Macroeconomics Exam 3

What is the financial system?

A network of institutions and markets that link savers with borrowers.

Why is the financial system important?

It promotes investment, economic growth, resource allocation, and risk sharing.

What is a bond?

A loan from investors to borrowers, repaid with interest over time.

What is a stock?

A share of ownership in a company, with potential for dividends or price gains.

What is the national income accounting equation?

Y = C + I + G + NX

In an open economy, what finances investment?

Private savings (S), public savings (T - G), and foreign inflows (M - X).

In a closed economy, how is investment financed?

By domestic savings only: I = Y - C - G.

Who demands funds in the loanable funds market?

Borrowers: firms, government, and consumers.

Who supplies funds in the loanable funds market?

Savers: households and foreign investors (in an open economy).

What happens to interest rates under expansionary fiscal policy?

\uparrow Government borrowing \rightarrow \uparrow demand for funds \rightarrow \uparrow interest rates.

What is crowding out?

Higher government borrowing raises interest rates and reduces private investment.

Is fiscal policy more effective in the short run or long run?

More effective short term; long term it may cause debt and crowding out.

What are the 4 functions of money?

Medium of exchange, unit of account, store of value, standard of deferred payment.

What is fiat money?

Money with no intrinsic value, backed by government (e.g., U.S. dollar).

What is commodity money?

Money with intrinsic value (e.g., gold, silver).

What is included in M1?

Currency + checking deposits.

What is included in M2?

M1 + savings accounts + small time deposits + money market accounts.

What is the role of the Federal Reserve (the Fed)?

Control the money supply, interest rates, and stabilize the economy.

What are the 3 tools of monetary policy?

Open market operations (OMO), reserve requirements, discount rate.

How does the Fed increase the money supply using OMO?

Buy government bonds \rightarrow injects money into banks \rightarrow \uparrow money supply.

How does the Fed decrease the money supply using OMO?

Sell government bonds \rightarrow removes money from banks \rightarrow \downarrow money supply.

What is the money multiplier formula?

1 / reserve ratio.

How do banks create money?

By lending out deposits and creating new deposits through fractional reserve banking.

What is the liquidity preference theory?

People hold money for transactions, emergencies, or speculation despite the opportunity cost.

What happens to money demand when interest rates rise?

Money demand falls (people prefer interest-earning assets).

What does the vertical money supply curve represent?

The fixed money supply set by the Fed.

What is the equilibrium interest rate?

The rate where money demand = money supply.

What happens to output when the Fed lowers interest rates?

Investment increases \rightarrow aggregate demand increases \rightarrow output rises.

What implements fiscal policy?

The government

What is the goal of fiscal policy?

To reach the potential output, NRU. (NRU = structural + functional). Cyclical = 0

In the US economy today, if the current trend were to continue, what phase would the economy be in?

If trend continues to two consecutive quarters of declining real GDP, then it would be a recession, which puts the economy in the “contraction” phase.

Who determines monetary policy?

The Federal Reserve System. (Has NOTHING to do with the government)

What is meant by OMOs? (Open market operations)

Buying or selling bonds issued by the Government.

What type of monetary policy (M) should the Fed use?

Contractionary monetary policy (CMP)

What happens as interest rate goes up?

Investments, consumption, and the GDP will go down

What happens if the discount rate increases?

Banks borrow less from the Fed

Less lending → ↓ Money supply

Real interest rate ↑ → Consumption & investment ↓ → Aggregate Demand ↓

What happens if the reserve requirement increases?

Banks lend less → ↓ Loans

↓ Money creation → ↓ Money supply

Real interest rate ↑ → ↓ Consumption/investment → ↓ Aggregate demand

Within the money market, what happens as the money supply goes down?

Interest rate goes up. Borrowed loans, investment expenditures, consumption, and the GPD goes down.

What happens when OMOs sell government issued bonds?

The reserves from the banking system go into the federal reserve. Reserves decrease the loans by the banks, which decreases checking accounts and money supply.

How do you calculate the rate of return of a bond?

(Face value - bond price / bond price)