Monetary policy
The use of money and credit controls to influence macroeconomic outcomes
The price of money is determined
in the money market
Interest rate
The price paid for the use of money
Money Supply (M1)
Currency held by the public, plus balances in transactions accounts
Money Supply (M2)
M1 plus balances in most savings accounts and money market mutual funds
Demand for money
The quantities of money people are willing and able to hold at alternative interest rates, ceteris paribus
Portfolio decision
The choice of how (where) to hold idle funds
Transactions demand for money
Money held for making everyday market purchases
Precautionary demand for money
Money held for unexpected market transactions or for emergencies
Speculative demand for money
Money held for speculative purposes, for later financial opportunities
The money supply curve is assumed to be a
vertical line
The Federal Reserve has the power to regulate the money supply through its
policy tools
Equilibrium rate of interest
The interest rate at which the quantity of money demanded in a given time period equals the quantity of money supplied
The Federal Reserve can alter the money supply through changes in
reserve requirements, the discount rate, or through open market operations
Federal Funds Rate
The interest rate for interbank reserve loans
Changes in interest rates affect
consumer, investor, government, and net export spending
The goal of monetary stimulus is to increase
aggregate demand
Stimulating the economy is achieved through
An increase in the money supply
A reduction in interest rates
An increase in aggregate demand
monetary restraint is achieved through
A decrease in the money supply
An increase in interest rates
A decrease in aggregate demand
To lessen inflationary pressures
the Fed will apply a policy of monetary restraint
Fed's open market operations have the most direct effect on
short-term rates
Reluctant Lenders
Banks may be unwilling to make new loans even when the Fed is injecting excess reserves into the banking system
Liquidity trap
The portion of the money demand curve that is horizontal; people are willing to hold unlimited amounts of money at some (low) interest rate
It is also harder for the Fed to restrain demand
Expectations - Optimistic consumers and investors may continue borrowing even though interest rates are higher
Global money - U.S. borrowers might tap global sources of money or local non-bank lenders not regulated by the Fed
Keynes believed that monetary policy
would not be effective at ending a deep recession
Equation of exchange
Money supply (M) times velocity of circulation (V) equals level of aggregate spending (P � Q)
MV=PQ
Income velocity of money (V)
The number of times per year, on average, a dollar is used to purchase final goods and services
V=PQ/M
The Equation of Exchange
The quantity of money in circulation and its velocity in product markets will always equal total spending and income (nominal GDP)
MxV=PxQ
Money-Supply Focus
the Fed should focus on the money supply itself, not interest rates
Natural rate of unemployment
Long-term rate of unemployment determined by structural forces in labor and product markets
Keynesian anti-inflation policy
is to shrink the money supply to drive up interest rates to slow spending
Monetarists favor
fixed money supply targets
Keynesians advocate
targeting interest rates, not the money supply
Inflation targeting
The use of an inflation ceiling ("target") to signal the need for monetary policy adjustments
Price stability is current
Fed's primary goal
Supply-Side Policy
Any policies that alter the willingness or ability to supply goods at various price levels will shift the aggregate supply curve
Stagflation
The simultaneous occurrence of substantial unemployment and inflation
No shift of the aggregate demand curve can solve
inflation and unemployment at the same time
Fiscal and monetary policies cannot reduce
unemployment and inflation at the same time
Because AS curve is upward-sloping
Rightward shifts of AD increase both prices and output
Leftward shifts of AD decrease prices and output
Phillips curve
A historical (inverse) relationship between the rate of unemployment and the rate of inflation; commonly expresses a trade-off between the two
Inflationary flashpoint
The rate of output at which inflationary pressures intensify; point of inflection on AS curve
Only a rightward shift of the AS curve can
reduce unemployment and inflation at the same time
Leftward AS shifts
create stagflation
Supply-side shocks can shift the AS curve to the left
Leftward shifts of aggregate supply cause rightward shifts in the Philips curve
Policy options to shift AS rightward include
Tax incentives for saving, investment, and work
Human capital investment
Deregulation
Trade liberalization
Infrastructure development
In Keynesian economics
tax cuts are used to increase aggregate demand
Marginal Tax Rate
The tax rate imposed on the last (marginal) dollar of income
Tax rebate
A lump-sum refund of taxes paid
Tax rebates do not
shift AS,
If the tax elasticity of supply were large enough
a tax cut might actually increase tax revenues
Supply-side economists favor
tax incentives that encourage saving
Government intervention in factor markets increases
the cost of supplying goods and services in many ways
Minimum-wage laws increase the cost to employers of hiring additional workers
shifting the aggregate supply curve leftward
Free trade pacts like the North American Free Trade Agreement (NAFTA)
tend to shift aggregate supply rightward
Infrastructure
The transportation, communications, education, judicial, and other institutional systems that facilitate market exchanges
The output of the American economy depends on
public as well as private investment
Short-run changes in capacity utilization involve
increased use of existing productive resources, moving us closer to the economy's production possibilities curve
Long-run changes in capacity
involve expansion of productive capacity - a shifting out of the PPC
Economic growth is referred to in terms
of real GDP, not nominal GDP
By using base period prices
growth is measured in real goods and services, not inflation distorted dollars
Growth rate
Percentage change in real output from one period to another
Calculated as the change in real output between two periods divided by total output in the first period
Growth in GDP per capita is attained only when the growth of output exceeds population growth
GDP Per Capita= total GDP/total population
Labor Force
All persons over age 16 who are either working for pay or actively seeking paid employment
Employment rate
The percentage of the adult population that is employed
Productivity
Output per unit of input
Labor productivity
Labor Productivity= total output/ total labor hours
From 1973 to 1995 productivity grew at
an average rate of 1.4 percent
...
growth rate of total output= growth rate of labor force + growth rate of productivity
Future growth depends on two factors
Growth rate of the labor force
Growth rate of productivity
Sources of productivity gains include
Higher skills - an increase in labor skills
More capital - an increase in the ratio of capital to labor
Technological advances - development and use of better capital equipment and products
Improved management - better use of available resources in the pr
A primary determinant of labor productivity
is the rate of capital investment
Net investment
Gross investment less depreciation
Savings are not just a form of leakage
but a basic source of investment financing
Virtually all U.S. investment has been financed with
business saving and foreign investment
Old growth theory
emphasized the importance of saving and investing in new plant and equipment
New growth theory
emphasizes the importance of investing in knowledge and ideas
Growth policy makes liberal use of the tools in the supply-side tool box
Increase human capital investment
Increase physical-capital investment
Maintain stable expectations
Pro-growth institutional framework
The tax code stimulates investment through
Faster depreciation schedules
Tax credits for new investments
Lower business tax rates
Continued economic growth is desirable so long as
It brings a higher standard of living
It brings an increased ability to produce and consume socially desirable goods and services
Fiscal policy
The use of government taxes and spending to alter macroeconomic outcomes
Structural deficit
Federal revenues at full employment minus expenditures at full employment under prevailing fiscal policy
Fiscal stimulus
Tax cuts or spending hikes intended to increase (shift) aggregate demand
Fiscal restraint
Tax hikes or spending cuts intended to reduce (shift) aggregate demand
Monetary Policy:
The use of money and credit controls to influence macroeconomic outcomes
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Monetary policy tools include
Open-market operations
Discount-rate changes
Reserve requirements
Who Makes Monetary Policy?
Monetary policy is made by the Federal Reserve's Board of Governors
Twice a year the Fed provides Congress with a broad overview of the economic outlook and monetary objectives
Supply-side policy
The use of tax incentives, (de)regulation, and other mechanisms to increase the ability and willingness to produce goods and services
Deciding whether to increase spending is a
fiscal policy decision
deciding how to spend available funds may entail
Supply-side policy
Supply-siders emphasize the need to improve production incentives
Cut marginal tax rates on investment and labor
Reduce government regulation
Focus any government spending on long-run capacity expansion
Stagflation
The simultaneous occurrence of substantial unemployment and inflation
If prices are rising before full employment is reached there may be
structural unemployment
High taxes or costly regulations might contribute to
stagflation
Fine-tuning
Adjustments in economic policy designed to counteract small changes in economic outcomes; continuous responses to changing economic conditions
Four obstacles to policy success
Goal conflicts
Measurement problems
Design problems
Implementation problems
Goal Conflicts
Most often goal conflicts originate in short-run trade-off between unemployment and inflation
The goal conflict is often institutionalized in the decision making process
The Fed is traditionally viewed as the guardian of price stability
The President and
Distributional goals may conflict with macro objectives
Anti-inflationary policies may require cutbacks in programs for the poor, the elderly, or others
These cutbacks may be politically impossible
Measurement Problems
The processes of data collection, assembly, and presentation take time
At best, we know what was happening in the economy last month or last week
An average recession lasts about 11 months, but official data generally don't confirm its existence until 8 m
Forecasts
In designing policy, policymakers must depend on economic forecasts � informed guesses about what the economy will look like in future periods
Those guesses are often based on econometric macro models, which are mathematical summaries of the economy's per
Leading Indicators and Crystal Balls
Many people prefer to use leading indicators
Leading indicators are things we can observe today that are logically linked to future production
One of the most popular is the Index of Leading Economic Indicators
Others disregard economists' forecasts and u
Design Problem
Suppose the outlook is bad and we want to steer the economy past looming dangers
We need to design an economic plan
It is difficult to predict how market participants will respond to any specific economic policy action
The U.S. is the largest player in global product and resource markets
The U.S. imported more than $2.5 trillion of goods and services in 2008
Imports
Goods and services purchased from foreign sources
he U.S. exported
$1.3 trillion of goods and $544 billion in services in 2008
Exports
Goods and services sold to foreign buyers
trade balance
trade balance= exports-imports
Trade deficit
The amount by which the value of imports exceeds the value of exports in a given time period
Trade surplus
The amount by which the value of exports exceeds the value of imports in a given time period
Why trade when
we import many of the things we also export
we could produce many other things we import
we seem to worry so much about trade imbalances
Closed economy
A nation that doesn't engage in international trade
Trade allows nations to specialize
and specialization increases total output
Production possibilities
The alternative combinations of final goods and services that could be produced in a given time period with all available resources and technology
Consumption possibilities
The alternative combinations of goods and services that a country could consume in a given time period
In the absence of trade
a country's consumption possibilities are identical to its production possibilities
Comparative advantage
The ability of a country to produce a specific good at a lower opportunity cost than its trading partners
Absolute advantage
The ability of a country to produce a specific good with fewer resources (per unit of output) than other countries
Terms of trade
The rate at which goods are exchanged; the amount of good A given up for good B in trade
most visible barriers to trade
Embargoes, export controls, tariffs, and quotas
Voluntary restraint agreement
An agreement to reduce the volume of trade in a specific good; a voluntary quota
Quota
A limit on the quantity of a good that may be imported in a given time period
Tariff
A tax (duty) imposed on imported goods
A tariff makes imported goods more expensive to domestic consumers, and less competitive with domestically priced goods
Dumping
The sale of goods in export markets at prices below domestic prices
Exchange rate
The price of one country's currency expressed in terms of another's; the domestic price of a foreign currency
An exchange rate is subject to the same influences that determine all market prices
demand and supply
The market demand for U.S. dollars originates in
Foreign demand for American exports
Foreign demand for American investments
Speculation
The supply of dollars originates in
American demand for imports
American investments in foreign countries
Speculation
A higher dollar price for euros will raise the dollar cost of European goods
...
Balance of payments
A summary record of a country's international economic transactions in a given period of time
...
current account balance = trade balance+ unilateral transfers
Depreciation (currency)
A fall in the price of one currency relative to another
Appreciation
A rise in the price of one currency relative to another
Foreign-exchange markets
Places where foreign currencies are bought and sold
Important reasons that foreign-exchange market supply or demand may shift include
Relative income changes
Relative price changes
Changes in product availability
Relative interest-rate changes
Speculation
Since 1985
the United States has been a net debtor
Gold Standard
An agreement by countries to fix the price of their currencies in terms of gold; a mechanism for fixing exchange rates
Excess demand for a foreign currency implies
A balance-of-payments deficit for the domestic nation
A balance-of-payments surplus for the foreign nation
Market supply and demand of currency naturally shift, moving the equilibrium exchange rate away from a fixed exchange rate
...
Balance-of-payments deficit
An excess demand for foreign currency at current exchange rates
Balance-of-payments surplus
An excess demand for domestic currency at current exchange rates
There are only two ways to deal with balance-of-payments problems when there are fixed exchange rates
Allow exchange rates to change
Alter market supply or demand so that they intersect at the established exchange rate
Foreign-Exchange Reserves
Holdings of foreign exchange by official government agencies, usually the central bank or treasury
Gold reserves are a potential substitute for
foreign-exchange reserves
Domestic adjustments
require a deficit country to give up full employment and a surplus country to give up price stability
Flexible exchange rates
A system in which exchange rates are permitted to vary with market supply and demand conditions; floating exchange rates
Managed exchange rates
A system in which governments intervene in foreign-exchange markets to limit but not eliminate exchange rate fluctuations; "dirty floats
Poverty threshold (U.S)
Annual income of less than $22,000 for a family of four (2009, inflation adjusted)
The current $22,000 threshold breaks down in the following way:
One third for food
Implied rent is about $700 per month
Over 38 million U.S. households were "poor" in 2008
making the poverty rate 12.5 percent
Poverty rate
Percentage of the population counted as poor
In-kind transfers
Direct transfers of goods and services, rather than cash, e.g. food stamps, Medicaid benefits, and housing subsidies
Over three-fourths of the world's population live in low-income or low-middle-income nations
Average income in those nations is under $4,000 per year - less than one-tenth of U.S. per capita GDP
Extreme poverty (world)
World Bank standard of less than $1 per day per person (inflation adjusted)
Severe poverty (world)
World Bank standard of less than $2 per day per person (inflation adjusted)
Millennium Poverty Goal
United Nations goal of reducing the global rate of extreme poverty to 15 percent by 2015
There are only two general approaches to reducing global poverty
Redistribution of income within and across nations
Economic growth that raises average incomes
Millennium Aid Goal
United Nations goal of raising foreign aid levels to 0.7 percent of donor-country GDP
For low-income nations
Immunization rates are low
Water and sanitation facilities are in short supply
Professional health care is hard to find
Stage 1: Traditional society
Rigid institutions, low productivity, little infrastructure, dependence on subsistence agriculture
Stage 2: Preconditions for takeoff
Improve institutional structure, increased agricultural productivity, emergence of an entrepreneurial class
Stage 3: Takeoff into sustained growth
Increased saving and investment, rapid industrialization, growth-enhancing policies
Stage 4: Drive to maturity
Spread of growth process to lagging industrial sectors
Stage 5: High mass consumption
High per capita GDP attained and accessible to most of population
Investment rate
The percentage of total output (GDP) allocated to the production of new plant, equipment, and structures
Microfinance
The granting of small ("micro"), unsecured loans to small business and entrepreneurs
A nation needs an institutional structure that promotes economic growth, including:
Property rights
Entrepreneurial incentives
Equity
Business climate