Chapter 5 Flashcards
GDP
Measures the total value of goods and services produced during a specific period.
National Income
The total income earned by firms and individual employees during a specific period.
Leading Economic Indicators
Predict future economic activity.
Coincident Economic Indicators
Tend to reach their peaks and troughs at the same time as business cycles.
Lagging Economic Indicators
Tend to rise or fall a few months after business-cycle expansions and contractions.
Producer and Consumer Price Indexes
Producer price index represents prices at the wholesale level.
Consumer price index represents prices paid at the retail level.
Other Inflation Indicators
Wage rates, oil prices, and the price of gold.
How a Stimulative Monetary Policy Reduces Interest Rates
The supply curve of loanable funds indicates the quantity of funds that would be supplied at various possible interest rates.
The Fed increases the supply of funds in the banking system, which can increase the level of business investment, and hence aggregate spending in the economy.
How Lower Interest Rates Increase Business Investment
Some firms are more willing to expand, as there is an inverse relation between the interest rate on loanable funds and the current level of business investment.
The effects of a stimulative monetary policy on the business cost of debt is to consider the influence of the risk-free rate on all interest rates.
Firms are able to borrow funds at lower rates.
How Lower Interest Rates Lower the Business Cost of Equity
The cost of a firm’s equity is based on the risk-free rate plus a risk premium that reflects the sensitivity of the firm’s stock price movements to general stock market movements.
Stimulative Monetary Policy Effects
Effects on the risk-free rate influences cost of debt and cost of equity.
Cost of capital is reduced, which reduces the required return on cost of products.
Encourages firms to spend more money, hire more employees.
Why a Stimulative Monetary Policy Might Fail
The Fed commonly buys and sells T-bills when engaging in monetary policy, it might not be able to completely control long-term Treasury yields.
Limited Credit Provided by Banks
Even if the Fed increases the level of bank funds, banks may be unwilling to extend credit.
Low Return on Savings
Lower interest income translates to lower spending.
Adverse Effects on Inflation
Effect of increase in money supply growth may be disrupted due to an increase in inflationary expectations.
Recognition Lag
The delay between the time a problem arises and the time it is recognized.
Implementation Lag
The difference between the time a serious problem is recognized and the time the Fed implements a policy to resolve that problem.
Impact Lag
The difference between the time a policy is implemented and the time its had its full impact on the economy.
Effects of Restrictive Monetary Policy
Increasing risk-free interest rate increases corporate cost of financing, therefore decreasing the level of business investment.
As economic growth is slowed, inflationary pressure may be reduced.
Restrictive vs. Stimulative Monetary Policy
Stimulative (loose-money) is intended to boost economic growth.
Restrictive (tight-money) is intended to reduce inflation.
Strong Economic Conditions
High inflation, low unemployment.
Weak Economic Conditions
Low inflation, high unemployment.
How Monetary Policy Responds to Fiscal Policy
If fiscal pressures create large budget deficits, this may place upward pressure on interest rates and the Fed may feel pressured to use a stimulative monetary policy to reduce interest rates.
Fiscal policy shifts demand for loanable funds, but monetary policy has a large impact on the supply of loanable funds.
Advantages of Inflation Targeting
The Fed would no longer face a trade-off between controlling inflation and controlling unemployment.
The Fed would not have to consider responding to any fiscal policy actions.
The Fed’s role would be more transparent and would lead to less uncertainty in financial markets.
Disadvantages of Inflation Targeting
The Fed could lose credibility if the inflation rate deviated substantially from the target rate.
Could result in a much higher unemployment level.
