Macroeconomics Flashcards
Categories of Economic Systems
(1) Capitalism
(2) Communism/ Socialism
(3) Mixed economies
Capitalism
AKA Free Enterprise
A system where private parties own most of the means of production and make most economic decisions
Communism/ Socialism
A system where government entities own most of the means of production and make most economic decisions
Mixed Economies
“In between” systems where both private parties and governments own substantial fractions of the means of production and make substantial fractions of the economic decisions
Benchmarks to Measure Economic Activity
(1) GDP
(2) Real GDP
(3) GNP
Gross Domestic Product
“GDP” or “Nominal GDP”
Total dollar amount at current market prices, of all the final goods and services produced within one country’s borders regardless of citizenship or headquarter location of parties involved
Two Ways to Calculate GDP
(1) Income Approach
(2) Expenditure Approach
Income Approach
Sums all income earned in the production of final goods and services, such as wages, interest, rents, business profits, plus adjustments for indirect taxes and economic depreciation
Expenditure Approach
Sums all expenditures to purchase final goods and services by households, businesses, the government, and foreign sectors, minus adjustments for expenditures produced abroad
Real GDP
GDP adjusted for inflation
Total dollar value of all the final goods and services produced expressed using a price level that is constant over time
Most commonly used and most comprehensive measure of economic production
How is Nominal GDP Adjusted to Yield Real GDP
By removing the effects of increases in price from the sum of total purchases of goods
Most commonly used and most comprehensive measure of economic production
Real GDP
Potential GDP
Computed in both nominal and real versions - helps to estimate the degree to which the economy is either underutilizing resources or “overheating”
Who Computes Potential GDP
The Congressional Budget Office
Gross National Product
Total dollar value of all goods and services produced by a country’s residents, including companies headquartered there regardless of whether they were produced within or outside that country’s borders
Inflation
Percentage rate of increase in the price level of goods or services, commonly reported on annual or year-on-year basis
If Inflation is Higher, Money is….
Losing it’s purchasing power
3 Common Measures of Price Inflation
(1) Consumer Price Index (CPI)
(2) Producer Price Index (PPI)
(3) GDP deflator
Consumer Price Index (CPI)
Compares the price of a fixed basket of goods and services a typical urban customer might purchase in an earlier base period and the price of the same basket at later times - used to convert “nominal” figures that are not readily comparable across years into “real” figures that use the same level of prices and are therefore more comparable
Hyperinflation
Similar to inflation except the value of currency is decreased at a much faster rate so prices increase much more rapidly
Deflation
General decline in price level, solution is to increase money supply
Producer Price Index (PPI)
Compares the price of a fixed basket of goods, inputs, and materials purchased by producers at the wholesale level
GDP Deflator
Most comprehensive measure of price levels including prices paid by all parties included in GDP instead of only consumers; Index used to convert nominal GDP into real GDP
Aggregate Demand Curve
Seeks to represent the relationship between:
(1) Total expenditures by consumers, businesses, government, and the foreign sector
AND
(2) The price level at a given point in time
Factors that Cause Aggregate Demand Curve to Slope Downwards
(1) Interest rate effect
(2) Wealth effect
(3) International purchasing power effect
Interest Rate Effect
Higher inflation rates increase nominal interest rates and may decrease consumer borrowing reducing the quantity demanded of items whose purchase is typically financed
Wealth Effect
Higher inflation rated reduced the value of most fixed income investments - having less wealth individuals may consume less
International Purchasing Power Effect
Domestic inflation makes domestic goods and services more expensive in relation to foreign ones, increases quantity demanded of foreign products and decreases quantity demanded for domestic goods and services
Aggregate Supply Curve
Seeks to represent the relationship between:
(1) Total goods and services produced
AND
(2) The price level at a given point of time
* Generally sloping upward
Possible Causes of Inflation
(1) Demand-pull inflation
(2) Cost-push inflation
Demand-Pull Inflation
“The demand curve shifted upward”
When aggregate spending increases, the demand curve moves to the right causing market equilibrium to occur at higher price levels
Excess demand bids up cost of labor and other resources
Causes of Excess Demand in Demand-Pull Inflation
(1) Improved expectations by consumers or businesses
(2) The foreign sector
(3) Government fiscal and monetary policy that turned out to be too loose
Short-Term Phillips Curve
In the short term there is a trade off between inflation and unemployment
Cost-Push Inflation
“The supply curve shifted inward”
If producers/suppliers within one country face increases in the costs of using some inputs the aggregate supply curve would shift to the left causing market equilibrium to occur at a higher price level and at a lower quantity
Since prices of many production inputs are set in international markets, individual countries may experience changes in input costs that are not strictly or directly related to economic conditions in that country
Stagflation
Used to describe periods of high inflation and high unemployment
Multiplier Effect
Increase in final income arising from any new injections
Increase in Output (Multiplier Effect Formula)
Change in spending / Marginal Propensity to Save
Business Cycles
Fluctuations in economic production typically lasting several years
Each business cycle includes one recession/contraction and one expansion
Begins at the peak from the previous expansion and ends at it’s trough
Expansion
Extended period of increased economic production
Recession/Contraction
Brief (typically) periods of decreased economic production
Recession - periods of at least two consecutive quarters of negative growth in real GDP
Depression
Recession that is either particularly deep or long lasting, no formal agreement as to boundary between recession and depression
Recovery
Early stages of an expansion, commonly thought to become a full expansion when the peak from the previous expansion is surpassed
Categories of Indicators Economists Track to Gauge, Evaluate, and Predict Current and Future Economic Conditions
(1) Leading indicators
(2) Coincident Indicators
(3) Lagging indicators
Leading Indicators
Seek to predict whether expansions (or recessions) are likely to end within the next few months
Examples Of Leading Indicators
(1) Stock market prices
(2) Average hours worked per week
(3) New orders for durable goods
(4) Average initial claims for unemployment insurance
(5) Building permits
(6) New private housing starts
Coincident Indicators
Normally move up and down simultaneously with economic expansions and recessions
Examples of Coincident Indicators
(1) Industrial production
(2) Manufacturing and trade sales
Lagging Indicators
Only move up and down months after economic change
Examples of Lagging Indicators
(1) Average prime rate for bank loans
(2) Average duration of unemployment
(3) Unemployment rate
Types of Unemployment
(1) Frictional
(2) Structural
(3) Cyclical
(4) Institutional
Frictional Unemployment
Result of normal turnover of workers between jobs or of new entrants to the workforce; unavoidable will always have some of this type of unemployment even at full employment
Structural Unemployment
Workers who lose their jobs as a result of changes in the demands for goods and services or of technological advances that reduce the need for their current skills
Addressing this type of unemployment generally requires retraining
Underlying problem is speed with which workers may be retrained to meet new demands and technologies
Cyclical Unemployment
Job losses resulting from fluctuations in the business cycle
Key concern during recession; decreases during expansions
Institutional Unemployment
Not recognized by all economists
Affects workers who can’t find employment as a result of government restrictions on the economy
Full Employment
“Natural” or “non-accelerating-inflation” rate of employment “NAIRU”
Rates below which unemployment may not fall sustainably without causing boom conditions that eventually may result in higher rates of inflation
Sum of frictional and structural unemployment (and institutional if recognized)
Interest Rates
Prices that borrowers pay in exchange for funds
Types of Interest Rates
(1) Nominal interest rate
(2) Real interest rate
(3) Risk free interest rate
(4) Federal funds rate (Discount rate)
(5) Prime Rate
Nominal Interest Rates
Those normally quoted by financial institutions
Real Interest Rates
Interest rates adjusted for inflation
Risk Free Interest Rates
Those that would be charged to borrowers if lenders had an absolute certainty of being repaid
Federal Funds Rate (Discount Rate)
Rates that commercial banks charge and pay one another for short-term loans of reserves at the Fed
Prime Rate
Rate banks charge their most creditworthy business customers on short-term loans
Types of Government Involvement in the Economy
(1) Fiscal policy
(2) Monetary policy
(3) Regulatory policy
Fiscal Policy
Involves government setting, applying, and changing levels of taxes, subsidies, and government spending
Expansionary Fiscal Policy
Uses deficit spending to increase aggregate demand and thus output
Appropriate Conditions for Using Expansionary Fiscal Policy
(1) Economic production is below potential
(2) Financial sector failing to lend funds adequately
(3) Unemployment rates are too high
Deficit Spending
Involves increasing spending levels without increasing tax revenues by equivalent amount
OR
Lowering tax revenues without decreasing spending by equivalent amounts
Federal Deficit
The amount by which government expenditures exceed revenues within a period of time
How is federal deficit financed?
Through the sale of US Treasurys
Federal Debt
Total amount of outstanding US Treasurys or the sum of past deficits
Contractionary Fiscal Policy
Uses budget surpluses to reduce aggregate demand and thus, inflation
Appropriate Conditions for the Use of Contractionary Fiscal Policy
(1) Economic production is above potential
(2) There are concerns about boom economic conditions and current or upcoming rates of inflation that are too high
Federal Surplus
Revenues exceed expenditures
Monetary Policy
Involves efforts by the Fed to manage credit conditions, interest rates, and the money supply
Key Goals of Monetary Policy
(1) Maximizing economic growth
(2) Minimizing unemployment rates
(3) Minimizing inflation rates
(4) Minimizing economic and financial fluctuations
Tools Used in Monetary Policy
(1) Reserve requirements (ratio)
(2) Discount Rate
(3) Open market operations
Reserve Requirements (Ratio)
May affect the total amount of lending in the economy by changing the percentage of customers deposits that banks are required to hold in reserves
Rarely used in recent decades
Discount Rate
May affect the total amount of lending in the economy by changing the interest rate that it charges banks for short term emergency loans
Rarely used as few banks request these loans to avoid stigma of telling the Fed they need emergency help
Open-Market Operations
Setting a target for the federal funds rate and buying and selling short-term US Treasurys to ensure that actual rate in the federal funds market meets it’s target
Most Highly Used Monetary Policy in Recent Decades
Open market operations
Expansionary Open-Market Operations
(1) Lower target for federal funds rate
(2) Buy government securities on the open market to increase the amount of reserves available for banks to lend
Contractionary Open-Market Operations
(1) Increase target for federal funds rate
(2) Selling government securities on open market
Regulatory Policy
Government may influence economic activity through regulations affecting environmental issues, labor issues, occupational health and safety, energy policy, healthcare, bank capital, lending practices, etc
Classical Economic Theory
Argues that, in the absence of government induced distortions, economies would be largely self stabilizing with only relatively small fluctuations in unemployment and inflation rates
Doesn’t support government intervention
Keynesian Theory
Argues that prices and wages in the economy do not adjust quickly enough on their own - economies would not self-stabilize quickly enough and governments must use fiscal policy to manage macroeconomic conditions
Monetarist Theory
Argues that to minimize fluctuations in both unemployment and inflation rates, central banks should target rate of growth in money (and thus lending) that are stable over time
Focuses on stable monetary growth not stable interest rates; argues that efforts by the fed to occasionally increase monetary growth by more than the long-term average are more likely to add instability than to succeed in minimizing it
Fed Actions Under Monetarist Theory
(1) Allow interest rates to climb if banks and borrowers wanted to lend and borrow more than the long-term average growth rate of money (and lending)
(2) Allow interest rates to fall if banks and borrowers wanted to lend and borrow less than the long-term average
Supply Side Theory
Argues that government policy should focus less on managing short-term fluctuations in the aggregate demand cure and more on removing impediments to economic productions thereby shifting the aggregate supply curve outward over the long term
Investigate what government laws and regulations may be counterproductive and update or remove them
Laffer Curve
If tax rates are high enough, increasing them further will not yield more revenue; under such conditions lowering tax rates may increase revenues
Theory Closest to Current Macroeconomic Thinking
New Keynesian Theory
New Keynesian Theory
Combines some elements of both Keynesian and Monetarist Theory
Argues that the relationships between monetary aggregates and economic conditions have been too loose to rely strictly on a constant rate of monetary growth to minimize fluctuations in unemployment and inflation rates. Policymakers should use both fiscal and monetary policy to manage macroeconomic conditions, loosening/tightening both in response to higher rates of unemployment/inflation
Austrian Theory
Provides insights as to how monetary policy may lead to dislocations in the allocation of resources play a role in the formation of bubbles, and contribute to boom-bust cycles
International Trade Theory
(1) Trade among individuals and firms across borders is mutually beneficial
(2) Over time trade tends to increase the average standards of living for all parties involved
(3) Trade across countries increases overall production (and consumption) as the different parties specialize in producing more of the products and services that as a result of differences in resources, climate, and specific skills, each party can provide more of
Types of Trade Related Advantages
(1) Absolute Advantage
(2) Comparative Advantage
Absolute Advantage
A country being able to produce a good at a lower cost than another country
Comparative Advantage
A country being able to produce a good at a lower relative cost than another country; opportunity costs are less
Natural Barriers to International Trade
(1) Transportation Costs
(2) Information Costs
Transportation Costs
Transportation costs may overwhelm the cost reductions offered by trade
Information Costs
Relative costs of many products across many countries are always changing, most firms find it easier to keep track of relative costs in relatively smaller numbers of markets - particularly those that are closer by - therefore individuals and firms routinely forgo many possible gains from trade
Greatly reduced due to improvement in communication technology
Tariffs
Taxes on imported goods
Effects of Trade Restrictions on Domestic Producers of Protected Goods
(1) Positive Effect
(2) Demand curve shifts to the right
(3) Availability of substitute goods have been reduced
(4) Sell more goods at higher prices
(5) Typically sought by management and unions - benefit from higher sales and prices
(6) Some gains passed on to owners, managers, and workers - higher wages and more job security
Effects of Trade Restrictions on Domestic Users
(1) Negative effect
(2) Supply chain shifts left
(3) Pay higher prices and are able to buy fewer goods
Effects of Trade Restrictions on Domestic Producers of Exported Goods
(1) Negative effect
(2) Demand curve shifts left
(3) Their consumers suffer as they pay higher prices on protected goods
Effects of Trade Restrictions on Foreign Producers Encountering Protection Elsewhere
(1) Negative effect
(2) Demand curve shifts left
(3) Lower sales and prices
Effects of Trade Restrictions on Foreign Users of Protected Goods
(1) Positive effect
(2) Supply curve shifts right as their producers will have to do more selling in their own market
(3) Can buy more goods at lower prices
World Trade Organization
International organization that:
(1) Provides a forum to resolve international trade disputes
(2) Provides a forum to continue to negotiate greater liberalization of international trade policies
(3) Seeks to help prevent trade wars and growth of other barriers
G-20
(1) Main forum that governments of the leading countries use to discuss global economic and financial stability
(2) Brings together 20 leading economies
(3) Includes both higher and lower income countries
Economic Union
Providing for the free circulation of goods, services, firms, capital, residents, and labor
Monetary Union
Share a single currency
Import Quotas
Place limits on the quantity of a good that may be imported during a period
Embargoes
Total bans on importing either a number of goods or nearly all goods from a country
Voluntary Export Restraint
Government impose limit on the quantity of some category of goods that can be exported to a specified country during a specified period of time
Foreign-Exchange Controls
Policies that may restrict the types of domestic parties that may use foreign currencies and their uses
Dumping
A manufacturer being found to have exported a product to one country at a price that was unjustifiably low and harmed the domestic producers of that country.
Regulations to determine whether firms priced their products below their cost of production are difficult to maneuver for all countries
Dual Pricing Strategies
Charging different prices in different countries
Export Subsidies
Used to encourage production and export of specific products
Forms of Export Subsidies
(1) Outright payments
(2) Favored tax treatment
(3) Access to subsidized lending
Countervailing Duties
Tariffs imposed under WTO rules when WTO panel finds that one country is in breach of international trade rules
If the country in breach refuses to correct the situation, the countries bringing the complaint may impose for an equivalent amount on products from the offending country
Balance of Payments
Summarizes a country’s transactions with other countries during a period of time
2 Key Components of Balance of Payments
(1) The current account
(2) The capital account
Current Account
Focuses on the flow of goods and services as well as flows of government grants, net interest and dividends, and net unilateral transfers during a specific period of time
What Makes up the Current Account
(1) Balance of trade
(2) Balance of goods and services
(3) Net interest and dividends
(4) Net unilateral transfers
Balance of Trade
Difference between goods exported and goods imported
Trade Surplus
Exports higher than imports
Trade Deficit
Imports higher than exports
Balance of Goods and Services
Difference between goods and services exported and goods and services exported
Net Interest and Dividends
Any interest and dividends received within a country from investments outside the country minus the interest paid to residents outside the country for investments within the country
Net Unilateral Transfers
Include foreign aid payments and pension payments. Affect to deficit or surplus
The Capital Account
Focuses on the flow of investments in fixed assets during a specific period of time.
Largely reverse image of current account - country with current account deficit will have matching capital account surplus
International Monetary Fund (IMF)
International organization that seeks to aid in the coordination of countries economic policies; may be only party willing to provide countries funding during crisis (at relatively low rates or at all).
Typical IMF Requirements in Exchange for Short Term Help
Countries must reduce their budget deficits and debts and engage in other supply side structural reforms over the long term
Repatriation of Currency
Process of importing foreign currency into your own country’s currency at the current exchange rate
The Spot Rate
Exchange rate at which a financial party will exchange two currencies at this time
The Forward Rate
Exchange rate at which a financial party will exchange two currencies at a specific future rate (called settlement rate)
Forward Market Currency is at a Premium if
It’s forward rate is higher
Forward Market Currency is at a Discount if
It’s forward rate is lower
Formula to Calculate Forward Premium or Discount
(Forward Rate - Spot Rate)/ Spot Rate X Months in a year/ Months in the forward period
Factors Affecting Foreign Exchange Rates
(1) Inflation
(2) Interest Rates
(3) Balance of payments
(4) Government intervention
(5) Long-Term Economic Stability
Safe Haven Effect
During international crisis, international investors tend to buy more of the currencies of the countries traditionally perceived to be more stable
Exchange Rate Systems
Used to manage the value of currencies relative to those of other countries
Types of Exchange Rate Systems
(1) Floating exchange rates
(2) Fixed exchange rates
(3) Managed exchange rates
Floating Exchange Rate
A country’s central bank never (or rarely) buys and sells foreign currencies to influence the exchange rate of it’s currency relative to those of other countries. Instead the currency’s exchange rates are set by the supply and demand of the currency by private parties and the actions of other foreign central banks - few countries have ever used
Fixed Exchange Rates
Country’s bank stands ready to buy and sell foreign currencies as needed constantly to maintain it’s rate “fixed” relative to the currency of a key trading partner
Managed Exchange Rates
Fall between floating and fixed exchange rates
Country’s central bank may buy and sell foreign currencies to minimize short term fluctuations in exchange rates away from long-term underlying trends and/or target a broad band within which the currency may fluctuate
Translation Risk
Risk that a company’s equities, liabilities, or income will change in value as a result of exchange rate changes; occurs when companies deal in foreign currencies or list foreign assets on their balance sheet
Transaction Risk
Exchange rte risk associated with the time delay between entering into a contract and settling it due to potential fluctuations in exchange rates
How to Manage Translation Risk
Matching assets and liabilities in each market entity operates in
How to Manage Transaction Risk
Matching as many revenues and costs as possible in each market or using derivatives or hedging contracts
Hedging Options
Permit but don’t require the holders to buy or sell commodities or instruments at a given price until some date or at some date
Call Options
Permit the holder to buy a security at a fixed price
Put Option
Permit the holder to sell a security at a fixed price
Forward Contract
Specifically-negotiated contracts in which two parties agree to exchange some quantity of a commodity or instrument at a pre-set price on a future date
Futures Contract
Standardized versions of forward contracts that are traded in exchange markets
Currency Swap
Contracts under which one party A agrees to make payments in one currency to party B and the other party B agrees to make payments to party A in the other currency independently of how spot rates change during that period of time
Money Market Hedges
Involve turning transaction risk into a loan. Involves the cost of certain interest payments but removes the possibility that currencies may change unfavorably
Interest Risk
For financial institutions, the risk that changes in economy wide interest rate levels may affect their earnings adversely
How to Manage Interest Risk
(1) Seeking to reduce the amount of assets with long maturities and increase liabilities with long term maturities
(2) Reduce the amount of fixed-rate long term assets and increase the amount of variable rate long term assets
(3) Use interest rate derivatives
Credit Risk
Risk that the parties one has lent to or who owe payments may fail to pay
How to Mitigate Credit Risk
(1) Diversifying one’s customers
(2) Selling future streams of payments
(3) Implementing internal control mechanisms to ensure that credit standards are appropriately tigght
(4) Require greater guarantees from borrowers
(5) Using derivatives
Liquidity Risk
Risk that while they may be solvent on a long term basis, their short term obligations might outweigh their access to liquid funds, makes them insolvent in the short term and therefore indefinitely
How to Mitigate Liquidity Risk
(1) Matching more of the maturities of assets and liabilities
(2) Maintain a large cushion of liquid assets
(3) Maintain a variety of long-term lines of credit with a variety of providers
Market Risk
Risk that sales of their products or the value of some of their assets may decline
How to Mitigate Market Risk
(1) Shift financing sources from debt to equity
(2) Diversify income streams and assets held
(3) Use hedging strategies
Country Risk
When investing overseas have very little control over political and financial risks associated with investing in a foreign country
Home Bias
Traditional tendency of most investors to have a large fraction of their portfolio in assets denominated in their own currency
Mutual Interdependence
Outcome of pricing decisions in oligopoly dependent upon reactions of organizations rivals
