Macroeconomics

The central bank in the U.S. is known as ? established in ? .

The Fed, 1914

What can be said about the behavior of the budget balance during every recession in the country?

The budget balance deteriorates sharply during every recession in the U.S.

What is the money multiplier, its formula and why in practice its value is less than the one implied by this formulation?

The money multiplier tells us that by how much the total money supply (in particular the checkable deposits which are part of M1 definition of money) will change due to an initial change in deposits. The formula is: 1/RRR, which tells us that if $1 of "new money" is deposited in the banking system, through fractional reserve banking and creation of deposits, total money supply can increase by $1 x (1/RRR). However, this formula was derived assuming that banks keep as reserves exactly what is required by law while in reality they do keep more than this amount for precautionary reasons.

List the major monetary policy tools that are typically at the disposal of a country's central bank in the order of the frequency they are usually used.

The most frequently used monetary policy is open market operation (OMO), then changes in discount rate and finally changes in required reserve ratio (RRR) which is usually stable unless there's a major monetary policy change by the country's monetary authorities.

What is the economic interpretation of the spending multiplier?

The over-simplified spending multiplier tells us that given certain assumptions an increase in an autonomous spending will increase GDP by a multiple of the original increase in spending. In particular, the change in GDP can be as large as the value of the multiplier (1/ 1-MPC) by the amount of change in autonomous spending.

When economists talk about the money supply, what measure or definition of money do they usually have in mind and what are its components?

The quantity of money can be best thought of as the "currency in circulation" plus various types of deposits. The most liquid of such measures of money is M1 definition of money, which includes "currency in circulation" and "checkable deposits."

Provide an economic interpretation for the following equation. I = SPRV + SGOV + NCI

The relationship shows three sources of financing domestic investment in a country. Domestic investment in an open economy can be funded through private and public savings as well as through the inflow of capital by foreigners. This latter source of funding was not available in a closed economy.

D&S Graph: The rest of the world cannot lend us as much due to dealing with their own crisis

The rest of the world is a source of supply of funds. Their crisis makes them less so. Supply curve falls and shifts leftward and the interest rate rises.

Using the available data presented in the book and discussed in class, what is the share of investment in U.S. GDP? What percentages of this investment are funded by which factors shown in the equation?

The share of investment in the US GDP is about 17%. About 5% of savings come from capital inflows and about 12% comes from private shavings to total about 17% in total savings in the share of the US GDP.

What is the purpose of issuing stocks and bonds?

To raise capital.

What items are included in M2 definition of money which are not included in M1? Which measure of money is more liquid?

Two major items that distinguish M2 from M1 are: Savings accounts and money market mutual funds (MMMF), adding them to M2 (besides M1), makes M2 a less liquid aggregate of money supply.

M1 measure or quantity of money consists mostly of ? and ? , which are ? assets.

currency in circulation, checkable deposits, highly liquid

Modern banking system is based on the ? system, in which, banks hold only ? as reserves.

fractional reserve, a fraction of the deposits

Fiat money is a money that has no ? value; the reason the public trusts and uses it as a ? is that the government has endorsed it as ? .

intrinsic, a medium of exchange, legal tender

The central bank (CB), is the ultimate ? in a country, in charge of ? and ? .

monetary authority, regulating & supervising banks, conducting monetary operations

M2 measure of money, includes M1 plus (the major differentiating item) ?.

saving accounts

What are the 3 potential sources of a $1 increase in the disposable income (YD) that you mentioned in your definition?

ΔYD = ΔY - ΔT + ΔTR, there are at least 3 sources that one could have an additional $1 in YD: 1) $1 increase in total income (Y), 2) $1 tax cuts (T) or 3) $1 increase in transfer payments (TR).

How have the "bank runs" been avoided or reduced in likelihood in modern economies?

(1) The modern banking system regulations require banks to keep a minimum required reserve as a ratio of total outstanding deposits; further banks usually keep as reserves an amount higher than the required reserves for precautionary reasons. (2) Deposit insurance: Central banks usually insure the deposits made by the public until a certain amount. So if anything happens to the banks where such deposits are located these accounts are protected by the central bank and the account holders do not need to worry about not getting their money back from troubled banks.

What is the interest rate formula?

(Face Value - Sold Value) / Sold Value

Define the marginal propensity to consume or MPC in two ways.

1. If the disposable income increases by $1, then consumption will increase by MPC dollars, and 2. MPC is the percentage of the additional disposable income that households spend on consumption.

Why is the demand for loanable funds downward sloping?

1. Interest rate constitutes the cost of borrowing money or its opportunity cost, and 2. the present value of any investment decreases with higher interest rates.

During which period did the U.S. budget balance demonstrated sustained improvement?

1990s, which was due to a growing economy and the Clinton administration's attempts to bring discipline to the budget.

When was the last time the U.S. budget balance was a surplus?

2001.

What are the implications of the government running a budget deficit in this context?

A budget deficit means that SGOV< 0, hence to fund a given amount of investment (I) the economy will need either more of private savings (SPRV) or capital inflow to the country (NCI). Put it another way, for given amounts of private saving and international capital flows (SPRV and NCI being the same), a budget deficit would decrease the amount of funds available for funding domestic investment.

What type of relationship exists between MPC and the multiplier?

A rise in MPC increases the value of the spending multiplier. It is so as a higher MPC implies that households will spend a higher fraction of their additional disposable income on consumption spending.

Compare interest rates.

All the interest rates that exist in an economy tend to move together despite differences in their level. The rate of return offered by the financial asset which is more risky is always higher than the relatively "safer" asset.

Consider the assumptions we made in examining the multiplier process. List at least 3 factors that reduce the value of the multiplier in reality.

Among the assumptions in deriving the "over-simplified" multiplier were: ⦁ All spending (initial autonomous and further by households) are made on new and domestic goods and services. In reality part of our additional disposable income is spent on used goods and also on foreign-made (imported) goods. Therefore, the actual multiplier which measures the impact on gross domestic products is lower. ⦁ Non-existence of income taxes in our model: In reality income taxes take away part of the rise in the disposable income, therefore reducing the impact of the multiplier process. ⦁ Prices are fixed: in reality, an increase in aggregate spending is usually accompanied by rising prices which in turn partially discourages spending, therefore relaxing this assumption reduces the actual value of the multiplier.

Use the diagram for loanable funds to explain how increased government spending can crowd out private investment spending.

An increase in government spending leads to a rightward shift in the demand for loanable funds and therefore raising the equilibrium interest rate. The rise in interest rate will discourage private investment spending if we assume the growth rate in the economy, business confidence and all other factors influencing investment spending by businesses are held constant (ceteris paribus). If this happens, we say that increase in government spending has crowded out the investment spending by businesses.

What are the main differences among stocks and bonds?

Generally speaking, stocks are riskier than bonds. This means that there is more uncertainty involved in their returns. Stocks provide returns in two forms: capital gains (changes in their purchase and sale prices, which could be none or negative) and dividend gains (distribution of corporate earnings, if any, to the shareholders). Bonds on the other hand provide "certain" nominal payments in the future. This does not mean they are "risk-less" since the issuing party might default on its payment or inflation might take away the real return over time.

D&S Graph: Government runs a larger budget deficit (hence needs to borrow more funds)

Higher government deficit (spending more than tax revenues) means government now has to borrow more funds to finance its higher spending. This increases D or shifts it to right, leading to a higher interest rate.

How is this equation different from the case where the economy is closed?

In a (fictional) closed economy domestic investment would have to be equal to and can be funded only through national savings.

What is the relationship between investment and capital? Show and describe it with an equation that involves both.

In the "law of capital," the next period's stock of capital (Kt+1) depends on the current stock of capital (Kt), how much it depreciates (dKt) and the amount of investment spending (It). In this equation, "d" stands for the depreciation rate.

D&S Graph: Increase in household savings

Increase in household saving, a source of the supply of funds, shifts S-curve to right, decreasing the equilibrium interest rate.

What factors that influence investment spending need to be held constant for the crowding out effect to occur? Why does relaxing this ceteris paribus assumption might not lead to the crowding out effect?

Investment spending by businesses is a negative function of interest rate, ceteris paribus. In other words, if other factors such as business confidence or economic growth change due to increases in government spending, we might not observe a crowding out effect. Imagine a situation in which increase in government spending is meant to stimulate the economy and this leads to improvement in business confidence and/or higher economic growth. In this situation, businesses might increase their investment spending despite higher interest rates.

Why is investment important?

Investment spending is what maintains and accumulates the stock of physical capital, which is one of the 3 sources of economic growth. Without investment, the stock of physical capital will decrease due to depreciation. If we desire to maintain or improve our standard of living we need enough investment spending on capital goods.

D&S Graph: Business are discouraged by an election outcome (in a fictional economy!) and decide to postpone investments in physical capital

Lower business investment means lower demand for funds: D decreases or shifts leftward, leading to a lower interest rate.

Explain why running a budget deficit might be bad for the economy? (One is related to the identity I=SPrv + SGov + NCI, and the other is related to the national debt)

One reason is related to the availability of funds for domestic investment as shown in the I-S equation. Anytime there is a budget deficit a larger burden falls on private and foreign savings to fund the country's investment, or equivalently, less funds will be available to fund domestic investment. The other reason is related to the fact that a country's national debt is the accumulation of its budget deficits over time. Each time a country runs a budget deficit it adds to its national debt. For example, national debt means we have to forego our income in the future to pay the interests on the debt.

Suggest a specific expansionary monetary policy and show its impact on the interest rate in the money market and then its impact on the GDP in the goods market (AD-AS model) in the short-run.

Open market (OM) purchases, total money supply in the economy increases: MS↑ and lowers interest rates.

Briefly describe how open market operations are implemented and how it affects macroeconomic variables.

Open market operations (OMO) are typically conducted by a country's central bank (CB) or a subdivision of it. In the United States, the Federal Open Market Committee (FOMC) -part of the Fed- in New York is in charge of OM operations. The main objective of any open market operation is to change the monetary base or the amount of high-powered money in the economy through purchase or sales of financial securities such as government bonds (such as T-Bills in the U.S.).

What is the present value formula?

PV = FV/(1+i)^n