Econ Final Exam

The Federal Government Debt, 1790-2047

When the federal government runs a budget deficit, it finances its activities by selling Treasury securities. •The total value of those securities outstanding is known as the federal government debt or the national debt. The national debt increased dramatically as a percentage of GDP during the two world wars and the two worst recessions. It is now at its highest level since 1947, and projected to increase further.

Result of the Lower Quality Loans

When the housing bubble burst, more of these lower quality loans were defaulted on than investors were expecting. •The market for securities based on these loans became very illiquid—few people or firms were willing to buy them, and their prices fell quickly. •Many commercial and investment banks were invested heavily in these mortgage-backed securities, and so suffered heavy losses. These problems were so profound that the Fed and the U.S. Treasury decided to take unprecedented actions.

What does an inverted yield curve signal?

When the yield curve is inverted, the yield on the 10-year govt bond is less than the yield on the 3 month treasure bill. This happens when the Fed has raised short terms rates too high and is a sign that a recession is impending a year from now.

Expenditure approach

Y = C+I + G + (exports -imports) Y is GDP which is the same as aggregate income or aggregate output or aggregate expenditure

income approach

Y = wages + rent + interest +profits+ proprietary income

Calculation of inflation rate from CPI:

[(new CPI -old CPI)/old CPI]*100

the Natural rate of unemployment

exists at the potential or full employment GDP Natural rate of unemployment = structural unemployment + frictional unemployment

2019 2nd quarter real GDP:

$19 trillion approximately

Fed's target inflation rate is 2%

(The Fed uses the Personal Consumption Expenditure(PCE) core inflation rate which excludes food and energy prices that are volatile)

Automatic stabilizers

(They are automatically built into the system. Congress does not have to approve) - Government spending on transfer payments (unemployment benefit insurance, welfare such as food stamps) automatically increases when the economy is a recession and automatically decreases when the economy is an expansion. This automatically stabilizes the economy since when the economy is weak, household receive more transfer payment (have more disposable income) and they can spend more...this will increase C (consumption) and will increase Y (GDP). - Taxes: in most cases, the amount of taxes paid by households automatically decreases when the economy is a recession and automatically increases when the economy is an expansion. When the economy is an expansion, most households will be receiving more income and therefore will automatically be paying more in taxes even though the tax rate has not changed. When these households pay more in taxes, their disposable income does not increase very much, so there is an automatic curb on spending. This automatic tendency that prevents consumption (C) by households from increasing too much will prevent inflation and will automatically stabilize the economy, thereby preventing it from getting "overheated."

Why does the Fed act like a "fool in the shower?" (class notes that elaborate on the power point slides)

- Because the "impact lag" of monetary policy is long and variable: in other words, time taken for an increase in money supply and decrease in interest rates to stimulate investment and consumption and thereby increase GDP is long, variable, and uncertain. In fact, in a prolonged economic slowdown like in Japan, monetary policy may have no impact at all, which is why, according to Keynes, in a recession we should use fiscal policy. During a recession, monetary policy can be like "pushing on a string" according to Keynes. You can pull a string like a leash on a dog and tighten monetary policy in an overheated economy; and this will work. However, you cannot be sure that you can make a dog go somewhere, unless it wants to, by pushing (loosening) its leash! Therefore, you cannot make monetary policy be effective in a recession. ⁻ The impact lag for fiscal policy is short: When govt. increases spending on say defense or on salaries of govt. employees, people are paid right away and start spending right away. This stimulates consumption and increases GDP soon. ⁻ The "recognition lag" for monetary and fiscal policy is the same: for the policy maker to recognize that something is wrong with the economy: either that economic growth is weak or that inflation is a threat ⁻ The "decision lag" for monetary policy is very short. It takes very little time for the FOMC to meet and to decide what to do to interest rates. ⁻ However the decision lag for fiscal policy is very long—it takes forever for the House and Senate to agree on a fiscal bill and then for the President to sign it.

If consumption expenditures for a household increase from $1000 to $1800 when disposable income Rises from $1000 to $2000, the marginal propensity to consume is

0.8

Understanding the past 5 recessions using the AD, SRAS, and LRAS

1. *November 1973(IV) to March 1975 (I): first oil shock. SRAS shifted left. Stagflation. Fed made inflation worse by increasing the money supply. 2. *January 1980 (I) to July 1980 (III): 2nd oil shock. SRAS shifted left. Stagflation. Fed did not accommodate the oil price shock this time. 3. *July 1981(III) to November 1982 (IV): This Recession is called a textbook recession since it was created by the Monetary contraction by former Fed Chair, Paul Volcker. The only way the inflation of 14% could be brought down in 1980 was to decrease the money supply. AD shifted left. Paul Volcker was known as an inflation hawk. He brought inflation down, but of course we had a recession. 4. *December 2007 - June 2009. The 2008 Great Recession. Causes of the Great Recession: Homeowners could not afford to make their mortgage payments because they bought houses they could not no longer afford when adjustable rate mortgage (ARM) interest rates went up. They had to sell off their houses when they could no longer afford to keep them. The price of houses fell. The burst of the housing bubble led to the fall in the price of the Mortgage Backed Securities. Investment banks that were holding the MBS went bankrupt. Credit markets froze. This caused the Great Recession.

Suppose that the Consumption Function: C = 400 + 0.8 YD. Note: MPC or the Marginal Propensity to Consume = 0.8

1. The govt purchase multiplier or autonomous investment multiplier: 1/(1-MPC) = 5 Example: Let the stimulus to the economy occur from the govt buying a B2 bomber aircraft: ΔG = $100 million, • then ΔY = [1/(1-0.8)]100 = 5*100 = $500 million. You do NOT have to memorize the tax and transfer multiplier. Comparing the 3 fiscal multipliers: the govt purchase multiplier, the tax cut multiplier, and the transfer payment multiplier which one is the largest multiplier? Answer: The govt purchase multiplier. This is where you get the biggest "bang for the buck." This is where the AD shifts the most to the right

The federal debt of the country

100% of the GDP. Think of it as the same size as real GDP.

Why can the Fed be blamed for the housing bubble and its burst?

2001: terrorist attacks made the 2001 recession worse, collapse of Enron (Energy trading company). Fed lowered interest rates dramatically in 2001 as in the federal funds graph you drew for paper 1. Subprime (Alt A) lending begins around 2002: lenders give ARM (Adjustable Rate Mortgage) loans based on stated income only. These were called NINJA loans: loans given to those with No Income No Job or Assets. House price increases as more and more households buy homes with easy credit and few background checks of creditworthiness. All was well when housing prices were rising. If home owners could not make their payments, they could sell their homes for a profit! Housing prices went above what could be justified by economic fundamentals such as growth in jobs and income. The Fed had lowered rates too much from 2001 and decided around 2004 to raise federal funds rate to avoid future inflation: Fed takes punch bowl away to stop the party Homeowners could not afford to pay the higher mortgage and higher monthly payments since the ARM adjusted upward with the higher federal funds rate that was raised by the Fed around 2004. Home buyers could no longer escape making payments by selling off their house for a profit. Millions of people went into foreclosure as banks sold their houses causing the price of houses to fall. (Increase in supply of homes causes its price to fall) MBS become worthless because people with subprime mortgages began to default on their mortgages. Investment banks--Bear Stearns, Lehman Brothers—failed or became bankrupt since they were holding worthless MBS. Financial institutions that held these MBS--banks, Washington Mutual, giant insurance company AIG that sold Credit Default Swaps as insurance against MBS—failed. Fannie Mae and Freddie Mac went bankrupt. Credit markets froze. This caused the 2007-2009 Recession. ** Economic policy to fight recession Fiscal stimulus package: increase G, increase transfer payments, decrease taxes (ARRA: American Reinvestment and Recovery Act) (ii) Monetary policy: Fed bought MBS. Banks now have a lot of excess reserves. However, inflation is under control. Fed conducted Quantitative Easing (QE) 1, QE 2, QE 3 which are "bond buying binges" conducted by Fed to increase money supply by increasing bank reserves. Fed tried Operation Twist: Fed bought long term govt bonds to lower long term interest rates and financed this purchase by selling short term govt bonds.

The deposit multiplier

= (1/RR) RR= required reserve ratio in decimal If the required reserve ratio is 20%, the deposit multiplier is 1/0.2 = 5. If the Fed buys $100 million worth of govt securities, the money supply will increase by $100 million times 5 = $500 million

Deficits, Surpluses, and Federal Government Debt

A budget deficit is the situation in which the government's expenditures are greater than its tax revenue. A budget surplus is the situation in which the government's expenditures are less than its tax revenue.

Inflation targeting

A framework for conducting monetary policy that involves the central bank announcing its target level of inflation. This policy has been adopted by central banks in some other countries, including the Bank of England and the European Central Bank. •The typical outcome of adopting inflation targeting appears to be that inflation is lower, but unemployment is (temporarily) higher. In 2012, the Fed announced its first explicit inflation target: an average inflation rate of 2 percent per year.

The Great Depression

AD shifted left because · G · Investment . Uncertainty in international trade caused by The Smoot Hawley Tariff (1930). Firms cut back on investment. ("animal spirits" as Keynes indicated in The General Theory , 1936) · The Fed was not aggressive in increasing the money supply because the US was on the gold standard. The Fed increased the monetary base, but the money multiplier decreased because currency holdings of household increased (currency drain increased) · Unemployment rate was 25% · Real GDP fell by 25% · The stock market fell by more than 33% in one week The SRAS kept shifting right as the nominal wage fell from 57 cents per hour to 44 cents per hour over 1929-1943. But the economy never really reached full employment equilibrium. It was taking forever. In the long run we are all dead, said Keynes in 1936. We got out of the Great Depression because of an increase in G coming from the New Deal spending on infrastructure (example, Hoover Dam) and finally because of an increase in spending on World War II. AD shifted right.

Apply the Concept: Central Banks, Quantitative Easing, and Negative Interest Rates

Adjusting the federal funds rate had been an effective way for the Fed to stimulate the economy, but it began to fail in 2008. Banks did not believe there were good loans to be made, so they refused to lend out reserves, despite the federal funds rate being maintained at zero. This is known as a liquidity trap: the Fed was unable to push rates any lower to encourage investment. But the Fed was certain the economy was below potential GDP, so it wanted to stimulate demand. It performed quantitative easing: buying securities beyond the normal short-term Treasury securities, including 10-year Treasury notes and mortgage-backed securities. •This pushed real interest rates into the negatives. The German government went a step further in 2016: it sold bonds with negative nominal interest rates. •Investors believed the guarantee of repayment was worth avoiding the risk of default from alternative bonds and deposits.

Required Reserve ratio

An increase in the required reserve (RR) ratio causes a decrease in the deposit multiplier (which is = 1/RR) and a decrease in the growth of money supply

Fed Goal #2: High Employment

At the end of World War II, Congress passed the Employment Act of 1946, which stated that it was the: "responsibility of the Federal Government... to foster and promote... conditions under which there will be afforded useful employment, for those able, willing, and seeking to work, and to promote maximum employment, production, and purchasing power." Price stability and high employment are often referred to as the dual mandate of the Fed.

The Role of Investment Banks

By the 2000s, investment banks had started buying mortgages also, packaging them as mortgage-backed securities and reselling them to investors. •These securities were appealing to investors because they paid high interest rates with apparently low default risk. But with more money flowing into mortgage markets, "worse" loans started to be made to people: •With worse credit histories (sub-prime loans) •Without evidence of income ("Alt-A" loans) •With lower down-payments •Who couldn't initially afford traditional mortgages (adjustable-rate mortgages start with low interest rates)

What is the largest component of GDP

C, it's roughly 2/3, 67 percent

The Effects of Fiscal Policy on Real GDP and the Price Level

Congress and the president carry out fiscal policy through: •Changes in government purchases •Changes in taxes A change in government purchases directly affects aggregate demand. A change in taxes changes income; this in turn affects consumption, and so it has an indirect effect on aggregate demand.

How Interest Rates Affect Aggregate Demand

Consumption •Lower interest rates encourage buying on credit, which typically affects the sale of durables. Lower rates also discourage saving. Investment •Lower interest rates encourage capital investment by firms: -By making it cheaper to borrow (sell corporate bonds). -By making stocks more attractive for households to purchase, allowing firms to raise funds by selling additional stock. •Lower rates also encourage new residential investment. Net exports •High U.S. interest rates attract foreign funds, raising the $US exchange rate, causing net exports to fall. (That is why Pres. Trump wanted the Fed to lower the federal funds rate so that the dollar could fall in value and cause US exports to be cheaper for foreigners and make US exports increase.)

Will President Trump's Proposals Raise the Rate of Economic Growth?

Could the Trump administration's proposals really achieve the goal of significantly raising growth rates? This could happen by: 1.Increasing the growth rate of hours worked, or 2.Increasing the growth in labor productivity. 1.Increasing the growth rate of hours worked This would require some combination of: •An increase in population growth -Unlikely, especially given proposed immigration restrictions. •An increase in hours worked per employee -This has trended downward since 1945 and is not likely to reverse. •An increase in the employment-population ratio -This has been decreasing, but decreased sharply during the 2007-2009 recession. -The Trump administration hopes to reverse this with apprenticeship programs and infrastructure spending. 2.Increasing the growth in labor productivity Labor productivity grew 1.2% per year from 2006-2016; it would have to grow 2.6% per year to achieve President Trump's goal. Trump administration policies for this include: •Reducing business taxes to increase investment spending •Increasing infrastructure spending •Increasing business startups by reducing regulations and taxes on small businesses Economists are far from unanimous about the likelihood of success for these proposals, and it is uncertain how much of President Trump's agenda will actually be enacted.

Fed Goal #4: Economic Growth

Economic growth, particularly stable economic growth, encourages long-run investment, which is itself necessary for growth. •It is not clear to what extent the Fed can really encourage long-run investment, beyond meeting the previous three goals; Congress and the president may be in a better position to address this goal.

Expansionary/Contractionary Fiscal Policy

Expansionary fiscal policy involves increasing government purchases or decreasing taxes. If the government believes real GDP will be below potential GDP, it can enact expansionary fiscal policy in an attempt to restore long-run equilibrium—decreasing unemployment. Contractionary fiscal policy involves decreasing government purchases or increasing taxes. •This works just like expansionary fiscal policy, only in reverse. •If the government believes real GDP will be above potential GDP, it can enact contractionary fiscal policy in an attempt to restore long-run equilibrium—decreasing inflation.

\\\Acronyms and News items:

FOMC (Federal Open Market Committee is the main policy making body of the Fed) FRED (Federal Reserve Economic Data is the best secondary source of all economic historical data), NBER: National Bureau of Economic Research. Is the body of economists that establishes the dates of the business cycle. In other words they declare when a recession begins and ends. Note: a recession is NOT defined as two consecutive quarters of negative GDP growth. The NBER defines a recession as a significant decline of economic activity across the country for more than just a few months.

Federal Government Expenditures, 2016

Federal government purchases consist of defense spending and "everything else," like salaries of FBI agents, operating national parks, and funding scientific research. Around half of federal expenditures are spent on transfer payments, like Social Security, Medicare, and unemployment insurance. The rest is spent on grants to state and local governments to support their activities, like crime prevention and education, and on paying interest on the federal debt.

What Is Fiscal Policy?

Fiscal policy refers to changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives. (State taxes and spending are not generally aimed at affecting national level objectives.) Some forms of government spending and taxes automatically increase or decrease along with the business cycle; these are automatic stabilizers. Example: Unemployment insurance payments are larger during a recession. Discretionary fiscal policy, on the other hand, refers to intentional actions the government takes to change spending or taxes.

The Limits to Using Fiscal Policy to Stabilize the Economy

For several reasons, fiscal policy may be even less effective than monetary policy at countercyclical stabilization: •Timing fiscal policy is harder, due to: -Legislative delay: Congress needs to agree on the actions -Implementation delay: Large spending projects may take months or even years to begin, even once approved. •Government spending might crowd out private spending Crowding out: A decline in private expenditures as a result of an increase in government purchases.

Arguments For and Against Inflation Targeting

For: •Makes it clear that the Fed cannot affect real GDP in the long run. •Easier for firms and households to form expectations about future inflation, improving their planning. •Promotes Fed account-ability—provides a yardstick against which performance can be measured. Against: •Reduces the Fed's flexibility to address, and accountability for, other policy goals. •Assumes the Fed can correctly forecast inflation rates, which may not be true. •Increased focus on inflation rate may result in Fed being less likely to address other beneficial goals.

Did Fiscal Policy Fail during the Great Depression?

Government expenditures increased after the Great Depression of the 1930s as part of the New Deal, enacted by Franklin D. Roosevelt. •Similarly, there was a budget deficit each year in the 1930s (except 1937). However recovery from the Great Depression was painfully slow. •Does show that expansionary fiscal policy didn't work during the 1930s? E. Cary Brown: "Fiscal policy... seems to have been... unsuccessful ...not because it did not work, but because it was not tried."

Supply Side Economics:

Govt. cuts tax rates. This causes households to keep more of their income (disposable income increases). So people will have an incentive to work more. People will also have an incentive to save more since they will pay lower taxes on the interest they earn from saving. The govt tax revenue will also increase (not decrease) even though the tax rate is lowered because now we have more people working for more hours and earning more income. The govt's tax base has increased, and even though the tax rate is lower, the govt ends up with more tax revenue and a lower budget deficit. Firms will invest more since there is more savings in the economy and so more funds are available to them for borrowing. This will also increase GDP since I (investment) increases.

The Government Purchases and Tax Multipliers

If the government increases its spending on goods and services, then aggregate demand increases immediately. This is the autonomous increase in aggregate demand. But then people receive this increased spending as increased income, and increase their consumption spending accordingly.This is the induced increase in aggregate demand. •The series of induced increases in consumption spending that results from the initial increase in autonomous expenditures is known as the multiplier effect.

How the Federal Budget Can Serve as an Automatic Stabilizer

In 2009, the federal budget deficit was 9.2% of GDP. •How much of this deficit was due to GDP being below potential, and how much was due to government spending and tax policies? We can identify this by looking at the cyclically adjusted budget deficit or surplus: the deficit or surplus in the federal government's budget if the economy were at potential GDP. •The CBO estimated that the budget deficit would be 7.1% of real GDP in 2009 if real GDP were at its potential. So this is the amount that spending needed to be cut, or taxes raised, in order to bring the federal budget into balance in the long run. The rest (2.1 percent) was due to automatic stabilizers.

Can the Fed Eliminate Recessions?

In our demonstration of monetary policy, the Fed •knew how far to shift aggregate demand, and •was able to shift aggregate demand exactly this far. In practice, monetary policy is much harder to get right than the graphs make it appear. •Completely offsetting a recession is not realistic; the best the Fed can hope for is to make recessions milder and shorter. Another complicating factor is that current economic variables are rarely known; we usually can only know them for the past—i.e. with a lag. In November 2001, NBER announced that the economy was in a recession that had begun in March 2001; several months later, it announced the recession ended... in November 2001

Summary of the housing price bubble, its burst, and the subsequent economic downturn that caused the financial crisis and the 2007-2009 recession, also known as the Great Recession. THIS IS IDENTICAL TO THE HANDOUT I GAVE YOU IN CLASS.

In the 1950s, 1960s, 1970s: Banks→ gave face-to-face, traditional 30 year fixed mortgages: fixed mortgages→Home Buyers→Buy homes ** 1980s approximately: Congress talks about "American Dream" to ↑ rate of home ownership; The role of GSEs (Government Sponsored Enterprises) increased. GSE: Fannie Mae (Federal National Mortgage Association (1938) and Freddie Mac Federal Home Loan Mortgage Corporation (1970). The GSEs enabled the expansion of the secondary mortgage market by "securitizing" mortgages into new products called mortgage-backed securities (MBS). The GSEs buy mortgages on the secondary market, pool them, and sell them as MBSs to investors on the open market. Because of this securitization, lenders or mortgage originators or banks could get loans off their books and give more mortgage loans to potential homeowners. More mortgage lending → leads to more buyers of MBS on the part of investors in the world capital market such as China, OPEC dollars → more money comes to loan originators who lend more to homeowners and this leads to more home ownership. ** Early part of 2000: Housing prices ↑↑ (Bubble). Lenders/Loan originators were everywhere ↑↑ The world capital market was flush with dollars held by China, OPEC, new emerging economies. As investors bought more and more MBS from the banks, the banks received more and more funds and provided more and more mortgage loans. Household bought more and more homes and home prices ↑↑.

The Fed Can't Target Both the Money Supply and the Interest Rate

It might seem that the Fed could "get the best of both worlds" by targeting both interest rates and the money supply. •But this is impossible: the two are linked through the money demand curve. •So a decrease in the money supply will increase interest rates; an increase in the money supply will decrease interest rates.

Why is MD downward sloping? Easy way to remember

Let me exaggerate: If interest rate increased from 2% to 20%, you would leave class now and withdraw from your checking account that earns very little or no interest and place your money in interest bearing assets such as T bills and time deposits (CDs). CDs are a part of M2. So if you think of the money demand curve as the demand for M1, the quantity of M1 demanded decreases when interest rate increases. Therefore the demand for M1 is downward sloping.

Responses to the Failure of Lehman Brothers

Many economists were critical of the Fed underwriting Bear Stearns, as managers would now have less incentive to avoid risk: a moral hazard problem. •So in September 2008, the Fed did not step in to save Lehman Brothers, another investment bank experiencing heavy losses. This was supposed to signal to firms not to expect the Fed to save them from their own mistakes. Lehman Brothers declared bankruptcy on September 15. •Financial markets reacted adversely—more strongly than expected. •When AIG began to fail a few days later, the Fed reversed course, providing them with a $87 billion loan. Reserve Primary Fund was a money market mutual fund that was heavily invested in Lehman Brothers. •Many investors withdrew money from Reserve and other money market funds, fearing losing their investments. This prompted the Treasury to offer insurance for money market mutual funds, similar to FDIC insurance. •Finally, in October 2008, Congress passed the Troubled Asset Relief Program (TARP), providing funds to banks in exchange for stock—another unprecedented action. Although these interventions took new forms, they were all designed to achieve traditional macroeconomic goals: high employment, price stability, and financial market stability.

Should the Fed Target the Money Supply?

Monetarists, led by Nobel Laureate Milton Friedman, said "yes". •Friedman advocated a monetary growth rule, increasing the money supply at about the long-run rate of real GDP growth. •He argued that an active countercyclical monetary policy would serve to destabilize the economy; the monetary growth rule would provide stability instead. Monetarism was popular in the 1970s, but since the 1980s, the link between the money supply and real GDP seems to have broken down: M1 seems to change "wildly," but real GDP and inflation do not react in the same way. •Now, targeting the money supply is not seriously considered.

Social Security and Medicare: Fiscal Time Bombs?

Social Security and Medicare have helped to reduce poverty among the elderly, while Medicaid helps improve the health of poor people. •But the aging population and rising health care costs are combining to put those programs in jeopardy. •Through 2090, the budget shortfall for these programs is estimated to be enormous: almost $50 trillion. How can these programs continue to exist? It is likely that a combination of these measures will eventually need to be adopted: •Increasing taxes •Decreasing benefits (including slower benefit growth, perhaps differently for different income groups) •Decreasing eligibility (SSI age already increasing from 65 to 67) But perhaps the most important element will be finding a way to reduce medical costs.

Contractionary monetary policy

Sometimes the economy may be producing above potential GDP. •In that case, the Fed may perform contractionary monetary policy: increasing interest rates to reduce inflation. Why would the Fed intentionally reduce real GDP? •The Fed is mostly concerned with long-run growth. If it determines that inflation is a danger to long-run growth, it can contract the money supply in order to discourage inflation, i.e. encouraging price stability.

Fed Goal #3: Stability of Financial Markets and Institutions

Stable and efficient financial markets are essential to a growing economy. The Fed makes funds available to banks in times of crisis, ensuring confidence in those banks. •In 2008, the Fed temporarily made these discount loans available to investment banks also, in order to ease their liquidity problems.

The Effect of a Poorly Timed Monetary Policy on the Economy.

Suppose a recession begins in August 2020. •The Fed finds out about the recession with a lag. •In June 2021, the Fed starts expansionary monetary policy, but the recession has already ended. By keeping interest rates low for too long, the Fed encourages real GDP to go far beyond potential GDP. The result: •High inflation The next recession will be more severe.

Choosing a Monetary Policy Target

The Fed can choose to target a particular level of the money supply or a particular short-term nominal interest rate. •It concentrates on the interest rate, in part because the relationship between the money supply (M1 or M2) and real GDP growth broke down in the early 1980s (M1) and 1990s (M2). There are many different interest rates in the economy; the Fed targets the federal funds rate: the interest rate banks charge each other for overnight loans. •The Fed does not set the federal funds rate, but rather affects the supply of bank reserves through open market operations.

Expansionary Monetary Policy

The Fed conducts expansionary monetary policy when it takes actions to decrease interest rates to increase real GDP. •This works because decreases in interest rates raise consumption, investment, and net exports. The Fed would take this action when short-run equilibrium real GDP was below potential real GDP. •The increase in aggregate demand encourages increased employment, one of the Fed's primary goals.

Discount Policy

The Fed lends to banks at the discount rate An increase in the discount rate raises all term short term rates and reduces the ability of banks to lend. This decreases spending.

The Goals of Monetary Policy

The Fed pursues four main monetary policy goals: 1.Price stability 2.High employment 3.Stability of financial markets and institutions 4.Economic growth We will consider each goal in turn.

The Federal Budget Deficit, 1901-2017

The U.S. federal government does not generally balance its budget. Sometimes its revenues are higher than its expenditure, but usually the reverse is true—especially so during wartime. Budget deficits also occur during recessions, as tax receipts fall, and automatic stabilizers like increases in transfer payments (unemployment insurance, food stamps, etc.) take effect. •These automatic stabilizers are important for limiting the severity of a recession; many economists believe that the Great Depression of the 1930s was more severe because most of these automatic stabilizers did not exist then.

What Is Monetary Policy?

The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy goals.

Countercyclical Fiscal Policy

The federal government's actions described on the previous slides constitute a countercyclical fiscal policy. Bear in mind that: •The effects described assume ceteris paribus: everything else is staying the same, including monetary policy. Contractionary fiscal policy is not really causing prices to fall; it's causing inflation to be lower than it otherwise would have

Fed Goal #1 is price stability

The figure shows CPI inflation in the United States. Since rising prices erode the value of money as a medium of exchange and a store of value, policymakers in most countries pursue price stability as a primary goal. After the high inflation of the 1970s, then Fed chairman Paul Volcker made fighting inflation his top policy goal. Volcker raised interest rates to fight the inflation and "caused" the 1982 recession, a textbook recession. To this day, price stability remains a key policy goal of the Fed.

Federal Government Revenue, 2016

The majority of federal revenues come from taxes on individual employment: individual income taxes and payroll taxes earmarked to fund Social Security and Medicare. Taxes on corporate profits constitute about one-eighth of federal receipts. The remainder of federal revenue comes from excise taxes (on cigarettes, gasoline, etc.), tariffs on imports, and other fees from firms and individuals.

Assumptions for the multiplier:

The textbook multiplier assume that there is no increase in the price level, no imports, and there is no crowding out of private investment because of expansionary fiscal policy

What is the yield curve?

The yield curve has the interest rate or the yield on govt bonds (treasuries) on the vertical axis and the term to maturity on the horizontal axis. Typically, the yield curve is positive sloped: the yield on the 10 year govt bond (10 year Treasury bond) exceeds the yield on the 3 month govt bond (3 month treasury bill). This is because the buyer of the bond is parting with the money for a longer time and has to be compensated for the economic uncertainty 10 years from now versus only 3 months from now.

Meaning of Unemployed:

To be considered unemployed, a person must be without work and have made specific efforts to find a job within the past four weeks.

Multipliers for Government Purchases

We can describe the total effect of a change (increase or decrease) in government purchases or taxes by measuring the change in equilibrium real GDP. •Remember from Chapter 12: •Govt purchase multiplier is = 1/(1-MPC) •C = 400 + 0.8 YD. Note: MPC or the Marginal Propensity to Consume = 0.8 •Example: Let the stimulus to the economy occur from the govt buying a B2 bomber aircraft: ΔG = $100 million, -then ΔY = [1/(1-0.8)]100 = 5*100 = $500 million.

How Does the Fed Manage the Money Supply?

We saw in the previous chapter that the Fed alters the money supply by buying and selling U.S. Treasury securities—open market operations. •To increase the money supply, the Fed buys those securities; the sellers deposit the sale proceeds in a checking account, and the money gets loaned out—increasing the money supply. •Decreasing the money supply would require selling securities.

What is crowding out?

When Govt purchases increase, it is possible that the increase in purchase is financed by the govt issuing new govt bonds to the public (i.e. by the govt borrowing from households). In order to induce the public to hold govt bonds, the govt pays a higher interest rate The higher interest rate will lead to a fall in I and C and therefore to a fall in Y. Overall, when Govt spending increases, GDP or Y increases by much less than it would if interest rate did not increase. Note: The real world multipliers are smaller because there is an increase in price level and interest rate. There is a crowding out of pvt. Investment (I) and consumption (C).When Govt purchases increase, it is possible that the increase in purchase is financed by the govt issuing new govt bonds to the public (i.e. by the govt borrowing from households). In order to induce the public to hold govt bonds, the govt pays a higher interest rate The higher interest rate will lead to a fall in I and C and therefore to a fall in Y. Overall, when Govt spending increases, GDP or Y increases by much less than it would if interest rate did not increase. Note: The real world multipliers are smaller because there is an increase in price level and interest rate. There is a crowding out of pvt. Investment (I) and consumption (C).

What Is the Role of the Federal Reserve?

When the Federal Reserve was created in the 1913, its main responsibility was to prevent bank runs. •After the Great Depression of the 1930s, Congress gave the Fed broader responsibilities: to act "so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Since World War II, the Fed has carried out an active monetary policy.

Which of the following policies shifts the AD curve the farthest rightward, or where do get the biggest "bang for the buck?"

an increase in government purchases of $20 billion

Discouraged workers

are left out of the labor force in the calculation of the unemployment rate in the household survey.

M1

currency in circulation with the public + checking deposits + travelers checks.

∆ Money Supply

deposit multiplier * ∆Reserves When the Fed sells govt bonds to the public, it is called as an Open Market Sale of Govt Securities by the Fed: The buyers of these securities pay for them with checks and bank reserves fall and money supply falls

What could cause the money demand curve to shift?

•A change in the need to hold money, to engage in transactions. For example, if more transactions are taking place (higher real GDP) or more money is needed for each transaction (higher price level), the demand for money will be higher. •Decreases in real GDP or the price level decrease money demand.

The Taylor Rule

is a rule developed by John Taylor of Stanford University that links the Fed's target for the federal funds rate to economic variables. where: •Equilibrium real federal funds rate is the estimate of the inflation-adjusted federal funds rate that would be consistent with maintaining real GDP at its potential level in the long run. •Inflation gap is the difference between current inflation and the Fed's target rate of inflation (could be positive or negative) •Output gap is the difference between current real GDP and potential GDP (could be positive or negative)

The Cyclically Adjusted Budget Deficit

is the deficit that is calculated as if the economy were at full employment. So if the economy is in a recession, the cyclically adjusted budget deficit is smaller than the actual budget deficit.

What causes the AD to shift:

monetary policy, fiscal policy, expectations, foreign factors

Fiscal Policy

o An increase in G causes the AD to shift to the right. o An increase in G gives the biggest bang for the buck. AD shifts to the right the most in this Fiscal policy—employed by President Obama to fight the 2008 Recession. o An increase in transfer payments causes the AD to shift to the right o A decrease in taxes each causes the AD to shift to the right.

Foreign Factors:

o An increase in foreign income will cause AD to shift to the right because our exports will increase. o A depreciation of the dollar will cause AD of the US to shift right because exports of the U.S. will increase. Boeing airplanes will cost less in yen to Japan Airlines.

Monetary Policy

o An increase in money supply will cause AD to shift to the right. This is called expansionary monetary policy. The Fed increases money supply by purchasing existing govt bonds from the public. This is called open market purchase of government bonds by the Fed. o A decrease in money supply will cause AD to shift to the left. The Fed decreases money supply by selling existing govt bonds to the public (called open market sale of government bonds by the Fed). This is called contractionary monetary policy. o A decrease in the interest rates will cause AD to shift to the right since C á and I á o Note: an increase in money supply leads to a decrease in the interest rate and vice versa.

REMEMBER:

o Expectations of rise in future income causes AD to shift to the right. o Expectations of a rise in future inflation causes AD to shift to the right. o Expectations of a future deflation causes AD to shift to the left

What makes the LRAS shift to the right? The Diagram will not be asked.

o Increase in labor supply o Increase in capital o Improvement in technology

GDP

refers to the market value of final goods and services produced within the geographic boundary of a country in a certain quarter.

Open Market Operations

refers to the open market sale or purchase of govt securities by the Federal Reserve (Fed). Open Market Purchases of Govt. Securities by the Fed: When the Fed purchases govt securities (T bills, T notes, T bonds) from the public, the Fed writes a check against itself (it created money). This increases bank reserves and therefore increases money supply as per the following formula:

The Fed raises rates in increments of 25 basis points:

so an increase from 2.5% to 2.75% is called a 25 basis point increase. It is not a 0.25% increase.

The 10-year treasury rate

the interest rate on the 10 year treasury bond issued by the government.

The discount rate

the rate at banks borrow from the Fed. is higher than the federal funds rate.

The federal funds rate

the rate at which banks borrow and lend reserves from each other for a very short period of time, often overnight.

The prime rate

the rate at which banks lend to their best customers (large corporations with good credit history). I won't ask you the number. It always higher than the discount rate.

What shifts the SRAS

· an increase in the price of raw materials causes the SRAS to shift to the left · an increase in nominal wage causes the SRAS to shift to the left Short run equilibrium is where only AD and SRAS intersect. Long run equilibrium is where all three: SRAS, LRAS, and AD interest. Three types of equilibrium (i) full employment (ii) over full employment (also called an inflationary gap, or boom, or an overheated economy) and (iii) below full employment or recessionary gap, or recession.

The Fed's two monetary policy targets are related in an important way:

•Higher interest rates result in a lower quantity of money demanded. Why? When the interest rate is high, alternatives to holding money begin to look attractive—like U.S. Treasury bills. •So the opportunity cost of holding money is higher when the interest rate is high.

Which inflation rate does the Fed actually pay attention to?

•Not the CPI: it is too volatile, and probably overstates inflation. •It used to use the PCE (personal consumption expenditures) index, a broad price index similar to the GDP deflator. Which inflation rate does the Fed actually pay attention to? •Since 2004, it has used the "core PCE": the PCE without food and energy prices. The core PCE is more stable; the Fed believes it estimates true long-run inflation better.

Alternatively, the Fed may decide to lower the money supply by selling Treasury securities.

•Now firms and households (who bought the securities with money) hold less money than they want, relative to other financial assets. •In order to retain depositors, banks are forced to offer a higher interest rate on interest-bearing accounts.

The Fed has three monetary policy tools at its disposal:

•Open market operations •Discount policy •Reserve requirements It uses these tools to try to keep both the unemployment and inflation rates low. It does this (at least, in "normal" times) by directly influencing its monetary policy targets: •The money supply •The interest rate (primary monetary policy target of the Fed)

For simplicity, we assume the Fed can completely control the money supply.

•Then the money supply curve is a vertical line— it does not depend on the interest rate. Equilibrium occurs in the money market where the two curves cross. When the Fed increases the money supply, the short-term interest rate must fall until it reaches a level at which households and firms are willing to hold the additional money.

Until the 1970s, when a commercial bank granted a mortgage, it would "keep" the loan until it was paid off.

•This limited the number of mortgages banks were willing to provide. A secondary market in mortgages was made possible by the formation of the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac"). •These government-sponsored enterprises (GSEs) sell bonds to investors and use the funds to purchase mortgages from banks. •This allowed more funds to flow into mortgage markets.