Econ O' Micks Flashcards
Quantity theory of money
A change in the money supply will cause a proportional change in price level because velocity and real output are unaffected by amount of money.
Quantity theory of money equation
Money Supply (M) x Velocity of Money (V) = Price (P) x Real Output (Y)
Money creation process
Reserves are the cash in a bank’s vault and deposits at Federal Reserve Banks. Under the fractional reserve banking system, a bank is obligated to hold a minimum amount of reserves to back up its deposits. Reserves held for that purpose, which are expressed as a percentage of a bank’s demand deposits, are called required reserves. Therefore, the required reserve ratio is the percentage of a bank’s deposits that are required to be held as reserves.
Banks create deposits when they make loans; the new deposits created are new money.
Three functions of money
Store of value, medium of exchange, accounting unit
Money market equilibrium
occurs when people are willing to hold all the money supplied by the monetary authorities at the prevailing interest rate; the supply of money equals the demand for money. It occurs at ie in the diagram.
Fisher effect
Rnom = Rreal + Rinflation + risk premium
The nominal rate of interest is comprised of three components:
A real required rate of return.
A component to compensate lenders for future inflation.
A risk premium to compensate lenders for uncertainty.
Roles of a central bank
Issue currency
The government’s bank, and bank of the banks
Lender of last resort to the banking sector
Regulator and supervisor of the payments system
Set monetary policy
Regulate banking system
Monetary policy tools
Open Market Operations.
The Central Bank’s Policy Rate.
Reserve Requirements.
Open Market Operations.
Open Market Operations. Since it can be undertaken easily and quietly, this is the most common tool used by a central bank to alter the money supply. For example, to increase the money supply, the central bank buys government securities from commercial banks. This increases the money supply.
The Central Bank’s Policy Rate.
The Central Bank’s Policy Rate. Sometimes banks find themselves in a position where they are not holding enough bank reserves relative to the value of the deposits they hold (i.e., they have extended too many loans!). As a result, they may need to acquire a short-term loan from the central bank to cover this shortage of required reserves. They may apply to the central bank for a loan; the interest charged on the loan is known as repo rate (in the U.S. it is called the discount rate).
An increase in the policy rate is restrictive on money supply - it tends to discourage banks from shaving their excess reserves to a low level.
In the U.S., borrowing from the Fed amounts to less than one-tenth of 1% of the available loanable funds of banks. A bank can go to the federal funds market to borrow to meet its reserve requirements. The market is where banks with excess reserves extend short-term loans to those banks seeking additional reserves. The interest rate in this market is called the federal funds rate. The federal funds rate and the discount rate tend to move together.
Reserve Requirements.
Reserve Requirements. The central bank sets the rules. Since banking institutions will want to hold interest-earning assets rather than excess reserves, an increase in the reserve requirements will reduce the supply of money, and vice versa. However, the central banks of developed countries have seldom used their regulatory power over reserve requirements to alter the supply of money, due to its disruptive impact on banking operations - small changes in reserve requirements can sometime lead to large changes in the money supply.
When a central bank lowers its interest rate….
Other short-term interest rates fall. Short-term rates move closely together and follow the official interest rate.
The exchange rate falls. The exchange rate responds to changes in the domestic interest rate relative to the interest rates in other countries (the interest rate differential). But other factors are also at work, which make the exchange rate hard to predict.
The quantity of money and the supply of loanable funds increase. This is because the fall in the interest rate increases reserves and increases the quantity of deposits and bank loans created. The fall in the interest rate also increases the quantity of money demanded.
The long-term interest rate falls. Long-term rates move in the same direction as the official interest rate. The long-term real interest rate influences expenditure plans.
Consumption expenditure, investment, and net exports increase. The change in aggregate expenditure plans changes aggregate demand, real GDP, and the price level, which in turn influence the goal of the inflation rate and output gap. Aggregate demand increases.
Real GDP growth and the inflation rate increase.
The Fed’s economic goals
prescribed by Congress are to promote maximum employment, stable prices, and moderate long-term interest rates.
inflation has a tendency to _____ revenue and _____ plants and equipment
inflation has a tendency to overstate revenue and understate plants and equipment
Three monetary targeting concepts
Central bank independence. Central bank independence exists on two dimensions. Goal independence is the freedom that the central bank has to select the objectives of monetary policy, whether they are low inflation, the target rate of unemployment, the level of GDP, etc. Instrument independence is the freedom that the central bank has to pick appropriate policies to produce a certain outcome in the economy. Most inflation-targeting countries only lay out the goals and not the operating procedures; the central bank does have operational independence.
Credibility. Central bankers who are unable to credibly convince the public that they are serious about fighting inflation will be faced with a high inflation rate as a result.
Transparency. It is well known that credibility requires transparency. The benefits of transparency are obvious: it improves the efficiency of monetary policy, allows for a more effective management of expectations, and promotes the discussion and evaluation of monetary policy.
Exchange Rate Targeting
Many countries have viewed pegging their nominal exchange rate to a stable, low-inflation foreign currency as a means of achieving domestic price stability. In a sense, countries that target their exchange rates against an anchor currency attempt to “borrow” the foreign country’s monetary policy credibility. However, this monetary policy deprives the central bank of its ability to respond to idiosyncratic domestic shocks. Such countries can become prone to speculation against their currencies.
neutral rate of interest
a neutral rate of interest would be one that encourages a rate of growth of demand close to the estimated trend rate of growth of real GDP.
Neutral rate
Neutral rate = Trend growth + Inflation target
Central banks cannot control the money supply. This is because:
They cannot control the amount of money that households and corporations put in banks on deposit.
They cannot control the willingness of banks to create money by expanding credit.
liquidity trap
“after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt (financial instrument) which yields so low a rate of interest.”
four desirable attributes of a tax policy
simplicity, efficiency, fairness, and revenue sufficiency.
budget deficit
total government spending exceeds government revenue. A budget deficit is financed through the issuance of government securities. Such issuance of securities adds to the national debt.
budget surplus
revenues exceed spending. Under a budget surplus, excess revenue is applied to the total outstanding debt accumulated during prior periods, therefore reducing it by the amount of the surplus.
arguments against being concerned about national debt:
The debt is owed internally by fellow citizens.
Some borrowed money may have been used for capital investment projects or enhancing human capital.
Large deficits require tax changes which may be desirable.
Richardian equivalence: the timing of any tax change does not affect consumers’ change in spending.
Debt could improve employment.
arguments for being concerned about national debt:
Higher deficits -> higher tax rates -> less incentive to work and invest -> lower long-term growth
The central bank may have to print money to finance a deficit. This may lead to high inflation.
crowding-out effect
reduction in private spending as a result of higher interest rates generated by budget deficits that are financed by borrowing in the capital market. It suggests that budget deficits will exert less impact on aggregate demand than the basic Keynesian model implies. Because financing the deficit pushes up interest rates, budget deficits will tend to retard private spending, particularly spending on investment. This reduction will at least partially offset additional spending emanating from the deficit.
MPC + MPS = 1 - t
marginal propensity to consume / save, tax rate
expenditure multiplier
ratio of the change in equilibrium output relative to the independent change in consumption, investment, and government spending or spending on net exports that brings about the change.
government purchases multiplier
magnification effect of a change in government purchases of goods and services on aggregate demand. It exists because government purchases are a component of aggregate expenditure; an increase in government purchases increases aggregate income, which induces additional consumption expenditure.
tax multiplier
magnification effect a change in taxes on aggregate demand. An increase in taxes decreases disposable income, which decreases consumption expenditure, aggregate expenditure, and real GDP.
fiscal multiplier
1/[1 - c (1 - t)]
balanced budget multiplier
magnification effect of a simultaneous change in government purchases and taxes on aggregate demand. A $1 increase in government purchases increases aggregate demand initially by $1, but a $1 increase in taxes decreases consumption expenditure by less than $1 initially, so a $1 increase in both purchases and taxes increases aggregate demand.
