Macro 13- 17 review Flashcards

If the government wants to reduce GDP by $500 million, the most appropriate action is:

contractionary fiscal policy, which includes a reduction in government spending by less than $500 million.

The specific amount will be determined by the marginal propensity to consume (MPC)—the higher the MPC, the smaller the required change in government spending.

To reduce GDP, the government

should enact contractionary fiscal policy, which it can do by increasing taxes or—in this case—reducing government spending.

contractionary fiscal policy

reduces aggregate demand

The government slashes funding for the Environmental Protection Agency, without changing any other spending.

This is contractionary fiscal policy because it involves a reduction in government spending, directly lowering aggregate demand.

The government raises taxes on households making more than $250,000.

This is contractionary fiscal policy because it increases taxes, indirectly lowering aggregate demand via consumption.

Expansionary fiscal policy

increases aggregate demand

The government decides to fill gaps in Medicare by making it available to more people.

This is expansionary fiscal policy because it increases government spending, which increases aggregate demand directly.

Current Output

found at the intersection of the current aggregate demand curve AD2 and the short-run aggregate supply curve SRAS.

Potential output is

found where the long-run aggregate supply curve LRAS intersects the aggregate demand curve (note that it doesn't matter which—any AD curve will intersect the LRAS at potential output)

Shortfall of output

Potential output - Current Output

If the current output is less than potential output,

then were experiencing a recession.

To correct the recession

the president should enact expansionary fiscal policy

The aggregate demand curve would shift to the left if the president used contractionary fiscal policy.

Contractionary fiscal policy would reduce spending, shifting the AD curve leftward. This would further increase the shortfall between actual and potential GDP in New Caprica, making the current situation worse rather than better.

Assuming that unemployment is high and spending is low, should the government pursue expansionary or contractionary fiscal policy?

Expansionary fiscal policy (increasing government spending or decreasing taxes) is the appropriate response to these recessionary conditions

Assuming that unemployment is high and spending is low, what will the appropriate policy do to the aggregate demand curve? Will it shift to the right or to the left?

Expansionary policy will shift the AD curve rightward.

Assuming that unemployment is high and spending is low, through which component(s) of aggregate demand (Consumption, Investment, Government Spending, or Net Exports) will the change occur?

If government spending is increased, AD will increase directly through its government spending component. If taxes are lowered, AD will increase indirectly through its consumption and investment component—lower taxes will increase disposable (spendable) income, allowing households to spend more.

disposable income equation

National income - Net taxes

Amount in taxes equation

Annual tax rate × disposable income

Financial markets

financial institutions through which savers can directly provide funds to borrowers

Adverse Selection

the problem of incomplete information - of choosing alternatives without fully knowing the details of available options

Moral Hazard

the actions people take after they have entered into a transaction that make the other party to the transaction worse off

The value of the MPC depends on

the behavior of consumers, and this is difficult to predict.In this case, the government overestimated the value of the MPC, so GDP ended up less than potential GDP.

The smaller the value of the MPC,

the smaller the impact of a change in government spending or taxes on GDP.

National debt formula

Nd=Sum of deficits = Sum of surpluses

-$54 million(deficit)=(surpluses)$300 million surplus - $446 million deficit + $107 million surplus + X

-54 million=-39 + X

15 million = X

annual rate of return

Expected Annual Net Income / Average Investment

How is the risk-free interest rate determined?

It is equal to the interest rate on U.S. government debt

Risk Free rate

is the interest rate at which one would lend if there were no risk of default.

Securitization refers to

combining several loans or other financial assets into a bundle and then selling that bundle in whole or in parts to financial investors

During the recent housing market crisis, lender

relied too much on securitization to diversify their financial investments

Wyatt can get cash out of the ATM at any time of day or night.

access money quickly and without (much, if any) cost so that it can be spend when and on whatever.

Instead of lending all his savings out to one borrower, Xander's bank makes the money in his savings account available to a variety of firms, with different characteristics and risk profiles, wishing to invest.

diversification which allows his savings to be loaned to several different borrowers so that the chance of all of them defaulting is much smaller than the chance of just one loan to a single borrower going unpaid.

When Yao's car suddenly breaks down, she can quickly withdraw funds from her savings account to pay the mechanic and rent a car.

access money quickly and without (much, if any) cost so that it can be spend when and on whatever.

Zirwat can get start-up funds for her new hair salon from a bank, instead of having to find people in her neighborhood willing to lend their extra money.

is an intermediary between savers and borrowers—in this case, allowing Zirwat to borrow the funds she needs all at once instead of inquiring about and receiving small loans from many individuals with savings to spare.

expected return

the return on a risky asset expected in the future

Expected Return rating (Lowest to Highest)

Cash

U.S. Fixed Income Bonds

Commodities

Real Estate

U.S. Equities (Stocks)

Expected Risk rating (Lowest to Highest)

Cash

U.S. Fixed Income Bonds

Real Estate

U.S. Equities (Stocks)

Commodities

Expected Risk

The risk after considering agreed actions that have not yet been implemented.

A change that makes people want to save more will shift the ________________________ The resulting new equilibrium in the market for loanable funds would be a _________________________

quantity of loanable funds supplied to the right.

lower interest rate and a higher quantity of funds saved and invested.

A change that makes people want to ___________________________________________________. The resulting new equilibrium in the market for loanable funds would be a _____________________.

save less will shift the quantity of loanable funds supplied to the left

higher interest rate and a lower quantity of funds saved and invested.

A change that makes firms want to invest more will shift the quantity of _______________. The resulting new equilibrium in the market for loanable funds would be a _______________________________________

loanable funds demanded to the right.

higher interest rate and a higher quantity of funds saved and invested.

A change that makes firms want to invest less will shift the quantity of _____________________. The resulting new equilibrium in the market for loanable funds would be a ___________________________________________

loanable funds demanded to the left.:lower interest rate and a lower quantity of funds saved and invested.

If workers are not confident about the economy so they will elect to save more.The supply of saving curve shifts to the right,_______________________________________________

the equilibrium interest rate falls, and the quantity of funds saved and invested increases.

Workers will decide to save more so they have funds to use in the event they lose their jobs. The supply of saving curve shifts to the right,

the equilibrium interest rate falls, and the quantity of funds saved and invested increases.

If firms are not confident about the economy, then they are reluctant to invest in new capital. The demand for funds (investment) curve shifts to the left,

the equilibrium interest rate falls, and the quantity of funds saved and invested decreases.

If the government reduces taxes and this increases the deficit, then they need to borrow more funds. The demand for funds (investment) curve shifts to the right,

the equilibrium interest rate rises, and the quantity of funds saved and borrowed rises. Note in this case that because the interest rate is higher, investment spending will be lower.

Public Savings Formula

= Taxes - Government spending

Private Savings Formula

= Income - Taxes - Consumer spending

National savings Formula

= Public savings + Private savings

In a closed economy, an increase in government spending

will increase the demand for loanable funds. All else the same, this will increase the equilibrium interest rate.

In an open economy, an increase in government spending

will increase the demand for loanable funds. All else the same, this will increase the equilibrium interest rate. As a result of this change in the interest rate, capital inflow can be expected to increase and this will cause the supply of loanable funds curve to shift to the right.

crowding out

a decrease in investment that results from government borrowing

Crowding out occurs

when an increase in government spending leads to an increase in the demand for loanable funds, and an increase in the equilibrium interest rate. The higher interest rate crowds out investment. In an open economy, the increase in capital inflow will push the interest rate back down towards its original level, and this will cause investment spending to fall by a smaller amount in an open economy.

In a closed economy, the government starts offering a national savings bond to increase private savings, which pays a higher return than many other options available on the market.

A relatively low-risk, high-return bond will encourage savings, shifting the supply curve to the right. This will lower the equilibrium interest rate and increase the amount of borrowing.

Suppose the economy is now open. Due to rapid economic expansion in China, the Chinese government decides to invest in U.S. Treasury notes with some of its surplus.

The supply curve will shift to the right due to this net capital inflow.

A new computer software program is introduced into the market, which offers businesses that purchase it promising returns on their investment.

Investment is represented by the demand curve in the loanable-funds model, and it will shift rightward as expectations about higher returns encourage more investment at any given interest rate

The government reduces the capital gains tax, which taxes earnings on assets in the stock market.

This will encourage more saving via stocks, increasing the overall level of national savings, all else equal. This will shift the supply curve of loanable funds rightward.

If banks kept 100 percent of deposits on hand, the reserve requirement ratio and the multiplier would be

1 and banks would not be able to create new money.

Banks create new money by making loans. If they were required by law to keep 100 percent of deposits on hand,

there would be no dollars to lend and therefore no ability to change the money supply.

Using the liquidity-preference model, the Federal Reserve can react to the threat of exceedingly high inflation via monetary policy by shifting the supply of money to the:

left with contractionary monetary policy, increasing the interest rate and lowering the equilibrium quantity of money.

When inflation is the major threat, the Fed can shift the supply of money to the

left with contractionary monetary policy. The intended effect is to increase the interest rate and lower the equilibrium quantity of money. This will cause a leftward shift of the AD curve and a decrease in output and the price level.

contractionary monetary policy

monetary policy that reduces aggregate demand

liquidity preference model of the interest rate

the interest rate is determined by the supply and demand for money

You decide to take $500 out of your piggy bank at home and place it in the bank. If the reserve requirement is 2 percent, how much can your $500 increase the amount of money in the economy?

500×.02=10

500-10=490

1/0.02 = 50

490×50= $24,500.

Open-market operations example

It's the major way the Federal Reserve System enacts monetary policy

This tool is best for everyday monetary policy

changing reserve requirements

This tool is good for emergency situations that require major, large-scale action

Even if they aren't interested in buying, selling, or borrowing from the Fed, changes in this tool may inconvenience bank managers:

Discount window policy

This tool goes through the Federal Reserve's role as lender of last resort

A major disadvantage of this tool is that it requires that banks want to borrow from the Fed

Assume that $1.8 million is deposited into a bank with a reserve requirement of 10 percent.

a. What is the money supply as a result?

b. If the government decides to raise the reserve requirement to 15 percent, what is the value of the money supply in this case?

a. 1.8/0.1 = 18

b. 1.8/0.15 = 12

Output is above potential,

so the economy is overheating.

Contractionary monetary policy will

cool down spending and stave off inflation

When the Federal Reserve pursues contractionary monetary policy,

it will sell some of its government bonds in an open-market sale. This will decrease reserves in the banking system and interest rates will rise. The increase in interest rates will reduce spending and the aggregate demand curve will shift to the left.

What would happen to each of these components of the liquidity-preference model if the Federal Reserve decides to raise the reserve requirement?

Money supply

Decrease

This requiring banks to hold more money as reserves will hurt their ability to create new money, shifting the money supply curve leftward.

What would happen to each of these components of the liquidity-preference model if the Federal Reserve decides to raise the reserve requirement?

b. Interest rates

Increase

The decrease in the supply of money will push interest rates upward, all else equal.