Final Review Macroeconomics 222 Chapter Coverage: The material in this course is comprehensive: all the material builds on previous material So the final exam will also be comprehensive. In particular, make sure you understand Chapter 10: AD/AS Chapter 11: Multiplier Model But you can expect slightly heavier weight on the chapters since the second exam Chapter 15: Financial Crises Chapter 17: Deficits and Debt Chapter 9: Growth Other important Chapters Chapter 2: the production possibilities frontier Chapter 7: Business Cycles Chapter 8: measuring the aggregate economy Chapter 13: Financial Sector and the Economy Chapter 14: Monetary Policy We did Not cover Chapters 6, 12 Chapter 2: the PPF Chapter 7: Business Cycles Examples of important concepts: Definition of business cycles Leading indicators: what to watch Different measures of unemployment Definition of labor force Problems and limitations Different measures of inflation CPI Wholesale price index GDP deflator Strengths and weaknesses of each Chapter 8: Measuring the Aggregate Economy Components of GDP Expenditure approach Income Approach Measuring GDP Real vs. nominal Limitations and errors International comparisons Chapter 10: The AS/AD model This model is used quite a bit over the last part of the course so we?ll do a very brief review Key Graph: Long Run Equilibrium The AS/AD model assumes that when AD falls Competition for inputs will fall, so price of inputs fall SRAS will shift out as price of inputs falls And eventually the economy will return to the long run maximum level of output AD Real Output Price Level SRAS GDP* LRAS AD2 SRAS2 Key Graph: Long Run Equilibrium Most of the material covered since the midterm covers types of policies the government can use to shift AD back without waiting for AS to respond Always keep in mind the equation AD = C+I+G+(X-m) Fiscal policy increases G Monetary policy indirectly effects I thru a lower interest rate AD2 Real Output Price Level SRAS GDP* LRAS AD1 The Multiplier Model (Chap 11) Difference between AS/AD model and multiplier model: The AS/AD model assumes that the economy will automatically return to long run equilibrium output The multiplier model was designed to represent the Keynesian view that this is not necessarily so. AD/AS model works well during ?normal? ups and downs of the business cycle, when output is only slightly off of the maximum and we don?t want to ignite too much inflation The Multiplier Model words well during crisis periods, when major drops in output are the issue and inflation is a secondary concern. Autonomous Component of Aggregate Expenditure Aggregate Expenditure in this model has the following equation (like AD in the AS/AD model): AE = C + I + G + (X-m) AE has an autonomous portion and an induced portion AE = Autonomous Expenditure + Induced Expenditure = AE0 + mpe*Y Where the autonomous portion of aggregate expenditure is: AE0 = C0 + I0 + G0 + (X0 ? M0) Aggregate Expenditure So, the AE curve Is the sum of Autonomous expenditures and induced expenditures Real Income Real expenditure Autonomous Expenditure AE Induced Expenditure Aggregate Production -Everything that is spent has to be earned -So aggregate production can be graphed as a straight line in the Real income/ Real production diagram It has an angle of 45o and a slope of 1. That means, that x=y 45o Real production Real income x y Aggregate Expenditure How do we ensure that expenditure does not exceed income? Answer: by looking for the point where Aggregate production (that is, aggregate income) intersects aggregate expenditure Real Income Real expenditure AE AP AP The Multiplier The main advantage of The Multiplier Model (and the source of its name) is the concept of ?the multiplier: The multiplier tells us the level of output associated with a certain level of autonomous aggregate expenditures And how much income will change in response to a change in autonomous expenditures. The multiplier equals 1/(1-mpe) Aggregate Expenditure So the multiplier will allow us to determine how much of a drop in output we?ll get when autonomous expenditure falls from AE1 to AE2 Real Income Real expenditure AE1 AP Y2 Y1 AE2 Aggregate Expenditure So the multiplier will allow us to determine how much of a drop in output we?ll get when autonomous expenditure falls And aggregate expenditure falls from AE1 to AE2 That is, it tells us what Y1-Y2 is Real Income Real expenditure AE1 AP Y2 Y1 AE2 Aggregate Expenditure Likewise, it shows us the increase in AE we get when the government uses its two fiscal policy tools: In can increase its own spending without changing the taxes it collects It can give everyone a tax rebate Real Income Real expenditure AE2 AP Y3 Y4 AE1 Chapter 13: The Financial Sector What are the roles of the financial sector? Short term role: to facilitate the day-to-day functioning of the economy Flow of payments through ?current accounts? (checking) and short term credit (provides liquidity). Facilitates the flow of savings into investment (which, recall, is a component of aggregate expenditure) The Circular Flow Model Government Households Firms Goods Market Goods Goods Factor Market Labor, capital Labor, capital Wages, interest The Savings to Investment Role of Financial Institutions. Households, firms and the government don?t spend everything they earn; some is saved So savings pass through financial intermediaries like banks or wall street firms Who then lend them to other households, firms and governments In return, they are paid interest for the money they lend. Money Money is another form of financial assets. It is highly liquid, that is you can turn it into real goods and services very easily and quickly Money serves as a medium of exchange It is a unit of account It is a store of wealth Ways of measuring the money supply 1. M1: cash and demand deposits (checking account deposits) in banks 2. M2: cash, demand deposits and savings account deposits, so ?bigger? than M1 How do banks ?create? money Banks take in deposits. Then, they lend those funds out, although they are required to keep a certain percentage of ?reserves? as cash on hand Then, the funds they lend out are deposited elsewhere, who also must hold reserves and lend out the rest. And so on?. Thus, the amount of cash in the economy is only a small portion of the actual money supply The actual supply uses the money multiplier MS = mm * cash, where the money multiplier = 1/(reserve requirement) Chapter 14 Monetary Policy How Monetary Policy Work Monetary Policy works primarily through the interest rate. Two basic mechanisms Policy to change certain influential interest rates that are directly controlled by the government. Using government policy that change the money supply to change the equilibrium interest rate. Interest Rates and Investment in the AD/AS Model Suppose the government pursues a policy that decreases the interest rate. The amount firms will invest at every price level will increase. So the AD curve will shift out. In the short run, this will lead to an increase in real output. Price Level Real Output SAS AD1 AD2 Y1 Y2=maximum output As the money supply shifts, the equilibrium interest rate changes. As people have more money, they are willing to lend more, and there is an increase in the supply of loanable funds?interest rate falls to same (nesw) equilibrium How can the money supply influence the interest rate? Demand For Money Money Supply 1 Money Supply 2 Interest Rate Int 1 Int 2 Money Loanable Funds S1 S2 D The US Central Bank The Federal Reserve System The Federal Reserve Board (or ?the Fed?) consists of: the Federal Reserve Bank in Washington, D.C., 12 regional Federal Reserve Banks that implement the Fed?s policies around the country The system is run by the Federal Reserve Board of Governors 7 members appointed by the President and confirmed by the Senate for staggered 14 year terms The Chairman of the Fed is the head of this Board Specific Duties of the Fed Providing banking services to the government Providing services to the financial system Issuing coins and currency Supervising and regulating financial institutions Gathering information about the economy Conducting Monetary Policy Serving as the ?lender of last resort? during financial crises. How does the Fed control the money supply Open market operations Changing the reserve requirement Changing the discount rate Open market operations The Fed buys bonds to add to its portfolio or sells bonds that it already holds in its portfolio If it buys bonds, it pays for them with cash. This increases the amount of money in circulation, so it is increasing the money supply. Therefore, this is an expansionary policy If it sells bonds, the buyers pay for them with cash. So the money supply decreases. This is a contractionary policy. The actual change in the money supply will be Money multiplier * change in cash Changing the reserve requirement The actual money supply depends on the size of the money multiplier, MS = mm * cash But the money multiplier equals 1/(reserve requirement) So, if the fed increases the reserve requirement, banks can?t lend as much, the money multiplier decreases?contractionary policy If the Fed decreases the reserve requirement, banks can lend more, the money multiplier increases?expansionary policy Changing the discount rate The discount rate is the interest rate charged to banks who borrow at the Fed?s ?discount window? Banks borrow at the discount window when they don?t have enough cash t meet their reserve requirements So, if this rate goes up, there will be more competition in the fed funds market (bank to bank lending to meet reserves) and interest rates will go up What is the Fed?s usual Goal To meet a target in the ?Fed Funds Rate? That is the rate in the market in which banks lend and borrow excess reserves Chapter 15 Financial Crises While the normal business cycle thru the use of fiscal and monetary policy Sometimes there are financial crises that can cause a country to go into not only a recession but a depression?. What causes financial crises? Notice that all these events several things in common: 1. a ?bubble? in the market for a financial asset. There is a general sense that some asset, which is increasing in price, will always increase in price Then panic selling starts, and the bubble bursts Collapse of the bubble has a major effect on consumer spending and decreases AD The collapse of the bubble feeds back into the overall financial system, leading to decreased credit availability and investment?more decline in AD Then Dynamic effects start to kick in People are so frightened by the decline in output that they expect it to keep decreasing So they decrease their spending C drops, leading to an even larger drop in AD?. But if a financial crisis ignites a depression, the crucial change is the change in expectations When the level of output drops (and the price level drops) Instead of just moving down the new AD2 These changes cause another shift of the curve to AD3 AD1 AD2 AD3 SRAS What can the government do when there is a financial crisis? 1. Try to stop the economy from starting down the path to a depression by stopping the ?panic? in its tracks. After the panic of 2008, the government flooded money into banks and important firms (GM) to keep them afloat The idea was to keep expectations from getting any worse than they already were and setting off a downward spiral. 2. Change Expectations FDR?s ?fireside chats? Employment programs and the New Deal CCC WPO Theatre 3. Try to ignite growth with monetary policy The problem is, that after a panic no one wants to lend People and firms save too much Interest rates fall to zero So monetary policy doesn?t work too well 4. Fiscal policy After the 2008 collapse, the government launched a massive stimulus package Most economists think that this package helped keep things from getting worse than they would have otherwise have gotten (hard to prove) Some argue that it wasn?t big enough But if may have been impossible to do any more 5. Institute Reforms Part of changing expectations is coming up with reasons why this will never happen again. Try to pass laws and regulations to outlaw the type of behavior that caused the bubble and led it to have such a major effect on the economy Reforms like deposit insurance and reforms of the stock market after the Great Depressions But there are some potential problems: Spending all that money means you have big deficits you have to lower some day You may have created some bad precedents Moral hazard Banks and other firms that got bailed out may come to believe that they can continue to engage in risky behavior Because if they lose enough money, the taxpayers will pick up the bill Chapter 17 The Federal Budget and Federal Deficit Fiscal policy involves the government borrowing to in increase the ?G? portion of AD Since this increase in expenditure is not financed by higher taxes, the government runs a deficit each year Deficit: annual shortfall of expenditures over tax revenues National debt: the accumulation of annual shortfalls over time; the total liability of the government Both the deficit and the debt have grown over time But they have particularly exploded during the current economic crisis What is the problem with an increasing debt: May ?crowd out? borrowing for investment Eventually we have to start paying some of it off?. Chapter 9: Growth Institutions that promote growth Classical Model: focus on accumulation of capital New growth theory: focus on technology Graphs Shift out PPF==Shifting potential outcome (LRAS)
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