Unit 5 and 6 Notes

Unit 4 and 5 was a brief two units but there are still several notes for it. If you don't understand something just  post a comment on here and ill be sure to try my best to help you! :D

From Short Run to Long Run

• AS curve doesn’t shift in response to changes in the AD curve in the short run.
• Nominal wages do not respond to price level changes
• Workers may not realize impact of the changes or may be under contract.
• Long Run – period in which nominal wages are fully responsive to previous changes in price level
• When changes occur in the short run they result in either increased or decreased producer profits – not changes in wages paid.
• In the long run increases in AD result in a higher price level, as in the short run, but as workers demand more money the AS curve shifts left to equate to production at the original output level.
• In the long run, the AS curve is vertical at the natural rate of unemployment (NRU), or full employment (FE) level of output. Everyone who wants a job has one and no one is enticed into or out of the market.
• Demand – pull inflation will result when an increase in demand shifts the AD curve to the right, temporarily increasing output while raising prices.
• Cost-push inflation results when an increase in input costs that shifts the AS curve to the left. In this case the price level increase is not in response to the increase in AD, but instead the cause of price level increasing.

The Philips Curve

• It represents the relationship between unemployment and inflation.
• The tradeoff between inflation and unemployment occurs over the short run.
• Each point on the Philips curve corresponds to a different level of output.

Long Run Philips Curve (LRPC)

• It occurs at the natural rate of unemployment (NRU).
• NRU is equal to Frictional + structural + seasonal
• The natural rate and fewer worker benefits create a lower NRU
• It is represented by a  vertical line
• There is no tradeoff between unemployment and inflation in the long run.
• The economy produces at the full employment output level
• The nominal wages of workers fully incorporate any changes in price level as wages 
• LRPC only shifts if the LRAS curve shifts
• Determinants for LRAS is the same for LRPC
• Increase in unemployment it will shift LRPC to the right
• Decreases in unemployment will cause LRPC to shift left

Short Run Philips Curve (SRPC)

• Goes to the ground
• Increase in AD causes the SRPC to shift up/left along the curve.
• Decrease in AD SRPC shits downward along the curve
• Determinants are the same as the AD graph but the shift is along the curve not the entire curve
• When SRAS shifts to the right then SRPC shifts to the left…the whole curve (determinants: resources, weather, input prices, technology…etc)

Supply Shock – rapid and significant increase in resource costs which causes SRAS curve to shift.

Example

• Assume that major political events stop the delivery of foreign oil to the country, shifting the SRAS curve in the aggregate model. On the Philips Graph, show how the SRAS shift would affect the SRPC. Use 4% as the original LRPC.

	Unemployment Rate	Inflation Rate
Last Year	3%	8%
This year	5%	3%

Misery index- combination of inflation and unemployment in any year

• Single digit misery is good

If the inflation rate persists and the expected rate of inflation rises then the entire SRPC moves upwards when that happens stagflation exists. If inflation expectations drop (because of new techonology or efficiency) then SRPC moves downward

Stagflation – high unemployment and high inflation occurring at the same time

Disinflation – inflation decreases overtime.

• You know you have disinflation when nominal wages increase, business profits fall as prices are rising, firms reduce employment thus unemployment increases

Laffer Curve – tradeoff between tax rate and government revenue

• As tax rates increase from 0, tax revenues increase from 0 to some maximum level and then decline

Criticism of the Laffer Curve

• Where the economy is located on the curve is difficult to determine
• Tax cuts also increase demand which can fuel inflation
• Empirical evidence suggest that the impact on tax rates on incentives to work, save, and invest are small 

Supply-side Economics or Reagonomics

• They support policies that promote GDP growth by urging that high marginal tax rates alone with the current system of transfer payment (employment compensation or social securities) provide disincentives to work, invest, innovate, and undertake entrepreneurial ventures
• They believe that the AS curve will determine economic growth, inflation, and unemployment
• Trickle-down effect- the rich gets the money first and the poor gets it last

Marginal Tax Rate

• Amount paid on the last dollar earned or on each additional dollar earned.
• Supply side economists believe that if you reduce the marginal tax rate more people would be inclined to work longer thus forgoing leisure time for extra income

Balance of Payments

• Measure of money inflows and outflows between the United States and the Rest of the World (ROW)
• Inflows are referred to as CREDITS
• Outflows are referred to as DEBITS
• The balance of Payments is divided into 3 accounts
• Current Account
• Capital/Financial Account
• Official Reserves Account

Double Entry Bookkeeping

• Every transaction in the balance of payments is recorded twice in accordance with standard accounting practice
• Ex. U.S. manufacturer, John Deere, exports $50 million worth of farm equipment to Ireland
• A credit of $50 million to the current account ( - $50 million worth of farm equipment or physical assets)
• A debit of $50 million to the capital/financial account (+ $50 million worth of Euros or financial assets)
• Notice that the two transactions offset each other. Theoretically, the balance payments should always equal zero…Theoretically.

Unit 4 Notes

Unit IV Notes!! This unit is a bit more rigorous than the other 3 units but if you pay attention and study these notes well you will have no problems! :)


Uses of Money

1. Medium of exchange – trade
2. Unit of account – establishes worth
3. Store of money – money holding value over a period of time

Types of Money

1. Fiat money – it is money because the government says so (like the dollar is worth a dollar because the government says so)
2. Commodity money – examples are gold and silver coins (Commodity money is a good (no physical money is exchanged))
3. Representative money – example is IOU (I owe you) backed by something tangible

Characteristics of Money

1. Durability – money is durable (physically)
2. Portability – easy to carry
3. Divisibility – you can make change in many different ways
4. Uniformity – all has the same value and looks the same
5. Scarcity – $2 dollar bill…
6. Acceptability – money is accepted everywhere (very useful and acceptable)

Money Supply: 

1. M1 money (use 75% of the time) – (M stands for money…) consists of currency in circulation, checkable deposits (demand deposits) , and travelers checks
2. M2 money (use 25% of the time)– consists of M1 money +savings accounts + money market accounts + deposits held by banks outside the US

Fractional reserve system 

1. a process by banks of holding a small portion of their deposits in reserve in loaning out the excess.
2. Banks keep cash on hand (required reserves) to meet depositors’ needs. 
3. Banks must keep reserve deposits in their vaults or at the federal reserve bank
4. Total Reserves
• Total funds held by a bank
• TR (total reserves ) = RR (required reserves ) = ER ( excess reserves)
• Excess reserve – those that are beyond required 
5. Banks can legally lend only to the extent of their excess reserves
6. Reserve Ratio = RR / TR ( how much the bank can actually lend out)

Significance of a Fractional Reserve System

1. Banks can create money by lending more than their reserves
2. The amount, set by the fed, is the Required Reserve Ratio
3. Required reserves don’t prevent bank panics because banks must keep their required reserves  (FDIC insures your money)
4. Reserve requirement gives the FED control over how much money banks can create
5. Typically the Required Reserve Ratio = 10%

Functions of the FED (Federal Reserve Bank):

1. Control the nation’s money supply through monetary policy
2. Issue paper currency
3. Serve as a clearing house for checks
4. Regulates banking activities
5. Serves as a bank for banks (they issue out loans)

Balance Sheet

1. It is a statement of assets and claims summarizing the financial position of a firm or a bank at some point in time
2. It must BALANCE

Assets vs Liabilities

1. Assets (is what you own) = Liabilities (is what you own) + Net Worth
2. Net Worth - is the claim of the owners against the firm’s assets

Multiple Deposit Expansion

How Banks Work (T chart)

1. Assets :
• Reserves:
• Required Reserves (rr) - % required by Fed. to keep on hand to meet demand
• Excess Reserves (er) - % reserves over and above the amount needed to satisfy the minimum reserve ratio set by Fed.
• Loans to firms, consumers, and other banks (earn interest)
• Loans to government = treasury security
• Bank Property – (if bank fails, you could liquidate the building/property)
2. Liabilities :
• Timed Deposits (CD’s)
• Demand Deposits ($ put into bank)
• Loans from: Federal Reserve and other banks
• Shareholders Equity – (to set up a bank, you must invest your own money in it to have a stake in the banks success or failure) 

Practice Calculating Reserve Ratios

1. The reserve ratio is 5%. You deposit $1000 into a bank. How much is the bank required to add to its reserves?
• .05 X 1000 = $50 in reserve ratio
2. How much money can the bank now loan out?
• 1000 (deposited) – 50 (reserve ratio) = $950 loaned out to next borrower
3. 100 Percent Reserve Banking
• Now suppose households deposit the $1000 at “Firstbank.”
• Firstbank’s balance sheet :
• Deposits $1000 goes under liabilities (the claim of non-owners)
• Reserves $1000 goes under assets (don’t forget each side has to balance)
• 100% Reserve Banking has no impact on size of money supply
4. Fractional-Reserve Banking
• Suppose banks hold 20% of deposits in reserve, making loans with the rest.
• Firstbank will make $800 in loans
• Firstbank’s balance sheet :
• Under assets reserves $200 and loans $800
• The money supply now equals $1800: the depositor still has $1000 in demand deposits, but now the borrower holds $800 in currency
• Thus, in a fractional-reserve banking system, banks create money

The Required Reserve Ratio

1. The % of demand deposits that must be stored as vault cash or kept on reserve as Federal funds in the bank’s account with the Federal Reserve.
2. The Required Reserve Ratio determines the money multiplier (1/reserve ratio)
• Decreasing the reserve ratio increases the rate of money creation in the banking system and is expansionary
• Increasing the reserve ratio decreases the rate of money creation in the banking system and its contractionary
3. Changing the required reserve ratio is the least used tool of monetary policy and is usually held constant at 10%

The Money Multiplier

1. The money multiplier shows us the impact of a change in demand deposits on loans and eventually the money supply
2. The money multiplier indicates the total number of dollars created in the banking system by each $1 addition to the monetary base (bank reserves & currency in circulation)
3. To calculate the money multiplier, divide 1 by the required reserve ratio.
• Money multiplier = 1/reserve ratio
• Ex. If the reserve ratio is 25%, then the multiplier = 4.

The four types of multiple deposit expansion question

1. Type 1: Calculate the initial change in excess reserves
• A.k.a. the amount a single bank can loan from the initial deposit
2. Type 2: Calculate the change in loans in the banking system
3. Type 3: Calculate the change in the money supply
• Sometimes type 2 and 3 will have the same result (i.e. no Fed involvement)
4. Type 4: Calculate the change in demand deposits

Ex 1.

1. Given the required reserve ratio of 20%, assume the Federal Reserve purchases $100 million worth of US Treasury Securities on the open market from a primary security dealer. Determine the amount that a single bank can lend from this Federal Reserve purchase of bonds.
• The amount of new demand deposits – required reserve =The initial change in excess reserves
• $ 100 million (20% * 100 million)
• $100 million - $20 million = $80 million in ER
2. Determine the maximum change in loans in the banking system  from this Federal Reserve purchases of bonds
• $80 million * (1/20%)
• $80 million * 5 = $400 million max in new loans
3. Determine the maximum change in the money supply from this Federal Reserve purchase of bonds.
• The maximum change in loans + $ amount of Federal reserve action
• $400 million + $100 million = $500 million max change in the money supply
4. Determine the maximum change in demand deposits from this Federal Reserve purchase of bonds
• The maximum change in loans + $ amount of initial deposit
• $400 million + $100 million = $500 million max change in demand deposits

Fiscal Policy vs. Monetary Policy

1. Fiscal Policy:
• Congress
•  Tax or Spend
2. Monetary Policy:
• Fed
• OMO (Open Markey Operations): Buy or Sell bonds/securities
• Required Reserves: The amount of money the bank is required to keep on hand
• Discount Rate: the interest rate charged by the Fed for overnight loans to commercial banks. Does not change the money supply directly
• Federal Funds Rate: the interest rate charged by one commercial bank for overnight loans to another commercial bank. FOMC sets a federal fund rate and then uses open market operations to guide the effective rate to the target rate

The Fed has several tools to manage the money supply by manipulating the excess reserves held by banks, a practice known as monetary policy.

Loanable Funds Market

• The market where savers and borrowers exchange funds (Q_LF) at the real rate of interest (r%)
• The demand for loanable funds or borrowing comes from households, firms, government and the foreign sector. The demand for loanable funds is in fact the supply of bonds.
• The supply of loanable funds or savings comes from households, firms, government and the foreign sector. The supply of loanable funds is also the demand for bonds.

Changes in the Demand for Loanable Funds

• Remember that a demand for loanable funds = borrowing (i.e. supplying bonds)
• More borrowing = more demand for loanable funds (shift right)
• Less borrowing = less demand for loanable funds (shift left)
• Examples
• Government deficit spending = more borrowing = more demand for loanable funds: D_LF shift right, r% increase
• Less investment demand = less borrowing = less demand for loanable funds: D_LF shift left, r% decrease

Changes in the Supply of Loanable Funds

• Remember that supply of loanable funds = saving(i.e. demand for bonds)
• More saving = more supply of loanable funds (shift right)
• Less saving = less supply of loanable funds (shift left)
• Examples
• Government budget surplus = more saving = more supply for loanable funds: S_LF sight right, r% decrease
• Decrease in consumers’ MPS = less saving = less supply of loanable funds: S_LF shift left, r% increase