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Practice Test #1 I do NOT set money supply or interest rates! I do NOT control taxes or spending Fiscal Policy vs. Monetary Policy Money Unit Wrap Up Monetary Policy Wrap-Up Monetary vs. Fiscal Policy • Monetary Policy does not put money directly into the economy – Fiscal Policy does! (Taxes & Gov’t Spending) • Instead it depends on cause/effect relationships: – ∆ in money supply => ∆ interest rates => ∆ in consumption/ investment • The Fed does not control the amount of money that: – households choose to hold as deposits – bankers choose to lend, individuals choose to borrow Credit Crunch This is why the Fed feared deflation in 2008-11! Monetarism Summary • Main message: Money is neutral & the economy self-regulates – Use Quantity Theory of Money MV = PY (where V is constant) – Inflation is purely a monetary phenomena • Monetarists do not support activist monetary policy stabilization: – i.e. expanding money supply during bad times and slowing during good – They focus primarily on price stability • Theory not compatible with upward sloping AS curve or Keynesian economics Classical Dichotomy • A Pre-Keynesian theory that separates nominal from real variables to analyze an economy – Nominal variables measured in monetary units – Real variables measured in physical units • Classical economists look at real variables---ignore nominal – Assume monetary neutrality for classical dichotomy – Keynesian economists reject this theory Review: Nominal Interest Rate = Real Interest Rate + Expected Inflation Real Interest Rate = Nominal Interest Rate – Expected Inflation Practice Free Response Austrian Economics • Friedrich Hayek (1899 – 1992) – Austrian School of Economics • Against active Fed Policy • Promoted “self regulation” of free market • Believed low interest rates led to Malinvestment Round 2 Round 2 http://www.youtube.com/watch?v=GTQnarzmTOc Round 1 http://www.youtube.com/watch?v=d0nERTFo-Sk The Inflation Tax • When the federal reserve prints money it is said to levy an inflation tax – a tax on everyone who holds money or saves money • Interest earned on savings is 100% taxed even though part of it merely compensates for inflation