Exam #2 Flashcards
What is a Fractional Banking System ?
A system in which banks hold a fraction of their deposits as reserves. Fractional reserve banking systems create money but doesn’t create wealth: Bank loans give borowers some neew money and an equal amount of debt.
Money Multiplier
the increase in the money supply resulting from one-dollar increase in the monetary base
What is the Velocity of Money?
the rate at which money circulates
the number of times the average dollar bill changes hands in a given time period
Velocity of Money Equation
V= (P*Y)/M
where V=velcoity, T=value of all transactions(Nominal GDP P*Y), M=Money supply,P=Price of output(GDP deflator), Y=Quanity of output(real GDP)
Fisher Equation
i=r+(pi); therefore an increase in pi (inflation) causes an equal increase in i. one for one effect
The oppourunity cost of holding money
the oppournity cost of holding money is the nomial interst rate,i.
Benefits of Inflation
Inflation allows the real wages to reach equilibrium levels without nomail wage cuts. Therefore moderate inflation improves the functioning of labor markets.
Nominal wages are rarely reduced even when the equilibrium wage falls. This hinders labor market clearing.
Costs of Inflation
- the shoeleather cost:the costs and inconveniences of reducing money balances to avoid the inflation tax. If inflation ^ then i^ which causes real money balances to decrease
- Menu Costs:the costs of changing prices-the higher the inflation the more frequently firms must change their prices and incur these costs
- Relative price distortions:
- Unfair Tax Treatment: some taxes are not adjusted to account for inflation such as the capital gains tax.
- General inconvenience: Inflation make it harder to compare nominal values from different time periods.
- Arbitrary redistribution of purchasing power
- Increased Uncertainty: when inflation is high, its more variable and unpredictable.
Quantity of Money Theory
Quantity of Money Equation= M*V=P*Y, pi=inflation=(DeltaM/M)-(DeltaY/Y);
Normal economic growth requires a certain amount of money supply growth to facilitate the growth in transactions. Money growth in excess of this amount leads to inflation. DeltaY/Y depends on the growth in the factors of production and technological process.
IS Curve
The IS curve represents equilibrium in the goods market.
Y= C(Y-_T)_ + I (r) + G underline indicates constant
Okun’s Law
Okun’s law: the negative relationship between GDP and unemployment.
Three Types of Unemployment
Natural Rate of Unemployment;Fricitonal Unemployement; Structural Unemployment
Money
is the stock of assets that can be realiy used to make transactions
Functions of Money
Medium of exchange: we use it to buy things;Store of Value:transfers perchasing pwer from the present to the future; Unit of Account:the common unit by which everyone measures prices and values.
Types of Money
- Fiat Money: has no intrinisic value(paper currency)
- Commodity Money: has intrinsic value(gold coins)
Monetary Control
Monetary policy is conducted by the central bank(Federal Reserve). To control the money supply the fed uses open market operations, the puracase and sale of government bonds
Reserves (R)
the portion of deposits that banks have not lent
Implications of the Quantity theory of money
the quantity theory of money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. Implies two things: (1) counties with higher money growth rates should have higher inflation rates. (2) The long-run trend in a country’s inflation rate should be similar to the long-run trend in the country’s money growth rate.
Real interest rate,r, adjusted for inflations
r=i-(pi); S=I which determines r
Quanity Theory of Money Summary
Quantity theory of money -assumes velocity is constant - concludes that the money growth rate determines the inflation rate - applies in the long run -consistent with cross-country and time-series data
Costs of Inflation
Costs of inflation Expected inflation shoeleather costs, menu costs, tax & relative price distortions, inconvenience of correcting figures for inflation Unexpected inflation all of the above plus arbitrary redistributions of wealth between debtors and creditors
Fricitonal Unemployment
frictional unemployment: caused by the time it takes workers to search for a job
- occurs even when wages are flexible and there are enough jobs to go around
- occurs because
- >workers have different abilities, preferences
- >jobs have different skill requirements
- >geographic mobility of workers not instantaneous
- >flow of information about vacancies and job candidates is imperfect
Reasons for wage rigidity
Reasons for wage rigidity 1. Minimum wage laws 2. Labor unions 3. Efficiency wages
Natural Unemployement
the long-run average or “steady state” rate of unemployment; depends on the rates of job separation and job finding
Structural Unemployment
results from wage rigidity: the real wage remains above the equilibrium level caused by: minimum wage, unions, efficiency wages
The Keynsian Cross
A simple closed economy model in whihc income is determined by expenditure.
I= planned investment
PE= C +I + G = planned expenditure
Y= real GDP= actual expenditure
The difference between actual and planned expenditure = unplanned inventory investment
Government Purchases Multiplier
The increase in income resulting from a $1 increase in G. The mulitplier is generally greater than 1.
∆Y/∆G = 1/ (1-MPC)
MPC - marginal propensity to consume
Implciations of Flexibile/Sticky Prices long/short run
In the long run prices are flexible, outut and employment are at their natural rates and the classical theory applies
In the Short run prices are sticky, shocks can pus output and employment away from their natura lrates.
When Prices are sticky
When prices are sticky output and employement depend on demand, which is effected by Fiscal Policy ( G and T), Monetary Policy (M), and exogenous changes ( C or I).
Tax Multiplier
The tax multiplier is negative: A tax reduces C which reduces income.
The tax mulitplier is greater than 1 because a change in tax has a multiplier effect on income
The tax mulitplier is smaller than government the government spending multiplier: Comumers save the fraction of a tax cut so the intital boost in spending from a tax cut is smaller than from an equal increase in G.
LM Curve
the LM curve represents the money market equilibrium
M/P= L(r, Y)
the intersection determines the unique combination of Y and r that satisfies equilibrium in both markets
The Phillips Curve
Phillips curve is derived from the SRAS curve
- states that inflation depends on expected inflation, cyclical unemployment, and supply shocks
- presents policymakers with a short-run tradeoff between inflation and unemployment
What shifts the IS curve?
Changes in Government Purchases or Taxes- increase/decrease in taxes or government spending
IS Curve Shocks:
- Stock market boom or crash -> change in wealth will change consumption
- Change in consumer confidence or business confidence will cause a change in I or change in C
What shifts the LM curve?
Changes in Monetary Policy- an increase/decrease in money supply
LM Shocks: a wave of credit card fraud may increase the demand for money.
More ATMs or the internet reduce the money demand
What is a supply shock & give examples?
A supply shock alters production costs and affects the prices that firms charge.
Examples of Supply Shocks are:
- Bad weather reducing crop yeilds, increasing food prices
- Works unionize increasing wages
- New environmental regualations that require emission reductions. Firms must increase prices to cover compliance costs.
Favorable Supply Shocks LOWER costs and prices
IS-LM Model
Can be used to analyze the effects of fiscal policy ( G and/or T) and Monetary Policy (M).
In the Long Run
In the long run prices are flexible, output is determined by factors of production & techonology, unemployment equals its natural rate.
In the Short Run
Prices are fixed, output is determined by aggregate demand, unemployment is negatively related to output
