ECN 211 Exam #3 Ruediger PDF

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ECN FINAL Chapter 20 A period of falling incomes and rising unemployment is called a recession if it is relatively mild and a depression if it is more severe Three Key Facts about Economic Fluctuations 1) Economic Fluctuations are Irregular and Unpredictable - Fluctuations in the economy are often called the business cycle. o It is somewhat misleading because it suggests that economic fluctuations follow a regular, predictable pattern 2) Most Macroeconomic Quantities Fluctuate Together. - Real GDP is the variable most commonly used to monitor short-run changes in the economy o Real GDP measures the value of all final goods and services produced within a given period of time. 3) As Output Falls, Unemployment Rises Explaining Short-Run Economic Flucutations The Model of Aggregate Demand and Aggregate Supply Model of Aggregate Demand and Aggregate Supply- Used to analyze fluctuation in the economy as a whole - Vertical axis is the overall price level and the horizontal axis is the overall quantity of goods and services produced in the economy. - Aggregate-Demand Curve- shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level. - Aggregate-Supply Curve- shows the quantity of goods and services that firms produce and sell at each price level The Aggregate-Demand Curve- A fall in price level, increases the quantity of goods and services demanded. - As price level falls, real wealth rises, interest rates fall, and the exchange rate depreciates. Why the Aggregate-Demand Curve Slopes Downward Economy’s GDPY = C + I + G + NX Y=GDP C= Sum of consumption I= Investment G= Government purchases NX= Net Exports 1) The Price Level and Consumption: The Wealth Effect

-A decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded. Conversely, an increase in the price level reduces the real value of money and makes consumers poorer, which in turn reduces consumer spending and the quantity of goods and services demanded. 2) The Price Level and Investment: The Interest-Rate Effect - A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded. Conversely, a higher price level raises the interest rate, discourages investment spending, and decreases the quantity of goods and services demanded. 3) The Price Level and Net Exports: The Exchange-Rate Effect - When a fall in the U.S. price level causes U.S. interest rates to fall, the real value of the dollar declines in foreign exchange markets. This depreciation stimulates U.S. net exports and thereby increases the quantity of goods and services demanded. Conversely, when the U.S. price level rises and causes U.S. interest rates to rise, the real value of the dollar increases, and this appreciation reduces U.S. net exports and the quantity of goods and services demanded. Sum Up 1) Consumers are wealthier, which stimulates the demand for consumption goods 2) Interest rates fall, which stimulates the demand for investment s 3) The currency depreciates, which stimulates the demand for Net Exports.

In the long run, the a-s curve is vertical, whereas in the short run the a-s curve is upward

Why the A-S Curve is Vertical in the Long Run? In the long run, an economy’s production of goods and services (its real GDP) depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.

Why the Long-Run Aggregate-Supply Curve Might Shift The long-run level of production is sometimes called potential output or full-time employment output. Natural Level of Output- is the rate of production toward which the economy gravitates in the long-run. - Any change in the economy that alters natural level of output shifts the long-run aggregate-supply curve Shifts Arising from Changes in Labor - Greater number of workers, the quantity of g/s supplied would increase, causing the a-s curve to shift to the right. o If workers are laid off and employment drops the curve shifts left. - If Congress raises minimum wage, the natural rate of unemployment would rise and the curve would shift left o Conversely, if a reform of the unemployment system made it harder to find new jobs, the natural rate of unemployment would fall and the supply curve would shift left Shifts Arising from Changes in Capital - An increase in the economy capital stock, increases g/s and the a-s curve shifts to the right. Shifts Arising from Changes in Natural Resources. - Discovery of a new mineral deposit shifts the a-s curve to the right o A change in weather makes farming more difficult, shift left Shifts Arising from Changes in Technological Knowledge - Computer use spread, the a-s curve shifts rights Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth inflation

Why the Aggregate-Supply Curve Slopes Upward in the Short Run - The Sticky-Wage Theory o The short run a-s curve slopes upward because nominal wages are based on expected prices and do not respond immediately when the actual price level turns out to be different from what was expected - The Sticky-Price Theory o Emphasizes that the prices of some goods and services also adjust sluggishly in repose to changing economic conditions. - The Misperceptions Theory o Changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output.

Why the Short-Run Aggregate-Supply Curve Might Shift

The Long-Run Equilibrium- is found where the a-d curve crosses the a-s curve

Stagflation- when the economy is experiencing both stagnation (falling output) and inflation (rising prices.)

Chapter 16- The Monetary System

Money- is the set of assets in the economy that people regularly use to buy goods and services from each other The Functions of Money Medium of Exchange- is an item that buyers give to sellers when they purchase goods and services Unit of Account- is the yardstick people use to post prices and record debts Store of Value- is an item that people can use to transfer purchasing power from the present to the future - When a seller accepts money today in exchange for a good or service - Wealth is used to refer to the total of all stores of value Liquidity- term used to describe the ease with which an asset can be converted into the economy’s medium of exchange. The Kinds of Money Commodity Money- when money takes the form of a commodity with intrinsic value. - Intrinsic Value- means the item would have value even if it were not used as money Fiat Money- money with no intrinsic value - A fiat is an order or decree Money in the U.S Economy Currency- the paper bills and coins in the hands of the public Demand Deposits- balances in bank accounts that depositors can access on demand simply by writing a check or swiping a debit card at a store Why credit cards aren’t money: - Deferring a payment, putting it off till later The Federal Reserve System Federal Reserve- The agency responsible for regulating the economy (FED) Central Bank- an institution designed to oversee the banking system and regulate the quantity of money In the economy The Feds Organization - Created in 1913 Money Supply- the quantity of money that is made available in the economy Monetary Policy- Decisions by the policymakers concerning the money supply. At the FED the policy is made up by the FOMC The Federal Open Market Committee - Made up of seven members - Through the decisions of the FOMC, the FED as the power to increase or decrease the number of dollars in the economy - Open-market operation- the purchase and sale of U.S. government bonds Money Creation with Fractional-Reserve Banking

Fractional-Reserve Banking- when the First National bank needs to keep only a fraction of its deposits in reserve Reserve Ratio- the fraction of total deposits that a bank holds as reserves Money Multiplier- the amount of money the banking system generates with each dollar The FEDS tools of Monetary Control - Can be broken into two groups: those that influence the quantity of reserves and those that influence the reserve ratio and thereby the money multiplier How the FED influences Quantity of Reserves 1) Open Market Operations- when the FED either buys or sells government bonds. a. To increase the money supply they would BUY bonds 2) FED Lending to Banks- Banks borrow from the FEDS discount window and interest rate on a loan called the discount rate. a. A higher discount rate discourages banks from borrowing which reduces the money supply How the FED influences the Reserve Ratio 1) Reserve Requirements- the regulations that set the minimum amount of reserves that banks must hold against their deposits a. An increase in reserve requirements raises the reserve ratio, lowers the MM and decreases the money supply 2) Paying Interest on Reserves- when a bank holds reserves on deposit at the Fed, the Fed now pays the bank interest with those deposits. Problems in Controlling the Money Supply 1) The Fed does not control the amount of money that households choose to hold their deposits in banks 2) Fed does no control the amount that bankers choose to lend The Federal Funds Rate- is the short-term interest rate that banks charge one another for loans

Chapter 17: Money Growth and Inflation

Money Supply, Money Demand, and Monetary Equilibrium In the long run, money supply and money demand are brought into equilibrium by the overall level of prices.

The Effects of a Monetary Injection. The explanation of how e price level is determined and why it might change over time is called t antity theory of money - According to the quantity theory, the quantity of money available in an economy determines the value of money, and growth in the quantity of money is the primary cause of inflation Nominal GDP = Price Level x Real GDP The Classical Dichotomy and Monetary Neutrality. - David Hume in the 18th century suggested that economic variables should be divided into two groups. - Nominal Variables- variables measured in monetary units - Real Variables- variables measured in physical units - The separation of real and nominal variables is now called the classical dichotomy. - Monetary Neutrality- the irrelevance of monetary changes for real variables o changes in money supply affect nominal but not real Velocity and the Quantity Equation - Velocity of money- the speed at which the typical dollar bill travels around the economy from wallet to wallet o Equation: V = (P x Y)/M § P- Price level (GDP deflator) § Y- Quantity of output (real GDP) § M- Quantity of money o Slight rearrangement: M x V = P x Y o This equation states that the quantity of money times the velocity of money equals the price of output times the amount of output

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o It is called the quantity equation because it relates the quantity of money to the nominal value of output. Elements to explain the equilibrium price level and inflation rate

o The$velocity$of$money$is$relatively$stable$over$time.$ o Because$velocity$is$stable,$when$the$central$bank$changes$the$ quantity$of$money$(M),$it$causes$proportionate$changes$in$the$ nominal$value$of$output$(P$×$Y).$ o The$economy’s$output$of$goods$and$services$(Y)$is$primarily$ determined$by$factor$supplies$(labor,$physical$capital,$human$ capital,$and$natural$resources)$and$the$available$production$ technology.$In$particular,$because$money$is$neutral,$money$does$not$ affect$output.$ o With$output$(Y)$determined$by$factor$supplies$and$technology,$ when$the$central$bank$alters$the$money$supply$(M)$and$induces$ proportional$changes$in$the$nominal$value$of$output$(P$×$Y),$these$ changes$are$reflected$in$changes$in$the$price$level$(P).$ o Therefore,$when$the$central$bank$increases$the$money$supply$ rapidly,$the$result$is$a$high$rate$of$inflation.$ The Inflation Tax Inflation Tax- When the government raises revenue by printing money. - Inflation tax is like a tax on everyone who holds money The Fisher Effect - The nominal interest rate is the interest rate you hear about at your bank - The real interest rates correct the nominal interest rate for the effect of inflation to tell you how fast the purchasing power of your savings account will rise over time. o Real Interest Rate = Nominal Interest Rate – Inflation Rate § Nominal Interest Rate = Real interest rate + Inflation rate - The adjustment of the nominal interest rate to the inflation rate is called the Fisher Effect. (Irving Fisher (1867-1947) Menu Costs- a term derived from a restaurant’s cost of printing a new menus Inflation-Induced Tax Distortions Capital Gains - profits made by selling an asset for more than its purchase price

Chapter 21

The Theory of Liquidity Preference- nominal and real interest rates differ by a constant

1) Money Supply- a decrease in discount rate encourages more bank borrowing which increases the money supply. 2) Money Demand- an increase in the interest rate raises the cost of money holding, therefor decreases the money demanded 3) Equilibrium Interest Rate- when the quantity of the money demand is the same as the quantity of money supplied The Downward Slope of the Aggregate-Demand Curve The analysis of interest-rate can be summarized in three steps: 1) A higher price level raises money demand 2) Higher money demand leads to a higher interest rate 3) A higher interest rate reduces the quantity of goods and services demanded Changes in the Money Supply 1) When the fed increases the money supply, lower IR, increased demand and shifts the demand curve to the right Changes in monetary policy aimed at contracting aggregate demand can be described either as decreasing the money supply or as raising the interest rate. How Fiscal Policy Influences Aggregate DemandFiscal Policy- refers to the government’s choices regarding the overall level of government purchases and taxes Changes in Government Purchases - Increase in demand for increases the demand curve to the right Multiplier Effect- the effect that each dollar spent by the government can raise to demand for g/s by more than a dollar A formula for the Spending Multiplier - MPC- marginal propensity to consume- the fraction of extra income that a household consumes rather than saves Multiplier = 1/ (1 – MPC) Total Change in Demand = Intial Change in Spending x Multipiler

The Crowding-Out Effect- the reduction in aggregate demand that results when a fiscal expansion raises the interest rate

Automatic Stabilizers- are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate...