Macroeconomics Review Flashcards

Define and Explain

• Pigou Effect:
  • Occurs during inflation or deflation.
  • Inflation: Prices rise, wealth decreases, aggregate demand falls.
  • Deflation: Prices drop, wealth increases, aggregate demand rises.
• Demand-Induced Recession:
  • Aggregate demand falls, leading to declines in output, employment, and prices.
• Animal Spirits of Capitalists:
  • Level of optimism and confidence in long-run profitability.
  • High confidence: Investment boom, aggregate demand shifts out and rises.
  • Low confidence: Investment slump, aggregate demand shifts in and falls.
• Overheating:
  • Actual output exceeds potential output.
  • Results in shortages of labor, capital, and materials, leading to inflation.
• Stagflation:
  • Economic condition of the 1970s.
  • Output and employment decline while price inflation increases.
• Adverse Supply Shock:
  • Aggregate supply curve shifts to the left.
  • Output and employment decrease, price inflation increases.
• Commodity Money:
  • Money of the 19th century with two values:
    • Value as money for transactions.
    • Value as a commodity (e.g., gold, silver).
• M1 and M2:
  • Two measures of the money supply.
    • M1: Narrow measure; transaction balances (currency held by the non-bank public and checkable bank deposits).
    • M2: Broad measure; transaction balances plus near money (liquid savings accounts).
• Medium of Exchange:
  • Basic function of money.
  • Money facilitates transactions by acting as an intermediary.
• Store of Value:
  • Money allows purchasing power to be transferred over time and space.
• Unit of Account:
  • Money serves to denominate prices and write contracts.
• Required Reserves and Excess Reserves:
  • Required Reserves: Percentage of deposits banks must hold in reserve. For example, a bank needs to hold (10\%)
    onumber of 10,000 deposit . which results in (1000)
  • Excess Reserves: Remaining amount that can be loaned out. For example, a bank can loan (9000)
• Liquidity Problem in Banking:
  • Large outflow of funds exceeds a bank's reserves, leading to potential failure.
• Insolvency Problem in Banking:
  • Bank suffers losses exceeding its capital due to bad loans or trades.
• Lender of Last Resort:
  • Federal Reserve provides emergency loans to prevent a financial panic.
• The Fed’s Dual Mandate:
  • Price stability: Low and stable inflation rate (2%).
  • High employment: 95%-96% employment rate.
• Open Market Operations:
  • Federal Reserve buying and selling bonds to conduct monetary policy.
• Open Market Purchase/Open Market Sale:
  • Purchase: Fed buys bonds, increasing deposits and reserves, expanding money and credit supply.
  • Sale: Fed sells bonds, decreasing deposits and reserves, shrinking money and credit supply.
• Federal Open Market Committee (FOMC):
  • Made up of 7 Board of Governors members and 5 of the 12 regional Federal Reserve Bank presidents.
  • Meets every six weeks for two days to discuss and vote on monetary policy.
• Federal Funds Rate:
  • Interest rate the Fed sets when conducting monetary policy.
  • Open market purchases decrease the federal funds rate.
  • Open market sales raise the federal funds rate.

True or False and Explain

1. False. A depreciation of the US dollar lowers the price of US exports and increases aggregate demand.
2. False. In a demand-induced recession, aggregate demand collapses, bringing output and employment down and price inflation down.
3. False. An increase in stock and real estate prices increases wealth and aggregate demand.
4. False. Paul Volcker curbed stagflation by first using contractionary monetary policy to decrease inflation, then expansionary monetary policy to increase output and employment.
5. False. A beneficial supply shock (wages fall and fall in energy prices) happens in aggregated supply.
6. False. An adverse supply shock reduces output and employment but increases price inflation.
7. False. Major wars increase aggregate demand, not decrease aggregate supply.
8. False. In a recession, output falls, unemployment rises, and price inflation decreases.
9. False. Money serves as a store of value for purchases over time and space.
10. False. Banks hold reserves as vault cash or as deposits at the Federal Reserve banks.
11. False. Banks borrow funds to meet reserve requirements, earn interest, and clear customer payments.
12. False. The Fed makes emergency loans to prevent a panic, not raise interest rates.
13. False. Banks hold bonds to earn interest and as marketable, secondary reserve assets.
14. False. Banks use funds to make out loans.
15. False. A run on a bank can lead to failure if not stopped, causing losses and a potential panic.
16. False. Losses exceeding capital indicate an insolvency problem, not a liquidity problem.
17. False. Open market operations are controlled by the Federal Open Market Committee (FOMC).
18. False. The main form of money is bank deposits.
19. False. Policy makers are likely to sell mid-size banks to bigger bank.
20. False. The Fed’s dual mandate is to maintain price stability and high employment.

Problems-Essays

Short Essay Questions

Money

• Economists define money by its function.
• Three functions:
  • Medium of exchange: Facilitates transactions.
  • Store of value: Transports purchasing power over time and space.
  • Unit of account: Denominates prices and contracts.

Banking

• Principal assets:
  • Reserves: Banks hold against deposits.
  • Bonds: Sellable assets for cash (secondary assets).
  • Loans: High-yield but risky assets.
• Principal liabilities:
  • Deposits: Cheap source of funds for loans.
  • Borrowed funds: More expensive but stable and elastic.
  • Bank capital: Owners' contribution (typically 7% of the total).
• Liquidity problem: Outflow of funds exceeds bank reserves.
• Insolvency problem: Losses exceed bank capital.
• Liquidity problem solution: Act as lender of last resort with emergency loans.
• Dealing with insolvent problems:
  • Small banks: Liquidation.
  • Mid-size banks: Acquired by bigger banks.
  • Large banks: Creative solutions based on the situation.

Aggregate Supply and Demand Problem

(1) A dramatic increase in oil prices

• Aggregate supply shifts left, output and employment fall, price level rises.
• Policy: Contract aggregate demand to control inflation, then use expansionary policy to restore output and employment.

(2) A collapse in stock and real estate prices

• Decreased wealth shifts aggregate demand left, reducing output, employment, and price inflation.
• Policy: Expand aggregate demand to restore output, employment, and prices.

(3) A large increase in military spending

• Aggregate demand shifts right, increasing output, employment, and price inflation.
• Policy: Contract aggregate demand to counter overheating.

(4) Business leaders become less certain and pessimistic about their future profits

• Decreased investment spending shifts aggregate demand left, reducing output, employment, and prices.
• Policy: Expand aggregate demand.

(5) An appreciation of the dollar

• Skip - no explanation

(6) An economic boom in the rest of the world

• Increased US exports shift aggregate demand right, increasing output, employment, and price inflation.

(7) An open market purchase of bonds by the Federal Reserve

• Skipped - no explanation given

Long Essay Question

1. What is the Fed’s Dual Mandate? Explain

   • The Federal Reserve's two goals set by Congress: price stability and high employment.

2. What is the Fed’s open market operations? Explain

   • The Federal Reserve buys and sells bonds to control the money/credit supply and interest rates.

3. How can the Federal Reserve use its open market operations to expand or contract the nation’s money and credit supply?

   • Open market purchase expands money supply; open market sales contracts it.

4. Describe the chain of command at the Federal Reserve which oversees its open market operations.

   • FOMC, including 12 regional presidents and 7 Board of Governors members, meets to discuss monetary policy, which the NY open market trading desk executes.

5. Give a detailed account of how monetary policy works to impact interest rates, aggregate demand, and the macroeconomy.

   • Expansionary Monetary Policy:
     • Open market purchase increases money supply, lowers interest rates, and increases borrowing and spending.
   • Contractionary Monetary Policy:
     • Open market sale reduces money supply, increases interest rates, reduces borrowing and spending, and shifts aggregate demand left.