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UNI 2 > Final Macroeconomic > Flashcards

Final Macroeconomic Flashcards

1
Q

Value of Each Growth Theory

A

1. Classical theory reminds us that our physical resources are limited, and we need technological advances to grow.
1. Neoclassical theory emphasizes diminishing returns to capital which means we need technological advances to grow.
1. Endogenous growth theory tries to explain productivity or technological growth within the model (endogenously).
1. New growth theory emphasizes the capacity of human resources to innovate at a pace that offsets diminishing returns.

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2
Q

Classical Growth Theory: Assumptions+Implications+Limitations

A

Main Idea: subsistence level contains population growth

Assumptions
- diminishing marginal returns to inputs
- population growth responds to income levels ( IE, increased output leads to increased population growth )
- fixed nature of natural resources, subsistence level of real GDP & wage

Predictions:
- When real GDP per capita rises above subsistence level a population explosion will bring it back down to subsistence level
- As population grows real wage falls until it hits subsistence level where population+economic growth stop

Implications
- we will always return to a subsisting ( just being able to survive) level of living as the population will grow in response to increases in GDP till GDP per capita returns to subsistence, must contain population

Limitations
- doesn’t take into account the increase in technology, which minimizes DMR, allows the rate of output to outstrip population growth and allow for higher stadnerds of living
- Importance of Labor: Mathluthisan-labor is beneficial up to a limit → (China’s Growth didn’t drive incomes back down to subsistence levels) → Solow-refute
- Inaccurate determination of total wages, didn’t consider how trade unions & demand impacts wages

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3
Q

Neoclassical Growth Theory: Assumptions+Implications+Limitations

A

Basic Idea: tech advance as key driver of growing long-term living standards, savings & investment super important, eventually output growth will only be driven by population growth until a shock occurs, c k y are constants determined by kSS

assumptions
- A,n,s,d is exogenous
- the economy is closed, and there are no government expenses
- tech affects economic growth+k growth not vice versa
- output produced annually is invest in new capital or in replacing depreciated capital (It), uninvested part of output is consumed by population (Ct)
- there are diminishing marginal returns to facts of production& constant returns to scale

limitations
- A is exogenous when it is affected by human & physical capital, wealth orR&D or technology
- not all forms of capital exhibit diminishing marginal returns

Implications
- there is a conditional convergence of K/L ratio amongst state. Rich countries will grow K slower than poor countries until, eventually, every country will reach a steady state with similar levels of K/L. The condition is that these countries demonstrate similar Saving rate
- factors affecting long-run standard of living, how rate of economic growth evolves over time

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4
Q

Endogenous Growth Theory: Assumptions+Implications+Limitations

A

Key Difference b/w Solow:
- economic growth is generated internally through endogenous forces (A is endogenous derived from model in terms of s,H, R&D not given or constant) & attacks assumption of diminishing marginal return of capital as capital used properly will increasingly increasing return k
- No steady state if graphs never intersect

Derivation:
1. Sn=sAK=sY
2. K_t+1=K_t+I-dK
I=K+K net investment+depreciation
3. sAK=K+K
k=changeK/K=changeY/Y=sA-d since gy=gk

assumptions
- technology (A) generated from within the economyso production function is not diminishing but constant (alpha>=1) y=Ak, MPK=A, dA/dk=Constant Marginal Return
- number of workers remains constantso growth in output/capital per labor equal
- closed economyimplications
- The growth of a country depends on rates of savings and investmentsg_Kss=g_A=g_RD+g_I=S
- the growth rate of output per worker = growth rate of output. Therefore, there are no diminishing returns to capital. Instead, MPK depends on technology levels, not K stock
- there are increased returns to scale in investments in human capital and private sector R$D ( this lasts because the private sector is motivated by growth)

Implication:
- Constant Determinants of Economic growth rate depends on savings rate, investment (R&D-generated by increasing K & offsets any tendency for MPK to decrease), Human capital not only exogenous productivity growth
Increasing returns to scale from capital investment in knowledge industries (edu, health, telecomm.)

limitations
- technological advancement is limitless ( exponential). This is not necessarily true
- does not take into account market failures generated by externalities. ( growth of technology leads to pollution, leads to a decrease in productivity)

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5
Q

New Growth Theory: Assumptions+Implications+Limitations

A

Basic Idea: Long run growth (y=real GDP per capita) grow because of choices that people make in the pursuit of profit and growth can persist indefinitely a perpetual motion machine

Assumptions
- Knowledge is not subject to diminishing returns
- Discovery result from choices, brings profit if patented or else is a public capital good, competition destroys profit & knowledge is not subject to DMR as increasing its stock makes L & K more productive (increases MPK+MPL)t
- Graph + Sala Table

implication
- real GDP per person grows because of choices that people make in the pursuit of profit, and that growth can persist indefinitely
- growth is a perpetual motion machine. Innovation -> new and better products and techniques -> better jobs and more leisure time -> higher standard of living -> want for an even higher standard of living ( choices in pursuit of self-interest) -> innovation

limitations
- New growth theory assumes that knowledge and innovation generate increasing or constant returns to scale, meaning that the more an economy invests in R&D or human capital, the higher the returns. However, in reality, diminishing returns to knowledge and innovation might occur. Not all investments in education or R&D lead to groundbreaking innovations, and knowledge may not always spill over efficiently to the entire economy.
- it is challenging to measure knowledge, human capital, or the effects of innovation.
- there are so many different things you could quantify as the determinants of growth, including (the environment, politics, civil liberties, etc)

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6
Q

How does an open economy change the IS-LM-FE

A

Open Economy: intl. Trade of g+s & world integration of financial mkts (capital flow) & currency appreciation/depreciation
- IS gets impacted by C+I+G+Nx from intl trade of g+s
- Currency appreciation/depreciation occurs from integration of financial markets

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7
Q

Nominal v. Real Exchange Rate + Formulas

A

Nominal Exchange Rate enom=# Foreign Currency/1 Base Currency: number of units of foreign currency can be purchased with a unit of domestic current

Real Exchange Rate: e=(enomxP_Domestic in Nominal Currency)/P_Foreign in Foreign Currency
price has an effect on currency (higher→ depreciates, lower → appreciates), number of foreign goods someone gets in exchange for one domestic good based on CPI/Price indexes of “baskets of goods assuming each country produces a single good
* Law of 1 Price: g+s priced same everywhere
* Affect’s nation’s net export, represents rate at which domestic goods can be traded for foreign goods → higher e means lower Nx, lower e means higher Nx
* Indicator of a country’s productivity relative to other

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8
Q

Calculate real exchange rate given e_nom=78Y/$ hamburger. Price of domestic $3 hamburger, Price of foreign 312Y hamburger.

A

0.75Y hamburger per $ hamburger

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9
Q

Exchange Rate Systems Differences

A

Exchange Rate Systems - Who Determines Exchange Rates

Flexible/Floating: no gov role, continuously adjusted by conditions of supply & demand in foreign exchange mkt
- Appreciation: enominal falls, buys less units of foreign currency, becomes “weaker”
Real Appreciation: incr in real exchange rate, same quantity of domestic goods can be traded for more foreign goods
- Depreciation: enominal rises, buys more units of foreign currency, becomes “stronger”
Real Depreciation: decr in real exchange rate, same quantity of domestic goods can be traded for less foreign goods
Depreciation: enominal rises, buys more units of foreign currency, becomes “stronger”

Fixed: set at officially determined levels maintained by commitment of nations’ central banks to buy & sell their own currencies at fixed rate
- Revaluation=appreciation: D>S
- Devaluation=depreciation: S>D

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10
Q

Purchasing Power Parity (PPP) + Derivation

A

Purchasing Power Parity (PPP): similar foreign & domestic goods should have same price in terms of the same currency (e=1) ignoring transpo & transaction costs. Very weak as assumes e=1 occurs only in very long run

enom=P_Foreign/P_Domestic

Derivation: incr in real exchange rate, same quantity of domestic goods can be traded for more foreign goods
e=enomP/PForeign Growth Accountingee=enomenom+PP-PForeignPForeign
enomenom=ee+foreign-=relative PPP is enomenom=foreign-

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11
Q

4%=6%(JAP)-2%(CAN), which country has more depreciation & appreciation

A

Countries with more inflation has higher depreciation/weaker, while the other with less inflation appreciates/stronger currency

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12
Q

Nominal & Real Expected Gross of Return on Foreign Bond (EGNR) + Derivation

A

Expected Gross of Return on Foreign Bond (EGNR) determines investment decisions in open financial asset mkt, assumes e=0
- Nominal: enominalfuture=enom(1+iforeign)(1+idomestic)
- Real: erealfuture=e(1+rforeign)(1+rdomestic)
i-nominal interest rates in foreign relative to domestic
Expected changes to exchange rate
- Derivation:
Interest Rate Parity: difference in returns don’t last long as i equalizes
Nominal: equilibrium for intl. asset mkt enomefnom(1+ifor)=1+i
Not Changing/Same Nominal Exchange Rate iDomestic=iForeign
Real: eefuture(1+rForeign)=1+r
Not Changing/Same Real Exchange Rate (e=efuture)rDomestic=rForeign

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13
Q

Given info solve for real exchange rate and solve for nominal exchange rate assuming PPP holds

CPICAN=125
CPICHINA=475
enom=5.5Y/$
CAn=2%
CHINA=8%

A
  1. Solve for real exchange rate:
    e=enomPPforeign=5.5125475=1.45
  2. Solve for nominal exchange rate assuming PPP holds: e=1 %enom=foreign-
    6%=8%-2%
    New enom=(1+%enom)old enom=(1+6%)5.5=5.83
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14
Q

Which country like which exchange system?

A

Fixed: large benefits from incr. Trade & integration, monetary policy coordinated closely
* Neutralizes: effects of fiscal policy & shocks to IS curve,
* Magnifies: monetary policy+shocks to LM curvef
* Currency Unions: share common currency by a group of countries reduces cost of trending, prevents speculative attacks on currencies, however monetary policies cannot be independent

Flexible: specific macroecon. shocks reduced by monetary policy
* Sensitivity to shocks increases for small open economy, allows correcting mechanisms of price level & e adjustment,
* Neutralizes: monetary shocks
* Magnifies: fiscal policy

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15
Q

Open Economy Mundell-Fleming Trilemma + Example

A

Only ⅔ features can be manipulated:
1. Fixed exchange rate to promote trade
1. Open capital marketsFree intl. movement of capital
1. Autonomy of monetary policy domestically.

Fixing currency and stabilization require opposing monetary policy.

For example, if a country pegs its exchange rate to another country and capital is free to move, the domestic interest rate will be forced to equal the interest rate in the base country

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16
Q

3 Policies to Fix Overvalued & Undervalued Currency

Fixed/Goal: 1USD/1CAD

A

Current: 0.8USD/1CAD undervalued/depreciated, worth less than wanted enom<efixed
1. Buy back/gatekeep domestic:MDdom>MSdom=enom
1. Float/Sell Foreign currency: MDforeign<MSforeign=foreign enom=domesticenom
1. Restrict intl trade

Current: 1.2USD/1CAD overvalued/appreciated, worth more than wanted enom>efixed
1. Float/Sell Domestic: MDdom<MSdom depreciate enom
1. Stop transactions
1. Buy/Gate Keep Foreign Currency: MDfor>MSfor appreciate foreign currency so domestic currency falls enom
1. Restrict intl trade

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17
Q

Overvalued v. Undervalued Exchange Rate

A

Overvalued e:
enom>efixed appreciated, worth more than fixed/wanted/mkt determined, support by

Undervalued e:
enom<efixed/mkt depreciated worth less than wanted/mkt determined, maintained forever if nation’s trading partners don’t lose reserves

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18
Q

Speculative Run

A

ending support for overvalued run by investors who sell assets denominated in overvalued currency to avoid losses (
S)

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19
Q

Fiscal Expansion in Flexible v. Fixed Exchange System

A

Flexible - Ineffective: fails Immediate Crowds out Nx, Y P rd=rf stays constant
ADIS shift right
rd>rfore appreciatescrowds out NxIS shift left until
rd=rfor, no change in Y & P

Fixed - Effective: Classical: Immediately P & e incr. & Nx crowded out, Keynesians say works in SR not in LR

Short Run: price & exchange rates fixed, fiscal policy effective for adjusting output

Long Run: P e increases due to fiscal+monetary expansion & crowds out Nx falls
ADIS shift right
rd>rforefixed appreciates>enom undervalued

To enomLM shift right so rd=rf

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20
Q

Monetary Expansion in Flexible v. Fixed Exchange System

A

Flexible-Effective:
Mundell using Keynesian Model:
LM shift rightrdom<rfore depreciates
NxADIS shift r until rd=rf
Result: effective, Y incr., r same

Classical: money neutrality holds immediately

Keynesian Model Predicts won’t work in long run-further adjustments in long term
ADY>Y potential=inflationary pressure P
LM=MP shift leftrd>rf=e appreciates
Nx=ADIS shifts left until rd=rf
Result: P incr., Y r Nx e same in long run, money neutral

Fixed-Ineffective:
LM=MS^/P shift rightrd<rf
=e depreciate
enom>efixed actual worth more than fixed

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21
Q

Munell-Fleming Model Key Takeways

A
  1. Monetary or Fiscal Depends on System: The efficacy of monetary and fiscal policies under different exchange rate regimes. In a fixed exchange rate system, fiscal policy is more effective than monetary policy. An increase in government spending directly impacts aggregate demand and output
  2. Trillema: A country cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. This is also known as the “policy trilemma” or “unholy trinity”.

Assumptions: PPP, perfect substitutes, small & open economy

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22
Q

Close+Open Economy IS Curve + Derivation/Slope + Shifts + Graphs

A

Closed: S=I, shows at every Y & r where the goods mkt is in equilibrium
* Derivation/Downward: as Y/r incr. the goods mkt equilibrium decr., Each Y/r incr. → savings incr. curve shifts right/investment curve decr. shifts left →moving the equilibrium (S=I) r & Y lower and lower
* Shift: at a constant output, anything that impacts AD, reduces desired S relative to I from Y=C+I+G (ex. Temporary incr. in gov expenditure with Y constant decr. SNational shifting curve left → higher equilibrium INT rate → IS curve shifts up)

Open: Good Mkt Equilibrium S^d-I^d=Nx
- As r incr. = S-I upward sloping, Nx downward sloping
- Downward Sloping: same reasons as closed economy (C+I+G) + effects on Nx
rInvestment into currency SMDD>S AppreciationNX=X-M=Y
YTransactions=MD=Nx shift left=SNational=S-I shift rightr equilibrium
- Shifts: factors that change AD=C+I+G & Nx = changes r clearing goods mkt at constant level of output
- Graphs: see doc

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23
Q

Business Cycle + Elements + Importance

A
  1. Fluctuation of actual GDP/aggregate economic activity around Normal growth path/potential/full-employment GDP
  2. Expansions, contractions, trough, peak
  3. Persistence: beginning of expansion/contraction tends to continue for a period of time

Importance: interpreting data & state of economy, guidance & discipline for developing econ. Theories of BC

Direction in which macro variable moves relative to direction of BC
* Pro: same direction (+)
* Counter: opposite direction (-)
* A: no clear pattern

Timing of variable’s turning points relative to turning points of BC for prediction
* Leading Variable: turns before BC turns
* Coincident Variable: turns same time as BC turns
* Lagging Variable: turns after BC turns

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23
Q

Keynesian v. Classical differences on Business Cycle meaning, speed of econ, monetary policy, money neutrality SR & LR

A

BC: Reps. disturbances in production & spending driving econ. Away from desirable level of output+employment for long periods of time due to wages & prices adjusting slowly → gov needs to intervene to put back GDP into potential GDP v. Reps. econ.’s natural phenomenon and best response to disturbances in production & spending

Speed: slow sticky P+W v. fast P flexible

Monetary: to slow focus on fiscal v. neutral LM shifts back very quickly from P flexible

Money Neutrality: SR not neutral v. money always neutral. Both agree higher MS=Higher Prices

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23
Q

LM Curve in Closed + Open Economy + Slope/Derivation + Shifts + Graphs

A

LM Curve: Asset Mkt Equality of Money Demanded & Supplied, relation b/w Y & r that clears the asset mkt, each point of the curve is where MD=MS

Closed
Upward Sloping: higher Y → more transactions → MD demand → equilibrium incr.
* MS Vertical: doesn’t depend on INT fixed
* **MD Downward **Sloping: higher r, attractiveness of money decreases
* Shifts: anything that changes real MS/MD relative to real MD/MS other than Y & r will impact r that clears mkt causing LM shift, usually moves due to price level adjustments to meet general equilibrium point. (ex.incr. MS → excess supply causes purchasing nonmonetary assets —> prices go up → decr. equilibrium r → curve shifts down right)

Upward Sloping LM: YMore transactions=MD → equilibrium r=LM positive sloping
MD Downward for Dollars Curve - Downward Sloping (higher e less buying domestic/more expensive): to to buy CAN goods, real + financial assets
MS Upward of Dollars Curve - Upward Sloping (higher e more buying foreign/cheaper): to buy foreign goods, buy real + financial assets in foreign countries

Shifts: any price adjustments required for new equilibrium

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24
Q

Income, Quality, Real Interest Rate Effects on Exchange Rate

A

Income Effects:
Domestic Output Rise YDomesticMore transactions=M>X=MDdomestic & MDForeign domestic currency depreciates/exchange rate falls Nx
Foreign Output Rise YForeignM=MDDomestic=MDforeign → domestic currency appreciates/exchange rate rise XDomesticNx
Quality Effects → More Demand for Currency=Rightward Shift of Demand
Real Interest Rate Effects on Exchange Rate:
Domestic r Rises=MD Rise: domestic country’s real & financial assets more attractive for investment, exchange rate appreciates (enom rises) reduces Nx
Foreign r Rises=MD Fall: supply of domestic currency incr., exchange rate depreciates, (enom lowers) incr. Nx

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24
Q

Conversion Formula: Given 3 month interest rate convert into annual

A

=i3 month domestic/12 months *3 months

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24
Q

Fiscal & Monetary Policy in IS-LM-FE + Graph

A

Fiscal Policy IS - r incr.: Expansion=G incr or T decr..
Short Run: incr. I or decr. S → r incr. → IS shifts up right → AD rise → P rise
Multiplier Effect & Crowding Out Effect Cancel out
Long Run: P incr. → LM shift left to new general equilibrium

Monetary Policy LM - Shifts back: Expansion=Incr. MS
Short Run: LM=MS/P shift right/incr. (P fixed) → IS-LM-FE equilibrium r decr. → AD rise exceeding full employment production → P incr.
Long Run: P incr. → LM=M/P shifts back decr./left
Result: change in nominal money supply causes the price level to change proportionally

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24
Q

Stabilization Policy

A

Stabilization Policy: use of fiscal & monetary policy to shift position of IS & LM to offset effects of such shocks

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25
Q

Investment Strategy for Adverse/Positive Supply Shocks

A

Negative/Adverse Supply Shock: lower GDP & higher prices
* Reduce investment in fixed income securities, most equity securities
* Incr. investment in commodities/based companies as profits likely to rise

Positive Supply Shock: higher GDP & lower prices
* Incr. investment in fixed income securities, most equity securities
* Decr. investment in commodities/based companies as profits likely to rise

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26
Q

Temporary Adverse Supply Shock=FE Line Shifts Left=Stagflation

A

FE/MPL decr. → Less Supply=P incr. (not IS shift, movement along) → LM=M/P decr. Shift left to general equilibrium point

Graph in doc

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27
Q

Investment Strategy Depending on IS Shift

A

Rightward Shift = Expansion or Fiscal Policy G incr. or T decr:
* Reduce investments in defensive companies/low risk & fixed-income longer-maturity securities (bonds)
* Incr. investments in cyclical companies, commodities, speculative/junk bonds as decr. in its default risk

Leftward Shift = Contraction or Fiscal Policy G decr. Or T incr.:
* Reduce investments in cyclical companies, commodities, speculative/junk bonds as decr. in its default risk
* Incr. investments in defensive companies/low risk, fixed-income longer-maturity securities (bonds) & investment-grade or government-issued fixed income securities

Higher price of asset the lower its nominal interest rate given the promised schedule of repayments
Price of a Nonmonetary asset (bonds) & r are inversely related for a given rate of inflation

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28
Q

FE Line Closed/Open

A

Vertical=regardless of r, output is at full employment level

Factors That Move Along Line: changes in r

Shift: Factors that cause Sustainable GDP Growth & AS =Shift FE: Y=AKLH
* Current level of labor L: immigration
* Capital K: investment
* Productivity MPK, MPL,MPH: technology

29
Q

Bank v. Overnight v. Settlement Rate

A

Bank Rate: INT of lended funds from BoC to domestic banks

Overnight Rate: INT b/w domestic bank transactions controlled by BoC

Settlement Balance Rate: INT gained by domestic banks for depositing in BoC

30
Q

Assets in the Asset Market

A

Assets Make up Asset Market: markets where people buy & sell real & financial assets (ex.Gold, Houses, stocks, bonds)
Monetary: money widely used, accepted as payment
Money: highly liquid, inflation risk, short term to maturity
Non-Monetary: bond, excess money
* Bonds: much bigger than stock mkt, differing default risk, term to maturity & liquidity
* Stocks: dividends not guaranteed, substantial price fluctuations, most shares in large corporations is liquid, no maturity
* Real Estate: very illiquid, provides shelter services, no maturity unless buy sell

31
Q

Bond Value (PV) v. Bond Yield Yield (r) negative relation

A

PV=FV/(1+r)^t

See doc for full timeline

  • Bonds: Lending money to government or firm to investment projects
  • Face Value: amount lent, price of bond at the time is was issued -
  • Maturity: when amount lent/face value will be returned (30-100 years usually) - 1 yr
  • Coupon Value: feature of bond depending on the interest offered, bond yield - $5
  • Money Returned = Face Value + Coupon
  • Yield Rate = (Money Return-Face Value)/Face Value
  • Interest Rate: interest received expressed as a % of the price of the asset i=Interest ReceivedPV, Interest Received=iPV Ex. (PV $50, Interest $5, Interest Rate 10% → PV $200 Interest rate 2.5% → PV $20 interest rate 25%)
  • Present Value: future return adjusting to inflation every year
  • There is an inverse relationship b/w the price of a bond & the nominal interest rate
  • Bond Price =C/(1+i)+C/(1+i)2+… +C/(1+i)m-1+C+F(1+i)M, C=coupon, F=face value, m=maturity
  • Opportunity Cost: When the market interest rate on comparable bonds rises, the price of existing bonds falls. When market interest rate on comparable bonds falls, the price of existing bonds rises
  • Interest Rate & Present Value Inverse Relation: Interest rate rises, opportunity cost increases for alternatives, less demand, price falls, Present Value falls, vice versa occurs
    Caution:
    Semi-annual: 2 installments per year dividing return in half
32
Q

Velocity + Equation

A

Velocity: real money demand is proportional to real income
V=(PY)/M, PY=Nominal GDP
MV=PY–> %M=pi+%Y, Central Bank can control inflation & GDP manipulating money supply

V Velocity: fixed/constant very volatile how many times a dollar changes hand, speed that money moves → more movement more economic activity
M Nominal Money Stock
Y Real Income
P Price Level

33
Q

Quantity Theory of Money

A

Quantity of Theory of Money: (Md)/P=kY,k=1V,kY=L(Y,r+e) assuming V is constant/fixed/exogenous/not dependent on anything
M/P=L(Y,r+pi^e)

34
Q

3 Functions of Money

A

3 Functions of Money: debit transactions, deposits, cash (not cheques;instructions to transfer, credit cards/debt;obtain loans to be repaid with money)
1. Medium of Exchange: deceive for transactions at less cost in time+effort
1. Unit of Account: basic unit measuring economic value
1. Store of Value: way of holding wealth

35
Q

Money Aggregates

A

Money Aggregates: measures of money stock, money circulating in an economy to satisfy its current monetary need

(Smaller the number, the more liquid)

M1+: a means of exchange, checking account balances + currency (are all means of payment/money)
M2: M1+personal & non-personal non-chequable deposits (some are not means of payment/liquid assets)
M3: a way to store value, M2+non-personal term deposits held by businesses & foreign currency deposit of CAN residents

36
Q

Liquidity + Turnover

A

Liquidity: property being instantly convertible into means of payment with little loss of value (money is most liquid)

Illiquidity/Liquidity: how quickly can asset be converted into money before mkt price changes

Turnover: how often traded, sold, bought, high cost/expenses for fees increases as turnover increases

37
Q

Money Supply + Who Controls

A

Money Supply: amount of money available in economy partly/indirectly set by central bank, influenced by:

OMO - Open Mkt Purchases+Sales of Gov Bonds to Public: low interest rates=more money by buying bonds injects money into the money market v. high interest rates=increasing the money supply by selling off bonds, pulling money out of the money market and decreasing the money supply.
* Incr. MS: BoC buys bonds from public to inject more money into circulation (Reason why US encourages foreigners to hold bonds)
* Decr MS: BoC sell bonds which public buys to pull money from circulation

Financing Own Expenditures by PRINTING MONEY - Purchase & Selling Gov Bonds Directly To GOV: reduces inflation

38
Q

Portfolio + How is it decided

A

Portfolio: set of assets of a wealth holder (for now just bonds & cash as perfect substitutes) decided based on
* Expected Return: (E(r)=Share of Profit+Capital Gain): rate of increase in value per unit of time (ex.20% if $10-$12), best guess of return of an asset, higher the more desirable and will want to own
* Risk: chance actual return differs from expected return assuming an individual is risk-averse, higher the more undesirable
* Liquidity: Liquidity: property being instantly convertible into means of payment with little loss of value (money is most liquid), more liquid more attractive
* Time to Maturity:

39
Q

Expected Return of Stock, Bond, Porfolio

A

Stock=Dividend paid by stock+Incr in Stock’s price=Dividend Yield+Capital Gain
* Dividend: profit share
* Capital Gain: profit after tax from selling stock

Bond=Coupon+Capital Gains+Income from reinvested coupon

Stock or portfolio - Risky Assets: E(Ri)=riskfree rate+(market/systematic risk of stock) x irisk premium
- i Market/Systematic Risk of Stock i: mkt risk + non-mkt risk
- Market Risk Premium: compensation for taking additional riskexpected market= return-riskfree rate

40
Q

Risk Aversion & Utility Theory for Risky Assets

A

Utility Theory for Risky Assets: weighs the return v. risks U=E(r)-1/2Asigma^2
* E(r) expected return
* A aversion: Risk Aversion (A): investors prefer less risk if expected return equal, equally risk-averse prefer high expected return, not minimize risk as will take risk if higher return (premium), tradeoff
* Sigma portfolio risk

41
Q

Time to Maturity Theories + Which Theories Explain Upward Slope of Yield Curve

A

Expectations Theory of Term Structure: bonds of diff maturities are perfect substitutes, N-year bond expected returns equals avg return on 1 yr bonds during current year & the N-1 succeeding years (1+s2)2=(1+s1)(1+1f1) or (1+s5)5=(1+s3)3(1+2f3)2
- If theory is correct buying a 2-year bond will be equivalent to buying 1-year bond then another 1-year bond after first matures

Liquidity Preference Theory: extra compensation/risk premium for holding long-term illiquid bond

Preferred Habitat/Segmentation Theory: time of maturity chosen based on need (ex.Pension for certainty)

Upward Slope: Expectation Theory + Term-Premium Theory: explains upward slope of yield curve (yield v. maturity)

42
Q

Spot Rate+Forward+Formula & Duration

A

Spot Rate: return per yr depending on maturity of bond

Duration (INT sensitivity of bond): measure of interest rate risk for bonds (similar to elasticity), long-term bond prices are more sensitive=have higher duration
Duration 5.2 means if INT increases by 1% the price of bond will change by 5.2%

43
Q

Demand for assets

A

Demand for Assets: amount of each asset that wealth holder desires to include in portfolio, trade-offs made among the 4 characteristics that make asset desirable

Risk-Return Trade-Off: higher expected returns comes with higher risk, real returns are much more stable than nominal as inflation is very volatile/sensitive to stock market

44
Q

Asset Market Equilibrium + Condition

A

Asset Market Equilibrium: when quantity of assets demanded = (fixed) quantity of assets supplied assuming all assets may be grouped into monetary (M) & non-monetary assets (NM)
Md+NMd=Ms+NMs =aggregate nominal wealth
(Md-Ms)+(NMd-NMs)=0
Asset Market Equilibrium Condition:
M determined by central bank
Y & r determined by equilibrium conditions in labor & goods markets
Real Md=Real Ms
MP=L(Y,r+e)
P=ML(Y,r+e) explains how P is determined in long run
%P=%M-%L(Y,r+e)

See doc

45
Q

Rate of Inflation v. Nominal Money Supply

A

Rate Inflation is closely related to rate of nominal money supply → in the long run equilibrium Ms=Md there will be a constant growth rate of money=constant growth rate of interest
PP=MM-L(Y,r+e)L(Y,r+e)
=gMs-gMd
=MM-YYY
=gM-gY
In practice/reality, e and currente as long as Me and Ye, if policy actions cause a change in e, i=r+e nominal interest rate will change all else being equal

Graph in doc

46
Q

Finance v. Money

A

Finance: study of managing money/portfolio, how HH& firms obtain & use financial resources while coping with risks that arise

Money: medium of exchange, store of value, how HH & firms hold & use it, how banks create & manage it, how quantity influences the economy

47
Q

Physical v. Financial Capital

A

Physical Capital: tolls, instruments, machines, building, items produced in past used today to produce g+s

Financial Capital: funds firms use to buy physical capital, investment in business, outgrowing physical capital market as technology advances

48
Q

Net Investment Equation

A

Net Investment=Gross Investment-Depreciation=Kt+1=Kt+I-Dep

  • Gross Investment: total amount spent on purchases of new capital & on replacing depreciated capital
  • Depreciation: decrease in
  • Net Investment: change in quantity of capital
49
Q

Wealth v. Saving

A

Wealth stock value of all things that people own can change when mkt value of assets change or savings change Wealth=Assets(Savings)-Liabilities
- Capital Gains v. Looses: market value of assets rise/fall
-
Saving flow amount of income not paid in taxes or spent on consumption which flows to/increases wealth Savings=Disposable Income-Consumption-Taxes=YD-C-T
- Stocks, bonds, etc.

50
Q

Financial Capital Markets + Institutions

A

Markets: funds to finance investment in loan, bond, stock markets sourced from savings
* Money market: maturity (asset held on to) less than 1 year
* Capital Market: maturity (asset held on to) more than 1 year

Institution: firm that operates as intermediary b/w buyer & seller
Banks, trust & loan companies, credit unions/caisses populaires, mutual funds (portfolio of diverse shares grows with economy), pension funds, insurance companies (property, casualty, life, reinforcement)
* Management Fee/Management Expense-Ratio:
* Book Value: initial $1000 return
* Current Value=Market Value=Net Asset Value

51
Q

Nominal v. Real Interest Rate

A

Nominal Interest rate(% of dollars borrowed/lent): dollars borrower pays and lender receives in interest in a year NR=rPV100%=(1+RR)(1+e)-1

Real Interest Rate: nominal interest rate removing effects of inflation on buying power of money NR-e=RR

52
Q

Where do funds come from for finance investment

A

SNational=I=SPrivate+(T-G)+(M-X)
=Household Saving+Gov Budget Surplus+Borrowing from Rest of World
* X-M Explanation 1: Import>Export, owe money, invested in you, borrowed from rest of world Ex>Imp more income to loan out to rest of world
* X-M Explanation 2: Y=C+I+G+X-M+T-TI=Spvt+(-Sgov)+M-X
* X-M Explanation 3: Balance of Payments Current Account Deficit=Financial Account surplus, vice versa, spend more money foreigners will give you more, spend less money give to foreigners.

53
Q

Desired Consumption & Saving

A

Desired Consumption: aggregate quantity of g+s HH want to consume given income & other factors closely linked to desire to save I=Sd=Y-Cd-G, only Cd is controllable

Desired National Saving: level of national saving when when aggregate consumption is at desired consumption

54
Q

Determinants of Saving (Supply of Loanable Funds)

A
  1. Current Income After Tax YD=Y(1-t)
  2. Expected Future Income
  3. Wealth
  4. Default Risk
  5. Real Interest Rate
  6. Tax Rate in Interest
  7. Fiscal Policy

See doc for effect

55
Q

Lifetime Budget Constraint + Implications on tradeoff, impatience, consumption smoothening, equilibrium r, substitution v. income effect.

A

Young: work→ consume using Income C1=Y1-S, S=Y1-C1
Old: don’t work → consume using savings C2=S=Y1-C1
Assumptions: Tax=0, no inflation, patience, kids, pension, etc.

**Lifetime Budget Constraint **Y1=C1+C21+r looks like present value equation PV=FV(1+r)t

56
Q

Investment of Loanable Funds

A

Investment/Demand of Loanable Funds; present & future trade-off by committing resources now to increase capacity to produce+profits in the future. Investment spending fluctuates sharply over business cycle (½ decline of I spending) playing a crucial role in long-run productive capacity of economy

57
Q

Shifts in SLF & DLF

A

DLF
* Factors that change MPK/Marginal Productivity of Capital (innovation)
* Expected Profit by Firms (ex.r)

58
Q

Ricardo-Barro effect

A

Ricardo-Barro Effect/Ricardian Equivalence: the positive and the negative effects of the tax cut without reduction of the current spending should exactly cancel = impact of Sgov & Spvt cancel out due to rational consumers predicting what will happen and acting accordingly, as G incr to a deficit, demand rises to finance deficit & supply goes up as consumers save more predicting taxes will rise in future canceling out each others effects to create same r but more funds

59
Q

Balance of Payments

A

Balance of Payments:CA+KA=0, CA=KA
Record of a country’s intl. Transactions, flow of funds into country (+) credit, flow of funds out of country (-) debit. Can be in surplus or deficit from stat discrepancy or black mkt

CA Current Account=NFP+NX: trade of g+s (Nx), investment income from assets abroad (NFP=dividends, interest, royalties) & current transfers b/w nations
CA=Nx+NFP=Exports-Imports+Income D from A-Income A from D

KA Capital/Financial Account: intangible exchanges, trades in existing assets real direct or financial portfolio, migrant funds, inheritances, intellectual property, KA=Capital Outflow-Capital Inflow

60
Q

Closed v. Open Economy S-I

A

Open S-I=Nx, CA_D+CA_F=0, SD-ID=CA –> rw Economy: national S & I will never be in equilibrium, will always have excess of demand (net importer) or supply (net exporter) in intl. Trade. Higher INT more funds saved in that nation, Low INT higher lending in that nation
- 2 Country World Economy: one is importer, one is exporter
- rw determined within model not given/fixed where desired intl lending=desired intl borrowing
- Sd=Id+CA=Id+(Nx+NFP) , Sd-Id=CA
- Goods Market Equilibrium Condition Sd=Id=Y-Cd-G Y goods supplied by firms=Cd+Id+G

61
Q

Absorption

A

Absorption=Cd-Id+G=total spending by domestic residents

62
Q

Desired Capital Stock + User Cost of Capital

A

Desired Capital Stock (PPE, plant, property, equipment): amount of K that earns largest expected profit determined by comparing cost (user cost of capital) & benefit (MPK) of each additional unit of capital which directly creates the DLF investment curve

User Cost of Capital (exogenous, line moves with r): expected real cost of using a unit of k uc=rpk+dpk, d=rate of depreciation, pk=real price of capital goods, r=expected rate of interest

See graph in doc

63
Q

Supply Shocks + Impacts on SLF & DLF

A

Temporary shifts domestic/desired savings curve
Incr Snational at given rw: incr net foreign lending, CA, Nx
Decr Snational in CA surplus: I same, fall in income, savings, net foreign lending, CA

Permanent shifts domestic/desired investment curve
Incr tech in CA surplus: same saving, incr MPK, domestic capital stock, Id, absorption, shrinks net foreign lending + CA

Permanent Positive Supply Shock→ Right Shift DLF desired investment rises at every r: tech innovation→MPK productivity increase→ return on investment increase → demand to invest increases
Savings curve unaffected
Domestic capital stock increase
Net foreign lending & current account shrink with higher domestic absorption

64
Q

Possible Effects of Fiscal Policy on IS

A

Crowding Out effect: G incr. Resulting in deficit → decrease in desired savings shifting curve raising r → incr. user/firm cost → decr. Desired investment
Budget surplus incr. Supply of funds: r falls, I increases, S decreases

Increase in budget deficit reduces CA=Snational amount, less saving would be sent abroad while CA falls

Budget Deficit Increases: -15+20-30=-25Sgov+Spvt=SNational & CA decrease same amount
Incr. in Budget Deficit by Decr in T=budget deficit reduces Snational only if Cd rises & Ricardian doesn’t hold

YD=C+Spvt if T decr. → YD incr., the only way for Snational=Spvt+Sgov to decr. Is if C increases so that Spvt stays constant or grows less than Sgov losses revenue from taxes

See doc diagram

65
Q

relationship between interest rates and bond prices

A

Inverse: hen interest rates rise,
bond prices fall; when interest rates fall, bond prices rise.
- This happens because the fixed coupon payments of a bond become less attractive when interest rates increase, causing the bond’s price to drop to make its yield competitive with current market rates. Conversely, when rates decline, the fixed coupon payments become more attractive, increasing the bond’s price

66
Q

What does bond yield indicate about the macroeconomic variables

A
  • GDP Growth: Bond yields can reflect expectations about economic growth. Rising yields
    may signal optimism about GDP growth, while falling yields can indicate slowing
    economic activity or potential recession.
    ● Inflation: Bond yields often rise with higher inflation expectations because investors
    demand a higher return to compensate for the erosion of purchasing power.
    ● Stock Market: Bond yields compete with stock returns for investor attention. Rising
    yields can lead to stock market declines as investors shift to bonds for better returns.
    ● Recession Expectations: An inverted yield curve (when short-term yields exceed
67
Q

Bond Price Formula + Given
Face Value (F) = $1,000
● Semi-annual Coupon Payment (C) = 6%×1,000/2 = 30
● Number of coupon payments (n) = 5 years (10 periods)
● Market Interest Rate (Semi-annual) (r) = 5%/2 = 2.5%

A

Cx((1-(1+r^(-n)))/r)+F/((1-r)^n)

1,043.73

68
Q

Conditional vs Unconditional Convergence

A

Conditional Convergence: living standards will only converge within a group of countries with similar characteristics
Unconditional Convergence: all countries or regions are converging to a common steady state potential level of income so living standards around the world become more or less the same
* Proof: all economies have access to same tech, capital, open to world, seeks highest real interest rate implies economic growth rate will converge for all, convergence of rich countries, but not for all

69
Q

Incr. vs Decr. in saving rate effect on LRLS

A
  • Trade off b/w current & future consumption
  • Increasing saving rate implies lower consumption currently, but in future higher consumption=living standards (raises output at every level of K/L) as a steady state with higher output per K/L is attained in long run
  • Decreasing saving rate implies higher consumption currently, but in future lower consumption=living standards (lowers output at every level of K/L) as a steady state with lower output per K/L is attained in long run
70
Q

Incr. vs Decr. in population growth effect on LRLS

A
  • Increasing population growth tends to lower living standards, a large part of current output must be devoted to just providing capital for the new workers to use
  • Decreasing population growth tends to lower living standards, a small part of current output will be devoted to providing capital for the new workers to use but lower total productive capacity, political influence in world, lower working-age people to population ratio creating an unsustainable pension system
71
Q

Incr. vs Decr. in productivity/technology effect on LRLS

A
  • Increased sustained productivity will improve living standards as it raises y at every k, saving per worker increases, higher steady state attained kSS
  • One-time productivity increases shifts economy to a higher steady state once to a higher living standard, must continue to increase to perpetually improve living standards
72
Q

Steady State Solow Model

A

Steady State (kSS=(sA+n)11- when sy=(n+d)k) National savings=Gross Investment or total output/labor=output/labor for population growth+depreciated capital at a specific k=KL capital to labor ratio, subsistence level
* No growth in productivity, output/labor (yt), consumption/work (ct) & capital stock/worker (kt), Yt Ct Kt grow at rate of growth of workforce (n), economies will always be moving to this point as long as they have same A &
* Area b/w investment(savings) in new capital & destruction of capital is k=change in capital per labor over time positive to the left of kSS (i>), negative if right of kSS(>i)

73
Q

7 Factors Affecting Money Demand

A
  1. Price Level
  2. Real Income
  3. Non Monetary Asset interest Rates
  4. Higher wealth: more transactions when one feels richer
  5. Higher Riskiness of Alternative Assets: money more desirable
  6. Low Liquidity of Alternative Assets: money holds high liquidity
  7. Higher efficiency of payment technologies: More ways of making payments reduces money → less need to hold money
  8. More transactions on average → money demand increases
74
Q

Overnight Rate, Settlement Balance Rate, Bank Rate definitions + relations

A

Bank Rate: INT of lended funds from BoC to domestic banks
Overnight Rate: INT b/w domestic bank transactions controlled by BoC
Settlement Balance Rate: INT gained by domestic banks for depositing in BoC

75
Q

Demand for Money + Function + Relation With Each Variable

A

Demand for Money: quantity of monetary assets people choose to hold in their portfolios dependent on the expected return, risk & liquidity relative to other assets.

Short Term (Prices Fixed): Md=L(Y,i)
Long Term (Prices Change): Md=P*L(Y,i),i=r+e
Real Money Demand Function: Md/P=L(Y,i)

  • P Price level (+): higher prices more money needed to conduct transactions → more demand for money
  • Y Real Income (+): higher income means more transactions + greater need for liquidity → more demand for money
  • i Non Monetary Asset Interest Rates (-): main reason for change in money demand, higher interest rates (i)/expected return on alternative assets means increased switching money to higher-return alternatives → less money for demand (Note: opposite effect if expected return on money increases (im)/alternative return falls) → more demand for money
76
Q

High Inflation + Credit Cards Effect on Money Demand and Velocity

A

High Inflation:
- MD: lowers, loses value quickly
- Velocity: increases enormously, exchange immediately, get rid of cash

Credit Cards:
- MD: lowers, less need to hold cash
- Velocity: increases, faster to make transactions

UNI 2 (5 decks)

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