Unit 4 - Money & Banking / Monetary Policy (3-21-16 - 3-27-16)

Unit 4 Video Summaries

Unit 4 Part 1: Types/Functions of $

There are three types of money, they are commodity, representative, and fiat money. Commodity money is money that can be used and is available. Representative money represents the quantity of a precious metal. Fiat money doesn't represent anything but the promise that the government says it has value. There are three functions of money. First is as a median of exchange (trade), second as a store of value(savings), and a unit of account(quality).

Unit 4 Part 3: Money Market
The money market graph is labeled interest on the y-axis, and labeled quantity of money on the x-axis. The money demand is always downward sloping, and is tied into the interest rate. The money supply is fixed and is set by the FED, meaning it only moves if told to move. When demand increases, it puts pressure on interest rates. If the FED wants to bring the rate back down, they increase the money supply.

Unit 4 Part 4: Tools of Monetary Policy
In regards to the tools of monetary policy, the FED uses expansionary, also known as easy money, and contractionary policies, also known as tight money. In the expansionary policy, the reserve requirement decreases. The lower the money in RR, it makes the incentive for the banks to be irresponsible with money. On the contractionary policy, the reserve requirement increases. Also for the expansionary policy, the discount rate goes down, but increases for the contractionary policy. Easy money policy buys bonds, and tight money policy sells bonds. The FOMC makes all decisions.

Unit 4 Part 7: Loanable Funds
The demand for loanable funds is always downward sloping. The y-axis is labeled interest, and the x-axis is labeled quantity of loanable funds. The supply is loanable funds is dependent on savings, meaning the more money people save, the more banks have to loan out. If there's an incentive to save more, the supply of loanable funds increases, shifting right. If there's a deficit, the government is demanding more in order to spend it.

Unit 4 Part 8: Money Creation Process
Banks make money by making loans. If the reserve requirement is 20%, and the loan amount is $500, how much $ is created? To find that, you must find the money multiplier by (1/RR). So, (1/0,2) = 5. Once you find the multiplier, you multiply that by the loan amount, which is $500. $500 multiplied by 5 is $2500, which is the answer to the problem. When the bank keeps loaning out money, the total amount of loanable funds will be $2500.

Unit 4 Part 9: Money Market, Loanable Funds, AS/AD
The money market, loanable funds, and as/ad graphs are all connection with one another. When the money demand increases, interest rate increases as well as AD. There a rightward shift that goes along for all three graphs.The fisher effect connects the increase in interest rates with the increase in price level.

Unit 3 - Fiscal Policy, Automatic Stabiliziers, Tax System (2-29-16)

Fiscal Policy: changes in the expenditures or tax revenues of the federal government

2 Tools of Fiscal Policy

• Taxes: government can increase or decrease taxes
• Spending: government can increase or decrease spending

Deficits, Surpluses, and Debt

Balanced Budget: Revenue = Expenditures
Budget Deficit: Revenues < Expenditures
Budget Surplus: Revenues > Expenditures
Government Debt: (Sum of all deficits - Sum of all surpluses)

Government must borrow money when it runs a budget deficit
They must borrow from:

• Individuals
• Financial Institutions
• Corporations
• Foreign entities or foreign government

Fiscal Policy Two Options

1) Discretionary Fiscal Policy (action)

• Expansionary Fiscal Policy - think deficit. Combats recession, increase government spending, decreases taxes.
• Contractionary Fiscal Policy - think surplus. Combats inflation, decrease government spending, increases taxes.

2) Non-discretionary Fiscal Policy (no action)

Discretionary vs. Automatic Fiscal Policies

Discretionary: increasing or decreasing government spending and/or taxes in order to return the economy to full employment. Discrestionary policy involves policy makers doing fiscal policy in response to economic problem.

Automatic: unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems.

 Automatic or Built-in Stabilizers

• anything that increases governments budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policymakers.

Economic Importance:

• taxes reduce spending and aggregate demand
• reductions in spending are desirable when the economy is moving toward inflation
• increases in spending are desirable when economy is heading toward recession

Examples: 

• Medicare
• Medicaid
• Social Security
• Unemployment

 Tax System

Progressive Tax System:

• Average tax rate (Tax revenue / GDP) rises with GDP

Proportional Tax System:

• Average tax rate remains constant as GDP changes

 Regressive Tax System:

• Average tax rate falls with GDP

Unit 3 - Classical vs. Keynesian (2-24-16)

CLASSICAL vs. KEYNESIAN

Modern Followers:

Classical:

• Adam Smith
• J.B. Say
• David Ricardo
• Alfred Marshall

Keynesian:

• Jim Keynes

Say's Law:

Classical:

• supply creates its own demand
• production = income = spending
• under spending is UNLIKELY

Keynesian:

• depressions refute Say's law
• demand creates its own supply
• under spending PERSISTS

Savings and Investments:

Classical:

• savings (leakage)  = investment (injection) income

Keynesian:

• savings NOT = investment
• future needs (precaution, habit, income level, interest rate)
• interest rate (rate of profit, expectations)

Loanable Funds Market:

Classical:

Keynesian:

• investment from savings, cash, and checking accounts
• lending creates money = money supply increases
• inflation and unemployment are unstable

Wage/Price Flexibility:

Classical: prices and wages are flexible downward
Keynesian: prices and wages are inflexible downward (ratchet effect)

Supply Curve:

Classical: vertical
Keynesian: horizontal

Output and Employment:

Classical: AS determines output and employment
Keynesian: AD determines output and employment

Unemployment:

(S = Savings, I = Investment)
Classical:

• cause: external (war)
• rarely exists due to wage price flexibility

Keynesian:

• usually exists
• cause: external (war), internal (S not equal to I)

Aggregate Demand:

Classical:

• AD determines price level 
• AD is reasonably stable if money supply is stable

Keynesian:

• AD changes due to the determinants
• AD is unstable even if money supply is stable due to fluctuations in investments

Basic Equation:

Classical: (MV = PQ)
Keynesian: (C + Ig + G + Xn)

Role of Government:

Classical:

• monetary rule maintain a steady money supply
• believes laissez faire is best
• economy is self-regulated

Keynesian:

• fiscal policy
• active government
• economy is not self-regulated

Inflation:

Classical: caused by too much money
Keynesian: caused by too much demand

How long the short run is:

Classical: short time
Keynesian: very long time

Emphasis today:

Classical: Micro-eco
Keynesian: Macro-eco

Classical:

• competition is good
• believe in invisible hand
• in long run, economy will balance at full employment
• economy is always close to or at full employment
• believe in triple down effect.

Keynesian: 

• competition is flaud
• AD is key, not AS
• leaks and savings cause recessions 
• in long run, we're all dead
• believe sticky wages block say's law

Unit 3 - Consumption & Saving, Spending & Tax Multiplier (2-25-16)

Disposable Income (DI): income after taxes or net income. (DI = Gross Income - Taxes)

2 Choices:
With disposable income, households can either:

1. Consume (spend $ on goods & services)
2. Save (not spend $ on goods & services)

Consumption

• Household spending

Ability to consume is constrained by: 

• The amount of disposable income
• The propensity to save

Do households consume if DI = 0?

• Autonomous consumption
• Dissaving

Saving

• Household NOT spending

The ability to save is constrained by:

• The amount of disposable income
• The propensity to consume

Do households save if DI = 0?

• NO

APC & APS

Average Propensity to Consume

Average Propensity to Save

• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 = DISSAVING
• -APS = DISSAVING

Marginal Propensity to Consume (MPC)

• Fraction of any change in disposable income that is consumed
• MPC = (Δ in Consumption / Δ in Disposable Income)

Marginal Propensity to Save (MPS)

• Fraction of any change in disposable income saved
• MPS = (Δ in Savings / Δ in Disposable Income)

MPC + MPS = 1

MPC = 1 - MPS

MPS = 1 - MPC

Spending Muliplier Effect

An initial change in spending (C, Ig, G, Xn) causes a larger change in aggregate spending or aggregate demand.

• Multiplier = (Δ in AD / Δ in spending (C, Ig, G, or Xn)

Calculating the Spending Multiplier

• Multiplier = (1 / 1 - MPC) or (1 / MPS)
• Multipliers are postive(+) when there is an increase in spending and negative(-) when there's a decrease

Calculating the Tax Multiplier

When the government taxes, the multiplier works in reverse.

WHY?

• Because now money is leaving the circular flow

Tax Multiplier (note: It's NEGATIVE)

• (-MPC / 1 - MPC) or (-MPC /  MPS)
• If there's a tax cut, then multiplier is positive(+), because there's more money in the circular flow

Unit 3 - Nominal, Real, and Sticky Wages, & Investment Demand (2-22-16)

Nominal Wages vs. Real Wages

Nominal: amount of $ received by a worker per unit of time. Ex:) Paid by hour, by day, etc.

Real: amount of goods and services a worker can purchase with their nominal wages.

Sticky Wages

Sticky: where your nominal wage level is set according to an initial price level, and does not vary due to labor contracts or other restrictions.

What is investment?

Money spent or expeditures on:

• New plants (factories)
• Capital equipment (machinery)
• Technology (hardware and software)
• New homes
• Inventories (goods sold by producers)

Expected Rates of Return

1) How does business make investment decisions?

• Cost/Benefit analysis

2) How Does business determine the benefits?

• Expected rate of return

3) How does business count the cost?

• Interest costs

4) How does business determine the amount of investment they undertake?

-Compare expected rate of return to interest cost

• If expected return > interest cost, then invest
• If expected return < interest cost, then do not invest

Real (r%) v. Nominal (i%)

Whats the difference?

• Nominal is the observable rate of interest. Real subtracts out inflation (π%) and is only known ex post facto

How do you compute the real interest rate (r%)

• r% = i% - π%

What determines the cost of an investment decision

• The real interest rate (r%)

Shifts in Investment Demand (ID)

1) Cost of production

• Lower costs shift ID --->
• Higher costs shift ID <---

2) Business Taxes

• Lower business taxes shift ID --->
• Higher business taxes shift ID <---

3) Technological Change

• New technology shifts ID --->
• Lack of technology shifts ID <---

4) Stock of Capital

• If an economy is low on capital, then ID --->
• If economy has much, then ID <---

5) Expectations

• Positive expectations shifts ID --->
• Negative expectations shifts ID <---

Unit 3 - LRAS and SRAS (2-19-16)

Full Employment

FULL EMPLOYMENT equilibrium exists where AD intersects SRAS & LRAS at the same point.

Recessionary Gap

Inflationary Gap

An INFLATIONARY GAP exists when equilibrium occurs BEYOND full employment output

Unit 3 - Aggregate Supply (2-18-16)

Aggregate Supply: the level of real GDP that firms will produce at each price level

Long-Run vs. Short-Run

Long:

• Period of time where input prices are completely flexible and adjust to changes in the price-level
• In the long-run, the level of REAL GDP supplied is independent of price-level

Short:

• Period of time where input prices are sticky and do not adjust to changes in the price-level (hard to shift)
• In short-run, level of REAL GDP supplied is directly related to price level

Long Run Aggregate Supply (LRAS):

• LRAS marks the level of full employment in the economy. (analogous to PPC)
• Because input prices are completely flexible in the long-run, changes in price-level do not change firms' real profits and therefore do not change firms' level of output. This means that the LRAS is vertical at the economy's level of full employment

Changes in Short-Run Aggregate Supply (SRAS):

• An INCREASE in SRAS in seen as a shift to the RIGHT --->
• A DECREASE in SRAS is seen as a shift to the left <---

SRAS is per unit cost of production.
Per Unit Production Cost = (Total Input Cost / Total Output)

Determinants of SRAS 

• Input prices
• Productivity
• Legal-Institutional Environment

Input:

1) Domestic Resource Prices

• Wages (75% of all business costs)
• Cost of capital
• Raw Materials (commodity prices)

2) Foreign Resource Prices
3) Market Power
4) Increase in Resource Prices = SRAS <---
5) Decreases in Resource Prices = SRAS --->

Productivity:

= (Total Output / Total Input )

• more productivity = lower unit production cost = SRAS --->
• lower productivity = higher unit production cost = SRAS <---

Legal Institutional Environment:

Taxes & Subsidies

• Taxes ($ to Gov.) on business increase per unit production cost = SRAS <---
• Subsidies ($ from Gov.) to business reduce per unit production cost = SRAS-->