Macroeconomics

Chapter 4

Money: is the stock of assets that can be readily used to make transactions

Primary Functions:

· Medium of Exchange: to buy

· Store of Value: transfer purchasing power from present to future

· Unit of Account: unit to measures prices and values

Money Supply: quantity of money available in the economy

Monetary Policy: The control and the adjustment over the quantity of money in an economy.

Federal Reserve System: Central Bank of the US, conduct US Monetary Policy, prints US dollar bills, regulates the banking system, and politically independent.

Policy Tools:

· Open Market Operations: Purchase and sale of government bonds by the FED.

To increase M, Fed buys government bonds from the public

To decrease M, Fed sells government bonds to the public

· Discount Rate: interest rate the Fed charges on loans to banks.

To increase M, Fed can lower the discount rate encouraging banks to borrow more from the Fed

To decrease M, Fed can increase the discount rate, discouraging banks to borrow from the Fed

· Reserve Requirements: regulations that impose a minimum reserve-deposit ratio for banks.

To increase M, Fed can decrease the reserve requirement

To reduce M, Fed can increase the reserve requirement

Chapter 5

Quantity Theory of Money

· A simple theory linking the inflation rate to the growth rate of the money supply

· The rate at which money circulates through the economy

· Number of times the average dollar bill changes hands in a given time period

M = quantity of money

V = velocity of money

P = price of output (i.e., GDP deflator)

Y = quantity of output (i.e., real GDP)

P ×Y = value of output (nominal GDP)

M ×V = aggregate spending

The Quantity Equation : MxV=PxY Aggregate spending = Nominal GDP

Inflation and Interest Rate:

- The Nominal interest rate, i, is not adjusted for inflation

- The Real interest rate, r, is the nominal interest rate adjusted for inflation, π , such that:

r = real interest rate

i = nominal interest rate

= inflation rate

i = r +

Fisher Effect: i = r +

Growth in M affects , which affects i.

Chapter 10

· Business Cycle: The periodic, but regular economy wide fluctuations of output, income, and employment.

- Recession: Period of falling output and rising unemployment. At least 10 months.

- Expansion: Period of rising output and falling unemployment.

· Okun’s Law: inverse relationship between Real GDP and the Unemployment Rate

· Aggregate Demand (AD):

Money Supply (M) increase: Price unchanged and Real GDP increase. Fed buy bonds. Lower discount rate

Money Supply (M) decrease: Price unchanged and Real GDP decrease. Fed sell bonds. Rising discount rate

Long Run: All prices are variable. Prices adjust

Short Run: Some prices are slow to adjust. Some prices are sticky or fixed. Sometime is costly Example: advertising.

-Aggregate Supply (AS):

Long Run (LRAS): Affect Price Vertical

Money Supply (M) increase: Price increase (inflation) and Real GDP unchanged. Unemployment remains at the natural rate. AD shift to the right.

Money Supply (M) decrease: Price decrease and Real GDP unchanged. AD shift to the left.

Short Run (SRAS): Affect Y (Real GDP) Horizontal

Money Supply (M) increase: Price unchanged and Real GDP increase. AD shift to the right. Unemployment decrease. EXPANSION

Money Supply (M) decrease: Price unchanged and Real GDP decrease. AD shift to the left. Unemployment increase.

Y = Y^ (Ability to Produce) (Does not depend on Price)

Y^ = Natural Output (Full employment output)

· Long Run Economic Equilibrium:

All three curves intersect

· Short-run economic equilibrium

Where AD intersects SRAS.

Why not inflation? Since unemployment is initially high, no upward pressure on wages

Risk: if the Fed is too aggressive in rising M, aggregate demand shifts too far an inflation could occur

Supply Shock: An exogenous event affecting the overall price level for example: natural disaster, war, oil, price fluctuation increase rise in P

Recession:

· Output level will fall

· Unemployment rises

· Lower income level

· Pay more for everything

Oil prices are so important because of the possibilities are so significant.

Stagflation: Recession and inflation (how to get rid of it)

· Option 1: No policy intervention “self-correction” wait for P to decrease

Problem: employees requires lower wages

· Option 2: The Fed may increase M by buying bonds

Recession ends:

· Initially Inflation stands, but not addition inflation because unemployment is still so high, but producers are hiring workers.

It took Us in 1973 so long (5 years) to step in instead of self correcting itself, because they didn’t want to be too aggressive (1980s economy was finally booming)

Short run: Sticky prices

· Means that in the short run economy fluctuations are explained by changes in AD

· AD increases (expansion)

· Ad decreases (Recession)

Chapter 11

IS-LM Model= r

IS: Market for Good & Services

LM: Market for Money

Market for good & services

· Actual Spending: Aggregate spending on final good & services in an economy. Nominal GDP (Y)

· Planned spending (PE): Amount that households firms and the government will like to spend on final good and services.

PE= (C+I+G)

C=C (Y-T)

I= I(r)

G= G^ (set via policy)

T= T^ (set via policy)

PE= C (Y-T^) + I^ + G^

In Equilibrium

· Actual Spending= planned spending

Y= PE

Y= C+I+G

Impact of Government Spending (vice versa)

G increases (stimulus bill)

If G increases, (C+I+G) increases, PE increases

PE shifts up

Y increases, unemployment decreases

Change in Y > Change in G “multiplier effect”

2 types of risk:

· Future inflation

· Budget deficit increases

Impact of tax cut (vice versa)

Tax decreases (tax cut)

If T decreases, C increases, (C+I+G) increases, PE increases

PE shifts up

Y increases, unemployment decreases

Change in Y > Change in T “multiplier effect”

2 types of risk:

· Future inflation

· Budget deficit increases

IS-Curve:

· Shows combination of R & Y for which the market for Good & Services are in Equilibrium

Why downward slopping?

If R decreases, I increase, PE increases, and Y increases

If Y increases, S increases, and R decrease

Fiscal Policy shifts IS curve

Due to G increase or T decrease (IS curve shifts right)

Due to G decrease or T increase (IS curve shifts left)

The market for money

M= Quantity of money

P= Aggregate price level

M/P= Real money balances

Demand for real money balances: Households demand money to conduct transactions “Holding Money”

[M/P]^D = L (r,Y)

r= opportunity cost of holding money or price of holding money

Supply of Real money balances: Fed can raise the money supply without causing inflation

M/P= Real money balance

M= M^(set via monetary policy)

P= P^(sticky)

(M/P)^S= M^/P^ (exogenous)

LM-Curve:

· Equilibrium in the market for money

· Shifts by Monetary Policy

Goods market: (IS-LS Model)

· Keynesian cross = IS curve

Money Market: (IS-LS Model)

· Demand and supply of real money balances= LM Curve

Keynesian Cross:-.

· PE shifts up (Y increase)

R decrease, T decrease, G increase

· PE shifts down (Y decrease)

r increase, T increase and G decrease

Money Market:

· [M/P]^S shifts right (r decrease)

M increase (fed buying bonds)

-[M/P]^S shifts left (r increase)

M decrease (fed selling bonds)

· [M/P]^D shifts right (r increase)

Y increase (expansion)

[M/P]^D shifts left (r decrease)

Y decrease (recession)