Buying side of demand
Producing side of aggregate supply
Aggregate Supply. SRAS: production in the short run LRAS: production in the long run
The quantity demanded of all goods and service (Real GDP) at different price levels, ceteris paribus.
Aggregate Demand Curve
A curve that shows the quantity demanded of all goods and services (Real GDP) at different proce levels, Ceteris paribus. Downward sloping curve indicated an inverse relationship between price level and the quantity demanded of Real GDP
Why does the Aggregate Demand curve curve slope downward?
The Real Balance Effecr
Interest Rate Effect
International Trade Effect
Real Balance Effect
The change in the purchasing power of dollar denominated assets that results from a change in the price level.
When price level falls, purchasing power rises, monetary wealth rises and more goods are bought.
When price level rises, purchasing power falls, monetary wealth falls and less goods are bought.
Interest Rate Effect
Changes in household and business buying as the interest rate changes.
Price level falls, purchasing power rises, less money needed to buy fixed bundle of goods, save more, supply of credit rises, interest rate falls, businesses and households borrow more at lower interest rate, and more goods are bought.
International Trade Effect
The change in foreign sector spending as the price level changes.
Price level in U.S. falls relative to foreign price levels, U.S. goods relatively less expensive than foreign goods, both Americans and foreigners buy more U.S. goods.
A change in quantity demanded
A change in quantity demanded of Real GDP is the result of a change in the price level. Movement along the AD curve.
Change in Aggregate Demand
Shift of the Aggregate Demand Curve. It is caused by a change in spending.
Consumption Factors that change Aggregate Demand
Wealth, Expectation of Future Prices, Expectations of Future Income, Interest Rates, Income Taxes
Wealth rises, Consumption rises, AD rises
Wealth falls, Consumption falls, AD falls
Expectation of Future Prices
Expect higher prices, consumption rises, AD rises
Expect lower prices, consumption falls, AD falls
Expectation of Future Income
Expect higher income, consumption rises, AD rises
Expect lower income, consumption falls, AD falls
Interest rate rises, consumption falls, AD falls
Interest rate falls, consumption rises, AD rises
Income taxes rise, consumption falls, AD falls
Income taxes fall, consumption rises, AD rises
Investment Factors that change Aggregate Demand
Interest rate, optimism/ pessimism about future sales, Business taxes
Interest rate (investment)
Interest rate rises, Investment falls, AD falls
Interest rate falls, Investment rises, AD rises
Optimistic future sales, Investment rises, AD rises
Pessimistic future sales, Investment falls, AD falls
Business taxes fall, Investment rises, AD rises
Business taxes rise, Investment falls, AD falls
Net Export Factors that change Aggregate Demand
Foreign Real National Income, Exchange rate
Foreign Real National Income
Foreign real national income rises, exports rise, net export rises, AD rises
Foreign real national income falls, exports fall, net exports fall, AD falls
US $ depreciates, exports rise, imports fall, net exports rises, AD rises
US $ appreciates, exports falls, imports rise, net exports fall, AD falls
Explain the real balance effect.
A rise in the price level causes purchasing power to fall, which decreases a person's monetary wealth. As people become less wealthy, the quantity demanded of Real GDP falls.
Explain what happens to the AD curve if the dollar appreciates relative to other currencies.
If the dollar appreciates, it takes more foreign currency to buy a dollar and fewer dollars to buy foreign currency. This makes U.S. goods more expensive for foreigners and foreign goods cheaper for Americans. In turn, foreigners buy fewer U.S. exports, and Americans buy more foreign imports. As exports fall and imports rise, net exports fall. If net exports fall, total expenditures fall,. As total expenditures fall, the AD curve shifts to the left.
The quantity supplied of all goods and services at different price levels. The SRAS curve is sloping upwards specifying a direct relationship between price level and the quantity supplied of Real GDP.
Why does the Aggregate Supply curve slope upward?
Sticky wages and worker misconceptions
Sticky Wage, the Real Wage Rate and SRAS
labor contracts. While firms pay nominal wages, they often decide how many worker to hire based on real wages.
Real Wage Equation
Nominal Wage/ Price Level
Real Wages change on Aggregate Supply (workers)
Price level rises, Real Wage falls, QS of labor rise
Price level falls, Real wage rises, QS of labor rise
Real Wages change on Aggregate Supply (firms)
Firms will employ more workers when it's cheaper to hire them.
Real wage rises, QD of labor demanded falls
Real wage falls, QD of labor demanded rises
An increase in price (which pushes real wages down) will result in an increase in output. Thus upward sloping.
If workers misperceive real wage changes, then a fall in the price level will bring about a decline in output. In response to the misperceive falling real wage, workers may reduce the quantity of labor they are willing to supply. With less producer, produce less goods
Changes in Aggregate Supply that shift supply
Wage rates, prices of non-labor inputs, productivity, supply shocks (adverse, beneficial)
Changes in Wage Rates
Profit per unit= Price per unit - Cost per unit
Higher wage rates mean higher costs and, at constant prices, translate into lower profits and a reduction in the number of units firms will want to produce.
Lower wage rates mean lower costs and, at constant prices, translate into higher profits and an increase in the number of units firm will decide to produce.
Changes in the Price of Non-Labor Inputs
Changes in the prices of non-labor inputs affect the SRAS curve in the same way as changes in wage rates do. An increase in the price of a non-labor input shifts the SRAS curve leftward
Changes in Productivity
I.e. More educated labor force, a larger stock of capital goods, technological advancements
An increase in labor productivity means business will produce more output with the same amount of labor, causing the SRAS curve to shift righrtward.
A decrease in labor productivity means businesses will produce less output with the same amount of labor, causing the SRAS curve to shift leftward.
Major natural or institutional changes that affect aggregate supply
Adverse supply socks shift the SRAS curve leftward
Beneficial supply shocks shift the SRAS curve rightward
If wage rates decline, explain what happens to the short-run aggregate supply (SRAS) curve.
AS wage rates decline, the cost per unit of production falls. In the short run, profit per unit rises. Higher profit causes producers to produce more units pf their goods and services. The SRAS curve shift right.
Give an example of an increase in labor productivity.
Ten workers produced 100 units of good X in 1 hour. This year, 10 workers produced 120 units of good X in 1 hours.
Discuss the details of the worker misperceptions explanation for the upward-sloping SRAS curve.
Workers initially misperceive the change in their real wage due to a change in the price level. If a nominal wage is $30 and the price level is 1.50 the real wage is $20. If the nominal wage falls to $25 and the price level falls to 1.10, the real wage is now $22.72. If they misperceive the price level to be 1.4, they believe the real wage is falling when it actually increasing. As such, QS decreases
Short Run Equilibrium
Where the quantity demanded of Real GDP equals the short-run quantity supplied.
Long Run Aggregate Supply
LTAS curve is a vertical line at the level of Natural Real GDP. It represents the output the economy produces when all economy wide adjustment have taken place and workers do not have any relevant misperceptions.
Short Run Equilibrium
QD of Real GDP = Short Run QS of Real GDP
Aggregate Demand curve intersects the short-run aggregate supply curve.
Long Run Equilibrium
When wages and prices have adjusted to their final equilibrium levels and workers do not have any relevant misconceptions. LRAS and AD curve intersect at this point.
The state of the economy as it moves from short run equilibrium to long run equilibrium. The QS and the QD of Real GDP are not equal.
What is the difference between short-run equilibrium and long-run equilibrium?
In long-run equilibrium, the economy is producing Natural Real GDP. In short-run equilibrium, the economy is not producing Natural Real GDP, although the quantity demanded of Real GDP equals the quantity supplied of Real GDP
Supply creates its own demand. Production creates demand sufficient to purchase all goods and services produced.
Say's Law implies that there cannot be either
A general overproduction of goods (where supply in the economy is greater than demand in the economy
A general underproduction of goods
Say's Law in a barter economy
A baker's act of supplying bread is linked to his dmenad for other goods. Supply creates its own demand.
If supplying some goods lead to a simultaneous demand for other goods, then Say's law implies that there cannot be wither a overproduction or underproduction of goods.
Say's Law in a Money Economu
Consumption falls and saving rises, economic forces are at work producing an equal increase to investment.
Saving Increase- Say's Law
Saving increases, interest rates decrease, amount of investment increases.
Classical View of the Credit Market
The interest rate is flexible and adjusts so that saving equals investment. Saving curve shifts rightward and puts pressure on the interest rate that moves downward. New equilibrium is established where once again the amount households save equals the amount firms invest
Explain Say's law in terms of a barter economy.
The act of supplying is motivated by the desire to demand. Supply and demand are opposite sides of the same coin.
According to classical economists, if saving rises and consumption spending falls, will total spending in the economy decrease? Explain your answer.
No, total spending will not decrease. For classical economists, an increase in saving (reflected in a decrease in consumption) will lower the interest rate and stimulate investment spending
What is the classical position on prices and wages?
Prices and wages are flexible; they move up and down in response to market conditions
Three States of the Economy
Recessionary gap, inflationary gap, long-run equilibrium)
Real GDP < Natural Real GDP
Unemployment Rate > Natural Unemployment Rate
Real GDP > Natural Real GDP
Unemployment Rate < Natural Unemployment Rate
Long Run Equilibrium
Real GDP= Natural Real GDP
Unemployment rate= Natural unemployment rate
Illustrate different combinations of goods in the economy can produce given the physical constraints of finite resources and the current state of technology. If the economy is operating at point between the institutional and physical PPF then the unemployment rate is less than the natural unemployment rate
Illustrate different combinations of goods in the economy can produce given the physical constraints of finite resources, the current state of technology and any institutional constraints. The economy is at the natural unemployment rate
What is the state of the labor market when the economy is in a recessionary gap? in an inflationary gap?
When the economy is in a recessionary gap, the labor market has a surplus. When the economy is in an inflationary gap, there is a shortage in the labor market.
If the economy is in an inflationary gap, locate its position in terms of the two PPFs discussed in this section.
The economy is somewhere above the institutional PPF and below the physical PPF.
Closing the Recessionary Gap
Wages rates fall, the SRAS curve shifts rightward. Price level falls, the real balance, interest rate and international trade effects increase the QD of Real GDP. Economy moves to long-run equilibrium.
Closing the Inflationary Gap
Wage rates rise, the SRAS curve shifts leftward. AS the price level rises, the real balance, interest rate and international trade effects decrease QD of Real GDP. The economy moves into long-run equilibrium.
The economy is self-regulating. Full employment is the norm: The economy always moves back to Natural Real GDP. Laissez-faire: A public policy of not interfering with market activities in the economy.
Economic growth macroeconomics deals with rightward shifts in the long-run aggregate supply curve.
If the economy is self-regulating, what happens if it is in a recessionary gap?
In a recessionary gap, the existing unemployment rate is greater than the natural unemployment rate, implying that unemployment is relatively high. As wage contracts expire, business firms will negotiate new ones that pay workers lower wage rates. As a result, the SRAS curve shifts rightward. As this happens, the price level begins to fall. The economy moves down the AD curve—eventually to the point where it intersects the LRAS curve. At this point, the economy is in long-run equilibrium.
If the economy is self-regulating, what happens if it is in an inflationary gap?
In an inflationary gap, the existing unemployment rate is less than the natural unemployment rate, implying that unemployment is relatively low. As wage contracts expire, business firms will negotiate contracts that pay workers higher wage rates. As a result, the SRAS curve shifts leftward. As this happens, the price level begins to rise. The economy moves up the AD curve—eventually to the point where it intersects the LRAS curve. At this point, the economy is in long-run equilibrium.
If the economy is self-regulating, how do changes in aggregate demand affect the economy in the long run?
Any changes in aggregate demand will affect—in the long run—only the price level, not the Real GDP level or the unemployment rate. Stated differently, changes in AD in an economy will have no long-run effect on the Real GDP that a country produces or on its unemployment rate; changes in AD will change only the price level in the long run.
Keynesian Challenged Say's Law of
1. Insufficient demand in the economy is unlikely.
2. Wages, price, and interest rates are flexible.
3. The economy is self-regulating.
4. Laissez-faire is the right and sensible economic policy.
Keynes's View of Say's Lawin a Money Economy
A decrease in consumption and subsequent increase in saving may not be matched by an equal increase in investment. Thus, a decrease in total expenditures may occur.
Keynes on Savings and Investment
Saving is more responsive to changes in income than to changes in the interest rate and that investment is more responsive to technological changes, business expectations, and innovations than to changes in the interest rate.
Keynes on Wages
The labor market may adjust slowly. In particular, a lowered demand for labor may not be met with a declining wage rate. Wage rates might be inflexible downward. If wage rates are inflexible downward, then the self-regulating properties of an economy are in question. Specifically, an economy might get stuck in a recessionary gap.
Keynes on Prices
Keynes said that the internal structure of an economy is not always competitive enough to allow prices to fall. Keynes suggested that anticompetitive or monopolistic elements in the economy sometimes prevent price from falling.
What do Keynesians mean when they say the economy is inherently unstable?
Keynesians mean that an economy may not self-regulate at Natural Real GDP. Instead, an economy can get stuck in a recessionary gap.
According to Keynes, why might aggregate demand be too low?
The main reason is that Say's law may not hold in a money economy. The question is why doesn't Say's law hold in a money economy? Keynes argued that an increase in saving (which leads to a decline in demand) does not necessarily bring about an equal amount of additional investment (which would lead to an increase in demand), because neither saving nor investment is exclusively affected by changes in the interest rate
Simple Keynesian Model
The price level is assumed to be constant until the economy reaches its full-employment or Natural Real GDP level.
There is no foreign sector. The model represents a closed economy, not an open economy. It follows that total spending in the economy is the sum of consumption, investment, and government purchases.
Monetary side of the economy is excluded
The relationship between consumption and disposable income. Consumption is directly related to disposable income and is positive even at zero disposable income.
Consumption Function Equation
C= C0+ (MPC) (Yd)
autonomous consumption- The part of consumption that is independent of disposable income.
Marginal propensity to consume- The ratio od the change in consumption to the change in disposable income: MPC= Change in C/ Change in Yd.
Disposable income- Income received less taxes
1. Consumption depends on disposable income
2. Consumption and disposable income move in the same direction
3. When disposable income changes, consumption changes by less (MPC)
Disposable Income less Consumption.
Marginal propensity to save (MPS) is the ratio of the change in saving to the change in disposable income
The number that is multiplied by the change in autonomous spending to obtain the overall change in total spending.
The multiplier is equal to 1/(1-MPC0.
If the economy is operating below Natural Real GDP, then the multiplier by the change in autonomous spending to obtain the change in Real GDP.
Change in Total Spending Equation
Change in total spending= Multiplier x Change in autonomous spending
The Multiplier and Aggregate Demand
An initial increase in autonomous consumption raides total spending and shifts the aggregate demand curve rightward. Because of the multiplier, the increase in autonomous spending generates additional incomes and additional spending, shifting the aggregate demand curve farther rightward.
How is autonomous consumption different from consumption/
Autonomous consumption is one of the components of overall consumption.
If the MPC= .70, what does the multiplier equal?
What happens to the multiplier as the MPC falls?
The multiplier falls.
Keynesian Aggregate Supply curve
The AS curve in the simple Keynesian model is horizontal until QN (Natural Real GDP) and vertical at QN. Any change in aggregate demand in the horizontal section fo not change the price level, but any changes in aggregate demand in the vertical section do change the price level.
Can the Private Sector Remove the Economy from a Recessionary gap?
Increasing spending to shift the AD curve rightward and create equilibrium sometimes could not happen. No matter how low interest rates fell, investment spending would not rise because of pessimistic business expectations with respect to future sales.
Simple Keynesian Model I
The price level is constant until Natural GDP is reached.
The AD curve shifts if there are changes in C, I or G
According to Keynes, it is possible for the economy to be in equilibrium and in a recessionary gap too.
SImple Keynesian Model II
The private sector may not be able to get the economy out of a recessionary gap, meaning not able to increase C or I enough to get the AD curve in to intersect the AS curve at the Natural Level of Real GDP. The government may have a management role to play in the economy. It to its Natural Real GDP level.
What was Keynes's position with respect to the self-regulating properties of an economy?
Keynes believed that the economy may not always self regulate itself at Natural Real GDP. The private sector of the economy are not always capable of generating enough AD in the economy so that the economy equilibrates at Natural Real GDP.
What will happen to real GDP if autonomous spending rises and the economy is operating at the horizontal section of Keynesian AS curve? Explain your answer.
The increase in autonomous spending will lead to a greater increase in total spending and to a shift rightward in the AD curve. If the economy is operating in the horizontal section of the Keynesian AS curve,
Real GDP will rise, and there will be no change in prices
An economist who believes the economy is self-regulating is more likely to advocate laissez- faire than an economist who believes the economy is inherently unstable. Do you agree or disagree? Explain your answer.
Agree, The economist who believes the economy is inherently unstable sees a role for government. Governement is supposed to stabilize the economy at Natural Real GDP. The economist who beleives the economy is self-regulating (capable of moving itself to Natural Real GDP) sees onlu a small, if any, role for government because the economy is already doing the job government would supposedly do.
Total Expenditures Curve
At different levels of Real GDP, we sum consumption, investment, and government purchases to derive TE curve.
Total Production Curve
45-degree line (it bisects the 90-degree ange at the origin). At any point on the TP curve, total production is equal to Real GDP. TP and GDP are different names for the same thing.
Three States of the Economy in the TE-TP Framework
At Qe, TE= TP and the economy is in equilibrium.
results in an unexpected increase in inventories, which signals firms that they have overproduced, which leads firm to cut back on production
The cutback in production reduces Real GDP. The economy moves to equilibrium
TE > TP
This results in an unexpected decrease in inventories which signals firms that they have underproduced, which lead firms to raise production. Increased production raises Real GDP and the economy moves into equilibrium
The economy is in equilibrium, however the Natural Real GDP is great than QE, so the economy is in a recessionary gap as well as being in equilibrium
Keynesian Model in terms of TE/ TP
1. The price level is constant until Natural Real GDP is reached.
2. The TE curve shifts if there are chanfes in C, I, or G.
3. It is possible for the economy to be in equilibrium and in a recessionary gap too.
4. The private sector may not be able to get the economy out of a recessionary gap.
5. The governement may have a mangement role in to play in the economy. Government may have to raise TE enough to stimulate the economy out of the recessionary gap and move it to its Natural Real GDP level.
What happens in the economy if total production (TP ) is greater than total expenditures (TE )?
When TP is greater than TE, firms are producing and offering for sale more units of goods and services than households and governments want to buy. As a result, business inventories rise above optimal levels. In reaction, firms cut back on their production of goods and services. This leads to a decline in Real GDP, which stops falling when TP equals TE.
What happens in the economy if total expenditures (TE ) are greater than total production (TP )?
When TE is greater than TP, households and businesses want to buy more than firms are producing and offering for sale. AS a result, business inventories fall below optimal levels. In reaction, firms increase their production of goods and services. This leads to a rise in Real GDP, which stops rising when TP equals TE.
3 Income Taxe structures
Progressive income tax, proportional income tax, regressive income tax
Progressive income tax
An income tax system in which one's tax rate rises as taxable income rises.
Proportional income tax
An income tax system in which a person's tax rate is the same regardless of taxable income
Regressive income tax
An income tax system in which a person's tax rate declines as his or her taxable income rises.
Marginal Tax Rate
The change in a person's tax payment divided by the change in his or her taxable income.
Government expenditures greater than tax revenues
Tax revenues greater than government expenditures
Government expenditure equal to tax revenues
The part of the budget deficit that would exist even if the economy were operating at full employment
The part of the budget deficit that is a result of a downturn in economic activity
The total amount the federal government owes to its creditors
Value Added tax
Value added is the difference between what a producer sells a final good for and what it pays for an intermediate good. VAT is a tax applied to the value added at each stage of production. VAT generates tax revenue and raises prices. The VAT is nothing more than a less visible sales tax.
What three taxes account for the bulk of federal tax revenues?
Individual income tax, corporate income tax, and Social Security taxes.
Changes in government expenditures and/or taxes to achieve particular economic goals, such as low unemployment, stable prices, and economic growth
Expansionary fiscal policy
Increase in government expenditures and/or decrease in taxes to achieve particular economic goals
Contractionary Fiscal Policy
Decreases in government expenditures and/or increases in taxes to achieve particular economic goals.
Discretionary Fiscal Policy
Deliberate changes of government expenditures and/or taxes to achieve particular economic goals
Automatic Fiscal Policy
Changes in government expenditures and/or taxes that occur automatically without additional congressional action.
Demand Side Fiscal Policy
A change in C, I, G, and NX can change aggregate demand and therefore shift the AD curve.
Demand Side Fiscal Policy- Decrease in government spending
Decreases aggregate demand and shifts the AD curve to the left.
Demand Side Fiscal Policy- Increase in government spending
Increases Aggregate demand and shifts the AD curve to the right.
Demand Side Fiscal Policy- Decrease in taxes
Increases aggregate demand and shifts the AD curve to the right.
Demand Side Fiscal Policy- Increase in taxes
Decreases aggregate demand and shifts the AD curve to the let
Expansionary Fiscal Policy- Recessionary gap
Increased government purchases, decreased taxes, or both lead to a rightward shift in the aggregate demand curve restoring the economy to the natural level of Real GDP.
Contrationary Fiscal Policy
Decreased government purchases, increased taxes, or both lead to a leftward shift in the aggregate demand curve restoring the economy to the natural level of Real GDP.
The decrease in private expenditures that occurs as a consequence of increased government spending (direct effect) or the financing needs of the Federal budget deficit
Complete Crowding Out
A decrease in one or more components of private spending completely offsets the increase in government spending.
Incomplete crowding out
The decrease in one or more components of private spending only partially offsets the increase in government spending.
Zero Crowding Out
Private spending remains constant. AD increases. Real GDP increases. Unemployment rate decreases.
Policymakers are not aware of changes in the economy as soon as they happen
Wait- and -see lag
After policymakers are are of a downturn in economic activity they rarely enact counteractive measures immediately. They want to be sure that the observed events are not just short-run.
After policymakers decide that some type of fiscal policy measure is required, Congress or the president will have to propose the measure, build political support for it, and get it passed.
After enacted, a fiscal policy measure takes time to be put into effect.
After a policy measure is actually implemented, it takes time to affect the economy.
Fiscal Policy may destabilize the economy
STAS is shifting rightward, healing the recessionary gap, but this information is unknown to policymakers. Policymakers implement expansionary fiscal policy, and the AS curve ends up intersecting SRAS2 instead of SRAS1 (point of equilibrium). Policymakers thereby move the economy into an inflationary gap, destabilizing the economy.
How does crowding out question the effectiveness of expansionary demand-side fiscal policy?
If there is no crowding out, expansionary fiscal policy is predicted to increase aggregate demand and, if the economy is in a recessionary gap, either reduce or eliminate the gap.
However, if there is, say, complete crowding out, expansionary fiscal policy will not meet its objective. The following example illustrates complete crowding out: If government purchases rise by $100 million, private spending will decrease by $100 million so that there is no net effect on aggregate demand.
How might lags reduce the effectiveness of fiscal policy?
Suppose the economy is currently in a recessionary gap at time period 1. Expansionary fiscal policy is needed to remove the economy from its recessionary gap, but fiscal policy lags (data lag, wait-and-see lag, etc.) may be so long that, by the time the fiscal policy is implemented, the economy has moved itself out of the recessionary gap, making the expansionary fiscal policy not only unnecessary but potentially capable of moving the economy into an inflationary gap.
Give an example of the indirect effect of crowding out.
The federal government spends more on a given program. As a result, the budget deficit grows, and the federal government increases its demand for loanable funds (or credit) to finance the larger deficit. Because of the greater demand for loanable funds, the interest rate rises in response to the higher interest rate, and business firms cut back on investment. An increase in government spending has indirectly led to a decline in investment spending.
Supply- Side Fiscal Policy
A cut in marginal tax rates increases the atractiveness of productive activity relative to leisure and tax avoidance activities. Shifts resources from the latter to the former, thus shifting both the short run and long run aggregate supply curves rightwards.
Shows the relationship between tax rates and tax revenues. AS tax rates rise from zero, tax revenues rise, reach a maximum at some ount and then fall with further increases in rate rates.
Tax base x Average tax rate.
If the % reduction in the rax rate is greater than the % increase in the tax base, tax revenues decrease
If the % reduction in the tax rate is less than the % increase in the tax base, tax revenues increase.
Give an arithmetic example to illustrate the difference between the marginal and average tax rates.
Let's suppose that a person's taxable income rises by $1,000 to $45,000 and that her taxes rise from $10,000 to $10,390 as a result. Her marginal tax rate—the percentage of her additional taxable income she pays in taxes—is 39 percent. Her average tax rate—the percentage of her (total) income she pays in taxes—is 23 percent.
If income tax rates rise, will income tax revenues rise too?
Not necessarily. It depends on whether the percentage rise in tax rates is greater or less than the percentage fall in the tax base. Here's a simple example: Suppose the average tax rate is 10 percent and the tax base is $100. Tax revenues then equal $10. If the tax rate rises to 12 percent (a 20 percent rise) and the tax base falls to $90 (a 10 percent fall), tax revenues rise to $10.80. In other words, if the tax rate rises by a greater percentage than the tax base falls, tax revenues rise. But then suppose that the tax base falls to $70 (a 30 percent fall) instead of to $90. Now tax revenues are $8.40. In other words, if the tax rate rises by a smaller percentage than the tax base falls, tax revenues fall.
Money as a Medium of Exchange
Anything that is generally acceptable in exchange for goods and services.
Money as a Unit of Account
A common measure in which relative values are expressed.
Money as a Store of Value
The ability of an item to hold value over time.
Double Coincidence of Wants
a trader must find another trader who is willing to trade what the first trader wants and at the same time wants what the first trader has (Barter economy). Exchanges take less time in a money economy than in a barter economy because a double coincidence of wants is unnecessary: Everyone is willing to trade what he or she has for money. The movement from a barter to a money economy therefore frees up some of the transaction time, which people can use in other ways.
Money Supply M1
M1= Currency held outside banks + Checkable deposits + Traveler's checks.
Money Supply M2
M2= M1 + Saving deposits (including money market accounts) + small denomination time deposits + money market mutual funds (retail)
Loans which must be repaid. They represent the use of someone else's money.
access to checkable deposits which are already part of the money supply.
Why (not how) did money evolve out of a barter economy?
Money evolved because individuals wanted to make trading easier (i.e., less time-consuming). In a barter economy, this need motivated people to accept the good with relatively greater acceptability than all other goods. In time, the effect snowballed, and finally the good with initially relatively greater acceptability emerged into a good that was widely accepted for purposes of exchange. At this point, the good became money.
If individuals remove funds from their checkable deposits and transfer them to their money market accounts, will M1 fall and M2 rise? Explain your answer.
No. M1 will fall, but M2 will not rise; it will remain constant. To illustrate, suppose M1 is $400 and M2 is $600. If people remove $100 from checkable deposits, M1 will decline to $300. For purposes of illustration, think of M2 as equal to M1 money market accounts. The M1 component of M2 falls by $100, but the money market accounts component rises by $100; so there is no net effect on M2. Thus M1 falls and M2 remains constant.
How does money reduce the transaction costs of making trades?
In a barter (moneyless) economy, a double coincidence of wants will not occur for every transaction. When it does not occur, the cost of the transaction increases because more time must be spent to complete the trade. In a money economy, money is acceptable for every transaction; so a double coincidence of wants is not necessary. All buyers offer money for what they want to buy, and all sellers accept money for what they want to sell.
The sum of bank deposits at the Fed and vault cash
Required Reserve Ratio
A percentage of each dollar deposited that must be held on reserve.
The minimum amount of reserves a bank must hold against its checkable deposits as mandated by the Fed.
r x Checkable deposits
Any reserves held beyond the required amount. The difference between (total) reserves and required reserves.
Reserves - Required reserves
A bank reduces its deposits at the Fed by $5 million and increases its vault cash by $5 million. What happens to the bank's reserves?
The bank's reserves remain constant. Since reserves equal bank deposits at the Fed plus vault cash, removing $5 million from bank deposits at the Fed and adding the $5 million to vault cash keeps the total dollar amount of reserves constant.
If a bank has $87 million in checkable deposits, and it is required to hold $6 million in reserves (required reserves $6 million), what is the required reserve ratio equal to?
Required reserves = r Checkable deposits, where r = required reserve ratio. If checkable deposits equal $87 million and required reserves equal 6 million, then r equals the required reserves divided by checkable deposits: $6 million $87 million = a required reserve ratio of 6.89.
If excess reserves are $4 million and (total) reserves are $6 million, what do required reserves and checkable deposits equal? Assume the required reserve ratio is 8 percent.
Required reserves: Reserves = Required reserves + Excess reserves. If reserves are $6 million and excess reserves are $4 million, then required reserves are $2 million. Checkable deposits: Required reserves = r Checkable deposits, where r = required reserve ratio. If required reserves are $2 million and r = 8 percent, then checkable deposits must equal $25 million; 8 percent of $25 million is $2 million.
The Financial System
A financial system is essentially a means of getting people with surplus funds together with people who have a shortage of funds. Stated differently, it is a means of getting savers and borrowers together.
Borrowers and lenders come together in a market setting, such as a bond market
Funds are loaned and borrowed through a financial intemediary
A financial intermediary transfers funds from those who want to lends funs to those who want to borrow them
Relates to an economic agent on one side of a transaction having information that an economic agent on the other side of the transaction does not have
The parties on one sid eof the market, who have information not known by others, self-select in a way that adversely affects the parties on the other side of the market
A condition that exists when one party to a transaction changes his or her behavior in a way that is hidden from and costly to the other party.
The bank's capital can be viewed as a cushion against insolvency, which exists when a bank's liabilities are greater than its assets. An insolvent bank has failed and can be shutdown
Insolvency: Liabilities > Assets.
The larger the bank's capital, the bigger the cushion against bank failure or insolvency.
Jack promises Samantha that he will pay for any expenses she has on her trip beyond $1,000. Does this create an adverse selection or moral hazard problem? Explain your answer.
It is a moral hazard problem. A moral hazard problem exists when one party to a transaction changes his or her behavior in a way that is hidden from and costly to the other party
Bank A finds that many of the loans it extended to individuals are not being paid back. How do the defaults affect bank A's capital or net worth?
A bank's capital or net worth is equal to the difference between its assets and liabilities
What do financial intermediaries do?
Financial intermediaries essentially bring lenders and borrowers together.
Board of Governors
Governing body of the Federal Reserve.
Board of Governors coordinates and controls the activities of the Federal Reserve System.
The board members serve 14-year terms and are appointed by the President with Senate approval.
To limit political influence on Fed policy, the terms of the governors are staggered—with one new appointment every other year—so a president cannot "pack" the board.
The President also designates one member as chairman of the board for a 4-year term.
Federal Open Market Committee
the major policymaking group within the Fed.
Authority to conduct open market operations—the buying and selling of government securities—rests with the FOMC.
The FOMC has 12 members: the 7-member Board of Governors and 5 Federal Reserve District Bank presidents.
Open Market Operations
The buying and selling of government securities by the Fed.
Functions of the Fed
Control the money supply
Supply the economy with paper money (Federal Reserve notes)
Provide check clearing services
Hold depository institutions' reserves
Supervise member banks
Serve as the government's banker
Serve as the lender of last resort
Serve as a fiscal agent for the Treasury.
Changes in the money supply, or in the rate of change of the money supply, to achieve particular macroeconomic goals.
The president of which Federal Reserve District Bank holds a permanent seat on the Federal Open Market Committee (FOMC)?
Federal Reserve Bank of New York.
What is the most important responsibility of the Fed?
The fed controls the money supply
What does it mean to say the Fed acts as "lender of last resort"?
the Fed stands ready to lend funds to banks that are suffering cash management, or liquidity, problems.
Fed vs. U.S. Treasury
The U.S. Treasury is a budgetary agency; the Fed is a monetary agency.
When the federal government spends funds, the Treasury collects the taxes and borrows the funds needed to pay suppliers and others. In short, the Treasury has an obligation to manage the financial affairs of the federal government. Except for coins, the Treasury does not issue money. It cannot create money out of thin air as the Fed can.
The Fed is principally concerned with the availability of money and credit for the entire economy. It does not issue Treasury securities. It does not have an obligation to meet the financial needs of the federal government. Its responsibility is to provide a stable monetary framework for the economy.
Open Market Purchase
The buying of U.S. government securities by the Fed
Open Market Sale
The selling of U.S. government securities by the Fed
M1 money supply
M1= Currency held outside banks + Cahckable deposits + Traveler's chacks
Maximum change in checkable deposits
(1/ratio) x change in Reserves
increase in ratio, decrease in checkable deposits
decrease in ratio, increase in checkable deposits
Why Banks borrow reserves
To increase loan making ability
To meet required reserve requirements
Federal Funds Market
A market where banks lend reserves to one another, usually for short periods
Federal Funds Rate
The interest rate in the federal funds market; the interest rate banks charge one another to borrow reserves
The interest rate the Fed charges depository institutions that borrow reserves from it; the interest rate charged on a discount loan
A loan the Fed makes to a commercial bank
The Discount Window
Fed sets discount rate below federa funds rate, banks borrow from Fed, Banks have more reserves, Banks may make more loans and checkable deposits, money supply rises.
Federal Funds Target Rate
If the Fed wants to change the money supply it takes two measures (1) It sets a federal funds rate target and then (2) uses open market operations to change the federal funds rate as to "hit" the target.
Term Auction Facility (TAF) Program
Instead of banks asking for a specific dollar loan (as in a discount loan), the Fed first identifies the total amount of credit it wants to extend. Then it allows banks to bid on the funds. The bidding process determines the TAF rate (interest rate) for the loans.
Recent Fed actions (2008)
the Fed extended its lender-of-last-resort function to institutions other than banks.
the Fed not only bought securities from nonbank institutions, but often bought securities that were not Treasury issues. Often they were mortgage-backed securities that institutions owned that were declining in value.