question

Law of Demand

answer

Holding all else equal, when the price of a good rises, consumers decreases their quantity demanded for that good. Inverse/negative relationship between the price and quantity demanded of a good.

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Ceteris paribus

answer

All else equal. Important because you know the variable that's causing the change in supply or demand.

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Substitution effect

answer

The change in quantity demanded resulting from a change in the price of one good relative to the price of other goods. Explains the demand curve, but not AD curve.

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Complementary goods

answer

Goods used and demanded together. Good #1 Price up, Good #2 Demand down

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Substitution goods

answer

One that can be used in place of another good. Good #1 Price up, Good #2 Demand up.

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Unrelated goods

answer

Products have no correlation; majority of products are unrelated goods. Ex: Bananas and watches

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Economizing problem

answer

Society's economic wants are insatiable, but economic resources are limited. Objective of economic activity is to fulfill WANTS

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Economic resources

answer

All natural, human, and manufactured resources that go into the production of a good

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Full employment

answer

Use of all available resources (both workers and capital equipment). Point on the PPC.

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Full production

answer

All employed resources must be used so that they provide the maximum possible satisfaction of our economic wants. Best point on the PPC.

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Productive efficiency

answer

The production of any particular mix of goods and services in the least costly way. Any point on the curve.

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Allocative efficiency

answer

Least-cost production of that particular mix of goods and services most wanted by society. The BEST point on the curve.

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Economic growth

answer

The ability to produce a larger amount 1. Increase in supplies or resources. 2. Improvements in resource quality 3. Technological advancements

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Resource market

answer

the place where resources or the services of resource supplies. Households own economic resources and sell to businesses, who buy them because are necessary for producing goods and services.

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Product market

answer

The place where goods and services produced by businesses are bought and sold. Businesses combine the resources obtained to produce and sell goods and services. Households use the income they have received from the sale of resources to buy goods and services.

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Circular Flow of model

answer

Complex, interrelated web of decision -- making and economic activity involving businesses and households. Households buy products and sell resources.

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Diminishing marginal utility

answer

Buyer will get less satisfaction from each successive unit purchased. Explains the downsloping demand curve.

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Income effect

answer

A lower price increases the purchasing power of a buyer's money income, which allows the buyer to purchase more of the product than he/she could buy before. Explains the demand curve, but not the AD curve.

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Determinants of Demand

answer

1. Consumers' preferences 2. Number of buyers. 3. Consumers' incomes. 4. Prices of related goods. 5. Consumer expectations about future prices and incomes.

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Normal goods

answer

Products whose demand varies directly with money income (steaks, furniture, and electronic equipment).

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Inerior goods

answer

Goods whose demand varies inversely with money income.

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Change in demand/supply

answer

Shift of demand curve

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Change in quantity demanded/supplied

answer

Movement from one point to another

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Law of Supply

answer

As price rises, the quantity supplied rises. As price falls, the quantity supplied falls. Price represents revenue, which is incentive to produce and sell the product. The higher the price, the greater the incentive and quantity supplied.

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Determinants of Supply

answer

1. Resource prices 2. Technology 3. Taxes and Subsidies 4. Price of other goods 5. Price expectations 6. Number of sellers/suppliers

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Surplus

answer

More supply than demand

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Shortage

answer

More demand than supply

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Open economy vs. closed economy

answer

Open economy: includes international trade, labor and resources go to exports and not imports, specialization and international trade increase the produce. Closed economy: no international trade.

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Why is specialization and trade good for a nation's economy?

answer

• Increases productivity of resources • Greater total output = economic growth • More efficient production • Mutually beneficial • Improves global resource allocation • More goods available to each country

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Terms of trade

answer

Has to be mutually beneficial to each country.

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Exchange rates

answer

The rate at which the currency of one nation can be exchanged for the currency of another nation 1. Competitive market 2. Linkages to all domestic and foreign prices

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Depreciation

answer

When the value of a currency decreases relative to another currency.

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Appreciation

answer

Value of a currency increases relative to another currency.

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GDP

answer

Total market value of all final goods and services produced in a given year. Must be: • Employed within the country (can be companies from foreign countries, but must be produced in US) • Only final goods, not intermediate goods GDP = C+I+G+Nx

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What does GDP not include?

answer

public transfer payments, private transfer payments, stock market transactions, secondhand sales.

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In GDP, what does Consumption include?

answer

Durable consumer goods Nondurable consumer goods Consumer expenditures for services

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In GDP, what does Investment include?

answer

All final purchases of machinery, equipment, and tools by business enterprises, all constructions (includes residential because can be rented), and changes in inventories. Investment in replacement capital and in added capital.

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Net private domestic investment

answer

Only investment in the form of added capital. Net investment = gross investment - depreciation.

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Depreciation

answer

Amount of capital used up over the course of a year/ amount of capital replaced.

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When gross investment > depreciation

answer

Net investment is positive Nation's stock of capital increases PPC shifts out

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When gross investment = depreciation

answer

Net investment is 0 No change in stock of capital PPC stays same

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When gross investment < depreciation

answer

Net investment is negative (disinvesting) PPC shifts in

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Disinvesting

answer

When the economy uses more capital than it's producing

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In GDP, what is included in government purchases?

answer

1. Expenditures for goods and services needed for public services. 2. Expenditures for social capital (schools, highways). DOES NOT INCLUDE GOVERNMENT TRANSFER PAYMENTS (like Social Security, unemployment welfare, etc.)

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In GDP, what is included in net exports?

answer

Exports minus imports.

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price index

answer

measure of the price of a specific collection of goods and services, called a "market basket," in a given year as compared to the price of an identical (of highly similar) PI = [(this year's price)/(base year's price)] x 100

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Real GDP

answer

deflated or inflated GDP Quantity of goods produced Real GDP = Nom GDP/Price index (In hundredths)

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Why is GDP not an accurate measure of our nation's well-being?

answer

Doesn't account for: 1. Nonmarket activities 2. Leisure 3. Improved product quality 4. Underground economy 5. Environment 6. Composition and distribution of output (GDP per capita) 7. Noneconomic sources of well-being

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Economic growth

answer

increase in real GDP or GDP per capita over some time period

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Rule of 70

answer

Approve # of years to double = 70 ÷ Annual percentage rate of growth Ex: 70/3 = approx 23 Applicable to lots of things (price level, savings account, GDP)

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Main sources of economic growth

answer

Increase inputs of resources Increase productivity of inputs (organization, education, motivation, efficient allocation, etc.)

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What are causes of the business cycle?

answer

Momentous innovations (irregular) Major changes in productivity Monetary phenomenon *Changes in level of total spending --> Most accepted theory

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What goods does the business cycle impact the most?

answer

Capital goods and consumer durables: - purchase can be delayed if they don't need it Service industries and nondurables less affected because are always in constant demand

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3 "groups" of people in an economic perspective regarding employment

answer

1. Less than 16/institutionalized (not potential members of labor force) 2. Not in labor force (potential workers, but not employed and NOT seeking work) 3. Labor force (able and willing to work) Includes: employed and unemployed

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Unemployment rate

answer

Unemployment rate = (Unemployment ÷ labor force) x 100

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Types of unemployment

answer

Frictional unemployment Structural unemployment Cyclical unemployment

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Frictional unemployment

answer

Between jobs There will always be this type of unemployment. This type of unemployment is desirable because people switch from low-paying/productivity jobs to better high ones = greater income for workers, better allocation of resources, larger RGDP

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Structural unemployment

answer

NO demand for a certain skill Occupationally and geographically Hard to get new jobs without retraining, more education, or relocating

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Cyclical unemployment

answer

Caused by a decline in total spending (during a recession) Deficient-demand unemployment BAD--you don't want this type of unemployment

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Full employment

answer

when there is ONLY frictional and structural unemployment

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Natural rate of unemployment (NRU)

answer

Economy is at potential output Economy can operate above NRU (recession) or below NRU (working overtime).

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GDP gap

answer

The difference between actual and potential GDP GDP gap = actual GDP - potential GDP Negative GDP gap means that unemployment is above the natural rate (recession) Positive GDP gap means inflationary pressures, cannot b e sustained

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Okun's Law

answer

For every 1 percentage point by which the actual unemployment rate exceeds the natural rate, a negative GDP gap of about 2 percent occurs.

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Inflation

answer

A rise in the general level of prices. Reduces purchasing power. Doesn't mean ALL prices are rising because prices rise unevenly

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Consumer Price Index (CPI)

answer

Compiled by the Bureau of Labor Statistics (BLS) Government uses index to report inflation rates Reports prices of a "market basket" of some 300 consumer goods and services th at are presumably purchased by a typical urban consumer

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Demand-pull inflation

answer

Caused by spending more than the economy can produce Excess demand bids up prices of limited output Demand pulls price level up

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Cost-push inflation

answer

When output and employment are both declining, while general price level rising. Caused by increases in prices in major resources like oil, which increases per-unit production costs, and decreases profits, which lowers incentive to supply more, thus pushing supply to the left. Causes a recession/stagflation.

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Per-unit production costs

answer

Average cost of a particular level of output PUPC = Total input costs ÷ Units of output

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Supply shocks

answer

Abrupt increases in costs of raw materials or energy inputs. Drives up per-unit production costs and product prices.

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Real income

answer

The purchasing power of nominal income Real income = Nominal income ÷ price index (in hundredths) Remains constant when nominal income and price index increase at the same rate.

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Difference between CPI and GDP deflator

answer

GDP deflator -- all items in domestic production, includes more than just consumer goods, BROADER MEASURE OF INFLATION CPI -- based on market basket of goods that are bought consumers, some goods produced abroad, MEASURE OF INFLATION OF ONLY CONSUMER GOODS

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Anticipated inflation

answer

Income receiver may be able to avoid or lessen the adverse effects of inflation on real income. Redistribution effects are less severe or are eliminated if people can adjust nominal incomes to reflect the expected price level rises.

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Unanticipated inflation

answer

Inflation whose full extent was not expected Redistributes real income away from some and towards others (uneven).

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Who is hurt by unanticipated inflation?

answer

1. Fixed-income receivers 2. Savers 3. Lenders

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Who is unaffected or helped by inflation?

answer

1. Flexible-income receivers (ex: Social security payments indexed to CPI) 2. Cost-of-living adjustments (COLA) 3. Debtors/borrowers

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Inflation premium

answer

Raising interest rate by the amount of the anticipated inflation. Lender can avoid being hurt by unanticipated inflation. High NIRs are consequences of inflation, not causes

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Real interest rate (RIR)

answer

Percentage increase in purchasing power (value) that the borrower pays pays the lender. RIR = NIR - inflation

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Nominal interest rate (NIR)

answer

percentage increase in money that the borrower pays the lender NIR = RIR + inflation

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Deflation vs. disinflation

answer

Deflation -- declines in price level Disinflation -- slowing in the rate of increase in price level

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Shortcomings of CPI

answer

1. Consumers substitute 2. Goods evolve 3. Quality differences

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Why is the unemployment rate sometimes inaccurate?

answer

1. Discouraged workers are not part of unemployed. 2. Part time workers are considered to be employed.

question

hyperinflation

answer

Extremely rapid inflation that has devastating impacts on real output and employment

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Relationship between consumption and disposable income

answer

Households spend a larger proportion of their DI when they are poor, while richer people spend a smaller proportion of their DI.

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Relationship between consumption and disposable income.

answer

DI increases, people save a larger proportion of their DI

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Dissaving

answer

Consuming in excess of after tax-income. Occurs at relatively low DIs Households can consume more than their incomes by liquidating (selling for cash) or by borrowing.

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Break-even income

answer

Income level at which households plan to consumer their entire income When C cuts 45 degree line. When savings schedule cuts x-axis

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Marginal propensity to consume (MPC)

answer

Change in consumption caused by a change in the DI MPC = change in C ÷ change in DI Slope of the consumption function MPC + MPS = 1

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Marginal propensity to consumer (MPS)

answer

Change in saving caused by a change in disposable incomce MPS = change in S ÷ change in DI MPC + MPS = 1

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Determinants of Consumption and Saving

answer

1. Wealth 2. Expectations 3. Household Debt 4. Taxes and transfers 5. Real interest rates (deals with borrowing *C and S usually move in the opposite direction EXCEPT FOR TAXES AND TRANSFERS

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Average propensity to consume (APC)

answer

APC = C ÷ DI A point on the C function

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Average propensity to save (APS)

answer

APS = S ÷ DI A point on the S function

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Change in the amount consumed

answer

Movement from one point to another on a consumption schedule Caused by a change in disposable income

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What is investment?

answer

Expenditures on new plants, capital equipment, inventories, etc.

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Expected rate of return

answer

r = Profit ÷ cost of investment Businesses only buy capital goods when they think such purchases will be profitable. Expected not guaranteed. Investment may or not may off as anticipated.

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Real interest rate

answer

The cost of borrowing money to purchase capital.

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Interest cost of investment

answer

Interest cost of investment = interest rate • money borrowed

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When will capital be bought/investment be undertaken?

answer

When the expected rate of return exceed the interest rate.

question

What interest rate is used in making investment decisions?

answer

Real interest rate because you want to compare real profit with real costs (in case of inflation)

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What is important to know about the investment demand curve?

answer

Investment is cumulative. Ex: $10 billion of investment includes $5 billion of investment at 14% r and $5 billion of investment between 12 and 14% r.

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To what point should investment projects be undertaken up?

answer

When r = i

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Investment demand curve

answer

Shows rates of return and quantity of investment demanded at each "price" (interest rate) of investment

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Shifts of the investment demand curve

answer

*In general, any factor that leads businesses to collectively expect greater rates of return on their investment increases investment demand (shift right) and vice versa. 1. Acquisition, maintenance, and operating costs 2. Business taxes 3. Technological change (technological progress lowers production cost or improves product quality, increases expected rate of return) 4. Stock of capital goods on hand (when economy is overstocked with production facilities and when firms have excessive inventories of finished goods, expected rates of return decrease) 5. Expectations (depends on forecasts of future sales, future operating costs, and future profitability of the product)

question

Why is investment so instable?

answer

Investment is the most volatile component of GDP. 1. Durability (purchases of investment can be postponed) 2. Irregularity of innovation 3. Variability of profits

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Multiplier effect

answer

A change in a component of spending that leads to a larger change in GDP.

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Spending multiplier

answer

Determines the change in GDP due to a change in a component of spending in GDP Multiplier = change in RGDP ÷ initial change in spending Multiplier = 1 ÷ MPS Initial change in spending can be in C, I, G, or Nx (but usually I) Multiplier works in both increases and decreases in intiial spending

question

What is the rationale behind the multiplier effect?.

answer

1. Economy has a repetitive, continuous flow of expenditures and income. 2. Any change in income causes consumption and saving to change in the same direction and fraction of the change in income. Initial change in spending will set of spending chain throughout the economy that accumulates. Because spending and re-spending effects will diminish with each successive round of spending, the cumulative increase in output and income eventually ends.

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Relationship between MPC/MPS and the multiplier

answer

The larger the MPC, the larger the multiplier The larger the MPS, the smaller the multiplier.

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Why does the multiplier overstate the actual outcome?

answer

Households use income to buy imports and pay taxes, which reduces the multiplier effect.

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AD AS model

answer

Enables economists to analyze changes in RGDP and the price level simultaneously. Provides keen insights on inflation, recession, unemployment, and economic growth.

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Aggregate demand

answer

Schedule or curve that shows the amount of real output that buyers collectively desire to purchase at each possible prive level.

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Why is does the AD curve have a downward slope?

answer

NOT the same explanation for a single product (that people buy more as the price of a production decreases) 1. Real balances effect/wealth effect 2. Interest rate effect 3. Foreign purchases effect

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Loanable funds market

answer

The market for dollars that are available to be borrowed for investment projects. Supply = savers Demand = investors/borrowers *Uses RIR

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Private savings

answer

Saving conducted by households and equal to the difference between disposable income and consumption

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Public savings

answer

saving conducted by government and equal to the difference between tax revenue collected and spending on goods and services

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Tax multiplier

answer

The magnitude of the effect that a change in taxes has on RGDP. Tm = change in GDP ÷ change in taxes = MPC • Multiplier = MPC ÷ MPS

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Balanced-budget multiplier

answer

When a change in government spending is offset by a change in lump sum taxes. Balanced-budget multiplier = 1

question

Real balances effect/wealth effect

answer

Higher PL = less consumption spending The higher price level reduces purchasing power of public's accumulated savings Public is poorer in real terms.

question

Interest rate effect

answer

When PL increases, consumers need money for purchases and businesses need more money for payrolls and resources, so demand for money increases. If MD increases, NIR will increase. Higher NIR = less investment spending and interest-sensitive consumption spending *By increasing the demand for money and increasing the interest rate, a higher price level reduces the amount of real output demanded.

question

Foreign purchases effect

answer

When US price level rises relative to foreign price levels, foreigners buy fewer US goods and Americans buy more foreign goods so Nx decreases.

question

Shifters of AD

answer

NOT PRICE LEVEL = NOT wealth effect, interest rate effect, or foreign purchases effect. Usually a change in spending --> multiplier effect. 1. Consumer spending (consumer wealth, consumer expectations, household indebtness, taxes) 2. Investment spending (RIR, r) 3. Government spending 4. Net export spending (national income abroad, exchange rates)

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Long run aggregate supply

answer

When changes in wages respond completely to change int he price level, those price-level changes to do not alter the amount of RGDP produced and offered for sale. At full-employment.

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Short run aggregate supply

answer

Based on per-unit production cost of any specific level of output. Price level must cover all the costs of production.

question

Why is the SRAS curved?

answer

When economy expands in the short run, PUPC generally rise because of reduced efficiency and rising input prices. Below capacity/full-employment output: Large amounts of unused machinery, equipment, and unemployed workers. Can put these resources back to work with little upward pressure on PUPC. *Large increases in real output without putting pressure on the price level Operating beyond full-employment output: Majority of resources are employed. Adding more workers to almost full employment = congestion in the workplace and reduces efficiency of workers. Adding more land resources when capital/labor resources are highly strained reduces the efficiency of land resources. Total output rises less than total input cost, PUPC increases a lot *Limited increase in real output as PL rises a lot

question

Shifters of SRAS

answer

Anytime when PUPC change 1. Domestic resource prices (wages, land, capital) 2. Price of imported goods (resources imported from abroad add to AS, added supply = reduced PUPC) 3. Input Prices (market power, ex: OPEC) 4. Changes in productivity 5. Legal institutional environment (business taxes and subsidies, government regulation)

question

Demand-pull inflation

answer

Cause: Increase in spending (AD shifts right) Effect: Pulls PL up

question

Shifters of LRAS

answer

Anything that affects the potential output or full employment 1. Availability of resources (more resources = more potential output) 2. Technology and productivity 3. Policy incentive (ex: tax incentives to invest in capital)

question

Recessionary and inflation gap

answer

When the economy is in equilibrium but not at the level of GDP that corresponds to full employment. The difference between GDPfull and GDPcurrent is the gap (or the amount in which GDP must rise/fall to GDPfull)

question

Recessionary gap

answer

When the economy is operating below full employment and likely experiencing a high unemployment rate. If prices are sticky, only real output decreases. Cyclical unemployment

question

Inflationary gap

answer

When the economy is operating about full employment. Because production is higher the GDP, a rising price level is the greatest danger to the economy.

question

Why are prices inflexible downward?

answer

1. Wage contracts (inflexible downward) 2. Morale, effort, and productivity (need efficiency wage for max productivity, lower wages impair morale and work effort = reduce productivity) 3. Minimum wage 4. Menu costs 5. Fear of price wars

question

Menu costs

answer

Firms that think a recession will be relatively short-lived and may be reluctant to cut their prices. Don't want to reprice items in inventory, print and mail new catalogs, communicate new prices to customers (all costly stuff)

question

Cost-push inflation

answer

When costs increase, AS curve moves left, pushes the PL up. THE WORST KIND OF INFLATION

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Fiscal policy

answer

Deliberate changes in government spending and tax collections designed to achieve full employment, control inflation, and encourage economic growth. Can help "push" the economy in a particular direction, but can't "fine-tune" it to a precise macroeconomic outcome (that's for monetary policy)

question

Discretionary/active fiscal policy

answer

Changes in government spending and the rate of taxes are at the option of the federal government.

question

Council of Economic Advisers (CEA)

answer

Established to assist and advise the president on economic matters and the Joint Economic Committee (JEC) at Congress

question

Employment Act of 1946

answer

Federal government has to use monetary and fiscal policy to maintain economic stability.

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Expansionary fiscal policy

answer

1. Increase government spending 2. Reduce taxes 3. Combination of the two

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Budget deficit

answer

Government spending in excess of tax revenues. Created by expansionary fiscal policy

question

Why are taxes less effective than government spending?

answer

Taxes increase DI, but people could save part of their disposable income.

question

Contractionary fiscal policy

answer

1. Decrease government spending 2. Increased taxes 3. Combination of the two

question

Budget surplus

answer

Tax revenues in excess of government spending.

question

Financing of deficits

answer

1. Borrowing -- increases demand for money, drives up interest rate, decreases private investment spending (weakens expansionary effect) 2. Money creation -- expansionary but potentially more inflationary

question

Disposing of surpluses

answer

1. Debt reduction -- gov pays back bonds, transfers surplus tax revenues back into the money market, SM increase, interest rates fall, increase private borrowing and spending (weakens anti-inflationary effect) 2. Impounding (letting budget surplus stand idle) -- govt withholds purchasing power from the economy, more anti-inflationary than paying off debt

question

Built-in/automatic stabilizers

answer

Anything that... 1. Increases the government's budget deficit or reduces its budget surplus during a recession 2. Increase budget surplus or reduces its budget deficit during inflation without requiring explicit action by policy makers. EXACTLY WHAT THE TAX SYSTEM DOES! *REDUCES, but doesn't eliminate the effects of the swings in GDP

question

Net tax revenues

answer

Net tax revenues = tax revenues - transfers and subsidies Varies directly with GDP -- GDP increase, tax rev increase, and vice versa

question

Progressive tax system

answer

Average tax rate rises with GDP Steepest Stabilizes the economy the most

question

Proportional tax system

answer

Average tax rate remains constant as GDP rises

question

Regressive tax system

answer

Average tax rate falls as GDP rises (Flat tax, sales tax) Doesn't really help stabilize the economy as much..

question

Evaluating fiscal policy

answer

Cannot look at changes in surplus or the deficit because they reflect automatic changes in tax revenues. 1. Adjust deficits and surpluses to eliminate automatic changes in tax revenues 2. Compare the sizes of the adjusted budget deficits to the levels of potential GDP

question

Full-employment budget

answer

"Standarized budget" • Eliminates the automatic changes from taxes • Measures what the budget deficit/surplus would be with existing tax rates and government spending levels if the economy was at full-employment • Compare the actual government expenditures with the tax revenues that would have occurred in that year at full-employment • If the full-employment budget deficits are zero in both years, there was no change in discretionary fiscal policy • If increases = expansionary, decreases = contractonary

question

Cyclical deficit

answer

a by-product of the economy's slide into recession Not a result of discretionary fiscal action's by the government

question

Loanable funds theory of interest

answer

Explains interest rate in terms of supply and demand for funds available for lending Assumes households/consumers are supplies of loanable funds and business are the sole demanders Assumes lending occurs directly between household and businesses.

question

Supply of loanable funds

answer

Upsloping -- households will supply a larger quantity of funds at high interest rates. ^ Savings viewed as relatively insensitive to changes in interest rates because people save for other reasons besides interest.

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Demand for loanable funds

answer

Downsloping -- a higher interest rate = smaller expected rate of return = less investments profitable = smaller quantity of loanable funds will be demanded

question

Shifters of the supply of loanable funds

answer

Anything that causes households to save more or less

question

Shifters of the demand of loanable funds

answer

Anything that increases the rate of return on potential investments. Ex: increased productivity, increase in consumer demand, increase in price of product.

question

Problems, criticisms, and complications of fiscal policy

answer

1. Recognition lag 2. Administrative lag 3. Operational lag 4. Political business cycles 5. Future policy reversals (if households expect future policy reversals, fiscal policy will fail) 6. Offsetting state and local finance 7. Crowding out effect

question

Crowding-out effect

answer

Reduces effectiveness of expansionary fiscal policy -- Increase government spending, increases the interest, reduces investment and consumption spending -- weakens or cancels the stimulus of the expansionary policy

question

Criticisms of the crowding-out effect

answer

1. Little crowding out will occur when fiscal policy is used during a significant recession 2. Policymakers can counteract the crowding-out effect by increasing the supply of money to offset the increased demand for money.

question

Net exports effect

answer

Reduces the effectiveness of fiscal policy (both expansionary and contractionary) Ex: Expansionary policy -- price level increases, US goods relatively more expensive, imports increase, exports decrease, net exports decrease Contractionary policy -- price level "decreases", US goods relatively cheaper, exports increase, imports decrease, net exports increases

question

Functions of money

answer

1. Medium of exchange - for buying and selling goods and services 2. Unit of account -- helps compare value of goods 3. Stores of values -- transfer purchasing power from present to future (relatively risk-free when inflation is nonexistent/mild)

question

M1

answer

1. Currency (coin and paper money) in the hands of the public 2. Checkable deposits

question

Token money

answer

Metal value is less than the face value of the coin. (USD)

question

What do you do to not double count in the total money supply?

answer

Exclude currency in banks

question

What is excluded from M1?

answer

Currency and checkable deposits owned by the US Treasury and Federal Reserve Banks, commercial banks, or other financial institutions.

question

Near-monies

answer

Highly liquid financial assets that do not function directly or fully as a medium of exchange but can be readily converted into currency deposits. Included in M2.

question

M2

answer

M1 + 1. Savings deposits, including money market deposit accounts. 2. Small (less than $100,000) time deposits. 3. Money market mutual funds.

question

Savings account

answer

Where a depositor can easily withdraw funds from at a bank or thrift or simply request that the funds be transferred from a savings account to a checkable account.

question

Money market deposit account (MMDA)

answer

An interest-bearing account through which banks and thrifts pool individual deposits to buy a variety of interest-bearing short-term securities. Have a minimum balance requirement and a limit on how often a person can withdraw funds.

question

Time deposits

answer

Funds in time deposits become available at their maturity. Higher interest rate. If cash in early, must pay severe penalty. (ex: After 6 months, person can convert time deposit to currency without penalty).

question

Money market mutual fund (MMMF)

answer

Redeem shares in a MMMF offered by a mutual fund company. Companies use combined funds to buy credit instruments like certificates of deposit and US govt securities. Offer interest on the money market account of their mutual fund depositors.

question

M3

answer

M1 + M2 + large ($100,000 or more) time deposits.

question

What is usually cited for money supply?

answer

M1 -- Because it is simple and includes only items directly and immediately usable as a medium of exchange.

question

What "backs" the money supply?

answer

1. Money as debt (paper money - FR, checkable deposits - commercial banks and thrift institutions) 2. Value of money (acceptability, legal tender, relative scarcity) 3. Money and prices (purchasing power, inflation/acceptability) 4. Stabilization of money's value (fiscal, monetary policy)

question

Total money demand (Dm)

answer

The total amount of money the public wants to hold at each possible interest rate. 1. Transactions Demand -- medium of exchange, Dt = nominal GDP, assume vertical (independent of interest rate) 2. Asset Demand -- store of value, depends on interest rate (when ir is low, more assets; when ir is high, less assets)

question

Advantages of holding money

answer

1. Liquidity -- most usable in making purchases 2. Lack of risk (ex: when price of bond falls, bondholder who sells the bond will suffer a loss, but money doesn't have that) *Money is attractive when prices of goods, services, and other financial assets are expected to decline

question

Disadvantage of holding money

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1. Does not earn interest

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Supply of money

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Vertical because govt provided economy with a particular stock of money.

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Functions of the Federal Reserve Bank

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1. Issuing currency 2. Setting serve requirements and holding reserves 3. Lending money to banks and thrifts. 4. Providing for check collection (adjusts the reserves of the two banks) 5. Acting as a fiscal agent for the government 6. Supervising banks 7. controlling the money supply

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Balance sheet

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Statement of assets and claims on assets that summarizes the financial position of the bank at a certain time. Assets = liabilities + net worth

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Fractional reserve banking system

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Only a fraction of the total money supply is held in reserve as currency. (What the US has) Characteristics: 1. Money creation through lending, which is limited by reserves that the banks have to keep 2. Vulnerable to panics or runs

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Vault cash

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Cash held by a bank; till money. Part of the reserves.

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Change in the composition of the money supply

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When a checkable deposit is deposited into a bank.

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Required reserves

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Amount of funds equal to a specified percentage of the bank's own deposit liabilities. Must keep these reserves on deposit. Includes vault cash. *Used to control the lending ability of commercial banks

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Reserve ratio

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Required reserves ÷ checkable deposits

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Excess reserves

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Actual reserves - required reserves

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Change in the total supply of money

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When a bank lends it creates money. When a loan is paid off, money is destroyed. When the bank buys bonds, money is created. When the bank sells bonds, money is destroyed.

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What is the maximum a bank can lend?

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Only an amount equal to its initial preloan excess reserves.

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Federal funds rate

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The interest rate paid on overnight loans from bank to bank. (To keep the required reserves)

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Bank's two conflicting goals

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Profit (wants to loan) vs. Liquidity/safety (need cash/reserves)

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Monetary multiplier

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Exists because the reserves and deposits lost by one bank become reserves of another bank. magnifies excess reserves into a larger creation of checkable-deposit money. m = 1 ÷ reserve ratio

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Maximum amount of NEW money created

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Excess reserves • money multiplier

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Total money supply (equation)

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Excess reserves • money multiplier + initial deposit

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Leakages of the money multiplier

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1.) Currency drains -- borrower might request that part of his or her loan be paid in currency, or might ask bank to redeem check in currency --> decreases excess reserves 2.) Excess reserves -- bank might put more in reserves

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Open-market operations

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Buying of selling bonds to banks/public *Most important instrument for influencing the money supply

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When happens when the Fed buys bonds from commercial banks?

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1. Commercial bank gives up securities to Fed. 2. Fed "pays" for the securities by increasing the reserves of the commercial banks. *Increases reserves, increases lending ability

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When happens when the Fed buys bonds from the public?

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1. Person gives up securities to Fed, gets a check drawn by the Fed. 2. Person deposits check in a commercial bank. 3. Commercial bank sends this check to the Fed, commercial bank reserves increase *Increases reserves, increases lending ability

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Difference between Fed buying bonds from banks and from public

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1. Bank -- increase the actual reserves and excess reserves of commercial banks by the ENTIRE amount of the bond purchases 2. Public -- increase checkable deposits, but then the reserve requirement makes the excess reserves less *Buying bonds from banks = more lending ability

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What happens when the Fed sells bonds to commercial banks?

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1. Fed gives up securities to the comm banks. 2. Comm bank pays by having the Fed decrease the comm bank's reserves.

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What happens when the Fed sells bonds to the public?

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1. Fed gives securities to person, person pays with a check drawn on a comm bank. 2. Fed clears this check by reducing comm bank's reserves. 3. Comm bank reduces person's checkable deposits.

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Difference between Fed selling bonds from banks and from public.

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1. Bank -- reduces the system's actual and excess reserves by the entire amount 2. Public -- decreases excess reserves less than ^ because of the reserve requirement

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How does changing the reserve ratio affect the money-creating ability of the banking system?

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1. Changes the amount of excess reserves 2. Changes the monetary multiplier.

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Discount rate

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Interest rate charged on loans from the Fed to comm banks.

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Easy money policy

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Buy securities, lower the reserve ratio, lower the discount rate

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Tight money policy

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Sell securities, increase the reserve ratio, raise the discount rate

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Easy money policy cause-effect chain

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Problem: unemployment and recession Fed buys bonds, ER increase, MS increase, NIR decrease, INV increase, AD increase, RGDP increase

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Tight money policy cause-effect chain

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Problem: inflation Fed sells bonds, ER decrease, MS decrease, IR increase, INV decrease, AD decrease, Inflation declines

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Problems and complications of monetary policy

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1. Lags (recognition and operational) 2. Changes in velocity of money 3. Cyclical asymmetry

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Velocity of money

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the number of times per year the average dollar is spend on goods and services MV = PQ

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Net exports effect (monetary policy)

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Easy money: lower interest rate, decreased foreign demand for dollars, dollar appreciates, net exports increase Tight money: higher interest rate, increased foreign demand for dollars, dollars depreciates, net exports decrease

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Monetary policy and trade balance

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Corrects a balance-of-trade deficit/surplus Easy money: recession = deficit, net exports effect = more exports, no more deficit Tight money: inflation = surplus, net exports effect = less exports, no more surplus

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Demand-pull inflation (extended version)

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AD increase, PL increase, (in the long run...) nominal wages increase, PUPC increase, SRAS decrease -- straight up inflation

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Cost-push inflation (extended version)

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AS decrease, AD increase (fiscal policy) -- straight up inflation AS decrease, AD stays (govt does nothing), nominal wages fall PUPC decrease, SRAS increase

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Recession (extended versoin)

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AD decrease, PL falls, nom wages decrease, PUPC decrease, SRAS increase

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Aggregate supply shock on the Philips curve

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Shift outward to the right

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Why is there no long-run trade off between inflation and unemployment?

answer

If AD is beyond full-employment, then profits, output, and employment may temporarily increase. AD pulls up PL. In long run, nominal wages increase, profits fall, SRAS decreases.

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Long-run Philips curve

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Vertical because no trade off between unemployment and inflation. Any rate of inflation is consistent with the 5 percent natural rate of unemployment.

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Disinflation

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Reductions in the inflation rate.

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What happens when the actual rate of inflation is lower than the expected rate?

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Profits temporarily fall, unemployment rate temporarily rises.

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Supply-side economics

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AS is the active force in determining the levels of inflation, unemployment, and economic growth. Focus on marginal tax rates (recommend lower tax rates).

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Taxes and incentives to work

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Lower taxes, encourage saving and investing, more technology, labor productivity rises, LRAS expands, keeps unemployment and inflation low

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Laffer curve

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Depicts the relationship between tax rates and tax revenues. Higher tax rates don't always equal more revenue.

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