Macro Part 2

Why does the AG graph slope downward? (inverse relationship with price level and real GDP)

1) Wealth effect: as price levels increase, real wealth decreases and consumption decreases

2) Interest rate effect: as the price level increases, wealth decreases, savings drop, and then investment drops

3) International trade effect: price levels increase (more expensive), demand for goods decrease from overseas and domestically, people buy more goods from overseas

What causes increases in AD?

1) increase in real wealth 2) increase in expected future income 3) increase in business firm confidence 4) increase in quantity of money 5) increase in government spending 6) increase in foreign income

What causes decreases in AD?

1) Increase in taxes 2) increase in interest rates (borrowing becomes more expensive and investment decreases) 3) increase in the value of the dollar (as the dollar becomes more valuable, people will start to buy more imported goods)

What is long-run aggregate supply?

The aggregation of supply after all prices have adjusted overtime.

What is short-run aggregate supply?

The aggregation of supply after some, but not all, have adjusted overtime.

What factors can shift LRAS?

• resources

• institutions (banks)

• technology

• important!! **shifting right means a change in the economy’s full employment output; unemployment ratedoes not change

Why does SRAS slope upward?

• sticky input prices (do not change, workers are tied to employment contracts and the cost of production remains the same while sales prices increase)

• menu costs (firms keep prices and goods become relatively cheaper)

• money illusion (workers resist nominal wage costs)

Factors that cause SRAS to decrease

1) input prices (makes more expensive to produce so companies will produce less) 2) temporary negative supply shocks 3) expected future prices (workers expect higher prices in the future, they then demand higher wages, production costs increase, firms then produce less)

What are the Fed’s Policy Tools

1) interest on reserves balances (IORB)

2) Overnight reverse repurchase agreement (ON RRP) facility

3) discount window

4) open market operations

What is IORB (interest on reserves balances)?

IORB is interest paid on funds that banks hold in their reserve balance accounts at a Federal Reserve bank. It is the Fed’s primary tool for guiding the federal funds rate.

What is Overnight reverse repurchase agreement (ON RRP)?

The federal reserve’s standing offer to a broad set of financial institutions to deposit funds at the Fed and earn interest. It is the Fed’s supplementary tool and acts as a floor for the federal funds rate.

What is the discount window?

It is when the Federal Reserve lends to banks at the discount rate. The discount window helps put a ceiling on the FFR.

What are open market operations?

The buying and selling of government securities by the Federal Reserve. They are responsible for ensuring that the reserves remain ample and filled.

What is the Federal Funds Rate (FFR)?

It is the interest rate set by the federal reserve.

What are the 3 functions of money?

1) Medium of exchange

2) Store of value

3) Unit of account - common measure used to express prices

What are the types of money?

1) Commodity money: something that has value on its own and can be used as money

2) Commodity-backed money: money that can be exchanged for a fixed amount of a valuable commodity

3) Fiat money: money that has no intrinsic value, but is accepted as payment

What are the two ways to measure money?

M1 and M2 distinction

What is the M1 measurement of money?

M1 is a narrow measure of money as it is easy to spend (currency is in circulation, checkable deposits, savings deposits and money market accounts deposits)

What is the M2 measurement of money?

M2 is a broader measurement of money. It is the M1 category, small-denomination time deposits and money market mutual fund shares.

What is the main differentiator between M1 and M2.

Liquidity (the ability to turn money into “cash” (spendable) without changing its market price)

What are assets to the banks?

Assets are what the bank owns or is owed (e.g. loans made to customers, reserves, and government bonds)

What are liabilities to banks?

Liabilities are what the bank owns to others (money customers deposit into their accounts)

What is owner’s equity?

What is left after subtracting bank liabilities from assets.

What are reserves?

Portion of the deposit in the bank set aside.

What is the federal reserve?

The central bank of the United States.

What are 3 main functions of the federal reserve?

1) Monetary policy

2) Central Banking

3) banking regulation

What is necessary to determine the dollar amount of required reserves?

When a reserve is not 0%…

required reserves = rr * deposits

What happens when the interest on reserves is raised by the Fed?

A higher federal funds rate (FFR)

How must the reserves be in order to set the FFR?

The reserves must be ample to control the FFR through raising the interest on reserves.

What is the dual mandate?

The Federal Reserve’s responsibility to use monetary policy to promote maximum employment and price stability.

How can the fed use its monetary policy tools to achieve maximum employment and price stability?

The fed lowers the FFR by decreasing its administered (interest) rates.