Macroeconomics
Limitations of GDP
Can obscure growing inequality and depletion of resources, Can't differentiate between spending on good things (education) and bad things (cigarettes), Doesn't measure the economic services that nature provides or those that don't come with a market price (like raising children), Fails to account for the value of social cohesion, education, health, leisure, clean environments
How is the federal reserve insulated from political pressure?
-Appointment of governors are staggered and have 14 year terms -Appointment of regional bank presidents are not done by politicians -No funding - the fed makes its own money -Accountable to Congress - still has to report to them
Federal Budget Process
-Budget is in the hands of the legislative branch (Congress). -President submits budget plan to Congress in February -Fiscal year is when the budget runs -Federal fiscal year begins October 1 → September 30 -Congress doesn't have to follow it, but it is used to see priorities -Congress develops budget resolution (April 15)
Federal Reserve Five key functions
-Conducts monetary policy -Promotes stability of the financial system -Promotes safety of individual financial institutions -Protects consumers and community development -Fosters payment safety
Big three goals of macroeconomic policy
-Economic growth (GDP) → when the economy's total output of goods increases -Full employment → availability of jobs -Stable prices (inflation) → low and stable price growth
Federal Reserve Bank Three Key Entities
-Federal open market committee (FOMC) consists of seven members of the Board of Governors and five regional bank presidents (one of which is always New York) -Twelve regional banks -Board of Governors (7 members) → includes chairman of the fed (currently Jerome Powell)
Reserves before 2008
-Required reserves (must have) - not earning any -interest on them -Excess reserves - banks usually used to invest or loan them out -Controlled amount of reserves (Supply and demand) -Now, fed policy revolves around amply reserves
Because interest rates on government bonds reflect the risk of default, __________
A country perceived as a higher credit risk must pay higher interest rates when it borrows
National Deficit
A deficit occurs when the government spends more than it collects in taxes and other income during a fiscal year -Must borrow money to pay for its excess spending -Federal Reserve auctions off Treasury securities
Cyclical Unemployment
Arises from the ups and downs of the economy Difference between the natural rate of unemployment and the actual rate of unemployment
How does arbitrage ensure that the FFR does not drop too far below the IOER rate?
Banks have an incentive to borrow at the FFR and deposit at the IOER rate
Goals of Macroeconomic Policy
Big three (economic growth/GDP, full employment, stable prices), rising standards of living, improved trade, equitable distribution of income
The Federal Reserve was created when
Congress passed, and President Wilson signed, the Federal Reserve Act
Monetary Policy (Before 2008)
Controlling interest rates → cost of using someone else's money -More reserves (money) means lower interest rates -Less reserves means higher interest rates Fed influences the level of reserves -Private banks set interest rates, but fed creates pressure Open market operations: buying/selling bonds -Buy to lower interest rates (expansionary), sell to raise (contractionary) Reserve requirements: how much banks must keep in reserves (doesn't change a lot) Discount rate: interest rate on loans banks take from the fed -Higher means less reserves, lower means more Lower interest rates stimulate a willingness to borrow, higher ones slow that down
How can governments protect themselves against the temptation to use printing money as a way to escape unsustainable debt?
Create a central bank that is insulated from the political process and that has clear objectives
Evidence suggests that a country with a central bank with a high level of independence ______________
Has lower average inflation rates
How might inaccurate estimations of potential GDP have led to flawed economic policy in the 1970s?
Inaccurate estimations may have caused the Federal Reserve to believe potential output was higher than it was, leading to overly stimulative policy, contributing to higher inflation
What is a major difference between the way households and countries manage debt?
Only households have a limited lifespan and attempt to pay off their debt at some point
Prior to 2008, the Federal Reserve moved the federal funds rate (FFR) higher and lower using _________
Open market operations
Output Gap
Output gap is the difference between real GDP and real potential GDP (actual GDP - potential GDP) / (potential GDP) x100 = output gap -Determines the business cycle
Financial Reserve dual mandate
Promotes maximum employment and stable prices (Balancing act)
As the data started to reveal the severity of the slowdown, how did businesses and investors seek to reduce financial risk?
Reduce holdings of risky financial assets and increase holdings of cash
Whereas the Federal Reserve used to set a single target for the FFR, it now
Sets a range that is 25 basis points wide
While all (up to) 19 FOMC participants attend meetings, discuss economic conditions, and share their views,the voting members of the FOMC include
Seven Federal Reserve Board Governors and five Federal Reserve Bank presidents (on a rotating basis). One of these is always the president of the New York Fed
How might the relatively short political terms of elected officials (the political business cycle) create an inflationary bias?
Elected officials might resist higher interest rates, fearing a slowing economy will reduce their chances of reelection
Unemployment
Employed: one that has a job Unemployed: those who are jobless but looking for work If you are not actively looking for work, you are not unemployed. Marginally attached worker: on & off Discouraged worker: gave up on finding a job Underemployed: workers who would like to find a full-time job but are currently working part-time (Not calculated in unemployment rate)
Core Inflation
Excludes food and energy prices. Subject to large shifts from change in supply and demand
aggregate demand and supply
Expansionary policy means a demand shift to the right → higher prices and GDP -Creates inflationary gap Contractionary policy means a demand shift to the left → lower prices and GDP -Creates recessionary gap
Net Exports (NX)
Exports minus imports. Doesn't count goods imported from other countries
Adjustments in the stance of monetary policy are communicated as a change in which of the following?
FFR
FFR change during the recession
FFR decreased and amount of reserves increased
How did the COVID-19 pandemic affect the unemployment rate?
The unemployment rate increased from a 50-year low rate of 3.5 percent to 14.7 percent in two months.
Potential GDP
The value that GDP would be at if all resources in the economy were fully employed. (No unemployment or underemployment of resources, Maximum sustainable output, Economic resources are fully employed at normal levels - serves as benchmark) Estimated by the Congressional Budget Office.
How are the seven Federal Reserve Board Governors appointed?
They are nominated by the president of the United States and confirmed by the Senate
How did the onset of the pandemic affect businesses and state and local governments?
They found it difficult to access funds to continue operations.
How did the Fed's liquidity and credit facilities support the flow of credit in the economy?
They kept markets working when the financial assets traded in those markets were difficult to sell.
How did the Fed's purchases of U.S Treasury securities and other financial assets help stabilize the financial system?
They kept markets working when the financial assets were otherwise difficult to sell.
Historically, how have governments (such as Germany in 1921-23 and Zimbabwe in 2007-09) dealt with extremely high levels of debt?
They ordered the central bank to finance deficits by creating money
Aggregate Supply
Total amount of goods and services businesses will supply. Can change in the short run and long run (SRAS vs. LRAS). Shifts due to any changes in economic resources AS = K + L + C + E
Aggregate Demand
Total amount of goods and services people will purchase at various price levels. Any changes in variables shifts the curve. Changes in monetary (interest rates) and fiscal policy. AD = C + I + G + NX
John Maynard Keynes
Wanted to solve the Great Depression by boosting effective demand - government uses temporary deficit to provide people with income Recognized that the plan could cause inflation, but said that it could be solved by raising taxes later
Gross National Product (GNP)
Was chief measurement of economy until 1992, GNP includes American-owned businesses overseas, Excludes foreign-owned branches in the US, Typically differ by <1%
Is the Fed audited?
Yes, the Government Accountability Office and external auditors audit the Fed
Market Basket
a selected group of consumer goods and services whose prices are tracked for calculating a consumer price index and measuring the cost of living. Constructed from spending diaries of consumers. Used to figure out what people are actually buying.
Natural Rate of Unemployment
Zero unemployment is not feasible → natural rate of unemployment is always there Associated with full employment natural unemployment = frictional + structural unemployment Changes because of government policies, labor force characteristics, & labor market institutions
Disinflation
a slower rate of inflation
What happens when economy is above potential GDP
above → positive output gap Unsustainable, expanding, low unemployment
Fiscal Policy
Spending and taxing policies created by the President and Congress
Gross private investment (I)
Spending now to increase output later ~11% of GDP → new housing, structures, machinery
Why is the U.S. Treasury market an important indicator for the rest of the economy?
Stress in this very large market most likely signals financial market stress more broadly.
GDP Expenditure Approach
Sum of all spending that occurs in purchasing output: GDP = C + I + G + NX Consumption by households (C) + Gross private investment (I) + Government (G) + Net Exports (NX)
Labor Force
Sum of the employed and unemployed Participation rate: (labor force/population aged 16≤) x 100 Military and the institutionally employed not counted
Which part of the Federal Reserve System's structure ensures that regional (Main Street) interests are represented?
The 12 Federal Reserve Banks
Which part of the Federal Reserve System's structure ensures that national interests are represented?
The Board of Governors
FFR (federal funds rate)
The FFR is the overnight lending interest rates banks charge one another to borrow money.
How did the Fed bolster economic activity?
The FOMC lowered its target range for the federal funds rate to near zero percent.
How did the Fed lower the cost of borrowing from the Fed?
The Fed lowered the cost of borrowing from its discount window.
What was one of the original purposes the Fed was created for?
The Fed was created to provide loans and act as a backstop during a financial crisis.
FOMC
The Federal Open Market Committee is the most powerful committee of the FED, because it makes the decisions that affect the economy as a whole by manipulating the money supply.
In the "ample reserves" framework of monetary policy, __________
The Federal Reserve moves the FFR into the target range primarily by adjusting the IOER rate
Thinking in terms of a supply and demand graph, how did the Financial Crisis move the supply of reserves?
The Financial Crisis moved the supply curve right into the flat portion of the demand curve
John Maynard Keynes solution to the great depression
The government should pump money made by selling treasury bonds into the economy to encourage "effective demand". Called for the government to create social programs for the unemployed during depressions to stimulate businesses. Traditional economy policy would've been to lower interest rates and increase the money supply, but that did not work
Economy is usually ________ potential GDP
below → negative output gap (recession) FOMC is likely to lower its target range for the federal funds rate to lower interest rates
Federal reserve is made up of ___________
one central bank and three key entities
Coincident indicators
change direction about the same time the economy does
Leading indicators
change direction before the economy does
Unemployment rate
percentage of people in the labor force who are unemployed (# of unemployed workers/labor force) x 100
Discretionary Spending
decided/allocated each year (controllable) Ex: defense, security
Frictional unemployment:
due to the time spent searching for a job or between jobs Inevitable, people are always entering the job market May be good, as people are trying to match their job to their skills
Structural unemployment
esults from changes in the underlying composition of the economy Mismatch between human capital and skills needed Geographical constraints Job market rigidity
Deflation
falling prices (inflation is negative) People will delay purchases - deflationary spiral Indicative of a recession
Lagging indicators
hange direction after the economy has done so
When the fed tries to stimulate the economy, they risk __________
having inflation occur
Cost-pull inflation
if production costs rise too fast, companies push up prices
Examples of leading indicators
index of building permits, housing starts, and manufacturers' new orders for durable goods.
Examples of coincident indicators
index of industrial production and the prime interest rate.
Federal Funds Rate (FFR)
interest banks charge banks for overnight loans -Influences consumer interest rates -What the fed most cares about - sets a target but not the actual rate
When the output gap is negative, the FOMC ___________________
lowers interest rates & target range for federal funds
Personal Consumption Expenditures (CPE)
measured by the BLA
Consumer Price Index (CPI)
measures prices of goods and services in a market basket of purchases made by urban consumers, measured by the Bureau of Labor Statistics.
GDP Income Approach
sum of all income
IOER (interest on excess reserves)
the Fed pays interest on reserves to banks as an incentive. Because of the IOER, banks can now earn money by leaving reserves with the fed. Directly proportional to FFR - banks will not lend in the market at anything less than the IOER Always greater than the FFR
National debt
the accumulation of past deficits and surpluses -The public holds the national debt → gov sells US Treasury securities to them -Japan is the top foreign holder -Interest is paid on the national debt each year
Mandatory spending
uncontrolled - Congress can't allocate it Ex: social security, medicare → eligibility programs Only way to control it is to change the law Discretionary bills are made by subcommittees and then signed into law by the President
Examples of lagging indicators
unemployment rate and expenditures on new plant and equipment.
Demand-pull inflation
when there is too much money chasing too few goods - excessive growth in demand
Government (G)
~20% of GDP → Spending of all levels of government (1/10 of spending is investment) Doesn't include transfer payments like Social Security or unemployment benefits
Consumption by households (C)
~70% of GDP → consumer durable & non-durable goods and services
n the ample reserves framework, what rate acts like a floor for the FFR?
ON RRP
ample reserves
(not limited) Reserves are the sum of money banks hold in deposit
Actual Unemployment
Actual = natural + cyclical unemployment
Unlike hawks or doves, owls feel that the budget ___________
Never needs to be balanced because a country that controls its own currency can simply create more money to pay its debts
Real vs. Nominal GDP
Nominal is the total, untouched number Real GDP accounts for inflation
Which measure do economists feel is a better measure of the U.S. debt burden?
Debt held by the public
How is "debt held by the public" different from the total public debt?
Debt held by the public is debt held external to the government.
Paul Volcker's strategy for reducing the high inflation rate of the 1970s was to
Decrease the money supply, even if that meant higher interest rates
Which of the following best describes how the Federal Reserve might use the current framework to increase employment during a recession to achieve its maximum employment objective?
Decrease the target rate range for the FFR
How inflation affects purchasing power
Diminishes purchasing power. People living on fixed incomes, savers, creditors, lenders, and low income families are the most harmed. Beneficial to borrowers. Opportunity cost of time and other resources spent trying to avoid paying higher prices.
Paradox of Thrift
Downward spiral when people save money during uncertain times. In uncertain times, the reduced spending of consumers persuades businesses to sell and invest less, therefore leading to a downward spiral
Expansionary Fiscal Policy
Increased spending and lower taxes. Increases consumer spending, business investments, aggregate demand, GDP, employment, and price level (inflation)
What two foundational beliefs that sometimes have tension are reflected in the structure of the Federal Reserve?
Independence and accountability
Inflation
Inflation is a persistent increase in the general price of goods and services when considered in the aggregate (Doesn't mean all prices are rising, only the average, Target is ~2%)
In the case of "intergovernmental debt," how does the government borrow from itself?
It uses surpluses from some government programs to buy U.S. Treasury securities
Contractionary Fiscal Policy
Lower spending and higher taxes. Decrease in consumer spending, business investments, demand, GDP, employment, and price level (deflation)
GDP (Gross Domestic Product)
The total market value (sale price) of all final goods and services (end product) produced annually in an economy. Measured by annual growth rate.