Macroeconomics and Monetary Policy

Posted on Sep 6, 2024 in Economy

Macroeconomics Basics

Aggregate Supply

1. Define aggregate supply.

Aggregate Supply: The total supply of all goods and services in the macroeconomy.

Aggregate supply is positively related to the price level.

2. Explain why the AS curve is upward sloping.

  • Aggregate Supply is positively related to the price level.
  • An increase in firms’ resources, increased productivity in workers, and resource prices going down.

Potential GDP

3. Define and explain potential GDP.

  • What the economy can produce if all resources are fully employed.
  • At potential GDP, cyclical unemployment would be zero, and any remaining unemployment would be accounted for by the natural rate of unemployment.
  • Potential GDP is sometimes referred to as full-employment GDP, which suggests that both workers and machines are fully employed.

4. List the factors that can shift the AS curve.

  • Changes in:
    • Amounts of resources
      • Labor, physical capital, human capital, technology
    • Productivity
    • Resource prices

Aggregate Demand

5. Define aggregate demand.

The demand for all US-produced goods and services.

Aggregate demand is negatively related to the price level.

6. List the components of aggregate demand.

  • Consumer Spending (C)
  • Investment spending (I)
  • Government spending (G)
  • Net Exports (NX)

7. Use the AS-AD model to show how changes in AS or AD lead to changes in the price level, real GDP, and the unemployment rate.

(Explanation of AS-AD model and its effects on price level, real GDP, and unemployment rate would go here, potentially with a graph)

8. Explain why the AD curve is downward sloping.

A higher price level:

  • Reduces the purchasing power of money = Consumption decreases
  • Causes interest rates to go up = Investment decreases
  • Makes U.S. goods more expensive relative to foreign-produced goods = Net Exports decrease

Say’s Law and Keynes’s Law

9. Explain Say’s Law and relate it to the neoclassical school of thought.

  • The major implication of Say’s law is that there can be no overproduction of goods and services.
    • If we produce $16.4T of output, that means we have $16.4T of income to spend.
  • This relates to the neoclassicals because they believed prices will respond instantly to surpluses and shortages.

10. Explain the main challenge to Say’s Law.

Recessions are the main challenge. In a recession, business failures heavily outnumber successes.

11. State and explain Keynes’s Law.

  • Wage prices are sticky, it’s costly for businesses to change prices, wages are likely “Inflexible downward” due to Unions, labor contracts, efficiency wages, and “psychological” resistance.

12. Explain the main challenge to Keynes’s law.

If aggregate demand is all that matters at the macroeconomic level, then the government could make the economy as large as it wanted, just by pumping up total demand through a large increase in government spending or enormous tax cuts to push up consumption.

13. Explain how economists can “live with” the two conflicting views of the macroeconomy (neoclassical and Keynesian).

  • The neoclassical theory applies in the long run.
  • The Keynesian theory applies in the short run.

14. Explain the role of sticky prices and wages in the Keynesian model.

If wages throughout the economy are sticky and don’t adjust immediately to changes in the economy, these short-run drops in aggregate demand can also lead to unemployment. When there’s a recession firms don’t immediately cut workers’ pay. They are more likely to stop hiring or to lay off existing workers. This leads to unemployment and a pattern of aggregate demand that doesn’t match the slow, long-term growth of aggregate supply.

Fiscal Policy

15. Explain and give examples of expansionary fiscal policy.

A policy of increasing aggregate demand or buying power in the economy. This policy includes tax cuts and spending increases which put more money into the economy.

16. Explain and give examples of contractionary fiscal policy.

The deliberate use of government spending and taxes to achieve macroeconomic goals:

  • Growth of GDP, low unemployment, and low inflation
  • Carried out by the president and Congress

17. Define and give examples of automatic stabilizers.

  • Government fiscal policies that, without any need for legislation, automatically stimulate aggregate demand when the economy is declining and automatically hold down aggregate demand when the economy is expanding.
  • Ex. Tax cuts and tax increases. Things that happen automatically to stabilize the economy without any government involvement.

18. Explain the four reasons why economists are skeptical of countercyclical fiscal policy.

  1. Problem of timing. Automatic stabilizers are built into the spending programs and the tax code, so they happen in real time as a recession or recovery unfolds.
    • Discretionary fiscal policy, in contrast, isn’t enacted until there’s already a problem, at which point it might be too late. Congress can take so long to address the problem that by the time they address it the economic problem might be different.
  2. Fiscal policy can have undesirable side effects.
  3. Politics – the intuition of contracting the government when the economy is going well and pumping it up in bad times is often not common political wisdom.
  4. Fiscal policy can ease the pain of a recession, at least somewhat, but the underlying causes of the recession still need to be addressed and worked through by both private markets and the public sector.

19. Explain which political party uses which economic policies.

  • Republicans often prefer to conduct expansionary fiscal policy with tax cuts and contractionary fiscal policy with spending cuts.
  • Liberals and Democrats often prefer to conduct expansionary fiscal policy with spending increases and contractionary fiscal policy with tax increases.

The Instant Economist – Money and Banking

Functions of Money

1. List and give examples of the three functions of money.

Economists do not define money by its form but as whatever object performs three functions in an economy: as a medium of exchange, a store of value, and a unit of account. A medium of exchange is something that can be exchanged for whatever is for sale. U.S. paper money, for example. As a store of value, money is an object that can be held for a time without losing significant purchasing power. When you receive money, you don’t need to spend it immediately because it will still retain value the next day or the next year. Money’s final function is as a unit of account, which means that the price of most items is measured with money.

2. Explain the advantages that money has over barter.

The great advantage of money is that it avoids the need for barter, the trading of one good or service for another. Barter is an inadequate mechanism for coordinating the wide range of trades that happen in a modern, advanced economy with a highly specialized division of labor.

Money Supply

3. Explain the difference between the M1 and M2 measures of the money supply.

A broader definition of money, M2, includes everything that’s in M1 plus savings accounts. Savings accounts are broadly defined as bank accounts on which you can’t write a check directly, but whose money you could easily access in other ways, as at an automatic teller machine or a bank. M2 money includes money market funds, those ultra-safe investment pools, and relatively small (less than $100,000) time deposits, that is, CDs. The point is you can withdraw and spend the money in M2, but it requires a greater effort and perhaps some penalty, whereas M1 can be spent very easily.

4. Explain the effect globalization has had on the process of catch-up growth.

Globalization is a much smaller cause, in part because so much of U.S. international trade is with other high-wage economies and in part because roughly two-thirds of jobs in the United States aren’t in competition with imports at all.

5. Explain whether or not credit cards are money.

They aren’t money. A credit card is just a method of short-term borrowing.

Banking System

6. Explain how the economy suffers when a large number of banks are in financial trouble.

When many banks are in financial trouble all at once, the economy as a whole can suffer. The quantity of loans available drops across the economy, and in a true financial crisis, banks may become reluctant to lend even to one another for short periods, which makes it difficult for money to fulfill its role in greasing the wheels of the economy.

7. Explain how the process of making loans allows banks to “create money.”

Banks actually create money by the process of making loans. To understand how this happens, think about what happens to the money you get in the form of a bank loan, say for a car or a house. First, you pay the loaned money to someone else. They take the money and deposit it in their bank.

8. Define “reserves.”

Refrain from using or disposing of (something); retain for future use.

The Federal Reserve

9. List the key elements of the structure of the Fed.

Number of elements we’ve talked about so far: the growing size of international financial capital flows; changes in exchange rates and the difficulty in fixing exchange rates; and banking system collapses.

10. Explain the three tools the Fed has to carry out monetary policy.

The Fed, or any central bank, has three traditional tools for working within the web of banking and money to expand or contract the money supply: reserve requirements, the discount rate, and open market operations.

11. Define “quantitative easing.”

It also has one newly minted tool developed in response to the 2007-2009 recession, called quantitative easing.

12. Explain how changes in the money supply lead to changes in interest rates.

The money supply affects the interest rate since, if there is more or less money in the bank, it would make the interest higher or lower because they aren’t making or people are putting as much money in the bank. If there is more money, then the interest rate would be lower; if there is less money, the interest would be higher.

13. Explain the Fed’s role as a “bank for banks” and a “lender of last resort.”

A central bank such as the Fed also has a role as a lender of last resort. That is, when a financial system is potentially endangered by a major financial crash, the central bank provides short-term loans so the financial system won’t explode or implode.

14. Explain how the Fed would use its monetary policy tools to fight either unemployment or inflation.

After the bubble pops and recession looms, the Federal Reserve can use monetary policy at that time to fight the recession. Before the recession of 2007-2009, central banks steered away from making decisions about asset bubbles.

15. Explain the effect that monetary policy has on the natural rate of unemployment.

There is concern that politicians would always be seeking more loans and lower interest rates; after all, politicians are unlikely to accept unpopular realities such as the natural unemployment rate, or the fact that monetary policy alone can’t quickly fix the aftermath of a housing bubble or a financial crisis.

16. Explain how unexpected deflation affects the repayment of loans.

An unexpected deflation can lead to an unexpectedly high number of loans not being repaid. Banks face unexpected losses and become less able and less eager to make new loans.

17. Explain why central banks aim for an inflation rate of about 2%.

A central bank needs to be on guard against deflation. In fact, many central banks aim at an inflation rate of about 2 percent, rather than zero, because they want a little wiggle room to avoid possible deflation.

18. Explain how monetary policy can be used to encourage economic growth.

Monetary policy can also be used to encourage economic growth. The main determinants of economic growth, as discussed earlier, are investments in human capital, physical capital, and technology interacting in a market-oriented environment.

19. Define what economists mean by a “bubble.”

A bubble occurs when prices rise not because of any characteristic of the good itself, but because investors expect prices to keep rising.

20. Explain why central banks don’t pay much attention to asset bubbles.

Before the recession of 2007-2009, central banks steered away from making decisions about asset bubbles. But since the recession, economists at places such as the International Monetary Fund have begun to propose that, in some way, central banks should be taking asset bubbles into their calculations.

21. List four practical problems related to the conduct of monetary policy.

Monetary policy has some practical problems: time lags, risks of overshooting, and what economists call “pushing on a string.”

Naked Economics – The Federal Reserve and Monetary Policy

Economic Growth and the Fed

1. Why is there a limit to how fast the Fed can get the economy to grow?

Eventually, it becomes impossible to meet consumer demands, and companies will raise prices, and workers will demand higher wages.

2. What is the “speed limit” of the economy?

  • The rate at which the economy can grow without causing inflation.
  • Somewhere in the range of 3% growth per year.

3. How does the Fed move interest rates?

By making changes in the quantity of funds available to commercial banks.

  • If banks are awash with money, then interest rates must be relatively low to attract borrowers for all the available funds. The opposite is true when capital is scarce.

4. What is the FOMC, and who are its members?

The board of governors, the president of the Federal Reserve Bank of New York, and the presidents of four other Federal Reserve Banks on a rotating basis. The Fed chairman is also the chairman of the FOMC.

5. Define the discount rate.

The interest rate at which commercial banks can borrow funds directly from the Federal Reserve.

6. Why don’t banks generally want to borrow from the Fed?

Borrowing from the Fed carries a certain stigma; it implies that a bank was not able to raise funds privately. Banks generally borrow from other banks.

7. Define the federal funds rate.

The rate that banks charge other banks for short-term loans.

8. How does the Federal Reserve inject money into a private banking system?

It trades new money for government bonds that the banks currently own.

9. What does Wheelan mean when he writes that “it is hard to abide by a speed limit that is not clearly posted”?

It’s hard to facilitate a sustainable pace of economic growth because we are only guessing at the rate at which the economy can grow without igniting inflation.

Money and Wealth

10. What is the difference between money and wealth?

  • Wealth consists of all things that have value – houses, cars, commodities, human capital. Money, a tiny subset of that wealth, is merely a medium of exchange, something that facilitates trade and commerce.
  • Money is not even necessary.

11. What do inmates in federal prisons use as money?

Cigarettes.

12. In what way is modern currency valuable?

  • It has purchasing power. Dollars have value because people peddling real things – food, books, pedicures – will accept them.
  • A dollar is a piece of paper whose value derives solely from our confidence that we will be able to use it to buy something we need in the future.

Inflation and Deflation

13. What are the two ways in which massive inflation distorts the economy?

  • Workers rush to spend their cash before it becomes worthless, a culture emerges in which workers rush out to spend their paychecks at lunch because prices will have gone up by dinner.
  • Fixed-rate loans become impossible because no financial institution will agree to be repaid a fixed quantity of money when that money is at risk of becoming worthless.

14. Explain the “inflation tax.”

  • Happens when a government is unable to raise taxes through conventional means, either because the infrastructure necessary to collect taxes does not exist or because your citizens can’t or won’t pay you more.
  • Government prints more money to pay government workers and soldiers and taxes people indirectly by devaluing the money that stays in their wallets.

15. Why is deflation bad?

Deflation causes consumers to postpone purchases because “why buy today when it will be cheaper tomorrow?” Meanwhile, asset prices fall, so consumers feel poorer and less inclined to spend. People feel poorer. Consumers spend less, the economy grows less, and the economy grows less.