ECO 202 Midterm

Reserves

Deposits that the bank keeps as cash in its vault oron deposit with the federal reserve 

Loans

Commercial consumer and real estate- large assets 

Securities

treasury bills-0 risk investments 

How do banks make a profit

Interest rate spread 

How do banks create money

Makes loans from the reserves loans, take from checking account 

What is our central bank

The Federal Reserve

Bord of Governors

1. 7 members appointed by the president to a 14 year non-renewable term confirmed by the US senate 

2. Chair appointed to a 4 year renewable term(Jerome Powell) 

Federal reserve district banks

The 12 regional banks within the Federal Reserve System that implement the monetary policy set by the Board of Governors and provide financial services to depository institutions and the federal government.

The federal open market committee

1. Responsible for open market interest rate changes 

2. Mets every 6-8 times a year 

3. 12 Voting members with 7 Board of governors, president of the N.Y fed and 4 Presidents from the 11 other federal banks  

Bank panics 

With a fractional reserve banking system, and the maturity mismatch between deposits and loans, bank panics cause banks to have liquidity problems 

-Fractional reserve banking: the maturity mismatch between

1. deposits and loans: money placed in a bank which is then used to provide loans to borrowers, who repay with interest 

2. contagions: the spread of economic instability from one market or country to others, often triggered by a crisis

3. asset deflations: the decline in the value of assets, such as real estate or stocks, often during economic downturns

Creating a banking system systematic risk hence needing a___

“lender of last resort”

The federal reserve was established to

prevent bank panics by serving as a lender of last resort .

Insurance deposits can stop bank panics BC…

 the money is guaranteed 

The bank panic during the 07’-09’ chrisses occurred in the shadow banking system, why were these banking systems so vulnerable to “bank’ runs?

The shadow banking system was vulnerable to "bank runs" because it relied on short-term funding and lacked the same regulatory oversight as traditional banks, leading to a liquidity crisis when investors rapidly withdrew funds.

In what sense was there a run on investment banks, they don't have deposits?

• Investment banks funded long term investments with short term loans

• No problems occurred as long as the renewed their short term loans 

• The run on investment banks occurred when lenders did not renew their short term loans 

The federal reserve has four tools of monetary policy(actions that the feds take to manage the money supply/ interest rates to pursue macroeconomic policy objectives)

1. open market operations 

2. Discount Policy

3. Reserve requirements

4. Interest rates

open market operations 

Buying and selling of treasury securities by the federal reserve in order to control the money supply

When the fed buys treasury securities…

…from banks the fed pays for the treasury securities by depositing the funds in the reserved accounts that the banks maintain with the fed’s 

When the Fed sells treasury securities from the banks….

…the fed receives payment from the securities by withdrawing the funds from the reserve account that the banks maintain with the feds

Discount policy

interest rate the fed charges on loans to the banks 

When a bank receives a loan from the reserves…

…increase by the amount of the loan 

Reserve requirements

A decrease by a central bank in the required reserve ratio converse required reserves into excess reserves, allowing banks to make more loans 

The feds pay banks interest…

…on reserves risk free

When the Fed decreases the interest rate it pays on bank reserves it…

…increases the incentives of banks to make loans rather than gold reserves. As banks increase the loans  they make the money supply increase

Quantity Theory of money

the long run of inflation

equation of exchange

• (M*V=P*Y) Money supply*velocity of money=Price level* Real GDP(nominal GDP)

Over the long run, the quantity theory of money accurately predicts inflations, but not over the short run due to erratic change in the short run in velocity

Inflation rate-> %change in price(inflation)=%change in the money supply+velocity-Real GDP

To use the quantity theory of money to explains and to predict inflation in the long run it is important to know that real GDP

real GDP, Y Equals

Potential GDP depends on

quantity of labor, the quantity of capital and the level of technology. The quantity of money does NOT affect potential GDP 

Quantity theory of money->

 %inflation= %money supply- %Real GDP 

The government budget constraint sheafs light on

why governments increase the money supply at a rate that leads to continual inflation 

Change in bonds change in the money supply

=Government budget 

The government budget constraints shows that government has three ways to pay for government spending

taxes, issuing bonds and printing money

Two ways to finance a budget deficit

(G+TR-T) Issuing bonds or transfering money 

When a government runs centennial high budget deficits and investors become unwilling to buy the government bonds

then the government can finance the budget deficit by only “printing” money.

Aggregate Demand(AD)-

Spending side of the economy

Aggregate Demand(AD)- Spending side of the economy 

Interest rates(monetary policy)-change consumption, investment spending and next exports 

Government Purchases(fiscal policy) change in government purchases 

Taxes- Income or business (fiscal policy) change consumption or investment spending

Expected future income- changes consumption 

Expected future profitability-changes investment spending

Foreign real GDP- changes Net exports 

Foreign exchange rate- changes net exports 

Household wealth- changes consumption 

Long run Aggregate Supply

cost/ producer side of the economy 

Long run Aggregate Supply- cost/ producer side of the economy 

Occurs at potential GDP which depends on the Quantity of labor, quantity of capital and technological advantages

Short-run Aggregate supply(SRAS)

Cost producer side of the economy

Short-run Aggregate supply(SRAS)-cost/produser side of the economy

Quantity of labor

Quantity of capitol 

Technological advantages 

Expected future price level(inflationary expectation) changes money wages therefore the cost of production
Price of natural resources(oil) changes input price therefore cost of production

What happened on the graph if there is a recession:

Decrease in AD or decrease in AS(agreat supply)- bringing everything to the left and up 

What happens on the graph if there is inflation

Increase in AD or Decrease in AS 

Interest rate

• Increase in interest rates raise the cost to firms and households of borrowing, reducing investment spending and consumption spending, decreasing AD curve

Government purchases (fiscal policy):

• Increase in government purchases increases AD curve

Taxes

• Increase in personal income taxes decreases consumption spending,  increase in business taxes decreases investment spending, decreasing AD curve

• Expected future income: 

• Increase in expected future income increases consumption spending, increasing AD curve

• Expected profitability:

• Increase in expected profitability increases investment spending, increasing AD curve

Foreign real GDP

• Increase in foreign real GDP increase net exports, increasing AD curve

• exchange rate: 

• Increase in exchange rate (dollar appreciates) decreases net exports, decreasing AD curve

• Household wealth:

• Increase in household wealth increases consumption spending, increasing AD curve

What would cuse the AD demand curve to shift to the left:

a decrease in foreign GDPI

LRAS Curve

• Draw at potential GDP (full-employment GDP)

Long-Run Aggregate Supply (LRAS)

• Supply (cost/producer) side of the economy

• Relationship in the long run between the price level & the quantity of real GDP supplied by firms

Potential GDP depends upon

• quantity of labor, quantity of capital, stock, and technology

• LRAS in US goes up each year

The policy issue is what rate does it grow

• If the long-run aggregate supply curve occurs at potential (full-employment) GDP, what is the unemployment rate along the LRAS curve?

• Natural rate of unemployment - no cyclical unemployment

Why is the SRAS curve positively sloped?

• As prices of final goods & services increase (i.e. the price level increases), the price of inputs – primarily wages – increase more slowly

Variables that Shift the SRAS Curve

• Quantity of labor, Quantity of capital, or technology changes 

Expected Future Price Level (inflationary expectations)

• changes in money wages & therefore costs of production

• Price of an Important Natural Resource - price of oil

• price of oil

  • Affects costs of production

• Increase in the price of oil causes SRAS curve to decrease

  • Increases cost of production, supply curve shifts left

As an economy moves out and up along a given short-run aggregate supply curve?: Cyclical unemployment decreases

Long-Run Macroeconomic Equilibrium

• Where AD intersects LRAS & SRAS

• Long-run equilibrium implies short-run equilibrium, but short-run equilibrium does not imply long-run equilibrium

• Short-run equilibrium is where AD intersects SRAS

Decrease in Aggregate Demand (AD):

Impact on Real GDP, Unemployment, & the Price Level in the Short Run & in the Long Run

• What would cause AD to decrease (shift to left), i.e. what would cause spending to decrease at each price level?

• Interest rate ⬆

• Government purchases ⬇

• Taxes ⬆

• Expected future income ⬇

• Expected future profitability ⬇

• Foreign real GDP ⬇

• Foreign exchange value of the dollar ⬆

• Household wealth ⬇

Why Does the SRAS Curve Shift to the RIght From a Below-Potential GDP Short-Run Equilibrium?

• With real GDP below potential GDP, the unemployment rate exceeds the natural rate of unemployment. The high unemployment (cyclical unemployment) puts downward pressure on nominal wages, which reduces the costs of production of firms, shifting SRAS to the right.

• Economists refer to the process of adjustment back to potential GDP as an automatic mechanism because it occurs without any actions by the government

Decrease in Aggregate Demand: Short

• Real GDP down, Unemployment rate up, Price Level down

• Does it cause a recession? yes

• Inflation? No, causes deflation

Decrease in Aggregate Demand: Long Run Effects

• Long-run effects:

  • Real GDP no change, Unemployment rate no change, Price Level down

  • Does it cause a recession? no

  • Inflation? No, causes deflation

Decrease in AD: Policy Options

• Do nothing (automatic mechanism), or expansionary monetary policy or expansionary fiscal policy

• What would cause AD to increase (shift to right), i.e. what would cause spending to increase at each price level?

• Interest rate ⬇

• Government purchases ⬆

• Taxes ⬇

• Expected future income ⬆

• Expected future profitability ⬆

• Foreign real GDP ⬆

• Foreign exchange value of the dollar ⬇

• Household wealth ⬆

Why Does the SRAS Curve Shift to the Left From a Above-Potential GDP Short-Run Equilibrium?

• With real GDP above potential GDP, the unemployment rate is below the natural rate of unemployment. The low unemployment (negative cyclical unemployment) puts upward pressure on nominal wages, which raises the costs of production of firms, shifting SRAS to the left.

• Economists refer to the process of adjustment back to potential GDP as an automatic mechanism because it occurs without any actions by the government

Increase in Aggregate Demand: short

• Real GDP up, Unemployment rate down, Price Level up

• Does it cause a recession? no

• Inflation? yes

Increase in Aggregate Demand:Long

• Real GDP no change, Unemployment rate no change, Price Level up

• Does it cause a recession? no

• Inflation? yes

Increase in AD: Policy Options

• Do nothing (automatic mechanism), or contractionary monetary polic or contractionary fiscal policy

Decrease in Short-Run Aggregate Supply (SRAS): Impact on Real GDP, Unemployment, & the Price Level in the Short Run

• What would cause SRAS to decrease (shift to the left), i.e. what would cause an increase in the cost of production at each level of real GDP?

  • Price of Oil ⬆

  • Expected Future Price Level (Inflationary Expectations) ⬆

  • Wages ⬆

  • Disruptions to Production (Covid-19)

Decrease in Short-Run Aggregate Supply (Shift to the Left): Short Run Effects Only

• Short-run effects: 

  • Real GDP down, Unemployment rate up, Price Level up

  • Does it cause a recession? yes

  • Inflation? yes

Increase in Short-Run Aggregate Supply (SRAS):Increase in Short-Run Aggregate Supply (SRAS):

• Price of Oil ⬇

• Expected Future Price Level (Inflationary Expectations) ⬇

• Wages ⬇

Increase in Short-Run Aggregate Supply (Shift to the Right): Short Run Effects Only

• Real GDP Increases Unemployment rate Decreases Price Level Decreases

• Does it cause a recession?- No

• Inflation?-No 

In the basic AD-AS model, an increase in the expected future price level (an increase in inflationary expectations) will in the short run lead to

• Decreases in real GDP,  Increases  in the unemployment rate, and  Increases  in the price level.: a decrease; an increase; an increase

In the basic AD-AS model, a decrease in oil prices will in the short run lead to

• no change in real GDP and  Decreases in the price level.