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Macro Free Responses Since 1995
GDP
Economic Growth
Money and Banking
Inflation
Recession
Monetary Policy
Fiscal Policy
Exchange Rates
Theories
GDP
The $ value of all final goods and services produced within the
borders of a country during a given period
Does not include, Intermediate or resold goods or services.
What are the two ways to figure out GDP? Expenditure and Income.
Expenditure Approach: C + I + G + XN (Exports-Imports)
Income Approach: Summing up factor payments plus economic profit.
Why do they both yield the same results? TR – TC = Economic Profit.
It does not include illegal or underground activity, household work,
or bartered goods.
Expenditure Approach is the top part of the circular flow diagram.
Income Approach is the bottom part of the circular flow diagram.
The impact of negative and positive externalities are not captured
Economic Growth
Economic growth can be illustrated two ways. LRAS and PPC
What will increase growth? Capital, human capital
How do interest rates affect growth? Lower interest rates, more capital
Capital stock will increase, workers become more productive both
Long-run aggregate supply and the production possibilities curve will
push outwards.
What about corporate taxes? They should also increase investment.
Money and Banking
What are the two types of reserves? Required and Excess
When there is a deposit, how much does the banks reserves increase?
Banks reserves increase by the full amount of the deposit.
How much does a banks loans go up by when there is a deposit?
It goes up by the amount of the deposit minus the required reserves.
How much does the banks required reserves go up by?
The deposit times the reserve ratio.
How much money can be created by the banking system?
Excess reserves times the multiplier.
How do you find the multiplier? 1 over the reserve requirement.
What are two assumptions you must make for the money supply to
increase by its maximum? All the excess reserves must be loaned out.
All the loans are re-deposited
Inflation
It is the increase in prices across the board. Not just one good.
What is an acceptable inflation rate? The Fed says 2.5 %. 2.5-3%
How does unanticipated inflation affect the following markets credit,
labor, and product?
Credit Market: Borrowers benefit by paying back loans in $ worth
less. Lenders get hurt because the get back $ worth less.
Labor Market: Employer’s benefit if output prices rise faster than
labor costs. Employees are hurt if their real wages have decreased.
Product market: If producers raise prices faster than costs, they are
helped. If producers have long term contracts on prices, then they
are hurt because costs could rise faster. Consumers are hurt because
real income is falling.
What can you do to fight inflation? Monetary of Fiscal Policy.
Recession
A recession is usually categorized by falling GDP and unemployment.
What is the full employment level? 96 percent of the labor force.
What makes up the labor force?
Full and part-time workers, unemployed and actively looking.
What type of unemployment makes up the 4 % during full employment?
Frictional: In-between jobs.
Structural: Job has been come obsolete because of technology.
If unemployment is above 4 %, what type of unemployment is that?
Cyclical: Caused by a drop in demand for goods and services. The
business cycle.
Okum’s law: For everyone 1 % of cyclical unemployment GDP falls?
2.5 % What can you do to fight a recession? Monetary and Fiscal Policy
Monetary Policy
Using the tools of monetary policy to influence the economy.
Three tools of monetary policy are
Reserve Ratio: The percentage banks are required to hold in reserves
either in their vault or with the Federal Reserve of their demand
deposits.
Discount Window: This is where banks can borrow money from the Fed
if the can’t meet their reserve requirement. They are charged an interest
rate called the discount rate. The Fed is the lender of last resort.
Open Market Operations: The buying and selling of government
securities in order for the Fed to maintain its target Fed Funds Rate.
OMO is carried out by the NY Fed. Policy is determined by the
Open Market Operation Committee.
Fed Funds rate is the rate banks charge each other to borrow money.
How can Monetary Policy help fight inflation?
Fighting Inflation with Monetary Policy
The Fed can raise the reserve requirement. This will decrease the
amount of excess reserves available for banks to lend out.
The Fed can raise the Discount rate. This will make it more expensive
for banks to borrow, therefore they will likely lend out less.
The Fed can use Open Market Operations. They can sell bonds to
banks and people. This will decrease the amount of reserves and
money available to lend out and spend.
Each one of these tools is aimed at lowering Aggregate demand,
shifting it to the left. This will cause Price and output to fall.
Because of the decrease in reserves, interest rates will rise.
Higher interest rates means bond prices are lower. Foreigners will want
our financial assets. Demand for the $ goes up, Supply of the $ goes
down. Exchange rate (International value of $) goes up, Exports down,
imports up.
Fighting a Recession with Monetary Policy
The Fed can lower the reserve requirement. This will increase
the amount of excess reserves available for banks to lend out.
The Fed can lower the Discount rate. This will make it less expensive
for banks to borrow, therefore they will likely lend out more.
The Fed can use Open Market Operations. They can buy bonds from
banks and people. This will increase the amount of reserves and
money available to lend out and spend.
Each one of these tools is aimed at increasing Aggregate demand,
shifting it to the right. This will cause Price and output to fall.
Because of the increase in reserves, interest rates will fall.
Lower interest rates means bond prices are higher. Foreigners will
not want our financial assets. Demand for the $ goes down, Supply
of the $ goes up. Exchange rate (International value of $) goes
down, Exports up, imports down.
Fiscal Policy
Fiscal Policy use two tools to influence economic activity.
Tax Cuts: Cutting or raising business and consumer taxes influence
business investment in capital and it also influences disposable income.
Government Spending: Government can either raise or lower
government spending on purchases.
Problems with Fiscal Policy.
Crowding Out: When the government runs a deficit they crowd out
the private sector from the loanable funds market. The supply of
bonds increases and bond prices fall causing interest rates to rise.
What has greater impact government spending or tax cuts?
Spending has a greater impact. Because people will save a portion of
the tax cut. How much depends on the marginal propensity to save.
How can Fiscal Policy help fight inflation?
Fighting Inflation with Fiscal Policy
When there is inflation the Fed wants to slow the economy down.
They can do this in two ways.
First, they can raise personal and business taxes.
Consumers will have less disposable income. Consumption goes
down causing AD to shift left.
Business has less money to spend on capital. AD shifts left.
Second, the government cuts back on its purchases. This cause firms
to have less sales and they layoff workers, they stop buying. AD
shifts to the left.
Government can use these two tools together or separately.
When AD goes down, Price and output go down, unemployment goes
up (depending on the range of the AS.)
You can also argue corporate tax affects AS.
Fighting Recession with Fiscal Policy
When there is a recession the Fed wants to pump up the economy.
They can do this in two ways.
First, they can lower personal and business taxes.
Consumers will have more disposable income. Consumption goes up
causing AD to shift right.
Business has more money to spend on capital. AD shifts right.
Second, the government spend more on its purchases. This cause firms
to have more sales and they hire workers, they increase buying. AD
shifts to the right.
Government can use these two tools together or separately.
When AD goes up, Price and output go up, unemployment goes
down (depending on the range of the AS.)
You can also argue corporate tax affects AS.
Exchange rate
Exchange rates depend on the supply and demand for the currency.
The greater the demand for a country the higher the exchange rate.
The higher exchange rate makes the currency appreciate.
When a currency is strong (appreciates) it makes exports more
expensive and imports cheaper.
When imports > exports a country has a trade deficit.
The country would need higher interest rates so that financial
capital flows into the country.
The greater the supply of the currency the lower the exchange rate.
The lower the exchange rate, the currency is depreciating.
A weak currency increases exports and lowers imports. This
causes a trade surplus and the country must send its currency
out to buy financial capital.
Theories
Keynesians: Believe that fiscal policy should be used to eliminate
recessions and inflation. In general they think monetary policy is
unreliable or less effective than fiscal policy. Low interest rates do not
necessarily induce increased business investment or consumer
spending.
Keynesians believe there is little or no crowding out
Monetarist: Advocate a money rule with no discretionary monetary or
fiscal policy. They believe fiscal policy is no good because of crowding
out. They believe the money supply should increase at the growth rate
of real GDP, 3-5 % a year or at an announced constant rate.
Monetarist believe that there is complete crowding out.
Phillips Curve
Long-run Phillips curve is vertical at the Natural Rate of Unemployment.
Increase in government spending cause a movement along the Phillips
Curve.
A drop in inflationary expectations will lead to a decrease in
unemployment and inflation at every level of aggregate demand.
Phillips curve shifts to the left.
Increased unemployment benefits will cause more people to be
unemployed
This will increase the natural rate of unemployment and shift the longrun Phillips curve.