CFA Book 2 Economics _ Allen Study 5 Flashcards
The estimation of GDP includes:
* goods an services purchased by final users for the current period.
Personal Consumption Expenditures
household spending on consumer durable and non-durable goods and servies during the period.
Gross Private Domestic Investment
* the flow of pricate sector expenditures on durable assets plus the addition to inventories during a period. * Net Investment reduces gross nivestmen for depreciation and obsolencence of machinery / physical goods during the year.
Net Private Domestic Investment
is the Gross Private Domestic Investment less an allowance for depreciation and obolescece of machinery and other physical assets during the year.
Private Domestic Inventory Investment
the change in the stock of goods and raw materials held during a period. Inventories need not be sold in order to contribute to GDP in teh current period.
Must inventories be sold in order to contribute to the GDP in the Current Period?
No, inventories need not be sold to contribute to GDP in the current period.
Government Consumption and investment
* includes government purchases * excludes transfer payments (i.e. Social Security) * e.g money spent on law enforcement, vertern’s hospitals, highways etc.
Government Expenditures
government expenditures include transfer payments (which are not considered for GDP)
Net Exports of Goods and Services
* exports minus imports * Exports are domestically produced goods sold to friegners. * Imports are foreign-made goods purhcased by domestic consumers, investors and governments.
Which of the following are included in the calculation of GDP? 1) HH consumption of durable goods, 2) HH consumption of non durable goods, 3) HH consumption of services, 4) fixed investment, 5) Inventory Additions, 6) Depreciation, 7) Gov consumption, 8) Gov Investment, 9) Gov Expenditures, 10) Imports, 11) Exports
= 1) HH consumption of durable goods + 2) HH consumption of non durable goods + 3) HH consumption of services + 4) fixed investment + 5) Inventory Additions + 7) Gov consumption + 8) Gov Investment + 11) Exports - 10) Imports ( #6 depreciation and #9 gov expend are not incl.)
Expenditure Approach
= Personal consumption expenditures + Gross Private Domestic Investment + Gov Consumption and Investment + Net Exports
GDP Income Approach
sum of the following: 1) wages (employee compensation) 2) self-employed labor earning 3) machines, buildings, land & physical assets 4) rents, corporate profits and interest payments 5) indirect business taxes (taxes on sale of goods) 6) depreciation 7) GNP - GDP adjustment (subtract net income earned abroad)
Sum of value Added vs. Value of Final Output
* two methods for calculating GDP based on expenditures * should be equal * final output relies on final sale price of a good * Sum of value Added adds up the values added at each state of production
Sum of Value Added
* a method for calculating GDP using based on expenditures * relies on adding up the values added at each stage of production * should equal the final sale price
Value of Final Output
* a method for calculating GDP using based on expenditures * relies on the observable final sale price of a good * should equal the Sum-of-value
Nominal GDP
* measures the value of goods and services at the current prevailing prices
Real GDP
measures the total expenditures on goods and services if prices were unchanged over the year
formula Nominal GDP vs. Real GDP
Nominal GDP t = P t x Q t Real GDP t = P b x Q t where: Q t = quantitiy produced in year t (current year) P t = price in current year (year t) P b = price in base year
GDP Deflator
* expenditure data is collected in current year prices * this is used to convert expenditure data into constant prices * price index
formula GDP Deflator
= \frac{\text{value of current output at P} _{t}}{\text{value of current output at P} _{b}} \times 100 = \frac{Nominal GDP}{Real GDP} \times 100
formula GDP Deflator
= \frac{\text{value of current output at P} _{t}}{\text{value of current output at P} _{b}} \times 100 = \frac{Nominal GDP}{Real GDP} \times 100
formula % of Nominal GDP
use when increases in inflation and GDP are stated in percentage terms: % of Nominal GDP = (1 + % Δ real GDP) (1 + % Δ inflation) - 1 % of Nominal GDP ≈ ( % Δ real GDP + % Δ inflation)
Statistical Discrepency
* The statistical discrepancy is the official “fudge factor” that ensures perfect equality between gross domestic product and gross domestic income in the National Income and Product Accounts . * “added” to gross domestic income when calculating GDP.
National Income
* income received by all factors of production used in generating all final output. * the sum of compenstation to employees, all profits (corporate and government) before taxes, interest income, rent, unincoroparted busienss net income and indirect busienss taxes less subsidies.
Capital Consumption Allowance
the depreciation measure for capital needed to produce output
Personal Income
* a measure of income and savings * all household income (earned or unearned) * an important measure of how much consumers can spend. = national income - indirect business tax - corporate income tax - undistributed business profits + transfer payments
Personal Disposable Income
* personal icome net of personal taxes * closely watched figure, shows how much households actually have available for spending.
Household Savings
= Personal Disposable Income - consumption expenditures - transfers to foreigners - interest paid by consumers
Aggregate Demand Curve
determined by aggregate income and current price levels where: 1) aggregate expenditures = aggregate income 2) the avaialable real money supply is willingly held by households and businesses
Fiscal Balance
= G - T where G = government spending T = taxes
formula Savings
S = I + (G - T) + (X - M) where: I = investment G = governement spending T = taxes X = exports M = Imports
three ways to consume private savings
1) investing 2) financing government deficits (where T >G) 3) running a trade deficit (M > X)
What is the implication of a fiscal deficit?
G - T < 0 must be sustained by having greater savings than investment rates and / or by running a trade deficit.
What is the impact of of an increase in real income on on aggregate consumption?
Aggregate consumption will increase.
What is the impact of a decrease in taxes on aggregate consumption?
Aggregate Consumption will increase.
Two factors that will increase aggregate consumption?
* an increase in real income * a decrease in taxes
Factors that determine investment decisions
* the level of real interest rates * aggregate output / income
Government spending is tends to be independent of:
economic factors such as interest rates and economic activity.
Taxes collected are dependent on:
* the level of economic activity * net taxes are positively related to aggregate income.
What is the relationship between aggregate income and net exports
higher income leads to a greater demand for imports.
what is the relationship between aggregate income and net taxes and imports?
Higher aggregate income increases net taxes and imports.
Fiscal Balance
= G - T where: G = gov spending T = Taxes
Trade Balance
= X - M where: X = exports M = imports
What is the relationship between income and the fiscal balance and the trade balance?
As income rises the fiscal balance and trade balance decrease.
The level at which savings exceeds investing is dependent on
* the real interest rate * higher rates will induce people to save more * lower interest rate will induce more investing as it is less beneficial to save in low-rate environments.
IS Curve
* the relationship that equates expenditures with interest rates. * Considers how interest rates impact saving and investment * does not consider the appropriate level of interest rates or the price levels in the market.
Assuming the real money supply is constant, an increase in real income must create an:
* increase real interest rates * so as to keep the demand fro money equal to the supply * known as the LM curve
The IS curve slopes:
* downward * there is an inverse relationship between savings and investment.
the LM curve slopes
* upward. positive slop * positive relationship between income and interest rates
Aggregate Demand Curve
the intersection of the LM and IS curves
what type of relationship exists between price level and real income
inverse relationship
Aggregate Supply Curve is the
* level of output that companies will produce at various prices. * supply curves can be viewed as short-term or long-term
what is the assumption regarding capital and technology in the short term?
capital and technology are fixed in the short term
The short term aggregate supply curve is affected by:
* resource prices and production costs * inflation * supply shocks
long-term aggregate supply is impacted by
* changes to the supply of resources (including labor) * improvements to productivity and technology * institutional changes that improve efficiency of resource use
What serves to ‘ration’ or allocate scarce goods and resources ?
Prices serve to ration or allocate scarce goods and resources to people who are willing to pay the highest price.
What does scarcity necessitate? What does scarcity result in?
* scarcity necessitates rationing * scarcity results in competition
Law of Demand
a rise in the price of a good will cause consumers to buy less of the good because they now have greater incentive to seek and use substitutes.
Derived Demand
* demand for factors or production * demand for factors of production is derived from the demand for goods and services.
formula Aggregate Production Function
Y (quantity of GDP supplied) = F ( L, K, T)
where: L = Labor Quantity K = Capital T = Technology
The Long Run Aggregate Supply shows
the relationship between the quantity of real GDP supplied and the price level over the long run, when real GDP = potential GDP
Increases in long-run aggregate supply (LAS) is caused by:
* an increase in the supply of resources * an improvement in technology or productivity * institutional changes that increase the efficiency of resource use.
Decreases in long-run aggregate supply (LAS) is caused by:
* a decline in resources (including labor) * a decline in the level of technology available * a shift in the institutional arrangements that reduce productivity and the efficiency of resource use
Productivity
* the average output produced per worker in a certain time frame * measured in terms of output per hour worked
How is productivity typically measured?
in terms of output per hour worked
The Short-Run Aggregate Supply shows:
the relationship between the quantity of real GDP supplied and the price level
Short Run Aggregate Supply Increases are due to:
* a decrease in resource prices/ production costs * a reduction in the expected rate of inflation * favorable supply shocks
What is the impact of economic growth on SAS and LAS
* both SAS and LAS shift outward, to the right * output expands and unemployment stays at its natural rate * if the money supply remains as is the price levels will fall
What is the impact of unanticipated increases in aggregate supply?
* lowers the price level and increases current GDP * in the long run aggregate supply does not increase because the unanticipated change is not expected to continue
What is the impact of unanticipated decline in aggregate supply?
* output declines (SAS shifts left and prices rise * if a decline in supply is permanent, LAS contracts with SAS, forcing the economy to stabilize at a new lower output equilibrium *assumes economy is at its long-run potential at the time of the decline.
What is the impact of persistent inflation in the short run.
it will be incorporated into long-term contracts which affect production costs in the short run.
Increases in Long Run Aggregate Supply (LAS) are caused by:
* increase in the supply of resources * improvement in technology and productivity * institutional changes that increase efficiency of resource use
Decreases in Long-run Aggregate Supply (LAS) are caused by:
* a decline in resources (including labor) * a decline in the available technology * a shift in institutional arrangements that reduce productivity and the efficiency of resource use.
Increases in short fun aggregate supply are caused by
* a decrease in resource prices / production costs * a reduction in the anticipated inflation rate * favorable supply shocks
What is the impact of economic growth on SAS and LAS
* shift outward (toward right) * output expands * unemployment stays at the natural rate * price levels fall (if the money supply does not change) *applies to anticipated changes in aggregate supply
What is the impact of an unanticipated increase in aggregate supply.
lowers the price level and increases current GDP.
What is the impact of a temporary decline in supply?
output declines (SAS shifts left) and prices rise.
What is the impact of a permanent decline in supply?
LAS contracts, along with SAS, forcing the economy to stabilize at a new, lower output equilibrium.
What is the long run impact of an unanticipated increase in supply -
In the long run aggregate supply… does not increase because the impetus to the supply rise is not expected to be repeated. large portions of the temporarily higher income is saved, money supply is expanded, loanable funds increase, interest rates fall, expenditures on interest sensitive capital goods and consumer durables rise
What is the impact of persistent inflation?
it will be incorporated into long-term contracts, which affect production costs in the short run.
What is the impact if actual and expected inflation rates are equal
there will be a persistent price increase for both goods and resources.
What is the impact if actual inflation is less than the anticipated inflation rate.
it is equivalent to a reduction in the price level when there is price stability or zero inflation.
What is the impact if the actual inflation rate is greater than the anticipated inflation rate?
* this will be equivalent of an increase in the price level. * goods and services prices will increase relative to resource prices, with firms expanding output and employment.
Aggregate Demand Curve
isolates the impact of price level on the quantity of goods and services through consumption, investment and net exports.
formula Aggregate Demand Y =
Y = C + I + G + X - M where: Y = quantity of real GDP demanded C = real consumption expenditure I = investment G = gov expenditures X = exports M = imports
Aggregate Demand is impacted by
* inflation (price levels) * expectations about the future * global economic conditions * fiscal and monetary policy
Aggregate Demand curve shifts tot he right due to:
* increase in real wealth * lower interest rates * increased optimism about the future * increase in expected future inflation * increase in income abroad * decrease in the exchange rate
What is the impact of an increase in real wealth on aggregate demand?
demand for all goods increase AD shifts right (Consumption Increases)
What is the impact of lower interest rates on aggregate demand?
* borrowing is less expensive therefore investment increases * increased investment causes AD to shift right
What is the impact of increased optimism about the future on aggregate demand?
* current investment increases * AD curve shifts right
What is the impact of an increase in the expected future inflation rate on aggregate demand?
* people are incented to increase spending today, consumption increases. * AD curve shifts right
What is the impact of increased income abroad on aggregate demand?
* exports demand increases * AD shifts right
What is the impact of a decrease in the exchange rate on aggregate demand?
* export demand increases. * AG shifts to the right.
What causes aggregate demand to decrease (AD curve shift to left)?
* real wealth declines * increase in real interest rate * pessimism about future demand * decline in expected future inflation * a decline in foreign income abroad * and increase in the exchange rate
What is the impact of an unanticipated increase in aggregate demand?
* causes output to increase, unemployment will fall (because of the time lag between the increased demand and an increase in resource prices.) * lag increases profits and output increases * resource prices catch up (increase), supply moved inward, new equilibrium is established at a higher price at the natural rate of unemployment at the economy’s long-run potential output
Impact of unanticipated decline in aggregate demand
* resource prices lag ahead of falling prices * output contracts below long-run potential * unemployment rises above the natural rate * lower prices and excess supply are considered: * resource prices fall * output increases to long-run potential * unemployment returns to normal rate
What will cause AD curve to shift?
* household wealth * consumer and business expectations * capacity utilization * fiscal policies * monetary policies * exchange rates * growth in global economy
What is the impact of changes in Household Wealth on the AD curve?
* increases in household wealth increase demand, shift AD curve to the right. * decreases in household wealth decreases demand, shift AD curve to left.
Wealth Effect
* Impact of Household Wealth on AD curve. * Increases in Household Wealth increase demand, shift AD curve right * Decreases in Household Wealth decreases demand, shift AD curve left.
What is the impact of consumer and business expectations on the AD curve?
consumers confident in job prospects/income will spend more, increasing demand and shifting the AD curve to the right.
What is the impact of changes in capacity utilization on the AD curve?
* high utilization means that companies seeking to increase productions are forced to invest in operations. * Higher investment shifts AD curve to the right
What is the impact of changes in fiscal policy on the AD curve?
* higher government spending shifts AD curve right * higher taxation rates will lower demand and shift the AD curve to the left.
What is the impact of changes in Monetary Policy on the AD curve?
* raising interest rates means draining bank reserves and reducing the money supply. * shifts AD curve to left.
What is the impact of changes in exchange rates on the AD curve?
* depreciating currency will make exports cheaper and imports more expensive. * increases net exports and shifts AD curve to the right
What is the impact of changes in growth in global economy on the AD curve?
* global growth will tend to boost demand for a country’s exports. * AD Curve willl shift to the right
What will cause shifts in short-run aggregate supply (SRAS) curve (but not LRAS)?
* nominal wages * change in input prices * future price expectations * changes in business tax and subsidies * changes in exchange rates
What is the impact of changes in nominal wages on the SRAS curve?
* increase to nominal wages result in an increase in production costs. * supply is reduced, SRAS shifts to the left
What is the impact of changes in change in input prices on the SRAS curve?
* higher raw material prices increase the cost of production * reduce supply and shift SRAS curve tot he left
What is the impact of changes in future price expectations on the SRAS curve?
* own output price increases will increase supply and shift SRAS to the right. * this tends to be modest and temporary
What is the impact of changes in changes to business tax and subsidies on the SRAS curve?
* higher taxes increase cost of production, reduce supply and shift SRAS left. * higher subsidies reduce production costs, increase supply and shift SRAS to the right.
What factors impact both LRAS and SRAS?
* supply of labor * natural resources * physical capital * human capital * technology
LRAS is not impacted by
price level.
LRAS is determined by
the level of potential GDP
what is the impact of the supply of labor on LRAS?
larger sources of labor will improve production and shift LRAS to the right.
what is the impact of natural resources on LRAS?
* access to new source or improved access to existing sources results in higher production and shifts LRAS to the right.
what is the impact of physical capital on LRAS?
* growth in business investment improves the supply of capital which boosts production and shifts LRAS to the right
what is the impact of human capital on LRAS?
improving the quality of the workforce will increase production and shift LRAS to the right.
what is the impact of technology on LRAS?
technological improvements will boost productivity of the workforce, shifting LRAS to the right
Long-run GDP equilibrium occurs where
aggregate demand and supply curves meet
long run GDP equilibrium assumes
both labor and capital are fully utilized at equilibrium, so that in the long run equilibrium GDP equals potential GDP
A shift in the AD curve to the left will impact real GDP in what way
real GDP will contract and price levels will decline. lower demand, leads to lower company stock valuations and higher unemployment
what is the short term impact on GDP of an economic downturn?
equilibrium GDP declines below potential GDP.
Consumption demand stabilizes the economy and aggregate demand by
* decreasing less than income during an economic recession and increasing less than income during and economic boom * generally stable throughout a business cycle
How do changes in real interest rates help to stabilize aggregate demand and correct economic fluctuations?
consumer optimism causes greater current spending and decreases the supply of loanable funds – causes increases in interest rates, and investments diminish, and aggregate demand shrinks. under business pessimism, demand for investment funds decrease, interest rates fall, current consumption rises and the opp cost of investment falls
How do changes in real resource prices help correct economic fluctuations?
* if output is temporarily greater then FE capacity, prices rise and supply falls * if output is temporarily less than capacity, excess supply and high unemployment reduce resource prices so supply rises, and output rises to FA with lower prices.
When is short-run equilibrium achieved?
when the quantity of real GDP demanded is equal to real GDP supplied.
When is long-run equilibrium achieved?
when real GDP is equal to potential GDP
If AS and AD increase at the same rate then:
GDP growth is achieved without inflation.
An equilibrium below full employment is one where:
potential GDP is greater than real GDP
How do changes in real interest rates impact aggregate demand under consumer optimism?
- help to stabilize aggregate demand and correct economic fluctuations. - consumer optimism provokes greater current spending and a decrease in the supply of loanable funds. - this causes interest rates to rise, investments to diminish and aggregate demand to shrink.
How do changes in real interest rates impact aggregate demand under business pessimism?
- help to stabilize aggregate demand and correct economic fluctuations. - the demand for investment funds decrease, depressing the real interest rate. Current consumption rises, and the opportunity cost of investment falls. Aggregate demand then increases.
How can real resource price changes help to correct economic fluctuations when out put is temporarily greater then the economy’s full employment?
- if output is temporarily greater than the economy’s full employment, then prices rise, supply falls and the economy is restored to FE at higher prices.
How can real resource price changes help to correct economic fluctuations when out put is temporarily lower then the economy’s full employment?
- excess supply and high unemployment reduce resource prices so that supply rises, and output rises to FE at lower prices.
When is short term equilibrium achieved?
when the quantity of real GDP demanded is equal to the real GDP supplied.
When is long run equilibrium achieved?
when real GDP is equal to potential GDP.
What is the impact of aggregate supply and aggregate demand increasing at the same rate?
real GDP growth without inflation.
Long run aggregate demand is primarily affected by:
* the growth rate in the quantity of money. * if the quantity of money experiences a fast increase aggregate demand also increases - and there is high inflation
An equilibrium below full employment is one in which:
potential GDP is greater than real GDP.
A business cycle is caused by:
wage rates being slow to adapt and keep real GDP at potential GDP as aggregate demand and short-run supply vary
GDP is impacted by:
* Economic Growth - growth in quantity of labor, human and physical capital and technical advances. * Inflation - tendency for aggregate demand to rise more quickly than the increases in long-run supply. * the Business Cycle - occurs because aggregate demand don’t move at the same page
What is the primary reason for a persistent increase in aggregate demand and inflation?
the growth in the quantity of money
Recessionary Gap
the condition where equilibrium GDP drops below potential GDP.
What are the impacts to the economy of a recessionary gap?
* reduced corporate profits * lower commodity prices * lower interest rates * demand for borrowing
What is the best investment strategy during a recessionary gap?
* favor defensive companies * reduce exposure to cyclical and commodities * seek low-credit-risk investments * reduce riskier/more speculative investments * favor longer maturity investments over shorter maturities
Inflationary Gap
* When equilibrium GDP is greater than potential GDP * increase in AD (when supply does not increase) * temporary situation
How would a government intervene during an inflationary gap?
* higher taxes * lower spending * higher interest rates / reduction of money supply growth
What are the economic impacts during an inflationary gap period?
* higher profits * higher commodity prices * higher rates * inflation
What is the best investment strategy during an inflationary gap period?
* favor cyclicals and commodities * reduce fixed-income investments (especially longer maturity) * increase exposure to riskier investments overall * reduce defensive strategy
what is the impact of an increase in aggregate supply?
- high economic growth and very low inflation.
what is the impact of a decrease in aggregate supply?
* stagflation * both high unemployment and high inflation
Self correction is slower when dealing with?
changes in aggregate supply.
What is the best investment strategy when there is a decline in aggregate supply?
* favor equities * reduce fixed-income exposure (higher prices tent to raise interest rates) * raise exposure to commodities.
What is the best investment strategy when there is a increase in aggregate supply?
reduce exposure to commodities.
What is the impact of an increase in aggregate demand and aggregate supply?
* real GDP and employment will rise * if AD increases more than AS prices will rise * if AS increases more than AD prices will fall.
What is the impact if both AD and AS curves decrease?
* real GDP and employment will decline * If AD decreases more than AS prices will fall * If AS decreases more than AS prices will rise
What is the impact if AD increase and AS decreases?
* Prices will rise * If AD increase more than AS decreases GDP will rise * if AS decreases more than AD GDP will fall
What is the impact if AD decreases and AS increase ?
* Prices will decline * If AD decreases more than AS increases GDP will decline * If AS increases more than AD decreases GDP will increase.
Economic Growth
* the annual percentage change in real GDP
Five main drivers of economic growth:
- Labor supply 2. Human capital 3. Physical Capital 4. Technology 5. Natural Resources
The input of labor to growth is measured by:
* total hours worked. total hours worked = labor force x avg. hours worked per worker
Human Capital measures:
* the knowledge base of workers. * derived from education and experience. * countries invest in human capital education and health infrastructure
Physical Capital
* refers to property and equipment used to produce goods/services * used to drive GDP. higher investment in capital leads to higher GDP.
How does technology impact economic growth?
* makes it possible to produce new types of goods, produce more goods or produce higher-quality goods. * crucial to overcoming existing GDP limits.
Total Factor Productivity
the component that measures the impact of technology when attempting to assess the growth in GDP.
Natural resources impact to economic growth.
* raw materials needed for growth * renewable and non-renewable * provide certain countries with distinct advantages for boosting GDP. * not a prerequisite for high growth and income
formula Production Function
Y = A x F (L,X) where: Y = overall economic output A = total factory productivity (TFP), serves as a proxy measure for technological progress L = the quantity of labor K = the amount of capital
The production function specifies two main sources of economic growth:
- the accumulation of necessary input such as capital, labor, and natural resources 2. new technology that improves efficiency of use of inputs
Two main assumptions of the production function?
- constant returns to scale (i.e. if all inputs increase by the same percentage, the final output will increase by that percentage) 2. each input has diminishing marginal productivity (as any one input increase the impact to the final output will be incrementally smaller over time.)
What is the main implication resulting from diminishing marginal productivity assumption?
sustainable growth cannot rely solely on increasing capital investments, and that the incomes of developed and developing countries will eventually converge. *the only way to sustain long-term GDP growth will be through TFP or technological progress.
Growth Accounting Equation
used to estimate growth potential GDP
formula Growth Accounting Equation
potential GDP growth = TFP growth + W L (labor growth) + W C (capital growth) where: W L and W C are relative shares of labor and capital in national income Generally W L + W C = 1
any countries, including the US, which is greater: share of labor or share of capital? what is the implication?
- share of labor is larger than share of capital - increasing the growth rate of labor will have a larger impact of GDP growth than an equivalent increase to the growth of capital.
Per Capita GDP growth is used to measure
the estimated purchasing power of the average person
formula Per capita potential GDP growth
Per capita potential GDP growth = TFP growth + W C (growth in capital to labor ratio) capital to labor ratio measures capital available per worker, weighted by their share of capital in national income
Capital-to-Labor ratio
measures capital available per worker, weighted by their share of capital in national income
Labor Productivity
the quantity of goods and services that a worker produces in one hour
formula Labor Productivity
Labor Productivity = real GDP / aggregate hours
formula Potential GDP
Potential GDP = aggregate hours worked x Labor Productivity
formula Potential Growth Rate
P otential Growth Rate = growth rate of labor force + growth rate of labor productivity
Drivers of productivity of Labor
* skill and education of workers * physical capital available * technology
Business Cyle
the term used to describe fluctuations in the overall level of economic activity, as measured by changes to real GDP or the unemployment rate.
Four phases of the business cycle:
- trough 2. expansion 3. peak 4. contraction
Trough
* starting point of business cycle * lowest point * end of an economic slowdown
Expansion
* second period in business cycle * economy grows from trough to peak during the expansion period
Contraction
* period after expansion * can become a recession or depression * economic activity declines * unemployment rate increases and consumer spending declines * banks will tend to intervene with stimulatory measures (i.e. lowering interest rates)
Early Expansion
* economic activity begins to improve * unemployment tends to lag (companies slow to hire) * consumer and business spending begins to improve * inflation lags, stays low * central bank stimulatory measures are still in plce
Late Expansion
* economic improvement and growth well underway * unemployment begins to decline * consumer and business spending increases * central banks may begin raising interest rates, * inflation begins to increase
Peak
* growth in the economy is at its highest point, and will begin to show slowing growth * unemployment continues to fall, business hiring starts to slow * spending is at a peak, but begins to slow * inflation is at its highest * central banks use restrictive measures (increase rates)
Describe Labor Usage throughout the business cycles
* tends to lag the business cycle
Describe Capital Spending throughout the business cycles
* Changes in conjunction with the business cycle * economic contraction abruptly reduces business spending (before making deeper cuts- i.e. labor) * Capacity utilization is low throughout the contraction phase * utilization remains low during the start of recover, but quickly increases as consumer spending increases (can be well before peak)
Inventory Level Changes Three steps:
- after peak, inventories accumulate. Consumer spending drops quickly, production takes longer to scale down. Reduction in inventories can only be done through reduction in production. 2. Once inventories have been reduced to desirable levels, production will pick up again to maintain levels. Higher will start. 3. Production will dramatically increase trying to keep up with increasing demand.
Three Prevailing Theories that Describe Business Cylcles
* Neoclassical / Austrian Theory * Keynesian Theory * Monetarist Theory
Describe the Classical View of the Economy
Market prices and wages decline during a recession quickly enough to bring the economy back to full employment within a short period of time. Say’s Law
Say’s Law
* states that production creates its own demand * overproduction relative to demand is impossible because the purchasing power generated by production to resource suppliers will be sufficient to purchase the goods produced.
Neoclassical Theory
* believe in the concept of the ‘invisible hand’ * markets will find an equilibrium price where supply equals demand. * shocks in the economy will be swiftly corrected within the free market, through changes in price, rates and or wages. * this theory suffered a great setback during the great depression (no prolonged downturns)
Austrian Theory
* expands on neoclassical theory * acknowledging the impact that the government policies have * believe the business cycle is caused by ‘misguided’ government intervention. * this theory does not require money to exist, believe equilibrium can be achieved through bartering
Keynesian Theory
* believe that markets will not always be able to efficiently correct, advocate for gov intervention through fiscal policy * during downturns the government should run fiscal deficits through tax cuts and higher spending * believe gov should only step in during crises periods
Compare Keynesians vs. Classicists with respect to production and demand
Keynesians: Producers generate output to meet total demand Classicists: Total demand meets production because production generates enough income to purchase goods and services.
Compare Keynesians vs. Classicists with respect to market corrections
Keynesians: no automatic forces generating equilibrium. Overproduction leads to unemployment and excess supply, underproduction leads to inflation and excess demand. Classicists: the pricing system corrects any production imbalances so equilibrium exists.
Monetarist Theory
believe - it’s important to consider the money supply - the view of short-term gov intervention fails to consider the long-term impact of those actions - it is difficult to time gov action - in a consistent, clear and limited role of gov and a steady growth of the money supply to control inflation - business cycles are driven by gov intervention and exogenous shocks.
The Keynesian Model Four Components of Aggregate Demand
- Consumption Function 2. Investment 3. Gov Expenditures 4. Planned Net Exports
Consumption Function
describes the positive correlation between disposable income and consumption. As disposable income increases, consumption expenditures increase, but by a smaller fraction than the increase in income.
Keynesian Model Investment
* Investment encompasses expenditures on fixed assets, and changes in inventories of raw materials and final products not sold. * Keynes assume these expenditures do not vary with income because they are determined by factors outside of the basic model.
Keynesian Model Government Expenditures
* assumed to be independent of income
Keynesian Model Planned Net Exports
* Planned net exports are independent of changes in domestic income level.
Aggregate Expenditure
the sum of spending on consumption (C), investment (I), government purchases (G) and net exports (X).
Keynesian Model equilibrium exists when
total output = planned C+ I + G + X or Real GDP = planned aggregate expenditures
If the economy is operating below full employment capacity, increases in AE lead to
expansions in both output and employment.
If the economy is operating at full employment capacity, increases in AE lead to:
inflation without increasing real output.
Monetarists believe:
* monetary instability is a major cause of fluctuations in real GNP * rapid growth of money supply is the major cause of inflation. * short-run aggregate supply is the same as Keynesian view * monetarist policy is the same as classical view.
Real Business Cycle Model
* seeks to expand on neoclassical models * asserts that money is not required in the economy. * business cycle is driven by causes like technological advancement,. * believe markets will quickly react to shifts in equilibrium. * place greater emphasis on aggregate supply than older theories
New Keynesians
* argue inflation is a primary cause of business cycles * attempt to link changes in monetary policies with changes in the business cycle. * believe that small economic shifts can cause extended breaks from equilibrium * places greater emphasis on aggregate supply
what is a crucial difference between older and newer business cycle theories?
newer theories place a greater emphasis on aggregate supply
Unemployment
refers to people who are not working but are actively searching for work.
Two Types of Unemployed People
* long-term unemployed - have been out of work for an extended period (3-4 months or longer) but still looking * frictionally unemployed - have landed a job and are in the period between having left the ond job but are not yet ready to begin the new job.
Long-term Unemployed
* been out of work for an extended period * 3-4 months or longer * still looking for work
Frictionally Unemployed
* Have a job, but are in the period between having left the old job and starting the new job.
Unemployment Rate
a ratio of the number of unemployed to the overall labor force
Labor Force
all the people who either have a job or are actively looking for a job.
The unemployment rate and labor force exclude which groups
* retirees * students * stay-at-home parents * underemployed * voluntarily unemployed * discouraged workers
Underemployed
* people who are working but have the qualifications to work at a higher paying job. * difficult to estimate * excluded from the official unemployment rate
Discouraged Workers
* unemployed people who have stopped searching for a job * excluded from the unemployment rate * unemployment rate often dips as people switch from being unemployed to discouraged
Voluntarily Umemployed
* people who choose to stay our of the labor force * usually due to refusing to take jobs that do not pay enough * excluded from unemployment rate
Seasonal Worker
* may be technically unemployed and receiving unemployment benefits but may not be looking fro a job during the months that their work is made impossible by the weather. * these workers overstate the unemployment rate
Part-time Workers
* may wish to work full time but cannot find full time work. * considered employed, thus understating the unemployment rate.
formula Employment / Population Ratio
Employment / Population Ratio = # of persons 16 yrs of age or older employed as civilians / total civilian population 16 yrs of age or older
the unemployment rate generally quoted by the government relies on:
surveys of households.
Two reasons the unemployment rate is a lagging indicator of the business cycle:
* the labor force is constantly expanding or declining with the business cycle. * businesses tend to delay layoffs until they are absolutely necessary - therefore an artificially low unemployment rate may prevail as the economy begins to contract.
Aggregate Hours
total hours worked by everyone employed, including full and part time workers
In the US aggregate overtime hours have been__________ while number of hours worked per person has been ___________.
increasing decreasing - because the number of people in the workforce has increased, but more part time than full time jobs have been created.
Real Wage Rate
how much goods and services an hour’s work can buy
formula Real Wage Rate
real wage rate = Money Wage Rate ($ per hour) / Price Level
How is real wages rate measured by the DOL?
* the DOL calculates average hourly earning of private manufacturing non-supervisory workers. * rose through 1970’s, steady until mid-1990s and then started increasing again
formula Real Wages
Real Wages = total wages and salaries ( from national income and product accounts) / aggregate hours * broader measure than DOL
Total Labor Compensation
* measure of real wages * includes wages, salaries, and supplemental pay (i.e. benefits)
When was the real wage growth rate slow across all measures of real wages?
* during the 1970’s * occurred at the same time with slower productivity growth
Three measures of real wages
* DOL: avg hourly earnings of private manufacturing non-supervisory workers * = total wages and salaries from national income and product accounts / aggregate hours * total labor compensation: wages, salaries and supplemental pay
Civilian Labor Force (working age population)
the total number of people 16 years of age or older who are either employed or seeking employment
Unemployed
a member of the civilian labor force who is currently not working, but is either currently seeking employment or waiting to start a new job.
Labor Force Participation Rate (LFPR)
the number of people in the civilian labor force over 16 years of age who are either employed or actively looking for employment, as a percentage of the total population 16 years and over.
formula Rate of unemployment
rate of unemployment = (number of persons employed / number of persons in the labor force) x 100
Temporary Unemployment
* Labor mobility may create temporary unemployment as workers move from contracting to expanding industries and move in and out of the labor force. * Younger workers also create temporary unemployment as they often switch jobs.
Imperfect Information
the lag between losing a job and finding a job due to lack of information which creates unemployement
Three Kinds of Unemployment
- Frictional unemployment 2. Structural unemployment 3. Cyclical unemployment
Frictional Unemployment
* occurs due to incomplete information. * available workers are unaware of job openings and employers are unaware of qualified available workers.
What determines the length of a job search
involves comparing the marginal benefit to the marginal cost of further searching for a job.
Structural Unemployment
* occurs due to changes in the basic structure of the economy that eliminates some jobs while generating new job openings for which unemployed workers are not well suited. * the retraining of workers for new sector jobs takes time and resources.
Cyclical Unemployment
occurs because the recessionary phase of business cycles creates inadequate aggregate demand for labor, leading to layoffs and cutbacks in production.
Full Employment
* the level of employment stemming from the efficient use of the labor force after subtracting the natural rate of unemployment, which is the level of unemployment that exists permanently due to information costs, dynamic changes, and the structural conditions of the economy. * full employment implies the natural, not zero, rate of unemployment.
Natural Rate of Unemployment
* the result of structural and frictional conditions on long-run average unemployment rates. * the sustainable rate in the long run. * full employment implies this level of unemployment
Three factors that affect the natural rate of unemployment
- Demographics 2. Minimum wage 3. Unemployment benefits.
How do demographics impact the natural rate of unemployment.
As the number of young workers increases, the natural rate of unemployment increases because younger workers move in and out of the work force frequently
How does the minimum wage impact the natural rate of unemployment?
increases in the minimum wage increases the natural unemployment rate because employers hire fewer workers.
How do unemployment benefits affect the natural rate of unemployment?
An increase in benefits reduces the opportunity cost of worker job search thus increasing the natural rate of unemployment.
Potential GDP
output achieved and sustained into the future, considering the labor force size, expected productivity by labor, and the natural rate of unemployment.
If the unemployment rate is lower than the natural rate of unemployment then real GDP is:
then real GDP is more than potential GDP.
If the unemployment rate is greater than the natural rate of unemployment then real GDP is:
less than potential GDP
Inflation
* a sustained increase in the price of goods and services
Inflation Rate
* the percentage change in price index * gauges how quickly prices are increasing
Deflation
* negative inflation rate * price levels are decreasing * damaging because while the value of money increases in this situation, it also means that liabilities become more expensive. * businesses tend to see lower revenues in a deflationary environment
Disinflation
* a decline in the inflation rate * the rate of inflation is slowing but still positive.
Hyperinflation
* a state where the inflation rate is extremely high * causes the purchasing power of money to quickly erode. * most often caused by poor government policies, where spending far exceeds tax revenues and monetary policy increases the money supply to accommodate spending.
What typically causes hyperinflation?
* poor government policies, where spending far exceeds tax revenues and monetary policy increases the money supply to accommodate spending.
Core Inflation
refers to an inflation rate that excludes the impact of food and energy prices.
Headline Inflation
inflation that captures all available goods and services.
Price Index
* the weighted average price of a basket of goods and services. * used in the measurement of inflation
formula Inflation as measured by the Consumer Price Index
Inflation = (this years CPI - last year’s CPI / last years’ CPI) x 100
Laspeyres Indices
Indices that hold the components of the consumption basket constant
Three Major Biases Laspeyres
- Substitution Bias 2. Quality Bias 3. New Product Bias
Substitution Bias
* the price of goods increases, people will tend to see out substitutes with lower prices. * As a result, keeping the basket of goods constant fails to capture this effect and the inflation measure will be upwardly biased.
Quality Bias
* if the quality of a good improves, people will be more satisfied with that good. * the price of that good may increase, but the price index will not consider the fact that the reason the price as risen is due to a real improvement in the good. * also results in an upward bias in the inflation measure.
New Product Bias
* Keeping a basket of goods constant means excluding products that are new to the market. * creates an upward bias in measured inflation.
What is the easiest way to correct quality bias?
Introduce adjustments for the quality of products in a basket of goods.
Hedonic Pricing
introduce adjustment for the quality of products in a basket of goods.
How is new product bias remedied?
regularly introducing new products in the basket of goods
How is substitution bias remedied?
use of the chained price index formulas which rely on calculating the geometric mean of multiple indices.
Chained Price Index Formulas
rely on calculating the geometric mean of multiple indices used to address substitution bias.
Two general forms of inflation:
* cost-push * demand-pull
Cost Push Inflation
refers to price levels rising due to increasing business costs (usually labor) which are passed onto the consumer.
Non-accelerated inflation rate of unemployment (NAIRU)
* aka NARU - natural rate of unemployment * measures the effective rate of unemployment in situations where on part of the economy has different unemployment rates than the prevailing rate
formula Unit Labor Costs
Unit Labor Costs = W / O where: O = hourly output per worker W = hourly pay per worker
Demand-Pull Inflation
* the market demand increasing prices, which compels workers to seek higher wages to keep up with the cost of living. * accounts for the relationship between GDP and capacity utilization.
How does the demand-pull perspective relate to the monetarists view:
inflation is due to the supply of money. An excess supply of money will essentially bring down its value, thus harming purchasing power and creating inflation.
What is the impact of inflation expectations:
- when businesses and consumers anticipate inflation they begin to act as if it is the case.
Economic Indicator
a variable that can provide information on the state of the economy.
Three Types of Economic Indicators
* Leading indicators * Coincident Indicators * Lagging Indicators
Leading Economic Indicators
have turning points that consistently tend to precede movements in the economy, and as such have predictive value in the near-term
Coincident Indicators
have turning points that consistently tend to match current movements in the economy, so they are valued for providing perspective to prevailing economic conditions.
Lagging Indicators
have turning points that consistently tend to happen after movements in the economy, and can be used to help gauge past conditions.
Diffusion Index
* used to compile several leading, lagging and coincident indicators * details the proportion of the index components that are moving in a manner that is consistent with the overall index.
Beige Book
* issued by the federal reserve * a compilation of polls the bank issues to it’s major branches.
The spread between the 10-year treasure and the overnight borrowing rate is used as:
* a leading indicator * to determine if the economy is heading towards and expansion or contraction * widening spread indicates economic improvement
The change in unit labor costs is what type of economic indicator?
a lagging indicator if this variable is rising, wages have been increasing and it is viewed as an indicator of economic recovery
What type of economic indicator is the S&P 500?
* a leading indicator * increasing indicates recovery
Monetary and Fiscal Policy are used by governments to
influence economic activity
Monetary Policy
Refers to actions by a government’s central bank that controls the money supply and credit in the economy
Fiscal Policy
refers to government decisions on taxes and budgets/spending.
Qualities of Money that functions a medium of exchange:
- be readily acceptable 2. have known value 3. be difficult to counterfeit 4. be easily divisible 5. have a high value relative to its weight
Three basic functions of money
- serves as a medium of exchange 2. provides a means for storing wealth 3. provides a measure of value and unit of account.
Promissory Notes
early banks provided notes to people as a record of how much gold they were holding.
Narrow Money
describes strictly the notes and coins in circulation, plus any other highly liquid deposits.
Broad Money
refers to narrow money plus any liquid asset that can be used in transactions.
US Fed Reserve definitions of M1 and M2 Money
M1 = narrow money M2 = broad money
Eurozone definitions of M1, M2 and M3 money
M1 = notes and coins M2 = M1 plus various deposits of up to 2 years of maturity M3 = M2 plus repos, money markets and other liquid securities
Quantity Theory of Money
total spending is proportional to the quantity (supply) of money
formula Quantity Theory of Money
M x V = P x Y where: M = Quantity of Money P = Price Level Y = Real Output V = Velocity of Money
Velocity of Money
measures how many times in a given period a unit of currency has changed hands, and is assumed to be fairly constant
The quantity theory of money posits that output and velocity are
determined by factors other than the amount of money in circulation.
formula Quantity Theory Equation
growth of real output + rate of inflation = growth rate of the money supply + growth rate of velocity
Velocity and Real Output are determined by what factors?
* technology * skill of labor * economic resource base * not by the supply of money
Demand for money is measured by:
the overall wealth that people will hold as money, as opposed to other assets
Three reason people choose to hold money:
- transaction related: cash held for financial transactions. ratios of transaction cash to real GDP remains constant 2. Precautionary: money held for emergency purposes, tends to rise in line with GDP 3. Speculative: relies on demand based on potential opportunities for other types of assets. rises if other assets are expected to decline in value.
the price of money
nominal rate of interest
demand curve for money slopes:
downward since the speculative demand for money falls as rates rise
the supply curve for money is
* vertical * it is assumed that the amount of money in circulation is fixed (or rarely changed)
Fisher Effect
the real rate of interest is stable, so that changes in the nominal interest rate are due to changes in the expected inflation rate
formula Fisher Effect
R nom = R real + π e where: π e is expected inflation
Roles of Central Banks
* supplier of currency * banker to government and all other banks * lender of last resort * regulator and supervisor of the system of payments * purveyor of monetary policy * supervisor of the banking system
describe the central banks role as sole supplier of currency
the central bank is charged with being the only supplier of a country’s currency.
fiat money
money that is not exchangeable into a commodity
describe the central banks role as banker to the government and all other banks
central bank handles the banking affairs of the government, including making loans to the government, as well as for all other banks in the country
describe the central banks role as a lender of last resort
* charged with lending to banks if they face cash shortages. * in order to prevent bank runs
Describe the central banks role as regulator and supervisor of the system of payments
- * sets procedures for how the country’s transactions are handled. * also responsible for setting procedures on payments with other central banks.
describe the central banks role as purveyor of monetary policy
* dictates monetary policy by setting the money supply of a country * will change the money supply as required by economic conditions * manage foreign currency reserves
describe the central banks role as supervisor of the banking system
* gov tends to give the central banks the ability to supervise any bank that can accept depsosits * sometimes a different gov baldy may take this role
Three characteristics of effective central banks:
- Independence: operate independently from its gov.; able to set rates as it sees fit. 2. Credibility: link between independence and public confidence. belief that they will adhere to policies at all times 3. Transparency: Decision making processes are transparent, clearly communicate often
Monetary Policy Mechanisms
* adjust interest rates at which banks lend to banks * adjust exchange rates indirectly through changes in interest rates
Why would a central bank increase the repo or repurchase rate?
to discourage inflation
Why would a central bank lower the repo rate?
to encourage spending.
If a country’s interest rate is relatively higher than another country’s, then:
money will flow into the country with higher interest rates, increasing the demand for that currency.
Inflation targeting and 1) the fed 2) European central bank 3) bank of England 4) bank of Canada
1) the fed: does not rely on inflation targeting 2) European central bank: mandated by law 3) bank of England: targets inflation, but allow small degrees of variation 4) bank of Canada: targets inflation, but allow small degrees of variation
Mandates of the Bank of Canada
* achieve price stability * keep inflation to a 1 to 3 percent range * agreement negotiated periodically
Mandates of the Reserve Bank of Australia
* stabilize the Australian currency * maintain full employment * encourage economic prosperity * inflation target of 2 to 3 percent
Mandates of the Bank of England
* maintain price stability * support government economic policies such as growth and employment * inflation target of 2%
Mandates of the European Central Bank
* price stability * high employment and standard of living * inflation target of no more than 2%
Bank for International Settlements (BIS)
* central banks cooperate through BIS * located in Switzerland, offices in Mexico and Hong Kong * acts as a bank for central banks * place for discussion and research regarding economic policy
Group of Seven
central bank representatives from US, United Kingdom, Japan, Germany, France, Canada, Italy
The economy runs most smoothly when
* prices are stable and easy to predict * stable prices promote real GDP growth
Sustainable GDP growth depend on
* available resources * environmental concerns * willingness and ability of citizens to save * technology advances
Real Business cycle theory says that real GDP fluctuations are:
also potential GDP fluctuations
Keynesian and monetarists say that real GDP fluctuations are:
avoidable and are deviations from potential GDP.
Monetarists belong to a school of economics that espouses:
* monetary instability is the major cause of fluctuations in real GDP * rapid growth of the money supply is the major cause of inflation.
What do monetarists feel is the major cause of fluctuations in real GDP?
monetary instability
What do monetarists believe is a major cause of inflation?
rapid growth of the money supply.
Discretionary Monetary Policy
* monetary policy that is instituted at the discretion of policymakers, and is not predetermined by rules or formulas.
What are monetarists feelings toward discretionary monetary policy?
do not believe discretionary monetary policy can stabilize the economy because of lengthy and unpredictable time lags between implementation and its primary effects.
Expansionary Monetary Policy
* monetary policy created to encourage aggregate demand * Can include: * purchases of treasury securities * lowering the required reserve ratio (not actively used) * lowering the discount rate
According to the Federal Reserve Act of 2000, the Fed’s mandate is:
* to maintain the long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production. * goal is to have maximum employment, stable prices, and moderate long-term interest rate
Maximum employment refers to
promoting the highest sustainable growth in potential GDP with real GDP close to potential GDP and keeping the unemployment rate near the natural unemployment rate.
When real and nominal rates are equal there is:
no inflation
The Fed works at having the growth rate in the quantity of money compatible with
growth in potential GDP
Core CPI
CPI without food and feul
Which index does the Fed feel is the better representation of inflation?
core CPI.
What is the Fed’s goal regarding inflation?
* low and stable inflation * not necessarily zero * current goal is 1 to 2 percent per year
Output GAP
* a measure (in percent) of how much real GDP varies from potential GDP * Fed tries to minimize this * positive output gap may indicate inflation * negative output gap is recesssionary
Parties Responsible for Monetary Policy
- the Fed: decision of the FOMC (federal open market committee) eight annual meetings 2. Congress: actions that influence the economy. 3. President: through appointing the board of governors.
The main role of monetary policy is:
to maintain price stability, generally by maintaining interest rates and closely monitoring inflation.
Expected Inflation
* the component of inflation that is predictable. * can be predicted and can be incorporated into wages, prices etc.
Unexpected Inflation
* more damaging * can take much longer to incorporate its effects into economic measures * Prices change more quickly than wages - when inflation increases purchasing power is eroded.
If inflation is perceived to be highly unpredictable, investors will require:
higher risk premiums on investments and the information content of asset prices will be diminished.
Two channels used to implement monetary policy:
- Interest rate path 2. Direct Path
Interest Rate Path for implementing monetary policy
- If the fed implements an expansionary monetary -policy the interest rate will fall (as money supply increases) - people will then transfer funds from cash to other financial assets - causing the supply of loanable funds to increase and - real interest rates to fall. - lower real interest rates stimulates investment and consumption aggregate demand shifts upward.
Direct Path to implementing monetary policy
* unanticipated increases in the supply of money leaves the public with excess money and stimulates spending and aggregate demand. * relies on the equation of exchange that shows whether an increase in either money or velocity will increase spending, therefore shifting aggregate demand upward.
Discount Rate
the interest rate that depository institutions must pay the Fed to borrow money at the discount window on a short-term basis
federal funds rate
the rate that the borrowing bank must pay the lending bank in the fed funds market the discount rate is typically equal to or lower than the fed funds rate
Instrument Rule
* based on the current economy, like the Taylor Rule, which makes the fed funds rate responsive to inflation and the output gap.
Targeting Rule
looks at forecasts and determines policy goals and instruments based on a desired future outcome. the fed tends to use targeting rules.
Taylor Rule
* changes the fed funds rate to achieve a target inflation rate. * if followed could results in low inflation and stable price levels.
What does the Fed do to increase the money supply?
buys treasury securities either on a temporary or permanent basis.
What is the tool of choice for the Fed’s conduct of monetary policy?
open-market operations.
How does the Fed cause the money supply to contract using open-market operations?
sells securities to US citizens. deposits will decline by the amounts sold.
If the central bank increases it’s base rate - 4 immediate channels impacted:
- banks will increase their own rates 2. translates to higher borrowing costs for consumers and businesses 3. borrowing declines due to higher costs 4. the value of assets (bonds and capital projects) drop due to higher rates
Downstream impact due to a central bank increase in its base rate:
* exporter profits may drop if higher rates cause exchange rates to appreciate * reduced assets will lower overall levels of wealth, which will hurt consumption * businesses will curtail spending * all of this leads to reduced demand, slow economic growth and curb inflation
A lower fed funds rate encourage banks to:
hold more reserves and lend less
If the fed fund rate is higher
there will be a greater quantity of overnight loans supplied and a smaller quantity demanded.
What is the indirect impact to the markets over a 1 to 2 year period of an increase in the fed funds rate?
- other interest rates, increase (particularly short-term rates) 2. exchange rates increase. dollar appreciates. 3. the quantity of money, and subsequently the supply of loanable funds decreases. 4. long-term interest rates rise 5. investments, exports and consumer expenditures decrease. 6. aggregate demand is lowered. 7. real GDP growth and inflation are lowered.
How might the Fed address a recession?
* take steps to restore full employment * may buy securities, increasing the bank reserves - banks will then make more loans * increasing the supply of money - therefore interest rates fall and the demand for money increases. * business expenditures will then increase leading to greater employment, c ausing income and spending to increase
How might the Fed address high inflation?
* Fed will sell securities, decreasing bank reserves and loanable funds * loans and money supply decrease * expenditures decrease, lower income and expenditures
What is the impact if the Fed reacts to strongly to: inflation? recession?
* inflation: push the economy into a recession * recession: increases inflation
Loose Links
refers to the fact that the long-term interest rate is loosely linked to changes in the fed funds rate. Real interest rates do not change exactly as inflation changes Real interest rates reflect future expectation of inflation
Time Lags
refers to the problem that the changes described above take place over a long period of time, and conditions can change while the initial action is being absorbed into the economy.
Two strategies not chosen by the Fed:
* instrument rule: monetary base * target rule: money, exchange rate, inflation rate
McCallum Rule
* Monetary base instrument rule * changes the growth rate in the monetary base to control inflation, but also considers changes in productivity growth rates and in aggregate demand * has the growth rate in the monetary based change in response to the avg growth rate of real GDP over the past 10 yrs minus the avg growth rate of the velocity of circulation over the past 4 years.
What is the pro and con with using the McCallum rule:
Pro: avoids the problem using the Taylor rule: the fed does not need to determine the long-run equilibrium interest rate or the output gap. Con: to work the demand for money and the monetary base need to be reasonably stable.
Why does the Fed not use the McCullum rule:
it believes that changing the demand for money and for the monetary bases would cause large fluctuations in the interest rate, and in turn, aggregate demand.
Similarities between the McCallum Rule and Taylor Rule
* both could result in low inflation and stable prices
McCallum Rule versus Taylor Rule
McCallum Rule: - less concerned with real GDP - less of a role for monetary policy - concerned about monetary base with a fluctuating fed funds rate Taylor Rule: - more responsive to real GDP, emphasis on current bus cycle - focuses on fed funds rate, with fluctuating monetary base
K-Percent Rule (Money Targeting)
* the quantity of money grows at k percent a year where k is the growth rate of potential of potential GDP. * requires that the demand for money and velocity of money to be stable * successfully used to control inflation in the 70’s (then abandoned) * caused too much fluctuation in aggregate demand
Floating Exchange Rate
an exchange rate that responds to changes in supply and demand for US dollars.
Fixed or Pegged Exchange Rate
* inflation could not be controlled * creates arbitrage opportunities
Crawling Peg Exchange Rate
* exchange rate changes at the same rate as domestic inflation minus the target inflation rate * could cause problems when the real exchange rates would need to be recognized and corrected as necessary, something that is difficult to do.
Inflation Rule Inflation Rate Targeting
Central banks that use inflation rate targeting choose publicly known policies to achieve the inflation rate desired.
Inflation Target is typically
a desired range for the consumer price index.
Fed’s Approach to Inflation
Fed’s current policies have an implied but not explicitly stated goal. has worked well
If the economy is expanding rapidly and the banks expect inflation to increase, central banks will
* increase interest rates. * this will reduce the growth in the money supply. * contractionary policy
Contractionary Monetary Policy
* policy’s that reduce the growth in the money supply. * increasing interest rates, sell assets on open market, increase reserve requirements. * impact: rates increase, exchange rates increase, economy will shrink, inflation will decrease.
If the economy is slowing and inflation is declining central banks will
* lower interest rates * this increases the growth in the money supply * exapnsionary monetary policiy
Exansionary Monetary Policy
* Increase the growth in the monetary policy * central banks will lower rates, purchase assets on the open market, and/or reduce reserve requirements * Impact: interest rate declines, exchange rates will drop, economy will grow due to lower borrowing costs
Neutral Rate
the interest rate that will neither slow down nor spur the economy
Supply Shock
- inflation caused by higher prices of inputs - increasing rates in this situation could make matters worse
Demand Shock
* inflation driven by high consumer confidence that has raised aggregate consumption * contractionary monetary policy could help (increase rates)
Exchange Rate Targeting
* practiced by some developing nations * exchange rates are controlled instead of targeting inflation * the country pegs its exchange rate to a currency of another economy with a good record of controlling inflation. * controls exchange rate by trading it’s own currency
Main limitation of the central bank monetary policy
* the central bank cannot control ho much money consumers and businesses will actually deposit or withdraw as the monetary policy changes.
Liquidity Trap
* people hold more money regardless of interest rates, due to low confidence in the economy. * the demand curve becomes more horizontal than downward sloping, increasing the money supply has little impact. * can lead to deflation
Quantitative Easing
the money supply is increased and that money is used to directly purchase assets. Used in the recent financial crises
Fiscal Policy
refers to changes in the tax revenue and government spending in an attempt to affect economic activity.
Fiscal Policy can be used to:
* impact aggregate demand * redistribute income and wealth * reallocate resources
Expansionary Fiscal Policy
* Gov runs a budget deficit. * reduce taxes to boost demand, raise investment and /or increase income * Increase gov spending on infrastructure so as to improve unemployment and output.
Contractionary Fiscal Policy
* lower government spending and increased taxes * gov seeks budget surpluses to temper excessive growth * deliberate responses or automatic stabilizers
Automatic Stablizer
- tools that take effect during various points of the business cycle
- i.e. unemployment benefits
- automatic and do not require a planned response
- help prevent large swings in aggregate demand
Tools at the government’s disposal:
* Current government spending * Transfer payments * Capital expenditures * Direct Taxes * Indirect Taxes
Transfer Payments
spending on social welfare such as unemployment benefits, disability benefits and social security
Capital Expenditures
Infrastructure spending that helps boost productivity and is expected to provide future tax revenue.
Direct Taxes
Taxes directly levied on people, like income tax, capital gains tax, and property tax
Indirect Taxes
typically taxes on spending, such as sales tax or value-added tax.
Goal of using fiscal policy tools?
* boost economic growth * provide a minimum level of income to all people * help boost output by promoting growth * subsidize new markets or products * ensure certain services are applied to all citizens
government purchase / expenditure multiplier
* gov purchases are part of aggregate demand. * when gov purchases change so does GDP * this changes consumption expenditures * the amount by which a change in investment consumption or gov spending changes income
tax multiplier
- smaller multiplier than gov purchasers. * Taxes are cut, people spend more, but only a percentage of the tax cut.
Balanced budget multiplier
- measures the impact on aggregate demand of simultaneous changes in government purchases and taxes when the budget balance is unchanged.
- positive multiplier, gov purchases increase demand, more than a tax increase will decrease demand.
Formula Marginal Propensity to Consume
MPC = additional consumption / additional income
formula Expenditure Multiplier
M = 1 / (1-MPC)
leakages that reduce the size of a multiplier
* savings * taxes * spending on imports
