Macroeconomics

Limitations of GDP

Can obscure growing inequality and depletion of resources, Can't differentiate between spending on good things (education) and bad things (cigarettes), Doesn't measure the economic services that nature provides or those that don't come with a market price (like raising children), Fails to account for the value of social cohesion, education, health, leisure, clean environments

How is the federal reserve insulated from political pressure?

-Appointment of governors are staggered and have 14 year terms -Appointment of regional bank presidents are not done by politicians -No funding - the fed makes its own money -Accountable to Congress - still has to report to them

Federal Budget Process

-Budget is in the hands of the legislative branch (Congress). -President submits budget plan to Congress in February -Fiscal year is when the budget runs -Federal fiscal year begins October 1 → September 30 -Congress doesn't have to follow it, but it is used to see priorities -Congress develops budget resolution (April 15)

Federal Reserve Five key functions

-Conducts monetary policy -Promotes stability of the financial system -Promotes safety of individual financial institutions -Protects consumers and community development -Fosters payment safety

Big three goals of macroeconomic policy

-Economic growth (GDP) → when the economy's total output of goods increases -Full employment → availability of jobs -Stable prices (inflation) → low and stable price growth

Federal Reserve Bank Three Key Entities

-Federal open market committee (FOMC) consists of seven members of the Board of Governors and five regional bank presidents (one of which is always New York) -Twelve regional banks -Board of Governors (7 members) → includes chairman of the fed (currently Jerome Powell)

Reserves before 2008

-Required reserves (must have) - not earning any -interest on them -Excess reserves - banks usually used to invest or loan them out -Controlled amount of reserves (Supply and demand) -Now, fed policy revolves around amply reserves

Because interest rates on government bonds reflect the risk of default, __________

A country perceived as a higher credit risk must pay higher interest rates when it borrows

National Deficit

A deficit occurs when the government spends more than it collects in taxes and other income during a fiscal year -Must borrow money to pay for its excess spending -Federal Reserve auctions off Treasury securities

Cyclical Unemployment

Arises from the ups and downs of the economy Difference between the natural rate of unemployment and the actual rate of unemployment

How does arbitrage ensure that the FFR does not drop too far below the IOER rate?

Banks have an incentive to borrow at the FFR and deposit at the IOER rate

Goals of Macroeconomic Policy

Big three (economic growth/GDP, full employment, stable prices), rising standards of living, improved trade, equitable distribution of income

The Federal Reserve was created when

Congress passed, and President Wilson signed, the Federal Reserve Act

Monetary Policy (Before 2008)

Controlling interest rates → cost of using someone else's money -More reserves (money) means lower interest rates -Less reserves means higher interest rates Fed influences the level of reserves -Private banks set interest rates, but fed creates pressure Open market operations: buying/selling bonds -Buy to lower interest rates (expansionary), sell to raise (contractionary) Reserve requirements: how much banks must keep in reserves (doesn't change a lot) Discount rate: interest rate on loans banks take from the fed -Higher means less reserves, lower means more Lower interest rates stimulate a willingness to borrow, higher ones slow that down

How can governments protect themselves against the temptation to use printing money as a way to escape unsustainable debt?

Create a central bank that is insulated from the political process and that has clear objectives

Evidence suggests that a country with a central bank with a high level of independence ______________

Has lower average inflation rates

How might inaccurate estimations of potential GDP have led to flawed economic policy in the 1970s?

Inaccurate estimations may have caused the Federal Reserve to believe potential output was higher than it was, leading to overly stimulative policy, contributing to higher inflation

What is a major difference between the way households and countries manage debt?

Only households have a limited lifespan and attempt to pay off their debt at some point

Prior to 2008, the Federal Reserve moved the federal funds rate (FFR) higher and lower using _________

Open market operations

Output Gap

Output gap is the difference between real GDP and real potential GDP (actual GDP - potential GDP) / (potential GDP) x100 = output gap -Determines the business cycle

Financial Reserve dual mandate

Promotes maximum employment and stable prices (Balancing act)

As the data started to reveal the severity of the slowdown, how did businesses and investors seek to reduce financial risk?

Reduce holdings of risky financial assets and increase holdings of cash

Whereas the Federal Reserve used to set a single target for the FFR, it now

Sets a range that is 25 basis points wide

While all (up to) 19 FOMC participants attend meetings, discuss economic conditions, and share their views,the voting members of the FOMC include

Seven Federal Reserve Board Governors and five Federal Reserve Bank presidents (on a rotating basis). One of these is always the president of the New York Fed

How might the relatively short political terms of elected officials (the political business cycle) create an inflationary bias?

Elected officials might resist higher interest rates, fearing a slowing economy will reduce their chances of reelection

Unemployment

Employed: one that has a job Unemployed: those who are jobless but looking for work If you are not actively looking for work, you are not unemployed. Marginally attached worker: on & off Discouraged worker: gave up on finding a job Underemployed: workers who would like to find a full-time job but are currently working part-time (Not calculated in unemployment rate)

Core Inflation

Excludes food and energy prices. Subject to large shifts from change in supply and demand

aggregate demand and supply

Expansionary policy means a demand shift to the right → higher prices and GDP -Creates inflationary gap Contractionary policy means a demand shift to the left → lower prices and GDP -Creates recessionary gap

Net Exports (NX)

Exports minus imports. Doesn't count goods imported from other countries

Adjustments in the stance of monetary policy are communicated as a change in which of the following?

FFR

FFR change during the recession

FFR decreased and amount of reserves increased

How did the COVID-19 pandemic affect the unemployment rate?

The unemployment rate increased from a 50-year low rate of 3.5 percent to 14.7 percent in two months.

Potential GDP

The value that GDP would be at if all resources in the economy were fully employed. (No unemployment or underemployment of resources, Maximum sustainable output, Economic resources are fully employed at normal levels - serves as benchmark) Estimated by the Congressional Budget Office.

How are the seven Federal Reserve Board Governors appointed?

They are nominated by the president of the United States and confirmed by the Senate

How did the onset of the pandemic affect businesses and state and local governments?

They found it difficult to access funds to continue operations.

How did the Fed's liquidity and credit facilities support the flow of credit in the economy?

They kept markets working when the financial assets traded in those markets were difficult to sell.

How did the Fed's purchases of U.S Treasury securities and other financial assets help stabilize the financial system?

They kept markets working when the financial assets were otherwise difficult to sell.

Historically, how have governments (such as Germany in 1921-23 and Zimbabwe in 2007-09) dealt with extremely high levels of debt?

They ordered the central bank to finance deficits by creating money

Aggregate Supply

Total amount of goods and services businesses will supply. Can change in the short run and long run (SRAS vs. LRAS). Shifts due to any changes in economic resources AS = K + L + C + E

Aggregate Demand

Total amount of goods and services people will purchase at various price levels. Any changes in variables shifts the curve. Changes in monetary (interest rates) and fiscal policy. AD = C + I + G + NX

John Maynard Keynes

Wanted to solve the Great Depression by boosting effective demand - government uses temporary deficit to provide people with income Recognized that the plan could cause inflation, but said that it could be solved by raising taxes later

Gross National Product (GNP)

Was chief measurement of economy until 1992, GNP includes American-owned businesses overseas, Excludes foreign-owned branches in the US, Typically differ by <1%

Is the Fed audited?

Yes, the Government Accountability Office and external auditors audit the Fed

Market Basket

a selected group of consumer goods and services whose prices are tracked for calculating a consumer price index and measuring the cost of living. Constructed from spending diaries of consumers. Used to figure out what people are actually buying.

Natural Rate of Unemployment

Zero unemployment is not feasible → natural rate of unemployment is always there Associated with full employment natural unemployment = frictional + structural unemployment Changes because of government policies, labor force characteristics, & labor market institutions

Disinflation

a slower rate of inflation

What happens when economy is above potential GDP

above → positive output gap Unsustainable, expanding, low unemployment

Fiscal Policy

Spending and taxing policies created by the President and Congress

Gross private investment (I)

Spending now to increase output later ~11% of GDP → new housing, structures, machinery

Why is the U.S. Treasury market an important indicator for the rest of the economy?

Stress in this very large market most likely signals financial market stress more broadly.

GDP Expenditure Approach

Sum of all spending that occurs in purchasing output: GDP = C + I + G + NX Consumption by households (C) + Gross private investment (I) + Government (G) + Net Exports (NX)

Labor Force

Sum of the employed and unemployed Participation rate: (labor force/population aged 16≤) x 100 Military and the institutionally employed not counted

Which part of the Federal Reserve System's structure ensures that regional (Main Street) interests are represented?

The 12 Federal Reserve Banks

Which part of the Federal Reserve System's structure ensures that national interests are represented?

The Board of Governors

FFR (federal funds rate)

The FFR is the overnight lending interest rates banks charge one another to borrow money.

How did the Fed bolster economic activity?

The FOMC lowered its target range for the federal funds rate to near zero percent.

How did the Fed lower the cost of borrowing from the Fed?

The Fed lowered the cost of borrowing from its discount window.

What was one of the original purposes the Fed was created for?

The Fed was created to provide loans and act as a backstop during a financial crisis.

FOMC

The Federal Open Market Committee is the most powerful committee of the FED, because it makes the decisions that affect the economy as a whole by manipulating the money supply.

In the "ample reserves" framework of monetary policy, __________

The Federal Reserve moves the FFR into the target range primarily by adjusting the IOER rate

Thinking in terms of a supply and demand graph, how did the Financial Crisis move the supply of reserves?

The Financial Crisis moved the supply curve right into the flat portion of the demand curve

John Maynard Keynes solution to the great depression

The government should pump money made by selling treasury bonds into the economy to encourage "effective demand". Called for the government to create social programs for the unemployed during depressions to stimulate businesses. Traditional economy policy would've been to lower interest rates and increase the money supply, but that did not work

Economy is usually ________ potential GDP

below → negative output gap (recession) FOMC is likely to lower its target range for the federal funds rate to lower interest rates

Federal reserve is made up of ___________

one central bank and three key entities

Coincident indicators

change direction about the same time the economy does

Leading indicators

change direction before the economy does

Unemployment rate

percentage of people in the labor force who are unemployed (# of unemployed workers/labor force) x 100

Discretionary Spending

decided/allocated each year (controllable) Ex: defense, security

Frictional unemployment:

due to the time spent searching for a job or between jobs Inevitable, people are always entering the job market May be good, as people are trying to match their job to their skills

Structural unemployment

esults from changes in the underlying composition of the economy Mismatch between human capital and skills needed Geographical constraints Job market rigidity

Deflation

falling prices (inflation is negative) People will delay purchases - deflationary spiral Indicative of a recession

Lagging indicators

hange direction after the economy has done so

When the fed tries to stimulate the economy, they risk __________

having inflation occur

Cost-pull inflation

if production costs rise too fast, companies push up prices

Examples of leading indicators

index of building permits, housing starts, and manufacturers' new orders for durable goods.

Examples of coincident indicators

index of industrial production and the prime interest rate.

Federal Funds Rate (FFR)

interest banks charge banks for overnight loans -Influences consumer interest rates -What the fed most cares about - sets a target but not the actual rate

When the output gap is negative, the FOMC ___________________

lowers interest rates & target range for federal funds

Personal Consumption Expenditures (CPE)

measured by the BLA

Consumer Price Index (CPI)

measures prices of goods and services in a market basket of purchases made by urban consumers, measured by the Bureau of Labor Statistics.

GDP Income Approach

sum of all income

IOER (interest on excess reserves)

the Fed pays interest on reserves to banks as an incentive. Because of the IOER, banks can now earn money by leaving reserves with the fed. Directly proportional to FFR - banks will not lend in the market at anything less than the IOER Always greater than the FFR

National debt

the accumulation of past deficits and surpluses -The public holds the national debt → gov sells US Treasury securities to them -Japan is the top foreign holder -Interest is paid on the national debt each year

Mandatory spending

uncontrolled - Congress can't allocate it Ex: social security, medicare → eligibility programs Only way to control it is to change the law Discretionary bills are made by subcommittees and then signed into law by the President

Examples of lagging indicators

unemployment rate and expenditures on new plant and equipment.

Demand-pull inflation

when there is too much money chasing too few goods - excessive growth in demand

Government (G)

~20% of GDP → Spending of all levels of government (1/10 of spending is investment) Doesn't include transfer payments like Social Security or unemployment benefits

Consumption by households (C)

~70% of GDP → consumer durable & non-durable goods and services

n the ample reserves framework, what rate acts like a floor for the FFR?

ON RRP

ample reserves

(not limited) Reserves are the sum of money banks hold in deposit

Actual Unemployment

Actual = natural + cyclical unemployment

Unlike hawks or doves, owls feel that the budget ___________

Never needs to be balanced because a country that controls its own currency can simply create more money to pay its debts

Real vs. Nominal GDP

Nominal is the total, untouched number Real GDP accounts for inflation

Which measure do economists feel is a better measure of the U.S. debt burden?

Debt held by the public

How is "debt held by the public" different from the total public debt?

Debt held by the public is debt held external to the government.

Paul Volcker's strategy for reducing the high inflation rate of the 1970s was to

Decrease the money supply, even if that meant higher interest rates

Which of the following best describes how the Federal Reserve might use the current framework to increase employment during a recession to achieve its maximum employment objective?

Decrease the target rate range for the FFR

How inflation affects purchasing power

Diminishes purchasing power. People living on fixed incomes, savers, creditors, lenders, and low income families are the most harmed. Beneficial to borrowers. Opportunity cost of time and other resources spent trying to avoid paying higher prices.

Paradox of Thrift

Downward spiral when people save money during uncertain times. In uncertain times, the reduced spending of consumers persuades businesses to sell and invest less, therefore leading to a downward spiral

Expansionary Fiscal Policy

Increased spending and lower taxes. Increases consumer spending, business investments, aggregate demand, GDP, employment, and price level (inflation)

What two foundational beliefs that sometimes have tension are reflected in the structure of the Federal Reserve?

Independence and accountability

Inflation

Inflation is a persistent increase in the general price of goods and services when considered in the aggregate (Doesn't mean all prices are rising, only the average, Target is ~2%)

In the case of "intergovernmental debt," how does the government borrow from itself?

It uses surpluses from some government programs to buy U.S. Treasury securities

Contractionary Fiscal Policy

Lower spending and higher taxes. Decrease in consumer spending, business investments, demand, GDP, employment, and price level (deflation)

GDP (Gross Domestic Product)

The total market value (sale price) of all final goods and services (end product) produced annually in an economy. Measured by annual growth rate.