macro unit 4 test
Inflation-induced tax distortions
-Almost all taxes distort incentives -Lawmakers fail to take inflation into account when writing tax laws so taxes become more problematic in the presence of inflation -Inflation exaggerates the size of capital gains and inadvertently increases the tax burden on this type of income -the income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation -because the after-tax real interest rate provides the incentive to save, saving is much less attractive in the economy with inflation ***When inflation raises the tax burden on saving it tends to depress the economy's long-run growth rate -ideal world tax laws would be written so that inflation would not alter anyones tax liability (rewritten to take account for effects of inflation)
shifters of supply loanable funds
-changes in private/public savings behavior -changes in foreign investment
assume a business is deciding whether to invest in a new project that is projected to generate profits of 90,000 each year for the next 3 years. project start up costs are 225,000. if business normally earns 11 percent on its investments should the business invest?
-consider each year separately. you divide your profits by 1+interest rate raised the power of the year it is
Federal Open Market Committee (FOMC)
-consists of the 7 board of governors, and all the regional presidents are there but only 5/12 can vote. NY can always vote jobs: -increase/decrease the # of dollars in the econ -primary tool-> open market operations (purchase and sale of gov bonds)
assume you have owned a 20 year $1000 bond w a coupon rate of 6 percent for 17 years. if current interest rates on similar bonds are 9 percent, at what price could you sell the bond for today?
-determine the interest of the bond that you are paid each year (original interest rate * principal). -determine each year separately. divide the interest you found by 1+ the new interest raised to the power of the year. in the last year of the bond you're paid the face value + interest
stock market
-equity finance -claim to partial ownership in a firm -firms raise funds for expansion by taking on additional owners -riskier than bonds but higher potential return -owners of stock share in profits or losses of the firm -do not mature or expire -traded on stock exchange (NASDAQ, NYSE) -determined by supply/demand, reflect future profitability
problems in controlling the money supply
-fed can't control the amount of money households choose to hod as deposits in the banks -fed can't control the amount bankers choose to lend
why is money effective?
-generally accepted (confidence its a legal lender) -scarce (can not be easily reproduced) -portable and dividable
market for loanable funds
-have to say *real* for the IR on the y axis -budget surplus is when you're higher up on supply curve than equilibrium, deficit lower down supply curve represents both private/public savings, and represents the savers particularly the households. demand curve comes from investment -firms borrow funds needed to pay for new equipment and factories. households borrow funds needed to buy a new house an increase in IR makes saving more attractive increasing the QUANTITY of loanable funds supplied
shifters of demand loanable funds
-if perceived business opportunities increase, demands for investment increase
economy in long run
-increase in money supply increases the price level -try to keep annual inflation rate at 2% for price stability
economy in the short run
-increase in money supply will increase Q. -fluctuations in econ activity. -recession occurs when fewer resources are used, high unemployment -higher demand for resources means increased wages and productivity, increase in price level and concerns about inflation
financial intermediaries
-institutions through which savers can indirectly provide funds to borrowers examples: banks, mutual fund
M2 money supply
-near money -includes all of M1 -saving deposits (money market accounts) -time deposits (certificate of deposit-> CD) -money market funds
how Fed influences quantity of reserves
-open market operations (buy bonds to expand) -discount rates (IR on loans Fed makes to banks, increase rate discourages investment)
12 regional banks of Fed
-regulate banks and ensure the health of the banking system -monitors banks' financial condition and facilitates bank transactions by clearing checks -makes loans to banks (lender of last resort) -control money supply through monetary policy
Fed's organization
-run by board of governors (7 members) -chairman -12 regional banks -federal open market committee (FOMC)
what determines a bond's risk?
-short term maturity date is less risky because interest rates over the long term change a lot -tax treatment: if the bond is tax exempt there is less interest (municipal bonds are tax exempt like if LT issues a bond) -if the bond issuer has a bad credit risk, it's more risky and has higher interest rates (detroit bonds vs. gov bonds)
How the Fed Influences the Reserve Ratio
1. reserve requirements (higher RR, less money loaned out, higher reserve ratio, lower multiplier, lower MS). used very rarely 2. paying interest on reserves (Fed pays interest on banks' reserves on deposit @ Fed. higher rate lower MS)
value of money
1/P is the quantity of goods and services that can be bought with $1 when price level rises, value of money falls determined by supply and demand. (money supply and money demand) determinants: supply: monetary policy demand: average level of prices (IR) (higher prices increase money demanded bc ppl hold money) long run overall level of prices adjusts to when demand for money equals supply if price below equilibrium, then people want to hold less money (decreased MD) so the price level must rise to meet equilibrim when price is low, value of money high, less quantity of money demanded so less money is demanded to buy these goods and services so downward slope increase in MS decreases the value of money but increases money demanded bc people use more dollars per transaction
reserve requirement money multiplier
1/reserve ratio how much $ created = multipler * excess reserves example question: if fed buys 100 B and RR is 10% what is total change in MS? or if jill deposits $100 cash into her account and the RR is 10% what is the total change in MS?
rule of 72
72 divided by interest rate (as percent) is # years to double your money
direction IR and bond prices move
IR and bond prices move in opp direction because present value decreases with higher IR
fed funds rate
IR at which banks make overnight loans to each other
income
flow of earnings per unit of time
money
generally accepted in payment for goods and services. not same as wealth/income!!
barter system
goods and services traded directly, no $ is exchanged. have to have double coincidence of wants. some goods can't be split so its hard (ex. 1 good is 5 chickens). might only accept certain goods
capital requirement
gov regulation specifying a minimum amount of bank capital to ensure that banks will be able to pay off their depositors. risky assets have higher requirement
intrinsic value
has value bc it exists as something else
money market accounts
have a limit of the amount you can withdraw
fractional money system
have reserve requirement around 3%. only a fraction is on hold, the rest is loaned out. then another bank is credited for more money, which is really just someone else's credit card debt. SO every transaction, the actual reserve is only up a fraction but total money supply up a lot
level and volatility of inflation
high inflation is typically unstable
direction price and interest rates move
higher prices, higher IR
how foreign consumers impact loanable funds
if consumers abroad spend more then theres decreased savings so savings shifts left
inflation vs. interest rate
if inflation is higher than the IR the lender is paid less purchasing power, therefore losing money
saving
individuals spend less than he or she earns and uses the rest to buy stock, bonds, or mutual funds
mutual funds
institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds -shareholders accepts all risks and benefits -allow people to diversify holdings (less risk) -give ordinary people access to skills of professional money managers
financial markets
institutions through which savers can DIRECTLY provide funds to borrowers includes bond markets and stock markets
unit of account
measures value of goods and services
functions of money
medium of exchange, unit of account, store of value
medium of exchange
money can easily be used to buy goods and services with no complications of barter system
M1 money supply
most liquid -currency in circulation -checkable bank deposits (checking accounts, demand deposits) -traveler's checks
Are credit cards money?
no because it is considered debt and you have to pay it back
commodity money
perform functions of money and has intrinsic value ex: gold, silver, cigarettes
dual mandate
price stability and max employment
national saving
private saving + public saving I = national savings I = Y-C-G or I= Y-T-C + (T-G) saving = investment in a closed econ
future value
PV * 1+IR raised to the year
present value
PV= stream of $/1+IR worth less over time due to inflation
invesment
purchase of new capital, such as equipment or buildings
fiat money
serves as money but has no other value/uses ex: paper money, coins, digital currency
how should you organize your investment portfolio in the short term vs long term
short term: mix of stocks and bonds for less risk long term: more stocks
relative price variability
since prices changes only every once in a while, inflation causes relative prices to vary. customers decide what to buy based on relative prices, so consumer decisions are distorted and markets are less able to allocate resources
banks
take deposits from people who want to save and use them to make loans to people who want to borrow. banks pay depositors interest and charge borrowers interest
federal reserve system
the central bank of the United States
menu costs
the costs of changing prices. this is why firms change costs infrequently. inflation increases menu costs example: cost of deciding on new prices, cost of printing new price lists and catalogs, cost of sending these new prices lists, cost of advertising, cost of dealing w customer annoyance of price changes
liquidity
the ease with which an asset can be accessed and used as a medium of exchange
reserve ratio
the fraction of deposits that banks hold as reserves reserve/deposits
financial system
the group of institutions that helps match the saving of one person with the investment of another
monetary neutrality
the idea that changes in money supply does not affect real economic variables
wealth
total collection of assets
nominal variables
variables measured in monetary units (dollars) dollar value
real varaibles
variables used in physical units (farmers measuring # of bushels) quantity. relative prices
interest on M1 and M2
very little interest because easy to get your money in and out
would you rather $100 now or $100 in 1 year?
you can find the future value of the $100 now by doing 100 * 1 + IR raised to the # of years or you can find the present value of the 100 in future by doing 100/1+ IR raised to the # of years. then compare either the 2 present values or the 2 future values to see which is more $
certificate of deposit
you give your money for a specified amount of time at a fixed interest rates. you cant get money out before that time
expansionary monetary policy investment graph
you will have lower interest rates so then you move down the curve for higher investment
T-account
your loans always stay the same as you keep moving down. but then u add the loans to the checkable deposits, the required reserve changes. so the excess reserves is checkable deposits- loans-required reserves. always add the loans to the original amount of checkable deposits
Simple Case of 100 Percent Reserve Banking
all deposits are held as reserves
purchasing power
amount of goods and services a unit of money can buy inflation decreases purchasing power and acceptability
budget surplus
an excess of tax revenue over gov spending T-G positive
central bank
an institution designed to oversee the banking system and regulate the quantity of money in the economy
cost of unexpected inflation
arbitrary redistribution of wealth (hyperinflation diminishes your debt, easier to pay off). usually benefits debtors
balance sheet for fractional reserve banking
assets (left side) reserves, loans, securities liabilities: deposits, debt, capital (owner's equity) to find number of reserves, multiply reserve ratio by # of deposits assets must equal liabilities money supply is the deposits + loans
stock index
average of an important group of stock prices ex: dow jones
demand deposits
balances in bank accounts that depositors can access on demand by writing a check (checks, debit cards)
bond market
debt finance -a certificate of indebtedness -maturity date: the date the loan will be repaid -principal/face value: the amount borrowed and to be repaid at maturity -can be bought/sold before maturity, price determined by interest rates
leverage
the use of borrowed money to supplement existing funds for purposes of investment
quantity theory of money
Mv=PQ PQ is value of goods produced MV is expenditures inflation is increase in P goal is to increase Q (production) a theory asserting that the quantity of money available determines the price level and the growth rate. in the quantity of money available determines the inflation rate
inflation fallacy
Inflation does not in itself reduce people's real purchasing power.
quantity eq
Mv= PQ increase ms leads to inflation bc doesnt really effect output
budget deficit
T is lower than G (negative public savings) shortfall of tax revenue from government spending
public saving
T-G (usually negative) government tax revenue-gov spending tax revenue that gov has left after paying for its spending
private saving
Y-T-C individuals portion of household income that is not used for consumption or paying taxes
chairman of Fed
directs Fed staff, presides over board meetings, and testifies regularly about Fed policy in front of congressional committees
inflation
economy wide phenomenon that concerns first and foremost, the value of the economy's medium of exchange. rise in price level, each dollar buys smaller quantity of goods
budget deficit shift loanable funds
effects supply. reduces national savings, because T-G is negative. shifts left. increases interest rate and decreases Q (crowding out effect bc more gov spending increases IR and shift supply left)
saving incentives shift loanable funds
ex: decrease capital gain taxes (taxes on interest) decrease taxes more saving! -shift loanable funds supply right. lowers interest rate and QLF increase
investment incentive shift loanable funds
ex: investment tax credit (gives you credit/break from taxes if they invest in certain projects) investment tax credits increase demand for loanable funds (shift right)
fisher effect
the one-for-one adjustment of the nominal interest rate to the inflation rate real interest rate = nominal interest rate - inflation rate a change in money should not effect real rate. the long run result is higher inflation rate and nominal interest rate does not hold in the short term tho bc inflation could be unanticipated
currency
the paper bills and coins in the hands of the public
money stock
the quantity of money circulating in the economy
velocity of money
the rate at which money changes hands V= PQ/M relatively stable over time
leverage ratio
the ratio of assets to bank capital (assets/capital) if leverage ratio is 20, that means for each $ gov provides, the bank has $20 in assets
bank capital
the resources a bank's owners have put into the institution (owner's equity)
shoeleather costs of inflation
the resources wasted when inflation encourages people to reduce their money holdings. making more frequent trips to the bank. the time and convenience u must sacrifice (ex of ppl in bolivia converting to US dollars bc more stable, or running to bank to pull out $)
inflation tax
the revenue the government raises by creating money no one receives a bill for this tax. when gov prints money price level rises and dollars less value. it's like a tax on everyone who holds money
classical dichotomy
the theoretical separation of nominal and real variables
double coincidence of wants
the unlikely occurrence that two people each have a good the other wants
