Lag
The time needed to decide what to do once a macroeconomic problem has been identified. o Once policy makers decide that some policy change is necessary, there is a consultation phase, law writing phase, law passage phase, political parties involvement
Transactions purposes
To facilitate exchange. It is the primary reason that money is demanded
People have three basic motives for holding money or cash instead of other assets:
Transactions purposes, Precautionary reasons and Asset purposes.
Legal Tender
U.S. currency that constitutes a valid and legal offer for payment of debt. It is a statement printed on all Federal Reserve notes- your paper money. Your paper money is issued by the Federal Reserve System.
Budget deficit
When government spending (for purchases of goods and services and transfer payments) exceeds tax revenues
Budget surplus
When tax revenues are greater than government spending
MPC=
^ C/^DI *Change in consumption spending divided by a change in disposable income. Note: income can be represented by the symbol Y.
A credit card payment
a guaranteed loan available on demand to the cardholder, which merely defers or postpones the cardholder's payment for a transaction using a demand deposit.
Fiat Money
a means of exchange that has been established not by custom and tradition or because of the value of the metal in a coin but by government fiat, or declaration.
Expansionary Fiscal Policy
aimed at increasing aggregate demand enough to return the economy to its potential output thereby reducing unemployment; policy used to close a contractionary/recessionary gap. Expansionary fiscal policy will tend to create a budget deficit. o Tools: 1. Increase government purchases of goods and services (spending). 2. Increase transfer payments. 3. Lower taxes. 4. Use some combination of these approaches
Contractionary Fiscal Policy
aimed at reducing aggregate demand enough to return the economy to potential output without worsening inflation; policy used to close an expansionary/inflationary gap. Contractionary fiscal policy, will tend to create or expand a budget surplus, or reduce a budget deficit o Tools: 1. A decrease in government purchases 2. Increase taxes 3. Decrease transfer payments 4. Some combination of the above
Traveler's checks, like currency and demand deposits
are also easily converted into currency or used directly as a means of payment.
Credit unions
are cooperatives, made up of depositors with some common affiliation, for example, the same employer or union
Commercial banks
are financial institutions organized to handle the everyday financial transactions of businesses and households through demand deposit accounts and saving accounts and by making short-term commercial and consumer loans.
Planned budget deficits
are used during economic recessions and planned budget surpluses are used during economic expansions to stabilize economic business cycles
Equivalent expansionary fiscal policy actions would
be to reduce taxes, increase transfer payments, and/or increase government purchases.
If unemployment is the most significant problem in the economy, which of the following actions would be an appropriate fiscal policy response?
both A and C above
Monetary policy making
by the Federal Reserve System. It controls the supply of money in our economy.
Propensity to
consume refers to how much you tend to spend on consumer goods and services out of your additional income.
Contractionary fiscal policy consists of:
decreased government purchases, increased taxes, decreased transfer payments.
Crowding out
government borrowing • drives up interest rates • crowds out (displaces) interest sensitive private investment needs • Government Absorbs more of the available loan-able funds
Budget surpluses exist when:
government tax revenues exceed its spending.
The major objective of the Federal Reserve System is to:
help in generating stabilization policies for the economy.
Supply-side economics stress that:
higher tax rates discourage people from working and investing as much as they would at lower tax rates.
A cut in taxes, combined with an increase in transfer payments, would:
increase AD.
Expansionary fiscal policy consists of:
increased government purchases, decreased taxes, increased transfer payments.
If inflation is the major problem in the economy, which of the following would be an appropriate monetary policy response?
increasing the discount rate
Open market operations
involve the purchase and sale of government securities by the Federal Reserve System. o Decisions regarding whether to buy or sell government bonds are made by the Federal Open Market Committee at its regular meetings.
Barter
is the direct trading of one good for another good o The traders must agree on the exchange rate between the two goods o Barter requires a double coincidence of wants.
The federal funds rate
is the interest rate charged in the federal funds market. It is the interest rate banks charge one another for overnight or short term borrowing. It is the Fed's target interest rate.
Discretionary Fiscal policy
is the use of government purchases, taxes, and transfer payments to alter GDP and the price level.
Which of the following measures is associated with an expansionary fiscal policy?
lowering taxes
Asset purposes
money has a trait—liquidity—that makes it a desirable asset. Other things being equal, people prefer assets that are more liquid to those that are less liquid. That is, people want to be able to easily convert some of their money into goods and services.
All decisions of the Fed are subject to approval by:
none of the above
Medium of Exchange
• Money is anything generally accepted in exchange for goods/services - making it a medium of exchange • Commodity money: anything that serves both as money and as a commodity; money that has intrinsic value, such as gold and silver
Money as a Store of Value
• Money serves as a store of value when it retains purchasing power over time: the better it preserves purchasing power, the better money serves as a store of value
The demand for money depends on
• Opportunity costs • Income levels (the higher your income the more you spend) • The price level. • If the price level increases, buyers will need more money to purchase their goods and services. • if the price level falls, buyers will need less money to purchase their goods and service
Supply siders believe taxes and regulations will cause people to
• Save less • Work less • Businesses invest less in capital
The Fed could also opt to use some combination of these three tools in its approach. These moves would:
• decrease aggregate demand • Cool or contract the economy • Lower the GDP These actions would be the monetary policy equivalent of a contractionary fiscal policy of raising taxes, lowering transfer payments, and/or lowering government purchases.
The Discount Rate
o Banks having trouble meeting their reserve requirement can borrow funds directly from the Fed. o The interest rate the Fed charges on these borrowed reserves is called the discount rate. o If the Fed wants to contract the money supply, it will raise the discount rate, making it more costly for banks to borrow reserves o If the Fed is promoting an expansion of money and credit, it will lower the discount rate, making it cheaper for banks to borrow reserves. o The discount rate changes fairly frequently, often several times a year. o There seems to be some stigma among bankers about borrowing from the Fed; borrowing from the Fed is something most bankers believe should be reserved for real emergencies. o The discount rate's main significance is that changes in the rate signal the Fed's intentions with respect to monetary policy.
The Reserve Requirement
o The Fed possesses the power to change the reserve requirements of member banks by altering the reserve ratio. o Relatively small reserve requirement changes can have a big impact on the potential supply of money by changing the money multiplier. o The tool is so potent, in fact, that it is seldom used o Changes in required reserves and excess reserves have the potential to disrupt the economy
The Recognition Lag
o The time needed to identify a macroeconomic problem and to assess its seriousness. o It may take two or three months before enough data are gathered to indicate the actual presence of a downturn
The government could use some combination of these three moves.
o These moves would • increase aggregate demand • Increase the GDP • Expand the economy
Multiplier effect
o Usually, when an increase in purchases of goods or services occurs, the ultimate increase in total purchases will tend to be greater than the initial increase. o Snowballing effect
Lags in Fiscal Policy
o may hamper its effectiveness and weaken discretionary fiscal policy o may in fact do more harm than good - Lag: the time required to approve and implement fiscal legislation
The largest single source of revenue for the federal government is the:
personal income tax.
Savings and loan associations
provide many of the same services as commercial banks, including checkable deposits, a variety of time deposits, and money market deposit accounts
When the economy goes into a ____, the amount of unemployment compensation and welfare payments ____ automatically.
recession; increase
Liquidity
refers to the ease with which one asset can be converted into another asset or goods and services.
Excess Reserves
reserve levels above that required by the Fed (money that can be loaned out to customers)
The money supply contracts when the Fed:
sells government securities/bonds.
Automatic stabilizers
smooth fluctuations in disposable income over the business cycle, thereby boosting aggregate demand during periods of recession and dampening aggregate demand during periods of expansion Two good examples of automatic stabilizers 1. Progressive income tax 2. Unemployment compensation
The government's fiscal policy is its plan to regulate aggregate demand by manipulating:
taxation, transfer payments, and spending.
Our central bank is known as
the Federal Reserve System. It is unique because it has is not one, but 12 different banks located around the country.
Marginal refers to
the fact that you received an extra amount of disposable income—in addition to your income, not your total income;
When banks have short term needs for cash to meet reserve requirements, they can take a very short-term (often overnight) loan from other banks in
the federal funds market
The money market
the market where money demand and money supply determine the equilibrium nominal interest rate. The quantity of money demanded varies inversely with the rate of interest.
M1:
the narrowest measure of money supply: 1. currency, including coins, held by Non-banking public 2. Demand deposits / Checkable accounts: Deposits in financial institutions against which checks can be written and ATM or debit cards can be applied 3. Travelers checks
National debt
the net accumulation of all federal deficits.
The Demand for Money
the relationship between how much money people want to hold and the interest rate o At higher interest rates on other assets, the amount of money (cash in your pocket) held will be smaller, because the opportunity cost of holding money will have risen. o The demand for money will be smaller at higher interest rates because of the opportunity cost of holding money will go up.
The Fed's most important policy objective is
the stability of the banking system and money supply.
Supply-siders believe that
these types of government policies could cause greater long-term economic growth by stimulating personal income, savings, and capital formation.
Implementation Lag
time needed to introduce the law and implement into policy o it might take a few months before the changes from the laws go into effect
Balanced budget
where government expenditures equal tax revenues
Gold standard
where the dollar was defined as equivalent in value to a certain amount of gold, and paper currency or demand deposits could be freely converted to gold coin.
Marginal propensity to save (MPS),
which is the proportion of an addition to your income that you would save or not spend on goods and services today
Unit of Account or Measure of value
• Is a common unit for measuring the value of each good and service • Eliminates the necessity of having to determine how much of each good exchanged for every other good