Macroeconomics Final Review: Key Concepts and Theories

Money

Any commodity or token that is generally acceptable as a means of payment.

Means of payment

A method of settling debt.

Functions of money

Medium of exchange, unit of account, store of value.

Medium of exchange

An object that is generally accepted in exchange for goods and services.

Barter

The direct exchange of goods and services without money, requiring a double coincidence of wants.

Unit of account

An agreed-upon measure for stating the prices of goods and services.

Store of value

Money can be held for a time and later exchanged for goods and services.

Currency

The notes and coins held by individuals and businesses.

Deposits

Money because the owner can use the deposit to make payments.

M1

Consists of currency and travelers' checks, and checking deposits owned by individuals and businesses.

M2

Consists of M1 plus time deposits, savings deposits, money market mutual funds, and other deposits.

Liquidity

The property of being instantly convertible into a means of payment.

Depository institution

A firm that takes deposits from households and firms and makes loans to other households and firms.

Commercial bank

A private firm that is licensed by the Federal Reserve or by a state agency to receive deposits and make loans.

Thrift institutions

Savings and loan associations, savings banks, and credit unions.

Money market mutual funds

A fund operated by a financial institution that sells shares in the fund and holds assets such as U.S. Treasury bills.

Goal of banks

To maximize the wealth of its owners.

Interest rate on loans

The rate at which banks lend money, which must exceed the interest rate paid on deposits.

Checks

An instruction to a bank to transfer money.

Credit cards

Enable the holder to obtain a loan, but must be repaid with money.

Liquid assets

Some saving deposits in M2 that are not a means of payment.

General acceptability

A characteristic of money indicating it is widely accepted.

Value stability

A characteristic of money indicating its value does not fluctuate significantly.

Transportability

A characteristic of money that allows it to be easily carried.

Storability

A characteristic of money that allows it to be stored for future use.

Divisibility

A characteristic of money that allows it to be divided into smaller units.

Cash assets

Notes and coins in its vault or its deposit at the federal reserve.

Securities

U.S government treasury bills and commercial bills, and longer-term US government bonds, and other bonds such as mortgage-backed securities.

Loans

Commitments of fixed amounts of money for agreed-upon periods.

Economic benefits of depository institutions

Depository institutions make a profit from the spread between the interest rate they pay on their deposits and the interest rate they charge on their loans.

Benefits provided by depository institutions

Create liquidity, pool risk, lower the cost of borrowing, and lower the cost of monitoring borrowers.

Regulation of depository institutions

Depository institutions are required to hold levels of reserves and owners' capital equal to those that surpass ratios laid down by regulations.

FDIC

Deposits are guaranteed up to $250,000 per depositor per bank by the Federal Deposit Insurance Company.

Federal Reserve System

The central bank of the United States.

Central Bank

The public authority that regulates a nation's depository institutions and controls the quantity of money.

Goals of the Fed

Keep inflation in check, maintain full employment, moderate the business cycle, and contribute towards achieving long-term growth.

Federal funds rate

The interest rate that banks charge each other on overnight loans of reserves.

Structure of the Fed

The board of governors, the regional Federal Reserve Banks, and the Federal Open Market Committee.

Board of governors

Seven members appointed by the president of the US and confirmed by the Senate, with terms for 14 years, staggered so that one position becomes vacant every 2 years.

Chairman of the Fed

One member appointed by the president for 4 years.

Federal Open Market Committee (FOMC)

The main policy-making group in the Federal Reserve System.

Feds' balance sheet

The largest and most important asset is US government securities, with mortgage-backed securities also held in recent years.

Monetary base

The sum of federal reserve notes, coins, and depository institutions' deposits at the Fed.

Open market operations

The purchase or sale of government securities by the Fed from or to a commercial bank or the public.

Last resort loans

The Fed is the lender of last resort, which means the Fed stands ready to lend reserves to depository institutions that are short of reserves.

Required reserve ratio

The minimum percentage of deposits that a depository institution must hold as reserves.

Excess reserves

Actual reserves minus desired reserves.

Desired reserves

The reserves that a bank plans to hold relative to its total deposits.

Desired currency holding

The fraction of money that people hold as currency, which increases when the total quantity of money increases.

Currency drain

The leakage of reserves into currency when banks make loans and increase deposits.

Currency drain ratio

The ratio of currency to deposits.

Money creation process

Begins with an increase in the monetary base, where the Fed buys securities from banks and pays with newly created bank reserves.

Money multiplier

The ratio of the change in the quantity of money to the change in the monetary base.

Money market

A virtual market where households and businesses demand money, and the Fed and banks supply money.

Demand for money

The relationship between the quantity of money demanded and the nominal interest rate when all other influences remain the same.

Nominal money

The amount of money measured in real dollars.

Real money

Nominal money divided by the price level.

Nominal interest rate

The opportunity cost of holding wealth in the form of money rather than an interest-bearing asset.

Real GDP

An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold.

Price level

A rise in the price level increases the quantity of nominal money but doesn't change the quantity of real money that people plan to hold.

Influences on money holding

Factors such as the price level, the nominal interest rate, real GDP, and financial innovation that affect how much money people choose to hold.

Shifts in the Demand for Money Curve

Shifts leftward when a decrease in GDP or financial innovation occurs, and rightward when GDP or financial innovation increases.

Money Market Equilibrium

Occurs when the quantity of money demanded equals the quantity of money supplied.

Long Run Equilibrium

The loanable funds market determines the real interest rate.

Nominal Interest Rate

Equals the equilibrium real interest rate plus the expected inflation rate.

Real GDP in Long Run

Equals the potential GDP, so the only variable in the long run is the price level.

Price Level Adjustment

Adjusts to make the quantity of real money supplied equal to the quantity demanded.

Transition from Short Run to Long Run

Starts in full-employment equilibrium.

Fed Increases Money Supply

If the fed increases the quantity of money by 10 percent, the nominal interest rate falls.

Effect of Falling Real Interest Rate

As people buy bonds, the real interest rate falls.

Impact of Falling Real Interest Rate

As the real interest rate falls, consumption expenditure and investment increase, aggregate demand increases, and with the economy at full employment, the price level rises.

Quantity of Real Money Decreases

As the price level rises, the quantity of real money decreases.

Nominal and Real Interest Rate Rise

As the nominal interest rate and the real interest rate rise, expenditure plans are cut back.

Restoration of Full-Employment Equilibrium

Eventually the original full-employment equilibrium is restored.

Quantity Theory of Money

Is the proposition that, in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.

Velocity of Circulation

Is the average number of times in a year a dollar is used to purchase goods and services in GDP.

Equation for Velocity of Circulation

Calling the Velocity of circulation V, the price level P, real GDP Y, and the quantity of money M: V=PY / M.

Equation of Exchange

States that MV=PY.

Equation of Exchange in Growth Rates

Money growth rate plus rate of velocity change equals inflation rate plus GDP growth.

Inflation Rate Formula

Inflation rate equals money growth rate plus rate of velocity change minus real GDP growth.

Financial Innovation

The development of a new financial product is to lower the cost of deposits or to increase the return from lending.

Influences on Financial Innovation

Two influences are: Economic environment and technology.

Aggregate Supply

The relationship between the quantity of real GDP supplied and the price level.

Quantity Supplied

The total quantity of real GDP that firms plan to produce during a given period.

Long Run Aggregate Supply (LAS)

The relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP.

Potential GDP

The level of GDP that is independent of the price level.

Short Run Aggregate Supply (SAS)

The relationship between the quantity of real GDP supplied and the price level when the money wage rate, the prices of other resources, and potential GDP remain constant.

Short Run Aggregate Supply Curve

An upward sloping curve that indicates a rise in the price level increases the quantity of real GDP supplied.

Factors that Shift Aggregate Supply

Changes in potential GDP and changes in the money wage rate.

Factors Affecting Long Run and Short Run Aggregate Supply

Changes in potential GDP, which shift both LAS and SAS curves rightward.

Reasons for Changes in Potential GDP

An increase in the full employment quantity of labor, an increase in the quantity of capital, and advances in technology.

Factors Affecting Short Run Aggregate Supply

Changes in the money wage rate or the price of any input in production.

Aggregate Demand

The relationship between the quantity of real GDP demanded and the price level.

Aggregate Demand Curve (AD)

Plots the quantity of real GDP demanded against the price level.

Wealth Effect

A rise in price level decreases the quantity of real wealth.

Substitution Effects

Changes in relative prices that affect consumption choices.

Intemporal Substitution Effect

A rise in price level decreases the real value of money and raises the interest rate.

International Substitution Effect

A rise in price level increases the price of domestic goods relative to foreign goods.

Factors that Shift Aggregate Demand

A change in any influence on buying plans other than the price level.

Expectations

About future income, future inflation, and future profits that change aggregate demand.