Macro Midterm 2

consumption

household spending on goods and services

consumption function

the positive relationship between consumption and income

marginal propensity to consume

the slope of the consumption function; extra consumption that arises from each additional dollar of income (changes in consumption/change in income)

saving

portion of income not spent in consumption (income-consumption)

dissaving

negative saving or borrowing (if consumption exceeds income)

consumption smoothing

the idea that you should maintain a steady path for consumption spending over time using saving and dissaving

permanent income

best estimate of a long-term average income

permanent income hypothesis

people spend based on a permanent income, not current income

hand to mouth consumers

consumers that spend all of their income, so change in consumption behavior is in response to a change in income (no dissaving)

determining aggregate consumption

how many consumption smoothers to hand-to-mouth consumers exist
how easy it is to access borrowing or saving instruments
how easy is it to anticipate changes in income

What causes a movement along the curve in the consumption function?

and increase in income, and thus an increase in consumption

What are the consumption shifters?

real interest rate, expectations, wealth, and taxes

real interest rate

nominal interest rate - inflation rate (purchasing power a saver earns for saving) (cost of consumption for households) (cost of borrowing/investing for firms)

substitution effect if the real interest rate increases

The benefit of saving increases, the opportunity cost of consuming increases, so saving should increase and consumption should decrease

income effect if the real interest rate increases

income earned on saving increases, so savers permanent income increases

What shifts the consumption function right?

increase real interest rate
pessimistic expectations
high taxes
decrease in wealth

What shifts the consumption function left?

low real interest rate
optimistic expectations
low taxes
high wealth

How do expectations shift the consumption function?

optimistic expectations shift left, and pessimistic expectations shift right

How does the real interest rate shift the consumption function

low real interest rates shift left, and high real interest rates shift right

How does wealth shift the consumption function?

high wealth shifts left, and low wealth shifts right

How do taxes shift the consumption function?

low taxes shift left, and high taxes shift right

compounding

process by which an assets earnings from interest are reinvested (interest earned on interest)

discounting

converting future values into their equivalent present value (FV / r^years) 

nominal interest rate

interest rate that includes inflation (dollars a saver earns or a borrower pays)

economic investment

purchase of new capital goods

What do economic investments exclude?

saving, buying stock, and buying gold

capital stock

total amount of goods in the economy at a given time

depreciation

capital goods that wear out, become obsolete, get damaged, or are rendered unusable due to age

capital growth

if investment excedes depreciation (total capital_{next year} = total capital_{this year} - depreciation_{this year} + investment_{this year})

What are the three main categories of investments?

business investment, inventories, and housing investment

business investment

spending by businesses on new capital goods

inventory investments

spending to maintain raw materials, works in progress, and unsold goods

housing investment

spending on building new homes or renovating existing ones

How do you calculate the present value of a stream of payments?

next year’s revenue / (depreciation rate + real interest rate)

rational rule for investors

Invest if the cost of investment is less than or equal to the present value

Investment drives the _________ ________.

business cycle (fluctuations in GDP)

Investment changes ______, but the total capital stock changes ______ over time.

quickly, slowly

Investments are long-term drivers of ________. 

prosperity

What is the cost of investing?

the real interest rate (a direct cost in borrowing, or an opportunity cost in reducing profits today in favor of investing)

What does the investment function look like?

firms demand for investing; a negative relationship between the real interest rate and the quantity of investments

What are the investment shifters?

expectations

taxes

lending standards

technology advancements

How do expectations shift the investment function?

optimistic expectations shift right, and pessimistic expectations shift left

How do taxes shift the investment function?

higher taxes (lower profits) shift left, lower taxes (higher profits) shift right

How do lending standards shift the investment function?

ease in getting loans (cost of borrowing is lower) shift right, and difficulty in getting loans (cost of borrowing is higher) shift left,

How do technology advancements shift the investment function?

increase productivity of capital (profits increase) shift right

market for loanable funds

the market for any funds that are used to buy, rent, or build capital (suppliers are households, and demanders are firms)

neutral real interest rate

the rate that supports the economy operating at its potential without sparking high inflation (the equilibrium in the market for loanable funds)

How does saving impact the market for loanable funds?

an increase in saving shifts the supply curve right, a decrease in saving shifts the supply curve left

How do taxes impact the market for loanable funds?

an increase in taxes (decreasing profits) shifts the demand curve left, a decrease in taxes (increasing profits) shifts the demand curve right

What are the three pillars of the financial sector?

banks, bond markets, stock markets

What are the primary functions of banks?

pools saving of many savers to make loans
spread risk of lending
solve informational problems
provide payment services

create long term loans from short term deposits

maturity transformation

using short term loans to make long term loans

bank run

when customers withdraw savings all at once because of a loss of faith that the bank will remain able to repay its depositors

bond

a loan structured as the borrower making a promise of future payment(s) in exchange for purchase of a bond by the lender for money now

face value

how much the bond pays at the end

present value of a bond formula

\frac{FaceValue}{\left(1+r\right)^{M}}

present value of a bond with coupons

\frac{coupon1}{\left(1+r\right)^1}+\frac{coupon2}{\left(1+r\right)^2}+\ldots+\frac{coupont}{\left(1+r\right)^{t}}

What are the primary functions of the bond market?

channels funds from savers to borrowers

fund government debt

spread risk 

create liquidity

default risk

the risk of not getting paid back

term risk

uncertainty of the future interest rate, there is an opportunity cost in not spending the money going towards the bond on something else

liquidity risk

you may not be able to sell whenever you want if there is an overflow of people wanting to sell

dividend

a share of the profits paid to shareholders

retained earnings

profit the company does not pay out

What are the primary functions of the stock market?

channel funds from savers to borrowers

spread risk

creates liquidity

efficient markets hypothesis

the theory that at any point in time the stock market price reflects all publicly available information about a company

the rule of 70

it takes 70/growth rate for something to double

production function

describes the way inputs are transformed into outputs (total production possible with a set of inputs)

factors of production

inputs of the economy: labor/ hours worked, human capital, and physical capital

human capital

the skills that workers bring to a job that make them more productive (measured through education)

The accumulation of capital

physical capital is a complement to labor

investment depends on the saving rate

there are diminishing returns to capital

institutions for growth of capital

property rights

government stability

efficient regulation

government policy encouraging innovation

trend growth

long run average growth

potential output

the level of output when all resources are fully employed

output gap

\frac{actualoutput-potentialoutput}{potentialoutput}\times100 (the percentage of potential)

business cycle

short term fluctuation in economic activity around trend (its is persistant)

recession

periods of declining economic activity over two or more quarters (short and sharp)

trough

low point of economic activity

expansion

period of positive and increasing economic activity (long and gradual)

peak

high point of economic activity

percent change of output

tells us where the economy is going; positive = growth

level of output

tells us where the economy is at

How do different economic indicators move with the business cycle?

though there are leading and lagging indicators, they move together 

How do different industries move with the business cycle?

they typically move together

What are some economic indicators that are used to analyze the business cycle?

realGDP, realGDI, employment, u-rate, inflation rate, consumer confidence, business confidence

macroeconomic equilibrium

the quantity of goods and services produced is equal to the aggregate expenditures/demand (when the output gap = 0) (occurs in the long-run)

aggregate expenditures

aggregate demand

Can aggregate expenditure differ from output?

Yes in the short term, but not in the long run because the business would need to adjust

What happens when the total quantity of output exceeds aggregate expenditure?

Here, quantity supplied would be greater than the quantity demanded, so firms adjust prices or the quantity supplied down to meet demand

What is the output gap formula looking at GDP?

[(GDP demanded - long-run GDP supplied) / long-run GDP supplied] * 100

economic overheating

when the actual GDP exceeds the potential GDP when resources are used in excess of what can be sustained

IS Curve

relationships between real interest rate and equilibrium GDP (negative slope)

Recall the expenditure approach to GDP

demand for consumption + economic investment demand + government demand+ (exports-inputs)

In the IS curve, how does each component of aggregate expenditures react to a decrease in the interest rate?

They all respond negatively in response of a change in interest rate.

consumption increases (cost of consumption decreases, prices fall)

investment increases (cost of borrowing decreases)

government expenditures increases (borrows more money)

net exports increase 

What is the relationship between the output gap and real interest rate?

negative

What is the relationship between the GDP and real interest rate?

negative

MP Curve

how the real interest rate is determined (fed funds rate + risk premium)

risk free interest rate

the “fed funds rate” that the fed sets according to economic activity

risk premium

determined by financial markets looking at the risk profile to add onto fed funds rate to create the real interest rate

Interest rate spread

risk premium = real interest rate - risk free rate

MP curve shifters

when the fed changes its rate or the risk premium changes