Economics SS4 Flashcards
Define the impact of monetary policy :
a. Expansionary
b. Contractionary
Expansionary :
- Increase the money supply
- Decrease interest rates
- Increase aggregate demand
Contractionary :
- Decrease the money supply
- Increase interest rates
- Slow economic growth and inflation
What is Monetary Policy?
Management of the supply of money and credit
What is Fiscal Policy?
Government decisions on taxing and spending
What is the impact of _____ fiscal policy?
a. Expansionary
b. Contractionary
a. Expansionary :
- Increase spending
- Decreases taxes
- Increase the budget deficit
- Increase aggregate demand
b. Contractionary :
- Decrease spending
- Increase taxes
- Decrease the budget deficit
- Reduce aggregate demand
What is the function of money?
- Medium of exchange
- Unit of account
- Store of value
What is fractional reverse banking system?
A bank is required to hold a fraction of its deposits in reserve; this fraction is the required reserve ratio.
What are the types of demand for money? Explain.
- Transaction demand : Increase with GDP
- Precautionary demand : Money held for unforeseen future needs, increases with GDP
- Speculative demand : Money held to take advantage of future investment opportunities, smaller when current returns are high, greater when risk is perceived to be high.
Supply of money is set by who?
Monetary authority
What is the Fisher Effect?
Riskless nominal interest rate = real riskless rate + expected inflation
What are the roles of Central Banks? (6)
- Issue currency
- Banker to banks and government
- Regulate banking and payments systems
- Lender of last resort
- Hold gold and foreign currency reserves
- Conduct monetary policy
a. What is the main objective of Central banks?
b. What are the others objectives of Central banks? (4)
a. Price stability (low inflation rates)
b. - Maintain full employment
- Promote economic growth
- Keep exchange rate tables
- Keep long-term interest rate moderate
What are are the additional costs of unexpected inflation?
Shifts wealth from lenders to borrowers
Less reliable supply/demand information in price changes
- Incorrect production decisions by firms
- Less stable business cycles
Definition of policy rate
Interest rate central banks charge banks for borrowed reserves
Define the impact of _____ the policy rate.
a. Increasing
b. Decreasing
a. Increasing the policy rate discourages banks from borrowing reserves; thus, banks reduce their lending
b. Decreasing the policy rate tends to increase the amount of lending and the money supply.
Describe open market operations (buy, sell securities)
- Central bank buys government securities for cash, reserves increase, money supply increases
- Selling securities decreases the money supply
Describe required reserve ratio. (Reducing, increasing)
- Reducing reserve percentage increases excess reserves and increases the money supply
- Increasing required reserve ratio decreases the money supply
Describe Central Bank Characteristics
- Independent
- Credible
- Transparent
Impact when a central bank buys securities
- Bank reserve increase
- Interbank lending rates decrease
- Short-term and long-term lending rates decrease
- Businesses increase investment
- Consumers increase durable goods purchases
- Domestic currency depreciates, exports increase
Overall, aggregate demand increases
Define
a. Interest rate targeting
b. Inflation targeting
c. Exchange rate targeting
a. Increase (decrease) money supply growth when interest rates are above (below) targets
b. Target band for inflation rate (1%-3%)
- Increase money supply growth when inflation is below target band, decrease money supply growth when inflation is above target band
- Target inflation band > 0 to prevent deflation
c. Target band for currency exchange rate with developed country
a. Determine the neutral interest rate
b. Explain when we are in a contractionary or expansionary situation (Policy rate <> Neutral Rate)
a. Neutral interest rate = Trend growth rate of real GDP + target inflation rate
b. Policy rate > neutral rate : Contractionary
Policy rate < neutral rate : Expansionary
What are the limitations of monetary policy? (5)
- Long-term rates may move oppositely to short-term term rates because inflation expectations change
- If monetary tightening is extreme, expectations of recession may make long-term bonds more attractive, decreasing long-term rates
- If demand for money is very elastic, people will holds currency even as money supply increases referred to as liquidity trap.
- Banks may desire to increase capital and not increase lending in response to expansionary monetary policy
- Short-term rates cannot be below zero - limits a central bank’s ability to act against deflation.
Explain
a. Expansionary Fiscal Policy
b. Contractionary Fiscal Policy
a. - Increase government spending
- Decrease taxes or both
- Increase aggregate demand
- Increase budget deficit
b. - Decrease government spending
- Increase taxes or both
- Decreasing aggregate demand
- Decreasing the budget deficit
Definition of automatic stabilizers
Recessions : Taxes and transfer payments tend to increase deficits
Expansions : Taxes and transfer payments tend to decrease deficits during expansions.
What are the fiscal policy objectives?
- Influence aggregate demand and economic growth
- Redistribute wealth
- Affect the allocation of resources to different sectors of the economy
What are the fiscal tools (spending)?
- Transfer payments
- Current Spending
- Capital spending
Whare are the fiscal tools (Revenue)?
- Direct taxes
- Indirect taxes
Describe fiscal multiplier
Initial government spending has a multiplied effect as it creates more spending
1 / [(1 - MPC) ( (1-t)]
Explain Ricardian Equivalence
- If a tax decrease causes taxpayers to anticipate higher future taxes, the resulting decrease in spending will reduce the expansionary impact of a tax cut.
- If the increase in saving (decrease in consumption) just offsets the tax decrease.
Describe Government debt
Debt ratio = Government debt / GDP
- If the real interest rate on government debt is less (greater) than the real rate of growth, debt ratio will decrease (increase) over time.
Describe reasons to be concerned about deficits
- Higher future taxes will decrease GDP growth
- Government borrowing can drive up interest rates and reduce (crowd out) private investment
- At some point, debt can become risky, interest rate rises, country may default or expand money supply and cause inflation.
Describe arguments that deficits are NOT concerning
- If deficit is to finance capital investment, future GDP will be higher
- Deficits don’t matter if Ricardian equivalence holds
- If the economy is operating below capacity government borrowing will not displace capital investment.
What are the three fiscal policy lags? Describe them
- Recognition lag : To identify the need for fiscal policy change
- Action lag : To enact legislation
- Impact lag : For the policy change to have the intended effect
Lag can cause fiscal policy changes to be destabilizing rather than stabilizing.
What are the fiscal policy limitations?
- If economy is at full employment, fiscal stimulus will result in higher inflation
- In economy is below full employment due to supply shortages, fiscal stimulus will lead to inflation rather than GDP growth
- If the economy has high unemployment and high inflation (stagflation), fiscal policy connate address both
Study Policy interaction slide 38
Compare GDP and GNP
GDP :
- Value of goods and services produced within a country’s borders
- Includes capital owned by foreigners and earnings of foreigners working in the country
GNP :
- Value of foods and services produced by a country’s citizens and their capital
- Includes earnings of citizens working abroad and earnings on citizens’ capital outside the country
Contrast absolute and comparative advantage.
Absolute advantage : Lower cost in therms of resources used
Comparative advantage : Lower opportunity cost to produce.
Explain Ricardian model
- Labor is the only factor of production
- Comparative advantage depends on relative labor productivity for different goods
Explain Heckscher-Ohlin Model
- Two factors of production : Capital and Labor
- Comparative advantage depends on relative amount of each factor possessed by a country
- The price of the more abundant resource will increase in each country.
Define
a. Tarrif
b. Quota
c. Export subsidies
d. Minimum domestic content
d. Voluntary export restraint (VER)
a. Tax imposed on imported goods
b. Limitation on the quantity of goods imported
c. Payments by government to domestic exporters
d. Required proportion of product content to be sourced domestically
e. Agreement by one country to limit the quantity of goods it will export to another country
What are the two primary goals of trade restrictions?
- Protecting domestic jobs
2. Protecting domestic producers
Study chart Module 13.2 - Trade restriction slide 11
What are the restriction on flow of financial capital?
- Outright prohibition
- Punitive taxation
- Restrictions on repatriation
What are the short-term benefit and the long-term cost of capital restriction?
- Short-term benefit for developing countries : Reducing volatile capital inflows and outlows
- Long-term costs of isolation from global capital markets.
Decribe the five trading blocs
- Free trade area (FTA): Removes all barriers to trade between member countries (e.g., NAFTA)
- Customs Union (CU): FTA + common trade restrictions with non-members
- Common Market (CM): CU + removes barriers to movement of labor and
capital among members - Economic Union: CM + members establish common institutions and economic policy
- Monetary Union: Economic union + members adopt a common currency (e.g., euro zone)
What are the objective of capital restrictions?
- Reduce volatility
- Maintain exchange rate target
- Keep domestic interest rates low
- Protect strategic industries
Describe the three accounts in the balance of payments (BOP).
- Current Account: Merchandise/services purchases, foreign dividends and interest, and unilateral transfers
- Capital Account: Sales/purchases of physical assets, natural resources, intangible assets, debt forgiveness, death duties, and taxes
- Financial Account: Domestic-owned financial assets abroad (official reserve, government, private) and foreign-owned domestic financial assets
See chart in note p.22
Describe the three International organizations
- International Monetary Fund (IMF)
- Monetary cooperation
- Growth of trade
- Exchange stability
- Multilateral system of payments
- Over come temporary BOP difficulties - World Bank
- Fight poverty
- Development and assistance - World Trade Organization
- Enforce global rules of trade
- Ensure trade flows smoothly and freely
- Dispute settlement process
- Multilateral trading sustem - agreements
Compare nominal and real exchange rate
- Nominal exchange rate is the quoted rate at any point in time
- Real exchange rate is the nominal exchange rate adjusted for
inflation in each country compared to a base period
Compare nominal and real exchange rate
- Nominal exchange rate is the quoted rate at any point in time
- Real exchange rate is the nominal exchange rate adjusted for
inflation in each country compared to a base period
Describe the market participants on the sell side.
Market makers : Largest ultinational banks
Describe the market participants on the buy side.
- Corporations
- Investment accounts : Real money and leveraged
- Governments, sovereign wealth funds, pension plans, central banks
- Retail market : Households (e.g., tourism)
What are the 8 exchange rate regimes?
- Formal dollarization
- Monetary union
- Currency board
- Conventional fixed peg
- Target zone
- Crawling peg (Active and passive)
- Managed floating
- Independently floating
Explain formal dollarization
Uses other country’s currency
Explain monetary union
Several countries use a common currency
Explain currency board
Commits to a fixed rate of exchange of domestic for a foreign currency
Explain conventional fixed peg
Maintain at peggedrate (± 1%) via direct intervention in the FX markets or indirectly via monetary policy changes
Explain target zone
Gives flexibility to maintain the exchange rate within a wider range (e.g., ± 2%)
Explain crawling peg (active and passive)
Allows exchange rate to move slowly with changes in fundamentals
- Active : Announced and implemented
- Passive : Managed but market driven
Explain managed floating
No target exchange rate ; managed through direct intervention or monetary policy
Explain independently floating
Market determined
Explan Marshall-Lerner condition
If WXEX +WM(EM –1)>0, depreciation of domestic currency will decrease trade deficit
Explain the J-Curve Effect
In the short run, due to existing contracts, export and import demand are relatively inelastic
- Currency depreciation initially leads to a larger trade deficit
In the long run, elasticities increase
- Currency depreciation leads to a reduction in the trade deficit
Formula of real exchange rate (p/b)
Nominal exchange rate (p/b) x [ CPI (b) / CPI (p)]
Formula of forward rate
F (p/b) = Spot (p/b) * [ (1+ib) / (1 + ip) ]
