Macroeconomics and Money, Banking, and Financial Markets Section of the Economics Comprehensive Exams

Discounting

"Discounting" enables you to calculate the yield to maturity on a bond, which is its "true" interest rate, or the present value of any future stream of income. In all cases, we assume that interest is compounded annually. PB (Bond price) = (Payments) x/(1+i)/\x

Economic Fluctuations

If all prices are stuck at a predetermined level, then when a short-run aggregate supply curve is drawn with real GDP (Y) along the horizontal axis and the price level (P) along the vertical axis, this curve: is Horizontal If the short run aggregate supply curve is horizontal, then changes in aggregate demand affect: Level of output but not prices

Money and Interest.

If the real interest rate is 2%, and the expected rate of inflation is 3%, the nominal interest rate should be: 5% (real=nominal-rate of inflation)

Distorted Price Signals

In a market economy, price signals prevent massive shortages and ensure that consumer wants are largely satisfied. Inflation distorted our perception of these price signals

Risk and Term Structure of Interest Rates

3 Types of Risk: 1) Market or Interest Rates Risk: Risk => when increases, then PB decreases 2) Default Risk or Credit Risk: The risk that a bond's intent and/or principle will not be paid. 3) Reinvestment Risk: the risk that interest rates will fall below your expected yield and decrease your income.

Financial instruments

Can be classified generally as equity based, representing ownership of the asset, or debt based, representing a loan made by an investor to the owner of the asset

The Fed's tools for controlling the money supply.

To reduce the money supply, the Federal Reserve: Sells government bonds Suppose the fed engages in large open market sale of US government securities. What will this affect have on the money supply? Fed purchasing=increase MS/ Fed Selling=decrease in MS The Money supply will decrease bc the selling of government securities Required Reserve Ratio. Discount Rate. Open Market Operations.

Fiscal policy

Use the closed economy savings/investment framework to show and explain how a fiscal policy change that leads to an increase in the government budget deficit will affect national savings, the real interest rate and the level of Investment spending in the long run. Make sure you specify the direction of the change in the fiscal policy variable you choose. (Graph) an increase in government budget deficit will lead to a decrease in national savings, driving the real interest rate up and the savings/investment down. G= Government Purchases TR= Transfer Payments G + TR= Total Gov't Spending T = Taxes Government Budget Deficit = (G + TR)-T Government Budget Surplus = T - (G+TR)

The open economy in an IS-LM model

Use the open economy IS-LM framework to show and explain why a country's monetary authority loses its ability to conduct an independent monetary policy under fixed exchange rates Increase Ms => Lm out to LM' Y increase and r decrease R< rw => capital outflows and pressure on e down and domestic money to depreciate => Fed sells foreign exchange => decrease in Ms => Lm shifts until LM = IS = BP Monetary policy is ineffective under fixed exchange rates Use the open economy IS-LM framework to show how monetary policy can be used to cause a country's money to depreciate against foreign money, and the effect that this depreciation would have on Net Exports and GDP once the economy returns to the new short run equilibrium An increase in the money supply causes depreciation Increase in Ms => LM out to LM' => r decrease => r<rw => capital outflows => e decrease and domestic money depreciates => increase in NX => IS shifts out to IS', where LM = IS = BP Therefore depreciation => increase in NX => increase y to y"

Required Reserve Ratio.

rr: 10% set by the Fed Reserve in the amount Banks create new money when they make loans under fractional reserve banking, and the opposite The amount that the bank wants to hold in addition to

The national debt: is it a problem?

Not necessarily

Determination of the rate:

1) Differentials in Inflation 2) Differentials in Interest Rates 3) Current-Account Deficits 4) Public Debt 5) Terms of Trade: A country's terms of trade is a ratio comparing export prices to import prices 6) Political Stability and Economic Performance.

Functions of Money

1) Medium of Exchange: Eliminates necessity of mutual coincidence of wants for exchange to take place, Reduces transactions costs 2) Unit of Account: Reduces transactions costs, Measuring and keeping track of prices in a market economy 3) Standard of Deferred Payment: Standard of measuring debt 4) A Stored Value: Money is the only asset whose nominal value can be known w/ certainty; a dollar is a dollar

The Balance of Payments

A nation's overall balance of international payments (current account + financial account + capital account + errors and omissions) is always in balance by definition The overall U.S. balance of payments must be balance because every transaction involves a corresponding payment; hence every credit generates a debit and vice versa. The purchase of US government bonds by the Chinese government is an example of a balance of payment entry that is a credit (+) in the US account.

Derivatives

A relatively new form of derivative contract (the first ones were traded in 2002) that is based on the future value of some national economic indicator, such as non-farm payrolls, the purchasing manager's index, retail sales levels and the gross domestic product. Most of these economic derivatives are in the form of binary or "digital" options, whereby the only payout options are full payout (in the money) or nothing at all (out of the money). Other types of contracts currently traded include capped vanilla options and forwards.

Measurements of the Money Supply.

A sudden decrease in the velocity of money suggests that: The money supply has increased. According to the equation of exchange, the rate of inflation or deflation is primarily determined by: The rate of growth in the money supply (Short answer) If the rate of growth in full employment real GDP is 3% and the velocity is constant, what must the rate of money growth be to maintain a 2% rate of inflation? ∆%M + ∆%V= ∆%P+∆%Y ∆%M=∆2%+∆3% =∆5% =Rate of money growth would be 5% (short answer) Given the scenario described in the question above, what will happen to the rate of change in prices (the rate of inflation or deflation) if the rate of money growth increases to 20%? ∆%M + ∆%V= ∆%P+∆%Y 20% - (3%) = ∆%P + 3% - (3%) 17%=∆%P+ 0% ∆%P= 17% The ∆%P would grow to 17% given a 20% increase in the growth of money Use the dynamic version of the equation of exchange to show what will happen to the rate of inflation if the rate of money growth increases from 0% to 10%, the rate of real GDP growth is 3% and the velocity is neither increasing nor decreasing. ∆%M + ∆%V= ∆%P+∆%Y 10%+V(constant)=P +3% ∆%P=7% Liquidity (adj.): a measure of the moneyness of an asset; a measure of how easy it is to turn something into money. Liquidity (noun): synonym of money M1 = currency + Bank deposits M2= M1 + Savings Deposits, Repudiate Accounts, etc. M3= M2 + a bunch of exotic less liquid assets

Money and Prices.

According to the money neutrality hypothesis, changes in the money supply will not affect: The level of real GDP Most economists believe that prices are: Flexible in the long run but many are sticky in the short run

Monetary Theory

An economic theory that details the procedures and consequences of using government-issued tokens as the unit of money, i.e., fiat money. Inflation is always and everywhere a monetary phenomenon Stock vs. Flow Variables Stock: a variable that exists AT A particular period of time Flow: a variable that exists OVER A particular period of time Money is a stock variable that measures a particular class of assets that perform a certain number of functions Money and prices. Money and interest. Measurements of the money supply. The Federal Reserve System (The Fed).

Financial intermediaries

An institution acting as a middle man to increase profit or prosperity of the buyer and lender They reduce transactions costs Reduce Asymmetric Information: the borrowers know something about the transaction that lenders don't

Nominal

Anything produced within a nation in a year. (including inflation) Raw Measure in Money Terms

Redistribution

Assuming everyone's nominal income is rising during inflationary period, income will be redistributed away from those whose money income are rising more slowly than the rate of inflation and toward those whose incomes are rising more rapidly.

Open Market Operations.

Basic tool that the Fed uses to control the money supply When the Fed buys bonds and other securities, Money supply increases When the Fed sells bonds and other securities, Money supply decreases

Monetary policy

Changes in monetary policy have an immediate and predictable effect on interest rates, bond prices, and stock prices. Use the liquidity preference framework to show how a large open market purchase of bonds by the Fed will affect the interest rates, bond prices, and stock prices. A large open market purchase of bonds => increase in MS => LM out. R down When interest rates decrease, price of bonds increase => Pb Increase Pb => increase in the demand for stock and an increase in price of stock Interest rates decrease => increase in Pb and increase in Ps

Money

Commodity Money: money backed by a commodity Fiat Money: money designated by gov't justified by a general consensus Credit Money: IOU as a major part of the money supply

Inflation

Definition: A decrease in the value of money ∏ = i (nominal interest rate) - r (real interest rate) Measurement: Price Index Problems with Inflation %change P (price) > 0, then Inflation %change P (price) < 0, then Deflation Inflation hurts creditors (lenders) helps debtors (borrowers)

Long Run Macroeconomics

Difference btw the Long Run and the Short Run Long Run: we assume that prices are flexible and have time enough to change to ensure full employment; when economy is producing at the Possibility Frontier. GDP in the Long Run: Y = AF(K,L) Short Run: we assume that prices are sticky or fixed. The determination and distribution of national income Basic open economy Macroeconomics Economic Growth Theory

Finance

Discounting Financial instruments Financial intermediaries Money Interest Rates

Efficient Markets Theory and the Stock Market

EMT: The (now largely discredited) theory that all market participants receive and act on all of the relevant information as soon as it becomes available. If this were strictly true, no investment strategy would be better than a coin toss. Proponents of the efficient market theory believe that there is perfect information in the stock market. This means that whatever information is available about a stock to one investor is available to all investors ST: The market in which shares of publicly held companies are issued and traded either through exchanges or over-the-counter markets. Also known as the equity market, the stock market is one of the most vital components of a free-market economy, as it provides companies with access to capital in exchange for giving investors a slice of ownership in the company.

Short Run Macroeconomics

Economic Fluctuations The IS-LM model

Exchange rates

Expresses the national currency's quotation in respect to foreign ones. For example, if one US dollar is worth 10 000 Japanese Yen, then the exchange rate of dollar is 10 000 Yen.

Per Capita

GDP divided per person within a nation Relativizes GDP by comparing one country's population to another Doesn't include distribution of wealth in a country Per capita GDP= Real GDP/Population

GDP

Gross Domestic Product (GDP): all of the FINAL GOODS and SERVICES that one produced within a country's borders measured at a current market price, during a certain calendar year Measures the economy's annual output of goods and services. Y(GDP)= Total expenditures=C+I+G+NX (Consumption, Investing, Gov't Purchases, and Net Exports - Imports) Consumption ex: Sinutab buys a carrot Rogaine pays tuition in UD's Graduate Program in Auto Upholstery Repair Investment: Zocor buys 3 Mercedes CL 500's to use in his high end taxi service Risperdal builds a factory to manufacture bird feed Government spending The US government buys a new jet from Lockheed Martin Inc. Exports Percocette, Dr. Doyle's French girlfriend, pays her bill at the Hotel Zaza in Dallas (From her own income) Imports Cialis buys a BMW M6 (made in Germany) When GDP declines (2 consecutive periods): A Recession occurs The "Broken Window Fallacy" refers to: assuming that increases in GDP that result from clean up expenditures following a natural disaster result in increases in aggregate economic well-being. * Clean up costs don't make us better off; Tailor example: instead of having his window smashed, he could have used the money from repairing the window to buy a tv or something, thereby spurring the economy. Y-C-G = NATIONAL SAVING (S) *The market is in equilibrium in a closed economy (Y=C+I+G), then it must also be true that S=I (short answer) Use the saving/investment framework to show what will happen to the real interest rate and the level of investment spending, if the government changes any of the fiscal policy variables in a way that will reduce the government budget deficit. A reduction in government budget deficit will decrease the real interest rate and increase savings & investment (graph) What determines the full employment, potential level of GDP in the long run? Y=AF(K,L) A=Technology/K=Capital/L=labor Y is determined by the state of production technology and the consent of K&L employed in the production process GDP Deflator (Filter): Converts Nominal into Real GDP Nominal Real Per capita

The Determination and Distribution of National Income

In the long run, what determines the level of total production of goods and services in an economy? The quantity of capital and labor and production technology Many 19th century economists argued that an increase in the capital stock would make workers worse off by allowing the replacement of workers with machines, which would increase competition among workers for increasingly scarce jobs, which would in turn reduce the level of employment and decrease real wages. Use the labor market framework to show how an increase in capital will really affect real wages and the level of employment in the long run. K increases DL/ MPL increases =- w/p to increase and L to increase. If capital stock increases, the demand and the managerial product of labor is higher, this will lead to the increase in real wages

Main theories of exchange rate determination

Interest rate parity Purchasing Power Parity

The IS-LM model

Investment-Savings (IS) (Gov't) Liquidity preference-Money Supply (LM) (Fed) curve

Economic Growth Theory

Less developed countries tend to experience large increases in borrowing from other countries as they undergo economic development and their economies begin to grow rapidly. This is because capital is very scarce in such countries, and rapid economic development is associated with a large increase in the expected future marginal product of capital. Use the open economy savings/investment framework to show why it is "normal" for such countries to experience large increases in borrowing from abroad during the early stages of their economic development MPKF increases = I increases= (r increase), (S,I)< 0 , NX < 0 If a country is experiencing economic development, the future marginal product of capital is increasing. This positive outlook leads to an increase in investment, and net exports will thus be less than zero. This country has to borrow from abroad

The Federal Reserve System (The Fed).

Multiple expansion of deposits The Fed's tools for controlling the money supply.

Meaning of a trade deficit or surplus

NX> 0, then Trade Surplus NX< 0, then Trade Deficit NX=o, then Trade Equilibrium According to Hume's Adjustment Mechanism if a nation has a trade deficit under a gold standard, gold will flow out of the country. This will cause the domestic value of gold to increase, which will cause domestic prices to fall. This will make the nation's exports cheaper and it will make domestic good more attractive than imports. The combination of more exports and less imports will reduce the deficit.

Real

Nominal GDP adjusted for inflation (price changes) Money supply will not affect real GDP

Is a trade deficit a problem?

Not necessarily because it allows a nation to spend beyond taxation. In addition, if it helps to expand the economy, then the expansion of the economy could actually make the size of the deficit as a percentage of the budget smaller. However, as stated before, if the deficit becomes too large, then a nation will end up giving up more of its economic growth to pay lender than expand, causing the economy to remain stagnant or shrink

Interest Rate

Price of Credit Real vs. Nominal

Ways to Finance the government budget.

Printing money. Borrowing from domestic public Borrowing from foreigners If domestic spending exceeds output, we import the difference- net exports are negative If domestic saving exceeds domestic investment, then net exports are positive and the capital and financial account balance is negative In a small open economy, if exports equal $5 billion and imports equal $7 billion, then there is a trade deficit and negative net capital outflow In a small open economy, if domestic investment exceeds domestic saving, then the extra investment will be financed by: borrowing from abroad In a small open economy, if domestic saving exceeds domestic investment, then the extra saving will be used to: make loans to foreigners If a US corporation purchases a product made in Europe and the European producer uses the proceeds to purchase a US government bond, the US net exports decrease and net borrowing from abroad increases In a small open economy, starting from a position of balanced trade, if the government increases the income tax, this produces a tendency toward a trade surplus and less foreign borrowing

Real vs. Nominal

Real: r (real interest rate) = i (nominal interest rate) - ∏ (the rate of inflation) Use the dynamic version of the equation of exchange to show what will happen to the rate of inflation if the rate of money growth increases from 0% to 10%, the rate of real GDP growth is 3% and the velocity is neither increasing nor decreasing. ∆%M + ∆%V= ∆%P+∆%Y 10%+V(constant)=P +3% Thus, ∆%P=7% If the nominal interest rate is 5%, what will the real interest rate be if the rate of inflation is what you calculated from above ↑ ? i= r + π 5%= r + 7% Thus, R= -2% The Investment function slopes downward to the right because there are fewer investment projects that are profitable as the interest rate decreases. When there is a fixed supply of loanable funds, and increase in investment demand results in a Higher Interest rate In a Classical model with fixed income, a reduction in the government budget deficit will lead to a Lower Interest rate Crowding out occurs when an increase in government spending increases the interest rate and investment decreases.

Problems with Inflation

Redistribution Distorted Price Signals Resources used to Cope

Financial Markets

Risk and Term Structure of Interest Rates Efficient Markets Theory and the Stock Market Banking and the Management of Financial Institutions Derivatives

Types of foreign exchange transactions

Spot foreign exchange: the rate at which one money can be exchanged for another on any given day. Forward foreign exchange: an exchange rate agreed upon today is to be paid at a specified date in the future. Difference between forward foreign exchange contracts and foreign exchange futures is forward contracts are "over the counter", i.e., they are individually made for each customer, while futures are exchange-traded standardized contracts.

International Finance

The Balance of Payments Balance of Trade = Investment-National Saving Meaning of a trade deficit or surplus Exchange rates

Measurement: Price Index

The CPI measures the rate of inflation/deflation

Resources used to Cope

The Hyperinflation experienced by interwar Germany illustrates how fiscal policy can be connected to monetary policy when government expenditures are financed by: Printing large quantities of money.

Balance of Trade = Investment-National Saving

The current account = the balance of trade + net unilateral transfers. The current account = financial account. So if the Balance of Trade = -$600 billion and the current account = -$400 billion, then unilateral transfers must = +$200 billion.

Purchasing Power Parity

The idea underlying the concept of purchasing power parity is the value of a currency is determined by what it will buy. If soybeans cost $10 per bushel in the US while costing 5 british pounds per bushel in the UK, according to the absolute Purchasing Power Parity the exchange rate should be 2$/ pound. A reason that we do not observe absolute PPP is that many goods and services are not traded internationally; thus we lack the arbitrage process that would result in PPP.

Discount Rate.

The interest rate that the Fed charges banks for overnight loan reserves

Effect of financing the deficit.

Use the open economy saving-investment framework to show how a large decrease in taxes will affect net exports and the balance on capital and financial account (KFA)? T↓ → Disposable income ↑ → C↑ → S↓→NX<0 NX<0 = we import more than export -Balance of Trade = NX+KFA -NX will decrease = NX<0 -KFA will increase=KFA>0 What does the change in the capital and financial account that you describe above, suggest about the volume of international borrowing or lending that the US is engaged in? The US to be able to import more will have to borrow for abroad. So, thus, the US will become a debtor nation (instead of a creditor nation) and borrow money from abroad in order to sustain its increase in consumption (due to the decrease in taxes) because now due to the rise in consumption. I>S so they need to borrow and be a debtor nation. Suppose that government spending on the wars in Afghanistan and Iraq increases significantly. Use the open economy Savings-Investment framework to show how this will affect the level of Net Exports. NX=Y- C - I - G => G increases =NX to decrease If government spending increased, then national savings would decrease, lending to a decrease in NX Will the change in the current account balance you describe above result in more or less borrowing from abroad? More bc there is less net exports Many people are concerned about reducing the size of federal government budget deficit. Give an example of change in one of the major fiscal policy variables that would lead to a reduction in the government budget deficit. Decrease Government spending or increase Taxes The level of GDP in the US seems to be stuck at a level that is considerably below full employment level of GDP. Use the closed economy IS-LM model to show what the effects would be on GDP and Real interest rates of the change in the fiscal policy variable that you describe above, and whether it would move the economy toward or further away from the full employment level of GDP. In other words, would this be a good time to try to balance the federal government? Decrease in G = decrease in consumption. IS shifts to IS'. Y down and r down Therefore the economy moves further away from full employment -> it is not a good time to balance the federal budget

The government budget

Ways to Finance the government budget. Effect of financing the deficit. The national debt: is it a problem?

IS curve

What does it represent? Investment-Saving Two equivalent interpretations are possible: first, the IS-LM model explains changes in national income when the price level is fixed in the short-run; second, the IS-LM model shows why the aggregate demand curve shifts. Hence, this tool is sometimes used not only to analyse the fluctuations of the economy but also to find appropriate stabilisation policies Why is it negative sloping? The IS curve slopes downward to the right because: when the interest rate falls planned spending increases, resulting in a higher equilibrium level of GDP What makes it shift? An increase or decrease in government spending generally shifts the IS curve

LM curve

What does it represent? Liquidity preference-Money Supply Two equivalent interpretations are possible: first, the IS-LM model explains changes in national income when the price level is fixed in the short-run; second, the IS-LM model shows why the aggregate demand curve shifts. Hence, this tool is sometimes used not only to analyze the fluctuations of the economy but also to find appropriate stabilization policies Why is it positive sloping? What makes it shift? An increase or decrease in the money supply makes the LM curve shift

Interest rate parity

What must be made equal for uncovered interest rate parity to hold is the rate of return on assets in both nations including the reward or penalty resulting from any expected change in the exchange rate over the time that the foreign asset is held.

Interest Rates

r= i - inflation