Macroeconomics terms pt 3

Economic growth

Policymakers aim to encourage stable economic growth, which allows households and firms to plan accurately and encourages firms to engage in the investment that is needed to sustain growth. Policy can spur economic growth by providing direct incentives for saving to ensure a large pool of investment funds, as well as by providing direct incentives for business investment. However, congress and the president may be better equipped to encourage economic growth than the Fed can.

The Fed has four main monetary policy goals that are intended to promote a well-functioning economy:

Price stability, high employment, stability of financial markets and institutions, and economic growth

Real exchange rate

Rate that corrects the nominal exchange rate for changes in prices of goods and services

Short-run Phillips curve vs Long-run

Short run cannot be vertical because there is only a trade-off between unemployment and inflation in the short run. There is no trade off in the long run, thus the long run supply curve is vertical.

Non-discretionary spending

Spending that is required by a budget, contract, or other commitment. A non-discretionary law is one that is enforced absolutely, and not at the discretion of authorities.

Stability of financial markets and institutions

The Fed promotes the stability of financial markets and institutions so that an efficient flow of funds from savers to borrowers will occur

Targets

The Fed uses variables, called monetary policy targets, that can affect directly and that, in turn, affect variables such as real GDP, employment, and price level, that are closely related to the Fed's policy goals.

Expansionary monetary policy

The Fed's policy of decreasing interest rates to increase real GDP. Lower interest rates cause an increase in consumption, investment, and net exports, which shifts the aggregate demand to the right.

Contractionary monetary policy

The Fed's policy of increasing interest rates to reduce inflation. Higher interest rates cause a decrease in consumption, investment, and net exports, which shifts the aggregate demand curve to the left. This helps the Fed to achieve its goal of price stability by decreasing inflation.

When the value of the dollar rises, households and firms in other countries will pay more for goods and services produced in the US, but US households and firms will pay less for goods and services produced in other countries. As a result...

The US will export less and import more, so net exports will fall.

Monetary policy

The actions the Federal Reserve takes to manage the money supply and interest rates to achieve macroeconomic goals

Fiscal policy effects on aggregate supply

The actual change in real GDP resulting from an increase in government purchases or a cut in taxes will be less than that indicated by the simple multiplier effect with a constant price level

Shifts in the demand curve for foreign exchange

The demand curve for dollars shifts to the right when incomes in Japan rise, when interest rates in the US rise, or when speculators decide that the value of the dollar will rise relative to the value of the yen.

Net capital flows

The difference between capital inflows and capital outflows

Net foreign investment

The difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment plus net foreign portfolio investment

Balance of trade

The difference between the value of the goods a country exports and the value of the goods a country imports

Balance of services

The difference between the value of the services a country exports and the value of the services a country imports.

Crowding out in the short run

The greater the sensitivity of consumption, investment, and net exports to changes in interest rates, the more crowding out will occur. Crowding out may reduce the effectiveness of an expansionary fiscal policy. Most economists agree that increasing government purchases in the short run will result in partial, but not complete, crowding out.

The market exchange rate is determined by...

The interaction of demand and supply

What is the federal funds rate?

The interest rate banks charge each other for overnight loans

Long-term real rate of interest

The interest rate that is most relevant when savers consider purchasing a long-term financial investment such as a corporate bond; the rate of interest that is most relevant to firms that are borrowing to finance long-term investment projects such as new factories or office buildings or to households that are taking out mortgage loans to buy new homes.

Short-term nominal interest rate

The interest rate that is the focus when conducting monetary policy; the interest rate most affected by increases and decreases in the money supply. Often, there is a close connection between movements in the short-term nominal interest rate and movements in the long-term real interest rate.

Relationship between the Phillips curve and the AS/AD model

The inverse relationship between unemployment and inflation that Phillips discovered is consistent with the aggregate demand and aggregate supply analysis-- AD/AS model indicates that slow growth in aggregate demand leads to both higher unemployment and lower inflation. This results explains why there is a short-run tradeoff between unemployment and inflation, as shown by the downward sloping Phillips curve.

Current account

The part of the balance of payments that records a country's net exports, net income on investments, and net transfers

Financial account

The part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country

Capital account

The part of the balance of payments that records relatively minor transactions, such as migrants' transfers and sales and purchases of nonproduced, nonfinancial assets

Balance of payments

The record of a country's trade with other countries in goods, services, and assets

Expected inflation increases the value of total production and the value of total income by...

The same amount

Multiplier effect

The series of induced increases in consumption spending that results from an initial increase in autonomous expenditures

Budget deficit

The situation in which the government's expenditures are greater than its tax revenue

Budget surplus

The situation in which the government's expenditures are less than its tax revenue

The federal government debt

The total value of the Federal Treasury bonds outstanding

Natural rate of unemployment

The unemployment rate that exists when the economy is at potential GDP. The long-run Phillips curve is a vertical line at the natural rate of unemployment.

Nominal exchange rate

The value of one country's currency in terms of another country's currency

How do interest rates affect aggregate demand?

They affect consumption, investment, and net exports.

Discretionary fiscal policy

When the government takes actions to change spending or taxes-- for example, the tax cuts and spending increases in the ARRA that Congress and the president enacted in 2009

What shifts the money supply curve?

When the money supply is increased (or the Fed buys securities), it moves to the right. When it is decreased (or the Fed sells securities), it moves to the left. Interest rate has no effect on the curve.

Full employment

When the only remaining unemployment is structural and frictional unemployment

When interest rates increase, consumption _____. When they decrease, consumption ______.

decreases, increases

When interest rates increase, investment _______. When they decrease, investment ______.

decreases, increases. Lower interest rates can also increase investment through their effect on stock prices because as rates decline, stocks become a more attractive investment relative to bonds and the increase in demand for stocks raises their prices, leading to increased funds for investments.

For the purposes of monetary policy, the Fed has targeted the interest rate known as...

federal funds rate

The short run Phillips curve is shifted when...

inflation rate changes

A higher rate of inflation than expected ______ the realized real real interest rate below the contracted real interest rate. The lender loses and the borrower gains. A lower rate of inflation than expected _____ the realized real interest rate above the contracted real interest rate. The borrower loses and the lender gains.

lowers, raises

To briefly review the dynamic model...

over time, potential GDP increases, which we show by shifting the LRAS curve to the right. The factors that cause the LRAS curve to shift also cause firms to supply more goods and services at any given price level in the short run, which we show by shifting the SRAS curve to the right. Finally, during most years, the aggregate demand curve also shifts to the right, indicating that aggregate expenditure is higher at every price level.

In the long run, real GDP returns to...

potential GDP

We calculate real interest rate by...

subtracting the inflation rate from the nominal interest rate

What is the federal funds rate determined by?

the demand and supply for reserves. Because the Fed can increase and decrease the supply of bank reserves through open market operations, it can set a target for the federal funds rate and usually come very close to hitting it.

An increase in the inflation rate increases employment (and decreases employment) only if...

the increase in the inflation rate is unexpected

In the long run, the Federal Reserve can affect...

the inflation rate but not the unemployment rate

If workers and firms have rational expectations, then...

the inflation rate will equal the expected inflation rate

Full employment is also known as...

the natural rate of unemployment

Because the inflation rate has no tendency to increase or decrease when the unemployment rate equals the natural rate, the natural rate of unemployment is sometimes called...

the non accelerating inflation rate of unemployment (NAIRU)

The natural rate of unemployment can change if...

the number of young and less-skilled workers increases, unemployment insurance systems, unions, and legal barriers to firing exist, or if a high rate of unemployment exists for a persistent amount of years

The Fed can use monetary policy to affect...

the price level and, in the short run, the level of real GDP, allowing it to attain its policy goals of high employment and price stability

If interest rates in the US decline relative to interest rates in other countries...

the value of the dollar will fall, and net exports will rise.

If interest rate rises, relative to interest rates in other countries...

the value of the dollar will rise, and net exports will fall.

The balance of payments is always ______ because...

zero, because if the balance does not equal zero, then some imports or exports of goods and services or some capital inflows or outflows were not measured correctly. A current account deficit must be exactly offset by a financial account surplus, leaving the balance of payments always equal to zero.

How do shifts in demand and supply affect the exchange rate?

1. Changes in the demand for US produced goods and services and changes in the demand for foreign-produced goods and services 2. Changes in the desire to invest in the US and changes in the desire to invest in foreign countries 3. Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies

Three sources of foreign currency demand for the US dollar

1. Foreign firms and households that want to buy goods and services produced in the US 2. Foreign firms and households that want to invest in the US either through foreign direct investment-- buying or building factories or other facilities in the US-- or through foreign portfolio investment-- buying stocks and bonds issued in the US. 3. Currency traders who believe that the value of the dollar in the future will be greater than its value today.

American Recovery and Reinvestment Act of 2009

A $840 billion package of spending increases and tax cuts that was by far the largest fiscal policy action in United States history. About 2/3 of the package took the form of increases in government expenditures, and 1/3 took the form of tax cuts. The POTUS and Congress intended the changes to federal expenditures and taxes from the stimulus package to be temporary. This package reduced the severity of the recession, but only in the slightest.

Net exports

A component of aggregate expenditure that is calculated by adding the balance of trade and the balance of services

Crowding out

A decline in private expenditures as a result of an increase in government purchases

Currency depreciation

A decrease in the market value of one currency relative to another currency

Entitlements

A government program guaranteeing access to some benefit by members of a specific group and based on established rights or by legislation.

Phillips curve

A graph showing the short-run relationship between the unemployment rate and inflation rate

Crowding out in the long run

A permanent increase in government spending will result in complete crowding out. In the long run, the decline in investment, consumption and net exports exactly offsets the increase in government purchases, and aggregate demand remains unchanged. In the long run, any increase in government spending must come at the expense of private expenditures.

Moral hazard problem

A reason for which the Fed and Treasury's decision to save Bear Sterns was criticized; if managers at investment banks believed that the Federal government would save them from bankruptcy, they would make riskier investments.

Disinflation

A significant decrease in the inflation rate

Fed policies during the 2007-2009 recession: after the bankruptcy of Lehman Brothers

After Lehman Brothers failed, the treasury announced a plan to temporarily provide insurance for deposits in money market mutual funds, similar to existing insurance on bank deposits. The Fed announced that for a limited time it would lend directly to corporations by purchasing three-month commercial paper issued by non financial corporations. Finally, in October, Congress passed the Troubled Asset Relief Program (TARP), under which the Treasury attempted to stabilize the commercial banking system by providing funds to banks in exchange for stock.

Open economy

An economy that has interactions in trade or finance with other countries

Closed economy

An economy that has no interactions in trade or finance with other countries

Currency appreciation

An increase in the market value of one currency relative to another currency

Fed policies during the 2007-2009 recession: housing bubble

Because of the credit crunch, investors were unwilling to buy mortgages because they were afraid of losing money if the borrower stopped making payments, or defaulted, on the loan. To reassure investors, Congress used to government-sponsored enterprises, Fannie Mae and Freddie Mac, to stand between investors and banks that grant mortgages.

Stimulus package of 2009

Because of the housing crisis, the resulting credit crunch, and rising oil prices, economists proposed to Obama that they cut taxes to increase household disposable income, which would increase consumption spending and aggregate demand.

Government purchases multiplier

Change in equilibrium GDP / Change in government purchases

Tax multiplier

Change in equilibrium real GDP / Change in taxes

Fiscal policy

Changes in federal taxes and purchases that are intended to achieve macroeconomic policy goals

Shifts in the money demand curve

Changes in variables other than the interest rate cause the demand curve to shift-- the most important variables that cause the money demand curve to shift are real GDP and the price level. An increase in real GDP shifts the demand curve to the right, a decrease shifts the demand curve to the left. An increase in price level shifts the curve to the right, a decrease in price level shifts it to the left.

How does fiscal policy affect aggregate demand during rising inflation?

Contractionary fiscal policy is needed; Congress and the POTUS decrease government purchases or raise taxes and the result is that real GDP and the price level fall.

The demand for money

Demand curve for money is downward sloping because when the interest rates fall, the amount of interest households and firms lose by holding money decreases. The interest rate is the opportunity cost of holding money; so, when the interest rates are low, opportunity cost of holding money is low, so the quantity of money demanded by households and firms will be high.

Equilibrium in the money market

Equilibrium occurs where the money demand curve crosses the money supply curve. 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. Rising short-term interest rates increase the opportunity cost of holding money, causing a movement up the money demand curve.

How does fiscal policy affect aggregate demand during a recession?

Expansionary fiscal policy is needed; Congress and the POTUS increase government purchases or cut taxes and the result is that real GDP and price levels rise.

Rational expectations

Expectations formed by using all available information about an economic variable

Taylor rule

Federal funds target rate = Current inflation rate * Equilibrium real federal funds rate + [ 1/2 * inflation gap ] + [ 1/2 * output gap ]

Federal Reserve Policy from the 1970s to the present

First, in 1979, Paul Volcker used a contractionary monetary policy to decrease the inflation rates. His policies cut inflation from 11% to 6%, but at a cost of increasing the rate of unemployment by 4%. As workers and firms lowered expectations, by 1987, equilibrium returned to the rate of unemployment. Alan Greenspan served as the Fed Chairman until 2006, when Ben Bernanke took over; both men, like Volcker, were determined to keep inflation rates low. Under Greenspan, inflation reached very low levels and the economy only experienced two short and mild recessions. Under Greenspan, the Fed stopped announcing target rates for M1 and M2 and instead announced the federal funds rate target. After 9/11, the Fed kept the federal funds rate at 1%. The Fed continued their policy of quantitative easing despite critics' warning.

Automatic stabilizers

Government spending and taxes that automatically increase or decrease along with the business cycle-- for example, when the economy is expanding and employment increases, government spending on unemployment insurance payments to workers who lost their jobs will automatically decrease.

How does the Fed manage the money supply?

If the FOMC (Federal open market committee) decides to increase the money supply, it will order the trading desk at the Federal Reserve Bank of NY to purchase US Treasury securities. The sellers of these securities deposit the funds they receive from the Fed in banks, which increases bank reserves. Typically, banks loan out these reserves, which creates new checking deposits and expands the money supply. If the FOMC decides to decrease the money supply, it orders the trading desk to sell Treasury securities, which decreases bank reserves and contracts the money supply.

Fed policies during the 2007-2009 recession: before the bankruptcy of Lehman Brothers

In March 2008, the Fed announced it would temporarily make discount loans to primary dealers, or firms that participate in regular open market transactions with the Fed (this change was intended to provide short term funds to these dealers). Also in March, the Fed announced it would loan up to $200 billion of Treasury securities in exchange for mortgage-backed securities. This temporary program made it possible for primary dealers that owned mortgage backed securities that were difficult or impossible to sell to have access to Treasury securities that they could use as collateral for short-term loans. Third, also in March, the Fed and the Treasury helped JP Morgan acquire the investment bank Bear Sterns, which was on the edge of failing. The Fed and Treasury were convinced that the failure Bear Sterns had the potential of creating a financial panic, as many investors and financial firms would stop making short-term loans to other investment banks. Finally, in early September, the Treasury moved to have the federal government take control of Fannie Mae and Freddie Mac; the Treasury believed that the bankruptcy of the two firms would cause a collapse in confidence in mortgage-backed securities.

Price stability

Inflation rates between the years 1979 to 1981 were the highest the US has ever experienced during peacetime. When Paul Volcker became the chairman of the Fed, he made fighting inflation his top policy goal. Later Fed chairs continued to focus on inflation.

Contractionary fiscal policy

Involves decreasing government purchases or increasing taxes-- both decrease aggregate demand

Expansionary fiscal policy

Involves increasing government purchases or decreasing taxes-- both increase aggregate demand

High Employment

Low rate of unemployment is a big policy goal. Unemployed workers and underused factories and office buildings reduce GDP below its potential level. Unemployment causes financial distress and decreases the self-esteem of workers who lack jobs. Because price stability and high employment are explicitly mentioned in the Employment Act, it is sometimes said that the Fed has a dual mandate to attain these goals.

Static model

Model of the economy that ignores two important facts: the economy experiences continuing inflation and the economy experiences long-run growth, with the LRAS curve shifting to the right each year.

Dynamic model

Model of the economy that takes into account these two facts: 1. the economy experiences continuing inflation and 2. the economy experiences long-run growth, with the LRAS curve shifting to the right each year

What are the two main monetary policy targets?

Money supply and the interest rate

When the value of the dollar decreases...

Net exports will increase

Real exchange rate formula

Nominal exchange rate * (Domestic price level / Foreign price level)

Real wage formula

Nominal wage/Price level * 100

Is government debt a problem?

Not right now, but if the debt becomes very large relative to the economy, the government may have to raise taxes to high levels or cut back on other types of spending to make interest payments on the debt

Quantitative easing

Policy that involves buying securities beyond the short-term Treasury securities that are usually involved in open market operations-- can be used to keep interest rates from rising