Quiz 2 Flashcards
most important function of macroeconomic policy
managing expectations (we want to give people certainty)
Expectations of inflation can drive reality…
If workers expect prices to rise they will demand higher wages. If firms expect wages and input prices to increase, they will try to increase the price of their own product
one of the central tasks of central banks is to
convince the public that the price level is unlikely to rise very much in the future. In order to do so, central banks must be credible — it is difficult to do
Federal Reserve Chairman Paul Volker
to kill inflation in 1970, he pushed the federal funds rate to unprecedented levels (20 percent at its peak), inducing the worst economic downturn since the Great Depression.
inflation targeting
In recent years, many central banks have adopted a strategy of inflation targeting. They pick and often announce a specific inflation target and then raise or lower interest rates as necessary.
Say’s law
supply creates its own demand
what if the public expects bad times ahead? What if expenditure (demand) falls below income (supply)
then the recession gap opens up and economic downward spiral begins
Keynesian economics
the government can come to the rescue and close the recessionary gap using monetary and fiscal policy
monetary and fiscal policy
Buy things with money that doesn’t exist today. Helps in the short term but in terms of the future we are piling up on debt which someone will eventually have to pay. If the government printed the money–inflation
monetary policy
If banks decreases interest rate it incentivise people to borrow more cause the cost is less– saving looks less attractive
Lower interest rate may encourage investment by making new plant and equipment cheaper to finance
problem: so low that people may think its more beneficial to hold on to money then hold on to another asset
fiscal policy
Rests on gov spending, taxation, and budget deficits
Keynes- expect bad times, gov can get things moving by spending more than it received in taxes and run a large budget deficit. If gov is spending people may expect better times ahead and also start spending
“income multiplier”
change in GDP
= (change in deficit spending by gov.) * income multiplier
How do we pay the deficit generated by fiscal policy? What about crowding out?
-We need to produce things first before we consume anything. In order to buy something you need to offer something up in exchange. SO supply creates a demand
-Have to sell something to demand something. How did you get your money? Supply your work for money now you can demand something. Supply is necessary for you to demand.
Broken window fallacy
if you break a window, have to pay someone to fix it. Guy that fixes it has money. Go to the store and buy groceries. Generating more production and increasing GDP
liquidity trap
low interest rate level at which holding money is more desirable than holding any other asset
Expectations affect other macroeconomic variable such as
interest and exchange rates
The negative relationship between
interest rates and price of bonds. Expect interest rates to go down, we will buy bonds which makes bond prices go up
The effect of trade deficits or monetary policy on
exchange rates. If they expect euros to appreciate they buy euros, if they expect it to depreciate they sell euros
“In establishing a new country, one of the first things government officials have to do is define a
unit of account; essentially define money
The Continental Congress unanimously resolved in 1785 that
the money unit of the united states can be one dollar
gold standard : Self-adjusting mechanism
if prices go up then we import more and that moves gold out of the country which means that the supply of money goes down which decreases prices. This also works in the opposite direction.
problem with the gold standard:
Under the gold standard, the value of the dollar depends on the value (scarcity) of gold. When the value of gold went up, prices of everything else went down and vice versa. This led to instability of prices.
-New gold mine, found more gold: prices go up.
-Instability of price if people find more gold
The Fed was created in
1914
at first banks used what to stabilize the business cycle?
the discount rate
in the beginning, the Fed had to keep a gold reserve of at least
40% of the currency it issued and should be able to exchange dollars at the $20.67 per ounce rate.
by the early 1930’s
however, many analysts had concluded that the gold standard was exerting too much discipline (!!)
timeline and evolution of money:
Every note represents gold, create a fed that decides we have gold equivalent to 40% of bills in circulation, then no just 30% and then in 1970’s 0%
Monetarists (following Milton Friedman) suggest…
suggest placing M1 money supply on a controlled upward growth path (say 3 to 5% every year)
M * V = P * Q
inflation targets done by
controlling short-term interest rates (the federal funds rate) through open market operations
Feds target was 2% for a long time
A way to think about the transition over the twentieth century is that in setting monetary policy, the government gradually shifted from
targeting one price of money (the exchange rate) to targeting another (the overall price level/ inflation rate).
