exam 1 Flashcards
Endogenous Variables
Variables the model explains
exogenous variables
Variables the model takes as a given
Differences between CPI and GDP deflator
1) GDP deflator measures the prices of all goods/services produced while CPI measures the price of only goods/services bought by consumers
2) GDP deflator only includes goods produces domestically
3) CPI is computed using a fixed basket of goods where the GDP deflator allows the basket of goods to change overtime as the composition of GDP chances
Reasons the CPI tend to overstate inflation
1) substitution bias. When relative prices change the true cost of living rises less rapidly then the CPI
2) Introduction of new goods
3) Changes in quantity
Money Supply
quantity of money available in the economy
Monetary Base (B)
total amount of money held by the public as currency (C) and by the banks as reserves (R)
Monetary Base (B)=
B=C+R. Total amount of money held by the public as currency (C) + by the banks as reserves (R)
The monetary base is directly controlled by who
The Federal Reserve
Reserve-deposite Ratio and formula
is the fraction of deposits (π·) that banks hold in reserve (i.e., ππ=π /π·). It is determined by business policies of banks and the laws regulating banks.
Currency-Deposit ration (cr) and formula
is the amount of currency (πΆ) people hold as a fraction of their holdings of demand deposits (π·; i.e., ππ=πΆ/π·)
M= and B=
M=C+D
Money supply = money held by the public as currency + the fraction of deposits that banks hold in reserve
B=C+R
Monetary base= money held by the public as currency + money held by banks as reserves
Money multiplier (m) formula
m=(cr+1)/(cr+rr)
Money Supply (M) formula
M=B*m
Money Supply=monetary base * money multiplier
Conclusions from the model of money supply
(1) The monetary base (π΅) is proportional to the money supply (π), and grows by the same percentage rate.
(2) As the reserve-deposit ratio (ππ) decreases, the more loans banks make, and the more money banks create from every dollar of reserves. Therefore, a decrease in ππ INCREASES π and π.
(3) As the currency-deposit ratio (ππ) decreases, the fewer dollars of the monetary base the public holds as currency, the more base dollars banks hold as reserves and the more money banks can create. Thus, a decrease in ππ INCREASES π and π.
Tightening or contractionary monetary policy
-Tightening or contractionary
-Increases the policy rate FFR and IOR
-If using OMO, quantitative tightening
-Increases market interest rate
-Reduces the money supply
Easing or expansionary monetary policy
-Lowers the policy rate (FFR) and IOR
-If using OMO, quantitative easing
-Lowers market interest rates
-Increases the money supply
What is on the Fedβs Balance Sheet
Assets: securities and loans to financial institutions
Liabilities: Currency in circulation and reserves
The Fed can influence the money supply (M) by
influencing the monetary base and influencing the reserve deposit ratio
Influencing the Monetary Base includes
open market operations, lender of last resort, and discount rate
Open Market Operation
Influencing the monetary base (B; increase in B increases M (money supply))
Buying bonds -> selling currency -> B increases
Selling bonds -> buying currency -> B decreases
Discount Rate
interest rate the Fed charges on loans
if this rate falls its cheaper for banks to borrow from the Fed so B increases
Reserve Requirements
Influencing the reserve-deposit ration (rr; increase in rr reduces money multiplier and money supply)
Banks have to have a minimum reserve amount
An increase in requirements tends to increase rr but is less effective when banks hold excess reserves
Interest on reserves
nfluencing the reserve-deposit ration (rr; increase in rr reduces money multiplier and money supply)
paid to banks for holding reserves
if the rate rises its more beneficial for banks to hold reserves so rr increases
Floor vs Corridor System
In a floor system IOR (interest on reserves) becomes the policy rate
FFR=IOR, federal fund rate=interest on reserves
for floor the supply curves intersects the demand curve in its elastic portion causing plentiful reserves
Implications of Floor system vs Corridor system
much higher level of reserves in the system
swells the size of the CB balance sheet to undesirable proportions
loss of monetary policy control (Policy rate changes donβt induce monetary expansion or contraction as effectively as it did under corridor systems.)
When do bank runs occur
occur when depositors fear that they wonβt be able to access their money at the bank
Illiquid
assets>liabilities, but does not have liquid assets (cash) on hand at a specific time. Illiquid banks can be saved
Insolvent
assets<liabilities. βunderwaterβ. Most often happens when loans are defaulted on. If saved through a bailout, an insolvent bank cannot pay back the loan
Sunspot Theory
Depositors run because other run. Can happen anytime, anywhere, to any bank, regardless of how financially sound it is. A run on an individual bank leads to contagion and a banking panic, where runs happen on more or all banks.
Bad news Theory
Depositors run on a banks that are insolvent
Depositors watch bank activity to make sure their deposits are safe. If they think the bank is in a risky position (Too many bad loans, not enough reserves), they run.
Costs of Bank Runs
- Depositors lose deposits
- Shareholders lose out
- after the run, banks liquidate assets quickly to try and stay liquid
- assets are sold at low prices to move them quickly in fire sale losses - To borrowers: interrupts bank-borrower relationship
- For banking panics: money supply contracts and can cause recession in its own right
Benefits of bank runs
- runs on insolvent banks stop a βwealth destroying machineβ
- the threat of runs encourage banks to run a sound opperation
Why are bank runs bad?
If a run is conducted on a solvent bank and it is forced to close, there is no benefit to offset the harm.
A solvent bank could become insolvent in a crisis due to fire-sale losses
What are the intentions of FDIC?
It is intended to preserve public confidence in the banking system.
Therefore, mitigates large swings of the currency-deposit ratio (ππ), and allow the Fed to have more control over the money supply.
Costs of FDIC
Bail out insolvent savings and loans institutions. Moral hazard because as the likelihood of being bailed out for risky behavior increases, the cost of engaging in risky behavior decreases
Inflation
increase in the general level of prices
Hyperinflation
inflation at an extraordinarily high level
Quantity Theory of Money
MV=PT
-π is the quantity of money, and π is the transactions velocity of money per period of time, so ππ is also the number of dollars exchanged in a year.
-π represents the amount of transactions per period of time, and π represents the price of a transaction, so ππ represents the number of dollars exchanged in a year.
The dollar amount of an economyβs output (PY) is only affected by what?
the money supply (M)
Quantity Theory of Money with income instead of transactions
MV=Py
-π refers to total income (output), and ππ refers to the dollar amount of output.
-π now refers to the income velocity of money, or the amount of times a dollar bill enters someoneβs income in a given period of time.
Nominal Variables
expressed in terms of money
Real Variables
measured in physical units such as quantity or relative prices
Assuming MV is fixed what is the relationship between Y and P
MV=number of dollars exchanged in a year
Y= nominal output
P= price level
If Y increase P decrease and vise versa. Real supply shocks affect scarcity and therefore prices
Assuming Py is fixed what is the relationship between M and V
Py= dollar amount of output
M=quantity of money
V= income velocity of money or the amount of times a dollar bill enters someoneβs income in a given period of time
If M increase then V decrease and vice versa. If more money is introduced to the economy the speed at which individual units circulate will decline
Is inflation a tax?
Inflation is a tax on money holders.Government generates revenue at the expense of citizens
In a modern fully-monetized economy, that tax applies to everyone
Political economy of revenue generating fiscal tools
taxation, seigniorage, and borrowing
Fisher Equation
uses inflation to connect nominal and real interest rates
π=π+π
.
π is the nominal interest rate.
π is the real interest rate.
π is the inflation rate.
Shoe-leather costs
the time and effort spent to minimize the effects of inflation on the eroding purchasing power of money.
Menu Costs
the transaction costs of changing menu prices in response to inflation.
Inflation and output in the short run
- Shoe-leather costs:the time and effort spent to minimize the effects of inflation on the eroding purchasing power of money
- menu costs:the transaction costs of changing menu prices in response to inflation.
- complicated financial planning
- unpredictability of relative prices
- rigid tax laws
Causes of Hyperinflation
Hyperinflation happens through excessive growth in the money supply.
Typically initiated to finance government debt.
Hyperinflation causes tax revenue to fall, as there is a delay between time taxes are issued and the time tax revenue is received.
Thus, there is a greater need for the govβt to finance the debt by increasing the money supply.
Deadly Downward Spiral Ensues!!
Consequences of Hyperinflation
Menu prices become incredibly large.
Extreme inconvenience and shoe-leather costs.
Hyperinflation could decrease revenue due to lags between the issuing of taxes and the retrieval of tax revenue.
Relative prices are distorted, affecting the ability to reflect relative scarcity.
Currency ceases to function, as barter becomes more feasible as a means of exchange.
Natural Rate of unemployment
the normal rate of unemployment around which the economy fluctuates
Frictional unemployment
The time it takes workers to search for a new job is frictional unemployment.
Ways to reduce and increase frictional unemployment
Reduce: government agencies advising job opening, industry shifts, and offering career training
Increase: unemployment insurance and welfare schemes. By making unemployment less costly, people tend to remain unemployment longer
Structural unemployment
Unemployment from sticky wages and job rationing
Cyclical Unemployment
Cyclical movements of the unemployment that correspond to business cycle fluctuation
Why are Wages Sticky?
- minimum wage laws
- higher minimum wages creates higher unemployment
Sticky prices
When labor supplied exceeds labor demanded, firms must ration scarce jobs among workers.
Wages are sticky to downward movements
European labor market vs US labor marker
- higher unemployment
- less hours works
- caused by more unions, higher tax rates, and extensive welfare
