U4 ECON

money

is any asset that can be used in making purchases. It serves three primary functions:

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Medium of Exchange: An asset used specifically for purchasing goods and services. This eliminates the "double coincidence of wants" required in a barter system (trading goods directly for other goods).

• Unit of Account: A basic measure of economic value. It allows us to compare the value of different goods (e.g., comparing the price of a car vs. a movie ticket).

• Store of Value: An asset that serves as a means of holding wealth over time.

M1:

A narrow measure. It includes currency (cash/coins) in the hands of the public and balances held in checking accounts.

M2:

A broader measure. It includes everything in M1 plus additional assets like savings deposits, small-denomination time deposits, and money market mutual funds.

***** Credit card balances are not considered money; they are liabilities (obligations to pay later).

Bank Reserves:

Cash or similar assets held by banks to meet depositor withdrawals.

Fractional-Reserve Banking:

A system where banks keep less in reserves than the total amount of their deposits.

Reserve-Deposit Ratio:

The ratio of bank reserves to total deposits.

The Federal Reserve System (The Fed)—- The Fed e central bank of the United States. It has two main responsibilities:

1. Monetary Policy: Determining and managing the nation's money supply.

2. Oversight/Regulation: Supervising financial markets and acting as a "lender of last resort" during crises.

Controlling Money: Open-Market Operations

The Fed’s primary tool for changing the money supply is the purchase or sale of government bonds.

Open-Market Purchase: The Fed buys bonds from the public. This puts more cash into the hands of the public/banks, which increases the money supply.

• Open-Market Sale: The Fed sells bonds to the public. The public pays the Fed, which removes money from circulation, decreasing the money supply.

banking panic is an episode where depositors, fearing for the safety of their money, rush to withdraw their deposits simultaneously.

• Because of fractional-reserve banking, banks do not have enough cash on hand to pay everyone at once.

• The Fed was created largely to stop these panics by providing emergency loans (via the discount window) to banks that are fundamentally healthy but short on cash.

Deposit Insurance: l

A system under which the government guarantees that depositors will not lose any money even if their bank goes bankrupt. In the U.S., the limit is typically $250,000 per depositor.

Financial Intermediaries:

Firms that extend credit to borrowers using funds raised from savers. Banks are the most common example, but this also includes savings and loan associations and credit unions.

Bond:

A legal promise to repay a debt, usually including both the principal amount (the amount originally lent) and regular interest payments.

Principal Amount:

The specific amount of money originally lent when a bond is issued.

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Credit Risk:

The risk that the borrower will go bankrupt and fail to repay the loan.

The Inverse Relationship:

This is a crucial concept. Bond prices and interest rates are inversely related. When the prevailing market interest rate rises, the price of existing bonds falls (and vice versa).

Dividend:

A regular payment received by stockholders for each share they own, usually determined by the firm's recent profits.

Risk Premium:

The extra rate of return that financial investors require to hold risky assets (like stocks) compared to safe assets (like government bonds).

Expected Future Dividends:

An increase in expected dividends raises the stock price.

Coupon Rate:

The interest rate promised when a bond is issued.

Required Rate of Return:

An increase in interest rates or the risk premium increases the required return, which lowersthe current stock price.

Financial Intermediaries: Institutions like banks or mutual funds that extend credit to borrowers using funds raised from savers.

Institutions like banks or mutual funds that extend credit to borrowers using funds raised from savers.

Mutual Fund:

A specialized intermediary that sells shares in itself to the public and uses the funds to buy a wide variety of different financial assets.

Diversification:

The practice of spreading one's wealth over a variety of different financial investments to reduce overall risk. (The "don't put all your eggs in one basket" strategy).

International Capital Flows:

Purchases or sales of real and financial assets across international borders.

Capital Outflows:

Purchases of foreign assets by domestic households or firms (money flowing out of the country).

Capital Inflows:

Purchases of domestic assets by foreign households or firms (money flowing into the country).

Trade Surplus:

When exports exceed imports

Trade deficit

When imports exceed exports

High Domestic Real Interest Rates: l

When the real interest rate in a home country (EX= U.S.) is high, domestic assets become more attractive to both foreigners and residents. This leads to increased capital inflows and decreased capital outflows.

• Low Domestic Real Interest Rates:

Conversely, if rates are low, investors look abroad for better opportunities, leading to net capital outflows.

Expansion:

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A period in which the economy is growing at a rate significantly above normal.

Boom

: A particularly strong and protracted expansion.

• Peak:

The beginning of a recession; the high point of economic activity prior to a downturn.

Trough:

The end of a recession; the low point of economic activity prior to a recovery.

Business Cycles (Cyclical Fluctuations):

Short-term fluctuations in GDP and other indicators. Despite the name, these are not regular or predictable like clockwork.

Unemployment:

Typically rises sharply during recessions and falls (more slowly) during expansions.

Durable vs. Nondurable Goods: Industries producing durable goods (cars, houses, heavy machinery) are much more sensitive to the business cycle than those producing nondurable goods (food, clothing) or services.

Potential Output / full-employment output;

the maximum amount of output (real GDP) an economy can produce when using its resources, such as capital and labor, at normal rates.

Recessionary Gap:

A negative output gap that occurs when potential output > actual output. This indicates wasted resources (like unemployed workers).

Expansionary Gap:

A positive output gap that occurs when actual output > potential output. This typically leads to increased inflation as resources are pushed beyond sustainable limits.

Natural Rate of Unemployment :

The part of the total unemployment rate that is caused by frictional and structural forces; when the economy is using its resources at normal rates.

During a recessionary gap, cyclical unemployment is positive.

Cyclical Unemployment:

The difference between the actual unemployment rate (and the natural rate

• During an expansionary gap, cyclical unemployment is negative (meaning the economy is "over-employed").

Keynesian Model

in the short run, firms meet the demand for their products at preset prices. Instead of changing prices every time demand shifts, they adjust their production levels. Therefore, fluctuations in spending lead directly to fluctuations in real GDP.

Menu Costs:

The costs of changing prices (e.g., reprinting price lists, updating websites). These costs explain why firms might keep prices stable even if demand shifts slightly.

Planned Aggregate Expenditure (PAE):

Total planned spending on final goods and service

Mutiple effect

The phenomenon where an initial change in spending (like government investment) leads to a much larger overall change in GDP because of the cycles of spending and income.

.Fiscal Policy: Decisions made by the government regarding the budget, specifically concerning the level of government spending and the amount of tax revenue collected.

• Government Purchases (G): Increasing is often used to close a recessionary gap.

• Taxes (T) : Changing taxes or transfer payments (like Social Security) affects disposable income, which then affects consumption.

• Stabilization Policies: Government policies used to affect PAE with the goal of eliminating output gaps.

• Deficit Spending: When government spending exceeds tax revenue.

Limits of Fiscal Policy

Legislative Lag: It takes a long time for Congress to pass spending bills or tax changes.

2. Competing Goals: Higher spending might close a recessionary gap but increase the long-term national debt.

3. Supply-Side Effects: Changes in taxes and spending don't just affect demand; they also affect the incentive for people to work and for firms to invest (supply)