ECO 205 Exam 4

in the short-run, real GDP and the price level are determined by…

the intersection of the aggregate demand curve and aggregate supply curve

aggregate demand curve

a curve that shows the total amount of goods and services (real GDP) that households, businesses, the government, and foreign buyers want to buy at different price levels

what happens as the price level goes up? (aggregate demand curve)

• money buys less

• consumers spend less

• businesses invest less

• U.S. goods are more expensive to foreign countries → exports dec.

• real GDP demanded decreases

what happens as the price level goes down? (aggregate demand curve)

• money buys more

• consumers spend more

• businesses invest more

• U.S. goods are cheaper to foreign countries → exports inc.

• real GDP demanded increases

the aggregate demand curve shows an ______ relationship between the price level and quantity of real GDP demanded

inverse

what is real GDP?

the total amount of goods and services in the economy

what happens as real GDP increases? (move right along AD curve)

more goods and services are demanded at a lower price level

what happens as real GDP decreases? (move left along AD curve)

less goods and services are demanded at a higher price level

aggregate supply curve

a curve that shows the total quantity of goods and services (real GDP) that firms are willing and able to produce at different price levels

what happens as the price level goes up? (aggregate supply curve)

• prices of goods and services are rising faster than wages and input costs

• higher profits for firms → produce more

• real GDP supplied increases

what happens as the price level goes down? (aggregate supply curve)

• prices of goods and services are falling faster than wages and input costs

• lower profits for firms → produce less

• real GDP supplied decreases

the aggregate supply curve shows a ______ relationship between the price level and quantity of real GDP supplied

direct

what happens if aggregate supply is greater than aggregate demand?

• there is a surplus

• prices fall (deflation)

• firms produce less

• higher unemployment

• may lead to a recession

what happens if aggregate demand is greater than aggregate supply?

• there is a shortage

• prices rise (inflation)

• firms produce more

• lower unemployment

• may lead to economic expansion

rising price levels is associated with…

inflation

falling prices levels is associated with…

deflation

4 components of aggregate demand (real GDP):

• consumption (C)

• investment (I)

• government purchases (G)

• net exports (NX)

equation for real GDP

Y = C + I + G + NX

what happens to the AD curve if a component of real GDP changes?

the entire curve shifts

what happens to the AD curve if the price level changes?

there is a movement along the curve

how does a higher price level lead to lower investment?

higher price level → higher demand for money → higher interest rates → more expensive to borrow → less investment

what happens to the AD curve when consumption decreases?

curve shifts left

what happens to the AD curve when investment decreases?

curve shifts left

what are some variables that shift the aggregate demand curve?

• monetary policy

• fiscal policy

if AS shifts left…

there are higher production costs and less output; real GDP dec.s, price level inc.s

if AS shifts right…

there are lower production costs and more output; real GDP inc.s, price level dec.s

if AD shifts right…

higher demand pushes prices and output up; real GDP inc.s, price level inc.s

if AD shifts left…

lower demand pushes prices and output down; real GDP dec.s, price level dec.s

monetary policy

the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives

what happens if the Federal Reserve causes interest rates to rise?

consumption and investment spending will fall

what happens if the Federal Reserve causes interest rates to fall?

consumption and investment spending will rise

monetary policies involve:

• money supply

• interest rates

fiscal policy

changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives

fiscal policy involves:

• government spending

• taxes

what happens when the government raises personal taxes?

consumption spending falls

what happens when the government raises business taxes?

investment spending falls

supply shock

an unexpected event that changes the cost or availability of goods and services; causes the short-run aggregate supply curve to shift

what happens when supply shock increases the cost and decreases the availability of goods and services?

AS curve shifts left (harder to produce things)

*can cause stagflation

what happens when supply shock decreases the cost and increases the availability of goods and services?

AS curve shifts right (easier to produce things)

stagflation

a combination of inflation and recession (low economic growth), usually resulting from a supply shock

money

an asset that people are generally willing to accept in exchange for goods and services or for payment of debts; makes trade easier and traders better off

asset

anything of value owned by a person or firm

commodity money

goods used as money that also have value independent of their use as money

ex. animal skins, precious metals

the existence of money allows for _______

specialization

what are the 4 primary functions of money?

• medium of exchange (widely accepted as payment for goods and services)

• unit of account (value is measured in a standard manner)

• storing of value (consumption can be deferred to a later date)

• standard of deferred payment (money facilitates exchanges across time)

in order to serve as money, a good should be:

• acceptable to most people

• of standardized quality (any two units are alike)

• durable

• easily transportable

• divisible

Federal Reserve

the central bank of the United States which oversees the size of the money supply; issues fiat money

fiat money

any money that is authorized by a central bank or government body; has value because the government says it does, not because it’s backed by a commodity like gold or silver

M1

the narrow definition of the money supply: the sum of currency in circulation, checking account deposits, and traveler’s checks (more liquid)

M2

a broader definition of the money supply that includes M1 + savings accounts, small time deposits, and money market mutual funds (less liquid)

the money supply classified as M1 is about ____ of the money supply classified as M2

1/4

how can banks increase the money supply?

by holding more money in checking accounts, through lending

do debit cards represent money?

no, they are a means of accessing checking account balances, which are classified as money

do credit cards represent money?

no, credit cards are a method of borrowing money and money transactions only occur when you pay your credit card loan

what do banks do with the money deposited to them?

make loans, invest in securities, and maintain reserves

what is a bank’s largest liability?

their deposit accounts, which are funds owed to depositors

reserves

deposits that a bank keeps available for its depositors as cash in its vault or on deposit with the Federal Reserve; money a bank does not lend out

required reserves

reserves that a bank is legally required to hold, based on its checking account deposits; set by the Federal Reserve

required reserve ratio

the minimum fraction of deposits banks are required by law to keep as reserves

what is the required reserve ratio? (%)

10%

ex. if a bank has $50,000 total deposits, they must keep $5,000 in reserve

excess reserves

reserves that are over the legal requirement

what happens when you deposit money at a bank?

it’s reserves (asset) increase but so do its deposits (liability) → the money supply does not change

simple deposit multiplier

the ratio of the amount of deposits created by banks to the amount of new reserves

simple deposit multiplier equation

1/ required reserve ratio

what happens when banks gain reserves?

they make new loans → money supply expands

what happens when banks lose reserves?

they reduce their loans → money supply contracts

discount loans

loans made by the Federal Reserve to banks

discount rate

the rate of interest charged on discount loans

what are some responsibilities of the Federal Reserve?

clear checks, audit banks to make sure they don’t fail, set the required reserve ratio, manage the money supply, promote stable economic growth

Federal Deposit Insurance Corporation (FDIC)

insures deposits in banks, up to a certain amount, to limit bank panics

*makes sure you get your money if a bank fails

Federal Open Market Committee (FOMC)

responsible for open market operations and managing the money supply in the U.S.

how often does the FOMC meet?

8 times per year

how can the Federal Reserve speed up the economy?

by taking actions that shift the AD curve right

how can the Federal Reserve slow down the economy?

by taking actions that shift the AD curve left

the three monetary policy tools used by the Federal Reserve

• open market operations

• discount policy

• reserve requirements

open market operations

the buying and selling of Treasury securities by the Federal Reserve in order to control the money supply

what happens when the Federal Reserve conducts an open market purchase?

inc. in money supply

what happens when the Federal Reserve conducts an open market sale?

dec. in money supply

discount policy

how the bank sets the discount rate

what happens if the Federal Reserve lowers the discount rate?

banks borrow and lend out more money → inc. in money supply

what happens if the Federal Reserve raises the discount rate?

banks borrow and lend out less money → dec. in money supply

open market purchase

the purchase by the Federal Reserve of government securities from banks and the public

open market sale

the sale by the Federal Reserve of government securities to banks and the public

an inc. in the money supply causes the economy to…

speed up

a dec. in the money supply causes the economy to…

slow down

what happens when the Federal Reserve lowers the required reserve ratio?

more loans are made → inc. in money supply

what happens when the Federal Reserve raises the required reserve ratio?

fewer loans are made → dec. in money supply

hyperinflation

rates of inflation in excess of 50% per month (~ 600% per year)

how does hyperinflation occur?

the money supply is increased at a rate far above the growth rate of real GDP

hyperinflation is associated with…

slow growth/severe recession

what are the four main monetary policy goals that the Federal Reserve pursues?

• price stability

• high employment

• stability of financial markets and institutions

• economic growth

stable economic growth encourages…

long-run investment, which itself is necessary for growth

what does the Federal Reserve use monetary policy tools for?

to keep both unemployment and inflation rates low

expansionary monetary policy

actions the Federal Reserve takes to increase the money supply and lower interest rates, which will increase real GDP (get out of a recession)

what is the effect of expansionary monetary policy?

money supply inc.s → interest rates dec. → consumption and investment inc.s → AD curve shifts right → real GDP and price level inc. → increased employment → inflation inc.s

when would the Federal Reserve conduct expansionary monetary policy?

when the economy is slowing down, or when unemployment is high and inflation is low (short-run equilibrium real GDP is below potential real GDP)

contractionary monetary policy

actions the Federal Reserve takes to decrease the money and raise interest rates, which will decrease real GDP

what is the effect of contractionary monetary policy?

money supply dec.s → interest rates inc. → consumption and investment dec.s → AD curve shifts left → real GDP and price level dec. → reduced inflation

when would the Federal Reserve conduct contractionary monetary policy?

when there is too much inflation (this can erode purchasing power and cause economic instability)

why would the Federal Reserve intentionally reduce real GDP through contractionary monetary policy?

if inflation is a danger to long-run growth, it will be beneficial to contract the monetary supply to encourage price stability