Macroeconomics Midterm 3: Application and Review Study Notes

Monetary Policy

Overview of Monetary Policy

Monetary policy refers to the actions undertaken by a nation's central bank to control the money supply and interest rates, with the aim of influencing macroeconomic outcomes such as inflation, unemployment, and economic growth.

• Central Bank: In the U.S., the Federal Reserve (Fed) is responsible for monetary policy.

• Policy Tools: The Fed uses tools such as open market operations, the discount rate, and reserve requirements.

• Goals: Price stability, maximum employment, and moderate long-term interest rates.

Interest Rate Changes and Economic Impact

Lowering interest rates is a common expansionary monetary policy tool used to stimulate economic activity.

• Lower Interest Rates: Encourage borrowing and investment, leading to higher aggregate demand.

• Expected Outcomes:

  • Higher inflation (due to increased spending)

  • Higher GDP growth (due to increased investment and consumption)

Example: If the Fed lowers interest rates, we expect higher inflation and higher GDP growth.

Aggregate Demand and Aggregate Supply Model

The AD-AS model is used to illustrate the effects of monetary policy on the economy.

• Aggregate Demand (AD): Total demand for goods and services in the economy.

• Aggregate Supply (AS): Total supply of goods and services.

Graph: The intersection of AD and AS determines the equilibrium price level and GDP.

Money and Banking

Bank Balance Sheets and Reserve Requirements

Banks must maintain a certain percentage of deposits as reserves. This is known as the reserve requirement.

• Reserve Ratio: The fraction of deposits that banks are required to keep in reserve.

• Example: If Smalltown Bank has $4900 in deposits and a 10% reserve requirement, it must hold $490 in reserves.

Bank Response to Deposit Withdrawals

• If deposits fall by $100, both assets and liabilities decrease by $100.

• If reserves fall below the required level, the bank must borrow funds to restore compliance.

Assets (A)	Liabilities (L)	Equity (E)
$500 in reserves $5000 in loans	$5000 in deposits	$500 in equity
$400 in reserves $5000 in loans + $90 in reserves (borrowed)	$4900 in deposits + $90 in debt	$500 in equity

Interbank Borrowing and Interest Rates

• Fed Funds Rate: The interest rate at which banks lend reserves to each other overnight.

• Discount Rate: The interest rate the Fed charges banks for short-term loans.

• Example: Smalltown Bank borrows $90 overnight from Big City Bank at the Fed Funds Rate.

Federal Funds Rate

Targeting the Fed Funds Rate

The Federal Reserve sets a target for the federal funds rate to influence economic activity.

• If the market rate is below the target, the Fed can sell bonds to reduce reserves and increase the rate.

• If the market rate is above the target, the Fed can buy bonds to increase reserves and decrease the rate.

Graphical Representation

The relationship between the quantity of reserves and the federal funds rate is downward sloping.

• As the Fed sells bonds, reserves decrease, and the rate rises.

• As the Fed buys bonds, reserves increase, and the rate falls.

Fiscal Policy

Overview of Fiscal Policy

Fiscal policy involves government decisions on taxation and spending to influence the economy.

• Expansionary Fiscal Policy: Increasing government spending or decreasing taxes to stimulate economic growth.

• Contractionary Fiscal Policy: Decreasing government spending or increasing taxes to slow economic growth.

Automatic Stabilizers

Automatic stabilizers are mechanisms that counteract economic fluctuations without additional government action.

• Progressive Income Tax: Tax revenues fall during recessions as incomes decline, helping stabilize the economy.

• Example: Lower tax revenues during a recession serve as an automatic stabilizer.

Fiscal Policy and the AD-AS Model

• A decrease in taxes shifts the aggregate demand curve to the right (from $AD_1$ to $AD_2$), increasing real GDP and the price level.

International Finance

Foreign Exchange Markets

International finance examines the flow of capital and currency between countries.

• U.S. Exports: Create a supply of foreign currencies and a demand for U.S. dollars in foreign exchange markets.

• Currency Demand and Supply:

  • U.S. exporters are suppliers of dollars.

  • Foreign buyers are demanders of dollars.

Action	Effect on Currency Markets
U.S. exports	Supply of foreign currency, demand for U.S. dollars
U.S. imports	Demand for foreign currency, supply of U.S. dollars

Exchange Rate Markets

• Exchange Rate: The price of one currency in terms of another.

• Supply and Demand: The exchange rate is determined by the intersection of currency supply and demand.

• Decrease in Demand: If demand for pesos decreases, the price of pesos in dollars falls.

Graphical Representation

The exchange rate market can be illustrated with supply and demand curves for a currency.

• Decrease in demand shifts the demand curve left, lowering the exchange rate.

International Trade

Overview of International Trade

International trade involves the exchange of goods and services across national borders, affecting domestic production and consumption.

• Benefits: Access to a wider variety of goods, increased efficiency, and economic growth.

• Example: Senegal may shift from importing strawberries to producing them domestically, illustrating the impact of trade and development.

Tariffs and Trade Policy

• Tariffs: Taxes on imported goods that can affect currency demand and exchange rates.

• Example: Tariffs on Mexican goods may reduce demand for pesos, causing the peso to depreciate relative to the dollar.

Competing Views in Macroeconomic Theory

Overview

Macroeconomic theory includes various schools of thought regarding the role of government, monetary policy, and fiscal policy in managing the economy.

• Keynesian View: Advocates for active government intervention through fiscal and monetary policy.

• Classical View: Emphasizes self-regulating markets and limited government intervention.

• Monetarist View: Focuses on the importance of controlling the money supply.

Additional info: These views influence policy debates and the design of economic stabilization measures.