FNCE 101
Expected real after-tax interest rate
(1 - tax rate on interest income)nominal interest rate - expected inflation
GDP Deflator equation
(Nominal GDP / Real GDP) x 100
What is the output gap formula
(Y-Y*)/Y* -> actual output - potential output / potential output
User cost of capital (uc) equation
(real interest rate + depreciation rate)real price of capital
Who does the Federal Open Market Committee (FOMC) consist of
- 7 governors - President of New York Fed - Four of the presidents of regional Feds
Discount window lending/borrowing
- Banks can borrow from the Fed at the discount rate - Set to be higher than Fed funds target rate Banks that are unable to borrow from other banks in the fed funds market may borrow directly from the central bank's discount window paying the federal discount rate.
Social Security benefits
- Benefits are based on AIME (averaged indexed monthly earnings) -- Average over the best 35 years of indexed taxable earnings -- Indexation based on average wage growth - Retirees receive monthly PIA (primary insurance amount) -- 90% of first $1k of AIME, 32% of $ between 1k-6k, 15% of AIME above $6k -- Average replacement rate is around 40% of AIME - Retirement age affects benefits -- For each year below 67, benefits go down by 8% -- For each year after 67 (until 70), benefits increase by 8%
Paper - Evidence on Income Effect (Cesarini, Lindqvist, Notowidigdo, and Ostling 2017)
- Cesarini et al. studied lottery participants in Sweden - Sweden has price-linked savings (PLS) accounts (rather than paying interest, pries randomly awarded) Data: amounts won + earnings in subsequent years Focus on income effect: real wage does not change - Finding: lottery price of $100k/yr -> $11k/yr lower earnings
What affects the saving rate of a household?
- Changes in their income (current or future income) - Changes in their wealth - Changes in the real interest rate - Changes in taxes (present or future taxes)
Why would lenders lend to subprime borrowers
- Charge higher interest rate from sub-prime borrowers - As long as house prices increase, not likely to default (can always sell) - Foreclosure: if borrower defaults, lenders can sell the house
M1 monetary aggregate
- Currency - Demand deposits - Other liquid deposits
What is considered liabilities for the federal reserve bank
- Currency held by public - Vault cash held by banks - Reserve deposits
What is considered liabilities for banks
- Deposits held by non-bank public
What can violate Ricardian Equivalence
- Difference between interest rate paid by government vs household - When future taxes increase - Financing method can be redistributive - Rational forward-looking
Interest rate on reserves (IOR)
- Fed pays interest rate on required reserve balances and excess reserve - But not all financial institutions in the fed funds market have access to IOR
What were the Fed's actions during COVID
- Fed reduced reserve requirements ratio: 10% -> 0% -> Eliminate incentive to hold reserves in order to satisfy regulatory requirement - Fed reduced discount window lending rate: 2.25% -> 0.25% -> Banks sometimes reluctant to borrow from discount window due to stigma -> To counter stigma, biggest banks agreed to borrow from the discount window - Fed reduced interest rate on reserves: 1.6% -> 0.1%
Paper - Evidence on Substitution Effect (Fehr and Goette 2019)
- Fehr and Goette studied bicycle messengers in Zurich - Experiment: divided messengers into two groups (Group A had higher fee per shipment in first month and Group B had higher fee per shipment in second month) - Labor supply margin: days and hours - Focus on sub effect: income effect identical in 2 groups - Finding: wage increase of 1% -> 1.2% more hours worked
What are the benefits of supplying labor
- Higher income -> higher consumption - Work can offer a measure of autonomy and discretion - Achieve a level of mastery or expertise
Non-monetary assets
- Include stocks, bonds, housing, businesses, cars, etc. - Pay interest rate i = r + pi^e - Supply is fixed at NM
Monetary assets
- Includes M1 + M2 (currency + deposit and savings accounts) - Pays close to 0 interest rate I^m - Supply is fixed at M, chosen by the central bank of the country
Adjustable-rate mortgages
- Interest rate changes with the short-term interest rate in the economy - Low initial interest rate that would increase after a few years
What are the costs of supplying labor
- Less time for other activities (leisure time) - Physically/mentally demanding
Paper - Identification Strategy (Pioneered by Kuttner 2001)
- Looking for: change in FFR orthogonal to economic conditions - Idea: futures market for FFR -- Recover market expectation for FFR at the end of the month -- Study difference before and after FOMC press release -- When economic conditions are bad -> market expects FFR to decline -- The difference leaves just the monetary policy surprise RESULTS The effect of Fed Funds rate on: - Stock prices. (Bernanke and Kuttner (2005) and Gurkaynak, Sack, and Swanson (2005) -> 25bp cut in FFR -> 1% increase in stock prices - Real interest rates. Nakamura and Steinsson (2020) -> 25bp cut in FFR ->. 25bp cut in 2-year real interest rates -> 25bp cut in FFR -> 5bp cut in 5-year real interest rates -> 25bp cut in FFR -> 0bp cut in 10-year real interest rates
How does the Fed affect FFR when reserves are "limited"
- Lowering M -> lower supply of money -> raise the FFR
M2 monetary aggregate
- M1 - Retail money market funds - Small denomination time deposits
What are limits to Ricardian Equivalence
- Myopia: some consumers do not think far ahead - Borrowing constraints: some consumers can't borrow enough to achieve their optimal consumption they have to spend tax cuts - Future generations may expect the burden of repaying tax cuts in the future
What are the two types of returns the treasury promises
- Nominal returns (most common) - Real returns -> Treasury Inflation-Protected Securities (TIPS)
Paper - 2016 Demonetization of India (Chodorow-Reich, Gopinath, Mishra, and Narayanan 2020)
- Nov 8, 2016: India unexpectedly declared 86% of existing currency in circulation is illegal -- Individuals can still deposit them Challenge: separate policy effect for contemporaneous factors Solution: printing press constraints varied across locations -- Compare regions without new notes with regions with new notes
Paper - Evidence on Substitution Effect (Oettinger 2019)
- Oettinger studied vendors in a baseball stadium - Vendors are approved to sell at all games (free to work or not work at any particular game and receive fixed commission rates on sales) - Labor supply margin: number of work days - Larger crowds -> higher wage per hour (due to quality of opponent and day of the week) - Finding: wage increase of 1% -> 0.5% more vendors
Open-market operations
- Open-market purchase: buy U.S. treasuries -> increase M - Open-market sale: sell U.S. treasuries -> reduce M
Defined Benefits (DB)
- Pension plan specifies the level of benefits - Contributions can adjust to meet required level of benefits Pro - benefits are not risky
Defined Contributions (DC)
- Pension plan specifies the level of contributions - Benefits depend on level of contributions and returns on contributions Pros - easier to implement, contributions are not perceived as tax
Reserve requirements
- Requirement for banks to keep minimum reserve-deposit ratio - For a long time, reserve requirement was equal to 10% of deposits - March 15th 2020: reduced to 0%
What causes prices to change (4)
- Rise in nominal costs -> higher wages -> higher prices (more money in circulation -> value of money declines, prices rise) - Household beliefs -> Political instability = if people believe currency is worthless it can become worthless, prices go up = inflation -> Belief deflation is coming = if people want to hold on their cash prices can fall - Technological innovation -> reduction in production cost s-> lower prices
What is considered assets for the federal reserve bank
- Securities - Gold
What happened in September 2008
- Sep 7 -> Fannie Mae and Freddie Mac placed into government conservatorship - Sep 15 -> Lehman Brothers filed for bankruptcy - Sep 17 -> Fed lent $85 billion to giant insurance company AIG -> these events ensued a full scale financial panic
Social Security Funding
- Social security is financed by payroll taxes -- 12.4% of earrings (up to $160k annual earnings in 2023) -- Split equally between employee and employer (6.2% each) - Difference between taxes received and benefits delivered paid from the Social Security Trust Fund -- When taxes > benefits -> add money to fund -- When taxes < benefits -> withdraw money from fund -- Invested entirely in U.S. treasury securities Current estimates: Social Security Trust Fund will run out in 2033
What is the objective of quantitative easing
- Stimulating demand by lowering yield on risky and long-term assets - Expanding private bank lending by easing financial conditions
Federal Reserve Act (1913)
- System of 12 regional Federal Reserve Banks - Leadership -> Federal Reserve Board -- Seven governors appointed by the president -- President appoints one to be the chairman--Four of the presidents of regional Feds(rotating)
What two tools do modern governments use to finance their expenditures
- Taxes (income taxes, corporate taxes, tariffs, etc.) - Issue debt (in the form of bills/notes/bonds)
What is considered assets for banks
- Vault cash - Reserve deposits - Loans extended to non-bank public
Cobb-Douglas Function
- share of income that goes to labor = 70% - share of income that goes to capital = 30% If capital and labor grow by 100%, also output grows by 100%
What is the hierarchy of the discount window, interest rate on reserves, federal funds rate, and (1-most expensive..)
1) discount window : interest paid on reserves 2) FFR 3) ARRP
What three groups affect the money supply
1. Central banks 2. Banks (depository institutions) 3. Public (households and firms, excluding banks)
Key asset characteristics for portfolio allocation decision
1. Expected return 2. Risk 3. Liquidity 4. Time to maturity
Retirement Income in the US
1. Government provided retirement benefits (US Social Security): - For 2/3 of retirees -> SS more than 50% of income - 1/3 of elderly households - SS close to 100% of their income 2. Home ownership: - 75% of US elderly are homeowners 3. Employer pensions: - 40-45% of elderly households have employer pensions 4. Supplementary individual elective pensions: - IRAs (Individual Retirement Arrangements) 5. Non-tax-favored instruments
Why should the government intervene
1. Information/self-control problems: individuals would not save adequately for retirement not here own 2. Market failure: adverse selection in annuitization markets 3. Redistribution: both within and across generations - Within generation -> redistribute based on life-time earnings - Across generations -> retirement programs can redistribute across cohorts
Limitations of market value
1. Misses nonmarket items such as home production, the value of environmental quality, depletion of natural resource 2. There is some adjustment to reflect the underground economy 3. Government services (not sold in markets) valued at their production cost
What does the portfolio of wealth holders consist of
1. Stocks, bonds, and mutual funds 2. Housing 3. Retirement accounts 4.Businesses 5. Money
Bretton Woods Agreement
1930s: Great Depression -> people trade their money for gold - 1931 -> UK abandons the gold standard - 1933 -> US abandons the gold standard Bretton Woods Agreement (1944) - US dollar pegged to gold - Several currencies pegged to the US dollar - Establish the International Monetary Fund 1971 - President Nixon terminates dollar convertibility to gold - US dollar becomes a fiat currency
Gross Investment
= Net investment + depreciation = (capital stock at time t + 1 - capital stock at time t)real price of capital + (capital depreciation rate x capital stock at time t x real price of capital)
Okun's rule of thumb
A 1 pp increase in (cyclical) unemployment (u - ū) is associated with a 2 pp decline in real GDP relative to its full employment potential
What variables are given and change for labor market
A = productivity K = capital stock
How does a decrease in A (productivity) or K affect the labor demand curve
A/K decreases -> MPN decreases -> labor demanded decreases
How does an increase in A (productivity) or K affect the labor demand curve
A/K increases -> MPN increases -> labor demanded increases
How often does the FOMC meet
About 8x a year but can meet more frequently depending on the state of the economy (decisions announced immediately after meetings)
How is the Board of Governors of the Federal Reserve system appointed?
All members of the Board of Governors, including the Chairman, are appointed by the President
What does capital and labor being homogenous mean
All types of capital goods affect production in the same way, all types of labor affect production in the same way
Limitation of benchmark labor market model
All workers who want to work for market wage can do so -> no unemployment in equilibrium
What is the formula for BASE
BASE = CU + RES
Reading -> The Allocation of Talent (Hsieh, Hurst, Jones, and Klenow) 2019
Back in 1960: 94% of doctors and lawyers were white men - Idea: large pool of talented women and black men not able to pursue their comparative advantage in 1960's - Result: declining discrimination explains - 30% of growth in GDP per capita between 1960-2010 Assumptions - Innate characteristics do not change across cohorts - Misallocation declining over time Forms of misallocation: - Labor market discrimination - Barriers to forming human capital - Social norms
What happens when the reserve-deposit ratio is less than one
Bank cannot meet obligations if many depositors attempt to withdraw their deposits
Bretton Woods Agreement
COME BACK
Differences between GDP deflator and CPI
CPI measures the price index of products in C GDP deflator takes in account products in G and I GDP deflator does not account for changing prices of imports GDP deflator accounts for changing prices of exports
Consumption goes on what price index
CPI or PCE price index
Ms / BASE equation
CU + DEP / CU + RES = cu + 1 / cu + res
cu equation
CU / DEP
Who determines money supply M
Central bank
The 4 spending categories
Consumption (C) Investment (I) Government purchases of goods and services (G) Net Exports (NX)
What kind of policy is Open Market Operations (OMO) considered
Conventional monetary policy
Rate of return of corporate stock vs money
Corporate stock: dividend yield + % increase in price Money: 0%
Risk of corporate stock vs money
Corporate stock: dividend yield + % increase in price Money: only inflation risk, promised nominal interest rate
What is the liquidity of corporate stock vs money
Corporate stock: more liquid than car or house Money: most liquid
What happens when G rises and current taxes increase
Current income decreases and Consumption demanded decreases
What happens when current taxes increase but G stays the same
Current income decreases and Consumption demanded decreases
What are the 2 types of pension plans
Defined Contributions and Defined Benefits
Risk premium
Difference in expected return between risky and safe assets
Labor force
Employed + Unemployed
Employment ratio
Employed / population 16+
Who sets an interest rate target
Federal Open Market Committee (FOMC)
Ricardian Equivalence
For a given pattern of government spending, the method of financing that spending doesn't affect households' consumption decision Consumption and spending are not affected by a change in taxes because consumers will foresee a future offsetting increase or decrease in taxes. (any increase in government expenditure that increases the budget deficit would lead to a corresponding decrease in consumption expenditure)
Tobin's q (long version)
For the benefits of capital, compute market value: V / K = stock market value of firm / capital stock For the cost of capital, use price of capital: pk If V / K > pk, firm should invest. If V / K < pk, firms should divest.
Marginal propensity to consume (MPC)
Fraction of additional current income which is consumed in the current period, between 0 and 1 - larger for low-income households change in consumption / change in income
What happens when G rises and future taxes increase
Future income decreases and Consumption demand decreases
What happens when future taxes decrease but G stays the same
Future income increases and Consumption demanded increases
If G is unchanged in all periods, what happens to future taxes
Future taxes will decline
Newly produced
GDP counts only things produced in a given period - Excludes goods produced in previous years but re-sold
Newly produced
GDP counts only things produced in a given period and excludes goods produced in previous years but re-sold (if an app was used to sell, the value of the service is new and counted in GDP)
GDP goes on what price index
GDP deflator
What are the (2) agencies that securitize mortgages
Government sponsored enterprises: Fannie Mae and Freddie Mac Private institutions -> private-label mortgage securities
Fiat money
Government-issued currency that isn't backed by a commodity. Can be used for paying taxes or debt.
Substitution effect of saving when real interest rate increases
Higher real interest rate raises benefits of saving -> more saving (at the aggregate, substitution effect dominates)
What is the income effect of labor supply's response to an increase in the real wage
Higher real wage -> more wealth -> leisure affordable -> lower labor supply
What is the substitution effect of labor supply's response to an increase in the real wage
Higher real wage raises benefits of working -> higher labor supply
Consumption-smoothing motive
Households will consume some, save some -> individuals strive to have a relatively even pattern of consumption over time
What variables are affected (graph)
I = Investment S = Savings C = Consumption
Income effect of saving when real interest rate increases
If saver, increases wealth -> reduces saving If borrower, reduces wealth -> increases saving
Saving Formula
Income - Consumption
What are the 4 effects of wealth increase
Income effect reduces labor supplied given real wage -> Lower labor raises its marginal productivity -> Firm willing to pay higher wage -> Labor supply meets demand at new wage rate
What should happen to nominal interest rate if inflation rate above target (2%)
Increase (cool economy)
What happens to CONSUMPTION AND SAVINGS when current income increases, expected future income increases, wealth increases, government purchases increases, taxes increases (with and without RE)
Increase Current income = C increases, S increases Increase expected future income = C increases, S decreases Increase wealth = C increases, S decreases Increase government purchases = C decreases, S decreases Increase taxes (RE holds) = C same, S same Increase taxes (RE doesn't hold) = C decreases, S decreases
How do modern governments finance expenditure
Increase current revenues by raising current taxes Issue sovereign bonds: borrow from the public + raise future taxes
Effects of changes in productivity (increase in current and future productivity)
Increase in current (but not future) productivity -> labor demand and the real wage increase = saving curve shifts right (current income increases) = investment curve doesn't change because MPKf is unchanged = real interest rate decreases = equilibrium S, C, and I increase Increase in future productivity -> current labor demand and real wage stays the same = saving curve shifts left (expected future income increases) = investment curve shifts right because MPKf increases = real interest rate increases = ambiguous effect on S, C, and I
Effect of change in income (current and expected income increase)
Increase in current income = Consumption increases, saving increases Increase in expected future income, Consumption increases, saving decreases
Effect of change in taxes
Increase in current taxes -> when Ricardian equivalence holds = no change to consumption or saving BECAUSE tax increase will decrease personal saving but will increase government saving = overall effect on saving is 0 -> when Ricardian equivalence doesn't hold (treated as a decrease in expected future income) = consumption decreases, saving increases
Effect of change in government purchases
Increase in government purchases (treated as a decrease in current income) = reduces after-tax income because current and/or future taxes will increase = Consumption decreases, saving decreases
Effect of interest rate, effective rate, and expected future MPK on investment
Increase in real interest rate = uc increases, desired investment decreases Increase in effective tax rate = tax-adjusted uc increases, desired investment decreases Increase in expected future MPK = desired capital stock increases, desired investment increases
Effect of change in the real interest rate
Increase in the real interest rate - Substitution effect: Consumption decreases, saving increases - Income effect: -> Lenders (+ net savings) = Consumption increases, saving decreases -> Borrowers (- net savings) = Consumption decreases, saving increases (For borrowers, substitution and income effects go in the same direction For lenders, they go in opposite directions)
Effect of change in wealth
Increase in wealth = Consumption increases, saving decreases
Effects on saving curve (increase Y - current output , increase expected Y - future output, increase wealth, increase G, increase taxes (when RE holds and doesn't hold)
Increased current output (Y) = right Increased expected future output = left Increased wealth = left Increased government purchases (G) = left Increased taxes (RE holds) = none Increased taxes (RE does not hold) = right
Effects on investment curve (increase in effective tax rate and expected MPKf)
Increased effective tax rate = left Increased expected MPKf = right
What happened in 2005
Interest rates rising -> house price growth slows down
What risk do investors want
Investors prefer to minimize risk
What kind of liquidity do investors want
Investors value higher liquidity
What time to maturity do investors prefer
Investors value lower time to maturity (less risk)
What rate of return do investors want
Investors want the highest return
Participation rate
Labor force / population 16+
Overnight Reverse Repurchase Agreements (ON RRP)
Like interest paid on reserves but available to all financial institutions
Similarity between cryptocurrency and commodity money
Limited supply (government can't print indefinitely)
What should happen to nominal interest rate if employment is below FE (y < 0)
Lower (stimulate economy)
What is the impact of lower interest rate overall
Lower interest rate = cost of borrowing is lower = people spend and invest more -> aggregate demand and GDP increases, cyclical unemployment decreases
What are the definitions of variables in Money Multiplier equation (M, CU, DEP, RES, BASE, res, cu)
M - money supply CU - currency held by non-bank public DEP - total deposits held by non-bank public RES - total bank reserves (reserve deposits + value cash) BASE - monetary base res - desired reserve-deposit ratio - the percentage of a commercial bank's deposits that it must keep in cash as a reserve, RES/DEP cu - desired currency-deposit ratio - the amount of currency that people hold as a proportion of aggregate deposits, CU/DEP
What is the formula for Ms (with BASE)
M = BASE (cu + 1 / cu + res)
What happens to nominal interest rate (i) and real interest rate (r) when M increases
M increases -> i decreases -> r decreases
Firm's desired capital stock
MPKf = uc / 1-t
What equations do you equate to find optimal labor
MPN = w
Real money demand function
Md / P = L(Y, r + pi^e)
Quantity theory of money equation
Md / P = kY V = 1 / k
Money demand function
Md = P x L(Y,i)
How does increase in expected inflation rate affect money demand
Md decreases
How does increase in nominal interest rate affect money demand
Md decreases
How does increase in real interest rate on alt. assets affect money demand
Md decreases
How does increased risk of money affect money demand
Md decreases
How does increase in real income/output (Y) affect money demand
Md increases
How does price level (P) increasing affect money demand
Md increases
Expenditure approach
Measures total spending on final goods and services produced within nation during a specified period
The functions of money
Medium of exchange, unit of account, store of value
Does minimum wage shift labor demand or labor supply curves and if so, which one
Minimum wage doesn't not shift labor demand or supply curves
Medium of exchange
Money allows people to trade their labor for money and then use the money to buy goods and services they desire (less time and effort)
What time to maturity does money have
Money has zero-time to maturity
Unit of account
Money is the basic unit of measuring economic value
How does the money supply grow usually
Money supply grows more than the growth in monetary base - Commercial banks extend more loans to public
How does the money supply grow in a liquidity trap
Money supply growth about equal to growth in monetary base - Despite the infection of money, banks don't extend more loans to the public
What happened in 2006-08
More defaults on subprime mortgages - Banks tighten their lending standards -> further decline in house prices - Many mortgages "underwater": amount owed > house price - Agents holding mortgage-backed securities suffered large losses
What is the formula for Money Multiplier
Ms / BASE = CU + DEP / CU + RES = cu + 1 / cu + res
What happens to P when Ms, Y, r, and expected inflation rate increase
Ms increases = P increases Y increases = P decreases r increases = P increases expected inflation rate increases = P increases
What variables are affected (graph)
N = labor Y = production
How does efficiency of payment technologies affect money demand
Negative relationship, people can operate with less money = money demand is lowered
How does risk (alt. assets) affect money demand
Negative relationship, risk makes alt. assets less attractive, raising money demand
Can the Fed reduce structural/frictional unemployment and if so, how
No
Similarity between cryptocurrency and fiat money
No intrinsic value
Does an increase in the Fed funds rate raise GDP
No. Fed lowers rate in recessions to stimulate the economy
What does the Federal Open Market Committee use to achieve the targeted fed funds rate
Open Market Operations (OMO)
Money demand function as P
P = Ms / L(Y, r + pi^e)
Neutrality of monetary policy
P goes up proportionally to how much the central bank increases M to
How does wealth affect money demand
Positive relationship, more wealth = more demand for money
Hawkish policy
Prevents excessive inflation -> interest rate increases combat inflation and maintain price stability, often at the expense of slower economic growth or higher unemployment in the short term
What is the P equation (asset market equilibrium)
Price level adjusts to reach equilibrium: P = M / L(Y, r + pi^e)
What are the key macroeconomic variables that affect money demand
Price level, real income, interest rate
What are the 3 alternative approaches to measure economic activity
Product, Expenditure, and Income Approach
res equation
RES / DEP
Difference between nominal and real GDP
Real GDP is nominal GDP adjusted for inflation. Real GDP is used to measure the actual growth of production without any distorting effects from inflation.
Paper - Do the rich save more? (Dynan, Skinner,a nd Zeldes 2004)
Richer households save more
Value of output
Sales + inventory changes (revenue)
Goods market equilibrium
Saving = Investment Y = Cd + Id + G
What happens to saving demand if households are rational
Saving demand doesn't depend on financing method -> Sd = Y - G - Cd
Interest rate for savings, debt, and credit card
Savings = 0-2% Mortgage debt = 5-6% Credit card debt = 15-25%
When the goods market is in equilibrium
Sd = Id
National Saving Formula
Sd = Y - G - Cd -> Income - Government purchases/spending - Consumption
Mortgage-backed securities
Security which is backed by a collection of mortgages (eliminates idiosyncratic risk -> Law of Large Numbers)
Does labor sourly increase by more if wage increase is permanent or temporary
Temporary
Who is in charge of monetary policy
The Fed (also responsible fo regulating securities markets and banking system)
Future marginal product of capital (MPKf)
The increase in production due to an additional unit of capital - with revenue taxes t: benefit is (1-t)MPKf
The money multiplier is greater than 1 when res < or > 1 and what is this called
The money multiplier is greater than 1 when res < 1 = fractional reserve banking
Phillips Curve
The negative empirical relationship between unemployment and inflation
Natural rate of unemployment
The rate of unemployment when there is no cyclical unemployment. That is, when the only individuals unemployed are due to structural or frictional unemployment
Why are individual mortgages risky
There's a possibility that an individual repays and a probability that the individual defaults
Which government expenditures are not purchases of goods and services
Transfers: Social Security payments, welfare, and unemployment benefits Interest payments on government debt
How does monetary policy find other ways to stimulate demand and investment in a liquidity trap
Unconventional ways to stimulate demand - Lower long-term riskless yield - Lower short-term risky yields
Unemployment rate
Unemployed / labor force
Store of value
Used to save purchasing power over time
Tobin's q (short version)**
V / Kpk = stock market firm value / amount of capital owned x price of new capital goods If Tobin's q > 1, firm should invest (cost of acquiring capital < value of capital) If Tobin's q < 1: divest
Value added
Value of output - cost of intermediate outputs
Real wage (w) formula
W / P
What do you add together for income approach (National Income)
Wages + Rent + Interest + Profit (+ taxes)
Important qualities for money as a medium of exchange
Widely accepted, divisible, easy to carry, not deteriorate quickly
Aggregate production function
Y = AF (K,N) Y = aggregate production A = productivity (effectiveness of use of K and N) K = capital stock N = labor
Closed Economy
Y = C + G + I
Income expenditure identity
Y = C + G + I + NX
What variables are given and change for the goods market
Y = production Yf = future production Af = future productivity G = government purchases Wealth
Real Income (Y)
Y increases -> Cd increases -> Money demand increases
Does real GDP = nominal GDP in the base year
Yes
Is inventory investment (change in inventories) treated as a final good
Yes (if increases then increases GDP, if decreases then decreases GDP)
Can the Fed reduce cyclical unemployment and if so, how
Yes through lower interest rate
Can the Fed change the amount of money and how
Yes, open market operations
Key characteristics of money (return, liquidity, risk)
Zero return - 0% nominal return Most liquid Relatively low risk - 0% nominal return guaranteed
Inflation equation (using CPI)
[(Current CPI - Past CPI) / Past CPI] x 100
Quantitative Easing
a monetary policy action where a central bank purchases predetermined amounts of government bonds or other financial assets in order to stimulate economic activity (purchase long-term U.S. securities and risky assets - mortgage-backed securities)
Forward Guidance
a tool that central banks use to provide communication to the public about the likely future course of monetary policy
What is the national income accounts
accounting framework used in measuring economic activity
Income Approach
adds up income generated by production
Market value
allows summing up different items by valuing them at market price
Product approach
amount of output produced (excluding intermediate inputs)
Time to maturity
amount of time until a financial security matures, and investor is repaid
Underwater mortgage
amount owed > house price. the outstanding balance of a mortgage loan > current market value of the property securing the loan
Why is real GDP a better measure of economic growth than nominal GDP
an increase in nominal GDP may show an increase in prices rather than an increase in output
Money
anything that is generally accepted in payment for goods or services, or in the repayments of debt
Firm equates... (to find the desired level of capital)
benefits and costs of investment Benefits: MPKf Costs: user cost of capital
MPK equation
change in Y / change in K
MPN equation
change in Y / change in N
How do changes in real wage affect the labor demand curve
changes along the demand curve
What happens to MPK when you decrease labor (K stays the same)
decreases MPK
What happens to MPK when you increase K
decreases MPK -> diminishing marginal returns
What happens to MPN when you decrease K (N stays the same)
decreases MPN
What happens to MPN when you increase N
decreases MPN -> diminishing marginal returns
Risk
degree of uncertainty in an asset's return
What goes in liabilities of the Fed balance sheet
deposits held by non-bank public
Net Exports
difference between exports and imports
Term premium
difference between long-term bond yield to what expectation theory would suggest (generally, term premium = 0)
Liquidity
ease and quickness with which an asset can be traded
The primary cost of cryptocurrencies
electricity usage
How do you determine labor supply
equate costs and benefits
How do you find the equilibrium level of labor and equilibrium real wage
equate labor supply and labor demand
What is intensive margin and how does it affect labor supply
existing workers work more, labor supply increases
What does the CPI indicate
focus on consumption
What does the Core PCE indicate
focus on consumption and excludes food and energy prices
Who determines r
goods market
Imports
goods produced abroad purchased by the country
Exports
goods produced in the country that are purchased by other countries
Cost of intermediate inputs
goods/services from other companies
Government purchases of goods and services
government spending on goods or services Public investment: highways, airports, bridges, and water and sewer systems
How does increased liquidity of alt. assets affect money demand
higher liquidity makes alt.a assets more attractive = money demand is lowered
Price Level (P)
higher prices -> more $ required to buy same products
Interest rate (i)
higher yield of alternative assets -> money less attractive
Expectation theory of the term structure
holding bonds with different terms to maturity over the same period should yield the same expected return
Velocity of money
how often money stock "turns over" each period
Inflation expectations
i - r nominal return (yield) - real return
Inflation expectations equation
i - r -> nominal return (yield) - real return
What is i and MM in the zero lower bound
i = 0 and MM = 1
Quantity theory of money
if real money demand is proportional to real income, Md / P = kY
Which effect dominates with permanent changes in real wage
income effect > substitution effect
Rate of return
increase in value of an asset per unit of time
What happens to MPK when you decrease K
increases MPK
What happens to MPK when you increase labor (K stays the same)
increases MPK
What happens to MPN when you decrease N
increases MPN
What happens to MPN when you increase K (N stays the same)
increases MPN
Subprime Borrower
individuals who are considered to represent a higher risk to lenders -> more likely to default on their mortgage payments
Cyclical unemployment
individuals who want to work and have necessary skills, but cannot find a job
What is the federal funds rate
interest rate banks charge each other for overnight loans
Unemployment
jobless and actively searching for a job
Who determines Y
labor market
Bank Reserve (RES)
liquid assets held by the bank (reserve deposits + vault cash)
Maximum employment
lowest level of unemployment that the economy can sustain while maintaining a stable inflation rate
Frictional unemployment
matching between workers and firms takes time
What is the Fed's dual mandate
maximum employment and stable prices
Real GDP
measure of GDP which accounts for price changes (allows comparison of overall economic activity)
What does the Bureau of Labor Statistics do (BLS)
measures consumption expenditure, wages, and employment statistics
Structural unemployment
mismatch between workers' skills and firms' requirements
Deflation
negative inflation (prices falling) occurs when the inflation rate falls below 0% (a negative inflation rate)
Growth rate formula
new amount - old amount / old amount
What is extensive margin and how does it affect labor supply
new workers enter labor market, labor supply increases
Velocity equation
nominal GDP / nominal supply -> PY / M
Taylor Rule
nominal interest rate (i) = inflation rate (pi) + 2% + 0.5y + 0.5(pi - 2%)
Final goods and services
not intermediate - if copper is exported its a final good and counted in GDP - if copper is used in production of electronics, it's an intermediate good and not counted - if copper is stored for for next year's production as inventory, it's a final good and counted in GDP
Net Factor Payments from abroad (NFP)
payments to domestically owned factors located abroad - payments to foreign factors located domestically
Effective tax rate
percent of income that an individual/corporation pays in taxes
What does the Bureau of Economic Analysis do (BEA)
prepares the National Income Accounts
Dovish policy
prevents high unemployment and low growth interest rate decreases
User cost of capital (uc)
price of capital services
Zero lower bound
problem that occurs when the short-term nominal interest rate is at or near zero, causing a liquidity trap and limiting the central bank's capacity to stimulate economic growth (i = 0)
Sovereign bond
promise to pay a specified amount over a specific time period
What does the Fed use ti influence long-term interest rates during zero lower bound
quantitative easing and forward guidance
Asset market equilibrium
quantities supplied and demanded in the market are equal for each type of asset (Md = M, NMd = NM)
Demand for money
quantity of monetary assets people want to hold
What is the price for the goods market
r
Fisher equation
real interest rate = nominal interest rate - inflation -> r = i - pi
Relationship between real price of capital goods and depreciation rate
real price of capital goods and depreciation rate have an ambiguous effect on gross investment/investment demand (but an unambiguous effect on desired capital stock) If pk increases, uc increases -> kt + 1 decreases -> I decreases I
What is the price for the labor market
real wage -> w = W / P
How does an increase in wealth affect labor and real wage
real wage increases and labor decreases
What happens to the Money Supply when res or reserve requirements increases, cu increases, there's an open market purchase, discount window borrowing increases, discount rate increases, interest rate paid on reserves increases
res or reserve requirements increases = Decreases cu increases = Decreases open market purchase = Increases discount window borrowing increases = Increases discount rate increases = Decreases interest rate paid on reserves increases = Decreases
What happens to cu + 1 / cu + res when res or reserve requirements increases, cu increases, there's an open market purchase, discount window borrowing increases, discount rate increases, interest rate paid on reserves increases
res or reserve requirements increases = Decreases cu increases = Decreases open market purchase = Unchanged discount window borrowing increases = Unchanged discount rate increases = Unchanged interest rate paid on reserves increases = Decreases
What happens to the BASE when res or reserve requirements increases, cu increases, there's an open market purchase, discount window borrowing increases, discount rate increases, interest rate paid on reserves increases
res or reserve requirements increases = Unchanged cu increases = Unchanged open market purchase = Increases discount window borrowing increases = Increases discount rate increases = Decreases interest rate paid on reserves increases = Unchanged
How does the Fed Reserve reduce M
sell US bonds to public
How do changes in A and K affect the demand curve
shift the demand curve
How does a beneficial supply shock shift the graph
shifts the graph of the production function upward
Liquidity trap
situation in which additional money supplied by the central bank is held by banks or the public, with no decline in interest rates or increase in spending
Bank run
situation in which many clients withdraw their money from the bank, because they believe the bank may cease to function soon
Consumption
spending by domestic households on final goods and services (including those produced abroad) - Consumer durables (ex: cars, TV sets, furniture, major appliances) - Nondurable goods (ex: food, fuel) - Services (ex: education, healthcare, financial services)
Investment
spending on new capital goods (fixed investment) plus inventory Investment = Business Investment + Residual Investment + Inventories Business (or nonresidential) investment: spending by businesses on structures, equipment, and intellectual property products (software, R&D, etc.) Residential fixed investment: spending on the construction of new houses and apartment buildings Inventory investment: increases in firms' inventory holdings
Inventories
stocks of unsold finished goods, goods in process, and raw materials held by firms
Monetary base (aka high-powered money)
the amount of cash circulating in the economy -> CU + RES -> (currency in circulation - vault cash) + (reserve deposits + vault cash)
Aggregate production
the collection of the goods and services produced by millions of firms, which employ millions of workers, who make hundreds of decisions, d daily
Investment curve
the demanded investment for a given real interest rate - downward sloping -> when r increases, investment demand decreases
Marginal product of capital (MPK)
the increase in production that results from a one-int increase in the capital stock
Marginal product of labor (MPN)
the increase in production that results from a one-unit increase in aggregate labor
Fed funds rate
the interest rate at which commercial banks borrow and lend their excess reserves to each other overnight
Full employment output
the level of output that firms supply when wages and prices in the economy have fully adjusted/used efficiently
Gross Domestic Product (GDP)
the market value of newly produced final goods and services within a nation during a fixed period = GNP - NFP
Money multiplier
the maximum amount of new money created by banks for every dollar of reserves
Money multiplier
the ratio between money supply and the monetary base
The trade-off between a person's current consumption and future consumption depends on
the real interest rate
Inflation
the rise in the average price level in an economy over a period of time
Final goods and services
those that are not intermediate - If exported, is a final good, and then counted in GDP - If used in production within the country, it's an intermediate good and not counted - If stored for next year's production as inventory, it's final good and counted in GDP
The fundamental identity of national income accounting
total production = total expenditure = total income
Future marginal product of capital (MPKf) Equation
uc / 1 - t
How does the Fed Reserve increase M
use newly printed money to buy US bonds from public
Commodity money
valuable, easily standardized, and divisible commodities
Gross National Product (GNP)
value of all finished goods and services produced by a country's citizens, both domestically and abroad
What goes in assets of the Fed balance sheet
vault cash, reserve deposits, loans extended to non-bank public
Sum of national income/how to calculate GDP under income approach
wages paid + income/profit + taxes paid + interest paid + change in inventory
Stanford Marshmallow Experiment
wait 15 minutes without eating it -> get another one (r=100%) -> consumption saving decision
Who determines pi^e
we take as given
When are prices considered stable
when consumers and businesses don't have to worry about rising or falling prices when making plans, or when borrowing or lending for long periods
What is y in taylor rule formula
y: output gap -> % difference between actual and full employment output -> (actual - full employment)/full employment
