Econ-Final Study Set

trade-offs between the 4 macroeconomic goals

  • The 4 goals (we are supposed to know this part already)

    • Growth in the standard of living (GDP)

    • Low unemployment

    • Low inflation

    • Sustainable balance of trade

  • Trade-offs

    • 1. Growth in the standard of living (GDP): 

      • Short-term: growth is illustrated by the movements of the AS curve to the right.

      • Long-term: growth is illustrated by movement of the potential GDP line (also known as Long Run AggregateSupply) to the right. 

      • The opposite is also visible.If an economy falls into a recession (short-term economic contraction), then the AD-AS equilibrium will move left -- substantially below potential GDP

    • 2. Low unemployment: also seen in short/long term

      • Short term = cyclical unemployment, because it goes up and down according to the business cycle.

      • Long term = natural rate of unemployment. This is essentially the rate of unemployment that a country has when its economy is healthy and running at or near capacity.

    • 3. Low inflation:

      • Idek can be seen in a AS-AD diagram ???

    • 4. Sustainable balance of trade:

      • Does not appear directly in AS-AD diagram 

      • Has several indirect ways:

        • Trade affects Aggregate Demand

        • Trade affects Aggregate Supply

        • A country’s movements in AS-AD affect its balance of trade.

Aggregate = combined/total

Aggregate Supply (WE DID EXERCISE SHEET ON THE SHIFT)

  • is the relationship between general prices and how much firms produce at each price level.(This assumes that the price of inputs -- the cost of doing business -- hasn't changed.)

  • Shifts because of a change in productivity, or a change in input prices

Aggregate Demand

  • curve shows quantity of goods and services demanded at each price level. Notice how the curve slopes downward to the right the way a microeconomic demand curve does. In many ways it reflects the law of demand.

  • Shifts because of personal behavior or government policy choices

Supply and Demand together

Potential GDP

  • Can see in graph above

  • How far that intersection is from Potential GDP indicates how well the economy is doing. 

Price Level

  • Seen on graph 

Real GDP

  • Seen on graph

finding equilibrium output and price in the AS-AD model

  • Just as Supply and Demand curves shift, so do Aggregate Supply and Aggregate Demand curves. Each moves to the left or right as the economy heats up and cools down. Where they intersect  -- or macroeconomic equilibrium -- is where an economy is performing at the moment.

  • At equilibrium, the total quantity of goods and services demanded equals the total quantity supplied

neoclassical vs. Keynesian views

  • Neoclassical economists: These economists think that supply drives economies.

    • Supply creates its own demand.

    • As production capacity (ability to supply) increases over time, so does demand. So the government should focus on beefing up production capacity. In other words, the government should focus on helping companies produce what they need to produce.

  • Keynesian economists: They think demand drives economies.

    • Demand creates its own supply.

    • Recessions and depressions are caused by a lack of demand, so the government needs to focus on boosting demand, not supply.

how monetary/fiscal policies (and the resulting shifts in Aggregate Supply and Aggregate Demand) affect prices

  • Aggregate supply: change in input prices

    • As costs INCREASE it shifts LEFT, (L)ess production

    • As costs DECREASE it shifts RIGHT, production (R)ises

  • Aggregate demand:

1) Shift to the Right (Rising Aggregate Demand):

  • Factories have to produce more to keep up with demand. That means GDP increases.

  • And to produce more, they have to hire more workers to handle the additional work. That means unemployment goes down (or employment goes up --  same thing).

  • With more people wanting to buy, prices in general will rise.

2) If the curve shifts to Left (Less Aggregate Demand) the opposite happens:

  • Factories produce less, because there is less demand for their products. That means GDP decreases.

  • They lay off workers, because they don't have enough work for them. That means unemployment goes up (or employment goes down --  same thing).

  • And because people don't want to buy as much, prices in general will fall.

Monetary policy: affects prices by influencing borrowing, investment, and liquidity in the economy. It is particularly effective in controlling inflation or combating deflation.

Fiscal policy: affects prices through changes in government spending and taxation, altering aggregate demand directly.


unemployment and Real GDP in the AS-AD model


Keynesian- Intermediate- and Neoclassical zones of the AS-AD model

  • In the Keynesian Zone, boosts in Aggregate Demand (a shift to the right) greatly affect Real GDP output, while having little effect on the price level.

  • In the Intermediate Zone, when Aggregate Demand increases, an economy experiences a tradeoff between employment/output on one hand and inflation on the other. Generally speaking, as an economy revvs up, it tends to generate a little inflation, so its' tough to have one without the other.

  • In the Neoclassical Zone, shifts to the right in Aggregate Demand greatly drive up inflation without getting much in the way of increased output or employment.

Stagflation

  • Economic STAGnation + inFLATION = STAGFLATION

Stagflation is a situation in the economy where three things happen at the same time:

  1. Slow or stagnant economic growth

  2. High unemployment

  3. Rising inflation

Deflation

  • Deflation is when the overall price level of goods and services in an economy decreases over time.

  • It means things become cheaper, but it can be a problem because it often happens during economic slowdowns, leading to lower profits for businesses, reduced wages, and higher unemployment.

fundamental principles and priorities of Neoclassical thought

  • Aggregate supply drives the economy

  • Long term is more important than short term problems

  • If government tries helping recession, the solution will create even more problems than the recession itself

    • So they would just ride it out (like a cold) 

  • Unemployment is low, and the economy is at or near Potential GDP. The Aggregate Supply curve is close to vertical. In this area, if the government tries to boost employment even just a little more, it will bring a lot more inflation for just a small increase in GDP and employment.


the role/importance of long-term GDP

  • Neoclassical thought rests on two main "building blocks." In the long run, Neoclassicals argue:

    • Potential GDP is what determines the size of the economy; and

    • Prices (and wages) are flexible over the long run, and will adjust to maintain equilibrium.


how Neoclassical thought differs from Keynesian thought

  • Neoclassical- focus on the long term

    • Supply side

  • Keynesian- focus on the short term 

    • Demand side


how Neoclassicals view the dynamics of Aggregate Supply and Aggregate Demand

  • Long run aggregate supply (potential GDP) is what determines the size of real GDP

    • Best technology, human and physical capital available

  • No short run aggregate supply 

  • Aggregate demand- plays little if any role in economic output

    • Changes in price level influence the AD curve via real balances

    • Argue that fiscal and monetary policy is unnecessary because the market self corrects


the importance of productivity

  • Place a strong emphasis on productivity as the key driver of long-term economic growth

  • Directly influences economies capacity to produce goods and services

  • Determines the natural rate of output


how Neoclassicals view the flexibility of prices

  • The economy is self correct

  • If an event disrupts aggregate demand and messes up equilibrium, over time things will re adjust

  • Cut prices and wages and ride it out. People will begin spending again at lower prices


wages and the AS-AD equilibrium

  • Argue that wages fully adjust, making the long run aggregate supply curve vertical 

  • If AD decreases, output temporarily falls below the natural level, causing unemployment. Wage flexibility allows wages to fall, reducing production costs and encouraging firms to hire more workers, returning the economy to full employment.

  • If AD increases, output temporarily exceeds the natural level, causing upward wage pressure as firms compete for workers. Rising wages increase production costs, reducing output back to its natural level.


how they view government's ability to manage the economy

  • Generally skeptical 

  • Government intervention is often viewed as unnecessary and potentially harmful, as it disrupts this natural adjustment process

  • individuals and businesses make decisions based on their expectations of future policies and outcomes

  • No monetary policy and fiscal policy necessary

  • Supply side policies 

    • Lowering taxes to incentivize work, saving, and investment.

    • Reducing regulation to promote efficiency and innovation.

    • Investing in education and infrastructure to boost productivity.

goal of Keynesian economics/analysis

  • Insufficient aggregate demand is the primary cause of a recession

  • Wages and prices can be “sticky”

  • the recessionary zone -- where the Aggregate Supply curve is relatively flat, and the equilibrium is far from Potential GDP, boosting employment and GDP has little effect on inflation. That means that when there's a recession, the government should increase AD by cutting taxes on consumers and businesses so they have more money to spend, and by increasing government spending. They can boost the economy, get people back to work and not have to worry about inflation


why wages and prices are sticky

  • There's no way to coordinate wage cuts so that everyone feels treated equally.

  • They lower the morale and productivity of a company's workers.

  • There's no way to coordinate price cuts for products and services. 

  • Businesses would suffer menu costs.


menu costs

  • Costs associated with having to change prices

  • Changing labels on all products

  • Keeping records of the price changes

  • Accounting and budgeting changes brought on by changes in cost and revenues

  • Communicating price changes through ads, catalogs and notices


components of Aggregate Demand

  • Consumption

  • Investment by business

  • Government spending

  • Net exports


what causes Aggregate Demand to shift

  • Consumption shifts…

    • Income

    • Real interest rates

    • Taxes 

    • Expectations of future income

    • Changes in wealth

  • Investment

    • Expected rate of return

    • Opportunity cost of investing in the company vs doing something else with the money

    • The creation of new lucrative technologies

    • Price of key inputs

    • Tax incentives of investment

    • Expectation about future economic growth

  • Government spending

    • Political mood

  • Net exports

    • Changes in relative growth rates between 2 economies 

    • Changes in relative prices between 2 economies


effects of a shift in Aggregate Demand

  • Believe shifts in AD have immediate and substantial effects on output and employment in the short run

  • The economy can be stuck below full employment without government intervention due to sticky wages and prices

  • Fiscal policy is often required to stimulate demand and return the economy to equilibrium.


permanent income hypothesis

  • Suggests that individuals make consumption decisions based on their expected long-term income (permanent income), not their current income. 

  • This means that temporary changes in income have little effect on consumption, while permanent changes can lead to significant changes in consumption and aggregate demand.


Phillips Curve

  • An illustration of the short term trade off between unemployment and inflation

  • A lot of one=less of the other

Barter

  • exchange (goods or services) for other goods or services without using money.

  • Only works when you want what the other person has and the other person wants what you have

double coincidence of wants

  • When you want what the other person has and they want what you have

3 functions of money

  • Medium of exchange

  • Unit of account

    • Acts as a denominator that both people can use to measure the relative values of their services 

  • Store of value

    • Money holds its value over a long period 

    • It doesn’t go bad

demand deposits

  • Funds held in an account at a financial institution that can be accessed and withdrawn by the account holder at any time without advance notice

asset-liability mismatch

reserve ratio and money multiplier

  • Money multiplier

    • Formula used to calculate how much money the banking system can generate from each $1 of bank reserves

    • 1/reserve ratio

  • Reserve ratio

    • The fraction of deposits that the bank has in reserves

causes of banks’ financial stress

  • Loan defaults- when the borrower doesn’t pay the loan back

    • At that point the bank has lost money that it has loaned out 

  • Asset liability time mismatch- when a bank makes too many long-term loans at too low of an interest rate 

    • Receiving a low rate of interest on long term goals 

    • But it must pay the currently higher market rate of interest to attract depositors, in the short term

  • Bank run 

    • Depositors think their bank is shaky and may fail 

    • They fear they won’t get their money back, so they rush to the bank to withdrawal their deposits before the bank fails

Diversification

  • the strategy of spreading economic activities or investments across different sectors, industries, regions, or asset classes to reduce risk and improve the stability of an economy. The concept is rooted in the idea that by not relying on a single sector or economic activity, an economy can better withstand shocks or downturns in any one area, leading to more sustainable long-term growth.

financial intermediaries

  • institutions or entities that act as middlemen between savers and borrowers in the financial system. Their role is to facilitate the flow of funds in the economy by channeling savings from individuals and businesses who have excess funds (savers) to those who need funds (borrowers) for investment or consumption. Financial intermediaries make it easier for both parties to access capital and manage risk

Types + tools of monetary policy

  • Expansionary “loose”-

    • increases the quantity of money and loans in an economy by reducing interest rates so that people and businesses find it cheaper to borrow money and then spend it.

  • Contractionary “tight”- 

    • It reduces the quantity of money and loans by raising interest rates, which makes it more expensive for people and businesses to borrow (and then spend) money. So it decreases Aggregate Demand, and it's something central banks do to fight inflation.

  • Open market operations- 

    • Increase money supply 

      • Buys government bonds

      • More money to lend out

      • Interest rate decreases

      • Cheaper to borrow money

    • Decrease money supply

      • The fed sells bonds to banks

      • Less money to tend out

      • Higher interest rates

      • Less spending

      • Aggregate demand goes down

  • Reserve requirements- 

    • The required percentage of deposits required to keep in a reserve 

    • Expansionary

      • Required to hold a smaller % of deposits in reserve

      • Leaves the banks with more money to lend out

      • The higher supply of money drives down interest rates

      • Consumers and businesses borrow more and spend more

      • Aggregate demand goes up

    • Contractionary 

      • Higher % of deposits in reserves

      • Less money to lends out

      • Interest rates increase

      • Borrow and spend less

      • Aggregate demand goes down

  • Discount rates-

    • The interest rate at which a central bank makes short-term loans to individual banks

    • Exansionary- 

      • Lowers discount rate

      • Lower reserves

      • More money to loan out

      • Interest rates decrease

      • Borrow and spend more

      • Aggregate demand increases

    • Contractionary- 

      • Raises discount rate

      • More reserves

      • Less money to loan out

      • Interest rates increase

      • Borrow and spend less

      • Aggregate demand decreases

  • Quantitative easing

    • Lends out money anonymously to financial institutions (not just banks), and purchased assets from financial institutions

  • Forward guidance

  • Rates on bank reserves


focus of U.S. monetary policy

  • Price stability 

    • To maintain low and stable inflation, usually targeting a 2% inflation rate. This helps create a predictable economic environment that supports long-term planning and investment.

  • Full employment

    • To minimize unemployment and achieve full employment, where nearly everyone who is willing and able to work can find a job.

  • Economic growth

    • To promote sustainable economic growth, fostering a stable economy that grows without excessive inflation or bubbles

  • Financial stability

    • ensuring the stability of the financial system and avoiding excessive risk-taking by financial institutions

  • Moderating long-term interest rates

    • By controlling short-term interest rates, the Fed also aims to influence long-term rates, which affect spending on big-ticket items like homes and cars.

effect on AD

  • Expansionary-

    • Boosts AD

  • Contractionary 

    • Reduces AD


GDP growth

  • Expansionary 

    • Accelerate GDP growth

  • Contractionary 

    • Slow GDP growth 


employment and prices

  • Expansionary 

    • Employment increases

    • Prices rise

  • Contractionary 

    • Higher unemployment

    • Reduces money supply and raises interest rates

      • Curbs spending and investment

foreign-exchange market

  • The market in which people exchange currency

  • Selling one currency to purchase another

  • Abbreviations

    • Forex

    • FX

    • Currency market

appreciating/strengthening vs. depreciating/weakening

  • Appreciating/Strengthening 

    • When currency A can buy more of currency B, then currency A has appreciated

    • Ex: 

      • Initial exchange rate $1= 1 euro 

      • Secondary exchange rate $1= 2 euro

  • Depreciating/Weakened 

    • When currency A can buy less of currency B, the currency A has depreciated

    • Ex: 

      • Initial exchange rate $1= 1 euro

      • Secondary exchange rate $1= .50 euros

  • If A ↑ then B ↓

  • If A ↓ then B ↑

winners and losers when currencies appreciate or depreciate

  • If the USD has appreciated against the euro…

    • American tourists are happy 

    • Italian pizzeria owners are happy

  • If a Euro has appreciated against the USD…

    • American tourists are mad, everything is more expensive

    • Pizzeria owners are selling fewer pizzas to american tourists

  • Who 😀 a strong currency:  People who are buying/importing things with that currency (Their currency can buy a lot of the other currency – we say it has a lot of buying power -- so goods in that foreign currency are cheaper)

  • Who ☹ a strong currency:  People who selling/exporting things with that currency (Their products are more expensive to those with weaker foreign currencies.)

  • Strong dollar 

    • Corporations don’t like converting their foreign profits into dollars when the dollar is strong

types of exchange-rate policies and how they work (how the central bank intervenes to maintain an exchange rate) and their pros and cons

  • Floating exchange rate- the value of the currency is determined by the forces of supply and demand in the foreign exchange market without direct intervention by the central bank.

    • Pros- 

      • allows XR to adjust naturally to inflation and rates of returns

        • Reflects true value of currency through supply and demand

      • Monetary policy can focus on inflation and unemployment

    • Cons- 

      • Raises the risk of exchange-rate volatility

        • Volatility stresses companies, forcing them to alter import/ export plans

        • Volatility can bankrupt companies

        • Volatility can trigger banking collapse

        • Most problematic for smaller countries (international trade is larger share of their GDP)

  • Hard peg-  currency is tied (or pegged) to another major currency

    • Pros- 

      • Offers the most stable exchange rate

    • Cons- 

      • uses foreign-currency reserves

        • expensive 

        • Inflationary 

      • Monetary policy focused on XR- not fighting inflation or recession

  • Soft peg-  currency is tied (or pegged) to another major currency

    • Pros- 

      • Offers a more stable exchange rate than a float

      • Offers a little more power to fight recession/ inflation than hard peg

    • Cons- 

      • Same as hard peg

  • Trade-offs of single currency

    • Pros- 

      • No volatility of FX risk with member countries

      • No foreign reserves needed

    • Cons- 

      • Country gives up national monetary policy altogether

      • One-size fits all monetary policy not always appropriate

problems caused by large exchange-rate changes

  • Uncertainty in trade

  • Inflation

  • Investment uncertainty 

  • Capital flight 

what causes exchange rates to shift

  • Interest rates- Higher interest rates tend to attract foreign capital, leading to an appreciation of the currency, as investors seek higher returns in that country. Conversely, lower interest rates may cause depreciation.

  • Inflation rates- Higher inflation in a country typically leads to depreciation of its currency, as purchasing power decreases relative to other countries with lower inflation.

  • Economic performance- Strong economic growth tends to attract foreign investment, leading to an appreciation of the currency, while weak economic performance can lead to depreciation.

  • Political stability- Countries with stable political environments tend to have stronger currencies, as investors prefer to hold assets in stable, predictable economies. Political instability can cause depreciation.

  • Foreign exchange reserves- Central bank reserves, along with interventions in the currency market, can influence exchange rates. If the central bank buys foreign currency, it can support its own currency.

connection between exchange-rate policies and monetary policy

  • Central banks use monetary policy to influence exchange rates, especially under fixed-rate systems, and must balance this with their domestic economic goals.

why central banks care about exchange rates.

  • they impact inflation, trade balances, financial stability, and the transmission of monetary policy.