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242 Cards in this Set
- Front
- Back
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Front
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Back
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What is monetary policy?
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Involves changes in the money supply to contract or expand the economy.
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What are the three kinds of money?
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Commodity money, Bank money, Fiat/Paper money
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What are the three functions of money?
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1. Medium of exchange (transaction), 2. Unit of account, 3. Store of Wealth/Value
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What is the price of money?
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The interest rate (payment made for the use of money finance something).
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Name three reasons why interests rates differ.
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1. Term/Maturity of the load (time to pay off)
2. Degree of risk 3. The more Liquid the loan, the lower the interest rate |
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If the nominal interest rate is 8 percent per year and the inflation rate is 3 percent per year, what is the real interest rate?
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Nominal = yield in $ per year per $ investment
Real interest rate = Nominal rate of interest - Inflation rate So, 5% |
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Name and describe the 3 sources of money demand.
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1. Transaction Demand (GDP dependant)
2. Precautionary Demand 3. Speculative Demand |
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What three characteristics of the modern banking system were also characteristics of the early goldsmiths?
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1. Paper money issued
2. Interest rates paid by banks 3. Fractional Reserve system |
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Suppose the reserve requirement is 20%. What is the money multiplier?
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Money Multiplier = 1 / Bank's Required Reserve Ratio
So, 5 |
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How does a bank run occur?
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When too many of the bank's depositors demand their money at the same time. (fear > self fulfilling prohecy)
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Why is the Federal Reserve considered the "lender of last resort?"
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The central bank is the 'bankers' bank' and can loan money to a bank to prevent it from collapsing.
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What are the three instruments of monetary policy? Which is the most important?
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1. Controlling the reserve requirement
2. Setting the Discount Rate (the rate at which commercial banks lend from the central bank) 3. Open Market Operations (buying and selling of bonds) [most important] |
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Suppose the Federal Reserve sells bonds. Is this contractionary or expansionary monetary policy?
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The central bank:
Sells bonds to Contract the money Supply Buys bonds to Expand the money Suply |
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Describe the monetary transmission mechanism.
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6 step process
1. Central bank reduces reserves 2. The money supply reduces 3. Interest rates go up 4. Investment, Consumption and Net Exports go down 5. Aggregate demand drops 6. Real GNP and inflation go down |
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Illustrate how to close a recessionary gap using monetary policy in the aggregate supply-aggregate demand framework.
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Expand the Aggregate Demand
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Which is more precise: monetary policy or fiscal policy? Why?
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Fiscal Policy is more precise.
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What is the Keynesian view of monetary policy?
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Keynesians believe that monetary policy should be used to fine tune the economy when it is near full employment. (but during a severe recession, they believe monetary policy is no effective)
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What is the Monetarist view of monetary policy?
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The monetarists do not believe in combined fiscal/monetary combination.
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Explain the Great Depression from a Monetarist perspective.
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People began hoarding cash and banks increased reserves led to contraction of the money supply.
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Use the Aggregate Supply-Aggregate Demand framework to illustrate stagflation.
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Simultaneous inflation and recession
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What is the Keynesian dilemma created by stagflation?
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It cannot deal with stagflation, because expansionary policies to reduce unemploynment simply create more inflation and contractionary policies deepen the recession. (keynesian can only solve have of the problem, and by making the other half worse).
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What is the Monetarist solution to stagflation?
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To set monetary targets and stick with them. Which turned out bad as well because interest rates seared.
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Why is the distinction between cyclical, frictional, and structural unemployment?
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Cycical = Occurs when economy dips into a recession.
Frictional = Arises because people move between jobs and imperfect information on the labor market. Structural = Occurs when there is a mismatch between the skills needed and the workers' skills (technology) or mismatch between geographic location of jobs and workers'. |
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Define the unemployment rate.
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Unemployment Rate = Unemployed / Labor Force (unemployed + employed) x 100
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Explain Okun’s law.
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OKun's Law = Relation between Output and Unemployment (when GDP declines, unemployment rises). Okun's law states that for every 2% in GDP Output drop (relative to potential GDP), unemployment rises by 1%.
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Illustrate demand-pull inflation.
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Demand-Pull Inflation = "too much money chasing too few goods"
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Illustrate cost-push inflation.
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Cost-Push Inflation = (supply side) occurs when external shocks drive up production costs.
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What is the Keynesian dilemma that arises with stagflation?
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Using expanionary policies to reduce unemployment would drive up inflation, and using contractionary policies to reduce inflation would drive up unemployment. The problem is that it would deepen a recession.
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What is the core or inertial rate of inflation?
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Core/Inertial Rate of Inflation = Tends to stay the same until a demand or supply shock changes things.
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Why are inflationary expectations important?
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Inflationary expectations contribute to actual inflation because it influences business, investors and consumers.(self fulfilling prohecy)
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What are adaptive expectations?
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Adaptive expecations expect next year's rate of inflation to be the same as this year's rate.
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What relationship does the Phillips Curve purport to illustrate?
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Philips found wages rose when unemployment was low but fell when unemployment was high. The curve shows Inflation vertically and Unemployment horizontally.
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According to the Monetarists, the disappearance of the Phillips Curve in the 1970s may best be explained through what two things?
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Natural rate of unemployment
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What is the natural or lowest sustainable rate of unemployment?
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Minimum unemployment rate = impossible to drive unemployment rate below this rate in the long-term.
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What are the policy implications of the Monetarist's natural rate theory, particularly with regard to Keynesian activism?
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1. Drop below the natural rate of unemployment / 2. rising inflation
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Is the natural rate of unemployment constant?
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NO - it changes with the structure of the economy.
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How do the Monetarists stop an inflationary spiral?
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Stop using keynesian expansionary policies and allow to return to the natural rate of unemployment.
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Illustrate how Supply-side economics offers a very painless way to avoid both the Keynesian stagflation dilemma and the bitter Monetarist cure for an inflationary spiral.
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Push out the supply curve (produce more)
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Illustrate the Laffer Curve.
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Displays marginal tax rate on vertical axis and total tax rate on the horizontal axis. Its a backward bending curve, illustrating that people will work less, the more they are taxed. (implication = tax cut increases total tax revenues)
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Calculate National Income
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National income Y = C + I + G + X − Z
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Equilibrium income is when....
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Planned Injections (I + G) equal Planned Withdrawals (S + T)
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What is the liquidity trap
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An increase in the money supply has no effect on the interest rate and aggregate demand.
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WHat is the LM curve?
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The LM Curve represents equilibirum values of the interest rate and national income
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What is Inflation Rate?
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The change in price level from one period to another.
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What is Deflation?
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Occurs when the price level falls.
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What is a Relative Price?
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The price of one good compared with another good (microeconomics).
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What is the Capital Stock?
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Consits of 1) Natural Resources and 2) Man-Made resources
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What is the Labor Force?
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That proportion of the population willing and able to work at going wage rates and working conditions.
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What are Entrepreneurs?
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Part of the labour force is made up of entrepreneurs and managers whose task is to combine capital and labor to produce goods and services. Entrepreneurs have skills such as enterprise, organizational, managerial, financial, risk taking skills.
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What is Purchasing Partity Power (PPP)
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A method of comparing countries by comparing a similar basket of goods and the cost of that basket is translated into a common currency.
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What is the Full-Employment Rate of Unemployment (AKA the Natural Rate of Unemployment)?
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(frictional unemployment) this is the unemployment present for the time required to match people with jobs.
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What is the Full-Employment Rate of Downtime?
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Full-employment rate of downtime = Unused capacity for factories and machine tools.
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What is Gross National Product (GNP)?
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Actual output of an economy. It is the value of all final goods and services produced in the economy in a year.
Firms: GNP = C + I (Consumer goods + Investment goods) Households: GNP = C + S (Consumer good purchased + Savings) |
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What is the GNP calculation?
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GNP is found by multiplying each good and service produced by its price and adding them together, so that;
Also; GNP = Y GNP = Y = C + I + G + X - Z |
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What is Gross National Expenditure (GNE) ?
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GNE is the value of total spending by households.
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What is Gross National Income (GNI) ?
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GNI is the value of the services of the factors of production hired by the firms.
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What is the "Business Cycle" ?
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The Business Cycle (boom or bust) refers to economy-wide fluctuations in production, trade and economic activity in general over several months or years (GNP/GNI changes). (peaks and troughs / expansion and recessions).
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What is the difference between GDP and GNP?
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GDP and GNP measure the same thing, however GDP defines the economy as existing within the country’s borders and GNP by factors of production.
So for an open economy: GNP = GDP + Net Income from Abroad Net Income from Abroad = production abroad by domestic companies minus domestic production owned by foreign companies |
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What is the "Net Income from Abroad" calculation?
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Net Income from Abroad = production abroad by domestic companies minus domestic production owned by foreign companies
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What are Exogenous Shocks?
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Outside-world events over which policy makers have no control but can have a significant impact on the economy.
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Y =
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GNP (= C + I + G + X - Z)
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C =
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Consumption Expenditure
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I =
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Investment Expenditure
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G =
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Government Expenditure
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X =
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Exports
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Z =
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Imports
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What is the calculation for National Income Identity?
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GNP = Y = C + I + G + X - Z
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How can we group Goverment Policy Tools?
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Government policy tools fall into two categories
1. Fiscal policy 2. Monetary policy |
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What is Fiscal Policy?
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Fiscal Policy involves control of government expenditure and tax rate.
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What is Monetary Policy?
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Monetary policy involves control over the supply of money, which directly affects interest rates.
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Q =
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Potential Output
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What are Supply-Side Factors?
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Factors which include the growth in quality and quantity of the capital stock (net investment) and labor force (education) and technological change - and are outside the control of the government.
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What is the Goverment Expenditure Multiplier?
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The ratio of total change in Y (GNP) resulting from a change in G (Government expenditure). [multiplier process]
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What is Disposable Income?
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Income earned minus taxes.
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R =
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Rate of interest (=price of money)
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What is the 'Inflationary Bias of Market Economics" ?
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*To achieve zero inflation rate might require a very high unemployment rate. Thus policy makers have to choose between this trade-off, inflation and unemployment.
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What determines the Potential Output of an economy?
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Potential output of an economy depends upon the quality and quantity of the capital stock and the quality and quantity of the labor force and existing technology.
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Expansion in Potential Output of an economy can be caused by what factors?
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* Growth in the quality and quantity of labor
* Growth in the quality and quantity of the capital stock * Growth in technological advances |
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How can we measurw Economic Activity?
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Can be done each period using one of three measures: GNE, GNP and GNI, which all measure the same thing from a different perspective, and must be equal.
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Aggregate Demand consists of four groups purchasing Goods & Services;
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1. Consumers (households)
2. Firms 3. Government 4. International (households, firms and government) |
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The Government can Increase Aggregate Demand (and subsequently achieve full employment) by:
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1. Increase Government expenditure (G) (results in multiplier)
2. Reduce tax rates (results in multiplier) 3. Increase the money supply |
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What is the Employment Gap?
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Occurs when producing below potential output (= waste of resources).
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What causes the Inflationary Gap?
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The Inflationary gap is caused by demand being higher than output.
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What are the 5 Macroeconomic goals of a goverment?
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1. Low inflation rate
2. Low unemployment rate 3. Balanced government budget 4. A positive balance of trade 5. Stable currency in international exchange markets |
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What is the Productive potential of the economy?
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The upper limit an economy can produce in Potential output (Q) during a given timeframe.
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When will society be able to increase Potential Output (shifting its PPF to the right)?
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If society sacrifices current consumption to add to its stock of resources sufficient extra resources to make good any depreciation and allow some net addition to the stock of capital goods or the labor force; then potential output of goods and services will increase (in t+1).
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Calculate Net Investment(NI)
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Net Investment (NI) = Gross Investment - Replacement Investment (RI)
*if net investment is positive, then stock of output increases and so does the productive potential of the economy. |
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RI =
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Replacement Investment
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What are the 4 types of unemployment?
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1. Frictional unemployment (generally short-term / takes time to match job and labor).
2. Structural unemployment (mismatch of job/labor characteristics) . 3. Seasonal unemployment (where level of productivity is dictated by a calendar). 4. Demand-Deficient Unemployment (insufficient demand to maintain full employment). |
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What are factors determining unemployment?
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1. The level of economic activity
2. The transmission of information 3. The rate of structural change 4. The ease of changing occupation and home 5. Institutional restrictions and barriers 6. The dependence on seasonal industries |
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Describe the Philips Curve in detail
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The Philips Curve shows what the consequences for inflation and unemployment would be in any given short-run period for various levels of aggregate demand (AD).
1. The philips curve shows the relation between inflation (INF) and Rate of Unemployment (U) as an inverse relationship (downward sloping curve, INF vertical and U horizontal).*So (in the short-run) lower unemployment can only be achieved at the expense of higher inflation and vice versa. 2. The philips curve shows the inflationary bias of the economy, that is, at Uf (full-employment unemployment rate), the accompanying inflation rate is INFf @ greater than zero. 3. The curvature (trade-off) is very important 4. Is for a short-run period and not necessarily for the long-run period |
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What is Inflationary Bias of an Economy?
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at Uf (full-employment unemployment rate), the accompanying inflation rate in INFf is greater than zero.
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Define Unemloyment Rate
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the number of unemployed as a percentage of the labor force in work or seeking work.
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What is the Full Employment Rate of Unemployment?
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Only have frictional unemployment
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U =
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Unemployment Rate
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Q and Y =
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Q = Potential Output and Y = Actual Output
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What is the calculation to measure the gap between Potential Output (Q) and Actual Output (Y)?
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% output gap = (Q-Y / Y) * 100
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What is Okun's law? How do you calculate it?
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US economist Arthur Okun found empirical evidence for the relation between unemployment rate and the output gap (between Q and Y)). The equation is:
U = ( (1/3) * (Q-Y) / Y) + Uf |
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Uf =
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Full Employment Rate of Unemployment
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What is Aggregate Demand (AD) ?
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Demand for output by consumers, firms and government
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What is an Inflationary Gap?
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Inflationary Gap = Demand > output (prices will rise)
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What is the Inflation Rate? How do you calculate it for t+0 and for t+1 ?
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Inflation rate is the percentage increase per year in the average price level from one time period to another.
INF(t+0) = (Pt+1 - Pt+0) / Pt+) INF(t+1) = Pt+0 * (1+INFt+o) |
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What is the Consumer Price Index (CPI)?
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Average level of prices of the goods and services consumed by a TYPICAL household.
Calculation CPI % = Current spend / previous spend |
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What is the GNP Deflator?
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Similar calculation to the Cost Performance Index but includes ALL goods and services produced in the economy rather than a selection.
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What are the expected costs of production and expected demand?
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These arxpectations that profit-maximizing firms use (influenced by experience and their interpretation of the state of the economy).
*the average price level that will be set at the beginning of the next period will depend on the level of aggregate demand in the current period. *The higher the level of aggregate demand in any short-run preiod, the higher will be the rate of inflation during that period. |
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What is the relation between Aggregate Demand and Unemployment?
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WHEN Aggregate Demand is High THEN unemployment is low.
WHEN Aggregate Demand is low THEN unemployment is high. |
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What is downward wage rigidity?
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When there is excess supply of labor, downward pressure on wages is limited. i.e. wages are “sticky” during high unemployment.
*at full employment, the average price level will therefore tend to rise at least somewhat, which is defined as an inflationary bias. |
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Calculate Net National Input (NNI)
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GNP - Depreciation = NNP
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What are the 3 ways of calculating GNP?
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1. Expenditure on final goods and services (GNE)
2. Value added by each producer (GNP) 3. Total income earned by each factor of production (GNI) |
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What is GNE?
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Gross National Expenditure is the total amount spent by households/governments/firms on final goods and services.
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Examples of incomes are....?
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- Wages and salaries
- Rent (land/capital) - Interrest - Gross profits |
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What are Gross Profits?
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What is left of receipts after all other payments have been made.
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The Equilibrium level of national income depend on what?
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Depends on the the level of aggregate demand.
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C + S = ...? Also C + I = ...?
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Y (national income), so we can conclude that S = I.
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I =
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Investment (inventories and capital goods)
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What is Effective Demand?
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Effective Demand is present when additional income is translated into actual expenditure.
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What is the purpose of investment in capital goods?
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1. Replacement investment
2. Net investment |
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Gross Investment (I) = ...?
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Gross Investment (I) = Replacement Investment - Net Investment
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Withdrawals from the Circular Flow of Income are...?
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- Savings
*A withdrawal is any part of the income of private households that is not passed on in the circular flow of income. * Any withdrawal has a contractionary effect on the level of national income (because it is not part of AD and does not create demand). |
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Injections into the Circular Flow if Income are....?
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- Investment
*An injection is any addition to the income of domestic firms that does not accrue from the expenditure of private domestic households. *Any injection has an expansionary effect on the level of national income (it creates demand). |
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What is "Unplanned Inventory Increase"? What's causing it?
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Business inventory of output stock that increased because of unexpected drops in demand.
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Explain the 45 degree line in a Consumption Function graph (Vertical = C and Horizontal = Disposable Income)
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The 45° construction line reflects the locus of points where consumption equals income. If the consumption function lies along the 45° line, then all income would be consumed and there would be neither saving nor dissaving.
> At levels of consumption above the 45degree line, consumption would exceed income and there would be dissaving. > At levels where consumption is below the 45degree line, consumption would be less than income and there would be saving. |
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What is an exogenous variable in an economic model?
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A variable can properly be treated as exogenous only if that variable is not influenced by the endogenous variables in the model.
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What is a "Complete Model"?
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A model is a complete model when it can be used to predict what the values of the endogenous variables will be when the value of the exogenous variables are known.
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What is Disposable Income?
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(Y d ) income minus taxes plus transfers
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What is the Marginal Propensity to Consume?
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The change in consumption accompanying a change in income. b = ΔC/ΔY.
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Calculate the linear consumption function for the Short-Run
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C = a + bYd
C= Consumption a = the amount of consumption that is independent of income b = marginal propensity to consume given by the slope of the consumption function, i.e. b = ΔC/ΔY. Yd = Disposable income |
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Calculate the linear consumption function for the Long-Run
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C = bYd
C = Consumption b = marginal propensity to consume given by the slope of the consumption function, i.e. b = ΔC/ΔY. Yd = Disposable Income |
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What is APC?
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Average Propensity to Consume
*The proportion of income consumed at any level of income. |
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What is MPC?
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Marginal Propensity to Consume.
*The change in consumption that accompanies a change in income. *The larger the MPC, the larger the multiplier |
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Calculate ACP
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Consumption expenditure divided by the level of disposable income:
APC = C / Yd |
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Calculate MPC
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Is given by the slope of the consumption function:
ΔC/ΔY C = a + bYd (short run) C = bYd (long-run) |
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What is the difference ACP and MCP in the short and in the long run?
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In the short run, MPC may be substantially less than APC because of the lag before consumption adjusts to changes in income.
In the long run, APC = MPC |
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What is the "Multiplier Process"?
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If MPC is high, then a large part of the initial increase in demand is passed on in the circular flow of income in the form of higher consumption.
*For the multiplier process to work there must be sufficient unemployed resources in the economy to satisfy an increase in aggregate demand (or inflation will occur). *If the value of MPC were zero, the multiplier would be 1. *If the value of MPC were 1, the value of the multiplier would be infinity and the economy would be unstable, swinging from zero output to full-employment output. |
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What is the basic Multiplier calculation?
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Multiplier = 1 / (1-MPC)
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What is the basic Investment Multiplier calculation?
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ΔY = ΔI / (1-MPC)
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What role does investment (I) play in the circular flow of income?
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Increased investment, through the multiplier, generates higher income; and higher income, through the accelerator, generates higher investment. (and vice versa).
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Explain the effects of the Multiplier and the Accelerator both moving in the same direction.
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The behaviour of the economy, in the reaction of income, output and employment to any initial change in aggregate demand, is therefore influenced by the size of the multiplier (given by the marginal propensity to consume) and the size of the accelerator (given by the capital–output ratio). The higher the multiplier and the greater the accelerator, the more explosive the reaction of the economy. The lower the multiplier and the smaller the accelerator, the more stable is the economy likely to be.
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How does a business assess a proposed investment?
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The business judges the investment based on 3 points:
1. The cost of the investment 2. The expected return from the investment in the form of increased income 3. The cost of financing the investment *The first two give the MEI *The 3rd gives R |
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What is MEI?
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MEI = Marginal Efficiency of Investment
Gives the rate of return over costs of an investment. |
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What is R?
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R = Rate of interest (i.e. cost of financing an investment)
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What is Present Value?
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a future amount of money that has been discounted to reflect its current value, as if it existed today
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PV =
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Present Value
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FI =
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Future Income
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What is the Accelerator Principle?
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The idea that some investments are determined by the rate of change of national income/output, i.e. I = f(Y)
* Many economists believe the accelerator combined withe the multiplier principle provide an explanation for economic activity. |
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As long as the Capital-Output Ratio is bigger than unity, then the Net Investment will ....?
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Exceed the increase in sales.
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What is the relationship between the multiplier process and MPC?
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The Higher MPC, the lower the leakages from the circular flow of income, the greater the multiplier, and the greater the change in income that will be associated with any initial change in aggregate demand. (and vice versa).
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Yd =
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disposable income (i.e. gross income minus taxes)
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T =
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Taxes (withdrawal)
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G =
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Government expenditure (injection)
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H =
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Households
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F =
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Firms
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S =
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Savings (withdrawal)
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I =
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Investment (injection)
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CM =
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Capital Market
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C =
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Consumption
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When is National Income in equilibrium, and when is there a budget deficit, and when a budget surplus?
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*Equilibrium national income = S + T = I + G (they can diverge and cause in-equilibrium - see below - in which case national input/employment will change until equilibrium is reached).
*IF S > I AND T < G THEN Budget Deficit (has an expansionary effect, leading to a rise in national income and employment, as long as there are unemployed resources in the economy). *IF S < I AND T > G THEN Budget Surplus (has a deflationary effect, leading to a fall in national income and employment). |
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Calculate National Income
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Y (output) = C + I + G
Y (income) = C + S + T Consequently, with a balanced government budget S = I +InvU (unintended inventories) |
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What happens if Planned Saving (S) do not equal Planned Investment (I)?
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This causes disequilibrium (because planned savings do not equal planned investment) and firms will reduce output to get rid of unintended inventories, causing national output to fall and unemployment to rise. For equilibrium national output to be reached planned savings and planned investment must be equal again.
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Government Taxation (in the circular flow of income) is... a withdrawal or injection?
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A withdrawal
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Government Expenditure (in the circular flow of income) is...a withdrawal or injection?
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An injection
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How come Government Expenditure can be part of BOTH aggregate demand AND expenditure?
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Because government expenditure generates both income and employment.
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What is a discretionary fiscal policy?
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A fiscal policy that manipulates G expenditure and taxation in a deliberate attempt to influence aggregate demand.
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What is an in-built stabilizer
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Any aspect of government expenditure and taxation policies that automatically reduces E and/or increases T when Y and output are increases, and increase E and/or T when Y and output are falling.
The most important in-built stabilizers are; * Taxes * Transfers * Price Supports Note that these can be Undesirable when there is very high unemployment, and a fiscal drag is the consequence (and any stimulus will be less effective because the in-built stabilizers reduce the multiplier effect). |
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What is Progressive Income Tax?
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Different taxation % brackets for different levels of income (usually higher % with higher income).
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What is a Non-Discretionary fiscal policy?
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A fiscal policy without discretionary actions to influence aggregate demand, it instead relies on in-built stabilizers (advocated by monetarists who believe discretionary policy will only increase the cyclical fluctuations)
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What do Keynesians think about discretionary fiscal policy?
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Keynesians believe that a discretionary fiscal policy has a stabilizing effect.
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What is an Unindexed Tax System?
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A tax system where thresholds are set in money terms and are not adjusted for changes in price levels.
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When are built-in stabilizers desired?
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In summary, in-built stabilisers are desirable where an economy has a pronounced tendency to oscillate around full employment without price inflation. In these circumstances in-built stabilisers reinforce the stabilising forces within the system. Where the economy departs substantially from full employment and exhibits either high unemployment or high inflation, in-built stabilisers may prevent the economy returning towards full employment with price stability, or may result in an unplanned transfer of income from private households to the government sector.
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Describe the relationship between injections and withdrawals, and consequent changes in national income.
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1. A given change in household savings or taxation or imports will have exactly the same effect on national income. In each case the initial change causes national income to change in the opposite direction.
2. A given change in business investment or government expenditure or exports will have exactly the same effect on national income. In each case the initial change causes national income to change in the same direction. 3. The change in income, as the result of some initial change in withdrawals (S, T or Z) or some initial change in injections (I, G or X) will be some multiple of the initial change, the size of the change being given by the relevant multiplier. |
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What is a Closed Economy?
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No international (import/export/resources/currencies) sector (usually used to simplify economic models)
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Z =
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Imported goods and services
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X =
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Exported goods and services
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In the circular model, imports are analogous to...?
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Household savings and taxation (withdrawal from domestic flow)
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In the circular model, exports are analogous to...?
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Investment and government expenditure (injection to the domestic flow)
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FT =
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Foreign Trade sector
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Equilibrium in the circular flow occurs when...?
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…the sum of withdrawals (T + S + Z) is equal to the sum of injections (I + G + X).
*Equality between the individual items is not necessary to achieve equilibrium. |
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n =
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Marginal Propensity to Import
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BRE =
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Business Retained Earnings
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NT =
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Net Taxes
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What are Business Savings / Undistributed Profits?
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Income generated and kept by firms (not going into household income)
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The Gross Profit of a business is divded in what three parts?
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1. Capital consumption allowances (depreciation)
2. Undistributed profits (withdrawal from the circular flow of income) 3. Dividends |
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Disposable personal income =
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'= Wages,salaries,rents,interests + dividends - taxes + transfer payments
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Business Retained Earnings (BRE) =
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'= Net Profit + Capital consumption allowances - direct business taxes - dividends
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Net Taxes =
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'= Indirect business taxes + direct business taxes + personal taxes - transfer payments
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Q =
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Potential Output
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Aggregate Demands consists out of which expenditures?
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1. Household Consumption (C)
2. Business Investment (I) 3. Government expenditure (G) 4. Exports (X) less imports (Z) So, AD = C + I + G + (X-Z) |
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Aggregate Expenditure (E) is calculated as...
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Same as aggregate demand:
So AE = C + I + G + (X-Z) |
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Full employment is denoted by...
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Yf
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Describe the difference between money income and real income (when measuring national income with a basket of goods and services)
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Money Income is measured by the price weights currently ruling. Real Income is measured by adjusting money income to allow for changes over time in the value of the ‘measuring rod’ of money. This, changes in money income include changes in price and quantity weights; changes in real income reflect changes only in quantity weights.
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What is the price index used to obtain Real GNP called?
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GNP Deflator.
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If T < G then there is a...
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Budget deficit (appropriate when there is a deflationary gap)
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If T > G then there is a...
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Budget surplus (appropriate when there is an inflationary gap)
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If T = G then the government should….
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Neither stimulate or deflate the economy.
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Functional Finance = ...?
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Is the decision made in fiscal policy to create a budget deficit or surplus or do nothing.
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What is money
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Money is anything that is generally acceptable for the settlement of debts
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What are the three types of money?
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1. Coins (legal tender)
2. Banknotes (legal tender) 3. Bank deposits (not legal tender) |
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What are the three functions of money?
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1. A medium of exchange
2. A unit of account 3. A store of wealth |
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What is Barter?
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The exchange of goods and services for other goods or services without using money
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What are the four characteristics of money?
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1. It must be widely acceptable
2. It must have a high value:weight ratio 3. It must be divisible to settle debts of differing denominations 4. It must not be easily produced, counterfeited or debased in value. |
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What is cloakroom banking?
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Cloakroom banking is where a bank acted only as a place of safekeeping, but did not add, through its own activities, to the money supply.
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What is convertibility?
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Convertibility is the act of bank converting a banknote into cash.
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What is Fractional Reserve Banking?
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Fractional Reserve Banking is a system where the deposit liabilities of the banks exceed their holdings of cash.
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What are the 2 competing pulls under a fractional reserve banking system?
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1. The pull of profitability (cash earns no interest, so less cash and more interest-bearing assets is greater profitability for the bank.
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Cash ratio (r) =
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The percentage of assets a bank holds in cash
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What are dividends?
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Income stockholders may receive each year.
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What 3 elements are on a bond?
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1. Redemption date (a future date when the bond will be returned for cash).
2. Redemption value (the amount of cash that will be returned to the bondholder). 3. Coupon payment (the money paid each year until the redemption date). |
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What is the Change in deposit (ΔD) formula ?
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ΔD = d x ΔC
d = credit or deposit multiplier ΔC = initial change in the cash reserves of the commercial bank |
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What is the Deposit multiplier formula ?
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d = 1 / r
r = cash ratio |
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What is the Credit multiplier formula ?
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d = ΔD / ΔC
D = Deposits (induced by change in the cash reserves of the commercial bank (C) |
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The smaller the cash ratio (r)….the...
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The greater the size of the credit multiplier and the greater the volume of bank deposits created on a given cad base, and vise versa.
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If the case reserve of a commercial bank with a 10% cash ratio increased by $100, what would be the increase in volume of bank deposits?
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'$1000
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What are the 2 limiting factors for the creation of bank deposits?
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1. The banks’ propensity to keep cash for liquidity purposes, as represented by the cash ratio.
2. The publics’ propensity to hold additional cash. |
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What is the function of a central bank?
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The function of a central bank is to control the commercial banks around it in such a way as to support the monetary policy of the economy.
*The central banks conducts its business as acting as the bankers’ bank and lender of last resort, and also as the government’s bank and manager of public debt. In this way the central bank is responsible for the conduct and operation of monetary policy that attempts to influence the level of economic activity and that involves regulating the supply of money and the cost and availability of credit. |
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What powers does the central bank have at its disposal?
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1. Monopoly of the note issue.
2. Ability to dictate the cash ratio and reserve requirements for commercial banks. 3. Credit controls. 4. Power to direct instructions to commercial banks and other financial institutions. 5. Open market operations (buying and selling of government bonds). |
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What does the central bank do in open market operations?
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1. Buy bonds: effect is to increase the money supply and reduce cost of borrowing. (expansionary policy). Leading to an increase in aggregate demand, private and public investment, consumption, exports; and in turn income, output and employment.
2. Sell bonds: effect is to reduce the money supply and increase the cost of borrowing. (contractionary policy). Leading to a decrease in aggregate demand, private and public investment, consumption exports; and in turn reduced income, output and employment. *Using normal supply and demand analysis, it can be seen that if the supply of money increases, the cost of borrowing (interest rates) must fall so long as there is no offsetting shift in the demand for money. Conversely, if the central bank sells bonds, this reduces the supply of money and (other things being equal) will increase the cost of borrowing (interest rates). |
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What are the 5 stages in which monetary policy can influence the level of economic activity?
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1. The central bank acts on the cash reserves of commercial banks.
2. Commercial banks act to change bank deposits and therefore the money supply. 3. A change in the money supply influences the cost of borrowing. 4. A change in the availability and cost of credit influences aggregate demand. 5. A change in aggregate demand leads, through the multiplier process, to some multiple change in income, output and employment. |
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Explain what Bonds are?
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If the central bank buys bonds, it pays by a cheque drawn on itself and payable to the seller, say a private citizen. The seller will then deposit the cheque with his/her bank. The commercial bank will present the cheque for payment to the central bank, which will credit the deposit of the commercial bank. Bankers’ balances have therefore increased by the value of the cheque.
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What is the difference between the naive and modern quantity theory of money?
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The Quantity Theory stresses the role of money as a medium of exchange.
Naive / Traditional form: Suggests a direct relationship between the money supply (M) and the level of Prices (P). Denotes as MV = PT, i.e. Money Supply * Velocity of Money = Price * Transactions in period. *MV is called the monetary side and PT the commodity side. It simply states expenditures must equal receipts. Because P can be said to equal Y and V can be assumed constant, we can rewrite this as MV = PY. Modern form: Suggests that changes in the money supply can indeed influence the level of real income (Y) as well as the price level (P) (and consequently aggregate demand). The effect on these variables depends on how close, or how far away, the economy is from full employment (as the closer the economy is to full employment, the more it will affect Price Level (P) more than the level of real income (Y), and after full employment it will only affect the price level (P). |
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Keynesian theory of Money = ?
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The Keynesian theory stresses the role of money as a store of wealth.
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In the Keynesian theory of money, what are the 3 types of demand for money balances?
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1. Transaction Demand for Money
2. Precautionary Demand for Money 3. Speculative Demand for Money |
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In the Keynesian Theory of Money, what is the Transaction Demand for Money?
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The Transaction demand for money arises from the fact that people need money to finance current transactions.
*The transaction demand emphasizes the role of money as a medium of exchange *The transaction demand for money is inversely related with the rate of interest. |
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In the Keynesian Theory of Money, what is the Speculative Demand for Money?
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The Speculative Demand for Money emphases the role of money as as store of wealth. Speculative balances are simply money held to speculate on the course of future events.
*Wealth in the form of money does not yield another return or income. So holding wealth in the form of money has an opportunity cost. *Speculative balances arise from the existence of uncertainty. |
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In the Keynesian theory of money and the speculative demand for money, what is the relation between bonds prices and the rate of interest?
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The price of existing bonds and the market rate of interest are inversely related. If the price of bonds is expected to fall, the interest rate will rise (its the same thing).
Conversely, if the price of existing bonds is expected to rise, it is the same thing as saying the rate of interest will fall. |
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What is Liquidity Preference?
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Liquidity Preference relates to the demand to hold assets as money rather than as interest-bearing bonds.
*The strength of the demand for liquidity preference varies inversely with the rate of interest when the rate of interest is low, liquidity preference is high; when the rate of interest is high, liquidity preference is low. |
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In the Keynesian theory of money, when the rate of interest is HIGH, the demand of money (for all 3 purposes) is…?
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When the rate of interest is high, the demand for money for all purposes, transactions, precautionary and speculative - will be low, and vice versa.
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What are the differences between keynes and the quantity theories of money?
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The Keynesian theory of money, in contrast to the Quantity theory, suggests that changes in the money supply do not lead directly to changes in aggregate demand. Instead, monetary policy affects aggregate demand indirectly through the cost of borrowing (interest rates), thus influencing those components of aggregate demand that are sensitive to changes in the cost of borrowing.
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What is the Liquidity Trap?
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It might be impossible to force the rate of interest below a certain flow, this is the liquidity trap.
*If a lower rate of interest were required in order to obtain a sufficient volume of investment, then monetary policy would be ineffective. Thus, monetary policy may be able to restrain the level of aggregate demand in an inflationary situation, but it may be ineffective in raising the level of demand in a deep recession. |
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When will there be demand-deficient unemployment?
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If Y < Q, there will be demand-deficient unemployment.
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What are some of the potential effects of Inflation? (5)
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1. Inflation impairs the efficiency of the price mechanism and raises the cost of buying and selling because money becomes less reliable as a standard of value.
2. Inflation penalizes people on ‘fixed’ incomes and favors those whose money incomes adjust quickly to price changes. 3. Inflation favors borrowers and penalizes lenders so long as its unanticipated. 4. Given a system of unindexed taxes, namely one where tax thresholds are specified in money terms rather than real terms, inflation will redistribute resources from the private to the public sector. 5. A continuing higher rate of domestic inflation than that experienced in other economies can lead to increased imports and reduced exports and can create potential problems for stable exchange rates. |
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What are the two theories around price inflation?
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1. Demand-pull
2. Cost-push |
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What is the demand-pull theory for inflation?
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The demand-pull theory sees price rises as a consequence of excess demand for goods and services namely demand that exceeds the capacity output of the economy at current prices.
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What is the cost-push theory for inflation?
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The cost-push explanation of inflation sees price roses as a consequence of bargains struck in the factor market, which raise the production costs of employers, who then pass on higher cost in the form of higher prices.
*Cost-push inflation originates with higher wage costs, which then push up prices. price inflation is then generated in the factor market, particularly in the labor market, and is then transmitted to the product market. *Cost-push inflation is more likely to occur in economies where prices and wages are not flexible downwards, which is a feature of many modern economies. (so its possible that the reaction of wages and prices is asymmetrical, excess demand will raise prices and wages, but deficient demand will not lower prices and wages). |
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The 3 most common assumptions in building economic models including expectations are?
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1. Expectations are static (tomorrow will be equal to today)
2. Expectations are adaptive (gradual changes) 3. Expectations are rational (assumes all have same info as economic policy maker) |
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What is the Efficient Market Hypothesis?
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The theory incorporating rational expectations, where markets work efficiently in the sense that all information is used to clear any market of excess demand or excess supply, so that the market price reflects equilibrium.
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What is the weakness of the Philips Curve?
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It is possible to interpret results as either supporting a demand-pull or cost-push explanation of inflation, and results have been so interpreted by differing schools of thought.
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A substantial increase in money supply goes hand in hand with a substantial increase in inflation, or vice versa. True?
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YES. A high rate of inflation cannot be sustained unless the money supply is expanded significantly.
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What do Keynesians and Monetarists agree on?
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Higher wage costs lead to higher prices and these can only be sustained if the money supply is increased.
*If the money supply is not increase, there will be higher unemployment. *However, Keynesians and Monetarists disagree on the amount and duration of unemployment that would be necessary to contain inflation, and of the long-term benefits relative to the short-term costs of a restrictive monetary policy. |
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What would be the ‘goods’ and ‘bads’ in macroeconomics?
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Goods:
1. Consumption expenditure 2. Investment expenditure 3. Government expenditure 4. International trade. Bads: 1. Unemployment 2. Inflation |
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W =
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National Welfare
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What is the The Laffer Curve?
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Laffer argued that if the tax rate were 100 per cent, no one would be willing to work since all wages and salaries would go in taxes; government tax revenue would then be zero. If the tax rate were zero, government tax revenue would also be zero.
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