ch 24: unemployment · 2020-03-19 · calculating the unemployment rate •start with the total...

CH 24: The Business Cycle

The Business Cycle• The four phases of the business cycle are:

• Expansion: where real GDP is growing

• Peak: the highest point of the business cycle

• Contraction: period where real GDP is falling

• A recession is two consecutive quarters where real GDP has fallen

• A depression is a prolonged period of economic decline

• Trough: the bottom of the business cycle where the contraction has ended and is about to make an upward turn

The Business Cycle

Peak

Trough

CH 24: Unemployment

Types of Unemployment

• Frictional unemployment: unemployment caused by people entering the job market/people quitting a job just long enough to look for and find another job

• People between jobs that are temporarily unemployed

• Examples: a parent reentering the workforce or a college graduate looking for a job


• Structural unemployment: unemployment caused by changes in the structure of the labor force make some skills obsolete

• Workers do not have transferable skills

• The jobs that have been lost will never come back

• Workers must learn new skills to get a job

• Also includes the outsourcing of jobs to other countries


• Cyclical unemployment: unemployment due to economic downturns/the business cycle (think due to recession and/or times of lower output by businesses)

• Seasonal unemployment: unemployment due to seasonal work


•Frictional and structural unemployment are present at all times because some people will always be between jobs or replaced by technology

•The economy is doing well if there is only frictional and structural unemployment

Full Employment• Full employment: an economic climate where nearly everyone who

wants a job has one

– Where there is no cyclical unemployment

– About 5-6% unemployment

• The natural rate of unemployment is the lowest rate of unemployment that policy makers believe is achievable under existing conditions

– The amount of frictional and structural unemployment when the economy is healthy and growing

– Generally, this is around 5%

Calculating the Unemployment Rate

• Who is part of the labor force?

• Must be at least 16 years old

• Willing and able to work

• Not institutionalized (in jail or hospital)

• Not in the military, in school full-time, or retired


• Start with the total civilian population and subtract those unavailable for work (those under age 16, in prison, or otherwise not available to work)

• Then, subtract those not in the labor force (homemakers, disabled, etc.)

• You are left with the potential workforce

• **OR, if given the number of employed and unemployed, you can add them together to get the labor force**


Unemploymentrate

# unemployed

# in labor forcex 100=

Other Ways to Measure Employment

• The labor force participation rate measures the labor force as a percentage of the total population at least 16 years of age

Labor force (those willing and able to work) x 100

Total population age 16 and over

CH 24: Price Indices and Inflation

Who Is Helped/Hurt by Unanticipated Inflation

Hurt

• People who borrow money (paying a loan back in “cheaper” dollars)

• A business where the price of the product increases faster than the price of resources

Helped

• Lenders: People who lend money (at fixed interest rates)

• People with fixed incomes

• Savers

Measuring Inflation

• A price index: a number that summarizes what happens to a weighted composite of prices of a selection of goods over time

• The price index is always 100 in the base year unless otherwise stated

• The most commonly used measurement of inflation for consumers is the Consumer Price Index (CPI)

Price Indices

• The CPI measures prices of the goods and services bought by consumers

• Looks at changes in prices of a market basket of goods and services (price of each good multiplied by the amount produced)

Price Indices

• If given the value of market baskets in two different years, you can calculate the price index

Year 2 x 100

Year 1 (or base year)

CPI= Year 2 - Year 1Year 1 or base year

x 100

• If you have the price indices, you can calculate the change in inflation (price level)

Price Indices

CH 25: GDP

GDP

• Gross Domestic Product (GDP) is the dollar value of all final goods and services produced within a country’s borders in one year

• GDP is measured in dollars

• Only measures final goods and services

What is NOT Counted in GDP

• Sale of used goods

• Intermediate goods

• Sale of stocks/bonds

• Work of homemakers

• Transfer payments (Social Security)

• The underground economy/black market

Calculating GDP

• Quantities of goods and services produced are multiplied by their per unit market price to determine a value measure of that good or service (P x Q)

–This weights the importance of each good by its price

• The sum of all of these values is GDP

Calculating GDP

Good Price Quantity Total

Shoes $50 10 $500

T-shirts $10 50 $500

Socks $6 100 $600

$1,600

Assume our economy only produces 3 goods.• What is the GDP for our economy?

The Components of GDP

GDP is divided into four expenditure categories:

1.Consumption (C) is spending by households on goods an services

• Includes durable and nondurable goods

• Durable goods are goods that last a long time (washing machines; refrigerators)

• Nondurable goods are goods that do not last long or are immediately consumed


• Investment (I) is spending for the purpose of additional production (NOT stocks/bonds)

– Includes new capital or machinery purchased by a firm

–New construction (new grocery store or new homes)

–Market value of unsold inventory


3. Government spending (G) is goods and services that the government buys

• Such as highways, airports, etc.

• Does NOT include transfer payments such as Social Security or welfare

4. Net exports (X-M or Xn) is spending on exports (X) minus spending on imports (M)


• This gives us the formula:

• GDP =C + I + G + (Xn)

Nominal GDP

• Nominal GDP is GDP measured in current prices

• It does not account for inflation from year to year

• Nominal GDP = Deflator x Real GDP100

Real GDP

• Real GDP is GDP expressed in constant, or unchanging, dollars and is adjusted for inflation

– It is the best measure of economic growth

–Considered more accurate because prices have been adjusted according to a base year

Real GDP

• Real GDP = Nominal GDP

GDP Deflator or Price Index

OR

• Real GDP= Nominal GDP

GDP Deflator or Price Index in hundredths

x 100

Calculating the GDP Deflator

• A deflator is an adjustment that accounts for inflation

– It tells us what output would have been with no inflation

– Economists favor the GDP deflator because it includes a larger number of goods

Calculating the GDP Deflator

• GDP Deflator =Nominal GDP

Real GDPx 100

•The GDP deflator measures the prices of all goods (not just the market basket) produced in a nation relative to a base year•This is a broader measure compared to the CPI

CH 26: AS/AD Model

Shifts in AD

Price Level

Real GDP

SRAS

AD

LRAS

P1

YP

Any component of GDP shifts AD:• C=Consumption• I=Investment• G=Government spending• Xn=Net exports

*Expansionary and contractionary monetary and fiscal policy also affect AD*

AD Shift Factors: Consumption

• When consumption increases (or consumers buy more goods/services), AD increases

• When consumption decreases (or consumers buy less goods/services), AD decreases

AD Shift Factors: Consumer Expectations of Economy/Price

• When consumers expect the economy to do well AD increases

• When consumers anticipate the economy will not do well or that a recession is coming, AD decreases

• If consumers expect the price of a good to increase, AD increases

• If consumers expect the price of a good to decrease, AD decreases

AD Shift Factors: Investment (Capital goods, tools, machinery; NOT stocks and bonds)

• When businesses increase investment, AD increases

• When businesses decrease investment, AD decreases

AD Shift Factors: Government Spending

• When government spending increases, AD increases (also known as an expansionary fiscal policy)

• When government spending decreases, AD decreases(also known as a contractionary fiscal policy)

AD Shift Factors: Xn or (X-M): Net Exports

• When net exports increase, AD increases

• When net exports decrease, AD decreases

• When the U.S. exports more goods to another country AD increases

• When the U.S. imports more goods from another country AD decreases

AD Shift Factors: Exchange Rates (FOREX)

• If the U.S. dollar depreciates, it makes U.S. goods less expensive and more attractive to other countries

–AD increases because foreign countries will want to import the less expensive goods from the U.S.

• If the U.S. dollar appreciates, it makes U.S. goods more expensive and less attractive to other countries

–AD decreases because foreign countries will not want to import the more expensive goods from the U.S.

AD Shift Factors: Fiscal Policy

• Expansionary fiscal policies are used to restore full employment when there is a recessionary (negative output) gap

– If the government increases spending or decreases taxes, AD increases

AD Shift Factors: Fiscal Policy

• Contractionary fiscal policies are used to restore full employment when there is an inflationary (positive output) gap

– If the government decreases spending or increases taxes, AD decreases

27-43

AD Shift Factors: Monetary Policy

• Expansionary monetary policy: If the Fed expands the money supply (buys bonds; decreases reserve requirement; or decreases discount rate) AD increases

• Contractionary monetary policy: If the Fed contracts the money supply (sells bonds; increases reserve requirement; or increases discount rate) AD decreases

Aggregate Supply: Sticky Wages and Prices• In the short-run, wages and the price of resources will not

increase as the price level increases

– The SRAS curve is upward sloping due to sticky wages and prices

• Sticky prices means that prices do not change when there is a change in AD (short-run)

• Sticky wages means that wages do not change when there is a change in AD (short-run)

Shifts in SRAS

SRAS Shifters: R.G.P.• Resource prices (input prices)• Government actions

(sales/excise taxes and subsidies)• Productivity/technology

SRAS Shift Factors: Resource/Input Prices

• If resource/input prices increase, SRAS decreases

• If resource/input prices decrease, SRAS increases

SRAS Shift Factors: Government Action: Sales and Excise Taxes

• Higher sales/excise taxes decrease SRAS

• Lower sales/excise taxes increase SRAS

SRAS Shift Factors: Productivity (or labor productivity impacted by technology)

• An increase in productivity increases SRAS

• A decrease in productivity decreases SRAS

SRAS Shift Factors: Business or Corporate Taxes

• Higher business/corporate taxes decrease SRAS

• Lower business/corporate taxes increase SRAS

SRAS Shift Factors: Inflationary Expectations (connects to Phillips Curve)

• If inflationary expectations increase, SRAS decreases

• If inflationary expectations decrease, SRAS increases

What happens if the government takes no policy action?

• This is often asked in the FRQs

• If the government takes no (policy) action (meaning there is no change in government spending and/or taxes), SRAS increases (shifts to the right) as resource/input prices and/or wages decrease (this is because the AS/AD model is self-adjusting to long-run equilibrium)

The LRAS Curve

Shifts in the LRAS are caused by changes in:

• Capital stock

• Resources

• Technology

If it shifts the PPC, it also shifts LRAS

Price level

Real GDP

LRAS1

YP

LRAS Shift Factors: Capital Stock/Goods

• If capital goods increase, LRAS increases

• If capital goods decrease, LRAS decreases

LRAS Shift Factors: Resources

• If available resources increase, LRAS increases

• If available resources decrease, LRAS decreases

LRAS Shift Factors: Technology

• If available technology increases, LRAS increases

• If available technology decreases, LRAS decreases

Inflationary (Positive Output) Gap

Price Level

Real GDP

SRAS

LRAS

P1

YP

AD1

Y1

Recessionary (Negative Output) Gap

Price Level

Real GDP

SRASLRAS

P1

YP

AD1

Y1

Positive and Negative Shocks

• A positive shock in AD causes output, employment, and the price level to rise in the short run (increase in AD)

• A negative shock in AD causes output, employment, and the price level to fall in the short run (decrease in AD)

• A positive shock in SRAS causes output and employment to rise and the price level to fall in the short run (increase in SRAS)

• A negative shock in SRAS causes output and employment to fall and the price level to rise in the short run (decrease in SRAS)

Demand-pull Inflation

• Demand-pull inflation: inflation that occurs when the economy is at or above potential output

• Characterized by shortages of goods and workers

• Due to excess demand, firms raise the prices of goods (and workers raise the price of their labor)

• Think of it as too many dollars chasing too few goods

• Cost-push inflation: inflation that occurs when the economy is below potential output

• Higher production costs increase prices

• A negative supply shock increases the costs of production and forces producers to increase prices

Cost-push Inflation

Stagflation

• Stagflation is an increase in inflation and unemployment (think 1970s)

AS/AD Model in the Long-Run

• In the long run, in the absence of government policy actions, flexible wages and prices will adjust to restore full employment

–An FRQ might ask “What happens when the government takes no policy action?”

• The appropriate response: wages and or resource/input prices decrease, which shifts SRAS to the left

• Since this model is self-adjusting to long-run equilibrium unemployment will revert to its natural state after a shock to AD or SRAS

Economic Growth

• Economic growth can be measured as the growth rate in real GDP per capita over time

• An increase in consumption or government spending does not cause economic growth

• Only investment causes growth since firms increase their capital stock (machinery and tools purchased by businesses that increase their output)

Aggregate Production Function

PC1

Productivity

Real GDP per Worker

GDP2

GDP1

GDP3

PC2 PC3

Productivity levels off because of diminishing returns

Physical Capital per Worker

CH 26W: Multiplier Model

Autonomous Expenditures

• Autonomous expenditures are expenditures that do not vary with income

• They are unrelated to one’s level of income

• They remain constant at all levels of income

• Examples: Food, shelter, rent/mortgage, etc. (These expenditures would still exist at zero dollars of income)

Induced Expenditures

• Induced expenditures are expenditures that change as income changes

– They are directly related to income

–When income changes, they change by less than income

– Examples: Changes in consumer spending and business purchases of capital goods

The Marginal Propensity to Consume (MPC)

• The marginal propensity to consume (MPC) is the change in consumption (C) that occurs with a change in disposable income (DI)

• This tells us how much people consume, rather than save, when there is an change in income

• The MPC is less than one because individuals consume only a portion of an increase in income (they tend to save some of their income)

The Marginal Propensity to Consume (MPC)

• It is always expressed as a decimal (or fraction)

• MPC= Consumer spending (Consumption)

Disposable Income

The Marginal Propensity to Save

• Marginal propensity to save (MPS) is the change in saving caused by a change in disposable income

– It is always expressed as a decimal (or fraction)

–MPS = Saving

Disposable income

MPC and MPS Formulas

• MPC + MPS = 1

• 1 – MPC = MPS

• 1 – MPS = MPC

The Spending Multiplier

• The (simple or fiscal) spending multiplier represents the multiple by which GDP increases or decreases in response to an increase or decrease in government spending or investment

–Multiplier=1/MPS

–Multiplier= 1/(1– MPC)


• A higher MPS, means a smaller multiplier

• A lower MPS, means a higher multiplier

• Multipliers are (+) when there is an increase in spending and (-) when there is a decrease


• An initial change in spending (C, IG, G, XN) causes a larger change in aggregate spending, or AD

• Multiplier = in AD (or real GDP)

in Spending

• Multiplier = Δ AD/Δ C, I, G, or X

= Total change in GDPMultiplier xInitial Changein Spending

The Tax Multiplier

• When the government increase taxes, the multiplier works in reverse

• If there is a tax cut, then the multiplier is +, because there is now more money in the circular flow

Tax Multiplier Compared to Spending Multiplier

• The tax multiplier is smaller than the spending multiplier

– It is always one less than the simple spending multiplier

• It first goes through the consumption function as disposable income

• As money is spent, some is saved and it is referred to as a leakage

• Tax multiplier= MPC/MPS

–Or: MPC x Spending Multiplier

= Total change in GDPTax multiplier xInitial Change

in Taxes

Transfer Payment Multiplier Compared to Spending Multiplier

• Transfer payments work the same way as the tax multiplier (the transfer payment multiplier is 1 less than the simple spending multiplier)

The Balanced Budget Multiplier

• Remember, that when government spending increases are matched with an equal size increase in taxes, that the change ends up being equal to the change in government spending

• The balanced budget multiplier is always 1, regardless of the MPC

Example: Balanced Budget and Tax Multiplier• Next, use the tax multiplier to identify the impact of increasing taxes

– Tax multiplier = MPC/MPS

– 0.9/.1= 9

• 9($100)= $900 [Tax multiplier x change in taxes]

• $100 increase in taxes decreases GDP by $900

– OR…MPC x spending multiplier (x change in taxes)

• 0.90 x 10= 9

• 9 ($100)= 900

• $100 increase in taxes decreases GDP by $900

Example: Balanced Budget Multiplier

• Balanced Budget Effect: change in real GDP

• +$1000-$900=+$100

• A $100 increase in spending, financed with $100 increase in taxes, created only $100 in new GDP

CH 28+29: The Financial Sector

Financial Assets

• The most liquid forms of money are cash and demand deposits (money deposited into a checking account)

– The opportunity cost of money is the interest that could have been earned from holding other assets such as bonds

• Other financial assets that people can hold in place of the most liquid forms of money include bonds (interest-bearing assets) and stocks (equity)

Stocks and Bonds

• Stock represents ownership of a corporation

– The stockholder is often entitled to a portion of the profit paid out as dividends

Stocks and Bonds

• Bonds (securities) are loans, or IOUs, that represent debt that the government, business, or individual must repay to the lender

– The bond holder has no ownership of the company and is paid interest

– The price of previously issued bonds and interest rates on bonds are inversely related

Reminder!!!

• Friendly reminder: although you can invest money into stocks and bonds, the word “investment” in economics ALWAYSrefers to business spending on tools and machinery

• DO NOT confuse the two

CH 28+29: Nominal versus Real Interest Rates

Real vs. Nominal Interest Rates

• A nominal interest rate is rate of interest paid for a loan, unadjusted for inflation

• The rate you “see” and pay for a loan

• Lenders and borrowers establish nominal interest rates as the sum of their expected real interest rate and expected inflation

• A real interest rate it is the nominal interest rate adjusted for inflation

• It can be calculated by subtracting the actual information rate from the nominal interest rate

• Real interest rate= Nominal interest rate – inflation

CH 28+29: Definition, Measurement, and Functions of Money

The Definition and Functions of Money

• Money is anything that is generally accepted as a means of payment for goods or services

• Money is a highly liquid financial asset —it is easily changeable into another asset or good

The Definition and Functions of Money

• Commodity money: something that performs the function of money and has alternative uses

• Examples: Gold, silver, cigarettes, etc.

• Fiat money: Something that serves as money but has no other important uses

• Examples: Paper money and coins

The Three Functions of Money

• Medium of exchange

– Money can easily be used to buy goods and services without bartering

• Unit of account (measure of value)

– Money measures the value of all goods and services

• Store of wealth

– Money allows you to store purchasing power for the future

Measures of Money• The money supply is measured using monetary aggregates

designated as M1 and M2

• M1 consists of coins and currency plus checking accounts (checkable deposits) and traveler’s checks

–It is highly liquid

• M2 consists of M1 plus savings deposits (money market accounts), time deposits (CDs = certificates of deposit), and mutual funds

–Considered near money; less liquid than M1 (have to covenrt to cash to use it)

Measures of Money

• The monetary base (MO or MB) includes currency in circulation and bank reserves

Why People Hold Money

• The transactions motive is the need to hold money for spending

• The precautionary motive is holding money for unexpected expenses and impulse buying

• The speculative motive is holding cash to avoid holding financial assets whose prices are falling

CH 28+29: The Fed and Monetary Policy

Monetary Policy

• Monetary policy: influencing the economy through changes in the banking system’s reserves, which in turn, influences the money supply and credit availability in the economy

Expansionary Monetary Policy

– Expansionary monetary policy is designed to counteract the effects of recession and return the economy to full employment

• It increases the money supply

• It decreases interest rates and it tends to increase both investment and output

• Also called the easy money policy

M i I Y

M=money supply i=interest rate I=investment Y=output

Impact of Expansionary Monetary Policy on AS/AD

Price level

Real GDP

AD1

P1 AD2

P2

Y1 Y2

SRAS

LRAS

Contractionary Monetary Policy

• Contractionary monetary policy is designed to counteract the effects of inflation and return the economy to full employment

– It decreases the money supply

– It increases the interest rate, and it tends to decrease both investment and output

–Also called the tight money policy

M i I Y

M=money supply i=interest rate I=investment Y=output

Impact of Contractionary Monetary Policy on AS/AD

Price level

Real GDP

AD1

P1

Y1

SRAS

AD2

Y2

P2

LRAS

Tools of Monetary Policy

1. Reserve requirement

2. Discount rate

3. Open market operations

– These are the 3 shifters of the money supply

– These tools are used by the Fed to regulate the amount of money in circulation

The Reserve Requirement

• The reserve requirement is the percent of deposits that banks must hold in reserve (the percent they can NOT loan out)

• Banks keep some of the money in reserve and loan out their excess reserves

• Reserves and interest rates are inversely related

Reserve Requirement

• By changing the reserve requirement the Fed can increase or decrease the money supply

–If the Fed increases the reserve requirement it contracts the money supply—banks have to keep more reserves and lend out less money (decreases the money multiplier)

–If the Fed decreases the reserve requirement it expands the money supply—banks have more money to lend out (increases the money multiplier)

Reserve Requirement

• If there is a recession, what should the Fed do to the reserve requirement?

– It should decrease the reserve ratio

• This means banks hold less money and have more excess reserves

• Banks create more money by loaning out excess reserves

• The money supply increases, interest rates fall, and AD increases

Reserve Requirement

• If there is inflation, what should the Fed do to the reserve requirement?

• Increase the reserve ratio

• This means banks hold more money and have less excess reserves

• Banks create less money

• The money supply decreases, interest rates increase, and AD decreases

The Discount Rate

• Discount rate: the interest rate the Fed charges for the loans it makes to commercial banks

• To increase the money supply, the Fed should decrease the discount rate

• To decrease the money supply, the Fed should increase the discount rate

Open Market Operations

• The primary way in which the Fed changes the amount of reserves in the system

• Open market operations occur when the Fed buys or sells government securities (bonds)

• To expand the money supply, the Fed buys bonds

• To decrease the money supply, the Fed sells bonds


• How are you going to remember this?

–Buy-BIG: Buying bonds increases the money supply

– Sell-SMALL: Selling bonds decreases the money supply


• There is an inverse relationship between bond prices and interest rates

–When the Fed buys bonds, the price of bonds rises and interest rates fall

–When the Fed sells bonds, the price of bonds falls and interest rates rise

Open Market Purchases

• An open market purchase is an expansionary monetary policythat tends to reduce interest rates and increase income

• When the Fed buys bonds, it deposits money in banks’ account with the Fed

• Bank reserves are then increased

• When banks loan out the excess reserves, the money supply increases (it also increases the monetary base)

Open Market Sales

• An open market sale is a contractionary monetary policy that tends to raise interest rates and lower income

• When the Fed sells bonds, it receives checks drawn against banks

• The bank’s reserves are reduced and the money supply decreases (it also decreases the monetary base)

The Federal Funds Market

• The federal funds rate is the interest rate that banks charge one another for one-day loans of reserves

• Federal funds are loans of excess reserves that banks make to one another

• (Often asked about on the AP exam)

The Federal Funds Market

• The Fed can increase or reduce reserves by buying or selling bonds

–By selling bonds, the Fed decreases reserves

• This causes the fed funds rate to increase (banks have lessreserves to loan out)

–By buying bonds, the Fed increases reserves

• This causes the fed funds rate to decrease (banks have more reserves to loan out)

The Fed Funds Rate as an Operating Target

• If the federal funds rate is above the Fed’s target range, it buys bonds to increase reserves and lower the Fed funds rate

• If the federal funds rate is below the Fed’s target range, it sells bonds to decrease reserves and raise the Fed funds rate

CH 28+29: Banking and the Creation of Money

Key Terms• Demand deposits: Money deposited in a commercial bank in a checking

account

• Required reserves (or reserve ratio): The percent of a deposit that banks must hold

• Excess reserves: Reserves that a bank can loan out beyond required reserves

• Bank balance sheet: A record of a bank’s assets, liabilities, and net worth

• Owner’s equity: Money put into a business or bank; not held in reserves

Banks and the Creation of Money

• Our banking system is a fractional reserve system

• Banks must hold a portion of deposits (known as the reserve requirement, which is set by the Fed) and can loan out the rest of the money

The Money Multiplier

• 1/r is the simple money multiplier

• The simple money multiplier is the measure of the amount of money ultimately created per dollar deposited in the banking system, when people hold no currency

• It tells us how much money will ultimately be created by the banking system from an initial inflow of money

• The higher the reserve ratio, the smaller the money multiplier, and the less money that will be created

Determining How the Money Supply is Impacted

• A customer deposits $100 into a bank. What is the immediate impact on the money supply?

–No impact—the money was already in the money supply (M1) so there is no change

Determining How Many Demand Deposits Will Be Created

• Remember, customer demand deposits can be withdrawn at any time

• To find the total amount of deposits that will be created, multiply the original deposit by 1/r, where r is the reserve ratio

Determining How Many Demand DepositsWill Be Created

• A customer deposits $100 into the bank. The reserve ratio is 10 percent (0.1). The amount of money ultimately createdfrom this deposit is:

–$100 x 1/0.1 = $1,000

–New money created = $1,000 – $100 = $900

Determining How Many Demand DepositsWill Be Created

• Why is the amount of new money created only $900 and not $1,000?

–Because the $100 deposit was already in the money supply (part of M1)

123

Change in Money Supply vs. Change in Loans

• The Fed buys bonds equal to $10 million and the required reserve ratio is 0.2. What is the maximum change in the money supply throughout the banking system?

–1/r =1/0.2=5

–5 *(10 million)=50 million

• Buying bonds creates money so the money supply increases by $50 million

124

Change in Money Supply vs. Change in Loans

• The Fed buys bonds equal to $10 million and the required reserve ratio is 0.2. What is the maximum change in loans throughout the banking system?

• 1/r =1/0.2=5

• 5 *(10 million)=50 million

• To loan this money out, a bank has to hold 20%

–50 million*(0.2)=10 million

– Total available for loans: 50 million -10 million= 40 million

Understanding a Bank Balance Sheet

Assets Liabilities

Loans $8,000Reserves $500Treasury bonds $1,500

Demand deposits $5,000Owner’s equity $5,000

Total: $10,000 Total: $10,000

• First, both sides of the balance sheet must equal one another• Demand deposits are always on the liability side (the bank “owes” this money to its

customers) • Loans are always on the asset side (money owed to the bank)• If the reserve requirement is not listed, you can figure it out by dividing reserves by demand

deposits (500/5,000=0.1 or 10%); **Be careful as the balance sheet can include terms such as total reserves as well as excess reserves; be sure to use the right numbers**

Bank Balance Sheet

Assets Liabilities

Loans $15,000Total reserves $ 5,000Treasury bonds $10,000


Total: $30,000 Total: $30,000

The reserve requirement is 10%. How much is the bank’s required reserves?To answer, we will look at the demand deposits.$20,000 x .1 = $2,000

Is the bank holding excess reserves? If so, how much?Yes: $3,000 (Total reserves – required reserves)

Sample Question: Bank Balance Sheet

Assets Liabilities

Loans $15,000Total reserves $ 5,000Treasury bonds $10,000


Total: $30,000 Total: $30,000

How much could the bank increase the money supply if it loaned out its excess reserves?$3,000 x 1/.1 = $30,000

Assume John deposits $1,000 into the bank. What is the initial change in the money supply?None—the $1,000 was already in the money supply

Bank Balance Sheet Practice

Assets Liabilities

Loans $15,000Required reserves $2,100Excess reserves $3,900Treasury bonds $5,000


Total: $26,000 Total: $26,000

If a customer deposits $1,000 into this bank:1. What is the required reserve ratio (before the deposit is made)? 10% ($2,000/$20,000)2. Will the money supply (M1) initially increase, decrease, or stay same? Stay the same3. How much is the required reserves? $2,1004. How much is the excess reserves? $3,9005. What is the maximum change in money supply from the deposit? $9,000 ($1,000 x 1/0.1= $10,000 - $1,000 (amount of initial deposit); OR $900 x 1/0.1)

CH 28+29: The Money Market

Draw the Graph: The Money Market

NOTE:•i=nominal interest rate

•I= Investment

Be careful!

QM1

MD or DM

MS

i1

Quantity of Money or QM

Nominal Interest Rate

(ir)

The Demand for Money

• What happens to the quantity demanded of money when interest rates increase?

–Quantity demanded falls because individuals would prefer to have interest-earning assets instead

• What happens to the quantity demanded when interest rates decrease?

–Quantity demanded increases

–There is no incentive to convert cash into interest-earning assets

132

Shifters of Money Demand1. Changes in price level

– An increase in the price level leads to an increase in the demand for money

– A decrease in the price level leads to an decrease in the demand for money

2. Changes in national income (GDP)

– When real GDP increases there will be an increase in the demand for money (when real GDP decreases there will be a decrease in the demand for money)

3. Changes in money technology

– We may decide to hold less cash as we use debit cards and credit cards more often (decreasing the demand for money)

Increase in Money Demand

QM1

MD1

MS

i1

QM

(billions of dollars)

Nominal Interest Rate (ir)

MD2

i2

Scenario: The price level increases.

Decrease in Money Demand

QM1

MD2

MS

i2

QM



(ir)

MD1

i1

Scenario: The price level decreases

Shifters of the Money Supply

• 1. Reserve requirement

• 2. Discount rate

• 3. Open market operations

Increase in Money Supply

QM1

MD1

MS1

i1

QM



(ir)

i2

MS2

QM2

Scenario: The Fed buys bonds on the open market

Decrease in Money Supply

QM2

MD1

MS2

i2

QM



(ir)

i1

MS1

QM1

Scenario: The Fed sells bonds on the open market

The Money Supply and AD

• How does this affect AD?

–An increase in the money supply leads to a decrease in interest rates, an increase in investment and therefore an increase in AD

IM I ADi

The Money Supply and AD

• How does this affect AD?

–Decreasing the money supply leads to an increase in interest rates, which decreases investment and AD

M i I AD

The Money Supply and AD• The economy is in a recession. Using the AS/AD model and

the money market, demonstrate an expansionary monetary policy to move the economy out of a recession.

QM1

MD1

MS1

5%

QM(billions of dollars)


2%

MS2

QM2

The Money Supply and AD• The economy has rising inflation. Using the AS/AD model and

the money market, demonstrate a contractionary monetary policy to move the economy out of an inflationary gap.

QM2

MD1

MS2

7%

QM



5%

MS1

QM1

CH 28+29: Loanable Funds

Loanable Funds Market

• The loanable funds describes the behavior of savers and borrowers

– This market shows the effect on the real interest rate (r)


• Demand for loanable funds: there is an inverse relationship between the real interest rate and the quantity of loans demanded

– At higher interest rates, households prefer to delay their spending and put their money in savings

– Simply put, the demand for loanable funds represents borrowers and investors

145


• Supply of loanable funds: there is a direct relationship between the real interest rate and the quantity of loans supplied

– An increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out)

– Simply put, the supply of loanable funds represents saversand lenders


• Borrowing is the demand for loanable funds

• Private investment is borrowing by businesses and consumers

• Government borrowing is deficit spending when government spending is greater than tax revenue


• Supply of loanable funds: there is a direct relationship between the real interest rate and the quantity of loans supplied

– An increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out)

– Simply put, the supply of loanable funds represents saversand lenders


• Saving is what makes lending possible so, the supply of loanable funds is the amount of money that is saved

• Private saving is the amount that households save instead of consume

• Public saving is the amount that the government saves instead of spends

• National savings = Public saving+ private saving

• A change in public or private saving will shift the supply of loanable funds


• Foreigners also lend money so the supply of loanable funds also depends the amount of money that enters or leaves the country

• Capital inflow: the amount of money entering the country

• Capital outflow: the amount of money leaving the country

• Net capital inflow = Inflow - outflow–A change in net capital inflow will shift the supply of loanable

funds


Demand Shifters

• Changes in borrowing by consumers

• Changes in borrowing by businesses

• Changes in borrowing by the government (such as deficit spending)

Supply Shifters

• Changes in private savings behavior

• Changes in public savings

• Changes in foreign investment (such as inflow of foreign financial capital)

Increase in the Supply of Loanable Funds

Real Interest Rate

Q of Loanable FundsQ1

S1 or SLF1

r1

D1 or DLF1

S2 or SLF2

r2

Q2

Decrease in the Supply of Loanable Funds

Real Interest Rate


S1 or SLF1

r2

D1 or DLF1

S2 or SLF2

r1

Q1

Increase in the Demand for Loanable Funds

Real Interest Rate


S1 or SLF1

r2

D1 or DLF1

r1

Q2

D2 or DLF2

Decrease in the Demand for Loanable Funds

Real Interest Rate


S1 or SLF1

r1

D1 or DLF1

r2

Q1

D2 or DLF2

Loanable Funds Example

Real Interest Rate


S1 or SLF1

r2

D1 or DLF1

r1

Q2

D2 or DLF2

Real interest rates increase

causingcrowding out

(of investment)

Government borrows from the private sector, increasing the demand for loans

Loanable Funds Example

Real interest rates increase

causingcrowding out

(of investment)

Government borrows from the private sector, increasing the demand for loans

Real Interest Rate


S1 or SLF1

r2

D1 or DLF1

S2 or SLF2

r1

Q1

**A correct answer for this could also be a decrease in the supply of loanable funds**

How are AS/AD, Loanable Funds, and the Money Market Connected?

• If there is an expansionary monetary policy, what are the results?

–AD increases

–MS increases

– The supply of loanable funds increases

How are AS/AD, Loanable Funds, and the Money Market Connected?

• If there is a contractionary monetary policy, what are the results?

–AD decreases

–MS decreases

– The supply of loanable funds decreases

CH 34: The Phillips Curve

Productivity, Inflation, and Wages

• Changes in productivity and changes in wages determine if inflation is coming

• There will be no inflationary pressures if wages and productivity increase at the same rate

• Inflation = Nominal wage increases - Productivity growth

Expectations of Inflation

• Rational expectations are based on economic models

– This looks at past trends but also the best information available to make a best guess of what inflation might be

• Adaptive expectations are based on past expectations

– If inflation increased in the past year, people will expect inflation to increase the following year

The Quantity Theory of Money

• The equation of exchange is: MV = PY

– M = Money supply

– V = Velocity

– P = Price level

– Y = Quantity of output

• Note: P * Y= GDP

The Quantity Theory of Money and Inflation

• Velocity of money is the number of times per year a dollar is spent and respent in a year

•Velocity = Nominal GDPMoney Supply

The Short-run Phillips Curve

• The short-run Phillips curve is a downward-sloping curve showing the relationship between inflation and unemployment when expectations of inflation are constant

The Short-Run Phillips Curve

• Actual inflation depends on both supply and demand forces and on how much inflation people expect

• At all points on the short-run Phillips curve (SRPC), expectations of inflation (the rise in the price level that the average person expects) are fixed

Short-run Phillips Curve

Inflation

Unemployment rate

Short-run Phillips Curve (SRPC)

The Long-Run Phillips Curve

• At all points on the long-run Phillips curve, expectations of inflation are equal to actual inflation

– The long-run Phillips curve (LRPC) is vertical at the natural rate of unemployment

– Factors that cause the NRU to change will cause the LRPC to shift

The Long-run Phillips Curve

Inflation

Unemployment rate

LRPC

5%

SRPC and LRPC in Long-Run Equilibrium

Inflation

Unemployment rate

LRPC

5%

SRPC

5%A

Point A represents the (long-run equilibrium)

What happens to SRPC based on shifts in the AS/AD Model?

• If there is an increase or decrease in SRAS, there is a shift in SRPC

• Positive supply shocks cause SRPC to increase while negativesupply shocks cause SRPC to decrease

SRPC Shift Factors

• Changes in productivity

• Changes in input prices

• Changes in inflationary expectations

• (These shift factors correspond to shifts in SRAS)

SRPC Shift Factors: Productivity

• If productivity increases, SRPC decreases (shifts to the left)

• SRAS increases (shifts to the right)

• If productivity decreases, SRPC increases (shifts to the right)

• SRAS decreases (shifts to the left)

SRPC Shift Factors: Input Prices

• If input prices increase, SRPC increases (shifts to the right)


• If input prices decrease SRPC decreases (shifts to the left)


SRPC Shift Factors: Inflationary Expectations

• If inflationary expectations increase SRPC increases (shifts to the right)


• If inflationary expectations decrease, SRPC decreases (shifts to the left)


AS/AD and the Phillips Curve

Correctly draw the LRPC and SRPC with a recessionary gap. What happens when SRAS increases?

Price Level

AD

SRAS1

Real GDPY2

P1

LRAS

SRAS2

P2

Y1

LRPC

SRPC1

UnemploymentUY

SRPC2

5%

U1

7%

Inflation


Correctly draw the LRPC and SRPC at full employment. What happens when SRAS falls?

Price Level

AD

SRAS1

Real GDPY1

P1

LRASInflation

SRPC1

UnemploymentUY

LRPC

SRAS2

SRPC2

P2

Y2 U1

Inflation and unemployment increase

6%

5%

What happens to SRPC based on shifts in the AS/AD Model?

• If there is an increase or decrease in AD, there is a movementalong the SRPC

• Demand shocks also cause a movement along the SRPC

AS/AD and the Phillips Curve Show what happens on both graphs if AD increases

Price Level

AD1

SRAS

Real GDPY1

P1

LRASInflation

SRPC

UnemploymentUY

LRPC

AD2

P2

Y2

Result: Higher inflation and lower unemployment

6%

5%

U1

Price Level

AD1

SRAS


Real GDPY1

P1

LRASInflation

SRPC

UnemploymentUY

LRPC

Correctly draw the LRPC and SRPC with a recessionary gap. What happens when AD falls?

AD2

P2

Y2

Result: Lower inflation and higher unemployment

U1 U2

6%

5%

YF

CH 31+32: Deficit and Debt

Fiscal Policy

• Fiscal policy refers to the government's policy on taxes and government spending and how they affect the flow of income in the economy

Expansionary Fiscal Policy

• Expansionary fiscal policy: a fiscal policy that increases aggregate demand (AD)

–Can be in the form of: an increase in government spending or a decrease in taxes (or an increase in transfer payments)

Contractionary Fiscal Policy

• Contractionary fiscal policy: a fiscal policy that decreases aggregate demand (AD)

–Can be in the form of: a decrease in government spendingor an increase in taxes (or a decrease in transfer payments)

What about Transfer Payments?

• A transfer payment is a payment that is given (or “transferred”) from the government to individuals who provide nothing in return (such as Social Security)

• What if the government decides to increase transfer payments?

– The change in real GDP is not as great because consumers will save some of the transfer payment

What about Taxes?

• What if the government decides to decrease taxes?

– Some of the tax cut will be saved and it will have less of an impact on AD/real GDP

Discretionary Fiscal Policy

• Discretionary fiscal policy involves actions taken by the government to correct economic instability/problems

– This is spending that has to be authorized by Congress each year

Nondiscretionary Spending

• Nondiscretionary spending is money the government is required to spend (also known as mandatory spending) and is often fixed by law

– It can include interest on the national debt as well as entitlement programs, such as Social Security and Medicare

CH 31+32: Deficit and Debt

The Federal Deficit and Debt

• Budget surplus: when annual government spending and transfer payments are less than tax revenue

• Budget deficit: when annual government spending and transfer payments are greater than tax revenue

• If the government increases spending without increasing taxes they will increases the annual deficit and the national debt

The Federal Deficit and Debt

• Deficit spending: when a government spends more than it collects in revenue for a given year

–Annual deficits contribute to the national debt, the total amount of money that our nation owes

• A government must pay interest on its accumulated debt, thus increasing the national debt

–As a result, they forgo using these funds for other uses

Financing the Deficit

• When the government borrows money to fund the deficit it is affecting private investment

– As the government borrows large amounts of money, its can increase interest rates, resulting in crowding out

– Higher interest rates discourage individuals and businesses from borrowing money, which reduces their spending and investmentactivities

• Private investment is crowded out by expansionary fiscal policy

–Leads to a decrease in interest-sensitive private sector spending

– In the long run this can lead to a decrease in economic growth

Financing the Deficit• Think back to the loanable funds market: If the government borrows

money to cover its deficit, it increases demand for loanable funds and crowds out private investment as the real interest rate increases

Real Interest Rate


S1 or SLF1

r2

D1 or DLF1

r1

Q2

D2 or DLF2

Automatic Stabilizers

• An automatic stabilizer is a built-in fiscal policy that works counter cyclically to stabilize the economy

– It supports the economy during recessions and help prevent the economy from becoming overheated during expansionary periods

– For example, tax revenues increase as GDP rises, which slows consumption and prevents the economy from overheating

• When GDP decreases, government spending increases and taxes fall

– Examples: welfare, unemployment insurance, and income taxes

CH 35: International Financial Policy and the FOREX

Balance of Trade (BOT)

• Balance of trade: the difference between exports and imports (Xn)

– Includes goods and services

Balance of Payments (BOP)

• Balance of payments: is a country’s record of all internationaltransactions

– It consists of the current account (CA) and the capital and financial account (CFA)

– Any transaction that causes money to flow into a country is a credit

– Any transaction that causes money to flow out of a country is a debit

– The sum of all credit entries should match the sum of all debit entries (CA+CFA=0)

Balance of Payments (BOP)

• Goods exported by the U.S. must be paid for in U.S. dollars

– Exports cause a flow of payments into the U.S.

• Goods imported by the U.S. must be paid for in foreign currency

– Imports cause a flow of dollars outside the U.S.

The Current Account

• The current account is made up of three parts:

–1. Net Exports: Difference between a nation’s exports of goods and services and its imports of goods and services

• Examples: Toys imported from China; U.S. cars exported to Mexico

• (We will use this one the most, especially in FRQs)

The Current Account

• 2. Investment Income: Income from the factors of production including payments made to foreign investors

• Example: Money earned by Japanese car producers in the U.S.

• 3. Net Transfers: Money flows from the private or public sectors

• Examples: Donations, aids and grants, official assistance

The Capital and Financial Account

• The capital and financial (CFA) account measures the purchase and sale of financial assets abroad

– Includes purchases of things that stay in the foreign country such as financial assets (stocks and bonds) and real estate

– Examples: A U.S. citizen buys German stock; a U.S. company buys a hotel in Russia

The Current Account and the Financial Account

• The current account balance and the financial account balance must equal zero

–When they do not, the central bank must buy or sell currency (known as official reserves—government holdings of foreign currencies) to resolve this imbalance

The Capital and Financial Account

• Net capital outflow: The difference between the purchase of foreign assets and domestic assets purchased by foreigners

– Financial account surplus = Inflow > Outflow

– Financial account deficit = Inflow < Outflow

The Current Account and the Capital and Financial Account

• The current account and the capital and financial account balance must equal zero–Why do the CA and CFA balance?

• Money that leaves a country must come back as either foreign purchases of goods/services (exports) or foreign purchases of financial assets

Current Account and the Financial and Capital Account

• When the current account is in a deficit it is due to importingmore goods and services than it is exporting

• Current account deficits must be offset by capital and financial account surpluses

– Increasing current account deficits means that capital inflows increase (this increases the supply of loanable funds

The Current Account and the Financial Account

• When the current account is in a surplus it is due to exportingmore goods and services than it is importing

• Current account surpluses will be offset by capital and financial account deficits

–Current account surpluses means that capital outflows increase (this decreases the supply of loanable funds)

Example: The Current Account and Capital and Financial Account

• Assume the U.S. and China have balanced trade. What happens if the U.S. imports more goods from China?

• The U.S. current account moves toward a deficit (AD decreases; value of U.S. dollar depreciates as U.S. supplies dollars to demand yuan)

– China’s current account moves toward a surplus as (AD increases; value of Chinese yuan appreciates as the U.S. demands it)

• The U.S. capital and financial account moves toward a surplus as capital flows in from China (increases U.S. supply of loanable funds)

– China’s capital and financial account moves toward a deficit as capital flows out to the U.S. (decreases China’s supply of loanable funds)

FOREX Shifters

• Changes in tastes and preferences (resulting in more imports)

– Example: U.S. buys more English tea

– The U.S. buys more imports

–U.S. demand for pounds increases

– Supply of U.S. dollars increases

–Pound: appreciates

–Dollar: depreciates

FOREX Shifters

• Changes in relative incomes (resulting in more imports)

– Example: U.S. disposable income increases

– The U.S. buys more imports





FOREX Shifters

• Changes in relative price level (resulting in more imports)

– Example: U.S. price level increases relative to Britain

–U.S. demand for cheaper imports increases





FOREX Shifters

• Changes in relative interest rates

– Example: U.S. has a higher real interest rate than Britain

–British people want to put money in U.S. banks

–Capital flow increases towards the U.S.

–British demand for U.S. dollars increases

–British supply more pounds

–Pound: depreciates

–Dollar: appreciates

FOREX Market Shifters

Changes in price level and changes in interest rates are double shifts

Exchange Rates• The demand for a currency in the FOREX arises from the

demand for the country’s goods, services, and financial assets

–There is an inverse relationship between the exchange rate and the quantity demanded of a currency

• The supply of a currency in the FOREX arises from making payments in other currencies

–There is a positive relationship between the exchange rate and the quantity supplied of a currency

Exchange Rates

• In the FOREX market, one currency is exchanged for another

– The price of one currency in terms of another is the exchange rate

• If one currency becomes more valuable in terms of the other, it appreciates

• If one currency becomes less valuable in terms of the other, it depreciates

Exchange Rates

• If a country’s currency appreciates that country’s exports will decrease and imports will increase

–Net exports will decrease

• If a country’s currency depreciates that country’s exports will increase and imports will decrease

–Net exports will increase

Exchange Rates

• The exchange rate of one currency is always the reciprocalof the exchange rate for the other currency

• Example: 1 USD = 100 Yen

–1 Yen = 1/100 USD

FOREX

– To demand one currency, you must supply your currency

– If Europeans want to buy U.S. goods they have to exchange euros for U.S. dollars

• This means supplying euros in order to demand U.S. dollars

The Supply and Demand for U.S. Dollars and Euros

U.S. Dollars/Euro

Quantity of Euros

S1

D

e1

Q1

S2

Q2

e2

If a European country wants to buy U.S. goods, what happens?

They will supply euros in order to demand U.S. dollars

The Supply and Demand for U.S. Dollars and Euros

This results in an increase in the demand for U.S. dollars.

They will supply euros in order to demand U.S. dollars

Euros/U.S. Dollars

Quantity of U.S. Dollars

S1

D1

e1

Q1 Q2

e2

D2

Explaining the Graph: The FOREX Market

• As Europeans supply more euros to purchase U.S. dollars, the euro depreciates

• As the demand for the U.S. dollar increases, the dollar appreciates

Explaining the Graph: The FOREX Market(Analyze both graphs together; graph whatever the FRQ asks)

U.S. Dollars/Euro

Quantity of Euros

S1

D

e1

Q1

S2

Q2

e2

Euros/ U.S. Dollars

Quantity of U.S. Dollars

S1

D1

e1

Q1 Q2

e2

D2

Explaining the Graph: The FOREX Market

• Which graph is correct?

–Depends on what the FRQ asked us to graph.

– In summary, if it helps you to graph both, do it (see next slide).

–Also note, that both supply and demand moved in the same direction—this is a sign you did it correctly.

Real Interest Rates and International Capital Flows

• In an open economy, differences in interest rates across countries change the relative values of domestic and foreign assets

– Financial capital will flow toward the country with the relatively higher interest rate

– The country with a higher real interest rate will have a greater supply of loanable funds as other countries increase their investment in their assets

ch 24: unemployment · 2020-03-19 · calculating the unemployment rate •start with the total...

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