Mac Econ Finale

The counter cyclical use of gov't spending and taxation powers to stabalize the economy

• 1946
• Federal gov't has responsibility to maintain full employment with stable prices.
• This act created the economic councle of advisors
• Fallow up was Humphrey Hawkins act

• Economy in recession then increase gov't spending and reduce taxes
• Actual GDP is below potential.
• To the left of Yxp

• Economy is beyond capacity then decrease gov't spending and incrase taxes
• Actual GDP is above potential
• to right of Yxp

• Use expansionalry fiscal policy
• Must increase G
• Change in Y = Change in G * Me
• Me is slope from Consumption function.
• This incrase in G with close the recesionary gap

• Anticipateion of higher taxes
• Deficit and debt
• Inflation and lower real wages

• GDP up so stimulte growth in economy
• Unemployment goes down

• Taxes opporate through households
• It will opporate throught the consumption function
• C = 300 + .6y - T

• Mt = - MPC/1-MPC
• Me > Mt

• Change in Y = Mt * change in T
• The negative number means we would have to lower taxes by that much to get to full employment

• 1) Time Lags: the political process can interfear and bog down
• 2) Actual size of Multiplier: due to inflation and high interest rates
• 3) The Political business cycle: politicians won't dow hat is neeeded for the economyh in an election year

• 1) Progressive tax system
• 2) Unemployment insurances- if strong then pays taxes

• Budget surplus = T - G - TR
• TR = Tax revenue
• If T > G + TR then Positive BS
• If T < G + TR then Negative BS ( deficit)

• The money the gov't borrows to finance the deficit
• The Gov't borrow by selling bonds, treasury bills, treasury notes
• Debt is sum of deficits

• 1) Deficits cause inflation
• 2) Deficts cause high interest rates that crowd out private investment
• 3) Deficits cause high interest rates that crowd out Nx
• 4) Sound finance argument
• 5) The burden argument

This results in negative cyclical unemployment so there are jobs and employee's demand higher nominal wages which puts it back at equilibrium but at a higher price level which is inflation

• Appreciate the ]dollar relative to other currencies. Foreigers want to invest in foreing secruites so that puts pressure on dollare and price of dollar rises
• Therefore cost of Nx goes up so reduces SAles abroad

• For 1,2,3: it depends on where we are in the business cycle
• If we are below full employment inflation and crowding out is less of a problem
• For 4,5: depends on what the defecxt and debt purchase like bridges (role of gov't)

• Balance the duget over the business cycle
• What drives the debate today is libertain view that governemnt should be radically reduced
• Starve the beast

• 1) Reduce trasactions costs: get together so can made a deal in limiting debt
• 2) Reduce financial risk: provide differenet typs of investment which allows to spread out to diff kinds
• 3) To provided liquid assests: assest easiliy turned into cash

• Loans
• Bonds
• Stocks
• Bank Deposits

• 1) Mutual Funds
• 2) Pension Funds
• 3) Life insurance
• 4) Banks

These create stock porfolios and sell shares in those portfolios to individuals

Type of mutual fund which holds assets to p;rovide for retirement

Life insurance guarentees payments to beneficiaries when the policy holder dies

Provide liquid assets based on band deposits to finance the spending needs of borrowers

• Eugene Fama
• It argus that asset prices will in the long run reflect their true value, due to the assumption that people are rational.
• If people are tarional they will use all avialable info to evaluate value of assets. As a result, asset prices will reflect value

• An asset that can easily be used to purchase goods and services
• Consists of cash and other things that are highly liquidible

• 1) Commodity money
• 2) Commodity backed money
• 3) Fiat money

• The medium of exchange is a good
• gold and silver

Paper currency issued that is backed by gold or silver

• Money whose vaulue derives entirely from it's status as the official currensy
• U.S. $ is fiat money

• 1) Medium of exchange
• 2) Unit of account
• 3) Store of Value

• Money facilitates the exchange of goods by eliminating the double concidence of wants.
• paying for somthing in exchange for somthing

Money is the standard of value in which we express the value of all goods and services

• Money holds purchsing power oaver time
• Money is a unit through which we express future values

• The federal reserve calcutes to measues of money
• 1) m1: currency in circulation + travelors checks + chekcing (demand) demands
• 2) m2: m1 + savings deposstis + small time deposties ( CD < 100,000) + mutual funds

• 2 Primary functions:
• 1) Hold demand depsoties and honor checks drawn on the deposites: helps trades take place
• 2) Make loans, lend money: important to facilitate investment int he private sector

Becaues banks are only required to hold a portion of total deposites on reserve

• 1) Deposit insurence (FDIC ensures depostis up to 250000)
• 2) Capital requirements: capital = assets - deposits
• 3) Reserve requirements: rules set by the fed establishing the iminimum reserves, 10 % min
• 4) The discount window: The federal reserve will provide loans to banks that are in trouble

• Assume:
• 1) The fed sets reserve ration =.2 (required reserves)
• 2) No bank in the system holds excess reserves
• 3) No cash reserves are ever leaked out of the systme

1/Reserve ratio

• 1) No leakage of cash from the banking system
• 2) Banks do not hold excess reserves
• 3) The willingness fo the individual actors to borrow and lend

• Federal reserve is the central bank of the U.S
• Established in 1913 in respons to serices of financial panics

• 1) Control the money supply
• 2) To serve as a lnder of last resort
• 3) Check clearing facilities for the banking systems
• 4) Issue currency
• 5) Act a s a fiscal agent for the Fed (gov't assist in making purchases)
• 6) Supervices and regulates the finacial sector

• Board of Governs
• FOMC
• 12 Districts
• Board of Directors

• 7 Members appointed by the president approved by senate
• 14 year terms
• Every 2 years a new member comes on

• Federal Open market committee
• 12 member; 7 board of governer, 5 district bank presidents
• New Yourk District bank is permanent mameber

• Banks in private sector
• 1 selected in ach istrcit to serve on the board

• A major funcito of the fed is to control the money supply for:
• 1) price stability
• 2) to attain "full employment"

• 1) Reserve requirements
• 2) Open market poerations
• 3) the discount rate

• If the Fed reduces teh reserve requiremnt theyn the money supply would increaset
• Banks able to loan more money

• The primay means by which the fed influences the money supply
• The FOMC buys and sells bonds in the opne market
• If the FOMC puchases bonds, the money supply will incdrease

• If the Fed lowers the discount rate, it signals that it will increase the money supply
• If the Fed increases the disount rate, it siganls that it will decrease the money supply

The rate banks charge each other for overnight loan

• 1932
• was established and given authority tomake loans to troubled banks.

• 1932
• created federal deposit insurance
• Increased the ability of banks to borrow from the Fed
• Seperated banks into two categories:
• Commercial (covered by deposit insurance)
• Investment (less regulated and allowed to trade in more risky financial assets)

• Prevented banks from paying interest on checking accounts.
• Argued it would lead to unhealthy competition.

• 1980
• Removed Regulation Q.
• Allowed S & L’s to offer checkable deposits.

• 1982
• Allowed S & L’s to undertake riskier investments (i.e., real estate development).
• With deregulation S & L’s faced a profit squeeze. Due to paying higher rates on deposits. At the same time they were locked into long-term fixed mortgages (though this legislation allowed new loans to have
• adjustable rates).
• Facing a profit squeeze, and with questionable regulatory oversight, S & L’s undertake risky investments that did not pay off.
• S & L’s begin to fail. Over 1,000 S & L’s closed between 1986-1995. costing tax payers $124 billion.

• 1999
• Eliminates Glass-Stegal rules that separate investment and commercial banks.
• Exempts financial derivatives (i.e., credit default swaps) from regulation.
• Note:
• Joseph Stiglitz argues this legislation allowed the risk-taking culture of investment banking to overtake the conservative culture of commercial banking.

• ThevTroubled Assets Relief Program TARP—Allowed the U.S. Treasury to purchase or insure up to $700 billion of ‘troubled assets.”
• The American Recovery and Reinvestment Act—2009.
• The Dodd-Frank Wall Street Reform and Consumer Protection Act—2010

• 2010
• Increasescapital requirements of investment banks.
• Regulatesderivatives (must be traded on exchanges). This repeals exemptions made under Gramm-Leach-Bliley Act).
• Creates“Bureau of Consumer Financial Protection” within the Federal Reserve.

• Money is Neutral
• It only affects prices, and does not affect employment and output
• Depict Quantity theory using the equation of exchange

• Ms * V = P * Y
• Y= real GDP
• P = Price level

• 1) Ms is exogenour ( its determend by the central bank)
• 2) Assumes velocity is contsnt because of peoples spending habits are stable
• 3) People demand money to carry out transactions
• 4) Y (GDP) is at potential so economy is self adjsuting

• Is is pure inflation where if money is increased, then price is increased in full proportion
• Moves AD right which just increases price

• Early monetarists: argued for the gold standard, commodity backed money linked to gold
• Later monetarists: argued for policy rule
• Early example policy rule was milton freedment who argued fed should incrase money supply as same rate GDP was increaseing

• Keynes like the nometarist saw that poeple demand moeny for transaction purposes.
• In addition, keynes argued that people also demand money for specualate purpose

• Money is viewed as an alternative form of wealth
• An alternavie asses tha is part of a a finacial portolio
• If money is an asset thent ehre is an opportunity cost to holding money. that opportunity cost is therate of recuts on the other assets (bonds)

• Indierect relationship
• If the real rat of interest is low, then there is a high demand for money
• If iterests rate low then people hold money because opportunity cost of holding it is lower

• 1) Changes in the price level
• 2) changes in teh real GDP
• 3) Technology changes
• 4) Changes in instituition

MD shifts right becasue more money demanded at every price level becase price increased

• Above equilibrium: surplus so interset rates should fall to clear market
• Below equilibrium: md>ms, shortage so upward pressur on interest ratses

Ms Shifts to the right, surplus so downward pressure on interst ratse

• Regarding why interst rates fall whent he fed increases the omeny supply
• the fed increses ms peole how now hold more money, people will increase their demand for bonds
• this increases demand for bonds, increse price of bonds and if price of bonds increases then interst rate on bonds will fall

PV= FV/(1 + r)

• Keynesiand transmisson mechansim:
• Suupose the fed increases ms (purchanse bonds in open market)
• This will make consumption move up and stimulate ad out to right and ms move out to right

• Output and employmebnt afffected
• Money supply increases to rates down, so consumpution and investment increase and Ad increates so potential increases

• An increase in the money suply will not change the real rate of interst due to inflation formula
• r = i -rate of inflation

Have historically argued for an activits central bank

• Developed by John Taylor
• In seetting monetary policy, the fed should target the federal funds rate, keeping inflation and ouptu in mind by taking account of both inflation and output

• 1 + 1.5* inflation + .5*output Gdp
• If actual GDP above potential then RFF increase so FRR would reduce moeney to dool down
• If Actual GDP below potential then reduce RFF which would increase money suppl

• Central Bank targets only inflation and strives to keep a very low rate of inflation
• Argument:
• 1) It is more transparent (can better judge what is going to be forward looking)
• 2) This promotes a greateer accoutnability becasue you can judge if cnetal bank has achieve its target

• Emerged in the 1970 as critique of keynesian ecoomics and policy
• 1) Milton Feedmen -"fooling" or natural rae model
• 2) Rober Lucas- rational expectaions model
• 3) Fin Kydland and Edward prescott- real business cycle model

• Assume:
• 1) Workers mispercieve movement in the price level
• 2) The economy is at capacity (unemployment = naturea)
• 3) Policy makers do not recogine the natual rate of unemploymebnt

• In long run economy will adjust to effeicndet equilibuium
• SRAS acknolege price rigidity and that actual GDP can differ
• The polidy maker swant to sitmualte AD to reduce uneimployment and grow GDP. Policy would increase Ms, or down tax up g

• Go to point b becasue workers have been fooled.
• They see the incres in nominal wage but bno tin price, so they don't see real wage is acually lower
• Over time they catch on, the demand and SRAS shifts up and back to potential

• Assumes
• 1) both employuers and workers can mispercieve movment in the price level
• 2) both the eoplyers na d woreker aer rational wehre ratiaonality incidcate the contiually seek all availabe info in ordder to acccuraely predict movement in the price level

• Same graph
• At point B both workers an demplyer are mispercieveing. workers daony see fall in real ages whild employers don't see fall in real profi
• Over time woerkes and employers see the rise in prices and sras shifts up

The economy moesv from A to B becasue workers are fooled. they dont see their real wagtes falling

• the econly moves from A to B becaseu both workers and emplyers mispercieve prices
• also it is possible both can form rational expecatiosn that accuratly prdice movemtn in the price leve. if this occures then economy moves ffrom a to c

• Assumes:
• 1) Prices are fully flexiable (no rigidity)
• 2) Fluctuations in output are due to changes in real GDP