Macroeconomics: Midterm 3
Financial Institution
firms that borrows and lends
budget surplus
government collects more taxes than they spend, lends these extra funds to earn interest Overall quantity of funds supplied > private supply of loanable funds - lowers the interest rate -> overall investment increases even though private saving decrease
Future value formula
present value (1 + r)^n = future value
Present value formula
present value = future value in one year / (1 + r)^n r = interest rate as decimal n = years
Net present value
present value of all future flows from a decision minus the initial cost of decision (If positive, do it; if negative, don't!)
If real GDP increases
the money demand curve shifts to the right
The graph shows the economy when consumers experience a decrease in consumer confidence. Draw a curve that shows how the economy returns to a full-employment equilibrium with no intervention by the government or central bank. Label it. Draw a point at the new long-run macroeconomic equilibrium. The economy returns to a full-employment equilibrium as _______.
the money wage rate falls (decrease in money wage rate -> SAS shift right)
currency in circulation
the notes and coins held by individuals and businesses - those locked in banks/safes do not count! - money in bank account is not currency!
Supply of AS-AD Model
the quantity of real GDP supplied is the total quantity of goods & services that firms plan to produce in a given year Aggregate supply: relationship between quantity of real GDP supplied and price level (cost of everything) Two supply curves 1. Short-run supply curve: relationship between quantity of real GDP supplied & price level when money wage, price of other resources, and potential GDP remain constant Full employment price level (FEPL): there is only one price level where real wage rate is at full-employment equilibrium (real GDP = potential GDP) Upward sloping short-run supply curve (SAS) 2. Long-run supply curve: Any % change in the price level will cause a matching % change in the money wage rate. This means we are always at full employment in long run (real GDP = potential GDP). - Firms end up producing exactly the same amount of stuff as before Vertical long-run supply curve (LAS) *FEPL & Potential GDP intersect at one spot only
If there is zero inflation, the nominal interest rate is equal to...
the real interest rate
The demand for loanable funds increases and the supply of loanable funds increases. As a result, the equilibrium real interest rate ______ and the equilibrium quantity of loanable funds ______.
rises, falls, or remains the same; increases
As a result, the equilibrium real interest rate ______ and the equilibrium quantity of loanable funds ______.
rises; increases, decreases, or remains the same
Joe has a term deposit that pays 4 percent a year and its value after two years will be $12,000. What is the present value of Joe's term deposit?
$11,094.67 (12,000 / 1.04^2)
What is the present value of $400, three years in the future if the interest rate is 5 percent? The present value of $400, three years in the future if the interest rate is 5 percent is
$345.54 (400 / 1.05^3)
Tom took out a $4,000 loan to buy a boat at an interest rate of 4 percent a year. He plans to repay the loan after 2 years. How much will he have to pay?
$4,326 (4,000 x 1.04^2)
M2
*everything in M1 + additional, not always means of payment 1. time deposits 2. savings deposits 3. money market mutual funds & other deposits
M1
*perfectly liquid 1. currency in circulation 2. traveler's checks 3. private checking deposits
Federal Reserve System
- central bank of US, bank of banks - regulate depository institutions - conducts monetary policy - 12 separate districts (NY most important as main policy making body) - prints all money
Why don't banks create infinite amounts of money?
- have limits 1. Size of monetary base - the larger, the more the loans banks can issue - the smaller, the less loans banks can issue 2. amount of desired reserves - how much banks want to keep in vault and fed reserves - the more, the less loans - the less, the more loans 3. amount of desired currency holding - the more cash the feds hold, the less loans
4 benefits of depository institutions
1. Create liquidity 2. Pool risk 3. Lower the cost of borrowing 4. Lower the cost of monitoring borrowers
3 types of markets
1. Loan 2. Bond 3. Stock
Two types of federal assets
1. US government securities (treasury bonds) 2. Mortgage-backed securities
commercial banks
1. accept payments, provide payment services 2. make loans 3. issue checks, credit cards, home loans
Three Kinds of Assets
1. cash assets & loans to other banks 2. securities 3. loans to businesses & households
Three factors that can change demand curve
1. change in expectations "consumer confidence" - expected income rises, spend more - expected inflation rate increases, spend more - future profits increase, spend more *demand curve shifts right (vice versa) 2. Monetary & fiscal policy monetary: increase in quantity of money, lower interest rates, increase in demand fiscal: increase disposable income, increase in demand; lower taxes & increase in transfer payments, increase in demand *demand curve shifts right (vice versa) - an increase in gov expenditure also increases demand 3. the world economy - rise in exchange rate decreases demand - increase in foreign income, increase in demand
What causes change in aggregate supply?
1. change in potential GDP - if it increases, LAS shifts right (vice versa) - FEPL stays the same (LAS & SAS must shift exact same distance) 2. change in money wage rate - If it increase, SAS shifts left, LAS stays the same (vice versa) - FEPL increases
Things that are not money
1. checks 2. debit cards 3. credit cards
6 key types of financial institutions
1. commercial banks 2. government-sponsored mortgage lenders 3. mutual funds 4. pension funds 5. insurance companies 6. federal reserve
Two types of federal liabilities
1. currency (dollar bills) 2. reserves of depository institutions
4 things that could cause shift to supply curve
1. disposable income - people deposit more when it goes up = more loanable funds 2. expected future income - future expected income falls, people save more = more loanable funds 3. wealth - if wealth increases, people stop savings = less loanable funds 4. default risk - default risk increases, people to depositing = less loanable funds
Classical Macroeconomics
1. economy does perfect job regulating self 2. things adjust naturally on own; back to full employment instantly 3. less worried about what gov should but shouldn't do 4. government shouldn't charge high taxes - creates disincentives that harm economy
Keynesian Macroeconomics
1. economy is rarely at full employment 2. money wage rate must fall, but process too slow on own 3. government should help economy fix more quickly - use monetary and fiscal policy to do so
Monetarist Macroeconomics
1. economy is self-regulating and will normally operate at full employment as long as monetary police is not erratic and pace of money growth is steady - taxes should be kept low
Monetary policy
1. increase of decrease quantity of money in circulation 2. influence interest rates
Defining Money: 4 key functions
1. means of payment: settle a debt 2. medium of exchange: generally accepted in exchange for goods and services 3. unit of account: standard unit like dollars or cents 4. store of value: can be held & exchanged later for goods and services - a good store of value fluctuates over time
If banks have no unplanned reserves, what is the banks' desired reserve ratio?
12.5% (250/2000 = .125 -> 12.5)
The graph shows the demand for money curve and the supply of money curve. The Fed decreases the quantity of real money supplied to $4.0 trillion. Draw a new MS curve that shows the effect of the Fed's action. Label it. Draw a point at the new equilibrium quantity of money and interest rate. Before the Fed decreases the quantity of money, the equilibrium interest rate is ____ percent a year. After the Fed decreases the quantity of money, at an interest rate of 2 percent a year, people want to hold _______ money than the quantity supplied, so they _______ bonds. The price of a bond _______ and the interest rate _______.
2 percent more; sell falls; rises
If the monetary base increases by $1 million and the quantity of money increases by $2.5 million, then the money multiplier is _____.
2.5 (2.5/1 = 2.5)
Daisy loans Alfred $10,000 and a year later, Alfred pays Daisy $10,400. If the inflation rate during that year is 1.5 percent, what is the real interest rate that Alfred is paying to Daisy? The real interest rate that Alfred is paying to Daisy is _______.
2.5 percent a year (400/10,000 = 4% -> 4.-1.5 = 2.5)
If the annual interest paid on a $500 loan is $25, the nominal interest rate is _____ percent per year. If the nominal interest rate is 5 percent per year and the inflation rate is 2 percent a year, the real interest rate is _____ per year.
5; 3 (5-2 = 3)
Business-cycle in AS-AD Model
Above full employment equilibrium: SRE puts real GDP above potential - double headed arrow = output Gap - positive = inflationary Gap Below full employment equilibrium: SRE puts real GDP below potential - double headed arrow = output Gap - negative = recessionary Gap
Stock markets
Bondholder loans company finances -> stockholder buys fraction of company -> traded in stock market
Bond Markets
Bonds issued by firms or governments that can be traded in these markets - US treasury have most reliable forms for bonds - There are also Mortgage-backed Securities (MBS) traded in bond market as well
How will we pay for new capital?
Borrow: enables GDP growth making us wealthier Firms: borrow for physical capital Households: borrow for houses and human capital
Cash assets & loans to other banks
Cash Assets: low risk, low return type 1: reserves "vault cash" type 2: deposit account at fed reserve Loans to other banks: low risk, low return (also assets)
Loan Markets
Households take out loans to buy house through a mortgage
Federal Deposit Insurance Corporation (FDIC)
If economy collapses and everyone tries to withdrawal all money at same time fed guarantees up to $250,000 per depositor
Steps to growing real GDP
Income -> put into savings -> invested into markets -> markets go capital -> GDP increases
Economic growth and inflation in AS-AD Model
LAS = potential GDP 1. If LAS increases, and AD stays the same, real GDP increases, price level decreases -> deflation! 2. If AD increases, and LAS stays the same, Real GDP stays the same, price level increases -> inflation! 3. If both increase at same speed, real GDP increases, price level stays the same -> no inflation! 4. If AD increases faster than LAS -> inflation!
The Bureau of Economic Analysis reported that real GDP during the second quarter of 2007 was $11.5 trillion and the GDP deflator was 120. The Congressional Budget Office estimated potential GDP to be $11.6 trillion in 2007. For the year 2007, draw: 1) the long-run aggregate supply curve 2) the aggregate demand curve 3) the short-run aggregate supply curve. Make the curves consistent with the numbers above and label them. Draw a point at the short-run equilibrium.
LAS @potential GDP AD @FPEL (120) and Real GDP (11.5) SAS @FPEL SRE @SAS & AD intersect
The table shows the amounts held as the various components of M1 and M2. The value of M1 is _______ billion. The value of M2 is _______ billion.
M1 = 220 billion *currency and traveler's checks + checking deposits M2 = 1040 billion *everything
Three tools to change monetary base
Open-market operation: purchase/sale of securities in loanable funds market - fed buys securities from banks, increases reserves at fed - fed sells securities to banks, reserves decrease at fed Last resort loans: when banks cannot get money from another, can borrow from fed at discounted rate - fed raises/lowers this rate depending on goals Required-reserve ratio: minimum percentage of deposits that depository institutions must hold at reserves - can lend out a percentage of these reserves - been at 0% since great depression though
The supply of loanable funds is determined by the _________. The supply of loanable funds changes when _______.
Saving decisions of households, which are influenced by the real interest rate, disposable income, expected future income, wealth, and default risk; disposable income, expected future income, wealth, or default risk change
Increase in the supply of money: Short run!
Short run = Qs > Qd "Shortage" Start at equilibrium -> fed increases the quantity of money -> supply curve shifts to the right -> people are holding more money than they want -> people buy bonds to get rid of money -> bond prices rise -> interest rate goes down -> New equilibrium at D(0) & S(1) Effects 1. real money went up 2. nominal interest rate goes down 3. firms & households borrow more 4. greater demand
Which body of the Federal Reserve System sets the majority of U.S. monetary policy?
The Federal Open Market Committee
How can the change in U.S. wealth differ from U.S. saving?
The change in wealth includes changes in the prices of assets owned and saving excludes these items
If firms reduce investment spending and the economy enters a recession, which of these contributes to the adjustment that causes the economy to return to its long-run equilibrium?
The eventual agreement by workers to accept lower wages
The Money Market (Supply)
The supply of money is determined by the Fed, therefore the supply curve is vertical If the interest rate is below equilibrium, quantity of money demanded exceeds the supplied (shortage) Shortage: people sell lots of bonds to gain money, price of bond goes down, interest rate goes up
When is the opportunity cost of holding money higher?
When interest rates are high
A higher exchange rate will result in
a decrease in net exports and a decrease in aggregate demand
Depository Institution
a financial firm that takes deposits from households and firms 1. commercial banks 2. thrift institutions 3. mutual funds Bank's goal: use deposited dollars to purchase assets and earn profits
A rise in the money wage rate with no change in potential GDP creates ______.
a leftward shift of the SAS curve and no change in the LAS curve
Bond
a promise to make specified payments on specified dates
AS-AD model
aggregate supply-aggregate demand model *demand & supply of everything (Aka real GDP) - price level on y-axis (use GDP deflator not CPI) - real GDP in dollars on x-axis (specify base year)
savings
amount of income not paid in taxes or spent on consumption of goods and services *Savings increase wealth!
Draw an aggregate demand curve in an economy with an above full-employment equilibrium. Label it AD. Draw a point at the above full-employment equilibrium. Draw a horizontal arrow at the equilibrium price level that shows the output gap. The output gap in the graph is ______ because ______.
an inflationary gap; potential GDP is less than real GDP
The graph shows a business cycle. Draw a vertical arrow that shows: 1) a recessionary gap. Label it 1. 2) an inflationary gap. Label it 2. Draw a point that shows the economy at full employment. At arrow 1 in the graph, the economy is in ______ full- employment equilibrium and the intersection of the AD and SAS curves is to the ______ of the LAS curve. At arrow 2, the economy is in ______ full-employment equilibrium and the intersection of the AD and SAS curves is to the ______ of the LAS curve.
a below; left an above; right
mortgage-backed securities
bond that is a combination of mortgages - bond-holder is entitled to all mortgage payments - can use proceeds to buy more MBS' - worth high price if home stays the same in value or homebuyers expected to pay all payments, but not valuable if home value drops or owners stop paying mortgage
A financial institution is a firm that operates on both sides of the markets for _____: It _____ in one market and _____ in another.
financial capital; borrows; lends
Increase in market value
capital gains
Decrease in market value
capital losses
Federal reserve
central bank of US, regulates private banks and monetary system, buys and sells bonds and MBS', regulate economy (& make profit)
Stock
certificate of ownership & claim to a firm's profits
We call the leakage of bank reserves into currency the currency drain, and we call the ratio of _____ to _____ the currency drain ratio.
currency; depostis
The "average overall increase across the board" wage increase _______.
decreases short-run aggregate supply because it increases firms' costs
Desired reserve ratio
desired deserves / deposits *must be equal or greater than required reserve ratio
If the price level and the money wage rate rise by the same percentage, the quantity of real GDP supplied ______ and there is a movement up along the ______ aggregate supply curve
does not change; long-run
currency
dollars in physical form represented by notes and coins
Assuming there are no leakages out of the banking system, a money multiplier equal to 5 means that:
each additional dollar of reserves creates $5 of deposits
Government Sponsored mortgage lenders
federal national mortgage association "Fannie Mae" federal home loan mortgage association "Freddie Mac" - create and sell mortgage-backed securities - buy these mortgages from banks
budget deficit
government spends more than it collects in taxes, government must borrow - raises the interest rate -> increase in savings, decrease in private borrowing -> overall decrease in demand - extra savings go to government
Fiscal policy
government's attempt to influence economy through taxes, purchases, and transfer payments
Loans to businesses and households
high risk, high return - every loan is an asset held by the lender - every loan loan issued by a bank is an asset held by that bank - hard to turn into cash - some borrowers default making it high risk - but banks can make a lot w/ high interest rate
Insurance companies
households and firms purchase in exchange for money in case something happens, company uses extra funds to buy stocks and bonds and make profit
If the interest rate is high, the quantity of loans supplied...
increases (decreases when low)
Starting from a full-employment equilibrium, an increase in aggregate demand ______, and creates ______ gap. In the long run, the money wage rate ______, short-run aggregate supply ______, and the economy returns to a full-employment equilibrium.
increases real GDP above potential GDP; an inflationary rises; decreases
A government budget deficit _______ loanable funds. A government budget deficit _______ the real interest rate, increases ______.
increases the demand of raises; private saving, and decreases investment
A government budget surplus _______ loanable funds. A government budget surplus _______ the real interest rate, decreases ______.
increases the supply of lowers; private saving, and increases investment
An open market purchase ______ the monetary base. An open market sale ______ the monetary base.
increases; decreases
Mutual funds
individual investors each buy small piece of mutual fund, pool together to buy lots of stock
Mortgage
legal agreement that the lender will get the home if borrower fails to make agreed payments
Net worth is the total market value of what a financial institution has _____ minus the market value of what it has _____.
lent; borrowed
The functions of depository institutions include _______.
lower the cost of monitoring borrowers
What is the relationship between real interest rates and investment, other things being equal?
negative relationship
The stated rate of interest on a loan is the __________.
nominal interest rate
The Fed conducts monetary policy primarily through
open market operations
Draw an aggregate demand curve. Label it AD. Draw an arrow on the AD curve that shows the international substitution effect when the price level falls. Label it 1. Draw an arrow on the AD curve that shows the international substitution effect when the price level rises. Label it 2. An international substitution effect arises because when the U.S. price level rises, _______.
people spend less on the more expensive U.S.-made items and they spend more on the less expensive foreign-made items
nominal interest rate
pieces of paper
Increase in the supply of money: Long run!
prices will adjust themselves to eliminate shortage by rising Quantity theory of money: In the long run, an increase in the nominal quantity of money brings an equal percentage increase in the price level - no change in real money, real GDP, employment, or real interest rate! In long run, supply and demand curve does not change!
Liquidity
property of being easily converted into a means of payment (M1 & M2)
Suppose the real interest rate falls. Draw either an arrow along the demand curve showing the direction of change or a new demand curve. When the real interest rate falls, the ______ because the ______ is the opportunity cost of loanable funds.
quantity of loanable funds demanded increases; real interest rate
The Money Market (Demand)
quantity of money demanded: inventory of money that people plan to hold demand for money: relationship between quantity of money demanded and real interest rate If the nominal interest rate goes up, the quantity of money demanded goes down, and the opportunity cost rises If the nominal interest rate changes and everything else stays the same, move along the curve
Demand of AS-AD Model
quantity of real GDP demanded is the total amount of final goods and services produced in the US that people, businesses, government, and foreigners plan to buy Aggregate demand: relationship between quantity of real GDP demanded and price level (cost of everything) When the price level increases, the quantity demanded decreases (vice versa) Downward sloping curve (AD) Two reasons why curve is downward sloping 1. wealth effect: when price level rises, real wealth decreases, people save more 2. substitution effects A. Intertemporal: price level increases, quantity of money decreases, interest rate rises, people save more, real GDP decreases B. International: price level increases, real GDP decreases, quantity of money decreases When the price level changes and everything else stays the same, move along the demand curve
real interst rate
real interest rate - inflation rate (stuff you can buy)
Draw an aggregate demand curve in an economy with a below full-employment equilibrium. Label it AD. Draw a point at the below full-employment equilibrium. Draw a horizontal arrow at the equilibrium price level that shows the output gap. The output gap in the graph is ______ because ______.
recessionary gap; potential GDP exceeds real GDP
The figure shows the demand for money curve in Epsilon. Draw the supply of money curve if the Fed wants the interest rate to be 6 percent a year. Label it. Draw a point at the equilibrium in the money market. If the interest rate is 5 percent, people will ______ bonds. Bond prices will ______. The interest rate will _______.
sell; fall rise
AS + AD Model
short-run equilibrium: where SAS and AD intersect - Real GDP = quantity supplied - always live in the short run - can be different from potential GDP long-run equilibrium: where real GDP demanded = potential GDP and at full employment If SAS, LAS, and AD all intersect at same spot economy is running perfectly - LRE = SRE = Potential GDP = quantity supplied = quantity demanded If SAS & LAS intersect at different spots, we are at short-run - must align for LRE - change money wage rate to change SAS, but not LAS - IF SAS is "too left", money wage rate will fall, SAS increase "shifts right" (vice versa)
Pension funds
take firm's earnings and worker's incomes to buy stocks and bonds that are payed to retired employees
When the price level, the money wage rate, and other factor prices rise by the same percentage, there is a movement along ______. Potential GDP ______. When the price level rises but the money wage rate and other factor prices remain the same, there is a movement along ______. The quantity of real GDP supplied ______.
the LAS curve; does not change the SAS curve; increases
loanable funds market
the aggregate of all the individual financial markets - how many dollars all together they want to borrow - the quantity of loanable funds demanded depends on the interest rate - the quantity of loanable funds supplied, also depends on the interest rate
financial capital
the funds that firms use to buy physical capital and that households use to buy a home or to invest in human capital
A new technology is developed that increases firm's expected profits. Draw a curve that shows the effect of this event. Draw a point at the new equilibrium quantity of loanable funds and the new equilibrium real interest rate. When a shortage or a surplus arises in the loanable funds market _______.
the real interest rate is pulled to the new equilibrium level
Monetary base
the sum of currency and reserves (total liabilities) - assets provide backing so they don't go broke - fed can change size of monetary base
crowding-out effect
the tendency for a government budget deficit to raise the real interest rate and decrease investment
What determines the supply of loanable funds?
the willingness of households and firms to save
currency drain ratio
total amount of currency / total amount of deposits
money multiplier
total amount of money deposited / total amount of deposits (reserve ratio)
Securities
type 1: US treasury bills (low risk, low return) type 2: Mortgage-backed securities (medium risk, medium return) *Can be converted to cash if bank runs out of money
Actual reserves - desired reserves =
unplanned reserves
Supply curve for loanable funds
upward sloping - if interest rate changes and everything else stays the same, movement along supply curve - if supply of loanable funds changes, shift of supply curve
wealth
value of the things people own
Demand curve for loanable funds
x-axis: loanable funds y-axis: real interest rate downward sloping curve - If interest rate changes, but everything else stays the same, movement along demand curve - if there is a change in expected profits, shift of demand curve
If the price level rises and the money wage rate remains constant, the quantity of real GDP supplied ______ and there is a movement up along the ______ aggregate supply curve.
increases; short-run
When potential GDP increases, ______. The graph gives a long-run aggregate supply curve and a short-run aggregate supply curve. Potential GDP increases and the full-employment price level remains constant. Draw the new long-run aggregate supply curve and the new short-run aggregate supply curve. Label the curves. Draw a point that shows the new value of potential GDP at the full-employment price level.
long-run aggregate supply and short-run aggregate supply increase. The LAS and the SAS curve shift rightward
Describe the process by which action by the Fed in times of recession flows through the economy. In times of recession, the Fed _______ the interest rate and __________ the quantity of money. The graph shows the U.S. economy in a below full-employment equilibrium in 2007. Draw a curve to show the result of actions taken by the Fed to move the economy back toward a full employment equilibrium. Draw a point to show the new short-run macroeconomic equilibrium
lowers; increases