econ 201 test 2
market for loanable funds
-'the market in which those who want to save supply funds and those who want to borrow to invest demand funds -the term loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption, and to the amount that investors have chosen to borrow to fund new investment projects
Holding other things constant, an increase in a nation's interest rate reduces a. national saving and domestic investment. b. national saving and the net capital outflow. c. domestic investment and the net capital outflow. d. national saving only.
C. domestic investment and the net capital outflow. A higher interest rate makes borrowing to finance capital projects more costly; thus, it discourages domestic investment. It also makes that nation's domestic bonds and other interest-yielding assets more attractive, which discourages investing abroad, and encourages foreigners to buy more of the nation's assets as well. This decreases net capital outflow.
The government in an open economy cuts spending to reduce the budget deficit. As a result, the interest rate ________, leading to a capital ________ and a real exchange rate ________. a. falls, outflow, appreciation b. falls, outflow, depreciation c. falls, inflow, appreciation d. rises, inflow, appreciation
C. domestic investment and the net capital outflow. A higher interest rate makes borrowing to finance capital projects more costly; thus, it discourages domestic investment. It also makes that nation's domestic bonds and other interest-yielding assets more attractive, which discourages investing abroad, and encourages foreigners to buy more of the nation's assets as well. This decreases net capital outflow.
the two measures of the money stock
M1: currency, demand deposits, traveler's checks, other checkable deposits M2: all of M1, savings deposits, small time deposits, money market mutual funds, a few minor categories
what is the one of the most important determinants of the quantity of money demanded
The higher prices are, the more money the typical transaction requires, and the more money people will choose to hold in their wallets and checking accounts. That is, a higher price level (a lower value of money) increases the quantity of money demanded.
fractional-reserve banking
a banking system in which banks hold only a fraction of deposits as reserves
stock
a claim to partial ownership in a firm and is, therefore, a claim to the profits that the firm makes
crowding out
a decrease in investment that results from government borrowing
trade policy
a government policy that directly influences the quantity of goods and services that a country imports or exports
capital requirement
a government regulation specifying a minimum amount of bank capital
How Net Capital Outflow Depends on the Interest Rate?
a higher domestic real interest rate makes domestic assets more attractive, so it reduces net capital outflow
what makes a bond more attractive?
a higher interest rate
capital flight
a large and sudden reduction in the demand for assets located in a country
budget deficit
a shortfall of tax revenue from government spending -If the government spends more than it receives in tax revenue, then G is larger than T. In this case, the government runs a budget deficit, and public saving (T − G) is a negative number.
balanced trade
a situation in which exports equals imports -exports=imports -net exports=0 -Y= C+I+G -saving = investment -net capital outflow = 0
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
demand deposits
balances in bank accounts that depositors can access on demand by writing a check
How does inflation redistribute wealth among debtors and creditors?
debtors will gain wealth if there is hyperinflation bc it will be easier to pay their debt. But if there is deflation then it will be hard for debtors to pay there debt if inflation is hard to predict then these redistributions of wealth will be more likely to occur
reserves
deposits that banks have received but have not loaned out
in an open economy nation's saving must equal
domestic investment plus its net capital outflow (I+NCO), all saving in the U.S. economy shows up as investment in the U.S. economy or as U.S. net capital outflow
financial markets
financial institutions through which savers can directly provide funds to borrowers
financial intermediaries and the two types
financial institutions through which savers can indirectly provide funds to borrowers, banks and mutual funds
imports
goods and services that are produced abroad and sold domestically
exports
goods and services that are produced domestically and sold abroad
For the economy as a whole what must saving be equal to?
investment
commodity money
money that takes the form of a commodity with intrinsic value (meaning that the item would have value even if it were not used as money) ex. gold
fiat money
money without intrinsic value that is used by money by government decree ex. us paper money
net capital outflow must always equal
net exports, NCO=NX
reserve requirements
regulations on the minimum amount of reserves that banks must hold against deposits
excess reserves
the amount of reserves that banks hold above the minimum
menu costs
the costs of changing prices
what does a bond identify
the date of maturity (the time at which the loan will be repaid) and the rate of interest that will be paid periodically until the loan matures
quantity equation
the equation M×V=P×Y, which relates the quantity of money, the velocity of money, and the dollar value of the economy's output of goods and services
reserve ratio
the fraction of deposits that banks hold as reserves
private saving
the income that houses have left after paying for taxes and consumption Y-T-C
discount rate
the interest rate on the loans that the Fed makes to banks
currency
the paper bills and coins in the hands of the public
monetary neutrality (long run or short run)
the proposition that changes in the money supply do not affect real variables but mainly in the long run bc over short periods of time—within the span of a year or two—monetary changes affect real variables
open-market operations
the purchase and sale of US government bonds by the Fed
money supply
the quantity of money available in the economy
leverage ratio
the ratio of assets to bank capital
bank capital
the resources a bank's owners have put into the institution generally in order to make profit
debt finance
the sale of bonds
Money
the set of assets in an economy that people regularly use to buy goods and services from other people
monetary policy
the setting of the money supply by policymakers in the central bank
public saving
the tax revenue that the government has left after paying for its spending T-G
national saving (saving)
the total income in the economy that remains after paying for consumption and government purchases
leverage
the use of borrowed money to supplement existing funds for purposes of investment
trade balance
the value of a nation's exports minus the value of its imports; also called net exports
net exports
the value of a nation's exports minus the value of its imports; also called the trade balance
unit of account
the yardstick people use to post prices and record debts
nominal variables
variables measured in monetary units
real variables
variables measured in physical units
mutual fund and their value
-an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds which allows u to diversify and it gives ordinary people access to the skills of professional money managers -If the value of the portfolio rises, the shareholder benefits; if the value of the portfolio falls, the shareholder suffers the loss.
what happens to currency when a central bank in any country increases the money supply and causes the price level to rise?
-it also causes that country's currency to depreciate relative to other currencies in the world -that money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy
what are the limitations of the purchasing power parity?
-many goods are not easily traded such as haircuts in France vs. us -even tradable goods are not always perfect substitutes when they are produced in different countries, some people have different preferences
stock index
-monitors the overall level of stock prices computed as an average of a group of stock prices -most famous stock index is the Dow Jones Industrial Average -Standard & Poor's 500 Index, which is based on the prices of the stocks of 500 major companies -stock indexes are watched closely as possible indicators of future economic conditions
effect of higher domestic interest rates on net capital outflow
-net capital outflow decreases -Because saving kept at home now earns higher rates of return, investing abroad is less attractive, and domestic residents buy fewer foreign assets -Higher interest rates also attract foreign investors, who want to earn the higher returns on U.S. assets
nominal vs. real interest rate
-nominal interest rate is the monetary return to saving and the monetary cost of borrowing. -The real interest rate is the nominal interest rate corrected for inflation; it equals the nominal interest rate minus the inflation rate. -the supply and demand for loanable funds depend on the real (rather than nominal) interest rate
closed economy (identity)
-one that does not interact with other economies. In particular, a closed economy does not engage in international trade in goods and services, nor does it engage in international borrowing and lending -actual economies are open but this is a useful simplification -Y=C+I+G (no net exports like w gdp of closed economy)
nominal exchange rate and example
-the rate at which a person can trade the currency of one country for the currency of another -when the exchange rate rises from 80 to 90 yen per dollar, the dollar is said to appreciate. At the same time, because a Japanese yen now buys less of the U.S. currency, the yen is said to depreciate
the nation of Ectenia has long banned the export of its highly prized puka shells. A newly elected president, however, removes the export ban. This change in policy will cause the nation's currency to ________, making the goods Ectenia imports ________ expensive. a. appreciate, less b. appreciate, more c. depreciate, less d. depreciate, more
A. appreciate, less Removing a ban on exports will increase the quantity of goods exported at any real exchange rate, causing net exports to rise as well. Net exports are the source of the demand for a nations currency; therefore, there is an increase in the demand for the nation's currency, which causes the currency to appreciate. A stronger currency makes it less expensive to import goods from other countries.
equation for the quantity of goods and services that can be bought with $1
1/P where P is the price level. Also known as the value of money measured in terms of goods and services.
A bank has capital of $200 and a leverage ratio of 5. If the value of the bank's assets declines by 10 percent, then its capital will be reduced to
100. How to calculate: leverage ratio of 5 means that if u multiply 200 by 5 you will get the banks assets which is 1000. If the banks assets declines by 10% that means they now have 900 in assets. But they still owe 800 so 900-800 is now the new amount in capital which is 100
what does it mean when there is a rise in price level?
A rise in the price level means a lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services. When the overall price level rises, the value of money falls.
If business leaders in Great Britain become more confident in their economy, their optimism will induce them to increase investment, causing the British pound to ________ and pushing the British trade balance toward ________. a. appreciate, deficit b. appreciate, surplus c. depreciate, deficit d. depreciate, surplus
A. appreciate, deficit An increase in investment means increased demand for loanable funds, which increases the interest rate. A higher interest rate will decrease net capital outflow and increase demand for the British pound, causing it to appreciate. As the currency appreciates, imports become cheaper and British exports become more expensive to foreigners, so the trade balance moves toward deficit.
how does inflation impact relative-price variability and the misallocation of resources
Because prices change only once in a while, inflation causes relative prices to vary more than they otherwise would. Consumers decide what to buy by comparing the quality and prices of various goods and services. When inflation distorts relative prices, consumer decisions are distorted and markets are less able to allocate resources to their best use.
store of value
an item that people can use to transfer purchasing power from the present to the future
money stock
-the quantity of money circulating in the economy, includes not only currency but also deposits in banks and other financial institutions that can be readily accessed and used to buy goods and services
the effects of saving incentives on the market for loanable funds
-A change in the tax laws to encourage Americans to save more would shift the supply of loanable funds to the right. As a result, the equilibrium interest rate would fall, and the lower interest rate would stimulate investment. -it increases the equilibrium quantity of loanable funds saved and invested -The tax change would alter the incentive for households to save at any given interest rate, so it would affect the quantity of loanable funds supplied at each interest rate. -Because saving would be taxed less heavily than under current law, households would increase their saving by consuming a smaller fraction of their income. Households would use this additional saving to increase their deposits in banks or to buy more bonds. -With a lower cost of borrowing, households and firms are motivated to borrow more to finance greater investment. -result is lower interest rates and greater investment
banks role as a medium of exchange
-A medium of exchange is an item that people can easily use to engage in transactions, like writing checks against their deposits and accessing those deposits with debit cards
how do banks influence the supply of money?
-If banks hold all deposits in reserves then they do not influence the supply of money because each deposit in the bank reduces currency and raises demand deposits by exactly the same amount, therefore leaving the money supply unchanged. -But when banks hold only a fraction of deposits in reserve, the banking system creates money. For example if they have $100 in liabilities and hold only 10% or $10 of that in reserves then they can loan out $90 in currency. The money supply is currency plus demand deposits so it is now $190 versus $100 that it would've been if they bank didn't loan any out. But, as a bank creates the asset of money, it also creates a corresponding liability for those who borrowed the created money.
the effects of investment incentives on the market for loanable funds
-If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable funds would increase -the demand curve shifts to the right and the equilibrium interest rate rises and the equilibrium quantity of loanable funds saved and invested rises -the tax credit would reward firms that borrow and invest in new capital, and change the demand for loanable funds -the increased demand for loanable funds raises the interest rate and the higher interest rate would stimulate saving and in turn increases the quantity of loanable funds supplied as households respond by increasing the amount they save -a reform of the tax laws encouraged greater investment, the result would be higher interest rates and greater saving.
savers vs. borrowers
-Savers supply their money to the financial system with the expectation that they will get it back with interest at a later date -Borrowers demand money from the financial system with the knowledge that they will be required to pay it back with interest at a later date
what happens after an injection of money?
-The immediate effect is an excess supply of money. People now have more dollars in their wallets than they want. At the current price level, the quantity of money supplied now exceeds the quantity demanded. -Now, people try to get rid of this excess supply of money in various ways. So there is a greater demand for goods and service but no change in the economy's ability to supply goods and services. -The greater demand for goods and services causes the prices of goods and services to increase. The increase in the price level, in turn, increases the quantity of money demanded because people are using more dollars for every transaction. -Eventually, the economy reaches a new equilibrium at which the quantity of money demanded again equals the quantity of money supplied.
supply and demand curve for money
-The supply curve for money is vertical because the quantity of money supplied is fixed by the Fed. -The demand curve for money slopes downward because people want to hold a larger quantity of money when each dollar buys less. -This equilibrium of money supply and money demand determines the value of money and the price level.
factors that might influence a country's exports, imports, and net exports
-The tastes of consumers for domestic and foreign goods -The prices of goods at home and abroad -The exchange rates at which people can use domestic currency to buy foreign currencies -The incomes of consumers at home and abroad -The cost of transporting goods from country to country -Government policies toward international trade
NCO and the demand for loanable funds
-When NCO > 0, the country is experiencing a net outflow of capital; the net purchase of capital overseas adds to the demand for domestically generated loanable funds -When NCO < 0, the country is experiencing a net inflow of capital; the capital resources coming from abroad reduce the demand for domestically generated loanable funds
relationship between nations saving and investment in an open economy
-When a nation's saving exceeds its domestic investment, its net capital outflow is positive, indicating that the nation is using some of its saving to buy assets abroad. -When a nation's domestic investment exceeds its saving, its net capital outflow is negative, indicating that foreigners are financing some of this investment by purchasing domestic assets.
The Effects of a Government Budget Deficit
-When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national saving. -The supply of loanable funds decreases, and the equilibrium interest rate rises. -When the government borrows to finance its budget deficit, it crowds out households and firms that otherwise would borrow to finance investment. -the supply curve shifts to the left, the equilibrium interest rate rises, and the equilibrium quantity of loanable funds saved and invested falls -When the government reduces national saving by running a budget deficit, the interest rate rises and investment falls -investment is important for long-run economic growth, government budget deficits reduce the economy's growth rate
the effects of a government budget deficit
-a budget deficit impacts national saving so it reduces the supply of loanable funds (curve shifts to the left) -The interest rate rises to balance the supply and demand for loanable funds so it crowds out domestic investment -the higher interest rate reduces net capital outflow. -Reduced net capital outflow, in turn, reduces the supply of dollars in the market for foreign-currency exchange causes supply to shift to the left -This fall in the supply of dollars causes the real exchange rate to appreciate (increase) -The appreciation of the exchange rate pushes the trade balance toward deficit
the effects of a government surplus
-a budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment -Higher investment, in turn, means greater capital accumulation and more rapid economic growth.
bond
-a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond also known as an IOU -The buyer of a bond gives his money to Intel to purchase something new in exchange for this promise of interest and eventual repayment of the amount borrowed
depreciation
-a decrease in the value of a currency as measured by the amount of foreign currency it can buy, weaken bc it can buy less foreign currency
purchasing-power parity
-a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries -As a result, countries with relatively high inflation should have depreciating currencies (currency is losing value), and countries with relatively low inflation should have appreciating currencies (gaining value) both circumstances leave the real exchange rate unchanged
trade surplus (nx and nco)
-an excess of exports over imports, net exports are positive, country sells more goods and services abroad than it buys from other countries -When a nation is running a trade surplus (NX > 0), it is selling more goods and services to foreigners than it is buying from them. What is it doing with the foreign currency it receives from the net sale of goods and services abroad? It must be using it to buy foreign assets. Capital is flowing out of the country (NCO > 0). -exports> imports -net exports>0 -Y> C+I+G -saving > investment -net capital outflow > 0
trade deficit (flow of goods and capital)
-an excess of imports over exports, net exports are negative, country sells fewer goods and services abroad than it buys from other countries -When a nation is running a trade deficit (NX < 0), it is buying more goods and services from foreigners than it is selling to them. How is it financing the net purchase of these goods and services in world markets? It must be selling assets abroad. Capital is flowing into the country (NCO < 0). -exports< imports -net exports<0 -Y< C+I+G -saving < investment -net capital outflow < 0
what happens to the supply and demand curve when the Fed increases the supply of money
-an increase in the money supply makes dollars more plentiful, the result is an increase in the price level that makes each dollar less valuable -supply curve shifts to the right, value of money decreases, price level increases
appreciation
-an increase in the value of a currency as measured by the amount of foreign currency it can buy, strengthen because it can buy more foreign currency
three ways in which bonds affect prices and interest rates
-bond's term—the length of time until the bond matures. The interest rate on a bond depends, in part, on its term. Long-term bonds are riskier than short-term bonds because holders of long-term bonds have to wait longer for repayment of principal. To compensate for this risk, long-term bonds usually pay higher interest rates than short-term bonds. -credit risk—the probability that the borrower will fail to pay some of the interest or principal also known as a default. When bond buyers perceive that the probability of default is high, they demand a higher interest rate as compensation for this risk -tax treatment—the way the tax laws treat the interest earned on the bond. The interest on most bonds is taxable income, the owner has to pay a portion of the interest he earns in income taxes. But owners of municipal bonds (state and local govts) are not required to pay federal income tax on the interest income. Because of this, they typically pay a lower interest rate than bonds issued by corporations or the federal government.
foreign direct investment vs foreign portfolio investment
-both increase NCO -mcdonalds setting up a restaurant in Russia vs. American buying stock in Russian company
how does the Federal Reserve influence the money supply? and how is it hard
-by influencing the quantity of reserves. 1. open market operations: can increase the money supply by buying bonds from the public which increases currency and then each new dollar deposited in a bank increases the money supply by more than a dollar because it increases reserves and, therefore, the amount of money that the banking system can create. The Fed can also reduce the money supply by selling government bonds to the public which the public pays for with its holdings of currency and bank deposits, reducing the amount of money in circulation. In addition, as people make withdrawals from banks to buy these bonds, so the banks find themselves with a smaller quantity of reserves. In response, banks reduce the amount of money they are lending, and therefore reverses the process of money creation. 2. lending reserves to banks: Fed can increase the money supply by increasing borrowing. Banks often borrow from the Fed and pay an interest rate on that loan called the discount rate. When the Fed makes loans then the banking system has more reserves so they can generate more money. To alter the money supply the Fed can change the discount rate. A higher discount rate discourages banks from borrowing reserves from the Fed. Thus, an increase in the discount rate reduces the quantity of reserves in the banking system, therefore reducing the money supply. But, a lower discount rate encourages banks to borrow from the Fed, increasing the quantity of reserves and the money supply. -influencing the reserve ratio and therefore the money multiplier 1. altering reserve requirements: Increasing reserve requirements means that banks must hold more reserves and, therefore, can loan out less. As a result, an increase in reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply. Conversely, a decrease in reserve requirements lowers the reserve ratio, raises the money multiplier, and increases the money supply. This is hard bc it is very disruptive to banks and banks often hold excess reserves. 2. Paying interest on reserves: The Fed can decide to pay interest on the amount of reserves the bank holds. When a bank holds reserves on deposit at the Fed, the Fed now pays the bank interest on those deposits. The higher the interest rate on reserves, the more reserves banks will choose to hold. Thus, an increase in the interest rate on reserves will tend to increase the reserve ratio, lower the money multiplier, and lower the money supply. its hard bc the fed cant control how much households deposit and how much banks lend out
how are money supply and money demand brought into equilibrium in the long run
-by the overall level of prices -If the price level is above the equilibrium level, people will want to hold more money than the Fed has created, so the price level must fall to balance supply and demand. -If the price level is below the equilibrium level, people will want to hold less money than the Fed has created, and the price level must rise to balance supply and demand. -At the equilibrium price level, the quantity of money that people want to hold exactly balances the quantity of money supplied by the Fed.
how are the prices at which shares are traded determined
-by the supply of and demand for the stock in these companies -the demand for a stock (and thus its price) reflects people's perception of the corporation's future profitability -When people become optimistic about a company's future, they raise their demand for its stock and thereby bid up the price of a share of stock. And when a company's prospects decline, the price of a share falls.
market for foreign-currency exchange (supply and demand)
-coordinates people who want to exchange the domestic currency for the currency of other countries -determined by the real exchange rate -the supply of dollars to be exchanged into foreign currency comes from net capital outflow. Because net capital outflow does not depend on the real exchange rate, the supply curve is vertical. -The demand for dollars comes from net exports. Because a lower real exchange rate stimulates net exports (and thus increases the quantity of dollars demanded to pay for these net exports), the demand curve slopes downward. -At the equilibrium real exchange rate, the number of dollars people supply to buy foreign assets exactly balances the number of dollars people demand to buy net exports.
how is deflation potentially worse than inflation?
-deflation is rarely as steady and predictable -redistribution of wealth toward creditors and away from debtors. debtors are often poorer, so these redistributions in wealth are particularly painful. -falling prices result when some event, such as a monetary contraction, reduces the overall demand for goods and services in the economy. This fall in aggregate demand can lead to falling incomes and rising unemployment.
interest rate for loanable funds and equilibrium
-interest rate is the price of a loan: the amount that borrowers pay for loans and the amount that lenders receive on their saving. -high interest rate makes borrowing more expensive, the quantity of loanable funds demanded falls as the interest rate rises -high interest rate makes saving more attractive, the quantity of loanable funds supplied rises as the interest rate rises -the demand curve for loanable funds slopes downward, and the supply curve for loanable funds slopes upward. -A shortage of loanable funds would encourage lenders to raise the interest rate they charge. A higher interest rate would encourage saving (thereby increasing the quantity of loanable funds supplied) and discourage borrowing for investment (thereby decreasing the quantity of loanable funds demanded). -Conversely, if the interest rate were higher than the equilibrium level, the quantity of loanable funds supplied would exceed the quantity of loanable funds demanded. As lenders compete for the scarce borrowers, interest rates would be driven down
the effects of an import quota
-iq: a limit on the quantity of a good produced abroad that can be sold domestically -When the U.S. government imposes a quota on the import of Japanese cars, nothing happens in the market for loanable funds or to net capital outflow. -The only effect is a rise in net exports for any given real exchange rate -As a result, the demand for dollars in the market for foreign-currency exchange rises, as shown by the shift right. -This increase in the demand for dollars causes the value of the dollar to appreciate -This appreciation of the dollar tends to reduce net exports bc us goods are more expensive compared to foreign goods, offsetting the direct effect of the import quota on the trade balance -In the end, an import quota reduces both imports and exports, but net exports (exports minus imports) are unchanged
the effects of capital flight
-people will move their capital to safer places resulting in an increase in net capital outflow. -the rightward shift in demand for loanable funds drives up the real interest rate -because net capital outflow is higher for any interest rate, that curve also shifts to the right -in the market for foreign-currency exchange, the supply of currency shifts to the right -This increase in the supply of currency causes it to depreciate so it becomes less valuable compared to other currencies -the depreciation of the currency makes exports cheaper and imports more expensive which pushes the trade balance toward surplus -the increase in the interest rate reduces domestic investment, slowing capital accumulation and economic growth. -in the country where more people invest, there is a fall in net capital outflow. currency appreciates in value and U.S. interest rates fall.
difference between bonds and stocks (riskiness)
-shares of stock are part owners of the company while the owner of a company bond is a creditor of the corporation -If the company is profitable then the stockholders enjoy the benefits of these profits, whereas the bondholders get only the interest on their bonds -if the company runs into financial difficulty then the bondholders are paid what they are due before stockholders receive anything at all -Compared to bonds, stocks offer the holder both higher risk and potentially higher return.
market for loanable funds in an open economy
-supply of loanable funds comes from national saving (S) -demand for loanable funds comes from domestic investment (I) and net capital outflow (NCO) -quantity of loanable funds supplied and the quantity of loanable funds demanded depend on the real interest rate
supply and demand for loanable funds
-supply of loanable funds: people who have some extra income they want to save and lend out, saving is the source of the supply of loanable funds (national saving: private and public) -demand for loanable funds: households and firms who wish to borrow to make investments. Investment is the source of the demand for loanable funds.
banks and their purpose for borrowing and saving
-take in deposits from people who want to save and use these deposits to make loans to people who want to borrow -Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. The difference between these rates of interest covers the banks' costs and returns some profit to the owners of the banks.
money multiplier
-the amount of money the banking system generates with each dollar of reserves -reciprocal of the reserve ratio, 1/R -if the reserve ratio is 1/20 (5%) then each dollar of reserves generates $20 of money, if it was 1/4 (25%) then it would be $4 so therefore the higher the reserve ratio, the less of each deposit banks loan out, and the smaller the money multiplier.
Federal Reserve
-the central bank of the US, run by its board of governors, which has seven members appointed by the president and confirmed by the Senate, have 14-year terms to give them independence from short-term political pressures -they regulate banks and ensure the health of the banking system, and control the quantity of money
liquidity and which is the most liquid
-the ease with which an asset can be converted into the economy's medium of exchange -money is the economy's medium of exchange, so it is the most liquid asset available. -Most stocks and bonds can be sold easily with small cost, so they are relatively liquid assets. -selling a house requires more time and effort, so it is less liquid
open market operation (what it does to the money supply)
-the fed's primary tool -the purchase and sale of U.S. government bonds -to increase the money supply, the Fed creates dollars and uses them to buy government bonds from the public in the nation's bond markets. The dollars from these sales are now in the hands of the public, therefore increasing the money supply. -to decrease the money supply, the Fed sells government bonds from its portfolio to the public. The dollars the Fed receives for the bonds are out of the hands of the public, therefore reducing the money supply.
financial system
-the group of institutions in the economy that help to match one person's saving with another person's investment -moves the economy's scarce resources from savers (people who spend less than they earn) to borrowers (people who spend more than they earn)
federal funds rate
-the interest rate at which banks make overnight loans to one another, set by supply and demand in the market for loans among banks -The Fed can use open-market operations to influence the market. For example, when the Fed buys bonds in open-market operations, it injects reserves into the banking system. With more reserves in the system, fewer banks find themselves in need of borrowing reserves to meet reserve requirements. The fall in demand for borrowing reserves decreases the price of such borrowing, which is the federal funds rate. Conversely, when the Fed sells bonds and withdraws reserves from the banking system, more banks find themselves short of reserves, and they bid up the price of borrowing reserves. Thus, open-market purchases lower the federal funds rate, and open-market sales raise the federal funds rate.
what does the purchasing power parity say about exchange rates?
-the nominal exchange rate between the currencies of two countries must reflect the price levels in those countries -if the purchasing power of the dollar is always the same at home and abroad, then the real exchange rate—the relative price of domestic and foreign goods—cannot change.
Fisher effect
-the one-for-one adjustment of the nominal interest rate to the expected inflation rate -when the Fed increases the rate of money growth, the long-run result is both a higher inflation rate and a higher nominal interest rate
net capital outflow and factors that influence it
-the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners -positive, domestic residents are buying more foreign assets than foreigners are buying domestic assets, capital flowing out -negative, domestic residents are buying less foreign assets than foreigners are buying domestic assets, capital flowing in -real interest rates paid on foreign assets vs domestic assets, economic and political risks of holding assets abroad, and govt policies that affect foreign ownership of domestic assets
real exchange rate
-the rate at which a person can trade the goods and services of one country for the goods and services of another -for example, if Swiss cheese is twice as expensive as a pound of American cheese, then the real exchange rate is ½ pound of Swiss cheese per pound of American cheese - (nominal exchange rate x domestic price index)/ foreign price index -This real exchange rate measures the price of a basket of goods and services available domestically relative to a basket of goods and services available abroad. -A depreciation in the U.S. real exchange rate means that U.S. goods have become cheaper relative to foreign goods: encourages consumers both at home and abroad to buy more U.S. goods and fewer goods from other countries. As a result, U.S. exports rise and U.S. imports fall; both of these changes raise U.S. net exports. -an appreciation (rise) in the U.S. real exchange rate means that U.S. goods have become more expensive compared to foreign goods, so U.S. net exports fall.
velocity of money and how to calculate it
-the rate at which money changes hands, relatively stable -To calculate the velocity of money, we divide the nominal value of output (nominal GDP) by the quantity of money. If P is the price level (the GDP deflator), Y the quantity of output (real GDP), and M the quantity of money, then V= (P x Y)/M
shoeleather costs
-the resources wasted when inflation encourages people to reduce their money holdings -people go to bank more often when high inflation so that they can keep more of their wealth in their interest-bearing savings account and less in their wallet, where inflation erodes its value.
inflation tax
-the revenue the government raises by creating money -When the government prints money, the price level rises, and the dollars in your wallet become less valuable. Thus, the inflation tax is like a tax on everyone who holds money. -if relied on heavily it will result in hyperinflation
How the market for loanable funds and real exchange rate relate in an open economy
-the supply and demand for loanable funds determine the real interest rate which then determines net capital outflow, which provides the supply of dollars in the market for foreign-currency exchange -then the supply and demand for dollars in the market for foreign-currency exchange determine the real exchange rate.
classical dichotomy and how is it helpful
-the theoretical separation of nominal and real variables, helpful to show differences -monetary changes have significant effects on nominal variables (such as the price level) but only negligible effects on real variables (such as real GDP)
balance sheet
-when assets (how much money the bank has) and liabilities (how much money the bank owes) exactly balance -right side of this balance sheet are the bank's liabilities and capital (also called owners' equity) -left side of the balance sheet shows the bank's assets
how does inflation raise the tax burden on income earned from savings?
1. Tax treatment of capital gains: Inflation exaggerates the size of capital gains and inadvertently increases the tax burden on this type of income. 2. Tax treatment of interest income: The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. Because the after-tax real interest rate provides the incentive to save, saving is much less attractive in the economy with inflation than in the economy with stable prices where the after tax real interest rate is higher.
A civil war abroad causes foreign investors to seek a safe haven for their funds in the United States, leading to ________U.S. interest rates and a ________ U.S. dollar. a. higher, weaker b. higher, stronger c. lower, weaker d. lower, stronger
D. lower, stronger When foreign investors increase the amount of U.S. assets they purchase, this decreases capital outflow, which, in turn, decreases the quantity of loanable funds demanded and leads to lower U.S. interest rates. As foreigners demand more U.S. assets, they also must demand more dollars to buy those assets, which causes the dollar to appreciate (grow stronger).
equity finance
The sale of stock to raise money
how does saving and investment contribute to long-run economic growth
When a country saves a large portion of its GDP, more resources are available for investment in capital, and higher capital raises a country's productivity and living standard.
costs and inconvenience because of inflation
When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account.
what effect does the real exchange rate have on the quantity of dollars demanded in the real exchange rate market?
an appreciation of the real exchange rate reduces the quantity of dollars demanded in the market for foreign-currency exchange bc U.S. goods become more expensive relative to foreign goods, making U.S. goods less attractive to consumers both at home and abroad, which also causes net exports to fall
closed economy
an economy that does not interact with other economies in the world
open economy
an economy that interacts freely with other economies around the world
budget surplus
an excess of tax revenue over government spending, T exceeds G which represents public saving
central bank
an institution designed to oversee the banking system and regulate the quantity of money in the economy
medium of exchange
an item that buyers give to sellers when they want to purchase goods and services
