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96 Cards in this Set

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inflation rate

computed as an annual percentage change in the price level

computed as an annual percentage change in the price level

inflation (definition)

percentage change in an economy's overall price level

two ways to estimate P:

two ways to estimate P:

consumer price index (CPI): price index for a bundle of consumer goods. based on a fixed basket of consumer goods. includes import but not exports or price of investment or gov't purchased goods


GDP deflator: (deflator=[nominal gdp/ real gdp]*100) not based on a fixed basket of goods, includes G, export prices and investment goods, but not import prices

two types of gov't policies that influence the economy

fiscal


monetary

two main entities involved with fiscal and monetary policies

fiscal authorities: executive and legislative; treasury reports and advises ~ controls gov't spending (G) and taxation (T)




monetary authorities: the central bank ("The Fed") ~ controls money supply; influences interest rates

fiscal authorities (fed, state, local) make decisions regarding taxation and spending

spending financed by taxing, borrowing by issuing bonds


treasury issues bonds when gov't requests to borrow (doesn't increase money supply)


~bonds purchased by domestic and foreign lenders


~CB may also buy bonds, falls under monetary supply



CB controls nation's

money supply by buying/selling assets, primarily short-term gov't bonds



M1=

currency in circulation + demand deposits




~ doesn't include reserves


~also includes traveler's checks


~not the same as income or spending(C)


~monetary auth.'s money NOT a part of M (CB)


~fiscal auth.'s money IS part of M (exec. legis.)

CB's money is not part of the money supply


Gov't (fiscal) money is part of the money supply

when CB buys (sells) things, the money supply will expand (contract)

Three important categories of interest rates:

discount rate, federal funds rate, (avg) interest rate


discount rate

bank's pay this rate on loans they take out form the CB




rate NOT determined by mkt and set by CB

federal funds rate

bank's pay/collect this rate on overnight loans they make to each other




rate determined by mkt


~banks w/extra cash will supply fed funds


~banks needing cash will demand fed funds


~CB can heavily influence this mkt rate by altering supply and demand forces when they buy/sell gov't bonds

(avg) interest rate

rate on all other loans (car, mortgage, cc, business, etc)


~ influence by two other rates and other factors



i & R

i ~ nominal (contract) interest rate




R ~ real interest rate (contract rate adjusted for inflation)

money stock (M) represents

-the assets being used in the economy to conduct transactions (like buying goods and svcs)


-measured using data (M1, M2,...)


-money takes on value b/c we expect others will value it

monetary base (MB)

includes currency and accts, called reserves, which private banks hold w/the economy's CB, which usually pay no interest

reserves ensure that

banks have sufficient cash on hand in case there is a run on the bank asking for currency withdrawals


~ CB sets a min req'd (floor) and banks are free to set their own reserves above this

M2

adds savings accts and money mkt acct balances to M1

quantity theory of money


MV = PY

allows us to make the (long run or avg) connection b/w money and inflation


It implies that, on average, changes in the growth rate of money lead one-for-one to changes in the inflation rate

MV = PY

M ~ money supply;


V ~ velocity of money;


P ~ general price lvl of real output


Y ~ real output lvl

V = PY/M, by definition, is

the value of all transactions divided by the amt of money in the economy = the avg times a unit of money changes hands (per period of time)



quantity theory for the price lvl




P is endogenous, all other variables are exogenous
~most developed countries have a constant positive inflation rate on avg. so, better to convert to a growth rate relationship...



P is endogenous, all other variables are exogenous


~most developed countries have a constant positive inflation rate on avg. so, better to convert to a growth rate relationship...

quantity theory for inflation

quantity theory for inflation

velocity is constant on avg (in the LR, g(v) = 0). Since g(p) = pi,

velocity is constant on avg (in the LR, g(v) = 0). Since g(p) = pi,

rate of inflation represented as... (definition)

rate of inflation represented as... (definition)

percentage in the overall price level for the coming year)

percentage in the overall price level for the coming year)

what drives money growth?

CB primarily decides (exog in model) - can be influenced by bank and consumer behavior, but the CB can alter the growth rate through the open mkt

what determines real output growth(pdxn fxn)?

growth in factors (K and L) and TFP (A)

how is inflation determined in the long run?

Since velocity is constant, it is determined by the difference b/w the money supply growth rate and real output growth rate


This only happens when excess money is spent on goods and svcs (this increase in AD causes the inflation, not the money supply growth by itself)

in LR equilibrium, the real interest rate (r) is equal to:

the marginal product of capital 

the marginal product of capital

the real interest, r...

is the return on an asset in purchasing power (goods and svcs)


~ isolated cases, but on avg, not negative, so MPK is not negative

nominal interest (i) is.. definition..

the average contract interest rate on an all interest bearing asset (savings acct or bond - loans!)


~ i represents the return on an asset in currency (dollars)


~ cannot be negative

Fisher equation

Fisher equation

the real interest is computed by subtracting inflation from the nominal interest rate

Fisher effect -

as inflation rises, borrowers and lenders eventually incorporate this into their negotiations

Fisher Effect in the SR

stickiness in the process and real interest rates may fall

Fisher effect in the LR

all inflation will be incorporated into loan contracts and the nominal interest rate will fully adjust, leaving real interest rates unchanged


~ lender wants higher return to compensate for inflation and borrower is facing a competitive loan mkt; so the nominal int rate eventually adjusts one-for-one w/the inf rate

what happens when there is a change in nominal int rates due to a change in loan demand or supply - in the SR?

if i falls, inflation is slow to adjust, so r falls as well.


decrease in r results in demand for investment goods (I) and AD rises.


increase in AD causes inflation to rise if economy moves past full employment output


as inflation rises, r falls further



what happens when there is a change in nominal int rates due to a change in loan demand or supply - in the LR?

i will begin to rise as lenders renegotiate contracts at higher returns to compensate them for the higher inflation


the upward pressure on nominal int rates continue until they have risen one-for-one w/inf, returning to its original value

definition: LR neutrality of money

a variable is neutral if a change in that variable leads only to nominal changes in the economy and no real changes; real variables like real int rates, real output, real consumption, real investment, etc are unchanged

Monetary policy is neutral in the LR (not SR) b/c...

nominal prices don't respond immediately to changes in the money supply


~higher de may lead to increased pdxn temporarily, but eventually prices will adjust and bring real output lvls back to avg


~lower de may lead to decreased pdxn in SR, with a return to avg pdxn in the LR once prices fall (inf slows) to bring quantity demanded back up

examples of individuals who are hurt during inflation:

~indiv who has a pension fund that is not indexed to inflation


~bank that issues loans at fixed rates, but pays int rates that move w the mkt


~indiv with a variable rate mortgage


~inf does not, on avgm lower stds of living

inflation can shift wealth

~people w/debts can pay back loans w/new cheap dlls while creditors wind up worse off in real terms


~may not cause net loss/gain to the economy as a whole, but it does cause changes in the distribution of wealth

Inflation can cause tax distortions, altering decisions and crating economic inefficiency:

~taxes are based on nominal incomes but economic decisions are made based on real variables ( like: capital gains are taxed on nominal returns)


~distortions are more severe when inflation is high

Inflation can cause inefficiency due to bad price signaling

~it is important for allocating resources efficiently in a competitive mkt


~inf distorts relative prices b/c some prices are faster at adjusting to inf than others are


~"shoe leather" costs of inf imply that people want to hold less money when inf is high (people spend resources transferring money rather than on more productive endeavors)

Inflation can cause inefficiency due to slow price adjustments

~"menu" costs are costs to firms of changing prices frequently


~costs arent generated by the rate of inf, but rather by unexpectedness and uncertainty generated from surprise changes



possible link b/w fiscal policy and inflation

gov't budget constraint says that the govt's uses of funds (G) must equal its sources of funds: tax rev (T), borrowing (B), and changes in the stock of money (M)

gov't budget constraint says that the govt's uses of funds (G) must equal its sources of funds: tax rev (T), borrowing (B), and changes in the stock of money (M)

Inflation "tax" - seignorage and inf tax are names for:

the revenue that the gov't obtains when the CB finances its deficit spending (change in M) (also called debt monetization)



what happens when the CB buy up gov't bonds

the money supply increases


~if its a temporary increase in money supply, avg rate of money growth may not change; doesn't cause long run changes in inf


~if it leads to a long run increase in money growth, inf will result

"inflation tax" shows up how on price level?

shows up as a rise; thus paid by people holding money (demand deposits and currency)


~an indiv holding land. if prices double, price of land also doubles. they don't pay the inflation tax

when is inflation tax most likely to occur?

~corrupt gov't (more likely)


~and/or a gov't viewed as a default risk (as debt rises, lender worry the gov't will have trouble paying back loans and they may stop the gov't altogether - if lenders are decreasing savings help in one asset it is b/c they're increasing savings held in another, less risky, asset)


~and/or when raising taxes is not politically feasible

what happens when taxes/borrowing are no longer an option?

gov't will result to "printing currency" to finance its spending


~lenders will be paid back in units of currency that are worth less in purchasing power (b/c inflation results)

when does hyperinflation end

when the rate of money growth falls rapidly. this can usually only be done by targeting both G and T


~gov't gets its finances in order through lower spending, higher taxes, and new loans



Great Inflation of the 1970s

~policymakers didn't realize that there was a productivity slowdown (the potential real output had declines causing the NATURAL rate of unemployment to rise) so they ran a monetary policy that grew the money supply too rapidly


~when M grows fast during recession, it will not necessarily cause inf and if it is slowed as economy nears full employment, there may be no increase in inf at all. however, if M grows fast when near potential output, inf will result

what does the LR model determine?

potential output and long run inflation


~growth accounting


~quantity theory of money (V is constant)



what does the SR model determine?

current output and current inflation


~deviations from potential


~potential output is the amt the economy would produce if all inputs were utilized at their LR sustainable levels



why would output deviate from potential output

b/c the economy can be hit by shocks (demand mostly, but occasionally supply shocks happen)

in SR models, assuming LR is given...

trend output level is determined by A, K and L


~potential output and the LR inf rate are exogenous in the SR model


~current level of output and the current inf rate are endogenous in the SR model



an output fluctuation is..

equal to the difference in actual and potential output, expressed as a percentage of potential output

SR output or output gap

SR output or output gap

can be positive, negative or zero (above, below or at potential output level)

can be positive, negative or zero (above, below or at potential output level)

a~ actual and potential output


b~ measure of the implied SR fluctuations



what happens to SR output when an economy is in recession/booming?

recession~ actual output is less than potential output, SR output is negative


boom~ actual output is above potential, SR output is positive

what happens to rate of inflation in a recession?

peaks at the start of a demand driven recession and the falls during recession


~vast majority of recessions are demand driven, but occasionally a supply driven recession occurs and is paired with rising inflation


~economy in a deep recession or recession w/low or no LR growth can experience deflation (price levels fall rather than simply slow in growth)

what does the Philips curve imply?

a boom increases inflation and a recession decreases inflation

behavior of an economy during a boom:

Firms produce above potential
~must raise wages and delay maintenance 
~may raise prices above prevailing inf rate b/c:
(1) pdxn is more costly (2) demand is higher b/c economy is booming
~inf rate increases, so the change in the inf rate is pos...

Firms produce above potential


~must raise wages and delay maintenance


~may raise prices above prevailing inf rate b/c:


(1) pdxn is more costly (2) demand is higher b/c economy is booming


~inf rate increases, so the change in the inf rate is positive when SR output is positive

behavior during a recession:

Firms cut costs and lay off workers b/c of low demand for their products


~inf rate will fall when all or most firms are cutting costs and demand is low


~change in the inf rate is negative



Philips curve

Philips curve

implies a positive relationship b/w the change in inf and SR output

a recession:

Begins when "economic activity" starts to fall


~not the same as when output falls below potential


~NBER defines start and ends


Ends when economic activity STOPS declining


~ends when we are at the worst part of the slump in economic activity

what does the SR model feature?

an open economy where booms/recessions in the rest of the world impact the economy at home


economy can exhibit both LR growth and SR fluctuations


CB manages monetary policy to smooth fluctuations

what 3 premises is the SR model based on

1. economy constantly being hit by shocks:


such as changes in oil prices, tech, spending, disasters that cause fluctuations in output or inf


2. monetary/fiscal policies affect output(thru AD):


3. there's a SR dynamic trade-off b/w unemployment and inf:


~gov't does not want to keep GDP high b/c it leads to increase in inf rate, which requires recession to lower it


~monetray policy works via changing money supply, which influences ff rates -> influences nominal int rates, if inf is low to adj -> influences real int rates -> altering demand (thru I and NX)

Ex: in 1979, inf was increasing b/c oil prices. Fed Reserve tightened monetary policy by decreasing money growth and pushed up on int rates...

Policy induces a recession b/c higher int rates discourage investment


As output declines, firms face lower demand and reduce costs


Inf falls dramatically

Fed funds mkt

large banks and financial institutions borrow from each other from one business day to the next

~CB uses this mkt to influence the economy

CB buys/sells treasury securities:
this alters the reserves in the banking system and shifts supply/demand in this ff mkt

when CB buys bonds,

money reserves at banks increase

~increases supply of ff and drives down the ff rate (more money to lend and int rates will be lowered by banks to entice borrowers)


~equivalent to increase in money supply (pushes down on int rates in the SR and stimulates investment demand)


changes in the nominal int rate leads to

changes in the real int rate, so long as they are not offset by corresponding changes to inf (true in SR when price adj is sticky)

changes in the real int rate, so long as they are not offset by corresponding changes to inf (true in SR when price adj is sticky)

According to classical dichotomy, in the LR,

there is complete separation of the nominal and real sides of the economy


~prices are flexible


~ real int rate determined in credit mkts and nominal int rate will adj w/inf

MP curve illustrates...

the CB's ability to "set" the real int rate (an avg for all loans) simply by targeting the nominal rate on fed funds
<- assumes all links are unbroken

the CB's ability to "set" the real int rate (an avg for all loans) simply by targeting the nominal rate on fed funds


<- assumes all links are unbroken

if CB can "set" real int rate at a particular value,

then MP curve is horizontal

to decrease avg real rate on all loans, the CB would buy treasury bonds from public:


~banks would find they have more reserves as bonds are traded for money


~causes increase in supply of ff and the ff rate would fall


~decline in borrowing costs for banks would increase the supply of loans to customers and all other mkt int rate would begin to decline


~if inf is sticky, nom int rate decline will cause real int rate to decline and then AD will rise






IS-MP diagram 

IS-MP diagram

graph of IS and MP curves


~combined w/Philips curve makes up SR model


~Economy is at potential when real int rate equals MPK (R=r) and there aren't AD shocks (SR output = 0)



~if CB raises int rate above MPK, inf is slow to adj in the SR, real int rate rises and investment falls, output declines

Expected inflation:

inflation rate firms think will prevail in the rest of the economy over the coming year
~modeled by assuming that firms expect the inf rate in the coming yr to equal rate of inf that prevailed during last yr

inflation rate firms think will prevail in the rest of the economy over the coming year


~modeled by assuming that firms expect the inf rate in the coming yr to equal rate of inf that prevailed during last yr

what if prices are below/above potential?

if output < potential, prices rise more slowly than usual (low demand for goods and svcs)


if output > potential, prices rise more rapidly than usual (high demand)

effect of SR output on inf in the PC is "demand-pull inf" b/c

increases in AD pull up the inf rate




IS-MP and PC togeteher:

~lowering LR inf rate comes w/slumping economy, which implies high unemployment and lost output


~once inf has declined, the real int rate can be lowered back to the MPK, allowing output to rise back to potential


~Inf rate will be permanently lower after process is complete

MP curve implies

increases in the nom int rate causes an increase in the real int rate

IS curve implies

increases in the real int rate decreases SR output through declining investment demand

PC implies

decreases in SR output decrease the change in inflation as firms set inflation lower due to lower demand

IS curve (definition)

captures the negative relationship b/w int rates and output in the SR

AD is used to derive IS curve

Y = C + I + G + NX <=> I = (T-G) + (Y=T=C) + (IM-EX)


I = public savings + private savings + foreign savings = S

IS curves slopes downward

increase in the int rate will decrease investment, which, will decrease output


~shows economic activity decreasing when int rates rise





IS curve represents

each combo of R and Y that yields credit mkt equilibrium (S = I)

Consumption doesn't vary with

~Current income, they purchase based on their expected LR income level


~Real int rate, R

MPK is exogenous

if its low relative to real int rate, firms should save their money rather than invest (lend)


if its high relative to real int rate, firms should invest (borrow)


~in SR, it is different from R


~in LR, they are equal due to profit maximizing behavior

IS curve equation

this is the gap b/w real int rate and MPK that matters for output fluctuations 

this is the gap b/w real int rate and MPK that matters for output fluctuations

when the real int rate changes, economy will move along IS curve

~increase in int rate rises borrowing costs and causes firms to purchase less capital, less pdxn, lower demand, economy contracts (left along IS curve, SR output declines)

wealth effect

higher int rates lead some people (those who hold lots of int bearing assets) to consume more b/w their wealth has increased


C doesn't change in this model

empirical evidence

~increase in gov't purchases financed by an increase of taxes will have a modest positive impact on the IS curve and will raise output in SR


~increase in gov't purchases today financed by borrowing will shift the IS curve out by a more moderate amount

if Americans import more, IS curve shifts left and reached SR output

more export, IS curve shifts outward