Exam 2

Front 1

inflation rate

Back 1

computed as an annual percentage change in the price level

Front 2

inflation (definition)

Back 2

percentage change in an economy's overall price level

Front 3

two ways to estimate P:

Back 3

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

Front 4

two types of gov't policies that influence the economy

Back 4

fiscal

monetary

Front 5

two main entities involved with fiscal and monetary policies

Back 5

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

Front 6

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

Back 6

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

Front 7

CB controls nation's

Back 7

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

Front 8

M1=

Back 8

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.)

Front 9

CB's money is not part of the money supply

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

Back 9

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

Front 10

Three important categories of interest rates:

Back 10

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

Front 11

discount rate

Back 11

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

rate NOT determined by mkt and set by CB

Front 12

federal funds rate

Back 12

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

Front 13

(avg) interest rate

Back 13

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

~ influence by two other rates and other factors

Front 14

i & R

Back 14

i ~ nominal (contract) interest rate

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

Front 15

money stock (M) represents

Back 15

-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

Front 16

monetary base (MB)

Back 16

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

Front 17

reserves ensure that

Back 17

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

Front 18

M2

Back 18

adds savings accts and money mkt acct balances to M1

Front 19

quantity theory of money

MV = PY

Back 19

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

Front 20

MV = PY

Back 20

M ~ money supply;

V ~ velocity of money;

P ~ general price lvl of real output

Y ~ real output lvl

Front 21

V = PY/M, by definition, is

Back 21

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)

Front 22

quantity theory for the price lvl

Back 22

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...

Front 23

quantity theory for inflation

Back 23

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

Front 24

rate of inflation represented as... (definition)

Back 24

percentage in the overall price level for the coming year)

Front 25

what drives money growth?

Back 25

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

Front 26

what determines real output growth(pdxn fxn)?

Back 26

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

Front 27

how is inflation determined in the long run?

Back 27

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)

Front 28

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

Back 28

the marginal product of capital

Front 29

the real interest, r...

Back 29

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

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

Front 30

nominal interest (i) is.. definition..

Back 30

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

Front 31

Fisher equation

Back 31

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

Front 32

Fisher effect -

Back 32

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

Front 33

Fisher Effect in the SR

Back 33

stickiness in the process and real interest rates may fall

Front 34

Fisher effect in the LR

Back 34

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

Front 35

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

Back 35

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

Front 36

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

Back 36

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

Front 37

definition: LR neutrality of money

Back 37

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

Front 38

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

Back 38

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

Front 39

examples of individuals who are hurt during inflation:

Back 39

~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

Front 40

inflation can shift wealth

Back 40

~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

Front 41

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

Back 41

~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

Front 42

Inflation can cause inefficiency due to bad price signaling

Back 42

~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)

Front 43

Inflation can cause inefficiency due to slow price adjustments

Back 43

~"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

Front 44

possible link b/w fiscal policy and inflation

Back 44

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)

Front 45

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

Back 45

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

Front 46

what happens when the CB buy up gov't bonds

Back 46

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

Front 47

"inflation tax" shows up how on price level?

Back 47

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

Front 48

when is inflation tax most likely to occur?

Back 48

~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

Front 49

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

Back 49

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)

Front 50

when does hyperinflation end

Back 50

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

Front 51

Great Inflation of the 1970s

Back 51

~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

Front 52

what does the LR model determine?

Back 52

potential output and long run inflation

~growth accounting

~quantity theory of money (V is constant)

Front 53

what does the SR model determine?

Back 53

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

Front 54

why would output deviate from potential output

Back 54

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

Front 55

in SR models, assuming LR is given...

Back 55

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

Front 56

an output fluctuation is..

Back 56

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

Front 57

SR output or output gap

Back 57

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

Front 58

Back 58

a~ actual and potential output

b~ measure of the implied SR fluctuations

Front 59

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

Back 59

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

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

Front 60

what happens to rate of inflation in a recession?

Back 60

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)

Front 61

what does the Philips curve imply?

Back 61

a boom increases inflation and a recession decreases inflation

Front 62

behavior of an economy during a boom:

Back 62

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

Front 63

behavior during a recession:

Back 63

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

Front 64

Philips curve

Back 64

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

Front 65

a recession:

Back 65

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

Front 66

what does the SR model feature?

Back 66

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

Front 67

what 3 premises is the SR model based on

Back 67

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)

Front 68

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...

Back 68

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

As output declines, firms face lower demand and reduce costs

Inf falls dramatically

Front 69

Fed funds mkt

Back 69

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

~CB uses this mkt to influence the economy

Front 70

CB buys/sells treasury securities:

Back 70

this alters the reserves in the banking system and shifts supply/demand in this ff mkt

Front 71

when CB buys bonds,

Back 71

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)

Front 72

changes in the nominal int rate leads to

Back 72

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)

Front 73

According to classical dichotomy, in the LR,

Back 73

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

Front 74

MP curve illustrates...

Back 74

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

Front 75

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

Back 75

then MP curve is horizontal

Front 76

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

Back 76

~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

Front 77

IS-MP diagram

Back 77

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)

Front 78

Back 78

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

Front 79

Expected inflation:

Back 79

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

Front 80

what if prices are below/above potential?

Back 80

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)

Front 81

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

Back 81

increases in AD pull up the inf rate

Front 82

IS-MP and PC togeteher:

Back 82

~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

Front 83

MP curve implies

Back 83

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

Front 84

IS curve implies

Back 84

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

Front 85

PC implies

Back 85

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

Front 86

IS curve (definition)

Back 86

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

Front 87

AD is used to derive IS curve

Back 87

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

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

Front 88

IS curves slopes downward

Back 88

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

~shows economic activity decreasing when int rates rise

Front 89

IS curve represents

Back 89

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

Front 90

Consumption doesn't vary with

Back 90

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

~Real int rate, R

Front 91

MPK is exogenous

Back 91

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

Front 92

IS curve equation

Back 92

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

Front 93

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

Back 93

~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)

Front 94

wealth effect

Back 94

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

Front 95

empirical evidence

Back 95

~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

Front 96

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

Back 96

more export, IS curve shifts outward