Macroeconomics CH 11-15

M1 measure of the money supply

Measures the most liquid forms of money. Currency in circulation, checking account balances, and saving account balances.

M2 measure of the money supply

measures currency in circulation, checking account balances, saving account balances, and adds a few more less liquid items such as small time deposits (aka CD’s)

Commodity-backed Money

Any form of money (generally paper money) that can be legally exchanged into a fixed amount of an underlying commodity. Until 1933, the dollar was backed by gold. A person could go to a “reserve bank” and exchange dollars for gold.

Full Faith and Credit

Our money is no longer backed by gold, but by “the full faith and credit of the United States government.” The U.S. dollar has value only to the extent that people trust the U.S. gov’t to keep using dollars and to keep their value roughly constant.

Fiat Money

Money created by rule, without any commodity to back it.

Three functions of money

A store of value, a medium of exchange, and a unit of account.

A store of value (money function)

it represents a certain amount of purchasing power that money retains over time.

-If you put $100 in a safe, you can expect to purchase about $100 worth of goods whenever you take that money out. The value obviously won’t be the same, but holding money is nearly always the most convenient way to hold onto wealth over time.

A medium of exchange (money function)

The ability to use money to purchase goods and services.

-Without money, people and firms would constantly have to search for mutually agreeable trades through bartering (someone has what you want and wants what you have).

A unit of account (money function)

A standard unit of comparison.

-Money allows us to make more informed decisions. Two competing job offers that pay you in shoes or eggs might make it difficult to wage which is the better option. Money gives a standard unit.

Do credit cards count as money?

No, these don’t count because they are a method of deferred payment. Any bills you receive will need to be paid with funds from your checking account (these funds do count as money).

One item in M2 but not in M1?

Small time deposits are not in this.

The Federal Reserve

The central bank of the U.S. consisting of a seven-member Board of Governors and 12 regional banks.

-Each regional bank monitors commercial banks in their region and collects economic data. Meet in NYC every 6-8 weeks.

Federal Deposit Insurance Corporation (FDIC)

Provides deposit insurance for all bank accounts up to $250,000. You’ll get your money back.

lender of last resort

The Fed acts as this. They will loan funds to any bank in danger of not being able to honor liabilities.

Cash as an asset/liability

Cash is an asset, a resource the bank possesses. But it’s also a liability, an amount the bank owes you and has promised you can get your cash back any time.

Dual Mandate

The Fed’s twin responsibilities: To use monetary policy to ensure price stability (stable inflation) and to maintain full employment (natural rate of unemployment).
-If both goods are met, the economy is considered to be performing well.

Monetary policy

Actions by the central bank to manage the money supply, in pursuit of certain macroeconomic goals.

Open-market Operations

The Fed’s sales or purchases of gov’t bonds to or from banks on the open market. The fed increases the money supply through these.

Fed wants to increase money supply

The Fed can buy a bond from one of the large banks it trades with. This purchase translates into larger deposits and reserves held by the commercial bank.

-Bank reserves increase when Fed buys bonds. Banks want to loan more reserves so they decrease interest rates, causing an increasing in spending in economy, firms produce more, GDP increases.

Fed wants to decrease the money supply

The Fed can sell bonds, accepting reserves from the buying banks as payment. The Fed then effectively destroys the money it receives.

Selling bonds decreases deposits, banks reserves decrease when fed sells bonds, bank has less reserves to loan, interest rates increase, spending decreases in economy and so does GDP.

Roles/Responsibilities of the Federal Reserve

Manages the money supply, acts as a lender of last resort, oversees the actions of regional banks, adjusts interest rates. The Fed has an interest in increasing the money supply in order to influence activity in the economy.

Bank Reserves

The money the bank must hold in their assets as mandated by the reserve ratio.

Excess Reserves

Any additional amount that a bank chooses to keep in reserve beyond the minimum amount required to maintain liquidity.

Required Reserves

The minimum proportion of deposits that banks were legally required (by the Federal Reserve) to keep on hand. In 2020, the Fed eliminated the reserve requirement, but banks still keep reserves to meet needs for liquidity.

Reserve Ratio

The percentage of required reserves the bank must hold. If the reserve ratio is 10% and you deposit $1,000 in the bank, then the bank must hold $100 on reserve. R is the reserve ratio.

Demand deposits

Funds held in bank accounts that can be withdrawn by depositors at any time without advance notice.

The money multiplier

The total amount of money created by banks’ lending activities/money created by the central bank. = 1/Reserve Ratio

Fractional Reserve Banking System

The U.S. economy operates under a fractional reserve banking system. Banks accept deposits and then by law must hold a percentage on reserve. The rest they are free to use to make loans or buy government bonds.

Examples of assets

Bank reserves, loans made by the bank, government bonds owned by the bank.

Examples of liabilities

deposits

Money supply

Currency in circulation + checking deposits.

What is a government bond?

A form of debt that represents a promise by the bond issuer (the gov’t) to repay the face value of the loan, at a specified maturity date, and to pay periodic interest at a specific percentage rate. These exist in order to help the gov’t pay off debts which happen when annual spending exceeds annual taxes collected (deficit).

Discount rate

The rate charged by the Fed if they were to loan funds to a bank. Lower discount rate = increase in money supply.

Federal funds rate

The rate banks charge each other to borrow reserves overnight.

-If a bank is short on reserves (lacking liquidity) at the end of a day, then it has to borrow from another bank to make up the difference. The following day the bank makes some adjustments to its balance sheet in order to solve its liquidity problem.

Keynesian Equilibrium

Firms choose to produce however much people want to buy. Explains why GDP grows at different rates from quarter to quarter.

Expansionary Monetary Policy

Feds should pursue this policy when the economy is in a recession (declining or negative real GDP growth rate).

Contractionary Monetary Policy

Feds should pursue this policy when the economy is in an expansion (Production/aggregate expenditure are above average, inflation rate rises. Unemployment rate is low.

Increased aggregate expenditure

Fed can buy bonds to increase reserves. More reserves = lower interest rates increase aggregate expenditure. This in turn will increase real GDP.

Decreased aggregate expenditure

Fed can change interest paid on reserves. Reserves pay more interest = banks make fewer loans.

Business Cycle

The downward/upward movement of GDP around its long-term growth trend (we called this potential GDP).

Inflation rate during a recession

This rate falls because during a recession the demand for goods and services is low.

Marginal propensity to consume (MPC)

The amount that consumption increases when disposable income increases by $1.

NX

Exports - Imports.
Exports: The value of what we produce and sell to foreigners.

Imports: The value of goods we purchase that are produced in other countries.

Planned Aggregate Expenditure

The amount of spending and production that businesses, households, and others are planning to make, consisting of planned consumption, investment, gov’t spending, and net exports.

Unplanned Inventory Investment

When sales are not as expected and we end up with some leftover inventory.

Factors causing change in PAE

Technological advancements, consumer confidence, people’s unpredictability.

Spending Multiplier

For any given change in autonomous expenditure, the change in equilibrium output will tend to be larger. Measures change in Real GDP caused by a change in autonomous expenditure.

Multiplier Effect

The idea that when people receive extra money, they go out and spend it.

Categories of gov’t spending

1. Spending on new goods/services: counts in GDP, part of PAE.

2. Transfer payments: Social security, don’t count in GDP until individual spends them

3. Interest payments: When gov’t is in deficit and issues bonds/securities to raise funds to pay debts, ppl who buy these are paid interest.

Government Budget

The difference between taxes collected and gov’t spending.

Fiscal Policy

Taxing and spending by the government budget balance and the government debt.

Monetary Policy

Tools that the central banks have in order to promote economic growth and control the money supply.

What happens to unemployment and inflation rate during a recession

During a recession, unemployment rate increases while inflation rate falls. Inflation rate falls because people are spending less and so firms lower prices, thus helping lower inflation.

Recessionary output gap

An output gap that occurs when equilibrium aggregate expenditure is below the level needed for full employment. Short run equilibrium output is below potential (full employment) output.

Inflationary output gap

Output gap that occurs when equilibrium aggregate expenditure is above the level needed for full employment. Short run equilibrium output is above potential (full employment) output.

The Financial System

The group of institutions in the economy that help match one person’s saving with another person’s investment.

Bond

A type of loan where investors lend money to gov’ts or corporations in exchange for interest payments and repayment of the principal. A form of debt that represents a promise by the bond issuer to repay the face value of the loan, at a specified maturity date, and to pay periodic interest at a specified percentage rate. AKA debt financing

Stock

A share of a company. A financial asset that represents partial ownership of a company. Companies sell shares of their company, and holders of stock are entitled to a share of the profits. AKA equity financing

Financial intermediary

Financial institutions through which savers indirectly provide funds to borrowers. This helps to reduce and diversify risk and provide liquidity

The primary job of the bank

The primary job of the bank is to make loans with people’s deposits.

Mutual fund

A portfolio of stocks, bonds, and other assets managed by a professional who makes decisions on behalf of clients. Each share represents a tiny bit of many different stocks and bonds.

Similarities/Differences between buying shares of stock vs buying shares of a mutual fund.

With stocks and mutual funds, you’re buying stocks or assets. However, in a mutual fund you let somebody else make the decisions for you. When you buy shares of stock, you are the one doing the research to see which stocks and bonds you should buy.

Financial Market

A market in which people trade future claims on funds or goods.

Private Saving

A type of saving which comes from individuals and firms

Public Saving

Refers to government saving. Taxes collected are basically the income of the government. A positive value means there’s surplus, a negative means there’s deficit.

Budget Deficit

The government is spending more money than they are gaining.

Budget surplus

The government is gaining more money than is being spent.

National saving

Private saving + public saving. The total of what individuals, firms, and the government save.

Wealth vs. Saving

Personal wealth is equal to your assets minus liabilities. Private saving is equal to your income subtracted by your taxes.

Crowding out

The reduction in private borrowing caused by an increase in government borrowing.

Variables that impact how much consumers save vs. spend

1. Falling interest rates

2. Preferences

3. Felling confident

4. Feeling wealthier (Consumption spending rises and savings will fall as they save a smaller amount of their same paycheck)

Variables that impact the amount of investment spending by firms

1. Technological advances (Investment spending rises, firms demand more funds)

2. Firm’s expectations, optimism, or pessimism

3. Taxes

4. Lower interest rates

In a closed economy, what is the relationship between national saving and investment?

We know that national saving = Y - C - G, so it follows that national saving = investment in a closed economy.

because GDP = Y = C + I + G

Personal balance sheet

Tracks assets, liabilities, and wealth. Assets on the left, liabilities on the right. Both sides always balance, and every transaction has two entries

Firm balance sheet

Tracks assets, liabilities, and owner’s equity. Assets on the left, liabilities on the right. Both sides always balance, and every transaction has two entries

Bank balance sheet

Tracks assets, liabilities, and bank capital. Assets on the left, liabilities on the right. Both sides always balance, and every transaction has two entries

Spending by firms..

is called investment. The largest category of investment spending is business capital (new buildings, equipment.) Firms always borrow funds to pay for investment spending, otherwise they’d have to wait until they have enough money from profit, slowing the economy.

Market for loanable funds

The market in which those who want to save SUPPLY funds and those who want to borrow to invest DEMAND funds. For our purposes we assume that this as well as public, government, nat’l, and investment spending formulas occur in a closed economy.

In the economy, buying stocks and funds is considered a type of..

savings