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LAST SECTION!
chapters 11, 12, 13
115
Economics
Undergraduate 2
05/29/2007

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Term
ceteris paribus
Definition
• A) lower price ? more output will be purchased
• B) higher price level ? less output will be purchases
Term
aggregate demand/aggregate supply model
Definition
• A schedule that shows the various amounts of real Domestic GDP which domestic and foreign buyers wll desire at each possible price level
• Shops level of output the economy will purchase at each possible price level
Term
aggregate demand
Definition
**relationship btw real GDP demanded and price level = an INVERSE (NEGATIVE) RELATIONSHIP
• its downward slope is NOT explained by the reasons that explain the downward slope of demand curve for good (like substitutes, complements, etc)
Term
wealth effect (real balances effect)
Definition
** explains why the aggregate demand curve slopes downwards
o A) a higher price level reduces purchasing power of accumulated assets held by households’
• you will only be able to buy less with the money you have in ur savings account
• ***therefore, the public is worse off, will reduce spending
o B) a lower price level produces opposite effect
• Households will spend more
Term
interest rate effect
Definition
**explains why Agg demand curve slopes downward
• a) along a given AD curve, we assume a fixed money supply
• b) a fixed money supply means that a higher price will increase the demand for money AND THIS IN TURN will INCREASE interest rates
? if demand goes up and supply is fixed, the price rises, interest rate increases
• c) the higher interest rate will reduce interest-sensitive spending (spending by households on durable goods…appliances, homes, cars; spending by businesses on capital goods)
? result: reduction in amount of real output (Y) demand
• at a LOWER PRICE LEVEL, opposite effect occurs. Interest rates will fall, amt of money demanded will increase
o this will stimulate interest-sensitive spending
Term
interest sensitive spending
Definition
(spending by households on durable goods…appliances, homes, cars; spending by businesses on capital goods)
Term
foreign purchases effect
Definition
*explains why AD curve slopes downward
o a) higher price level—will reduce exports, will reduce real output demanded
o b) lower price level-will increase exports, increase real output demanded.
Term
• 1. Decrease in the price level shifts the AE schedule UPWARD and increases Real GDP
• 2. Increase in the price level shifts the AE schedule DOWNWARD and reduces real GDP
Definition
What does an increase/decrease in price level do to the AE schedule and gdp?

I THINK THIS MIGHT BE WRONG...#8.
Term
• 1. Changes in consumer spending
• 2. Changes in investment spending
• 3. Change in govt spending
• 4. Change in net export spending
Definition
WHat are the determinants of AD (factors that shift the curve)?
Term
aggregate supply schedule
Definition
: a schedule showing the level of real domestic output available at each possible price level
• a HIGHER price level creates an incentive for firms to produce and sell more output, while LOWER price levels reduce output
**three segments = horizontal, and intermediate (upsloping), vertical
Term
horiozntal segment of AS curve
Definition
**part of AS curve
a) Price level is constant
o b) you have a constant price level, you can increase output w/o increases in price level d) (bc you have excess capacity)
o c) less than full employment
Term
intermediate (upsloping) segment of AS curve
Definition
o a) increases in output are accompanied by increase in price level (as you increase output, you will increase price level
o prices are rising, but you are still not at full employment (bc economy doesn’t come into full employment all at once, it happens little by little
o b) per unit production cost rises
o c) this is where premature demand-pull inflation occurs
Term
vertical segment of AS curve
Definition
o a) economy has reached full employment (therefore can’t produce any more that this time…if we try to produce more, we will only cause an increase in price level/inflation)
Term
• 1. Changes in input prices
• 2. Changes in productivity
• 3. Change in legal-institutional environment
Definition
What can cause AS curve to shift?
Term
fiscal policy
Definition
***govt tool for economic stabilization
use of govt purchases, transfer payments, taxes, and borrowing to influence aggregate economic activity
Term
discretionary fiscal policy
Definition
most important
• deliberate manipulation of taxes and govt spending by congress to alter real GDP and employment to control inflation and to stimulate economic growth
**2 types: expansionary and contractionary
Term
expansionary: a type of discretionary fiscal policy
Definition
o addresses the problem of recession
o purpose is to increase aggregate demand and real GDP.
• Shifting agg demand curve can be done through taxing, increase spendin
o Y = c + Ig+G+XN ag expend/agg demand
Term
o 1. Increase govt spending
• If you increases G, Y increases, but by a greater amount than the initial increase G bc multiplier effect
o 2. Decrease taxes
• if you Decrease Tx, Y Increases but by a greater amount that initial decrease “Tx” bc of mu
Definition
What are the policy options for expansionary fiscal policy and what will they result in?
Term
contractionary: a type of discretionary fiscal policy
Definition
designed to address demand pull inflation….trying to buy more than we can produce at that given point in time “too much money chasing too few goods”
Term
o 1. Decrease govt spending (purchases)
o 2. Increase taxes
o 3. Combination
Definition
what are the policy options for contractionary fiscal policy?
Term
non-discretionary fiscal policy
Definition
• reflects what economists call “automatic stabilizers” or “built-in stablizers”
• structural features of govt spending and taxation that smooth fluctuations in disposable income, and hence consumption, over business cycle
• institutional features that have been built into budget process, will change automatically with business cycle
o will not solve problems of recessions, but when a downturn in economy (recessio) occurs, these built-in (automatic) stabilizers will make it less severe
Term
o 1. Federal income tax (progressive)
o 2. Unemployment compensation
o 3. Public assistance
• **these won’t SOLVE your problems during recessions, but it will make them less servere
Definition
three elements of nondiscretionary fiscal policy
Term
cyclical deficit
Definition
o The deficit caused by recession and the resulting decline in tax revenues.
Term
structural deficit
Definition
o (you can also have deficit when economy is at full employment)…this is the extent to which expenditures exceed tax revenues when the economy is at full employment
Term
full employment budget
Definition
• Also called the standardized budget
• Measures what the deficit or surplus would be if the economy were at full employment throughout the year
• If there is a deficit with it, it is a structural deficit
• gives info as whether the govt’s fiscal policy is expansionary, neutral, or contractionary
Term
timing problems (recognition lag, administrative lag, and operational lag), political problems (other goals, state and local finance, expansionary bias, political business cycle), and the crowding out effect
Definition
What are the inherent problems of fiscal policy?
Term
problem of crowding-out effect
Definition
when an expansionary fiscal policy (deficit spending) increases the interest rate and reduces private spending, and thereby reduces private spending with the result being the weakening or canceling of the fiscal policy stimulus
o ex: Consumer spending on Durable goods goes down ? I decreases
Term
recognition lag
Definition
**timing problem of fiscal policy
***it takes us awhile to figure out we are in a recession (“two consecutive quarters where real GDP declines”….will take you at least 6 months to know!)
Term
administrative lag
Definition
o the time btw the need for fiscal policy and the action…needs to go through congress
**timing problem of fiscal policy
Term
operational lag
Definition
you don’t see a positive response the next day or next week…it takes at least 18 months
**timing problem of fiscal policy
Term
state and local finance political problem
Definition
the problem is that is often “pro-cyclical” (fed govt cannot tell state and local govts what to do with respect to fiscal policy).
• Ex: federal govt lowers taxes to stimulate economy, but state and local govt raise taxes at same time (bc they need more revenue) This cancels out the federal govt effects.
**political problem of fiscal policy
Term
expansionary bias
Definition
as a politican, it is easier to get support for tax decrease over a tax increase
**part of political problems of fiscal policy
Term
political business cycle problem
Definition
prior to election time, policitians often take fiscal policy action solely to get re-elected
*part of political problems of fiscal policy
Term
pro cyclical
Definition
fed govt cannot tell state and local govts what to do with respect to fiscal policy).
• Ex: federal govt lowers taxes to stimulate economy, but state and local govt raise taxes at same time (bc they need more revenue) This cancels out the federal govt effects.
Term
stagflation
Definition
• Simultaneous high levels of unemployment and inflation
• How to fix it:
• a) Supply-side fiscal policy (supply-side economics)—increase aggregate SUPPLY (kind of reflected Say’s Law and Keynesian)
• b) govt deregulation
Term
money
Definition
anything that is generally accepted as a medium of exchange
o Functions:
• A) medium of exchange—most imp function
• B) unit of account—standardized way to quote prices and therefore measure relative worth
• C) store of value—you can transport purchasing power from one period to another
Danger: when price level rises, purchasing power falls
Term
unit of account
Definition
standardized way to quote prices and therefore measure relative worth
Term
store of value
Definition
you can transport purchasing power from one period to another
Danger: when price level rises, purchasing power falls
**Funciton of money
Term
commodity money
Definition
• items used as money that have an intrinsic value in some other use
• ex: salt, wheat, tobacco, etc (No longer used)
Term
fiat money (token money)
Definition
• items designated as money that are intrinsically worthless
? ex: a coin and paper money has no value except to buy
• it's status is given to it by govt, govt assures that it will not engage in currency debasement
**it is legal tender
Term
currency debasement
Definition
taking actions that will intentionally make the money worth less than it is
**govt makes promises not to do this
Term
legal tender
Definition
money MUST be accepted in the settlement of debt, even if agreement was made for diamonds)
Term
M1 money
Definition
most narrowly defined money supply
o Money can be directly used for transactions
o Standard measure of the money supply
o At end of 2006: $1, 371 Trillion
• Made of currency held outside of the bank, checkable deposits, and non-bank issued travelers checks
Term
M2 (Broad Money)
Definition
o Includes M1 plus “near monies”—close substitutes for transactions money
o Near monies can be readily converted to M1 money
o At end of 2006: $6, 977 T
o Components of this money:
• 1. Savings deposits
• 2. Time deposits (certificate of deposits) less than $100,000
• 3. Money Market Mutual Funds—limited check writing
Term
near monies
Definition
close substitutes for transactions money
Term
M3 money
Definition
includes M2 plus time deposits of 100,000 or more
o $10, 155 T
Term
L money
Definition
includes M3 PLUS:
o 1. Commercial paper
o 2. US savings bonds
o 3. Short-term treasury securities
Term
credit cards
Definition
• not considered part of money supply
• considered a short-term loan
Term
financial intermediary
Definition
• accumulate funds from savers and lend them to borrowers
• most are depository institutions (such as commercial banks and thrift institutions), which accept deposits and make loans
Term
• a) savings and loan associations
• b) credit unions
• c) mutual savings banks—functions similar to a credit union
Definition
What are the different types of thrift institutions?
Term
• the promise of the US government not to engage in Currency Debasement (doing anything to erode purchasing power)
Definition
What backs the Money supply in the US?
Term
• The value of Money is its purchasing power (The goods and services that you are able to buy with that money)
• Therefore, the value of money varies INVERSELY with the price level
o If the price level increases, the Value of money decreases
o If the p
Definition
What is the value of money and how does it vary with the price value?
Term
purchasing power
Definition
the goods and services you are able to buy with your money
Term
transactions demand (Dt)
Definition
o main reason to hold money.
o Involves use of money to make purchases (to buy G&S)
o this demand varies DIRECTLY w/ nominal GDP
• decrease nominal GDP, decrease demand
o **independent of interest rate
Term
? Interest rate is opportunity cost of holding money
o When interest rate rises, money becomes more expensive to hold,
• **when R increases, Da decreases
• **when R decreases. Da increases
Definition
Why does the asset demand for money vary inversely with the interest rate? (Unlike Dt, which is independent of the interest rate)
Term
asset demand (Da)
Definition
o relates money’s use as store of value (you can transport purchasing power from one period to another)
o this demand for money varies INVERSELY w interest rate
Term
total demand for money
Definition
• combination of Transactions Demand and Asset Demand
o = Dt + Da
• Varies INVERSELY with interest rate
Term
supply of money
Definition
• 1. NOT dependent on the interest rate
• 2. dependent on the federal reserve system (FED)—it sets supply of money based on its monetary policies
• 3. If it changes, the interest rate changes
Term
o if FED wants to change interest rates, it has to change money supply
o increase Sm, decrease R
o decrease Sm, increase R
Definition
How does increasing the money supply affect the interest rates?
Term
1. you move up or down the curve if interest rate changes
2. Shift if:
o a) nominal GDP changes
o b) number of transactions in economy changes
o c) change in the price level
• increase price level, increase Dm (u will need more money for transaction
Definition
How is the money demand curve affected if interest rate changes?
Term
o a) nominal GDP changes
o b) number of transactions in economy changes
o c) change in the price level
• increase price level, increase Dm (u will need more money for transactions
• decrease price level, decrease Dm (less money for same amt of transac
Definition
What factors cause a shift in the money demand curve?
Term
Money supply curve
Definition
will not change unless FED changes this directly
Term
federally chartered commercial banks
Definition
your right to start a bank comes from Federal govt (can use National in name)
o must join federal reserve system

o 1. under Monetary control of Federal Reserve (even if you haven’t joined)
o 2. can use services of Federal Reserves (borrow money, use check-clearing services, etc)
Term
state chartered commercial banks
Definition
your right to start a bank comes from state govt
o have option to join or Not join federal reserve system
o 1. under Monetary control of Federal Reserve (even if you haven’t joined)
o 2. can use services of Federal Reserves (borrow money, use check-clearing services, etc)
Term
thrift institutions
Definition
financial intermediaries,
• a) savings and laoan associations
• b) credit unions
• c) mutual savings banks—functions similar to a credit union
• ***not permitted to join federal reserve system, but subject to:
o a) monetary control from Fed Reserve
o b) but can use services of Fed Reserve
Term
actual reserves
Definition
consists of vault cash plus the bank's deposit with the Federal Reserve Bank
Term
required reserves
Definition
the dollar amt of reserves that banks and thrift institutions are legally required to hold.
**based on a percentage of checkable deposits
**they are met by vault cash and the deposit with the federal reserve bank (this only applies to checking accounts/ deposits--they don't have this w/ CDs, etc)
Term
excess reserves
Definition
**caluclated as actual reserves minus required reserves
**reserves in excess of required reserves
**a bank can safely lend up to this amount
Term
required reserve ratio
Definition
fraction of reserves to checkable deposits that banks and thrift institutions are required by regulation to hold.
**this dictates the minimum amt of checkable deposits that must be held in reserve
Term
federal funds rate
Definition
• The interest rate banks charge one another for overnight borrowing of excess reserves
• Also, target interest rate for monetary policy
Term
o If you have negative excess reserves. Interst rate u pay is federal funds rate
**Banks and thrifts must balance profitability and liquidity (profitable to meet expectations of investors but also they have to be liquid enough to meet depositors’ demand
Definition
why would you need to borrow excess reserves overnight?
Term
balance sheet
Definition
shows assets on right, liabilities and Net worth left at a certain point in time.) Only applies to checking accounts
Term
assets
Definition
valuable resources owned by business
o Include:
• Cash
• Deposit with Fed Reserve Bank
• Loans
Term
liabilities (debts or obligations)
Definition
debts or obligations
**include: demand deposits and Net worth
Term
net worth
Definition
assets minus liabilities
Term
fractional banking system
Definition
when only a portion of deposits are held as reserves
Term
when banks and other depository institutions make loans
Definition
How is M1 money created?
Term
money multiplier
Definition
. For the banking system as a whole, the potential to create money is based on this
Term
board of governors
Definition
**7 members apptd by the president and **Confirmed by the senate, serve one 14 year term, president designates one chair-person.
**have authority over federal reserve banks
**major responsibility: setting monetary policy
Term
federal open market committee
Definition
**12 members (7 board governors and 5 federal reserve bank presidents --president of NY bank is always one of the five)
**makes decisions based on "open-market operations" which is most important tool of monetary policy
Term
open market operations
Definition
involves the purchase and sale of US govt securities for the purpose of influencing the money supply and therefore promoting economic stability
Term
open-market desk of new york federal reserve bank
Definition
executes open-market operations as directed by FOMC
Term
federal reserve banks and branches
Definition
12 federal reserve banks and 25 branch banks
**serve as banks for member banks, nonmember banks, and thrift institutions
Term
federal advisory committee
Definition
**consists of 12 prominent commercial bankers (one from each fed. res. district)
**meet periodically with board of governors to advise them on banking matters
**purely advisory committee, the board doesn't have to listen
Term
member banks
Definition
either state or federally chartered, 6000 banks, have about 70% of the bank deposits in US
Term
nonmember banks
Definition
9000 banks, have not elected to join Fed Reserve system; can use Fed's services, but are subject to Fed's monetary control
Term
thrift institutions
Definition
• a) savings and loan associations
• b) credit unions
• c) mutual savings banks—functions similar to a credit union
**CANNOT join federal reserve, but can use Fed's services, but are subject to Fed's monetary control
Term
monetary policy
Definition
the regulation of the money supply in order to influence aggregate economic activity
• goal is to move us to potential GDP (we want Y to = potential GDP (full employment GDP)
• goal is to promote economic stability
• this is the main responsibility of the federal reserve
Term
tools of monetary policy
Definition
open market operations, required reserve ratio, discount rate, and monetary policy actions
Term
open market operations (a tool of monetary policy)
Definition
o most important tool of monetary policy
o involves the purchase and sale of govt securities (bonds) by the federal reserve
o if country is in inflation, you want to raise interest rates
**composed of buying and selling govt securities
Term
o when the fed purchases govt securities, this increases bank reserves and increases the money supply
• when Sm increases, interest rate decreases
• **changes the next day
o this would reflect an EASY monetary policy
o Problem: UNEMPLOYMENT
Definition
What happens when the government buys government securities, what monetary policy does it represent, and what is the problem that accompanies it?
Term
o When the fed sells govt securities, this reduces bank reserves and decreases the money supply.
o (when the fed sells, other banks have to pay for them, and when the check clear, those banks lose excess reserves
• When Sm decreases, interest rate incr
Definition
What happens when the government sells government securities, what monetary policy does it represent, and what is the problem that accompanies it?
Term
federal funds rate
Definition
Target interest rate for open market operations
Term
federal funds rate
Definition
target interest rate for open market operations
• the interest rate banks charge one another for the overnight borrowing of reserves
o FED does this for you
• When this rate increases, banks are going to try and avoid having negative excess reserves
• **to change the interest rates, you need to change money supply
Term
prime rate
Definition
• The interest rate a commercial bank charges its most credit-worthy (select) corporate customers
• Once federal funds interest rate changes, this rate changes, and then others begin to change
Term
advantages of open market operations
Definition
• 1. Precision—you can make big changes, small changes in interest rate (precise…you can do it a quarter of a point if you want)
• 2. Flexibility—you can make small/large changes and then reverse position. (Lower then raise)
• 3. Predictability—you know that if you decrease money supply, interest rates will rise. And the opposite.
Term
required reserve ratio
Definition
• percentage of demand deposits that must be in reserves
• (only is a reserve on demand deposits)
• raising or lowering this IMPACTS a bank’s ability to make loans and thus create money
• board of governors can change this
Term
? decrease excess reserves, decrease potential for banks and thrifts to make loans and create M1 money
o A TIGHT MONETARY POLICY
Definition
What happens when you inrease required reserve ratio and what kind of monetary policy is this?
Term
this will increase excess reserves, increase potential for banks and thrifts to make loans and create money
o AN EASY MONETARY POLICY
Definition
What happens when you decrease required reserve ratio and what kind of monetary policy is this?
Term
current required reserve ratio
Definition
btw 3 and 10%. (ever since April 1992)
• Overall, considered to be an ineffective tool
• Why? Results not very predictable
o Can decrease potential for banks and thrifts to make money
o Can get around this by selling off other assets, which will build back up their excess reserves (ex: they can sell govt securities)
• While this increases potential for banks and thrifts to give out loans, this does not guarantee they will make money
Term
discount rate
Definition
• the interest rate federal reserve banks charge on loans they make to commercial banks and thrift institutions
• ***Problem: results are unpredictable, NOT used today
They do, however, change it periodically, but only to keep it in line with other interest rates
Term
decreasing the discount rate
Definition
if you did this to the discount rate, it could increase/encourage borrowing and thus the M1 money supply
Term
increase in the discount rate
Definition
if you did this to the discount rate, it could discourage/decrease borrowing and therefore decrease in money supply
Term
monetary policy
Definition
official statements and urgings by chairperson of board of governors. More of a qualitative action.
**types: easy (expansionary) and tight (contractionary)
Term
easy (expansionary) monetary policy
Definition
• Designed to address the problem of recession (economy is at less than full employment)
• Designed to increase aggregate demand (shift to right)
• Increases the money supply
Options
o 1. Reduce the reserve ratio
o 2. buy govt securities
o 3. lower the discount rate
Term
o 1. Reduce the reserve ratio
o 2. buy govt securities
o 3. lower the discount rate
Definition
What are the easy monetary policy option, which are designed to increase aggregate demand (shift to right)?
Term
tight (contractionary)
Definition
• Addresses the problem of inflation
• Goal is to reduce aggregate demand (shift to left)—you want to shift it to the left to hit equlibrium at full employment
• Decreases the money supply
• Ex: selling of govt securities
OPTIONS
• 1. INCREASE the reserve ratio
• 2. Sell government securities
• 3. Raise the discount rate
Term
• 1. INCREASE the reserve ratio
• 2. Sell government securities
• 3. Raise the discount rate
Definition
What are the options for tight monetary policy options, which are designed to reduce aggregate demand (shift to the left)?
Term
things you can do to shift the AD curve RIGHT
Definition
o G Increases, --fiscal policy option
o Tx decreases-fiscal policy option
o Sm increases—monetary policy option
Term
Things you can do to try and shift the AD curve left (try to reduce inflation)
Definition
o G decrease
o Tx increase
o Sm decrease
Term
goal of monetary and fiscal policy
Definition
• goal: shift AD cruve
Term
expansionary fiscal policy
Definition
• Govt spending (G) increase—goal to increase Y move to y* (full employment GDP)
• Tx increase-- goal to increase Y move to y* (full employment GDP)
• If G increases, Y increases by multiplier effects (Y will go up more than initial increase in G bc of mult effect)
• If Dm goes up, and Sm is constant, we move to a higher interest rate SEE GRAPH)
• IF Dm goes up, R increases, I will decrease
o Net result is Increased Y, but by reduced amt
Term
contractionary fiscal policy
Definition
• G dereases, Tx Increases (goal decreases)
• G derease, Y decreases by multiplier effect ?Dm decreases, R decreases,Investment Increases -? net result is Y decreases, but by reduced amt
Term
expansionary monetary policy
Definition
• Sm increasees—goal increase Y move to y*
o If sm increase, R decrease ? I increases ? Y increases. Dm increases. Because this R decreases less than it otherwise would.
Term
contractionary monetary policy
Definition
• Ms decrease—goal is to decrease Y
• Sm decreases, R increases, I will decrease, Y will decrease? Dm decreases, then this R drops to some degree
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