Econ Final

Chapter 15: Federal Reserve

1. Open Market Operations

• Buying/Selling T-Securities:

  • Decrease money supply → Sells securities.

  • Increase money supply → Buys securities.

2. Reserve Requirements

• Adjusts reserve ratio for banks:

  • Higher ratio = Decrease in the money supply.

  • Lower ratio = Increase in money supply.

3. Discount Rate Policy

• Adjusts the interest rate (i/r) the Fed charges banks for loans:

  • Raising the rate: Discourages borrowing, and decreases money supply.

  • Lowering the rate: Encourages borrowing, and increases money supply.

4. Interest on Reserves

• Increase in interest rate on reserves → Banks hold more reserves → Decreases money supply.

• Decrease in interest rate on reserves → Banks hold fewer reserves → Increases money supply.

5. Federal Funds Rate

• The interest rate determined in the Federal Funds market:

  • Discount rate: The highest rate the Fed sets.

  • Used for overnight loans between banks.

6. Key Terms

• Reservation Rate: The lowest rate banks are willing to accept when lending.

• Arbitrage: Simultaneous purchase and sale of funds/goods to profit.

Monetary Policy

1. Policy Types

• "Ease" Policy (Expansionary):

  • Low rates to address unemployment or recession.

• "Tighten" Policy (Contractionary):

  • Increases rates to slow down the economy and control inflation.

2. Expansionary Policy

• Fed reduces Federal Funds Rate (FFR) to boost the economy:

  • Increases real GDP.

  • Decreases unemployment.

  • Y = C + I increases (Output = Consumption + Investment).

3. Contractionary Policy

• Fed increases FFR to reduce inflation:

  • Decreases real GDP.

  • Reduces spending and inflationary pressure.

  • Y = C + I decreases.

4. Key Note

• Monetary policy is counter-cyclical: It works against the direction of the business cycle.

Fiscal Policy

1. Overview

• Changes in federal taxes and purchases aimed at achieving economic objectives.

2. Key Concepts

• Automatic Stabilizers:

  • Government spending and taxes adjust automatically with the business cycle.

• Federal Government Expenditures:

  • Transfer payments, grants to states, and interest on national debt.

  • Today, 2/3 to 3/4 of all government spending is for transfer payments.

3. Transfer Payment Programs

• Social Security: Reduces elderly poverty.

• Medicaid: Improves healthcare for low-income individuals.

• Medicare: Improves elderly health

4. Expansionary Fiscal Policy

• Shifts Aggregate Demand (AD) curve to the right to close a recessionary gap:

  • Increases government purchases or decreases taxes.

  • Positive multiplier effect → Boosts economic growth.

5. Contractionary Fiscal Policy

• Shifts AD curve to the left to reduce inflation:

  • Decreases government purchases or increases taxes.

  • Negative multiplier effect → Slows economic growth.

Key Economic Terms

1. Ceteris Paribus

• "All other things remain equal."

• The assumption used in analyzing monetary policy.

2. Multiplier Effect

• Autonomous Spending Increase → Induced Consumption Increase → Rise in AD:

  • Government Purchase Multiplier:
    Δ in equilibrium GDP / Δ in government purchases.

  • Tax Multiplier:
    Δ in equilibrium GDP / Δ in taxes.

  • Note: Tax multiplier is less than government purchase multiplier.

3. Recessionary Gap

• The difference between potential real GDP (Yp​) and current real GDP (Y):
  Yp​−Y

Fiscal Policy

Types of Fiscal Policy

1. Contractionary Policy:

   • Shifts AD (Aggregate Demand) left.

   • Results in lower prices, reduced real GDP

   • rising inflation.

   • Achieved by:

     • Decreasing government purchases.

     • Increasing taxes (negative multiplier effect).

2. Expansionary Policy:

   • Shifts AD to the right.

   • Equilibrium occurs with higher prices and increased GDP.

   • Recession 

Key Concepts

• Ceteris Paribus: Assumes all other factors remain unchanged, including monetary policy.

• Multiplier Effect:

  • Autonomous Increase in AD: Initial government spending boosts AD.

  • Induced Increase: Consumers spend more due to higher income.

  • Government Purchases Multiplier: ΔEquilibrium Real GDP/ΔGovernment Purchases

  • Tax Multiplier: ΔEquilibrium Real GDP/ΔTaxes

    • Note: Tax multiplier is less effective than the government purchases multiplier.

• Recessionary Gap:

  • The difference between potential real GDP (Yp​) and current real GDP (Y).

Budget and Deficit

• Surplus: The government collects more than it spends.

• Deficit: The government spends more than it collects.

• Balanced Budget: Spending equals revenue.

• Deficit vs. Debt:

  • Deficit: Annual shortfall in revenue.

  • Debt: Accumulation of all prior deficits.

Exchange Rates

• Nominal Exchange Rate: Value of one currency in terms of another.

• Currency Appreciation: Increase in market value relative to another currency.

• Currency Depreciation: Decrease in market value relative to another currency.

Factors Affecting Exchange Rates

1. Changes in demand for U.S.-produced goods and services (and foreign goods).

2. Changes in investment desires in the U.S. and abroad.

3. Changes in expectations of future currency values.

Systems of Exchange Rates

• Currency Floats: Determined by demand and supply.

• Pegging: Fixed exchange rate:

  • Pegged above equilibrium: Overvalued.

  • Pegged below equilibrium: Undervalued.

• Real Exchange Rate:

  • Adjusts nominal exchange rate for price differences between countries.

    • Real Exchange Rate=Nominal Exchange Rate×(Domestic Price/Foreign Price)

Taylor Rule: r = p + 0.5y + 0.5(p - 2) + 2

• r= federal funds rate, p=inflation rate, y= % deviation of real GDP from its target