Kingston Macro 211 Exam 3 Flashcards

Terms Definitions
What is money?
Money replaces barter. Money in the broadest sense is anything that is used as a medium of exchange, a store of value and a unit of account
What is barter?
The direct trading of goods (or services_ for other goods and services
What constitutes the "official" money supply in the U.S.?
M1-contains only those elements of money supply that can be used as a medium of exchange (coins, currency, checkable deposits, traveler's checks)M2- includes everything in M1 plus time deposites (savings accounts, certificates of deposits)
Why are credit card charges not considered part of the money supply?
Because credit cards (or credit balances or credit limits) are essentially short-term loans from financial services institutions. Credit card balances ultimately have to be paid off with M1 or M2.
What are the basic differences amount the M1 and M2 definitions of money supply?
The differences have to do with the degree of liquidity. M1 has perfect (100%) liquidity. M1 can convert to M1 with no loss of value. M2 has to be converted into M1 before use.
What backs of gives value to the money supply today? How is this different from previous periods in American history?
The money supply today has no precious metal backing (gold standard). Today the only support is belief (confidence) that the Fed will maintain the value of the U.S. dollar over time.
Describe the structure of the Fed.
The Fed has a governing board (7 persons nominated by the President/confirmed by the Senate). 12 Fed District Banks whose presidents constitute the Federal Advisory Council. Basically an independent central bank.
List and explain the 5 functions of the Fed.
1.) To clear and collect checks 2.) To supervise member banks 3.) to act as a fiscal agent for the U.S. government 4.) To supply the economy with paper money and 5.) to control the money supply. (More recently the Fed has assumed the responsibility of protecting consumer interests.)
Why do banks and other financial institutions accept deposits?
Because they are able to make loans with parts of these funds to make a profit.
What is the legal reserve requirement and how is its value determined?
It is the percentage of deposits that banks cannot loan out, but rather must be held in the form of required reserves. Its value is determined by the percentage of deposits.
What is meant by the money "multiplier?"
The money multiplier is the ratio of the change in the money supply that the banking system can create to the original amount of the excess reserves available. The max value of the MM is the reciprocal of the legal reserve requirement.
Explain the difference between legally required and "excess" reserves.
Legally required reserves cannot be loaned by banks. Excess reserves are those reserves above and beyond the amounts that are legally required. Only excess reserves can be used to make new loans.
What is the discount rate? How does the Fed use it to change the money supply?
Commercial banks and other deposit holding institutions may borrow excess reserves from their Fed District Bank. In order to do so, they must agree to pay interest on the excess reserves that they borrow. The interest rate charged by the Fed on such loans is called the discount rate.
Explain how changes in the legal reserve requirement cause the money supply to change.
If the Fed wishes to increase the money supply, it could reduce the legal reserve requirement. For any given amount of deposits held by the banking system, required reserves will decline and excess reserves will rise. The product of the increase of excess reserves and the money multiplier allows you to calculate the maximum increase in the money supply that could result.
What are "open market" operations and how do they impact the size of the money supply and rates of interest in the economy?
Open market operations involve the purchase or sale of government bonds by the Fed. If the Fed wants to increase the money supply, it will buy government bonds from commercial banks. When these banks sell their bonds to the Fed, they are paid by the Fed with funds that constitute excess reserves. When new excess reserves become available, the commercial banking system is able to expend the money supply by some multiple of the initial rise in excess reserves. The maximum value of the money multiplier is the reciprocal of the legal reserve requirement.
What monetary policy tools are available to the Fed to increase the money supply?
A.) Lower the legal reserve requirement B.) Purchase government bonds C.) Reduce the discount rate
What monetary policy tools are available to the Fed to decrease the money supply?
A.) Increase the legal reserve requirement B.)Sell government bonds C.) Raise the discount rate
Describe the "chain of causation" associated with Keynesian monetary policy?
If the Fed wants to use monetary policy to shift the aggregate demand schedule to the right, it will undertake actions to increase the money supply. As the money supply rises, the interest rates fall, expenditures rise, AD schedule shifts to right. Multiplier is reciprocal to the marginal propensity to save.
Explain the transactions, precautionary and speculative demand for money.
a) transactions demand for money b) precautionary demand for money c) speculative demand for money. The first two depend positively on GDP and are unrelated to the rate of interest. The third is negatively related to the rate of interest and unrelated to the level of GDP. The total demand for money is the sum of the transactions demand, the precautionary demand and the speculative demand for money at any given GDP level.
What factors determine the extent to which the maximum value of the money multiplier is achieved?
a.) No leakages into cash at each round of re-lending and re-depositing in the money supply expansion process b.) Banks must be willing to loan out all of their excess reserves c.) Banks must be able to find willing borrowers for their excess reserves
Why did Keynes believe that monetary policy would be ineffective during a serious recession or depression?
At some point, further increases in the money supply would not cause the rate of interest to decline (liquidity trap) and that a decline in the rate of interest might not stimulate additional investment spending.
What factors can limit the effectiveness in addition to the problem of the liquidity trap?
A major constraint on monetary and fiscal policy is given by the shape of the aggregate supply schedule. The steeper the schedule, the more effective both monetary and fiscal policies will be in changing the equilibrium level of real GDP. Flatter the AS schedule, the greater would be the impact of and change in AD
Provide examples of the different tools of monetary policy working (or not working) in the same direction/
To increase the money supply, the Fed could lower the legal reserve requirement, lower the discount rate, or buy government bonds. To reduce the money supply, the Fed could raise the legal reserve requirement, raise the discount rate, or sell government bonds.
Provide examples of monetary and discretionary fiscal policies working (or not working) in the same direction.
Increase equilibrium real GDP-discretionary fiscal policy could shift AD to the right by increasing government expenditures, reducing taxes or a combination. To shift AD to left, government expenditures could fall, tax collections rise.
What is the "quantity theory of money?"
The equation of exchange is given by MV=PQ where M is the money supply, V is the velocity of money, P is the average price level (price index) and Q is real GDP
How did the Classical economists use the quantity theory of money?
As a theory of long-run movements of the price level. They assumed that Q was fixed at full employment and that V was fixed or changed very slowly over time. The result is an equation in which a 10% change in M(the money supply) leads to a proportionate (10%) change in price level.
How do modern" Monetarists" use the quantity theory of money?
They use the quantity theory as the demand for holding money balances-money is held only for the purpose of buying goods and services.
What is meant by the "velocity" of the money supply?
The average number of times each dollar is spent to purchase a part of the economy's GDP in a given year. Nominal GDP/(Money supply) or GDP/M=V
Why does monetarism depend importantly on the stability or at least the predictability of the velocity of money?
Monetarists believe that future values of GDP can be predicted if the money supply and the velocity of money can be known or predicted. Because the only reason for holding money balances in the monetarist theory is the buy goods and services, there is only one level of nominal GDP that will allow the quantity of money supplied to be equal to the quantity of money demanded.
How can the quantity theory of money be written as demand schedule for the holding of money balances?
The quantity theory of money in monetarist terms can be written as MV=GDP. or M(s)V=GDP as a function of time.
According to Monetarists, how could the modern quantity theory of money is used in the short-run and in the long-run? Which approach do modern Monetarists prefer?
Essentially, the monetarists believe that increases in the money supply will not work because of the crowding out problem. They believe increases in the money supply will shift the AD schedule to the right and cause equilibrium GDP to right in the short run. In long run, increases in aggregate demand caused by either monetary or fiscal policy will only cause inflation.
Describe the "chain of causation"
Monetarists deny any relationship between the demand for money and the rate of interest. As a result, there is only one level of GDP at which the quantity of money demanded would be equal to to the quantity of money supplied by the Fed. If the Fed increases the money supply, then the initial quantity equality between the quantity of money demanded and supplied is disturbed, and GDP rises to a higher level at which, once again, the quantity of money demanded is equal to the quantity of money supplied. Essentially, if the Fed increase the money supply, people spend the extra money causing the AD to shift right and the level or real and price level (and hence nominal GDP) to rise.
What are the principle policies advocated by Monetarists today, and how do they differ from those advocated by Keynesian monetary economists?
Monetarists believe that the Fed should estimate the growth rate of real GDP and then increase the money supply by the same percentage. If V is fixed and real GDP rises, a constant money supply would cause the average price level to fall. If real GDP rises by 10% and V is fixed, then 10% increase in the money supply would allow the price level to remain unchanged
What is the Phillips curve? What did it look like during the 1960's?
It shows the combinations of inflation rates and unemployment rates actually observed in an economy over a period of time. The 1960 curve showed a very stable inverse relationship between inflation rates and unemployment rates. The Phillips curve becomes steeper as the economy moves up the schedule, and flatter as the economy moves down the schedule
How can the AD-AS theory be used to explain the stability and shape of the Phillips curve in the US during the 1960's?
If the short-run aggregate supply schedule is upward sloping and stable, then rightward (and leftward) shifts of the AD schedule would trace out a negatively sloped Phillips curve. For example, if AD increases, the price level rises and the level of real GDP rises. As the level of real GDP rises, the unemployment rate declines. So, an increase in AD is associated with a reduction in the rate of unemployment and a rise in the price level.
How does the shape of the long-run Phillips curve differ from the shape of the short-run Phillips curve.
The long-run Phillips curve is vertical. The short run is negatively sloped because the short-run AS schedule is positively sloped.
What is meant by the "natural" rate of unemployment?
The unemployment rate associated with the level of real GDP at which the vertical long-run AS schedule is drawn. This is the unemployment rate towards which the economy will tend in the long-run.
Define the concept of adaptive expectations and explain how it gives rise to an upward-sloping Phillips curve in the short-run, but not in the long run.
The theory of adaptive expectations is based on the idea that workers form their expectations about future inflation rates on the basis of inflation rates in the recent past. Increases in AD can temporarily raise real GDP and reduce the actual unemployment rate below the natural rate of employment, but in the long run, increases in AD can only cause inflation and cannot permanently reduce the unemployment rate below the natural rate.
Define the concept of rational expectations and explain how it gives rise to a vertical Phillips curve in the long-run.
Workers use all available information to set their wage demands for the coming year. They do no just extrapolate past inflation trends to predict those in the future. According to this theory, an increase in AD cannot increase real GDP because workers immediately demand higher wages to offset the higher prices they know (or predict) that increases in AD will cause. As a result, rational expectation theory predicts that as the AD schedule shifts to the right, the short-run AS schedule shifts to the left, causing the economy to move to a high inflation rate, but with the same real GDP. As a result- the same unemployment (natural) rate.
What events or policies would shift the short-run Phillips curve downward and to the left, or upward and to the right?
It could be shifted downward and to the left by reducing structural employment, increasing education and training of the labor force, technological change, or reduction in income taxes (shift of AS downward and to the right). Up and right same as AS schedule: increased energy costs, increased government regulations or an increase in wage rates not caused by increases in worker productivity.
What policies would shift the Long-run Phillips curve to the right?
Government programs designed to reduce structural or frictional unemployment would shift the long-run AS schedule to the right and Phillips left.
If the short-run Phillips curve is upward-sloping, and the long-run is vertical, how should the effectiveness and desirability of short-run stabilization polices (monetary and fiscal polices) be evaluated?
If the short-run P curve is upward sloping then increases in AD can reduce the unemployment rate and increase real GDP in the short-run, but not in the long run. The basic question is whether the short=run benefits of a higher real GDP and higher living standards are worth the long-run cost of higher inflation and production at a real GDP level once again consistent with the natural rate of unemployment.
Explain how changes in the money supply cause the rate of interest to change in Keynesian monetary theory.
In K theory, an increase in the money supply will cause a reduction in the rate of interest. This decline in the rate of interest will increase the amount of investment spending. A rise in investment spending will shift the AD schedule to the right by an amount equal to the rise in investment spending times the aggregate expenditure multiplier.
Explain why Monetarists argue that the Fed should increase the money supply at the same rate as the growth rate of real GDP
The Monetarist equation is MV = GDP = PQ where GDP is, in this case, nominal GDP which is equal to real GDP (Q) multiplied by the average price level. If the velocity of money (V) is fixed, then an increase in Q (real GDP) would cause the price level to fall if the money supply does not increase.
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