Macroeconomics Test 2
The determinants of aggregate demand consist of spending by
domestic consumers, by businesses, by government, and by foreign buyers.
The recession of 2001, however ended the
expansionary phase of the business cycle. Expansion resumed in the 2002-2007 period, before giving way to the severe recession of 2007-2009.
Rightward shifts of the aggregate supply curve, caused by large improvements in productivity, help
explain the simultaneous achievement of full employment, economic growth, and price stability that occurred in the United States between 1996 and 2000.
This inflexibility results from
fear of price wars, menu costs, wage contracts, efficiency wages, and minimum wages.
Most economists believe that fiscal policy can help move the economy in a desired direction but cannot reliably be used to
fine-tune the economy to a position of price stability and full employment.
The aggregate demand-aggregate supply model (AD-AS model) is a
flexible-price model that enables analysis of simultaneous changes of real GDP and the price level.
The Fed adjusts the Federal funds rate to a level appropriate
for economic conditions.Under an expansionary monetary policy, it purchases securities from commercial banks and the general public to inject reserves into the banking system. This lowers the Federal funds rate to the targeted level and also reduces other interest rates (such as the prime rate)
When the price level is fixed, changes in aggregate demand produce
full-strength multiplier effects.
The reassembly of the wreckage from the financial crisis of 2007-2008 has
further consolidated the already consolidating financial services industry and has further blurred some of the lines between the subsets of the industry.
fiscal policy consists of deliberate changes in
government spending, taxes, or some combination of both to promote full employment, price-level stability, and economic growth.
Changes in the cyclical-budget deficit or surplus provide meaningful information as to whether the
government's fiscal policy is expansionary, neutral or contractionary.
Banks earn interest by making loans and by purchasing bonds; they maintain liquidity by
holding cash and excess reserves. The Fed pays interest on excess reserves.
The federal government responded to the deep recession of 2007-2009 by
implementing highly expansionary fiscal policy
Money creation is thus limited because,
in all likelihood, checks drawn by borrowers will be deposited in other banks, causing a loss of reserves and deposits to the lending bank equal to the amount of money that it has lent.
Fiscal policy requires increases in government spending, decreases in taxes, or both - a budget deficit- to
increase aggregate demand and push an economy from a recession.
Increases in aggregate demand to the right of the full employment output cause
inflation and positive GDP gaps (actual GDP exceeds potential GDP)
The determinants of aggregate supply are
input prices, productivity, and the legal-institutional environment.
The federal funds rate is the
interest rate that banks charge one another for overnight loans of reserves.
Because the short-run aggregate supply curve is the only version of aggregate supply that can handle simultaneous changes in the price level and real output,
it serves well as the core aggregate supply curve for analyzing the business cycle and economic policy.
In recent years, the Fed has used monetary policy to
keep inflation low while helping limit the depth of the recession of 2001, to boost the economy as it recovered from the recession, to help stabilize the banking sector in the wake of the mortgage debt crisis, and to promote recovery from the severe recession of 2007-2009.
Nevertheless, banks often can obtain higher interest rates by
lending out excess reserves on an overnight basis to banks that are short on required reserves. These loans are made in the Federal funds market, and the interest paid on the loans is called the Federal funds rate.
The aggregate demand curve shows the
level of real output that the economy demands at each price level.
Commercial banks create money--checkable deposits, or checkable deposit money-- when they
make loans. They convert IOUs, which are not money, into checkable-deposits, which are money.
The price level may not fall during recessions because
of downwardly inflexible prices and wages.
Modern banking systems are fractional reserve systems:
only a fraction of checkable deposits is back by currency.
More substantive problems associated with public debt include the following
payment of interest on the debt may increase income inequality, interest payments on the debt require higher taxes, which may impair incentives, paying interest or principal on the portion of the debt held by foreigners means a transfer of real output abroad, Government borrowing to refinance or pay interest on the debt may increase interest rates and crowd out private investment spending, leaving future generations with a smaller stock of capital than they would have had otherwise.
A change in the determinants of aggregate supply will change the
per-unit production costs at each level of output and therefore will shift the aggregate supply curve.
The aggregate demand curve is downsloping because of the
real-balances effect, the interest-rate effect, and the foreign purchases effect.
Shifts of the aggregate demand curve to the left of full employment output cause
recession, negative GDP gaps, and cyclical unemployment.
The multiple by which the banking system can lend on the basis of each dollar of excess reserves is the
reciprocal of the reserve ratio. This multiple credit expansion process is reversible.
Monetary policy has two major limitations and potential problems:
recognition and operation lags complicate the timing of monetary policy, in a severe recession, the reluctance of banks to lend excess reserves and firms to borrow money to spend on capital goods may contribute to a liquidity trap that limits the effectiveness of an expansionary monetary policy.
In 2001 the Bush administration and congress chose to
reduce marginal tax rates and phase out the Federal estate tax.
The prime interest rate is the benchmark rate that banks use as a
reference rate for a wide range of interest rates on short-term loans to businesses and individuals
Under a restrictive monetary policy, the Fed sells securities to commercial banks and the general public via open-market operations. Consequently, reserves are
removed from the banking system, and the Federal funds rate and other interest rates rise.
Unless stated otherwise, all references to "aggregate supply" refer to
short-run aggregate supply and the short-run aggregate supply curve.
Changes in the actual budget deficit or surplus do not
since such deficits or surpluses can include cyclical deficits or surpluses.
The extent of the shift is determined by the
size of the initial change in spending and the strength of the economy's multiplier.
In 2003 the Bush administration and Congress accelerated the tax reductions scheduled under the 2001 tac law and cut tax rates on capital gains and dividends. The purposes were to
stimulate a sluggish economy. By 2007 the economy had reached its full employment level of output.
The increase in investment in public capital that may result from debt financing may partly or wholly offset the crowding-out effect of the public debt on private investment. Also, the added public investment may
stimulate private investment, where the two are complements.
The concern that a large public debt may bankrupt the U.S. government is generally a false worry because
the debt needs only to be refinanced rather than refunded, and the Federal government has the power to increase taxes to make interest payments on the debt.
The slope of the aggregate supply curve depends upon
the flexibility of input and output prices.
The long-run aggregate supply curve is veritcal at
the full-employment output level.
Built-in stability arises from net tax revenues, which vary directly with
the level of GDP.
The aggregate supply curve shows
the levels of real output that businesses will produce at various possible price levels.
changes in reserves affect
the money supply
The market for money combines the total demand for money with
the money supply to determine equilibrium interest rates.
The amount of money demanded for transactions varies directly with
the nominal GDP.
At the intersection, the quantity of real GDP demanded equals
the quantity of real GDP supplied.
The total demand for money consists of
the transactions demand for money plus the asset demand for money.
Since flexibility of input and output prices vary over time, aggregate supply curves are categorized into
three time horizons, each having a different underlying assumptions about the flexibility of input and output prices.
Certain problems complicate the enactment and implementation of fiscal policy. They include
timing problems associated with recognition, administrative, and operational lags, the potential for misuse of fiscal policy for political rather than economic purposes, the fact that state and local finances tend to be pro-cyclical, potential ineffectiveness if households expect future policy reversals, and the possibility of fiscal policy crowding out private investment.
Commercial banks keep required reserves on deposit in a Federal Reserve Bank or as vault cash. These required reserves are equal
to a specified percentage of the commercial bank's checkable-deposit liabilities.
Built-in stability lessens, but does not fully correct
undesired changes in real GDP.
Deficits caused by changes in GDP are called
cyclical deficits
The cyclically adjusted budget removes
cyclical deficits from the budget and therefore measures the budget deficit or surplus that would occur if the economy operated at its full employment throughout the year.
In 2008 the Federal government passed a tax rebate program that sent $600 dollar checks to qualified individuals. Later that year, it created a $700 billion emergency fund to keep key financial institutions from failing. These and other programs increased the
cyclically adjusted budget deficit from - 1.2 percent of potential GDP in 2007 to --2.8 percent in 2008.
The long-run aggregate supply curve assumes that
nominal wages and other input prices fully match any change in the price level.
The short-run aggregate supply curve assumes
nominal wages and other input prices remain fixed while output prices vary.
Money vanishes when banks sell bonds to the public because
bond buyers must draw down their checkable-deposit balances to pay for their bonds.
The goal of monetary policy is to
help the economy achieve price stability, full employment, and economic growth.
changes in the interest rate affect
investment
The advantages of monetary policy include
its flexibility and political acceptability.
Money is destroyed when
lenders repay bank loans.
Interest rates and bond prices are
inversely related.
The four main instruments of monetary policy are
open-market operations, the reserve ratio, the discount rate, and the term auction facility.
Leftward shifts of the aggregate supply curve reflect increases in
per-unit production costs and cause cost-push inflation, with accompanying negative GDP gaps.
The aggregate supply curve is relatively steep to
the right of the full-employment output level and relatively flat to the left of it.
The ability of a single commercial bank to create money by lending depends on
the size of its excess reserves.
The commercial banking system as a whole can lend by a multiple of its excess reserves because
the system as a whole cannot lose reserves. Individual banks, however, can lose reserves to other banks in the system.
When the economy continued to plunge, the Obama administration and Congress enacted a massive $787 billion stimulus program to be implemented over 2 1/2 years. The cyclically adjusted budget deficit shot up from
2.8 percent of potential GDP in 2008 to - 7.3 percent in 2009.
The main categories of the U.S. Financial services industry are
commercial banks, thrifts, insurance companies, mutual fund companies, pension funds, securities firms, and investment banks.
Generally speaking, a commercial bank can lend only an amount equal to
its excess reserves.
The public debt is the total accumulation of all past Federal government deficits and surpluses and consists of
Treasury bills, Treasury notes, Treasury bonds, and U.S. savings bonds.
The operation of a commercial bank can be understood through its
balance sheet, where assets equal liabilities plus net worth.
Anything that is accepted as a medium of exchange, a unit of monetary account and a store of value can
be used as money.
Rather than making loans, banks may decide to use excess reserves to
buy bonds from the public. In doing so, banks merely credit the checkable-deposit accounts of the bond sellers, thus creating checkable-deposit money.
The aggregate supply curve is generally
upsloping because per-unit production costs, and hence the prices that firms must receive, rise as real output expands.
An upsloping aggregate supply curve
weakens the multiplier effect of an increase in aggregate demand because a portion of the increase in aggregate demand is dissipated in inflation.
The interest-rate effect means that,
with a specific supply of money, a higher price level increases the demand for money, thereby raising the interest rate and reducing investment purchases.
The immediate-short-run aggregate supply curve assumes that
both input and output prices are fixed.
Banks lose both reserves and checkable deposits when
checks are drawn against them.
Excess reserves are equal to
actual reserves minus required reserves
changes in aggregate demand
affect the equilibrium real GDP and the price level.
changes in investment affect
aggregate demand
nevertheless, fiscal policy is a valuable backup tool for
aiding monetary policy in fighting significant recession or inflation.
The intersection of the aggregate demand and aggregate supply curves determines
an economy's equilibrium price level and real GDP.
The foreign purchases effect suggests that
an increase in one country's price level relative to the price levels in other countries reduces the net export component of that nation's aggregate demand.
Actual Federal budget deficits can go up or down because of
changes in GDP, changes in fiscal policy, or both.
changes in the money supply alter
the interest rate
The amount of money demanded as an asset varies inversely with
the interest rate.
In response to the financial crisis, Congress passed the
Wall Street Reform and Consumer Financial Protection Act of 2010.
In general the public debt is not a vehicle for shifting economic burdens to future generation, because
Americans inherit not only most of the public debt (a liability) but also most of the U.S. securities (an asset) that finance the debt.
Changes in these factores alter the spending by these groups and shift the aggregate demand curve.
Changes in consumer spending (consumer wealth, expectations, household borrowing,and taxes), changes in investment spending (interest rates, expected returns --> expected future business conditions, technology, degree of excess capacity, business taxes), change in government spending, change in net export spending (national income abroad, exchange rates).
Monetary policy affects the economy through a complex cause-effect chain:
Policy decisions affect commercial bank reserves, changes in reserves affect the money supply, changes in the money supply alter the interest rate, changes in the interest rate affect investment, changes in investment affect aggregate demand, changes in aggregate demand affect the equilibrium real GDP and the price level.
With output prices fixed, the aggregate supply curve is
a horizontal line at the current price level.
Today, nearly all economists view monetary policy as
a significant stabilization tool.
During recession, the Federal budget automatically moves toward
a stabilizing deficit; during expansion, the budget automatically moves toward an anti-inflationary surplus.
Decreases in government spending, increases in taxes, or both -- a budget surplus--
are appropriate fiscal policy for decreasing aggregate demand to try to slow or halt demand-pull inflation.
Policy decisions affect
commercial bank reserves
The real-balance effect indicates
that inflation reduces the real value or purchasing power of fixed value financial assets held by households, causing cutbacks in consumer spending.
