Unit V: The Phillips Curve

4/8/16

The Phillips Curve

-The Long-Run Phillips Curve measures unemployment and (? inflation?)

Note: Natural rate of unemployment is held constant.

-Because the Long-Run Phillips Curve exist at the natural rate of unemployment, structural changes in the economy that affect unemployment will also cause the LRPC to shift.

-Increases in unemployment will shift LRPC to the right

-Decreases in unemployment will shift LRPC to the left.

-SRPC has a tradeoff between inflation and unemployment (when one increases the other decreases). (inverse relationship)

-LRPC: There is no tradeoff between inflation and unemployment.

1. The economy produces at the full employment output level.

2.It is represented by a vertical line.

3. It occurs at the natural rate of unemployment.

Natural unemployment rate (NRU)= Frictional +Structural +Seasonal

Fe= 4-5%

LRAS shifters also shifts LRPC.

-The major LRPC assumption is that more worker benefits create higher natural rates and fewer worker benefits create lower natural rates.

-The misery index, a combination of inflation and unemployment in any given year.

-Single digit misery is good.  

Unit V: Long-Run and Short Run Aggregate Supply

4/7/16

Short Run Aggregate Supply

In macroeconomics, this is the period in which wages (and other input prices) remain fixed as price level increases or decreases.

Long Run Aggregate Supply

Period of time in which wages have become fully responsive to changes in price level.

Effects over Short-Run

-In the short run, price level changes allow for companies to exceed normal outputs and hire more workers because profits are increasing while wages remain constant.

-In the long run, wages will adjust to the price level and previous output level will adjust accordingly.

Equilibrium in the Extended Model

The Long AS Curve is represented with a vertical at full employment level of real GDP

Demand Pull Inflation in the AS Model

-Demand-pull: Prices increase based on the increase in aggregate demand

-In the short run, demand pull will drive up prices, and increase production

-In the long run, increases in aggregate demand will eventually return to previous levels

Cost Push & the Extended Model

Cost-push arises from factors that will increase per unit costs such as increase in the price of a key resource

Dilemma for the Government

-In an effort to fight cost-push, the government can react in two different ways.

-Action such as spending by the government could begin an inflationary spiral

-No action, however, could lead to recession by keeping production and employment levels declining 

Unit IV: Final Notes

*When a customer deposits cash or withdraws cash from their demand deposit account, it has no effect on the money supply

 It only changes:

1.    The composition of the money

2.    Excess reserve

3.    Required reserves (due to the changes of DD)

Single Bank: loan money from excess reserves (ER) only

Banking system: ER X multiplier = total money supply

When the FED buys or sells bonds, ER is created.

$200 x (1/.2) = $1000

RRR= 20% 

Unit IV: Countercylical Policies: Keynesian Fiscal Policy versus Monetary Policy

In the early 21^st Century, here in the USA:

An efficient, “full employment” economy will probably have:

1.    An annual unemployment rate of 4-5%

2.    An annual inflation rate 2-3%

If the economy goes into recession:

3.    The Real GDP will decrease for at least 6 months.

4.    The unemployment will go to 6% or more.

5.    The inflation rate will probably go to 2% or less.

If the Congress enacts Keynesian Fiscal Policies to attempt to slow/stop the recession, then:

6.    The policy will try to improve C or G (parts of AD)

7.    Congress decrease federal taxes.

8.    Congress will increase job and spending programs.

9.    The federal budget will probably create a deficit,

10.                       Due to the changes in Money Demand, interest will increase. (Crowding out might occur, but Keynesian don’t care)

If the Federal Reserve employs Monetary Policy options to slow/stop the recession, then:

11.                       The policy will target improvement in the Ig (part of AD)

12.                       The Fed will target a lower federal fund rate.

13.                       The Fed can lower the discount rate.

14.                       The Fed can buy bonds (Open Market Operations)

15.                       The Fed can (theoretically) lower the reserve requirement

16.                       These Fed policies will lower the interest rates through changes in the Money Supply.

17.                       These options should increase Ig.

If the economy suffers from too much demand-pull inflation or cost-push inflation, then

18.                       The unemployment rate will go to 4% or less.

19.                       The inflation rate will probably go to 4% or more.

If Congress enacts Keynesian Fiscal Policies to attempt to slow/stop the inflation, then:

20.                       The policy will try to decrease C or G (parts of AD)

21.                       Congress will increase federal taxes.

22.                       Congress will decrease job and spending programs.

23.                       The federal budget will probably create a surplus.

24.                       Due to changes in Money Demand, interest rates will decrease.

If the Federal Reserve employs Monetary Policy options to slow/stop the inflation problems, then:

25.                       The policy will target decreases in Ig (parts of AD).

26.                       The Fed will target a higher federal funds rate.

27.                       The Fed can increase the discount rate.

28.                       The Fed can sell bonds (Open Market Operations).

29.                       The Fed can (theoretically) raise the reserve requirement, but probably won’t because it is too complex for the banks.

30.                       These Fed policies will raise the interest rates through changes in the Money Supply.

31.                       These options should lower Ig. 

Unit IV: Three Tools of Monetary Policy

Only a small percentage of your bank deposit is in the safe. The rest of your money has been loaned out. This is called “Fractional Reserve Banking”. The FED sets the amount that banks must hold. The reserve requirement (reserve ratio) is the % of deposits that banks must hold in the reserve and not loan out.

When the Fed increases the money supply it increases the amount of money held in bank deposits.

1.    If there is a recession, what should the FED do the reserve requirement?

Decrease the Reserve Ratio

                               I.            Banks hold less money and have more excess reserves

                            II.            Bank create money by loaning out excess

                         III.            Money supply increases, interest rates fall, AD increases

2.    If there is inflation, what should the to the reserve requirement?

Increase the Reserve Ratio

                               I.            Banks hold more money and have less ER

                            II.            Banks create less money

                         III.            Money supply decreases, interest rates go up, AD down

#2 Discount Rate- The discount rate is the interest rate that the FED charges commercial banks.

Example: If the Banks of America needs $10 billion, they borrow it form the U.S. Treasury (which the FED controls) but they must pay it back with interest.

To increase the money supply, the FED should decrease the Discount Rate (Easy Money Policy).

To decrease the money supply, the FED should increase the Discount Rate (Tight Money Policy).

#3 OMO (Open Market Operations)

-The FED (Federal Reserve) buys/ sell government bonds (securities)

- This is the most important and widely used monetary policy.

To increase the money supply, the Fed should buy government securities.

To decrease the money supply, the FED should sell government securities.

Monetary Policy	Expansionary (Easy Money)	Contractionary (Tight Money)
OMO (Open Market Operations)	Buys Bonds	Sell bonds
Discount Rate	Down	Up
Reserve Requirement	Down	Up
	AD up GDP up Loans up MS up “i” down	AD down GDP down Loan down MS down “i” up

Federal Fund Rate- This is where FDIC member banks loan each other overnight funds, so instead of borrowing from the FED they can borrowing from each other.

Ex: Wells Fargo borrows from Chase

Prime Rate in the interest rate that banks gives to their most credit worthy customers.

Unit IV: Components and Definitions

Components and Definitions

Liabilities:

1.    Cash deposits from the public= DD

2.    Owner’s equity or stock shares= Values of the bank stocks as held by the public

Assets:

1.    RR= The percentage of the DD in the Vault

2.    Excess reserves= The remaining % of DD, used for loans

3.    Property= usually a statement of the bank’s property

4.    Securities= Previously purchased bonds held by the bank as investments

5.    Loans= previously loaned funds now owned back to the bank

Assets	Liabilities
1.    DD or CD 2.    Owner’s equity	1.    RR 2.    ER

 Remember= DD=RR+ER

Bonds can move two ways:

1.    The Fed sells to the banks and increases the amount.

2.    The Fed buys from the banks and decreases the amount.

Banks and the Money Supply

The Money Multiplier process creates new money for the economy,

Scenario #1:

A private citizen takes that they possess and put in into a bank account.

·       The cash placed into the bank is already part of the money supply.

·       The deposit is counted as a bank liability.

·       A percentage must be placed into the required reserve.

·       The remainder is placed into ER.

·       The bank will want to lend all of the ER, if possible

·       The amount in ER is multiplied by the multiplier

·       This will be assumed to become new loans in the banking system

·       This will be counted as the change in the money supply

Scenario #2

·       The Fed buys bonds back from the public.

·       The public now has new cash

·       This new cash is new loans

·       Assume that the public puts cash into the DD

·       A set percentage is placed into RR

·       The remainder becomes ER

·       ER are multiplied by the Money Multiplier (1/RRR)

·       The amount becomes new loans and is new money supply

·       The total change in the Money Supply is the amount of demand deposits plus the new loan amount

Scenario #3

·       The Fed buys bonds back from the member banks

·       The bank now has new ER

·       No money is needed to be placed into RR since this is not owed to the public

·       All of these ER are multiplied by the multiplier

·       This amount becomes new loans

This change is the change in the money supply  

Banks and the Creation of Money

Banks and the Creation of Money

Bank Balance Sheets

Key Concepts Notes for an AP Macro Class

       I.            How do banks “create” money? Banks “create” money by lending deposits.

    II.            Where do the loans come from? Loans come from deposits who take cash and place it into accounts of the bank.

 III.            How are the amounts of potential loans calculated? They are calculated by

Bank Liabilities (the right side of the T-Account Sheet):

#1= Demand deposits (DD) or checkable deposits (CD)

-cash deposits from the public

- are a liability because they belong to the depositors and can be withdraw by depositors

#2- owner’s equity stocks held by the public ownership of bank shares

Key concept for AP concerning liabilities:

-         If DD comes in from someone’s cash holdings, then that DD is already of the money supply

-         If the DD comes in from the purchase bonds (by the FED), then this creates new cash, and therefore creates new money supply  

Bank Assets (the left side of the T Account Sheet):

#1= Required reserves (RR)- percentages of demand deposits that must be held the vault, so that some depositors have access to their money (5%,10%,20%)

#2=Excess Reserves (ER) is the source of new loans

#3=Property

#4=Securities (bonds)- purchased by the bank or new bonds sold to the bank by the federal reserve; these bonds can be purchased from the bank, turned into cash, that immediately become available as ER.

#5=Loans

The Monetary Multiplier (also known as): Tax and spending multiplier

The formula is simple: 1 divided by the reserve requirement (ratio)= 1/RRR

Excess reserves are multiplied by the multiplier

Monetary Policy Problem II

https://youtu.be/ukGum9d7Wck