Macro final unit 3

It's important to note that banks maintain only a small fraction of their assets in bank reserves in reserve against their checking and saving deposits.

Bank reserves: Vault cash plus deposits of banks with Federal reserve banks.

Four Key Markets and the Circular Flow of Income

-First, the resource market (bottom loop) coordinates businesses demanding resources and households supplying them in exchange for income. -second, the loanable funds market (lower center) brings the net saving of households plus the net inflow of foreign capital into balance with the borrowing by businesses and governments. -Third, the foreign exchange market (top right) brings the purchases (imports) from foreigners into balance with sales (exports plus net inflow of capital) to them. -Finally, the goods and services market (top loop) coordinates the demand (consumption, investment, government purchases, and net exports) with the supply of domestically produced goods and services (real GDP).

output is less than long-run potential

-Given the lower than expected price level, many employers will find themselves committed to wages and other resource prices that are extremely high relative to the prices they can get for their products. -Profit margins will be squeezed, causing producers to reduce output and lay off employees. Unemployment will rise above its natural rate, and current output will fall short of the economy's potential GDP. -Recessionary conditions will be present.

Chapter 11: Keynesian economics provided a reasonable explanation for the prolonged depressed conditions of the 1930s.

-Keynes believed that spending motivated firms to supply goods and services. -Keynes rejected the view that lower wages and interest rates would get the economy back on track and eliminate abnormally high rates of unemployment. -Keynes also rejected the potential effectiveness of interest rate cuts to get the economy back on track.

Money as a store of Value

-most people hold some of their wealth in the form of money. -Liquid asset: An asset that can be easily and quickly converted to money without loss of value. Store of value: An asset that will allow people to transfer purchasing power from one period to the next. some disadvantages of using money as a store of value. The value of a unit of money—a dollar, for example—is measured in terms of what it will buy. Its value, therefore, is inversely related to the price level in the economy.

3. Fiscal policy is much less potent than the early keynesian view implied.

Both the crowding-out and new classical models indicate that there are secondary effects of budget deficits that will substantially, if not entirely, offset their impact on aggregate demand. -In the crowding-out model, higher real interest rates and a decline in net exports offset the expansionary effects of budget deficits. - In the new classical model, higher future taxes lead to the same result. --Both models indicate that fiscal policy will have little, if any, effect on current aggregate demand, employment, and real output during normal economic times.

The central message of Keynes

Businesses will produce only the quantity of goods and services they believe consumers, investors, governments, and foreigners will plan to buy. If these planned aggregate expenditures are less than the economy's full-employment output, output will fall short of its potential. Moreover, reductions in spending will often be amplified by the multiplier and tend to feed on themselves. Downturns will breed pessimism among both consumers and investors, which will lead to lower prices for assets such as stocks and houses, causing total spending and output to plummet downward by even larger amounts. When total expenditures (aggregate demand) on goods and services are deficient, market economies do not have an automatic mechanism that will return the economy to full employment. Prolonged unemployment will persist.

output is greater than long-run potential

-when the price level increases more than was anticipated. -In this case, firms will pump out more output to boost their profits. Employment expands and unemployment falls below its natural rate. -An economic boom is present

Summary

An unexpected change in the price level (rate of inflation) will alter the rate of output in the short run. An unexpected increase in the price level will stimulate output and employment during the next year or two An unexpected decrease in the price level will cause output and employment to fall.

Federal Open Market Committee (FOMC)

Federal Open Market Committee (FOMC): A committee of the Federal reserve system that establishes Fed policy with regard to the buying and selling of government securities—the primary mechanism used to control the money supply. it is composed of the seven members of the Board of governors and the twelve district bank presidents of the Fed. -Federal Open Market Committee (FOMC) is a powerful committee that determines the Fed's policy with respect to the purchase and sale of government bonds and other financial assets.

The banking industry in the United States operates under the jurisdiction of the Federal Reserve System, the nation's central bank.

Federal reserve system: the central bank of the United States; it carries out banking regulatory policies and is responsible for the conduct of monetary policy. Central bank: An institution that regulates the banking system and controls the money supply.

In the short run, the goods and services market will gravitate toward a price level that brings quantity demanded and quantity supplied in the economy into balance.

If a price level lower than P were present, the aggregate quantity demanded would exceed the aggregate quantity supplied. Purchasers would want to buy more goods and services than producers would be willing to produce. This excess demand would place upward pressure on prices, causing the price level to rise toward P. --In contrast, at a price level greater than P, the aggregate quantity supplied would exceed the aggregate quantity demanded. Producers would be unable to sell all the goods they produce. This would result in downward pressure (toward P) on prices.

budget deficit: a situation in which total government spending exceeds total government revenue during a specific time period, usually one year.

A budget deficit occurs when total government spending exceeds total government revenue from all sources. When this happens, the government must borrow funds to finance the excess of its spending relative to revenue. It borrows by issuing interest-bearing bonds that become part of what we call the national debt, the total amount of outstanding government bonds.

2. Changes in the real interest rate.

A change in the real interest rate in the loanable funds market will influence the choices of consumers and investors in the goods and services market. -A lower real interest rate makes it cheaper for consumers to buy major appliances, automobiles, and houses now rather than in the future. A fall in the real interest rate makes both consumer and investment goods cheaper, both households and investors will increase their current expenditures in response. In turn, their additional expenditures will increase aggregate demand, shifting the entire AD curve to the right. -A higher real interest rate makes current consumption and investment goods more expensive, which leads to a reduction in aggregate demand, shifting the AD curve to the left.

Shifts in Aggregate Supply

Factors like an increase in the stock of capital or an improvement in technology will expand the economy's potential output and shift the LRAS curve to the right Factors like favorable weather or falling resource prices (say, a temporary drop in the price of a major import like oil) will shift the SRAS curve to the right,

Let's summarize what we've learned: In long-run equilibrium

If long-run equilibrium is present, unemployment will be at its natural rate. Let's summarize what we've learned: In long-run equilibrium, (1) output will be equal to its potential, (2) full employment will be achieved, and (3) the actual rate of unemployment will be equivalent to the natural rate of unemployment. It is this long-run maximum sustainable output that economists are referring to when they speak of "full-employment output" or "potential GDP."

budget surplus: a situation in which total government spending is less than total government revenue during a time period, usually a year.

a budget surplus is present when the government's revenues exceed its total expenditures. The surplus allows the government to reduce its outstanding debt.

the resource market

a highly aggregated market that includes the markets for labor services, natural resources, and physical capital. -In the resource market, business firms demand resources because they need them to produce goods and services. Households supply labor and other resources in exchange for income. The forces of demand and supply determine prices in the resource market. The payments made to households and the suppliers of other resources sum to national income. Some of that income is taxed and used to finance the expenditures of governments.

2. shift from interest-earning checking deposits to money market mutual funds.

a number of banks began to encourage customers to move deposits from interest-earning checking accounts into money market deposit accounts. Each of these accounts provides customers with similar services. However, because interest-earning checking deposits are included in M1 but money market deposits are not, this shift reduced the size of the M1 money supply figures.

The restrictive fiscal policy

a spending reduction and/or an increase in taxes—will shift the government budget toward a surplus (or smaller deficit). Keynesians believe that a shift toward a more restrictive fiscal policy is the proper prescription with which to combat inflation generated by excessive aggregate demand.

Marginal propensity to consume (MPC)

additional current consumption divided by additional current disposable income. MPC =Additional consumption /Additional income

both monetary and fiscal policy

are used to promote business stability, high employment, the growth of output, and a stable price level.

The goods and services market

constitutes the top loop of the circular-flow diagram. In this market, sometimes called the product market, businesses supply goods and services in exchange for sales revenue. -This market counts all items in the economy's GDP.

Monetary policy

encompasses actions that alter the money supply—the amount of cash in our billfolds and deposits in our checking accounts. The direction of monetary policy is determined by a nation's central bank, the Federal Reserve System in the United States.

Chapter 9: Fiscal policy

relates to the government's taxation and spending policies to achieve macroeconomic goals. In the United States, fiscal policy is conducted by Congress and the president.

The Fed has four major tools it can use to control the money supply: (1) the establishment of reserve requirements for banks (2) buying and selling U.S. government securities and other financial assets in the open market (3) the volume of loans extended to banks and other institutions (4) the interest rate it pays banks on funds held as reserves.

reserve requirements: The Federal Reserve System requires banking institutions (including credit unions and savings and loan associations) to maintain reserves against the checking deposits of their customers. The reserves of banking institutions are composed of (1) currency held by the bank (vault cash) and (2) deposits of the bank with the Federal Reserve System. The Fed imposes the reserve level. The Fed's control over reserve requirements, however, is important for another reason. By altering reserve requirements, the Fed can alter the funds banks have available to extend loans and undertake other investments. (If the Fed wanted to increase the supply of money, it would reduce the reserve requirements. The lower reserve requirements would increase the excess reserves of banks, placing them in a position to extend more loans and thereby increase the money supply.) (The higher reserve requirements increase the funds that banks must maintain in reserve against the checking deposits of their customers. In order to meet the higher reserve requirements, many banks will reduce their outstanding loans and investments. As the volume of loans (and other forms of credit) extended by banks declines, so, too, will the money supply.) :Thus, an increase in the reserve requirements will reduce the supply of money.

short-run equilibrium

short-run equilibrium is present in the goods and services market at the price level P, at which the aggregate quantity demanded is equal to the aggregate quantity supplied. This occurs at the output rate Y, where the AD and SRAS curves intersect. At the price level P, the amount that buyers want to purchase is just equal to the quantity that sellers are willing to supply.

The exchange rate

the price of one currency relative to another—brings the purchases from foreigners into balance with the sales to them because rates of exchange are also subject to the laws of supply and demand.

Ricardian equivalence

the view that a tax reduction financed with government debt will exert no effect on current consumption and aggregate demand because people will fully recognize the higher future taxes implied by the additional debt. (Suppose you knew that your taxes were going to be cut by $1,000 this year, but that next year they were going to be increased by $1,000 plus the interest on that figure. Would this year's $1,000 tax cut cause you to increase your consumption spending? New classical economists argue that it would not. They believe that most people would recognize that their wealth is unchanged and would therefore save most of this year's tax cut to be better able to pay next year's higher taxes. Correspondingly, new classical economists argue that when debt is substituted for taxes, people will recognize that the additional debt means higher future taxes and that therefore they will save more in order to pay them.)

Money also serves as a unit of account. -Unit of account: A unit of measurement used by people to post prices and keep track of revenues and costs.

we use units of money—the dollar in the United States—to measure the exchange value and cost of goods, services, assets, and resources. Money serves as a common denominator for the expression of both costs and benefits.

Changes in long-run aggregate supply

(1) resource base, (2) level of technology, and (3) institutional arrangements that affect its productivity and the efficient use of its resources. Changes in any of these three determinants of output will cause the LRAS curve to shift. -Productivity: The average output produced per worker during a specific time period. it is usually measured in terms of output per hour worked.

Saving

--The portion of after-tax income that is not spent on consumption. saving is a "flow" concept. -net saving of the household sector supplies funds to the loanable funds market. The demand for funds arises from businesses to finance investment projects and from government to finance budget deficits.

3. Changes in the expectations of businesses and households about the future direction of the economy. An increase in the consumer sentiment index indicates that consumers are more optimistic about the future. A decline indicates increased consumer pessimism.

-An expanding economy will mean strong sales and improved profit margins. Similarly, consumers are more likely to buy big-ticket items, such as automobiles and houses, when they expect an expanding economy to provide them with both job security and rising income in the future. -When investors and consumers expect an economic downturn (a recession), they will cut back on their current spending to avoid overextending themselves. This pessimism leads to a decline in aggregate demand, shifting the AD curve to the left.

The most common broad definition of the money supply is M2. It includes all the items included in M1 plus (1) savings deposits, (2) time deposits of less than $100,000 at all depository institutions, and (3) money market mutual funds.

-M2 (money supply): equal to M1 plus (1) savings deposits, (2) time deposits (accounts of less than $100,000) held in depository institutions, and (3) money market mutual fund shares. -Depository institutions: Businesses that accept checking and savings deposits and use a portion of them to extend loans and make investments. Banks, savings and loan associations, and credit unions are examples. Gwartney, James D.; Stroup, Richard L.; Sobel, Russell S.; Macpherson, David A. (2014-02-03). Economics: Private and Public Choice (Page 253). South-Western College Pub. Kindle Edition. --For example, if you maintain funds in a savings account, you can easily transfer the funds to your checking account. Money market mutual funds are interest-earning accounts offered by banks and brokerage firms that pool depositors' funds and invest them in highly liquid short-term securities.

In the United States, the banking system consists of savings and loan institutions, credit unions, and commercial banks.

-Savings and loan associations Financial institutions that accept deposits in exchange for shares that pay dividends. historically, these funds were channeled into residential mortgage loans, but today they offer essentially the same services as a commercial bank. -Credit unions Financial cooperative organizations of individuals with a common affiliation (such as an employer or a labor union). they accept deposits, including checkable deposits, pay interest (or dividends) on them out of earnings, and lend funds primarily to members. -Commercial banks Financial institutions that offer a wide range of services (for example, checking accounts, savings accounts, and loans) to their customers. Commercial banks are owned by stockholders and seek to operate at a profit.

New classical economists: economists who believe that there are strong forces pushing a market economy toward full-employment equilibrium and that macroeconomic policy is an ineffective tool with which to reduce economic instability.

-The new classical economists stress that debt financing simply substitutes higher future taxes for lower current taxes. Thus, budget deficits affect the timing of the taxes but not their magnitude. --(In the Keynesian model, a tax cut financed by borrowing will increase the current income of households, and they respond by increasing their consumption.) New classical economists argue that this analysis is incorrect because it ignores the impact of the higher future tax liability implied by the budget deficit and the interest payments required to service the additional debt. Rather than increasing their consumption in response to a larger budget deficit, new classical economists believe that households will save all or most of their increase in disposable income so that they will be able to pay the higher future taxes implied by the additional government debt.

two forces that underlie the self-corrective mechanism of macroeconomic markets.

1. Changes in real resource prices will help direct an economy toward equilibrium. 2. Changes in real interest rates help stabilize aggregate demand and redirect economic fluctuations.

When we constructed the aggregate demand curve, we assumed that several other factors affecting the choices of buyers in the goods and services market were constant. Changes in these "other factors" will shift the entire aggregate demand schedule, altering the amount purchased at each price level.

1. Changes in real wealth. ownership of stocks and housing constitutes a large share of the wealth of Americans. -An increase in real wealth that would result from a stock market boom, for example, will increase aggregate demand, shifting the entire curve to the right (from AD0 to AD1). -In contrast, a reduction in real wealth decreases the demand for goods and services, causing AD to shift to the left (from AD0 to AD2

Changes in short-run aggregate supply

1. Changes in resource prices. -A reduction in resource prices will lower production costs and therefore shift the SRAS curve to the right -an increase in the price of resources used in production will increase firms' costs, shifting the SRAS curve to the left.

Let's consider four changes during the past several decades that have altered the nature of money and the reliability of money supply growth figures as a gauge of monetary policy.

1. Introduction of interest-earning checking accounts. - In turn, the growth of these deposits pushed up the growth rate of the M1 money supply. The growth of M1 during the 1980s, however, was misleading. To a degree, it reflected a change in the nature of the M1 money supply. Interest-earning checking accounts are less costly to hold than currency and demand deposits. In essence, interest-earning checking accounts are partly medium-of exchange money and partly savings.

Both Keynesian and non-Keynesian—are now largely in agreement on the following three issues.

1. proper timing of discretionary fiscal policy is both difficult to achieve and crucially important. -Given our limited ability to forecast ups and downs in the business cycle, the delays that inevitably accompany fiscal changes, and the structure of political incentives, the effectiveness of discretionary fiscal policy as a stabilization tool is limited.

Appreciation: an increase in the value of a currency relative to foreign currencies. an appreciation increases the purchasing power of the currency over foreign goods.

A fall in the dollar price of foreign currency—shown by a movement down the vertical axis —means a dollar will buy more units of various foreign currencies. This will make it cheaper for Americans to purchase things from foreigners. Thus, we say that the dollar has appreciated, meaning that it will now buy more foreign goods than it previously could.

shifts in aggregate supply

A long-run change in aggregate supply indicates that it will be possible to achieve and sustain a larger rate of output. changes that temporarily alter the production capacity of an economy will shift the SRAS curve, but not the LRAS curve.

Medium of exchange

An asset that is used to buy and sell goods or services. -without money, in which goods were traded for goods. If you wanted to buy a pair of jeans, for example, you would first have to find someone willing to trade you the jeans for your labor services or something else you were willing to supply. -money frees us from cumbersome barter procedures and "oils the wheels" of trade.

there are two ways of measuring gross domestic product (GDP), the aggregate domestic output of an economy. First, GDP can be measured by adding up the spending of consumers, investors, governments, and foreigners (net exports) on goods and services produced during the year. This method is equivalent to measuring the flow of output as it moves through the top loop—the goods and services market— of the circular-flow diagram.

Alternatively, GDP can be measured by summing the income payments, both direct and indirect, received by the resource suppliers who produced the goods and services. This method uses the bottom loop—the resource market—to measure the flow of output.

Chapter 10: it is important to distinguish between price-level changes that are anticipated and those that are not.

Anticipated changes are foreseen by economic participants. unanticipated changes catch people by surprise.

3. other things being constant, a lower price level will make domestically produced goods less expensive relative to foreign goods.

As a result, if prices fall in the United States, for example, imports will decline as Americans find that many domestically produced goods are now cheaper than are products produced abroad. At the lower price level, Americans will tend to purchase fewer Japanese automobiles, Korean textiles, Italian shoes, and other imports because these items are now more expensive relative to domestically produced goods. At the same time, foreigners will increase their purchases of American-made goods that are now relatively cheaper. Therefore, net exports (exports minus imports) will tend to rise. The increase in net exports at the lower U.S. price level will directly increase the quantity demanded of domestically produced goods. This international-substitution effect is a third reason the aggregate demand curve slopes downward.

There are three major reasons a lower price level will lead to an increase in the aggregate quantity of goods and services demanded by purchasers. -1. a lower price level will increase the purchasing power of money.

As the level of prices declines, the purchasing power of money increases. For example, suppose that you have $2,000 in your bank account. Consider how a 20 percent reduction in the level of prices will influence your wealth and spending. At the lower price level, your $2,000 will buy more goods and services. In fact, your $2,000 will buy as much as $2,500 would have purchased at the previous higher price level. Other people will be in the same position you are. They will be wealthier and able to buy more.

A lower price level will (1) increase the purchasing power of money, (2) lower interest rates, and (3) reduce the price of domestically produced goods relative to goods produced abroad. Each of these factors will tend to increase the quantity demanded in the goods and services market.

At a higher price level, (1) the wealth of people holding money would be less; (2) the demand for money would be greater, which would lead to higher interest rates; and (3) domestic goods would be more expensive relative to those produced abroad. Each of these factors would tend to reduce the quantity demanded of domestically produced goods.

Aggregate demand curve: a downward-sloping curve showing the relationship between the price level and the quantity of domestically produced goods and services all households, business firms, governments, and foreigners (net exports) are willing to purchase.

Because demand in the goods and services market aggregates, or combines together, the purchases of all consumers, investors, governments, and foreigners, it is called "aggregate demand." -the good becomes less expensive relative to others. In contrast, a price reduction in the aggregate goods and services market indicates that the level of prices in the entire economy has declined. When this happens, the prices of all goods are lower. When the prices of all goods produced domestically fall by the same proportion, there will be no incentive for domestic buyers to substitute one good for another.

2. automatic stabilizers reduce fluctuations in aggregate demand and help keep the economy on track.

Because they are not dependent upon legislative action, automatic stabilizers are able consistently to shift the budget toward a deficit during a recession and toward a surplus during an economic boom. Thus, they add needed stimulus during a recession and act as a restraining force during an inflationary boom.

5. Changes in income abroad.

Changes in the income of a nation's trading partners will influence the demand for its exports.

Anticipated change: A change that is foreseen by decision-makers in time for them to make adjustments.

Decision makers have time to adjust to them before they occur. For example, suppose that, under normal weather conditions, a new drought-resistant hybrid seed is expected to expand grain production in the Midwest by 10 percent next year. As a result, buyers and sellers will plan for a larger supply of grain and lower grain prices in the future. They will adjust their decision making behavior accordingly.

Money in most modern nations is fiat money—money with no intrinsic value.

Fiat money: Money that has neither intrinsic value nor the backing of a commodity with intrinsic value; paper currency is an example. -Governments often designate it as "legal tender," meaning it must be accepted as payment for debt. But the main thing that makes money valuable is the same thing that generates value for other commodities: demand relative to supply. People demand money because it reduces the cost of exchange. When the supply of money is limited relative to the demand, money will become more valuable. When the supply of money grows more rapidly than the output of goods and services, prices will rise.

Fiscal stimulus must be felt during recessions and restraint during inflationary booms.

First, a change in fiscal policy will require legislative action. The political process moves slowly. This is particularly true in a country like the United States that has a number of checks and balances built into its political system. This process will take a significant amount of time. Second, a change in policy will not immediately impact the macroeconomy. Even after a policy change is adopted, another six to twelve months will generally pass before it will have much impact on the economy. Third, because of these delays, if fiscal policy is going to exert a stabilizing influence, policy-makers need to know what economic conditions are going to be like twelve to eighteen months in the future. However, this is a big problem because our ability to forecast when the economy is about to dip into a recession or experience an economic boom is extremely limited.

Keynesians argue that the federal budget should be used to promote a level of total spending (aggregate demand) consistent with the full-employment rate of output.

First, an increase in government purchases of goods and services will directly increase aggregate demand. As the government spends more on highways, flood-control projects, education, and national defense, for example, these expenditures will increase demand in the goods and services market. Second, changes in tax policy will also influence aggregate demand. For example, a reduction in personal taxes will increase the current disposable income of households. As their after-tax income rises, people will spend more on consumption. In turn, this increase in consumption will stimulate aggregate demand. Similarly, a reduction in business taxes increases after-tax profitability, which will stimulate both business investment and aggregate demand.

three major reasons why high tax rates are likely to retard the growth of output.

First, as we have explained, high marginal tax rates discourage work effort and productivity. -When marginal tax rates soar to 55 or 60 percent, people get to keep less than half of what they earn, so they tend to work less.

While budget conditions are often used to gauge the direction of fiscal policy, it is important to recognize that changes in the size of the deficit or surplus can originate from two different sources.

First, changes in the size of the deficit or surplus may merely reflect the state of the economy. Second, changes in the deficit or surplus may reflect discretionary fiscal policy. -Discretionary fiscal policy requires passage of tax and/or spending legislation by Congress and the president that alter the size of the budget deficit (or surplus).

There are two kinds of checkable deposits.

First, there are demand deposits, non-interest-earning deposits with banking institutions that are available for withdrawal ("on demand") at any time without restrictions. Second, there are other checkable deposits that earn interest but carry some restrictions on their transferability. --Thus, the M1 money supply comprises (1) currency in circulation, (2) checkable deposits (both demand deposits and interestearning checkable deposits), and (3) traveler's checks.

It is important to think of the interest rate in two ways.

First, there is the money interest rate, the percentage of the amount borrowed that must be paid to the lender in addition to the repayment of the principal. Second, there is the real interest rate, which reflects the actual burden to borrowers and the payoff to lenders after accounting for the impact of inflation.

Third, high marginal tax rates encourage people to substitute less-desired tax deductible goods for more-desired nondeductible goods.

High marginal tax rates make tax-deductible expenditures cheap for people in high tax brackets. Because purchasing tax-deductible goods lowers their tax bill, people will often buy them even though they do not value them as much as it costs to produce them.

equilibrium in the long run

However, a second condition is required for long-run equilibrium: decision-makers who agreed to long-term contracts influencing current prices and costs must have correctly anticipated the current price level at the time they arrived at the agreements.

2. Changes in the expected rate of inflation.

If sellers in the goods and services market expect the future rate of inflation to increase, they will be less motivated to sell their products at lower prices in the current period. -an increase in the expected rate of inflation will reduce the current supply of goods, thereby shifting the SRAS curve to the left. When sellers scale back their expectations of future price increases, their incentive to sell in the current period rises. -a reduction in the expected rate of inflation will increase short-run aggregate supply, shifting the SRAS curve to the right.

Controlling the money supply—a summary

If the Fed wants to increase the money supply, it can decrease reserve requirements, purchase additional financial assets, extend additional loans, and/or lower the interest rate it pays banks on excess reserves. On the other hand, if the Fed wants to reduce the money supply, it can increase the reserve requirements, sell some of its asset holdings, extend fewer loans, and/or pay banks a higher interest rate on their excess reserves.

Presentation of the Crowding-Out Effect in an Open Economy

In an open economy, the higher interest rates will also increase the inflow of capital from abroad, which will cause the dollar to appreciate and net exports to decline. Thus, in an open economy, the higher interest rates will trigger reductions in both private investment and net exports, which will weaken the expansionary impact of a budget deficit.

When an economy is operating below its potential capacity, Keynesians believe the government should institute expansionary fiscal policy Expansionary fiscal policy: an increase in government expenditures and/or a reduction in tax rates, such that the expected size of the budget deficit expands.

In other words, the government should increase its purchases of goods and services or cut taxes or both. Of course, this policy will increase the government's budget deficit. To finance the enlarged budget deficit, the government will have to borrow from either private domestic sources or foreigners.

The long-run aggregate supply (LRAS) curve

In the long run, a higher price level won't change the relationship between product and resource prices. Once people have time to adjust their prior commitments fully, competitive forces will restore the usual relationship between product prices and costs. Profit rates will return to normal, and firms will not have any additional incentive to pump out extra goods and services. --The long-run aggregate supply (LRAS) curve shows the relationship between the price level and quantity of output after decision-makers have had time to adjust their prior commitments, or take steps to counterbalance them, when the price level changes. the LRAS curve is vertical.

Aggregate supply curve: The curve showing the relationship between a nation's price level and the quantity of goods supplied by its producers. in the short run, it is an upward-sloping curve, but in the long run the aggregate supply curve is vertical.

In the short run, some prices, particularly those in labor markets, are set by prior contracts and agreements. Households and businesses are unable to adjust these prices when unexpected changes occur, including unexpected changes in the price level. In contrast, the long run is a time period long enough that people are able to modify their behavior in response to price changes.

4. substitution of electronic payments for checks and cash.

Increasingly, money is becoming electronic. More and more consumer purchases are being handled with debit cards, credit cards, and electronic transfers rather than by check or cash. These changes in payment methods make it possible for both individuals and businesses to hold smaller money balances (cash and checking deposits) than would otherwise be the case. They also reduce the comparability across time periods of the money supply data, particularly the M1 figures.

It is important to distinguish between money and credit.

Money is a financial asset that provides the holder with future purchasing power. Credit is a liability acquired when one borrows funds. (credit cards do not have purchasing power. They are merely a convenient way of arranging a loan. Credit cards make it possible for people to buy things throughout the month and then pay for them in a single transaction at the end of the month.)

Unanticipated change: A change that decision makers could not reasonably foresee. The choices they made prior to the change did not take it into account.

New products are introduced, technological discoveries alter production costs, droughts reduce crop yields, and demand expands for some goods and contracts for others.

The supply-side effects of a tax change are fundamentally different from the demand-side effects.

On the demand side, lower taxes increase the after-tax incomes of consumers and thereby stimulate consumption and aggregate demand. On the supply side, lower tax rates increase the incentive of people to work, supply resources, and use them more efficiently and thereby increase aggregate supply. *Supply-side economics is a long-run, growth-oriented strategy, not a short-run stabilization tool.

The Keynesian theory challenges the view that a responsible government should constrain spending within the bounds of its revenues.

Rather than balancing the budget annually, Keynesians stressed the importance of countercyclical policy, that is, policy designed to "counter" or offset fluctuations in aggregate demand. -Countercyclical policy: a policy that tends to move the economy in an opposite direction from the forces of the business cycle. such a policy would stimulate demand during the contraction phase of the business cycle and restrain demand during the expansion phase.

This proportion of the percentage of reserves that must be maintained against checkable transaction deposits is called the required reserve ratio.

Required reserve ratio: the ratio of reserves relative to a specified liability category (for example, checkable deposits) that banks are required to maintain. -Excess reserves: Actual reserves that exceed the legal requirement.

3. supply shocks. Supply shock: An unexpected event that temporarily increases or decreases aggregate supply.

Supply shocks can also alter current output without directly affecting the productive capacity of the economy.

when fiscal changes alter tax rates, they influence the incentive of people to work, invest, and use resources efficiently. Thus, tax changes may also influence aggregate supply.

Supply-side economists: economists who believe that changes in marginal tax rates exert important effects on aggregate supply. -From a supply-side viewpoint, the marginal tax rate is crucially important. (the marginal tax rate determines the breakdown of a person's additional income between tax payments on the one hand and personal income on the other.) (Lower marginal tax rates mean that individuals get to keep a larger share of their additional earnings.)

Board of Governors

The Board of Governors is the decision-making hub of the Fed. This powerful board consists of seven members, each appointed to a staggered 14-year term by the nation's president with the advice and consent of the U.S. Senate.

Chapter 12: Crowding-out effect: A reduction in private spending as a result of higher interest rates generated by budget deficits that are financed by borrowing in the private loanable funds market.

The crowding-out effect implies that the demand stimulus effects of budget deficits will be weak because borrowing to finance the deficits will increase interest rates and thereby crowd out private spending on investment and consumption. -Keynesians respond that even if crowding out occurs when the economy is at or near full employment, it will be less important during a recession, -The proponents of crowding out counter that while this may be true during the recession, the deficits will mean more borrowing and less private spending as the economy begins to recover. -As the result of this crowding in, restrictive fiscal policy will be largely ineffective as a weapon against inflation.

The Federal Reserve

The Federal Reserve (and most other central banks) is supposed to regulate the money supply and provide a monetary climate that is in the best interest of the entire economy. Congress has instructed the Federal Reserve, or the Fed, as it is often called, to conduct monetary policy in a manner that promotes both full employment and price stability. There are three major centers of decision making within the Federal Reserve: (1) the Board of Governors (2) the district and regional banks (3) the Federal Open Market Committee.

The short-run aggregate supply (SRAS)

The short-run aggregate supply (SRAS) curve shows the various quantities of goods and services domestic firms will supply in response to changing demand conditions that alter the level of prices in the goods and services market. -SRAS curve in the goods and services market slopes upward to the right.

3. Widespread use of the u.s. dollar outside of the united states.

The U.S. dollar is widely used in other countries. To a degree, this has been true for a long time. However, in recent years, many countries have relaxed legal restraints that limited the domestic use of foreign currencies The movement of these funds abroad (and our inability to measure them with any degree of precision) reduces the reliability of the M1 money supply figures and their growth as an indicator of monetary policy.

Fractional reserve banking: A system that permits banks to hold reserves of less than 100 percent against their deposits. Required reserves: the minimum amount of reserves that a bank is required by law to keep on hand to back up its deposits. if reserve requirements were 15 percent, banks would be required to keep $150,000 in reserves against each $1 million of deposits.

The United States has a fractional reserve banking system. Banks are required to maintain only a fraction of their deposits in the form of vault cash and other reserves. These are called required reserves. -our banks also do not have enough reserves to pay all depositors at once.

Most of these failures were the result of "bank runs"—panic withdrawals when people lost confidence in the banking system.

The bank failures of the 1920s and 1930s led to the establishment of the Federal Deposit insurance Corporation (FDiC) in 1934. Federal Deposit insurance Corporation (FDiC): A federally chartered corporation that insures the deposits held by commercial banks, savings and loans, and credit unions. The FDIC guarantees the deposits of banking customers up to some limit—currently $250,000 per account.

the corporate profit tax

The corporate profit tax is a highly important automatic stabilizer because corporate profits are highly sensitive to cyclical conditions. During a recession, corporate profits decline sharply, and so, too, do corporate tax payments. In turn, the decline in tax revenues will enlarge the size of the budget deficit. In contrast, when the economy is expanding, corporate profits typically increase much more rapidly than wages, income, or consumption. This increase in corporate profits will result in a rapid increase in the "tax take" from the business sector during the expansion phase of the business cycle. --Thus, corporate tax payments will go up during an expansion and fall rapidly during a contraction, even though no new legislative action has been instituted.

federal funds market

The discount rate is closely related to the interest rate in the federal funds market. The federal funds market is a private loanable funds market in which banks with excess reserves extend short-term loans (sometimes for as little as a day) to other banks trying to meet their reserve requirements. The interest rate in the federal funds market fluctuates with the demand for loanable funds. -If the Fed wants to lower the federal funds interest rate, it will purchase government securities or other financial assets and thereby inject additional reserves into the banking system. This will expand the supply of money and reduce the federal funds rate. -if the Fed wants to increase the federal funds rate, it will sell some of its asset holdings and thereby drain reserves from the system. In turn, the reduction in the reserves will lower the money supply and place upward pressure on the federal funds rate.

fiscal policy involves the use of the government's spending, taxing, and borrowing policies.

The federal budget is the primary tool of fiscal policy. When the supply of money is constant, government expenditures must be financed with either (1) taxes or revenues derived from other sources or (2) borrowing. If the government's revenue from taxes and other sources is equal to its total expenditure, a balanced budget is present. -Balanced budget: a situation in which current government revenue from taxes, fees, and other sources is just equal to current government expenditures.

loanable funds market

The loanable funds market is the market in which money is borrowed and loaned. It matches people who want to borrow money with those who want to lend it. -If you borrow money to go to college or buy a car, you are participating in the loanable funds market.

Foreign exchange market

The market in which the currencies of different countries are bought and sold. -International transactions, therefore, generally require one of the trading partners to convert its domestic currency to that of the other partner. Exchanges like this take place in the foreign exchange market. (-For example, if an American firm purchases glassware from a Mexican supplier, the firm would typically exchange dollars for pesos and then use the pesos to pay for the glassware. This generates demand for pesos.)

The Fed's huge increase in purchase of assets and extension of loans has dramatically increased the monetary base.

The monetary base is equal to the currency in circulation plus the reserves of commercial banks (vault cash and reserve deposits with the Fed). The monetary base is important because it provides the foundation for the money supply. The currency in circulation contributes directly to the money supply, while the bank reserves provide the underpinnings for checking deposits.

open market operations

The most common tool used by the Fed to alter the money supply is open market operations—the buying and selling of U.S. securities and other financial assets on the open market. If the Fed wants to expand the money supply, it simply purchases more of these financial assets. When the Fed buys things, it injects "new money" into the economy in the form of additional currency in circulation and deposits with commercial banks. In essence, the Fed creates money out of nothing. If the Fed wants to reduce the money supply, it sells some of its current holdings of government securities or other assets.

Deposit expansion multiplier: the multiple by which an increase in reserves will increase the money supply. it is inversely related to the required reserve ratio. Potential deposit expansion multiplier: the maximum potential increase in the money supply as a ratio of the new reserves injected into the banking system. it is equal to the inverse of the required reserve ratio.

The multiple by which new reserves increase the stock of money is called the deposit expansion multiplier. It is determined by the ratio of required reserves to deposits. In fact, the potential deposit expansion multiplier is merely the reciprocal of the required reserve ratio (r). *The lower the percentage of reserves required, the larger the potential expansion in the money supply generated by creation of new reserves. However, the fractional reserve requirement does place a ceiling on the expansion in the money supply resulting from the creation of new reserves.

Multiplier principle: The concept that an increase in spending on a project will generate income for the resource suppliers, who will then increase their consumption spending. in turn, their additional consumption will generate income for others and lead to still more consumption. as this process goes through successive rounds, total income will expand by a multiple of the initial increase in spending.

The multiplier principle builds on the point that one individual's expenditure becomes the income of another.

M1 (money supply): the sum of (1) currency in circulation (including coins), (2) checkable deposits maintained in depository institutions, and (3) traveler's checks. Currency: Medium of exchange made of metal or paper.

The narrowest definition of the money supply, M1, focuses on this function. Based on its role as a medium of exchange, it is clear that currency—coins and paper bills—falls into this definition.

Expenditure multiplier

The ratio of the change in equilibrium output to the independent change in investment, consumption, or government spending that brings about the change. numerically, the multiplier is equal to 1 divided by (1 - mPc) when the price level is constant.

trade surplus

The situation when a country's exports of goods and services are greater than its imports. -when a trade surplus (exports are greater than imports) is present, there must also be an outflow of capital.

trade deficit

The situation when a country's imports of goods and services are greater than its exports. -When a trade deficit is present, there must be an inflow of capital. ---Are trade deficits bad? Trade deficits imply that a nation is borrowing financial capital from foreigners.

What Factors Affect Aggregate Demand?

These factors increase aggregate demand (AD): 1. An increase in real wealth 2. A decrease in the real rate of interest 3. Optimism about future economic conditions 4. A rise in the expected rate of inflation 5. Higher real incomes abroad 6. A depreciation in the foreign exchange value of a nation's currency

the district and regional banks

There are 12 Federal Reserve District Banks with 25 regional branches spread throughout the nation. -Federal Reserve banks are bankers' banks; they provide banking services for commercial banks. -The district banks are primarily responsible for the monitoring of the commercial banks in their region. -The district banks also play an important role in the clearing of checks throughout the banking system.

What Factors Affect Long-Run and Short-Run Aggregate Supply?

These factors increase long-run aggregate supply (LRAS): 1. An increase in the supply of resources 2. Technology and productivity improvements 3. Institutional changes that improve the efficiency of resource use

A few fiscal programs tend automatically to apply demand stimulus during a recession and demand restraint during an economic boom. Programs of this type are called automatic stabilizers.

They are automatic in that, without any new legislative action, they tend to increase the budget deficit (or reduce the surplus) during a recession and increase the surplus (or reduce the deficit) during an economic boom. (Automatic stabilizers: Built-in features that tend automatically to promote a budget deficit during a recession and a budget surplus during an inflationary boom, even without a change in policy.)

Depreciation: a reduction in the value of a currency relative to foreign currencies. a depreciation reduces the purchasing power of the currency over foreign goods.

This makes foreign purchases more expensive for Americans. Thus, we say the dollar has depreciated. As the dollar depreciates, a unit of foreign currency will purchase a larger quantity of dollars. This depreciation in the dollar makes American goods less expensive for foreigners.

Inflationary premium: a component of the money interest rate that reflects compensation to the lender for the expected decrease, due to inflation, in the purchasing power of the principal and interest during the course of the loan. it is determined by the expected rate of future inflation.

This premium for the expected decline in purchasing power of the dollar is called the inflationary premium. It is equal to the expected rate of inflation. The relationship between the real interest rate and money interest rate is Real interest rate =Money interest rate = Inflationary premium

circular flow of output and income

Thus, there is a circular flow of output and income between these two key sectors, businesses and households. This circular flow of income is coordinated by four key macroeconomic markets: (1) goods and services, (2) resources, (3) loanable funds, (4) foreign exchange.

Equilibrium: a balance of forces permitting the simultaneous fulfillment of plans by buyers and sellers.

When a market is in equilibrium, the forces exerted by buyers and sellers balance one another. Buyers are willing to purchase all the units that sellers are willing to supply at the current price level.

unemployment compensation

When an economy begins to dip into a recession, the government will pay out more money in unemployment benefits as the number of laid-off and unemployed workers expands. -Simultaneously, the receipts from the employment tax that finance the unemployment compensation system will decline because fewer workers are paying into the system. (this program will automatically run a deficit during a business slowdown.) During an economic boom, the tax receipts from the program will increase because more people are now working, and the amount paid out in benefits will decline because fewer people are unemployed. (the program will automatically tend to run a surplus during good times.)

extension of loans by the Fed

When banking institutions borrow from the Federal Reserve, they must pay interest on the loans. -The interest rate that banks pay on these short-term loans from the Federal Reserve is called the discount rate. -Discount rate: the interest rate the Federal reserve charges banking institutions for short-term loans. -an increase in the discount rate will reduce borrowing from the Fed and thereby exert a restrictive impact on the money supply. -a lower discount rate will make it cheaper for banks to borrow from the Fed and exert an expansionary impact on the supply of money.

4. Change in the expected rate of inflation.

When consumers and investors believe that the rate of inflation will go up in the future, they have an incentive to spend more during the current period. -This expectation of higher inflation will stimulate current aggregate demand, shifting the AD curve to the right. If people expect inflation to decline in the future, this will discourage current spending. When prices are expected to decline (or at least increase less rapidly), people will have an incentive to wait before they buy things. -This expectation of lower inflation will cause current aggregate demand to fall, shifting the AD curve to the left.

the progressive income tax

When incomes grow rapidly, the average personal income tax liability of individuals and families increases. With rising incomes, more people will find their income above the "no tax due" cutoff. Others will jump up into higher tax brackets. (Therefore, during an economic expansion, personal income tax revenues increase more rapidly than income, because income will grow at a more incremental pace.) -the budget moves toward a surplus (or smaller deficit), When incomes decline, many individuals will be taxed at lower rates or not at all. (Income tax revenues will fall more rapidly than income, automatically enlarging the size of the budget deficit during a recession.)

Second, high tax rates will adversely affect the rate of capital formation and the efficiency of its use.

When tax rates are high, foreign investors will look for other places to put their money, and domestic investors will look for investment projects abroad where taxes are lower.

2. the interest-rate effect: a lower price level will reduce the demand for money and lower the real interest rate, which will stimulate additional purchases.

When the average price of everything is lower, consumers and businesses will need less money to conduct their normal activities. Households will be able to get by just fine with a smaller money balance because, at the lower price level, they will be spending a smaller amount on food, clothing, and other items they regularly purchase. Similarly, businesses will need less money to pay employee wages, taxes, and other business expenses. At the lower price level, both consumers and businesses will attempt to reduce their money balances and shift more funds to interest-earning assets like bonds and savings deposits. This will channel more funds into the loanable funds market, placing downward pressure on interest rates.

equilibrium in the long run

When the price level expectations about the long-term contracts turn out to be correct, then the current resource prices and real interest rates will tend to persist into the future. Profit rates will be normal. The choices of buyers and sellers will harmonize, and neither will have reason to modify their previous contractual agreements when they come up for renegotiation. Thus, the current rate of output (YF) is sustainable in the future. This also corresponds to full employment in the economy. potential GDP is equal to the economy's maximum sustainable output consistent with its resource base, current technology, and institutional structure. When long-run equilibrium is present, the actual output achieved is equal to the economy's potential GDP. When full-employment output is present, the job search time of unemployed workers will be normal, given the characteristics of the labor force and the institutional structure of the economy. Only frictional and structural unemployment will be present; cyclical unemployment will be absent.

6. Changes in exchange rates.

changes in exchange rates influence the relative price of both imports and exports. -If the dollar appreciates, imported goods will be cheaper for Americans to buy, and goods exported from the United States will be more expensive for foreigners to purchase. -If the dollar depreciates, the effect will be just the opposite. When the value of the dollar falls, foreign-produced goods become more expensive for U.S. consumers, whereas U.S.-produced goods become cheaper for foreigners.

Chapter 13: money is the item commonly used to pay for goods, services, assets, and outstanding debts.

money is an asset that performs three basic functions: It serves as a medium of exchange, it provides a means of storing value for future use, and it is used as an accounting unit.

Interest rate the Fed pays banks on reserves

the Fed can set the interest rate on these reserves at whatever level it chooses. This provides it with another tool with which to conduct monetary policy. -If the Fed wants the banks to expand the money supply by extending more loans, it will set the interest rate paid on excess reserves at a very low level, possibly even zero. This will encourage banks to reduce their excess reserves, extend more loans, and thereby expand the supply of money. -if the Fed wants to reduce the money supply, it can increase the interest rate paid on excess reserves and thereby provide commercial banks with a stronger incentive to hold excess reserves rather than extend more loans. This will reduce the money expansion multiplier and thereby reduce the money supply.

Federal Reserve vs the U.S. Treasury,

the Fed is concerned primarily with the availability of money and credit for the entire economy. The Fed does not issue U.S. securities. It merely purchases and sells them as a means of controlling the economy's money supply. the Fed can purchase government bonds by writing a check on itself without having deposits, gold, or anything else to back it up. In doing so, the Fed creates money out of thin air. The Fed does not have an obligation to meet the financial responsibilities of the U.S. government. That is the domain of the Treasury.

the u.s. treasury 1. Is concerned with the finances of the federal government 2. Issues bonds and sells them to investors to finance the budget deficits of the federal government 3. Does not determine the money supply When the Treasury issues and sells bonds, it does so in order to generate additional funds to cover the spending of the federal government.

the Federal reserve 1. Is concerned with the monetary climate of the economy 2. Does not issue bonds 3. controls the money supply and often uses the buying and selling of bonds issued by the u.s. Treasury to do so when the Fed sells bonds, in effect, it takes the revenues and holds them, keeping them out of circulation.

Federal Reserve vs the U.S. Treasury,

the Treasury is a budgetary agency. If the federal government is running a budget deficit, the Treasury will issue U.S. securities as a method of financing the deficit. (-the Treasury is primarily interested in obtaining funds so that it can pay Uncle Sam's bills.) the Treasury does not issue money. Borrowing— the public sale of new U.S. securities—is the primary method used by the Treasury to cover any excess of expenditures in relation to revenues from taxes and other sources.

The major advantage of automatic stabilizers is that

they institute countercyclical fiscal policy without the delays associated with legislative action. They minimize the problem of proper timing, in other words. These stabilizers automatically reduce tax revenues collected and increase government spending, giving the economy a shot in the arm. Automatic stabilizers help apply the brakes to an economic boom, increasing tax revenues and decreasing government spending. -Three of these built-in stabilizers deserve specific mention: unemployment compensation, the corporate profit tax, and the progressive income tax.