Macro Chapter 11.12.13

what are economic fluctuations (business cycles)

refer to the short-run changes in the growth rate of real GDP
- economic growth rates are never constant and there are fluctuations in the RGDP due to recessions and expansions

what is the output gap

the percent deviation between RGDP and trend RGDP
=((RGDP- trend RGDP)/ trend RGDP)x100

who determines when we are in a recession

the National Bureau of Economic Research (NBER)
specifically the Business Cycle Dating Committee

what is a peak

when RDGP is at its maximum after rising in a recovery/expansion period

what is a recession

downturn after the peak when RGDP falls. the growth rate of RGDP during a recession is negative
- a period of at least 2 consecutive quarters of declining RGDP

what is a trough

RGDP is at its minimum after a recession

what is an expansion (recovery)

upturn after trough when RGDP rises again
the growth rate of RGDP during a recovery is positive

what is a trend line

represents the level of RGDP the economy would attain if it had maintained a steady rate of economic growth, thereby avoiding the fluctutations

when does an economic expansion begin

at the end of one recession and continues until the start of the next recession
- they are the periods between recessions

what is NBER's definition of a recession

a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in RGDP, real income, employment, industrial production and wholesale-retail sales

when did the last expansion begin according the NBER

June 2009

what are the three patterns of economic fluctuations

-co-movement of macroeconomic variables: real consumption, real investment, employment, RGDP
- limited predictability of fluctuations
- persistence in the rate economic growth

what is co-movement of macroeconomic variables

real consumption, real investment, employment and RGDP all increase and contract together during economic recessions and expansion

what is limited predictability

recessions and expansions have variable lengths
- they don't follow a repetitive and easily predictable cycle so we can't forecast when a recession or expansion will end at the time of its beginning, except when it is a month or two before the actual end

what is persistence in the rate of economic growth

economic growth tends to be persistent for some number of quarters
- when the economy is growing, it will probably keep growing the following quarter and vice versa

what is the role of countercyclical policy

to reduce the intensity of economic fluctuations and smooth the growth rates of employment, RGDP andprices

during a recession what kind of policy is enacted and what does it do

expansionary policy and it aims to reduce the severity of the downturn by shifting the labor demand to the right and expanding economic activity (GDP)

during excessive expansion or an economic boom what kind of policy is enacted and what does it do

contractionary policy and it is used to slow down the economy when it flows too fast or overhears to avoid asset price bubbles due to bandwagon behavior

what do countercyclical monetary and fiscal policy have that are the same and how are they different

they have different tools and work differently but they both work by shifting the labor market curve
- in a recession they shift it to the right

what do monetary and fiscal policy do in a recession

monetary policy cuts interest rates and increases the money supply while fiscal policy would cut tax rates and increase government spending

why should we adopt policies that have a reducing effect on the growth rate of GDP and level of employment in an economic boom

these negative effects are by-products of an effort to control inflation during an economic boom due to excessive aggregate demand

with wages being downward rigid, what type of policy is more effective and what does it do

countercyclical. expansionary policy shifts the labor demand curve to the right but the real wage can't fall so the economy moves to partial recovery

why is countercyclical policy more effecting in downward rigid cases

because there is no wage response, the full force of expansionary policy impact employment. the rightward shift in the labor demand curve translates into an increase in employment

what is the definition of monetary policy

refers to the actions taken by the Federal Reserve System (Fed) to change interest rate and money supply
- aimed at stimulating the economy during a recession or slowing down the growth rate in an economic boom

what is the dual mandate of the Fed

controlling inflation and minimizing the unemployment rate

when the economy is in a recession what is the fed worried about and what kind of policy does it enact

they are worried of unemployment so they conduct expansionary monetary policy which involves lowering interest rates and/or increasing the growth rate of money supply
- goal: to increase labor demand and reduce unemployment

when the economy is in a boom, what is the fed worried about and what kind of policy does it enact

they are worried about inflation so they conduct contractionary monetary policy which involves raising interest rates and/or slowing down the growth rate of money supply
- goal: slow down the rate of inflation

what are the conventional and unconventional tools of monetary policy

conventional: open market operations, discount window and discount rate, reserve requirements
unconventional: interest on required reserve balances and excess balances, quantitative easing (special OMO)

what are open market operations

the fed's purchases or sales of short term government securities, normally treasury bills or t-bills in order to control the federal funds rate and other short term interest rates

who conducts OMO

the Federal Open Market Committee (FOMC)

what is the federal funds rate

the interest rate that commercial banks charge to make loans to each other from their excess reserve deposits at the Fed using the Fed wire system
- commercial bank to commercial bank

what is the primary tool of monetary policy

the Fed's control of the federal funds rate

what are bank reserves

the amount of money a given bank keeps on hand either in cash (in its vault) and/or in deposit at the Fed

why do banks keep reserves

- to comply with regulation: required reserves
-excess reserves (liquidity): for customers' needs

what is the reserves (federal funds) market

where banks obtain loans of reserves from another bank

what does the demand curve ffr the federal funds market look like and what does that mean

it is downward sloping and that implies that a higher for increases the cost of holding reserves and reduces the quantity of reserves demanded by optimizing banks and vice versa

reserves are a what for banks

a liquidity safety net and they want a big net.
- having a lower interest rate increases the quantity of reserves demand

what are the 5 factors that shift the demand curve for reserves

- economic expansion or contraction
-changing liquidity needs
- changing deposit base
-changing reserve requirement
- changing interest paid

what does the supply curve for the federal funds market look like and what does it mean

it is modeled as a vertical line
- implying that in the day-to-day operations of the Fed there is a given amount/quantity of reserves et by the Fed
- the Fed fixes the supply of reserves each day

what is expansionary OMO

goal: stimulate the economy and reduce the unemployment rate
to achieve this goal: the Fed targets a lower fed funds rate which increases the supply of reserves to banks purchasing t-bills from commercial banks and paying them with reserves from t he Fed

what are the effects of expansionary OMO

- increase in the supply of reserves shifts the reserves supply curve outwards towards the right
-the equilibrium fed funds rate falls
-both banks and eventually households are able to borrow at a lower interest rate
- the labor demand curve will eventually shift outwards towards the right and unemployment will hopefully fall

what is contractionary OMO

goal: control inflation
to achieve: targets a higher ffr and other short-term interest rates. the Fed sells t-bills to commercial banks- banks pay for the t-bills by drawing down their reserve deposits

what are the effects of contractionary OMO

-the supply of reserves in the funds market will decrease and shift inwards to the left
- the equilibrium ffr will rise
- both banks and eventually households will borrow at higher interest rates- this decreases consumption, investment and inflation

for a given demand of reserves, increase the SS of reserves does what and vice versa

reduces the interest rates and vice versa

what is the effective federal funds rate

the weighted average rate for all these types of negotiations
- determined by the market but is influenced by the Fed through open market operations to reach the ffr target

what are some alternative strategies to implement monetary policy

1. the Fed holds reserves fixed even when the demand curve shifts
2. the Fed would target a given ffr and find/pick the level of reserves that achieves the target ffr

what is the discount rate

the interest rate banks pay when they borrow reserves/funds directly from the Fed itself, but not from the commercial banks

the Fed is the what

lender of last resort

what are the 4 main types of lending from the discount window

primary credit, secondary credit, seasonal credit and emergency credit

what is primary credit

available to healthy banks on a very short-term basis
- well capitalized banks can use primary credit as a backup rather than a regular source of funding
-primary credit rate is higher than the fed funds rate
3.25

what is secondary credit

this is available to banks which are not eligible for primary credit
- such banks would be experiencing severe liquidity problems
-use as a backup source of funding on short-term basis to facilitate an orderly resolution of serious financial difficulties
- higher than the primary credit rate
3.75

what is seasonal credit

available to banks that experience seasonal swings in their loans and deposits
- eligible depository institutions are usually located in agricultural or tourist areas
- is a floating rate based on market rates
3.40

what is emergency credit

the board of governors may authorize a Reserve Bank to provide emergency credit to a participant in a program or facility with broad-based eligibility
- EX: SIFI's

what is the reserve requirement

the amount of money (funds/reserves) commercial banks must hold at hand in cash and/or with the Fed against a specified amount of net deposit liabilities

reserve requirement ratios on net transactions differed based on....

the amount of net transactions accounts at the depository institution

if banks are not required to hold any reserves with the Fed, this implies that

implies that the Fed is conducting a very highly expansionary monetary policy

during a recession, why does the Fed lower the interest on reserves

to encourage banks to lend out money to the business community

during an economic boom, why does the fed raise the interest on reserves

to discourage banks from lending out the money to the business community and encourage them to keep more reserves at the Fed

why did the Fed start paying interest on reserves in 2008

1. the interest on reserves reduces the effective tax (opportunity cost) on reserves at the Fed
2. helps improve the implementation of monetary policy
3. the fed could expand its lending as much as it needs without making the fed funds rate fall to 0

the opportunity cost of holding reserves by a bank equals?

the interest rate a bank would earn from lending out the funds minus the interest payment on reserves by the Fed

what is quantitative easing

refers to policies that are designed to directly increase money supply by a specified amount of dollars

why and when in Quantitative easing done

conducted when conventional OMO is no longer effective, when interest rates are already very low so that it is impossible to cut them any further

how is quantitative easing done

The Fed creates money/reserves electronically in its balance sheet
-uses the newly created reserves to buy US bonds from commercial banks
- commercial banks end up holding fewer bonds but accumulating a lot of excess reserves
----commercial bank may want to get rid of some of the extra excess reserves by making more loans

how can QE stimulate the economy

-increasing bank reserves
- the Federal government auctions large quantities of securities for expansionary fiscal policy

what is the formula for the interest rate of a discount bond

=((Face value price-current price)/current price)*100

what are the limitations of QE

- if commercial banks do not loan out the extra reserves, the effectiveness of QE is severely diminished
- can cause hyper-inflation because it involves a significant increase in money supply
-when the economy recovers, the Fed has to conduct reverse QE: sale of US bonds back to commercial banks to retrieve the excess reserve
- QE requires a highly independent central bank to avoid manipulation of monetary policy for political purposes especially during the elections year

the effectiveness of monetary policy depends on what

expectations about the future interest rates and inflation

what is the formula for long-term expected real interest rate

=LT nominal interest rate- LT expected inflation rate

for the Fed to encourage household and business to borrow more money, what needs to happen

the LT expected real interest rate must be lowered

how can the Fed lower to the LT nominal interest rate

by holding the federal funds rate low for a long time

what is forward guidance

the Fed's effort to influence today's expectations about future monetary policy
- done through conferences, press releases, publication and avoiding policy time inconsistency

what is time consistence

if the Fed promises that it will keep interest rates low, it should not make any surprise increases in interest rates without effective communication with the business community

what is the zero lower bound

refers to the case in which the nominal interest rate hits 0%, a boundary line it cannot cross
ex: Japan

what are the problems with hitting the zero lower bound

- the nominal interest rate cannot drop below that level- can't be negative.- no bank will lend money at a negative nominal interest rate
- problem if the inflation rate is low or negative because of the expected real interest rate which will shift the demand curve for labor to the left and start a recession or deepen an existing one

who is Paul Volker and what did he do

he reduced the growth of money stock to fight inflation in the 80's but his action raised interest rates and started a major recession

what is there a tradeoff between

short-term output growth and inflation

to minimize the risk of too much monetary expansion, central banks use what

formulas to conduct monetary policy so that the risk of too much monetary expansion is minimized

what is the Taylor rule

ffr= LR for target+ 1.5(inflation rate-inflation rate target)+ .5 (output gap in %)

observations from the Taylor Rule

- when the inflation gap rises, the Fed raises the ffr
- when the output gap increases, the Fed raises the ffr to minimize business cycle fluctuations

what is fiscal policy

refers to the tax and spending policies of the federal government

who determines fiscal policy decisions

they are determined by the Congress and Presidential Administration

what is expansionary fiscal policy and when is it conducted

it is conducted during a recession.
-involves higher public spending and lower tax rates to stimulate the rate of economic growth

what is contractionary fiscal policy and when is it conducted

it is conducted during an economic boom
-involves lower public spending and higher tax rates to slow down the growth rate of (excessive) aggregate demandw

what are the two types of fiscal policy

automatic stabilizers (countercyclical fiscal policy) and discretionary countercyclical fiscal policy

what are the automatic countercyclical components

tax revenue and expenditure items in the federal budget that change with changes in the state of the economy to stabilize it and smooth out economic fluctuations

why are they called automatic"

they don't require additional debate and action by the legislative branch

why are taxes used as automatic stabilizers

higher income earners pay a higher fraction/percentage of their income than lower income earners
-tax collections rise faster than income

when the economy is BOOMING, how do taxes act as an automatic stabilizer

people earn more but they also are taxed at higher rates with our any new deliberate regulations/interventions from the policy makers
-increased taxes serve to put a check on spending, just as a contractionary fiscal policy would

when the economy is in a RECESSION, how do taxes act as an automatic stabilizer

people earn less money but they also end up paying lower taxes
-lower tax brackets prevent aggregate demand from falling too much just as an expansionary fiscal policy would

when the economy is BOOMING, how does government spending act as an automatic stabilizer

fewer people are eligible for government assistance programs and so government spending on them falls- thus fiscal policy automatically becomes contractionary

when the economy is in a RECESSION, how does government spending act as an automatic stabilizer

more people become eligible for government assistance programs and so government spending automatically increases and policy becomes automatically expansionary

what is discretionary countercyclical fiscal policy

deliberate new decisions and changes in government expenditure and taxation in response to economic fluctuations

during a recession, government expenditure is increased while tax revenues decline. what effect does this have on the government deficit

it makes the deficit increase

what is the spending multiplier

the number of times an initial change in spending brings about a change in the equilibrium GDP
-via consumption, government expenditure or net exports

what is the formula for the spending multiplier

=change in GDP/ change in spending

what is the tax multiplier

the number of times a change in taxes brings about a change in GDPw

what is the formula for the tax multipler

=change in GDP/ change in taxes

why is the tax multiplier always negative

an increase in taxes would reduce GDP and vice versa

what are some specific fiscal policies that target the labor market

-when the government extends the eligibility for unemployment insurance benefits
- can increase the unemployment insurance payment
-may subsidize wages and thereby encouraging job creation

how would increasing the unemployment insurance help the labor market

it would reduce the economic hardship of the unemployed, prevent household consumption form falling too much and supper a little bit of labor demand
-downside: might reduce the incentive for the unemployed to seek and find new jobs because of moral hazardw