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Economics Unit 4 Notes and Terms Fiscal and Monetary Policy Economic Statistics Rules of Thumb aka “The Economic Sweet Spot” Good 1-3% Inflation Bad Bad 3-4% Growth (RGDP) Good Good 4-6% Unemployment Bad Economic Statistics- Expansionary Policy 3% CPI Increase/ Inflation Rate -2% Growth in RGDP 10% Unemployment Rate What is the problem with the economy? Recession! How do you know this? Unemployment is at a very high rate, higher than it’s normal range of 3-5%. The economy is also shrinking, since the RGDP is negative. Economic Statistics- Expansionary Policy 3% CPI Increase/ Inflation Rate -2% Growth in RGDP 10% Unemployment Rate What can the Congress and the President do to solve/ help this situation? Increase the amount of income for people! This will put more money into the economy and get it expanding again. 1. Fiscal Policy- Using Taxes and Government Spending to achieve specific economic goals. 2. Expansionary Fiscal Policy- Efforts by Congress and the President to stimulate the economy and get it expanding. Used during a recession. Tries to increase aggregate demand. 1. Taxes- Decrease 2. Government Spending- Increase 3. Transfer Payments- Increase Economic Statistics Rules of Thumb aka “The Economic Sweet Spot” Good 1-3% Inflation Bad Bad 3-4% Growth (RGDP) Good Good 4-6% Unemployment Bad Economic Statistics- Contractionary Policy 15% CPI Increase/ Inflation Rate 5% Growth in RGDP 4% Unemployment Rate What is the problem with the economy? Inflation! How do you know this? CPI is going up at a very high rate. Higher than it’s normal range of 2-3%. Economic Statistics- Contractionary Policy 15% CPI Increase/ Inflation Rate 5% Growth in RGDP 4% Unemployment Rate What can the Congress and the President do to solve/ help this situation? Decrease the amount of income for people! This will put less money into the economy and get it to slow down or contract. 3. Contractionary Fiscal Policy- Efforts by Congress and the President to constrict the economy and get it contracting. Used during an expansion with high inflation. Tries to decrease aggregate demand. 3 “Tools” of Fiscal Policy: 1. Taxes- Increase 2. Government Spending- Decrease 3. Transfer Payments- Decrease 4. Discretionary Stabilizers- Fiscal policy tools that require Congress and the President to take some action. Examples- increase or decrease taxes, create or eliminate a tax break, Spend more on infrastructure, national defense, education, NASA, FBI, national parks 5. Automatic Stabilizers- Fiscal policy tools that do not require Congress and the President to take some action. Examples- Welfare, food stamps, unemployment compensation, section 8 housing, AHCCS, other programs based on income U.S. Income-Maintenance System Entitlement Programs Social Security Earned-Income Tax Credit (EITC) Medicare and Medicaid Unemployment Compensation Public Assistance “Welfare” Supplemental Security Income (SSI) Program Temporary Assistance for Needy Families (TANF) Food-Stamp Program Section 8 Housing Vouchers 6. Barter- Trading of goods and services without the use of money. Not very efficient! It lacks a “coincidence of wants”. Trueques (barter markets) of Argentina Baseball cards! Pogs! Marbles! 7. History of Money- Sources of money’s value Commodity Money- An item that has value of its own is used as money Examples: Gold, Silver, Salt, Beaver pelts, fishhooks, tobacco, shells Representative Money- An item that has value because it can be exchanged for something valuable on its own is used as money Examples: Gold and Silver certificates Fiat Money- Govt. says it is money and we accept it Examples: U.S. Coins and Currency Yap Island Stone Money Rai stones Commodity, Representative, or Fiat Money? U.S. Currency Features 8. Functions of money 1. Medium of exchange Accepted in trade for G & S 2. Store of value Can be saved for use at a later date 8. Functions of money 3. Unit of Account/ Measure of value Easy to judge the worth of different products 4. Standard of Deferred Payment Used as a standard benchmark for specifying future payments for current purchases, that is, buying now and paying later. 9. Characteristics of money- Why do we use certain items as money? 1. Divisibility Easy to break into smaller units 2. Portability Easy to carry or transport 3. Durability Lasts a long time 4. Stability in value Holds its value over time (no inflation!) 10. M1- Measure of the supply of money in circulation. Used by the Federal Reserve and others to measure the growth of money in circulation. Includes the following: 1. Coins and Currency 2. Demand Deposits/ Checking Accounts/ Debit 3. Traveler’s Checks 11. M2- Another measure of the supply of money. Used for the same reason as M1. Many economists feel it more accurately reflects the "readily available" supply of money(the money that can relatively quickly be turned into cash). M2 includes everything in M1 plus the following major components : 1. 2. 3. 4. Savings Accounts Money Market Accounts (MMA’s) Certificates of Deposit (CD’s) Eurodollars (U.S. $ in Euro banks) 12. M3 = M2 + Large Time Deposits Broadest definition of the money supply M1 M2 Currency + 54% M1 Checkable Deposits + 46% 20% February 2006 Small Time Deposits + 15% Money Market Mutual Funds Held By Individuals + (MMMF) 11% Savings Deposits Including Money Market + Deposit Accounts (MMDA) 54% Totals $1,375 Billion $6,758 Billion 13. The Federal Reserve (The Fed)- Central bank of the U.S. Privately owned and financed by member banks in the U.S. Very important and powerful. The Fed is given power by law to conduct the following major functions: 1. Check clearing- Clears checks written under one bank and then deposited in another bank. 2. Bank Regulation- Keeps banks honest and depositors' money safe from banks misuse. 3. Providing Currency- Issues, but does not print, new money when banks turn in old, worn out currency. 4. Regulating the money supply (using the 3 tools)Increase or decrease the money supply to fight inflation and / or prevent the economy from entering a recession. 14. Structure of the Fed (Major parts)1. Regional Banks- 12 regional banks; AZ in the 12th district; San Francisco HQ of 12th district; New York most important district. Regional banks are in charge of the 1st 3 functions listed above. Phoenix Federal Reserve Cash Processing Facility Cash Vault: Built to 1550 N 47th Ave withstand an airplane crash Phoenix, AZ 85043 Armored Car Trap Cash Processing Robots at Federal Reserve Facility 14. Structure of the Fed (Major parts)2. Board of Governors- 7 members, appointed to 14 year terms by the President and confirmed by the Senate. Oversee all operations of the Fed. Janet Yellen, current chairman of the Fed (1st woman!) Benjamin Bernanke, previous chairman of the Fed Fed Salary Facts Fed Chairman Makes $199,700 All other members make $179,700. Salaries are not very high when compared to what a private banker could make These numbers are as of November, 2015. 14. Structure of the Fed (Major parts)3. Federal Open Market Committee (FOMC)- 12 members (7 BofG's and 5 district bank presidents) Decides monetary policy (see below). 7 members, appointed by president, confirmed by the Senate 12 regional bank presidents All 7 of B of G serve on FOMC 5 of the branch presidents serve on the FOMC too, 1 of 5 is always from NY branch Framework of the Federal Reserve System and the Relationship to the Public Board of Governors Federal Open Market Committee 12 Federal Reserve Banks Commercial Banks Thrift Institutions (Savings and Loan Associations, Mutual Savings Banks, Credit Unions) The Public (Households and Businesses) GLOBAL PERSPECTIVE Central Banks, Selected Nations Australia: Canada: Euro Zone: Japan: Mexico: Russia Sweden: United Kingdom: United States: Reserve Bank of Australia (RBA) Bank of Canada Central Bank of Europe (CBE) Bank of Japan (BOJ) Banco de Mexico (Mex Bank) Central Bank of Russia Sveriges Riksbank Bank of England Federal Reserve System (the “Fed”) (12 Regional Federal Reserve Banks) 15. Monetary Policy- The control of the supply of money by the Fed to achieve specific economic goals. Changing the money supply will cause the aggregate demand curve to shift! 16. The Three(3) Tools of Monetary Policy 1. Open Market Operations (OMO)- Sets the Federal Funds Rate = IR Banks charge Banks Buying and Selling Government Bonds (Securities) Fed Buys bonds Decrease in Fed Funds Rate Increase in $ supply Fed Sells bonds Increase in Fed Funds Rate Decrease in $ supply Buy Bigger, Sell Smaller Tools of Monetary Policy Fed Buys $1,000 Bond from the Public Check is Deposited New Reserves $1000 $800 Excess Reserves $4000 Bank System Lending $200 Required Reserves $1000 Initial Checkable Deposit Total Increase in the Money Supply, ($5000) 2. Discount Rate (DR)- IR Fed charges Banks Fed decreases DR Banks borrow more $ Banks lend out more $ Increase in $ Supply Fed increases DR Banks borrow less $ Banks lend out less $ decrease in $ Supply Many days, there is less than $100 million in discountwindow loans outstanding. That leapt to almost $46 billion after the Sept. 11, 2001, terrorist attacks on the U.S. disrupted the money markets. Link to change in FFR and DR rates 3. Reserve Requirements (RR)- Fed decreases RR Banks Lend out more $ Increase in $ Supply Fed increases RR Banks Lend out less $ Decrease in $ Supply Link to use of technology to reduce required reserves Economic Statistics Rules of Thumb aka “The Economic Sweet Spot” Good 1-3% Inflation Bad Bad 3-4% Growth (RGDP) Good Good 4-6% Unemployment Bad Economic Statistics- Expansionary Policy 3% CPI Increase/ Inflation Rate -2% Growth in RGDP 10% Unemployment Rate What is the problem with the economy? Recession! How do you know this? Unemployment is at a very high rate, higher than it’s normal range of 4-6%. The economy is also shrinking, since the RGDP is negative. Economic Statistics- Expansionary Policy 3% Inflation -2% Growth (RGDP) 10% Unemployment What can the Federal Reserve do to solve/ help this situation? Increase the money supply! This will put more money into the economy and get it expanding again. 17. Expansionary Monetary Policy (Easy money) Efforts by the Fed to stimulate the economy and get it expanding. Used during a recession. Tries to increase aggregate demand. 1. Open Market Operations (OMO) Fed Buys bonds/ Decreases Fed Funds Rate 2. Discount Rate (DR) Fed decreases DR 3. Reserve Requirements (RR)Fed decreases RR Expansionary Monetary Policy CAUSE-EFFECT CHAIN Problem: Unemployment and Recession Fed Buys Bonds, Lowers Reserve Ratio, or Lowers the Discount Rate Excess Reserves Increase Federal Funds Rate Falls Money Supply Rises Interest Rate Falls Investment Spending Increases Aggregate Demand Increases Real GDP Rises Economic Statistics- Contractionary Policy 15% CPI Increase/ Inflation Rate 5% Growth in RGDP 4% Unemployment Rate What is the problem with the economy? Inflation! How do you know this? CPI is going up at a very high rate. Higher than it’s normal range of 1-3%. Economic Statistics- Contractionary Policy 15% CPI Increase/ Inflation Rate 5% Growth in RGDP 4% Unemployment Rate What can the Federal Reserve do to solve/ help this situation? Decrease the money supply! This will put less money into the economy and get it to slow down or contract. 18. Contractionary Monetary Policy (Tight money) - Efforts by the Fed to constrict the economy and slow it down. Used during an expansion with high inflation. Tries to decrease aggregate demand. 1. Open Market Operations (OMO) Fed Sells bonds/ Increases Fed Funds Rate 2. Discount Rate (DR) Fed increases DR 3. Reserve Requirements (RR)Fed increases RR Restrictive Monetary Policy CAUSE-EFFECT CHAIN Problem: Inflation Fed Sells Bonds, Increases Reserve Ratio, or Increases the Discount Rate Excess Reserves Decrease Federal Funds Rate Rises Money Supply Falls Interest Rate Rises Investment Spending Decreases Aggregate Demand Decreases Inflation Declines 19. Prime rate- The interest rate that the biggest banks charge their biggest and best customers. When the Fed increases Discount and/ or Federal Funds rate banks raise their Prime rate which causes other rates(car, home loans, etc.) to increase. If the Fed decreases its rates banks do the same with their prime and other rates. Fed ↑ Money Supply Banks borrow more Banks lend/ create more ↓ Prime rate ↓ rates for homes, cars, education ↑ C, I ↑ AD. 20. Budget Deficit- When government spending exceeds government revenue. When the government spends more than it makes. To make up the deficit the government is forced to borrow money. A yearly total. $433 billion for 2015. Budget Deficit vs. Budget Surplus A deficit exists when Government Spending is > Tax Revenue. So: G > T A surplus exists when Government Spending is < Tax Revenue. So: G < T A balanced budget exists when: Government Spending = Tax Revenue. So: G = T 21. National Debt- The sum of all past budget deficits. Currently $18.6 trillion (November, 2015). Who do we owe the debt to? As of February 2012, China ($1.18 trillion), Japan ($1.09 trillion), and Brazil ($225.5 billion) are the biggest foreign holders of our debt. 22. Discretionary Spending- Spending that is not required by law. Examples: ∆Taxes/ Tax deductions, Defense, NASA , Education, law enforcement, etc. 23. Entitlement Spending- Spending programs required by law to be paid to anyone who meets criteria set by law. Examples: S.S, Welfare, Stud. Loans, Food Stamps This then puts a squeeze on discretionary spending such as defense, NASA, national parks, law enforcement, education, etc. 24. Transfer payments- Payments made to individuals/ households by the government. Examples: S.S, Welfare, Stud. Loans, Food Stamps Balanced Budget There are good economic reasons (crowding out) for a balanced budget. A balanced budget exists when: Government Spending is = Tax Revenue. So: G = T Balanced Budget A deficit exists when Government Spending is > Tax Revenue. So: G > T So, to have a balanced budget the government must: ↓ G or ↑ T or ↓ Transfer payments 12. The Monetary Equation of Exchange MxV = P x Q Money X Velocity = Price Level X Quantity M = M1 Velocity = The number of times a dollar is spent Price Level = The rate of inflation (GDP Price Deflator) Quantity = Real GDP Real GDP (Q) x Price Level (P) = Nominal GDP 13. Money Multiplier = 1/ Reserve Requirement X Initial Deposit Example: If the Fed has a Reserve Requirement of 20% this means 1 ÷ .2 = 5 5 is the money multiplier $1000 initial deposit $800 (80%) in excess reserves and $200 (20%) in required reserves $1000 x 5 = $5000 of money in circulation $800 x 5 = $4000 new money created by the banking SYSTEM (not by 1 bank) $1000 initial deposit + $4000 new money = $5000 in circulation Refer to Money Creation Simulation for more examples Bank (1) Acquired Reserves and Deposits Bank A $100.00 Bank B 80.00 Bank C 64.00 Bank D 51.20 Bank E 40.96 Bank F 32.77 Bank G 26.21 Bank H 20.97 Bank I 16.78 Bank J 13.42 Bank K 10.74 Bank L 8.59 Bank M 6.87 Bank N 5.50 Other Banks 21.99 (2) Required Reserves (Reserve Ratio = .2) (3) Excess Reserves (1)-(2) $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 (4) Amount Bank Can Lend; New Money Created = (3) $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $400.00 Monetary Multiplier or Checkable-Deposit Multiplier Monetary Multiplier = or in Symbols… Graphic Example 1 Required Reserve Ratio 1 m = New Reserves $100 $80 Excess Reserves $400 Bank System Lending Money Created R $20 Required Reserves $100 Initial Deposit The Monetary Multiplier W 13.2 Reversibility Making Loans Creates Money Loan Repayment Destroys Money Multiple Step Money Expansion Multiple Step Destruction of Money 26. Crowding Out Effect- The rise in interest rates caused by increased borrowing by the federal government. ↑ Interest rates ↓ C, I ↓ AD ↓ GDP Contractionary impact DO NOT Draw the graph! 27. Crowding In effect- The decrease in interest rates caused by decreased borrowing by the federal government. ↓ Interest rates ↑ C, I ↑ AD ↑ GDP Expansionary impact DO NOT Draw the graph! How the Fed’s actions affect all of the participants in the economy Federal Deficits and Surpluses – 1990 - 2005 as a Percentage of Potential GDP (1) Year (2) Actual Deficit (-) or Surplus (+) (3) Standardized Deficit (-) or Surplus (+) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 -3.9% -4.4% -4.5% -3.8% -2.9% -2.2% -1.4% -0.3% +0.8% +1.4% +2.5% +1.3% -1.5% -3.4% -3.5% -2.6% -2.2% -2.5% -2.9% -2.9% -2.1% -2.0% -1.2% -1.0% -0.4% +0.1% +1.1% +1.1% -1.1% -2.7% -2.4% -1.8% Source: Congressional Budget Office The Global Greenback U.S. Currency Circulating Abroad Russians $40 Billion Argentineans $7 Billion Polish $6 Billion U.S. Profits from Dollars Leaving Black Markets and Illegal Activities Seeking Stable Purchasing Power Soviet Union Collapse Brazil Inflation Issues Asian Market Exchanges Bank Panics of 1930-1933 Series of Bank Panics Before Deposit Insurance Mass Withdrawals From Fear Move to Cash Reduced Money Supply Through Reduction in Loans Multiple Contraction Slowed Lending and the Economy 1933 National Bank Holiday for One Week Resulted in FDIC and 25% Drop in Money Supply Contributed to the Great Depression Regulation Protects the System Today