Principles of Economics: Macroeconomics Quiz 4

shifts in currency supply

Shifts in imports (into a country) + Shifts in financial outflows (from a country) ●Strength of the domestic economy ●Trade barriers protecting domestic producers ●Foreign innovation and marketing ●Domestic prices ●Foreign prices ●Interest rate differentials ●Business profitability ●Political risk ●Expected exchange rate movements

overview: determining exchange rates

●Changes in a Country's Income: demand for imports depends on the income in a country ○An increase in income leads to an increase of supply of one currency -> which tends to lower the price of that currency relative to foreign currencies ●Changes in a Country's Prices: demand for imports depends on the prices compared to its international competitors ○An increase in inflation in one country makes foreign goods relatively cheaper -> domestic demand for foreign goods increases while foreign demand of domestic currency decreases ●Changes in Interest Rates: people invest in what will yield the highest return ○A rise in domestic interest rates (relative to foreign interest rates) -> increase in demand for domestic assets -> increase in demand for domestic currency while the supply of domestic currency decreases ●Changes in Trade Policy: a change in trade barriers causes the value of a country's currency to fluctuate ○Increased trade barriers -> restricts accessibility to free trade of currency -> increase in the value of a country's currency

characteristics of the business cycle

●Demand-focused (think Keynesian-style models) ●NOT predictable; no period is the same time of period and each is unique ●Recessions are sharp and short, expansions are long and gradual ●Conditions are persistent ●Effects many parts of the economy simultaneously: states/provinces, indicators (GDP, employment, retail sales, industrial production ●Different industries rise and fall together; public sector follows a different pattern than private ●Leading Indicators ●Lagging Indicators

Quantity theory of money

A theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate; Prices rise when the government prints too much money - inflation is always and everywhere a monetary phenomenon ●Equation of Exchange

International trade

Comparative advantage is the basis of (international) trade •Imports •Exports •Geography is irrelevant; the lowest opportunity cost determines comparative advantage and specialization •Trade Costs General Rule: produce what you are good at; buy/trade what you aren't

Government Spending

Evaluated as a share of available resources (% GDP) ●Federal: social insurance + military = ~80% of total spending ●State: health care + human services + education ●Local: neighborhood + community services ●Stable overtime, driven by increases in social insurance +decreases in military spending ●Determined by entitlement programs •Mandatory Spending •Discretionary Spending

determining exchange rates: A graph

Example: Chinese consumers want to buy more foreign goods ●When quantity of yuan supplied equals the quantity of yuan demanded, the balance of payments is zero ●To buy foreign goods, Chinese consumers must convert their currency, resulting in an increase in yuans supplied to the Forex. ●A resulting decline in the price of yuan avoids a balance of payment deficit

Macroeconomic Shocks IS Curve

IS Curve: changes in spending ●Spending Shocks= any change in aggregate expenditure at a given real interest rate and level of income ○Consumption: wealth, consumer confidence, government assistance, taxes, inequality ○Investment: GDP, business confidence, investment tax credits, corporate taxes, easier lending standards, more cash reserves, uncertainty ○Government Spending: fiscal policy (spending bills, automatic stabilizers) ○ Net Exports: Global GDP, domestic currency value, trade barriers

history and declining influence of QTM

Originally introduced by Nicolaus Copernicus and followers of the School of Salamanca ●Noted the increase in prices following the import of gold and silver ●Expanded by John Stuart Mill (Scottish Enlightenment), Karl Marx, John Maynard Keynes Declining Influence ●Velocity is not constant; velocity can offset or add to the effect of money supply changes on price level ●Money and goods inflation are not closely connected

shifts in currency demand

Shifts in exports (from a country) + Shifts in financial inflows (into a country) •Strength of the global economy •Barriers to trade in foreign market •Domestic innovation and marketing •Foreign prices •Domestic prices •Interest rate differentials •Business profitability •Political risk •Expected exchange rate movements •NOT the exchange rate

The US financial account

Tallies the change in ownership of assets ●Difference between financial inflows and outflows ●Surplus in country's that attract investors ●I = S + financial account surplus Ex.When a government buys and sells official reserves (government holdings of foreign currencies) or by buying and selling other international reserves (i.e. gold)

IS-MP Equilibrium

Ultimately useful in forecasting economic conditions and understanding business cycles; changes in aggregate expenditures create macroeconomic fluctuations ○Strong aggregate expenditures lead to a booming economy and full employment (IS curve shifts right) ○Insufficient spending can lead to economic slumps and unemployment (IS curve shifts left) ○Monetary policy attempts to correct large fluctuations (shifts MP curve) ○Fiscal policy attempts to correct large fluctuations (shifts IS curve through increase in G, multiplied effect on AE)

central bank

an institution designed to oversee the banking system and regulate the quantity of money in the economy; a type of banker's bank whose financial obligations underlie an economy's money supply •Usually part of the country's government, except for the US •Lender of Last Resort= a lender to those who cannot borrow anywhere else •Serves as financial adviser to the government - the fed controls the amount of money in the economy but uses that amount to target an interest rate, not to control the money supply

aggregate expenditure

consumption + planned investment + government purchases + net export the total amount of goods and services that people want to buy across the whole economy ●Used to assess how much people/businesses buy (not unsold inventory) ●When total quantity of output excess aggregate expenditure, businesses cut back production ●Macroeconomic Equilibrium ●In the short run, demand conditions determine output ○In the long run, supply drives output ○In the short run, actual GDP can fall short (or over) potential output (output gap) ■Output gap is a balance between demand-side (actual output) and supply-side (potential output) factors ○Output Gap=the gap between actual and potential output as a percentage of potential output

real interest rate

the opportunity cost of spending ●Affects each component of aggregate expenditure: ○Lower interest rates boost consumption (especially on big ticket items) ○Lower interest rates boost investment ○Lower interest rates boost government spending (creates extra funds) ○Lower interest rates boost net exports (makes domestic currency cheaper)

financial (and capital) account

the part of the balance of payments account in which flows of payments related to the buying and selling of financial and capital assets are listed; difference between financial inflows and financial outflows

inflation expectations

the rate at which average prices are anticipated to rise next year Why does inflation matter? ●Prices are set to account for inflation expectations, driven by;○Marginal costs (change in inputs) ○Competitor's prices ●Inflation expectations creates inflation; self-fulfilling prophecy ○Rational Expectations ○Adaptive Expectations ○Extrapolative Expectations ○Monetary policy tries to shape inflation expectations →convince people inflation will be low How are expectations measured? ●Surveys: consumers, businesses ●Forecasts: annual surveys of professional economists ●Inflation Swaps: financial securities whose payoffs are tied to future rates; bets on future inflation

the US current account

Broader than net exports because it tracks all income flows ●Doesn't count sale of assets as income; it's a transfer of existing assets ●Changing international ownership of assets is measured separately (financial account) ●When a deficit = -NX →reflects imbalance between savings and investment

calculating the deficit

Financing: the government sells bonds to private individuals and the central bank ●Printing money is a simple loan, but can cause inflation problemsAccounting: promises to pay versus payment incurred ●Social Security system ●The way deficits are summarized and measured defines the understanding →The cyclical deficit can be eliminated through growth in income, and therefore easy to calculate. cyclical deficit= tax rate x (potential output- actual output) →Which can be used to determine the structural deficit structural deficit= actual deficit - cyclical deficit

growth policies

General policies geared towards growth: ●Encouraging savings and investment ●Formalizing property rights and reducing bureaucracy and corruption ●Providing more of the right kind of education ●Promoting policies that encourage technological innovation ●Promoting policies that allow taking advantage of specializationThe Problem: converting growth policies into politically acceptable ideas

inverted yield curve

a yield curve in which the short-term rate is higher than the long-term rate ●Based on the assumption that when the Fed pushed up the short-term interest rate, the long-term interest rate moves up as well; when the long-term interest rate does not move up in response, standard monetary policy will not work

exchange rates

the rate at which one country's currency can be traded for another country's currency; nominal exchange rate ●Foreign Exchange (Forex) Market= the market for foreign currencies, determines exchange rates (in US dollars) ●People exchange currencies to buy goods or assets in other countries Nominal exchange rate= number of units of a foreign currency/ number of dollars

Macroeconomic Shocks

- financial shock - spending shock - supply shock - Framework allows for any shock to the macroeconomy to have predictive power - the first step is identifying the shock and moving the appropriate curve.

causes of inflation

- inflation expectations - demand-pull inflation - cot-push inflation - inflation= expected inflation+demand-pull inflation+cost-push inflation

The Federal Reserve Tasks

1. Conduct monetary policy - influence the money supply and credit in the economy 2. Supervise and regulate financial institutions 3. Serve as lender of last resort to financial institutions 4. Provide banking services to the US government 5. Issue coin and currency 6. Provide financial services (such as check clearing) to commercial banks, savings and loan associations, savings banks, and credit unions

The Fed Model: A Visual

1. Find the output gap (equilibrium of IS-MP model) ○ Uses the real interest rate (MP Curve), find the equilibrium point (with IS Curve) 2. Assess inflation (Phillips Curve) ○ Using the output gap from the IS-MP equilibrium, find the corresponding unexpected inflation on the Phillips Curve ○ Don't forget to consider expected inflation (obtained through official reports or surveys)

Macroeconomic Shock

1. Identify the shock (and which curve shifts) 2. Find the output gap 3. Assess inflation ○ Note: effects on real interest rates are largely driven by monetary policy; not accounted for here (for now)

operation twist

=selling short-term Treasury bills and buying long-term Treasury bonds without creating more new money; changes the composition of the Fed's portfolio to lower long-term interest rates

labor market philips curve

A Phillips Curve linking unexpected inflation to the unemployment rate ○Same concept, different measure of excess demand

Supply Shocks and the Philips Curve

Cost-push inflation: unexpected boost to production costs pushed sellers to raise their prices ●Ex. Any factor that causes rising production costs shifts Phillips Curve up Supply Shock= any change in production costs that leads suppliers to change the prices they charge at any given level of output; shift the Phillips Curve ●Unexpected costs; does not include planned price changes

Movements vs Shifts in the Philips Curve

Demand-pull inflation leads to movement along the Phillips Curve Cost-push inflation leads to shifts in the Phillips Curve (Philips Curve depicts short-run tradeoffs; inflation expectations are long-run concerns)

the fomc meeting

Each member must be prepared to answer the following questions: 1. What are your forecasts for the US economy? 2. What are the right policy choices given the economic outlook? 3. How should the Fed communicate its plans effectively to the public?

Moving Forward

Five major criticisms of the Keynesian Framework: ●Not conceived on microfoundations(I.e. Homo economicus) ○Money illusion, sticky wages don't fit ●Prescribes too large a role for the government, limiting individual freedoms ●Suggest the amount of money matters to aggregate output ○Classical's think the amount of money determines price level, not output ●Assumes people are not rational, emotional consumption functions (I.e. influenced by optimism/pessimism) ●Not a perfectly competitive equilibrium model--> gives way to Monetarists of the 1970s

Working Backwards

For each of the following examples, assess what shock hit the macroeconomy: 1. "This makes no sense," said a Wall Street economist, "why is inflation falling even though the economy remains in good shape? The Phillips curve teaches us that inflation falls when the economy is weak." 2. At a meeting of the Federal Reserve, policy makers were puzzled. "For some reason output is booming, despite the fact that we haven't cut interest rates at all." 3. Our sales are falling as is output throughout the economy," noted Ford's chief economist. She continued, noting that she might attribute this to higher interest rates on auto loans, although she added that these higher interest rates were somewhat puzzling given that the Fed hadn't changed its benchmark interest rate.

interest rates in the long and short run

In the long run, classical macroeconomic theory assumes: 1. Output: determined by the supplies of capital and labor available production technology for turning capital and labor into (the natural level of) output 2. Interest Rate: for any given level of output, the interest rate adjust to balance the supply and demand for loanable funds 3. Price Level: for any given level of output, the price level adjusts to balance the supply and demand for money; changes in the supply of money lead to proportionate changes in the price level In the short run, the interest rate is required to bring the money market into equilibrium because prices are sticky - unresponsive to changing economic conditions. The operation of the economy in the short run (daily, weekly, quarterly) reverses the order of analysis used to study the economy in the long run.

determining exchange rates: a visual

Key Points: ●Self-Fulfilling expectations undermine the argument in favor of letting markets determine exchange rates ●A country fixes the exchange rate by standing ready to buy and sell its currency anytime the exchange rate is not at the fixed exchange rate ●A country can maintain a fixed exchange rate above its market price only as long as it has reserves

Macroeconomic Shocks MP Curve

MP Curve: changes in the real interest rate ●Financial Shocks= any change in borrowing conditions that change the real interest rate at which people can borrow ○Monetary Policy: risk-free rate, expected future interest rates ○Risk Premium: default risk, liquidity risk, interest rate risk, risk aversion

A labor philips curve application

Original intent: labor market measurements to assess the output gap, or whether the economy is producing below its potential ●Unemployed workers: unused resource ●Okun's Rule: close link between the output gap and unemployment ○In a previous lesson, Okun's rule use actual output (GDP growth) and unemployment rate. ●Labor Market Phillips Curve

Goals and Targets of Central Banks

The Fed goals ● Ultimate Goals: stable prices, acceptable employment, sustainable growth, moderate long -term interest rates ● Intermediate Targets: consumer confidence, stock prices, interest rate spreads, housing starts ● Operating Target: Fed funds rate

limitations of purchasing power parity

Trade and consumption is complex; there is no one measure of PPP. ●Exchange rates do not always move to ensure that a dollar has the same real value in all countries all of the time. ○Many goods and services are not easily traded ○Goods are not always perfect substitutes when they are produced in different countries ●Real exchange rates fluctuate over time ●Purchasing-power parity provides a reasonable first approximation

lender of last resort

a central bank's role as the lender that financial institutions turn to when they're having trouble getting loans ○ Ensures financial stability along with maximum employment and stable crises ○ "Too big to fail" - when a large financial firm fails and causes widespread economic chaos

currency depreciation

a change in the exchange rate so that one currency buys fewer units of a foreign currency

currency appreciation

a change in the exchange rate so that one currency buys more units of a foreign currency

balance of payments

a country's record of all transactions between its residents and the residents of all foreign nations ●Includes buying and selling of goods and services (imports and exports), interest and profit payments, capital inflows and outflows ●Current Account ●Financial (and Capital) Account

Philips Curve

a curve illustrating the link between the output gap and unexpected inflation; excess demand creates inflationary pressure ●Last time we met the Phillips Curve, we compared inflation and unemployment (more on this shortly) ●Upward-sloping: higher output leads to greater inflationary pressure ●When the output gap is equal to 0, inflation is equal to expected inflation ●Used to forecast future inflation

yield curve

a curve that shows the relationship between interest rates and bonds' time to maturity

recession

a decline in real output that persists for more than two consecutive quarters of a year

structural stagnation

a downturn that leads slow economic growth and prevents the economy from returning to its past trend unless there are major changes to the structure of the economy

short-run Phillips curve

a downward-sloping curve showing the relationship between inflation and unemployment when expectations of inflation are constant

IS-MP Framework

a framework used to forecast economic conditions and how they'll respond to monetary and fiscal policy ●Used to understand how interest rates effect the economy; why rates rise and fall ●IS Curve (how the output gap depends on the real interest rate) + MP Curve (what the real interest rate will be)

multiplier

a measure of how much GDP changes as a result of both direct and indirect effects flowing from each extra dollar of spending

purchasing power parity (ppp)

a method of calculating exchange rates that attempts to value currencies at rates such that each currency will buy an equal basket of goods ●First seen in reference to GDP determination ●A unit of currency must have the same real value in every country ●Based on the law of one price -that a goods must sell for the same price in all locations ●Arbitrage:the process of taking advantage of price differences for the same item in different markets ●If the purchasing power of a dollar is always the same and home and abroad, then the real exchange rate cannot change. ●Nominal exchange rates change when price levels change; they also change depending on the money supply.

Monetary policy

a policy influencing the economy through changes in the banking system's reserves that influence the money supply, credit availability, and interest rates in the economy ● Controlled by the central bank; our book alleges this is almost entirely based on the process of setting interest rates ● Expansionary Policy ● Contractionary Policy General Rule: expansionary policy increases nominal income; the effect on real income is dependent on how the price level responds %change real income= %change nominal income- %change price level

monetary policy

a policy of influencing the economy through changes in the money supply and interest rates(more on this in a later chapter) ●Setting a nominal interest rate to influence the real interest rate (which depends on inflation) ●Federal Funds Rat

contradictory policy

a policy that decreases the money supply and increases the interest rate

expansionary policy

a policy that increases the money supply and decreases the interest rate

inflation target

a publicly stated goal for the inflation rate ○ Typically 2% in the US ○ Easily targeted by monetary policy (setting interest rates) ○ Assumed to be correlated with the unemployment rate (easier to target than full employment)

business cycle

a short-run, temporary upward or downward movement of economic activity, or realGDP, that occurs around the growth trend ●Peak = highest total output in a given period ●Downturn: decrease in total output; recession ●Trough = low point in economic activity ●Upturn: increase in total output; expansion

deficit

a shortfall of revenues under payments; summary measures of the state of the economy ●Government deficit occurs when government expenditures exceed government revenuesGenerally fluctuates due to: changes in economic growth rates, changes in the level of taxation, changes in spending ●Structural Deficit ●Cyclical Deficit

social security system

a social insurance program that provides financial benefits to the elderly and disabled and to their eligible dependents and/or survivors

classical growth model

a theory of growth that emphasizes the role of capital in the growth process ●Capital= physical inputs to production saving-> investment-> increase in capital-> growth ●Objects to government deficits ●Law of Diminishing Marginal Productivity ○Primarily applicable to physical productivity such as farming *Grew out of favor when per capita output did not stagnate; technology is a more important factor than capital

new growth theory

a theory of growth that emphasizes the role of technology in the growth process technological advance-> investment-> further technological advance-> growth 1.Increases in technology are not as directly linked to investment as are increases in capital 2.Increases in technology have enormous positive spillover effects ○Positive Externalities ○Patents

Long-run Philips Curve

a vertical curve at the unemployment rate consistent with potential output

debt

accumulated deficits minus accumulated surpluses ●Deficits and surpluses are flow measures (defined for a period of time), debt is a stock measure (defined at a point in time) ●To judge a country's debt, look at debt in relation to assets ○Assets: skilled workforce, natural resources, factories, housing stock, holdings for foreign assets ○Government-specific assets: tax revenue ○Assets indicate the ability to pay off debt

equation of exchange

an equation stating that the quantity of money times the velocity of money equals the price level times the quantity of real goods sold - V=(pxQ)/M v= velocity p= price level (i.e. GDP deflator, CPI) q= quantity of output (income, real GDP) m= quantity of money - or mxv=pxq

surplus

an excess of revenues over payments

real exchange rate

an exchange rate adjusted for differential changes in price level; measured as a good versus a currency ●Measures (un)competitiveness of products ●Exchange rate for output; determines net exports real exchange rate= domestic price in dollars/ foreign price converted into dollars

Spending Shock

any change in aggregate expenditure at a given real interest rate and level of income ○ Shifts IS Curve (i.e. changes aggregate expenditure - consumption, investment, government spending, net exports)

Financial Shock

any change in borrowing conditions that changes the real interest rate at which people can borrow ○Shifts MP Curve(i.e.changes real interest rate-risk less rate and/or risk premium)

Supply Shock

any change in production costs that lead suppliers to change the prices they charge at any given level of output ○Shifts Phillips Curve(i.e.changes production costs-input prices, productivity, exchange rates) ○ Note: can cause changes in output (even if output gap remains unchanged

law of diminishing marginal productivity

as more and more of a variable input is added to an existing fixed input, eventually the additional output produced with that additional input falls

depression

deep and prolonged recession

current account

differences between income received from abroad and income paid to citizens abroad; includes exports and imports (trade balance) - Merchandise Account + Services Account + Net Investment Income Account + Net Transfers Account ●Tallies up income flows into and out of a country ●Balance of Merchandise Trade ●Balance of Trade ●Net Investment Income: payments on foreign owners of US capital assets, payments to US owners of foreign capital assets; a type of holdover from past trade and services imbalances ●Net Transfers: includes foreign aid, gifts, other payments to individuals not exchanged for goods or servicesWhen the Current Account is a deficit, the supply of USD exceeds the demand of USD

adaptive expectations

expectations based in some way on the past

extrapolative expectations

expectations that a trend will accelerate

external debt

government debt owed to individuals in foreign countries

international debt

government debt owed to other governmental agencies or to its own citizens; on average, citizens' incomes are neither better or worse off

risk premium

he extra interest that lenders charge to account for the risk of loaning money ○The interest rate seen by consumers includes the risk-free rate and the risk premium ○Determined by financial markets

IS curve

illustrates how lower real interest rates raise spending and hence GDP, leading to a more positive output gap ●Constructed by adding up the level of aggregate expenditure at each real interest rate ●Downward-sloping because lower real interest rates boost aggregate expenditure, leading to higher GDP and a more positive output gap ●Similar to a macroeconomic demand curve -shows the demand for all types of output

fiscal austerity

increasing taxes and decreasing spending ●When debt is high, deficits should be kept low to protect the financial health of the country

demand-pull inflation

inflation caused by excess demand ○When demand exceeds productive capacity in the short-run, driving prices up When the economy is at full capacity, expectations are equal to actual inflation →demand-pull inflation is driven by the output gap; leads inflation to diverge from expectations

cost-push inflation

inflation that results from an unexpected rise in production costs; "supply shocks"

discount window

lending directly to banks; not often used (and certainly not through the traditional windows at district reserve banks) ● Used to help banks get to their reserve requirement

forward guidance

providing information about the future course of monetary policy in order to influence market expectations of future interest rates ○ Pushes down interest rates on longer-term loans (home mortgages, five-year car loans, longer-term business loans, etc.)

quantitive easing

purchasing large quantities of longer-term government bonds and other securities in an effort to lower long-term interest rates○ Similar to OMO but focused on long-term bonds

taylor rule

set the Fed funds rate at 2% plus current inflation if the economy is at desired output and desired inflation; if the inflation rate is higher than desired, increase the Fed funds rate by 0.5 times the difference between desired and actual inflation; similarly, if putout if higher than desired, increase the Fed funds rate by 0.5 times the percentage deviation ● Dependent upon the estimate of potential output fed funds rate= 2% + current inflation

The Federal Reserve

the central bank of the United States ● Created in 1913 after a series of bank failures ● Comprised of 12 regional banks and the main bank in Washington DC ○ Regional banks handle administrative matters and gather information about business and banking conditions in their geographical regions ● Run by a Board of Governors - seven governors (including the Chair) appointed by the president to serve 14-year terms ○ One person appointed Chairperson for a four-year term

rational expectations

the expectations that the economists' model predicts

trade costs

the extra costs incurred as a result of buying or selling internationally, rather than domestically •Determine whether it's worth buying or selling internationally •Determine how important international trade is in a particular sector

net exports

the foreign purchases of domestically produced goods (exports) minus the domestic purchase of foreign goods (imports) •NX = net exports -net imports

The Fed Model

the framework that uses the IS curve, the MP curve, and the (modern) Phillips Curve to link interest rates, the output gap, and inflation. ● Specific to the US (and the book authors' experience in the US government) with broader implications Real federal funds rate ->real interest rate-> output gap-> unexpected inflation-> inflation MP Curve-> IS Curve-> Philips Curve-> +Expected Inflation ● Steps: ○ Find the output gap (equilibrium of IS-MP model) ○ Assess inflation (Phillips Curve)

fixed exchange rate

the government chooses a particular exchange rate and offers to buy and sell its currency at that price ○Provides international monetary stability; force governments to make adjustments to meet their international problems ○Fixed exchange rates can become unfixed and create enormous monetary instability

flexible exchange rate

the government does not enter into foreign exchange markets at all, but leave the determination of exchange rates totally up to currency traders; floating exchange rate ○Provides for orderly incremental adjustments and flexible domestic monetary and fiscal policies ○Allows speculation to cause large jumps in exchange rates, a departure from market fundamentals

partially flexible exchange rate

the government sometimes buys or sells currencies to influence the exchange rate, while at other times letting private market forces operate; managed exchange rate; "dirty float"

fiscal policy

the government's use of spending and taxes to influence economic conditions (more on this later too) ●When enacted, IS curve shifts ●Expansionary Policy ●Contractionary Policy ●Discretionary Fiscal Policy ●Multiplier change GDP= change spending x multiplier

interest rate on excess reserves

the interest rate a central bank pays to banks on reserves that are in excess of required reserves

federal funds rate

the interest rate set on overnight loans that are almost certain to be repaid the next day (also called the risk-free rate) ○ US-specific term, but a similar concept exists in other central bank systems ○The interest rate the Fed charges other banks, which influence a private bank's interest rates

reserve requirement

the percentage a central bank sets as a minimum amount of reserves a bank must have ● Raising the reserve requirement lowers the money supply, and vice versa ● In normal times, banks hold as little reserves as possible to maximize profits ● The amount of reserves depends on the types of liabilities held by the bank; checking accounts ~10%, long-term liabilities 0-2% ○ Post-2008: banks were not lending, increasing excess reserves, leading to an interest rate on excess reserves to incentivize lending ○ Interest Rate on Excess Reserves ● Secondary Reserves: Treasury bonds; banks hold assets in bonds to get additional reserves if needed

open market operation

the purchase and sale of US government bonds ● Increase money supply: Fed creates dollars -> buys government bonds from public -> public has more dollars ● Decrease money supply: Fed sells government bonds -> dollars are out of the hands of the public ● If the money supply increases too much, prices rise. When prices rise (inflation), unemployment decreases in the short run. FOMC: 7 Board of Governors + 12 Regional Presidents ● Has the power to increase or decrease the number of dollars in the economy ● Most recent meeting: November 5, 2020 Therefore, the Fed has power over inflation, employment, and production in the US.

investment

the purchase of goods (called capital goods) in the future to produce more goods and services •Business Capital = business structures, equipment, intellectual property •Residential Capital = landlord's apartment building, property owner's personal residence

credit easing

the purchase of long-term government bonds and securities from private financial corporations for the purpose of changing the mix of securities held by the Fed toward less liquid and more risky assets

discount rate

the rate of interest the Fed charges for loans it makes to banks ● An increase in the discount rate makes it more expensive for banks to borrow, discouraging borrowing and contracting the money supply ● Typically higher than the Fed Funds rate

fed rule-of-thumb

the recipe that describes how the Fed often sets the interest rate federal funds rate- inflation= neutral real interest rate+ 1/2 x (inflation-2%) + output gap

dual mandate

two goals of stable prices and maximum sustainable employment - inflation target - fed-rule-of-thumb

predicting inflation

use productivity and changes in wages - inflation= nominal wage increase - productivity growth

monetary base

vault cash, deposits at the Fed, plus currency in circulation ● Directly determines the money supply, indirectly determines the amount of credit that banks extend ● Central banks borrow from financial institutions to set the price floor for borrowing money ● Includes most liquid currencies ● Should not be confused with money supply - total currency circulating in public plus the non-bank deposits with commercial banks

negative interest rate

when the Fed charges banks to deposit money held at the Fed

excess demand

when the quantity demanded at the prevailing price exceeds the quantity supplied ●Sign of a strong economy, reasons to increase prices ●Causes inflation to rise above expectations

insufficient demand

when the quantity demanded at the prevailing price is below what's supplied ●Sign of a weak economy, reasons to restrain price ●Causes inflation to fall below expectations

Limitations of Central Banks

● There are multiple interest rates: the Fed does not have the control over the economy as the practice of interest rate targeting suggests ● Long-term and short-term interest rates can differ ● The Fed has little influence over long-term interest rates ● Attempts to contract the money supply can flip the yield curve (short-term interest rates > long-term interest rates) ● Policy credibility: inflationary expectations should not be built into standard practices; it can lead to stronger contractionary policy to correct a steeper yield curve ● The real interest rate cannot be observed because it depends on inflation ● Monetary Regime = a predetermined statement of the policy that will be followed in various situations implements feedback rules (I.e. the Taylor Rule)

determining the exchange rate

●Demand for (US) currency reflects foreign consumers buying (American) exports and investing (in the US) ●Supply for (US) currency reflects (American) consumers buying imports and investing abroad Thus, supply and demand determine the exchange rate ●Clarify which market is being analyzed ●Specify the price being evaluated ●State the origins and destinations

Types of Supply Shocks

●Input prices ○Input prices change marginal costs, leading to a change in prices ○Common input price changes: oil, commodities, wages ■Wage-Price Spiral = a cycle where higher prices lead to higher nominal wages, which leads to higher prices ●Productivity ○More productive firms need less of each input to produce the same output ○Ex. Constant nominal wage increases + diminishing productivity growth →cost-push inflation ●Exchange Rates ○Direct effect: when domestic currency depreciates, foreign goods are more expensive ○Indirect effect: more expensive foreign goods lead to higher prices on domestic goods ■Businesses that rely on imported inputs ■Businesses that compete with imported products ■Businesses that export their products

common macroeconomic indicators

●Real Gross Domestic Product (GDP) ●Real Gross Domestic Income (GDI) ●Nonfarm Payroll ●Unemployment Rate ●Initial Unemployment Claims ●Business Confidence ●Consumer Confidence ●Inflation ●Employment Cost Index ●The stock market (i.e. S&P 500)

Shifts in IS Curve: booms/busts of the business cycle

●Strong aggregate expenditure →booming economy + full employment ●Insufficient spending →economic slump + unemployment ○Keynes: periods of negative output gaps create a new equilibrium →government involvement is necessary to avoid being stuck in the worse equilibrium

tracking the economy

●Track many indicators (vs only a few) ●Use broad indicators (vs narrow ones) ●Distinguish between just-in-time data and leading/lagging indicators ●Look for signals (vs focusing on volatile patterns) ●Adjust the outlook when data differs from expectations

structural deficit

the part of the budget deficit that would exist even if the economy were at its potential level of income

US Budgets

Deficit= when the amount of money the government collects in taxes and other revenue in a given year is less than the amount it spends ●Financed by the sale of Treasury securities (bonds, notes, bills) ●FY 2019 = $984b→Debt = $16.8t Budget Process: 1.Departments and agencies submit proposals (about 1.5 years before the budget goes into effect) 2.The President submits a plan 3.The House and Senate create budget resolutions 4.Appropriations committees distribute funding (12 subcommittees overseeing a different group of agencies) 5.Chambers vote on appropriation bills 6.The President signs the bills into law

IS-MP Framework: Macro Equilibrium

Ultimately useful in forecasting economic conditions and understanding business cycles; changes in aggregate expenditures create macroeconomic fluctuations ○Strong aggregate expenditures lead to a booming economy and full employment (IS curve shifts right) ○Insufficient spending can lead to economic slumps and unemployment (IS curve shifts left) ○Monetary policy attempts to correct large fluctuations (shifts MP curve)

contractionary policy

a policy that decreases government spending and/or increases taxes

expansionary policy

a policy that increases government spending and/or decreases taxes

consumption

spending by households on goods and services •Goods: durable goods, nondurable goods •Services: intangibles, spending on education •Exception: purchases of new housing

imports

to buy goods or services from foreign sellers •Financial Inflows= investments made outside of a country

exports

to sell goods or services from foreign sellers •Financial Outflows = investments made to other countries

macroeconomic equilibrium

occurs when the quantity of output buyers want to purchase is equal to the quantity of output sellers collectively produce

elements of qtm

1.The velocity of money (V) is relatively stable over time. ○Velocity of Money= the number of times per year, on average, a dollar gets spent on goods and services 2.Because velocity is stable, when the central bank changes the quantity of money (M), it causes proportionate changes in the nominal value of output (P x Q). 3.The economy's output of goods and services (Q) is primarily determined by factor supplies (labor, physical capital, human capital, and natural resources) and the available production technology. In particular, because money is neutral, money does not affect output. 4.With output (Q) determined by factor supplies and technology, when the central bank alters the money supply (M) and induces proportional changes in the nominal value of output (P x Q), these changes are reflected in changes in the price level (P). 5.Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation.

financial account

Net Financial and Capital Derivatives Account + Net Domestic Acquisitions of Foreign Financial Assets Account + Net Foreign Acquisition of Domestic Assets Account ●Net Financial and Capital Derivatives: includes buying and selling of relatively small financial instruments ●Net Acquisitions of Foreign Financial Assets (and vice versa): bonds, stocks, ownership rights to real estate ●Net Capital Outflow = Net Foreign Investment = an indicator of overall of capital ○Combines both government and private demand for assets; deficits refer to a private balance of payments deficit because the government is tasked to offset the imbalance by buying its own currency in the foreign exchange market (in a free trade market) There is not only a demand for USD to buy goods and services, but there is also a demand for USD to buy assets

when is the IS curve used?

The IS Curve shows the (negative) relationship between real interest rates and the output gap ●Recall: the output gap is partially a forecasted variable (i.e. potential output) ●Can be used to forecast a change in economic conditions ○Changes in the real interest rate: move along the IS curve ○Changes in other factors of aggregate expenditure: IS curve shifts Missing: what determines the real interest rate? ●Short answer: the financial markets

balance of payments in the US

The US is a net debtor nation ●The inflow of capital into the US exceeds the outflow of capital from the US ●Net debtor nations are expected to experience negative investment income; this not the case in the US →many investors buy US assets for the safety of the investment, not the return on investment *Statistical Discrepancy is the amount that must be added or subtracted to force the measured balance of payments to zero; occurs due to the difficulty of accurately counting every transaction between an economy and the rest of the world.

inflow = outflow

The current account offsets the financial account; the gap between income and expenditure + how it's paid for ●Current account deficit = financial account surplus ●Current account surplus = financial account deficitUS: current account deficit + financial account surplus (income paid abroad- income from abroad)/current account deficit= (financial inflows- financial outflows)/ financial account surplus

MP curve

illustrates the current real interest rate, which is shaped by monetary policy and the risk premium; "monetary policy" curve (slightly inaccurate name) ●Moves when the central bank changes the risk-free rate or when financial markets manipulate the risk premium (or sometimes both) ●Alternatively called the LM (liquidity and money) curve ○The new name refers to the fact that in the US, the Fed simply announces the risk-free rate. Previously, the Fed implemented monetary policy by changing the money supply. ○The LM approach applies to countries with more complex approaches to monetary policy. ○"A similar idea, but an older approach to monetary policy" (p. 462).

patents

legal protection of a technological innovation that gives the owner of the patent sole rights to its use and distribution for a limited time

transfer payment

payments to individuals that do not involve production by those individuals; not included in GDP calculations (I.e. Social Security, unemployment insurance)

discretionary fiscal policy

policy that temporarily changes government spending or taxes to boost or slow the economy

positive externalities

positive effects on others taken into account by the decision maker; result from the common knowledge aspect of technology

government purchases

spending on goods and services by local, state, and federal governments - transfer payment

mandatory spending

spending on programs that does not get determined annually; instead it is set in law

discretionary spending

spending that Congress appropriates annually

Say's Law

supply creates its own demand; classical view of growth

output gap

the difference between actual and potential output, measured as a percentage of potential output ●Tells how well the economy is doing vs its potential ●Negative output gap: idle resources; corresponds with high unemployment ●Positive output gap: resources are being used with an unsustainable intensity; corresponds with burnout and equipment breakdown ●Scales economic activity (GDP) to the level of potential output ○Levels: recent highs and lows in GDP ○Changes: whether GDP is growing or shrinking output gap= (actual output- potential output)/ potential output x 100

balance of trade

the difference between the value of goods and services exported and imported; a more meaningful statistics because it includes services

balance of merchandise trade

the difference between the value of goods exported and the value of goods imported; discussed as the summary of how the US is doing in the international markets

potential output

the level of output that occurs when all resources are fully employed ●Long-run oriented; growth occurs when the economy produces more goods and services from existing production processes and resources ●Focused on forces that shift out the production possibility curve ●Supply-focused; assumes demand is sufficient to buy whatever is supplied ○Say's Law ●Productivity = output per unit of input

cyclical deficit

the part of the budget deficit that exists because the economy is operating below its potential level of output ○Potentially eliminated through growth in income

nominal exchange rate

the rate at which a person can trade the currency of one currency for the currency of another ●The commonly used exchange rate(s) % change in real exchange rate= % change nominal exchange rate + domestic inflation - foreign inflation

lagging indicators

variables that follow the business cycle with a delay; i.e. unemployment - Okun's Rule = for every percentage point that actual output falls below potential output, the unemployment rate is around half a percentage point higher

leading indicators

variables that tend to predict the future path of the economy; i.e. business confidence, consumer confidence, stock market

moving forward

●IS-MP: links interest rates and output ●Phillips Curve: links unemployment and inflation ●Fed model: links interest rates, output, and inflation ●AD-AS: links output (GDP) and prices (inflation) ●Tools: monetary + fiscal policy