Unit 5 & 6

From Short Run to Long Run

• AS curve does not shift in response to changes in the AD curve in the short run
• Nominal wages do not respond to the price level changes
• Workers may not realize the impact of changes or may be under contract

Long Run

• Period in which nominal wages are fully responsive to previous changes in price level
• When changes occur in the short run, they result in either increased or decreased producer profits - not changes in wages paid
• In the long run, increases in AD result in higher price level, as in the short run, but as workers demand mare $ the AS curve shifts left to equate production at the original output level, but not at a higher price
• In the long run, the AS curve is vertical at the natural rate of unemployment (NRU), or full employment (FE) level of output. Everyone who wants a job has one and no one is enticed into or out of the market

Demand-Pull Inflation

• Will result when an increase in demand shifts the AD curve to the right, temporarily increasing output while raising prices

Cost-Push Inflation

• Results when an increase in input costs that shifts the AS curve to the left. In this case, the price level increase is not in response to the increase in AD, but instead the cause of price level increasing

Phillips Curve

• Represents the relationship between unemployment and inflation
• The trade off between inflation and unemployment only occurs in the short run
• Given SRAS curve an increase in AD will cause price level and real output to increase which increases inflation and reduces unemployment
• Each point on the Phillips curve corresponds to a different level of output

Long Run Phillips Curve (LRPC)

• It occurs at the natural rate of unemployment (NRU), it is represented by a vertical line
• There is no trade-off between unemployment and inflation in the long run
• The economy produces at full employment (FE) output level
• Nominal wages of workers fully incorporate any changes in price level as wages adjust to inflation over the long run
• LRPC only shifts if the LRAS curve shifts (same determinants)
• Increase in Un will shift LRPC rightwards
• Decrease in Un will shift LRPC leftwards

Short Run Phillips Curve (SRPC)

• Assumed to be stable because short run AS curve is stable
• If inflation persist and the expected rate of inflation rises then the entire SRPC moves upward.
• If move upward, cause of stag flation
• If inflation expectation drop due to new technologies or then the SRPC moves downward

Supply Shocks

• Rapid and significant increase in resource cost which causes SRAS to shift

The Natural Rate of Unemployment

• = frictional + structural + seasonal
• Natural rates and few worker benefits create a lower NR

Misery Index

• Combination of inflation and unemployment in any given year
• Single digit misery is good
• Standard increase rate is 2-3%
• If inflation rate persists and the expected rate of inflation rises then the entire SRPC moves upward
• When this happens, stagflation exists
• If inflation expectations drop, the the SRPC moves downward

Stagflation

• Occurs when you have high unemployment and high inflation occurring at the same time
• 1946 - 1964 = baby boom, civil rights, movement and womens' movement
  
  
  
  
  

Disinflation

• When inflation decreases over time
• You know when nominal wages increase
• Business profits fall as prices are rising
• Firms reduce employment thus unemployment increases

Laffer Curve

• Relationship between tax rates and government revenue
• The higher the tax rate you set, the less money you will collect
• Laffer curve is controversial and debatable
• As tax rates increase from 0, tax revenues increase from zero to some maximum level

Criticism of the Laffer Curve

• Where the economy is actually located on the curve is difficult to determine
• Tax cuts increase demand which can fool inflation
• Empirical evidence suggest that the impact of tax rates on incintives was to work saving and invest are small

Supply-Side Economics or Reaganomics

• Support policies that promote GDP growth by arguing that high marginal tax rates along with the current system of transfer payments (unemployment compensation & social security) provide disincitives to work invest innovate and undertake entrepreneur ventures.
• Lower tax rate induces more work thus AS decrease.
• The lower the marginal tax rate make leisure work more expensive

Trickle-Down Effect

• The rich gets the money first then the poor

Marginal Tax Rate

• Amount paid on the last dollar earned or on each additional dollar earned
• SSE believe that if you reduce marginal tax rates, more people would be inclined to work longer, this foregoing leisure time for extra income

Balance of Payments

• Measure of money inflows and outflows between the U.S. and the rest of the world (ROW)
• Inflows are referred to as CREDITS
• Outflows are referred to as DEBITS
• Balance of payments is divided into 3 accounts:
• Current account
• Capital/financial account
• Official reserves account

Double Entry Bookkeeping

• Every transaction in the balance of payments is recorded twice in accourdance with standard accounting practice.

Current Account

• Balance of Trade or Net Exports
• Exports of good/services - imports of goods/services
• Exports create a credit to the balance of payments
• Imports create a debit to the balance of payments

Net Foreign Income

• Income earned by U.S. owned foreign assets - income paid to foreign held U.S assets.
• Ex.) Brazilian bonds - interest payments on German owned U.S. treasury bonds

Net Transfers (Tend to be Unilateral)

• Foreign aid  -> a debit to the current account 
• Mexican migrant worker sends money to family in Mexico

Capital/Financial Account

• Balance of capital ownership
• Includes the purchase of both real and financial assets
• Direct investment in the U.S is a credit to the capital account
• Toyota factory in San Antonio
• Direct investment by U.S. firms/individuals in a foreign country are debits to the capital account
• The Intel Factory in San Jose, Costa Rice
• Purchase of foreign financial assets reps a debit to the capital account
• Warren Buffet buys stock in Petrochina
• Purchase of domestic financial assets by foreigners represents a credit to the capital account
• United Arab Emirates Sovereign wealth, fund purchase a large stake in the NASDAQ

Relationship between Current and Capital Account

• Current account and the capital account should zero each other out, that is... if the current account has a negative balance (deficit), than capital account should then have a positive balance (surplus)

Official Reserves

• Foreign currency holdings of the U.S. states federal reserve system
• When there is a balance of payments, surplus the Fed accumulates foreign currency and debits for balancing of payment
• When there is a balance of payments, deficit the Fed deputes its reserves of foreign currency and credits the balance of payment
• The official reserves zero out for balance of payments

Unit 4: Money, Banking and Monetary Policy

The Uses of Money

1. Medium of Exchange : Money's most important function used to facilitate transactions such as bartering or trading.
2. Unit of Account : Establishes worth. Providing a common measure of the value of goods and services being exchanged
3. Store of Value : Money holding value over a period of time

Types of Money

• Commodity Money :  Money that would have value even if it were not being used as money. No physical money is exchanged

          Example : Gold and silver

• Representative Money : Backed up by something tangible

          Example :  an IOU

• Fiat Money : Money because the government says so

          Example : Dollar bill is worth a dollar

Characteristics of Money

• Durability : Money is durable
• Divisibility : There are combinations to make the same amount
• Uniformity : It is the same in every state
• Portability :  It is easy to carry around
• Scarcity : Not everyone has money, or at least a lot of money
• Acceptability : Money is acceptable everywhere

Money Supply

• M1 Money : it includes currency in circulation, checkable deposits (demand deposits), physical dollars and coins, traveler's checks
• M2 Money - it includes M1 Money, Savings accounts, Money market accounts and deposits held by banks outside the United States

Fractional Reserve System

• A process by banks of holding a small portion of their deposits in reserve and loaning out the excess
• Banks keep cash on hand (required reserves to meet depositor needs)
• Banks must keep reserve deposits in their vault or at the federal reserve bank

Total Reserves

• Total funds held by the bank
• Total Reserve = Required Reserve + Excess Reserve

Excess Reserves

• Reserves beyond those that are required
• Banks can legally lend only to the extent of their excess reserves

Reserve Ratio

• Reserve Ratio = Required reserve/ total reserve

Significance of a Fractional Reserve System

• Banks can create money by lending more than their reserves
• Required Reserves do not prevent bank panics because banks must keep their required reserves 
• Reserve requirements gives the FED control over how much money banks can create

Functions of the FED

• Control the nation's money supply through monetary policy
• Issue paper currency
• Serves as a clearing house for checks
• Regulates banking activities
• Serves as a bank for banks 

Balance Sheet

• A statement of assets and claims summarizing the financial position of a firm or a bank at some point in time
• Must balance at all times
• Assets (own) = Liabilities + Net Worth (owe)

Assets

• Reserves:

        -Required Reserves (rr) - % required by Fed. to keep on hand to meet demand

        -Excess Reserves (er) - % reserves over and above the amount needed to satisfy the

        -minimum reserve ratio set by Fed.

• Loans to firms, consumers, and other banks (earns interest)
• Loans to govt. = treasury securities
• Bank property - (if bank fails, you could liquidate the building/property)

Liabilities and Equity

• Demand Deposits (money that is put into bank)
• Timed Deposits (CD's)
• Loans from: Federal Reserve and other banks
• Shareholders equity - (to set up a bank, you must invest your own money in it to have a stake in the banks success or failure)

The Required Reserve Ratio

• The percent of demand deposits that must be stored as vault cash or kept on reserve as federal funds in the banks accounts with the FED
• The RR ratio determines the money multiplier (1/RR)
• Decreasing the RR ratio increases the rate of money creation in the banking system and is contractionary
• Changing the RR ratio is the least used tool of monetary policy and is usually held constant at 10%

The Money Multiplier

• Money multiplier shoes us the impact of a change in demand deposits on loans and eventually the money supply
• The money multiplier indicates the total number of dollar created in the banking system by each $1 addition to the monetary base (bank reserves and currency in circulation)
• To calculate the money multiplier divide 1 by the required reserve ratio

         -money multiplier = 1/reserve ratio

Required Reserve = Amount of deposit * Required Reserve Ratio

Excess Reserve = Total Reserves - Required Reserves

Maximum amount a single bank can loan = The change in excess reserves caused by a deposit

Total change in loans = Amount single bank can lend * money multiplier

Total change in money supply = Total change in loans and amount of money of FED action

Total change in demand deposits = Total change in loans + cash deposited

Fiscal Policy

• Congress

1. Tax or

1. Spend

Monetary Policy

• FED

         1. OMO (Open market operation) : buy or sell bonds

• Expansionary - Buy bonds from the public

• Contractionary - Sell bonds to the public

         2. Reserve Requirement : bank's mass requirement

• Expansionary - Decrease the reserve ratio

• Contractionary - Increase the reserve ratio

         3. Discount Rate : interest rate charged by the Fed for overnight loans to commercial 

             banks

• Expansionary - Decrease discount rate

• Contractionary - Increase discount rate

         4. Federal Fund Rate : interest rate charged one commercial bank for overnight loans 

             to another commercial bank

• Expansionary - Decrease FFR

• Contractionary - Increase FFR

Prime Rate : The interest rate bank charges to their credit worthy customers

Loanable Funds Market

• Market where savers and borrowers exchange funds (Qlf) at the real rate of interest (r%)
• The demand for loanable funds, or borrowing comes from households, firms, government and the foreign sector. The demand for loanable funds is in fact the supply of bonds.
• The supply of loanable funds, or savings comes from households, firms, government, and the foreign sector. The supply of loanable funds is also the demand for bonds

Changes in Demand for Loanable Funds

• Demand for loanable funds = borrowing (supplying bond)
• More borrowing = more demand for loanable funds ->
• Less borrowing = more demand for loanable funds <-
• Government deficit spending = more borrowing = more demand for loanable funds
• Less investment demand = less borrowing = less demand for loanable funds

Changes in Supply of Loanable Funds

• Supply of loanable funds = saving
• More saving = more supply of loanable funds
• Less saving = less supply of loanable funds
• Government budget surplus = more saving = more supply of LF
• Decrease in consumers' MPS = less saving = less supply of LF