econ final
Reserve Requirements
% of checking deposits that must be kept in the reserve
tax multiplier
(-b+d)/(1-b+d)= (-MPC+MPIM)/(1-MPC+MPIM) ∆Y=[(-b+d)/(1-b+d)]∆T tax multiplier is less than zero as long as b>d or the MPC is greater than MPIM. as long as households consume more domestic goods than foreign goods out of an increase in income, the tax multiplier will be negative. An increase in taxes will lead to a multiplied increase in real GDP
Keynesian Monetary Policy Transmission mechanism
(M↑ → i↓ → I↑ → AD↑ → P↑ → Y↑) If the Federal Reserve increases the money supply by purchasing government bonds in the secondary market, the quantity of bank reserves will increase. As banks begin to lend out these reserves, money supply will increase. The increase in money supply in the Keynesian model is an increase in real GDP via the Keynesian monetary policy transmission mechanism which proceeds as follows:
functions of money
1. a medium of exchange 2. a unit of account 3. a store of value 4. a standard of deferred payment
models of aggregate supply
1. classical aggregate supply curve 2. fixed-price Keynesian aggregate supply curve 3. ordinary upward-sloping aggregate supply curve 4. neo-Keynesian aggregate supply curve 5. neo-classical aggregate supply curve
spending multiplier
1/(1-b+d) = 1/(1-MPC+MPIM) ∆Y= [1/(1-b+d)]∆AEo occurs because one person's spending becomes another person's income (when someone receives income MPS is saved portion, and they will spend the rest) increase in autonomous aggregate expenditures leads to a multiplied increase in real GDP. Multiplier here is smaller than in the simple model where imports are fixed.
Product market-AS/AD graph
AS is upward sloping AD is downward sloping P is y axis Y is x axis
store of value
Allows accumulation of wealth Money is durable
standard of deferred payment
Allows debts to be expressed + repaid Money is fungible (mutually interchangeable)
unit of account
Allows measurement + comparison of value Allows for accounting of revenues, costs + profits Reduces the number of relative prices that must be considered Money is standardized
determinants of AD: C, I, G, X-M
Consumption (consumer income, wealth, expectations, demographics, personal taxes, interest rates) investment (interest rates, cost of capital, business confidence, capacity utilization, business taxes, regulations, technology) government (fiscal policy, monetary policy, social policy, wars, natural disasters) net exports (income, foreigners' income, foreign prices, exchange rates, protectionism)
supply-side economics
During the Reagan Administration of 1981 to 1989, many of Reagan's economic advisors favored the idea of supply-side economics, which was also known as Reagonimics. The idea was that government could influence the supply side of the economy through income tax cuts. and deregulation to help stimulate the economy. It was believed that income tax cuts would increase labor supply by increasing after-tax wages. Deregulation could help to spur investment and employment by reducing costs to businesses. These increases in the aggregate supply curve would help to increase real GDP while inflation was brought under control at the same time. The Tea Party Republicans that came to power in the elections of 2008, 2010 and 2012 represent more recent adherents to the ideas of supply-side economics. Their drives to cut the deficit through spending cuts and to eliminate the Affordable Care Act display a faith in the free market that only supply-side economists can love.
Federal Reserve System Structure
Federal Reserve Act of 1913: created a reserve bank to provide a pool of reserve funds for member banks → Board of Governors: 7 members with staggered, 14-year terms, to provide political insulation → Federal Open Market Committee : 7 governors, NY FED president, 4 other rotating Presidents → 12 regional Federal Reserve Banks (To avoid concentration of economic + political power) → 1900 (book says 2,800) Member commercial banks
I,G,X,M
I = investment spending G = government spending X = exports M = imports AE = C + I + G + (X - M)
M2
Includes more assets than M1 (includes M1 + personal savings) = small denomination time deposits (<$100,000) (certificate of deposits) + savings deposits+ money market deposit accounts + non-institutional money market mutual fund shares
Laffer curve and Reagean
Laffer believed that t* was small but he was wrong. When Reagan reduced income tax rates in the 1980s tax revenue did not increase. Instead, we ended up with the largest budget deficits that the federal government had ever known up to that time. The US national debt tripled during the years of the Reagan Administration. The tax cuts led to reductions in tax revenue, not the increases predicted by the Laffer curve.
Laffer curve
Laffer theorized that there must be a relationship between tax revenue and tax rates such that for some ranges, cuts in tax rates would increase tax revenue as work effort increased. this increase in tax revenue from increased income would more than compensate for the decrease in tax revenue from lower tax rates. Laffer believed that at income tax rates of 0% and 100% the government would not earn any tax revenue. Between those rates, tax revenue would first rise but eventually fall as the higher tax rates discouraged work effort. A Laffer curve shows that as income tax rates (t) increase, tax revenue (T) first rises and then falls. At 0% tax rates there is no tax revenue because there are no taxes. AT 100% tax rates there is no tax revenue because no one is willing to work. In between these two extremes lies an optimal tax rate t* that will maximize the tax revenue for the government.
simplified M1 M2 M3
M1 = cash and checks M2 = M1 + personal savings M3 = M2 + institutional savings
MPC
MPC = marginal propensity to consume - slope of the consumption function, it tells us the change in consumption that results from a $1.00 change in disposable income. Since MPC is positive, it means that the consumption function slopes upwards. An increase in income causes an increase in consumption spending. MPC has to be less than one in this model for the economy to have equilibrium. when income increases by a dollar, some of that dollar is spent and some of it is saved. The portion consumed is the MPC. b = MPC = ∆C/∆Yd MPC is slope of the consumption function. 0 < b < 1
MPS
MPS = marginal propensity to save MPS = 1-b = the slope of the saving function MPS tells us how much saving increases when disposable income increases by a dollar. (1-b) = MPS = ∆S/∆Yd 0 < MPS < 1 MPC + MPS = 1 Whatever is not consumed out of a dollar increase in income will be saved
equation of exchange
MV = PY M = money supply, V = velocity, P = price level, Y = real GDP, PY = nominal GDP. If velocity and real GDP are constant, any change in money supply will lead to a proportionate change in the price level. The amount of purchases that spenders are willing to make depend on the quantity of money in circulation P = MV/Y where V is constant. This provides the relationship between price level and the amount of real GDP that spenders want to purchase. This equation is the demand curve for the classical model. The rectangles under the demand curve always have the same area (PY = MV). If money supply increases the rectangles will get larger and the aggregate demand curve will shift to the right. The AD curve shows that as price level falls, the amount of desired spending in the economy increases.
medium of exchange
Money reduces the transaction costs of exchange Money acts as a lubricant Money avoids the necessity of bartering Bartering requires a mutual coincidence of wants Money is liquid
money market graph
Money supply is vertical and Money demand is downward sloping. Y axis is i and x axis is money supply (M)
Janet Yellen
She was the Chair of the Board of Governors of the Federal Reserve System
FOMC
The FOMC is made up of the seven members of the Board of Governors, the New York Fed president, and 4 other Federal Reserve Bank presidents who rotate each year.
Keynesian equilibrium
Y = AE output is equal to spending in extended model with imports and taxes: AE = (Co + bYd) + I + G + (X-(Mo+dYd)) AE = AEo + (b-d)Yd AE = AEo + (b-d)(Y-T) AE = AAEo + (b-d)Y - (b-d)T AE = AEo - (b-d)T +(b-d)Y Y = AE so Y = AEo - (b-d)T +(b-d)Y Y - (bed)Y = AEo-(b-d)T Y(1-b+d)=AEo-(b-d)T Y* = [1/(1-b+d)]AEo+[(-b+d)/(1-b+d)T] ∆Y= [1/(1-b+d)]∆AEo+[(-b+d)/(1-b+d)]∆T
Keynesian cross diagram
Y = AE is the 45 degree-line Plot AE on the same graph They "cross" at the Keynesian equilibrium when AE > Y, spending is greater than output so inventories decrease and outputs increase when Y > AE, spending is less than output so inventories increase and outputs decrease Y* = (1/1-b)*AEo
disposable income
Yd = Y -T
money neutrality
a change in money supply has no effect on real variables, only nominal variables. changes in AD which are caused by changes in the money supply, only affect the price level but have no effect on real GDP since the aggregate supply curve is vertical.
aggregate supply
a model that shows the quantity of output that firms and workers are willing and able to produce at different price level. to derive the AS curve we assume market clearing and no money illusion
aggregate demand
a model that shows the quantity of real GDP that spenders in the economy are willing and able to purchase at different price levels. in classical model, depends on money supply
consumption function
a model that shows the relationship between consumption spending and disposable income in the economy C = consumption spending Y = GDP, measured as either output or income Co = autonomous consumption spending, the level of subsistence consumption spending when income = 0 b = the marginal propensity to consume (MPC); must be less than one for the economy to have equilibrium T = taxes Yd = disposable income, Yd = Y-T C = Co + bYd
saving function
a model that shows the relationship between saving and disposable income in the economy since Yd = C + S S = Yd - C = Yd - (Co + bYd) S = Yd - Co - bYd S = -Co + (1-b)Yd saving in the economy is equal to a fixed amount of dissaving -Co plus a variable amount of saving that increases with income (1-b)Yd.
crowding out effect
an increase in government spending will lead to an increase in real interest rates, causing investment and consumption to decline
determinants of AD
any variable that causes a change in aggregate expenditures (except for a change in the price level) will also cause a change in aggregate demand, as changes in price level lead to movements along a given aggregate demand curve
ordinary upward sloping AS
as the price level increases, the quantity of desired output that firms and workers are willing and able to produce will also increase
import function
assume imports depend on income M = Mo + dYd M is imports, Mo is autonomous import spending (the amount of import spending when disposable income is equal to zero), d is MPIM, Y is disposable income d = MPIM = marginal propensity to import (the change in import spending resulting from a one dollar increase in the economy) MPIM must be less than one for economy to have equilibrium MPIM = ∆M/∆Yd
history of money
barter --> commodity money --> coins --> fiat money --> checks --> electronic money
M3
broadest measure of money supply, includes most assets M3 = M2 + large denomination time deposits (>$100,000) + institutional money market mutual funds + repurchase agreements + term Eurodollars
informal powers
carrot side- invite bankers to fancy luncheons (provide better treatment to those who hold high levels of excess reserves, or may want to discourage use of discount loans) sticks- if bak does not hold excess reserves or uses discount window too often, Fed has ability to punish bank through more frequent examinations or more stringent regulations
changes in money demand
caused by changes in real income, changes in price level and changes in household preferences for holding money
determinants of aggregate supply
changes in the price level leads to movements along a given AS curve, or a change in the quantity of aggregate supply.
automatic stabilizers
consist of government policies and programs that reduce the volatility of the business cycle by moderating fluctuations in income. Examples include progressive income taxes, unemployment insurance, welfare programs, agricultural price support,s and the stability of government spending
monetary policy
consists of changes in the money supply and interest rates to influence some macroeconomic variable. AN increase in the money supply will lead to lower interest rates, which will increase investment spending and thus cause an increase in aggregate demand. Changes in the money supply that are meant to increase aggregate demand are known as expansionary monetary policy. An increase in money supply will aead to an increase in aggregate demand, ceteris paribus.
labor market
consists of demand and supply. labor demand is the quantity of labor that firms in the economy want to hire at different wage rates in order to maximize their profits. labor supply is the quantity of labor that households in the economy want to provide to firms to maximize their happiness. the classical model assumes that the labor market always clears, so that real wages are flexible enough to bring the labor market to equilibrium. since the model assumes no money illusion, real wages are the relevant variable for labor demand and supply decisions
MPIM
d = MPIM = marginal propensity to import MPIM is the change in import spending resulting from a one dollar increase in income in the economy MPIM must be less than one to have equilibrium in the economy MPIM = ∆M/∆Yd
increase in AS caused by
decrease in resource prices increase in technology increase in business confidence increase in quantity of resources increase in capacity utilization increase in value of the dollar decrease in business taxes or regulations
money demand
demand for money depends on three factors. Households hold money due to the transactions motive (for planned purchases), the precautionary motive (for unplanned purchases), and the speculative motive (for investment purposes). The first two depend on the price level and real income, while the latter depends on nominal interest rates. we focus on the speculative demand for money.
why AS is upward sloping
due to profit motive. Along a given AS curve resource prices, such as nominal wages and interest rates, are being held constant. As the price level increases, producers in the economy will earn more revenue for each unit of output. If revenue per unit is increasing but the cost per unit is remaining the same, then firms in the economy will earn a higher profit per unit of output and the quantity of output produced will increase. An increase in the price level will lead to an increase in desired output, so the AS curve is upward sloping. Profit motive (P↑,profit per unit↑, units produced↑, Y↑)
fiat money
evolved over time to further reduce the transaction cost of exchange. it is an asset that is acceptable because the government says it is, or by government fiat. Most paper currencies are true fiat money, having no other intrinsic value. "this note is legal tender for all debts, public and private"
quantity theory of money
if velocity and real GDP are constant we have the quantity theory of money. MV=PY where V and Y are constant. Any change in the money supply will lead to a proportionate change in price level. If price level doubles, money supply will double.
spending multiplier
in equilibrium GDP Y* = (1/1-b)AEo where 1/1-b is the spending multiplier and AEo is autonomous aggregate expenditures
neo-Classical AS curve
in this model there are two distinct AS curves, one for the short run and one for the long run. In the short run wages are fixed and workers in the economy suffer form money illusion so that they are unaware of price changes in the economy. in the long run the economy is similar to the classical model in that wages are flexible and there is no money illusion. In the long run wages have enough time to adjust to changes in contracts and workers have enough time to learn about price changes in the economy. In the long run the AS curve is vertical, similar to the classical model. In the short run the AS curve is upward-sloping similar to the ordinary model
paradox of thrift
in this model, an increase in saving will reduce GDP since an increase in saving means a reduction in consumption spending. With a reduction in consumption spending, the economy will see a multiplied decline in real GDP Keynesian cross: increase in saving --> decrease in consumption spending --> decrease in AE function --> decline in real GDP Leakages/injections diagram: increase in saving from So to S1 causes the leakages function to shift upward. At the old equilibrium leakages (S+T+M;income received by households not spend on current domestic output) are greater than injections (I+G+X;spending by other sectors of the economy besides households) so income falls until a new equilibrium is reached. Increase in savings has led to decline in real gDP in fixed-priced Keynesian model.
causes of increase in AD
increase in consumer income, increase in household wealth, increase in expectations of future prices, increase in expectations of future income, increase in the number of young or old people, increase in income equality, decrease in interest rates, increase in business confidence, decrease in cost of capital, increase in capacity utilization, decrease in business taxes, decrease in business regulations, increase in government spending, decrease in personal taxes, increase in money supply, increase in spending on social programs, increase in spending on wars or natural disasters, increase in foreigners' income, increase in foreign prices, decrease in value of the dollar, decrease in protectionism
interest rate effect
interest rate effect( P↓, money demand↓, i↓,I↑, AE↑,Y↑) The interest rate effect describes that a decrease in the price level leads to a decrease in money demand, which leads to a decrease in interest rate, which then leads to an increase in investment spending as the cost of borrowing decreases, which therefore leads to an increase in AE and a multiplied increase in the equilibrium level of GDP.
International trade (net export) effect
international trade effect(P↓, domestic prices↓, X↑, AE↑, Y↑) , the international trade effect says that a decline in price level means that domestic prices decrease which leads to increased exports, increased AE and a multiplied increase in the equilibrium level of GDP.
fiscal policy
is a change in government spending or taxes meant to influence some macroeconomic variable such as real GDP growth, the unemployment rate, or inflation
aggregate supply
is a model that shows the amount of desired output that firms and workers in the economy are willing and able to produce at different price points
aggregate demand
is a model that shows the amount of desired spending that consumers, investors, governments and the foreign sector are willing and able to purchase at different price levels in the economy. The aggregate demand curve is downward-sloping; a decrease in the price level will lead to an increase in desired spending as purchasers in the economy can afford to buy more goods and services
production function
is a model that shows the relationship between quantity of labor employed in the economy and the amount of real GDP produced. As labor increases, real GDP increases. But t because of the law of diminishing returns, real GDP increases at a decreasing rate. Along a given production function we assume that capital and technology are held constant. A change in capital or technology will lead to shifts in the production function. L = quantity of labor (# of workers, or labor hours/year) K = quantity of capital (units of tools, machines, factories) Y = read GDP (annual output measured in base year prices) P = price level (CPI or GDP price deflator) wage = nominal wage rate (earnings per hour measured in current dollars) W = real wage rate (purchasing power of nominal wage rate)
term auction facilities
is a temporary program managed by the United States Federal Reserve designed to "address elevated pressures in short-term funding markets" Access to 28 and 84 day funding were given to deposit-taking institutions and the program was open to all banks with access to the primary discount window. The last TAF auction was held March 8, 2010.
commodity money
is an asset that has an intrinsic value apart from its use as money. It is a commodity that has another use. eg cocoa beans in Aztecs, almonds in India, cattle in Europe (origin of capital and chattel), salt in Roman Empire China and North Africa (origin of salary)
capacity utilization
is the amount of factory capacity in the economy that is currently being utilized, or how much factory space and time is being used up compared to the maximum that could be used. For example, i the economy could produce 200 billion pounds of output in a year, and if it produces 160 billion pounds instead, then capacity utilization is 80%. Capacity utilization determines whether or not firms need to build new factories. If capacity utilization is low, so that there is excess capacity, then current factories are not being used to their full potential, so there is not much sense in building new factories if there is still a lot of space in the old factories. As capacity utilization increases, current factories begin to get used up, so it is more likely that firms will ned to build new factories. An increase in capacity utilization will lead to an increase in investment spending and an increase in AD, ceteris paribus.
inflationary gap
is the decrease in aggregate expenditures necessary to return the economy to full employment when actual real GDP is more than potential GDP
GDP gap
is the difference between potential real GDP and actual real GDP
Gresham's law
is the idea that bad money drives out good money if two coins are circulating at the same time, one of high quality and one of low quality, then people will spend the low quality coins and hoard the high quality coins examples in the US include silver quarters (those minted before 1964) and Delaware quarters.
recessionary gap
is the increase in aggregate expenditures required to bring the economy to full employment when actual real GDP is less than potential real GDP
M1
is the most liquid = currency and coins + checking account deposits (demand deposits) + travelers' checks + other checkable deposits (which includes share draft accounts at credit unions and Negotiable Order of Withdrawal accounts at commercial banks)
federal funds rate
is the rate that banks charge each other for loans from their Federal Reserve Accounts. The FOMC sets a target for the Federal Funds rate, and the NY Fed then conducts open market operations in an effort to maintain the Federal Funds rate at target level.
discount rate
is the rate that the Fed charges for discount loans to member banks from its discount window
national debt
is the sum of all funds that the government owes to all of its creditors that has not yet been paid off. The national debt is cumulative. When the nation runs a budget deficit in a given year, that amount is added to the national debt. over the course of the year, the national debt increases as the government borrows money to fund a deficit during that year or declines as debt from previous deficits is paid off.
classical model:
it is assumed markets always clear. In the labor market, real wages are flexible enough so that the market is always in equilibrium. If the quantity of labor demanded is always equal to the quantity of labor supplied, then there is no involuntary unemployment.
investment function
model that shows the relationship between interest rates and investment spending in the economy. As interest rates decline, investment spending increases as the opportunity costs of the funds used for capital purchases becomes less. It is therefore downward sloping. y axis is i and x axis is I
equilibrium in the ordinary AS/AD model
occurs at the intersection of the AS and AD curves. At that price level, the quantity of desired spending is just equal to the quantity of desired output. Spenders in the economy are are purchasing just the quantity of output that firms and workers want to produce. In the classical model the price level was variable so prices and spending adjusted to the fixed amount of output produced in the economy. In the fixed-price Keynesian model the price level was fixed so output adjusted to spending in the economy. In the ordinary AS/AD model both prices and output adjust to bring the economy to a new equilibrium. If the price level is too high, overproduction results. Firms reduce the price level. If the price level is too low, overconsumption results. Consumers increase the price level.
complete crowding out
occurs when an increase in government spending is exactly offset by declines in private spending, so that the aggregate demand curve remains unchanged
discretionary fiscal policy
occurs when the government decides to change government spending or taxes through changes in legislation or regulation to influence the macroeconomy. IT requires action by the government.
tools of monetary policy
open market operations discount lending reserve requirements informal powers
real income (wealth) effect
real income effect(P↓,real income↑,C↑,AE↑,Y↑) The real income effect describes that a decrease in price level increases the purchasing power of nominal income, so real income increases. Higher real income leads to households increasing consumption spending which increases AE and therefore leads to a multiplied increase in the equilibrium level of real GDP.
why AD is downward sloping
real income effect(P↓,real income↑,C↑,AE↑,Y↑) interest rate effect( P↓, money demand↓, i↓,I↑, AE↑,Y↑) international trade effect(P↓, domestic prices↓, X↑, AE↑, Y↑)
determinants of AS continued
resource prices, technology, business confidence, quantity of resources, capacity utilization, value of the dollar, business taxes and regulations
paradox thrift: comparing classical and keynesian saving
short term is best explained by keynesian (increase in saving leads to decrease in GDP) long run is best explained by classical model loanable funds markets ( increased saving means real interest rates decline and investment spending increases and with greater investment more capital is formed and the economy has potential for greater rates of growth in the future)
monetarist model
still uses the quantity theory but relaxes the assumptions that velocity and real GDP are constant. if velocity is stable the na stable rate of growth in real GDP can be achieved through a stable rate of growth in the money supply. If the money supply increases too quickly then inflation will result, if the money supply grows too slowly then recession may result. Unlike the classical model it relaxes the assumption that real GDP is fixed and it assumes velocity is stable enough that it can be treated as constant. The money supply times a stable velocity is equal to nominal GDP (PY).
say's law
supply creates its own demand. in the process of production, enough income is generated to purchase the output produced. If not prices will adjust
money supply
supply of money is fixed by the central bank and is independent of interest rates. The money supply curve is vertical
relationship between tax and spending multiplier
tax multiplier = 1 - spending multiplier
progressive tax system
the average income tax rates increase as income increases, so that high income people pay a higher percentage of their income in taxes than do low income people
regressive tax system
the average tax rate declines as income increases so that the poor pay a higher percentage of their income in taxes than do the rich
proportional tax system
the average tax rate is constant as income increases. all income classes pay the same percentage of their income in taxes
budget deficit
the difference between government spending and tax revenue for a given year. when the government has a budget deficit, it is spending more than it is earning in tax revenue that year (G-T)
tools of monetary policy summary
the fed can increase money supply through open market purchases, lowering the discount rate, providing liquidity through other lending facilities, reducing reserve requirements or using its informal powers
classical dichotomy
the idea that real variables can be separated from nominal variables in the classical model
market for loanable funds
the market where funds are lent and borrowed r = real interest rates investment (I) = demand for loanable funds saving (S) = supply of loanable funds - real interest rates (r) adjust in the loanable funds market so saving = investment - connects lenders and borrowes
open market operations
the process of having the FED either buy bonds from banks for sell bonds to banks FED uses open market operations to set a target for the federal funds rate → rate that banks charge each other for loans from their father reserve accounts
aggregate expenditures
the sum of all the spending in the economy by different sectors such as households, firs, governments and the foreign sector. Household spending = consumption (C) spending by firms = investment spending (I) government spending is by the government (G) spending by foreign sector is net export spending (X - M) AE = C + I + G + (X - M)
Keynesian Model of monetary policy
velocity and real GDP are not constant or stable, especially in the short run. The demand for money plays a greater role in determining real GDP than suggested by the classical model. Also the classical model ignores the effects of interest rates and investment in determining the level of real GDP
keynesian model
wages may be sticky, involuntary unemployment may result. If wages cannot fall to their equilibrium, a surplus in the labor market or involuntary unemployment, may result.
twin deficits
when the economy has both budget deficits and trade deficits
discount rate (lending facilities)
→ rate that FED charges for loans (discount loans are loans that he Fed makes directly member commercial banks from the discount window lending facility) to member banks
