EC102 final
short run and long run phillips curve of 1960s
!) as US economy's equilibrium moved up the short-run philips curve during the 1960s 2) workers and firms expected an inflation rate of 1.5% 3)but actually experienced an inflation rate of 4.5% -as a result short run phillips curve shifted up, which made the short-run trade-off between employment and inflation worse
Reserve requirement goes down
-R goes down -(R +E) goes down -1/ (R + E) goes up -change in total deposits goes up -change in money supply goes up
what is not included in the M1 definition of the money supply
-The funds in your savings account. -Your Citibank Platinum MasterCard.
what happens to equilibrium/ interest rates in the money market if the Fed buys bonds
-interest rates go down
what happens to equilibrium/interest rates in the money market if the Fed sells bonds
-interest rates go up
The Federal Reserve uses two definitions of the money supply, M1 and M2, because
M1 is a narrow definition focusing more on liquidity, whereas M2 is a broader definition of the money supply
Suppose you have $2000 in currency in a shoebox in your closet. One day, you decide to deposit the money in a checking account. How will this action ultimately affect M1 and M2 ?
M1 will increase and M2 will increase
imports formula
MPI x Y
levels form of quantity equation
MV = PY
Which of the following is usually the cause of stagflation?
a supply shock as a result of an unexpected increase in the price of a natural resource
When actual GDP is below potential GDP the budget deficit increases because of:
an increase in transfer payments and a decrease in tax revenues
Excess reserves
are reserves banks keep above the legal requirement.
Y=C+I+G+NX gov spending multiplier: more general formula
assume NX= 0 assume I= a constant assume C= C0 + Cy(Y-T) assume TR = 0
federal deficit as a percentage of GDP
avg historical deficit 2.9%
When the economy is experiencing an expansion an automatic stabilizers will cause:
transfer payments to decrease and tax revenues to increase.
Friedman defined the "natural rate of unemployment" as the
unemployment rate that exists when the economy produces potential GDP.
If the Fed believes the inflation rate is about to increase, it should
use a contractionary monetary policy to increase the interest rate and shift AD to the left.
If the Fed believes the economy is about to fall into recession, it should
use an expansionary monetary policy to lower the interest rate and shift AD to the right.
treasury undertakes what policy if is in a recession
expansionary fiscal policy
long run phillips curve equation
expectations catch up to reality -the unemployment rate goes back to natural rate, whether inflation is high or low
Where LR and SR Phillips Curves intersect
expected inflation = actual inflation
a $1M loan defaults
loans -$1M bank capital -$1M
decision lag fiscal policy
long
impact lag monetary policy
long
MPI
marginal propensity to import
Short run phillips curve equation
monetary policy can reduce u-rate below the natural u-rate by making inflation greater than expected
change in money supply if someone deposits money
positive change in total deposits + negative change in cash held by the public
why lags in stabilization policy can actually destabilize the economy
potential GDP greater than actual GDP
what happens when someone deposits $500 cash
reserves +$500 checking deposits +$500
changes in balance sheet when bank buys $1000 in bonds
reserves -$1000 bonds +$1000
changes in the bank balance sheet if bank is robbed $500
reserves -$500 bank capital -$500
changes in balance sheet when bank loans out $500 in cash
reserves -$500 loans +$500
An increase in interest rates affects aggregate demand by
shifting the aggregate demand curve to the left, reducing real GDP and lowering the price level.
When the Federal Reserve sells Treasury securities in the open market,
the buyers of these securities pay for them with checks and bank reserves fall.
When the Federal Reserve purchases Treasury securities in the open market,
the sellers of such securities deposit the funds in their banks and bank reserves increase.
Milton Friedman argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation, since
the long-run Phillips curve is vertical, there is no trade-off between unemployment and inflation in the long run.
Fed buys $1M in Bonds
total deposits= initial change in reserves x 1/R = $1M x 1/(.1) =$10M change in money supply =total deposits + cash held by public =$10M + 0 =$10M -buying bonds is expansionary monetary policy
expansionary fiscal policy
-G goes up -TR goes up -T goes down
crowding out
-G, TR go up -and/or T goes down -nominal GDP goes up -Md goes uo -i goes up -C,I,NX go down -AD go down -AD curve ends up to the left of where it would have been after expansionary fiscal policy if there were no crowding out
M2
-M1 -Savings deposits -time deposits -money market mutual funds and other deposits M2 = $12.2 Trillion in 2015
growth rates form of quantity equation
%∆M + %∆V = %∆P + %∆Y
expected inflation
*a measure of how much people expect the price level to change* -varibale Friedman and Phelps introduced to bridge the gap between the short run and long run
What is not money
*checks* -checkinf deposits are *credit cards* -allow you to take a short-term unsecured loan
M1
*currency and traveler's checks* -cash in the hands of the public *checking deposits* -Held at commercial banks, S & Ls, Savings Banks, and Credit Unions M1 = $3 trillion in 2015
monetary policy vs fiscal policy
*monetary policy* -done only by the fed -OMOs to affect M^s and i *fiscal policy* -done by the treasury dept. at the direction of the legislative or executive branch -changes in G,T or TR
why does the Fed target i instead of M
- i is easier to control than M - i is more closely related to the economic variables the Fed ultimately cares about: -inflation -unemployment
two assumptions that turn the quantity equation into the quantity theory
- in the long run %∆V = 0 -in the long run %∆M does not affect %∆Y
Fed sells $1M in Bonds
-$1M x 1/(.1) = -10M no cash held by public -just -$10M -selling bonds is a contractionary monetary policy
What does the Federal Reserve Do?
-*conduct monetary policy* -clear checks -issue new currency and remove damaged currency -evaluate bank mergers and expansions -lender to member banks -Liason between local community and the Federal Reserve System -Perform bank examinations
Natural-rate hypothesis
-1968 Milton Friedman and Edmund Phelps claim that *unemployment eventually returns to its normal or "natural" rate, regardless of the inflation rate* -based on LRAS curve -if LRAS is vertical, in the long run the Phillips Curve is vertical -no trade off between inflation and unemployment in the long run
Depository Institutions
-Essential Activity: take deposits and make loans -Commercial Banks -Thrift Institutions -Money Market Mutual Funds
contractionary fiscal policy
-G goes down -TR goes down -T goes up
when the economy is in macroeconomic equilibrium
-actual GDPequals=potential GDP -SRAS=AD=LRAS -total unemployment=frictional unemployment+structural unemployment
how long-run phillips curve is related to model of aggregate demand and aggregate supply
-an increase in the money supply increases aggregate demand -raises price level -increases inflation rate -leaves output and unemployment at their natural rates
short-run phillips curve and expected inflation
-at every point on a SR Phillips Curve, expected inflation is the same
four classic hyperinflation
-austria, hungary, germany and poland -slope of the money line: rate at which the quantity of money was growing -slope of the price line- inflation rate -the steeper the lines the higher rates of money growth or inflation
Liquid to Illiquid
-cash -checking Deposits M1^^^^^ -saving deposits -time deposits M2^^^ (all the above) -stocks and bonds -real estate -fine art
to get out of inflationary Gap, fed undertakes
-contractionary policy
decreasing t
-decreasing t makes a higher gov purchases multiplier -lower tax rates yield larger multipliers
consumption function when we incorporate tax rates
-depend on income -consumers have disposable incomes of (1-t)Y consumption function= C = Č + MPC(1-t)Y
liabilities
-deposits -bank capital (A-L)
to get out of recessionary gap, Fed undertakes
-expansionary policy
the phillips curve and monetary policy
-expression of the classical idea of monetary neutrality -increase in money supply -AD shifts right -price level increases -in the long run GDP is at its potential level -unemployment is at the natural rate
hyperinflation
-generally defined as inflation exceeding 50% per month -price level increases more than a hundredfold over the course of a year -excessive growth in the money supply always causes hyperinflation -clear link between quantity of money and the price level
What is Fiscal Policy?
-government purchases (G) -taxes (T) -transfer payments (TR)
In terms of the economy, "just as the party gets going" refers to a situation in which real GDP is ________________ potential GDP, which will result in an _______________ the inflation rate.
-greater than -an increase in
economic consequences if fed buys bonds
-i goes down -Consumption, investment, net exports go up -aggregate demand goes up -national income goes up -unemployment goes down -inflation goes up
economic consequences if fed sells bonds
-i goes up -consumption, investment, net exports go down -aggregate demand goes down -national income goes down -unemployment goes up -inflation goes down
LR effects of monetary policy
-in the long run, monetary policy only affects the price level -faster money growth only causes faster inflation
increasing MPI
-leads to smaller gov purchases multiplier -an increase in the amount of additional income leaving the country as payments for imports decreases the multiplier effects of additional government purchases
Functions of money
-medium of exchange -store of value -unit of account
automatic stabilizers
-programs which tend to stabilize demand by expanding or shrinking with the economy without any additional legislative action
examples of automatic stabilizers
-progressive income tax -unemployment compensation -welfare payments -food stamps
discount rate
-rate that banks have to pay if they borrow from the Fed
Assets
-reserves -loans -bonds -other assets
thrift institutions
-savings and loan associations (S & Ls) -savings banks -credit unions
deposits
-savings deposits -checking deposits
Fed Monetary Policy Tools
-set the reserve requirement (R) -set the discount rate -conduct open market operations
money supply curve when fed sells bonds
-shifts left
Money supply curve when Fed buys bonds
-shifts right
Phillips curve 1960s
-showed negative association between inflation rate and unemployment rate -low unemployment with high inflation -low inflation with high unemployment -anything inbetween -people believed it was stable
open market operation example:
-the Fed sells $1,000,000 in T-Bonds to a bond dealer -bond dealer pays for bonds by an electronic transfer of $1 mil from their checking account -the bond dealers bank balance reserves sheet shows a 1 mil decrease in reserves Assets: + 1M, Deposits - 1M Assets: Reserves -1M Liabilities: Deposits -1M
Open Market Operations
-the fed buys or sells T-bonds -changing the reserve requirement
money demand also depends on nominal GDP (P x Y)
-the position of Md depends on nominal GDP -an increase in nominal GDP shifts Md to the right
shifts in the short run phillips curve
-there is a different short-run phillips curve for every expected inflation rate -each short-run Phillips curve intersects the long-run Phillips curve at the expected inflation rate
reserves
-vault cash -deposits with the Fed
long-run phillips curve if fed lowers r
-when fed lowers r, AD shifts right, the rate of inflation increases -unemployment remains at its natural rate in the long run
what happens to real GDP if we increase both gov spending and taxes by both $10bil
-would cancel each other out and equal 10 mil -the balanced budget multiplier is 1: equal dollar increases in gov spending and taxes increase real GDP by that amount in the short run at least
how the long-run Phillips curve is related to the model of aggregate demand and supply
1) monetary policy increases aggregate demand 2) raises the price level 3) increases the inflation rate 4) leaves output and unemployment at their natural rates
money multiplier
1/(R+E)
federal debt
= total of accumulated deficits = total amount owned by govt
%∆P/ pi
=%∆M - %∆Y
%∆M
=%∆P + %∆Y
gov purchases multiplier in an open economy
=1/ 1- [MPC(1-t) - MPI]
Budget balance
=T - (G +TR) T = govt revenues (G +TR) = govt expenditures
Changes in interest rates affect aggregate demand. Which of the following is affected by changes in interest rates and, as a result, impacts aggregate demand? A Consumption of durable goods B The value of the dollar C. Government spending D. Business investment projects
A Consumption of durable goods B The value of the dollar D. Business investment projects
Which of the following is a monetary policy tool used by the Federal Reserve Bank? A Decreasing the rate at which banks can borrow money from the Federal Reserve. B. Buying $500 million worth of government securities, such as Treasury bills. C. Increasing the reserve requirement from 10 percent to 12.5 percent. D. All of the above.
All of the above.
Suppose you decide to withdraw $100 in cash from your checking account. Which one of the following choices accurately shows the effect of this transaction on your bank's balance sheet. A. Your bank's balance sheet shows an increase in reserves by $100 and an increase in deposits by $100. B. Your bank's balance sheet shows a decrease in reserves by $100 and a decrease in deposits by $100. Your answer is correct.C. Your bank's balance sheet shows an increase in reserves by $100 and a decrease in deposits by $100. D. Your bank's balance sheet shows a decrease in reserves by $100 and an increase in deposits by $100.
B. Your bank's balance sheet shows a decrease in reserves by $100 and a decrease in deposits by $100.
Which of the following is not a policy tool the Federal Reserve uses to manage the money supply? A Reserve requirements. B. Changing Income tax rates. Your answer is correct.C. Discount policy. D. Open market operations.
Changing Income tax rates.
Which of the following is true with respect to hyperinflation? A. In the presence of hyperinflation, firms and households avoid holding money. B. It is caused by central banks increasing the money supply at a rate much greater than the growth rate of real GDP. C. It can be hundredslong dash—even thousandslong dash—of percentage points per year. D. All of the above.
D. All of the above.
Which of the following will not have an effect on the long minus run Phillips curvethe long−run Phillips curve? A. Extended periods of high unemployment. B. Changes in unemployment insurance. C. Changes in demographics. D. Changes in monetary policy.
D. Changes in monetary policy.
Which of the following best explains how the economy will adjust from the short-run equilibrium point to the new long-run equilibrium point? A. Due to the lower price level, firms and workers will be willing to accept lower wages and prices and SRAS will shift to the right further. B. Due to the recession, workers and firms will be willing to accept lower wages and prices and AD will shift to the left to point B. C. Due to the higher price level, consumption and investment spending will decrease and the economy will be at B. D. Due to the higher price level, workers will demand higher wages, and firms will raise prices and cause SRAS to shift to the left to point C.
D. Due to the higher price level, workers will demand higher wages, and firms will raise prices and cause SRAS to shift to the left to point C.
"I recently read that more than half of the money issued by the government is actually held by people in foreign countries. If that's true, then the United States is less than half as wealthy as the government statistics indicate." disagree or agree
Disagree. Money is currency plus checking deposits. Wealth is the value of assets minus debts.
If the government increases expenditure without raising taxes, this will A A increase the budget deficit and require the government to borrow additional funds. B. cause the interest rate to increase, thereby, reducing private investment and crowding out the private sector. C. cause a decrease in the domestic exchange rate which will increase exports and decrease imports. D. All of the above. E. A and B only.
E. A and B only.
The term "crowding out" refers to a situation where
Government spending increases interest rates and decreases private investment
in addition to the Federal Reserve Bank, what other economic actors influence the money supply?
Households, firms, and banks
What changes should they make if they decide a contractionary fiscal policy is necessary?
In this case, Congress and the president should enact policies that decrease government spending and increase taxes.
If Congress and the president decide an expansionary fiscal policy is necessary, what changes should they make in government spending or taxes?
In this case, Congress and the president should enact policies that increase government spending and decrease taxes.
NAIRU
Nonaccelerating Inflation Rate of Unemployment -the unemployment rate at which the inflation rate has no tendency to increase or decrease
How does the quantity theory provide an explanation about the cause of inflation?
The quantity equation shows that if the money supply grows at a faster rate than real GDP, then there will be inflation.
customer makes a loan payment of $1000: $800 interest + $200 principal
Reserves +$1000 Loans -$200 bank capital +$800
changes in balance sheet when bank loans out $500 by crediting a deposit account for the borrower
Reserves -$500 checking deposits +$500 loans +$500 checking deposits -$500
balanced budget
T = (G + TR)
budget deficit
T< (G + TR)
budget surplus
T> (G + TR)
Decision lag
Takes time to decide on a policy to deal with the problem
What is the difference between the federal budget deficit and federal government debt?
The federal budget deficit is the year-to-year short fall in tax revenues relative to government spending (T < G + TR), financed through government bonds. The federal government debt is the accumulation of all past deficits.
As the figure to the right indicates, the Fed can affect both the money supply and interest rates. However, in recent years, the Fed targets interest rates in monetary policy more often than it does the money supply. Which interest rate does the Fed target?
The federal funds rate
If the short-run aggregate supply curve (SRAS) were a horizontal line, what would be the impact on the size of the government purchases and tax multipliers ?
The impact of the multiplier would be larger if the SRAS curve is horizontal
When the Federal Reserve decreases the discount rate,
The money supply will increase.
Why does a $1 increase in government purchases lead to more than a $1 increase in income and spending?
Through the government purchases multiplier, the $1 increase in government spending will lead to an increase in aggregate demand and national income, which will lead to an increase in induced spending.
Impact lag
Time it takes for policy we make to impact economy
recognition lag
Time it takes to realize there might be a problem
What is the relationship between the federal funds rate falling and the money supply increasing?
To decrease the federal funds rate, the Fed must increase the money supply.
How does lowering the target for the federal funds rate "pour money" into the banking system?
To increase the money supply, the Fed buys bonds on the open market, which increases bank reserves.
How do the banks "create money"?
When there is an increase in checking account deposits, banks gain reserves and make new loans, and the money supply expands.
Relationship between inflation and unemployment: inflationary gap
Y actual > Y potential price level goes up unemployment < natural rate
Relationship between inflation and unemployment in a Recessionary Gap
Yactual < Y potential price level goes down unemployment > natural rate
Is it possible for Congress and the president to carry out an expansionary fiscal policy if the money supply does not increase?
Yes, because fiscal policy and monetary policy are separate things.
If the economy adjusts through the automatic mechanism, then a decline in aggregate demand causes
a recession in the short run and a decline in the price level in the long run.
Contractionary Monetary Policy
actions which decrease the money supply
Expansionary Monetary Policy
actions which increase the money supply
the balance sheet has to balance
bank capital= A- L A =L + Bank Capital
Phillips curve in short run
can slope downward
As the interest rate increases,
consumption, investment, and net exports decrease; aggregate demand decreases.
"The role of the Federal Reserve is to remove the punchbowl just as the party gets going." When he said "to remove the punchbowl," he meant to engage in _______________ policy.
contractionary
Each year that the federal government runs a deficit, the federal debt
grows
Such views are rare today because
in the long run there is no tradeoff between inflation and unemployment
Credit cards are
included in neither the M1 definition of the money supply nor in the M2 definition.
Total change in Deposits
initial deposit x (1/R (+E))
The federal funds rate
is the rate that banks charge each other for short-term loans of excess reserves.
If government purchases were to decrease by $300 billion or if taxes were increased by $300 billion, the equilibrium level of real GDP would decrease by
more than $300 billion.
change in money supply if someone withdraws money from bank
negative change in total deposits + positive change in cash held by the public
velocity of M1
nominal GDP/ M1 Money Stock = (P x Y)/ M
velocity of M2
nominal GDP/ M2 money stock
E
percentage of their deposits banks are holding as excess reserves
R
reserve requirement
decision lag monetary policy
short
impact lag fiscal policy
short
Each year that the federal government runs a surplus, the federal debt
shrinks
Such views of the trade-off between inflation and unemployment might have existed in the 1960s because the Phillips curve was widely viewed as
stable.
When Federal Reserve Chairman Ben Bernanke said that the public's expectations of inflation could "become embedded in wage and price decisions," he meant
that workers, firms, consumers, and the government will all take the inflation rate into account when making decisions.
equilibrium in the money market
where money supply curve and money demand curve intersect
a change in i causes a change in the quantity of money demanded
with an increase in i there is a smaller quantity of money demanded -shifts up along Md curve
govt spending multiplier
∆Y = (1/1-MPC)∆G ∆Y = (1/1-Cy)∆G
tax multiplier
∆Y= (-MPC/1-MPC)∆T ∆Y= (-Cy/1-Cy)∆T -will always be smaller than money multiplier