Midterm 2 Flashcards
Gini Coefficient (Def & Formula)
Number summarizing inequality based on Lorenz Curve
- Closer to 1: more inequality
- Closer to 0: less inequality
Formula: A / (A+B)
Area A: area between the LoPE & Lorenz
Area B: area under the LoEP
Lorenz Curve
graph displaying income distribution in the economy
** The higher the number, the more inequality**
High Inequality Graph
The Lorenz Curve is heavily bowed out from the Line of Perfect Equality and the Gini Coefficient will be closer to 1. A Is larger than B.
Extreme Inequality Graph
Poorest 80% holds almost no income with the highest 1% holding majority
Gini will be closer to 1 and A is majority
Very unsustainable for economy
Near Perfect Equality
Gini is around 0.1 with low inequality creating a small gap between rich & the poor
Most people are earning similar income with a small gap between the richest and poorest
Lorenz Curve is not as bowed out and runs closely to LoPE
What analysis does the Gini Coefficient provide?
- The Gini allows us to track trends in income inequality across countries
- The richest quintile or top 20% tends to gain larger share over time in countries
- Coefficients change over time with globalization, tech ∆s, education, & government politics
- Denmark & Sweden have lower Ginis – more equal distribution
- US & Mexico have high coefficients –> signals inequality in income distribution
Globalization
low wage manufacturing jobs in high-income countries (US) will transfer to lower-wage countries (China)
- low-skilled workers in high-income countries lose their jobs because of competition & cheap labor in low-income countries
- wage suppression or exploitation may occur in these low-wage countries
Skill-Based Tech ∆
Technological ∆s that disproportionally benefit high-skilled workers in comparison to low-skilled workers
- Automation, AI, etc.
Race Between Education & Technology
Skill gaps are created as tech advancements call for more high-skilled workers but education systems fail to keep up
- Skill Gap: high-skilled jobs available w/o enough people to fill them
- Affordability of higher education is an issue that prevents increases in this sector of employment
Superstar Effect
Explores how people in certain fields (athletes/celebs) earn disproportionate amount of income due to their global & market reach
- Wealth is concentrated in the hands of elite like L. James or The Rock
Immigration Effect
Low-skilled immigration can expand the labor supply, especially in industries like agriculture, construction, etc.
- Benefits high-skilled workers as the labor supply increases
- More competition in low-skilled sector –> income can decrease
Union Power Effect
Decline of union power weakens ability to negotiate higher income
- Unions helped bring equality, decline in power brings inequality
Financial Overview of the US Government
- US government generates its revenue from taxes w/ personal income taxes producing one of the largest amounts
Average Tax Rate (Formula & Def.)
Measures overall proportion of income paid in taxes
- Formula: ATR = T / I
T: Total Taxes Paid
I: Total Income
Marginal Tax Rate (MTR) (Formula, Def, & Example)
Percentage of tax applied to an individual’s or corporation’s last dollar of income
- Formula: MTR = ∆T / ∆I
Example: If someone earns an extra $1,000 and their taxes increase by $200, their MTR is:
* MTR = 200 / 1,000 = 20%
Income Tax Brackets are ______ so they are ______.
Income Tax Brackets are progressive so higher income brackets are taxed at higher rates
Equity Principles
Provides guidelines for a fair/just tax system
Benefits Principle
People should pay taxes based on the benefits they receive from the government
- Gasoline Tax: people pay taxes on gas which are then used for road construction – drivers benefit from better roads – FAIR
- Toll Roads: people using toll roads pay a fee for construction/maintenance – the more they use the roads the more they pay
Ability-to-Pay Principle
Argues that taxes should be based on financial capacity rather than the benefits they receive from the service
- Vertical Equity (Vertical Hierarchy): Taxpayers with larger financial capacity should be taxed more because they can afford to contribute more
- Progressive system where people are taxed more as their income increases
- Horizontal Equity: Taxpayers with similar incomes should pay same amount
- However this is difficult as different components, family size/tax deductions influence amount paid for people with similar incomes
Three Types of Tax Systems
- Progressive Tax
- Regressive Tax
- Proportional Tax
Progressive Tax
Requires those with larger incomes to give larger fraction of their income in taxes
* The amount taxed increases with each income bracket
- The US System is progressive and aligns with vertical equity
- Reduces income inequality w/ larger amount of taxes coming from elite & being redistributed into g&s enjoyed by everyone
Proportional Tax
In this system, everyone pays same % of income in taxes, regardless of their income
- A flat rate is applied, and although perceived fair, income inequality is not reduced like progressive tax
- High earners still pay more as their income is higher and the percentage takes larger chunk (VE)
Regressive Tax
Lower-income people pay larger % of their income than high-income people
- Sales & excise taxes are usually regressive because everyone pays same tax on goods, regardless of income
EXAMPLE
- Person A earns $20k and Person B earns $200k
- Sales Tax of 10% on goods and both spend $5,000 on taxable goods
- 5k * .10 = $500
- 500/20K = 2.5%
- 500/200K = .25%
- This tax goes against Vertical Equity because it places a larger burden on lower-income earners and takes more from those who have less
Double Taxation
Corporate profits are taxed and shareholders are additionally taxed when given their dividends
- Taxed twice
- Shareholders are taxed twice from corporate profits & dividends
- Labor Market: companies may look to reduce large tax & move internationally
- Decrease in jobs & investment in Domestic Labor Market
- Customers: to maintain profit, consumers may see prices rise & tax burden shifts
- Inflation, lower-income people are impacted
Debt Ceiling & US Federal Debt
Debt Ceiling: cap on the amount US treasury can borrow to account for government spending (Public & Intragvnmntl Debt)
- Doesn’t authorize new spending, rather helps cover payment on existing obligations
- If ceiling isn’t adjusted financial instability can break out
- US Treasury: manages government finances – collecting taxes, paying bills, & issuing debt
- Debt will push Treasury to borrow (ie. through bonds) to cover spending
- The Fed: central bank responsible for managing MS & stabilizing financial system through monetary policy
- Intragovernmental Debt: represents debt the government owes itself – when it borrows from its programs & funds to finance other operations
- IE: when Treasury borrows from Social Security Trust Fund to cover general expenses
- Intergovernmental Debt: money owed by different levels of government or between different government entities
- Impacts total national debt
Key Role of Money
- It is a medium of exchange that eliminates bartering
- Standard measure of value across all goods & services
- Can transfer wealth into the future as money retains its value
Types of Money
- Fiat Money: has no intrinsic value and receives value from government decree (USD)
- Commodity Money: money with intrinsic value because its made of or represents something valuable (gold)
Money Supply (Def. & Structure)
Total amount of money available in an economy at a specific time
- M0 (Base Money)
- M1 (Narrow Money)
- M2 (Broad Money)
M0 (Base Money)
- Most basic form of money consisting of currency in circulation & reserves held by banks at central bank (Fed)
- Currency in Circulation: cash
- Reserves held by banks are not included in public circulation of currency but are the basis of bank lending
- M0 creates the foundation upon which other money forms are created
M1 (Narrow Money)
- Most liquid form of money, usually used for immediate transactions
- Currency in Circulation
- Demand Deposits: checking & other accounts where money can be withdrawn on demand
- Snapshot of money available for immediate transactions – most liquid
M2 (Broad Money)
- Broader measure of money supply, using components of M1 and less liquid forms of money
- M1: currency in circulation & demand deposits
- Savings Deposits: interest based accounts with savings, that can be accessed but not immediately available like checking
- Money Market Mutual Funds (MMMF): vehicles that pool money from multiple investors to invest in short-term, low-risk financial instruments
- invests in highly liquid, short-term assets offering interest based earnings while maintaining easy access to funds
Credit Cards & PayPal
Credit Cards: a form of short-term borrowing that isn’t a part of M1/M2
- MS is only included in the process when debt is paid – draws from M1/M2
PayPal: payment intermediary with funds drawn from M1/M2 if linked to bank account
- Must be linked to bank account to count in M1/M2
Liquidity
How quickly assets can be turned into spendable cash
Personal Balance Sheets
Summarizes a person’s assets while providing a current snapshot of their finances
- Liabilities: what you owe
- Assets: what you own
- Net Worth = A - L
Bank Accounting
Banks keep BS to track reserves (depos in the bank) & loans
- Assets: loans, investments, cash
- Liabilities: deposits & borrowings
Equity
Ownership value in a bank after all debts are paid. Represents what is left for shareholders once liabilities have been subtracted from assets
- Similar to Net Worth
Fractional Reserve Banking
Banks only hold a fraction of deposits as reserves and lend out the rest
- Required Reserves (RR): minimum amount of reserves a bank must hold & not lend out
- Formula: RR = R * D
- R: Required Reserve Ratio
Example: If you have a $100 deposit and R= 20%
- RR= 100 * .20 = 20 – $20 must be held and $80 can be lent out
- Excess Reserves: funds a bank holds beyond its required reserves. Can be lent out, invested, or held in cash
- Excess reserves provide banks with flexibility and a buffer against unexpected withdrawals
- ER = Actual Reserves - Required Reserves
Crypto
Cryptocurrencies like Bitcoin are highly speculative as investors can gain or lose large sums
Potential Social Benefits
- Reduced transaction costs as banks are eliminated
- Decentralized with no central authority like Fiat currencies
- Digital Gold: compared to the resource because of its finite supply and ability to store value
Potential Social Costs
- Mining it costs large amounts of energy
- Can facilitate illegal activity because of its anonymous ability
- No central bank to support failing crypto market as a last resort
- Large price fluctuation – high-risk situation
Money Multiplier (Def & Formula)
Money Multiplier: explains how banks increase MS & create money by loaning out deposits
* Shows how much Total MS can increase from an initial deposit
Example
- If $10k is deposited, the bank an loan out most, keeping $1k if the Reserve Ratio is 10%
- It loans out $9k, which will be put in another bank, and repeat the process, creating more money as it does
MM Formula: MM = 1/R
- With a Reserve Ratio of 10% and a $10k deposit …
* The deposit could multiply by 10
* MM= 1/.10 = 10 –> $10k * 10 = 100,000 v
Money Multiplier in Reverse
- When money is withdrawn it impacts the MS in a similar, but reversed, fashion
- Bank loses money, lends less, MS decreases
Example
- Bank loses money, lends less, MS decreases
- If $10K is withdrawn and put under a mattress, the deposits decreases by $10K
- ∆TD = - (Withdrawls) * MM ==> ∆TD = - 10,000 * 10 = -100,000
- The cycle of money creation stops, the bank can’t loan out that 10,000 which could have multiplied into 100,000
- ∆MS = ∆TD + ∆Cash ==> ∆MS = -100,000 + 10,000 = $90,000
- MS decreases by $90,000
Federal Reserve System
- The Fed controls Money Supply through Open Market Operations, Discount Rate, & Reserve Requirements
Open Market Operations
Buying & selling of government bonds to increase/decrease MS
- Expansionary Policy: buying bonds put money into the banks –> increases Money Supply
- Contractionary Policy: Selling bonds takes money from the banks –> decreases Money Supply
Discount Rate
Interest rate the Fed charges banks for loans, impacting how much the bank can loan
- Rate that is charged to commercial banks when they borrow directly from the Fed’s Discount Window (usually for short-term liquidity needs)
* Lower Rate: banks borrow more, increasing their reserves –> lend more
* Higher Rate: banks borrow less, lend less to meet reserve requirement –> money is tighter
Fed influences how much is available for loans through interest rate
Reserve Requirement: the amount Fed requires commericial banks to hold in reserves
Fed Quick Facts
Dual Mandate: looks to maintain price stability & maximum employment
Independent Authority: their independence is crucial for unbiased decisions
Inflation (π)
Inflation (π) : The percentage change in price level (P), or π = %∆P
- Occurs when money supply grows at a faster rate than the economy’s output
Two Perspectives of Price Level
- P: price of a basket of goods & services
- 1/P: discerns the value of money by seeing how much $1 can buy of a given g&s
- If P=1 – $1 can buy a full unit of a g/s
- If P=2 – $1 can only buy half a unit of g/s
- When P increases, the value of money decreases
- As Price Level increases, the amount of g/s money can buy decreases –> money has less value because it can’t buy as much
Money Supply, Money Demand, & Equilibrium
- Money Supply: amount of money in the economy
- Determined by the Fed
- Money Demand: amount of money held by people
- Determined by price level as the price of g/s will either push ppl to save or spend
Long Run Equilibrium: in the long-run, the price level will adjust until MS=MD
Impact of Monetary Injection
- Monetary Injection will increase MS, putting more money into the economy, fixing short-term issues
- Lowers interest rate
- Banks have more money to lend
- MS increase puts more money into the hands of businesses & the ppl
- However, in long run, more money in the economy can lead to inflation as there are more dollars competing for the same g/s
Quantity Equation (Formula, What it Shows, & Example)
Formula: M x V = P x Y
M: Money Supply
V: Velocity of Money (measures how often money ∆s hands in given period)
P: Price level
Y: Real GDP (total amnt of g&s produced)
- Illustrates how circulation of money in the economy impacts the value of g/s produced & the prices they are listed at
- An increase in Money Supply or Velocity can lead to an increase in Price Level (inflation) or Output of goods
Example
If the price of candy bars is $2, and the economy produces 4 bars, then:
Nominal GDP: P * Y ⇒ 2 * 4 = 8
Y = Nominal GDP / P ⇒ 8/2 = 4
If Money Supply is $2, then velocity of money is:
V = P * Y / M → V = 4 * 2 / 2 ⇒ 4
SO … each dollar is spent 4 times in the economy
Growth Rate Format of Quantity Equation
%∆M + %∆V = %∆P + %∆Y
- %∆P – aka inflation rate
When velocity of money or growth rate of velocity of money is stable equation is simplified to:
π = %∆M - %∆Y
- If MS increases and output doesn’t match, inflation will increase (Price level rises)
- If MS doesn’t increase at same percentage as output, price level will decrease
Fisher Effect (Equation, Example, and Effect)
Fisher Equation:
i = r + π
- The nominal interest rate, the rate “seen on paper,” is composed of the real interest rate & inflation
- r shows us how much “buying power” our money has after accounting for price changes
- π tells us the rate at which price levels increase over a period
We can understand that while nominal rates may look attractive, what really matters is how much those rates translate into real purchasing power after factoring in inflation
- If inflation is high, it eats into the gains you make from interest, reducing how much more you can buy with your money over time
Example
- You invest in a bond with a 12% nominal interest rate and inflation is 4%. What is your real interest rate?
* r = i - π ⇒ r = 12 - 4 = 8
After accounting for inflation, the true return we will receive is 8%
- If inflation rises to 6%, then the real interest rate will ?
- r = i - π ⇒ r = 12 - 6 = 6
The real interest rate will decrease to 6%, meaning we will have a smaller return and inflation has reduced real purchasing power as our money will buy less
- r = i - π ⇒ r = 12 - 6 = 6
- Fisher Effect: states that nominal interest rates will increase proportionally with inflation to maintain same real interest rate
- Purchasing power decreases with inflation, so Fisher Effect ensures that when inflation increases, nominal interest rate grows as well so the returns on loans are maintained and purchasing power for lenders doesn’t decrease
Cost of Inflation
- Inflation Tax
- Shoeleather Costs
- Menu Costs
- Relative Price Variability
- Confusion & Inconvenience
- Inflation Induced Tax Distortions
Inflation Tax
When government prints money to finance their spending rather than collecting taxes, it creates seigniorage, the revenue from printing money
- MS increases, as more money is circulating, leading to inflation and reduction in value of money (PPwr)
- Value of savings or money held will decrease
Shoeleather Costs
Refers to the costs gained when they try and get rid of their cash holdings during times of high inflation
- When inflation rises, value of money decreases, so people try and get rid of cash/convert it into physical assets to retain value
-The soles of their shoes diminish as they run back in forth trying to do this
Menu Costs
Costs businesses gain when trying to adjust prices during periods of inflation
- High inflation means businesses have to change their prices, and with it their menus, advertisements, websites, products in store, etc.
* Frequent price adjustments lead to admin costs, and can result in confused customers
Relative Price Variability
Inflation impacts prices of g&s unevenly, distorting economic view on g&s
- When prices of some g/s change faster in comparison to others, consumers may misinterpret this as signals of shortages/surpluses
- Influences decisions in a way that may not accurately represent economic changes
Confusion & Inconvenience
High inflation leads to uncertainty for consumers
- With rapidly changing prices, consumers and producers have trouble predicting trends or making future decisions
- Contracts with fixed payments (ie. loans/leases) are harder to evaluate because future payments may not reflect real value because of inflation
Inflation-Induced Tax Distortions
occurs when people are taxed on unadjusted income that does not reflect inflation. Meaning people are taxed on “profits,” that acutally represent rise in prices, not an actual increase in what their money can buy
