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Money Market & Multiplier July 14, 2010

Posted by petrarcanomics in Role of Government.
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Money Market Model

The money market  model is money supply and money demand curves and their effect on nominal interest rates and the quantity of money.

Money Multiplier

The money multiplier is a value that you multiply any change in the money supply by to calculate its effect on real national output.

money multiplier = 1 / the reserve requirement

For example, if the Fed took the expansionary policy action of purchasing a hundred billion dollars in bonds from member banks with a reserve requirement of twenty percent, then the total impact of this on the economy would be an increase of 500 billion dollars in real national income or output.

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Tools of Federal Reserve Board July 14, 2010

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Federal Reserve Board Chairman Ben Bernanke
Federal Reserve Board Chairman Ben Bernanke

Open market operations – the process of the Fed buying and selling bonds and securities from its member banks. Expansionary open market operations involves the Fed buying bonds and securities from its member banks to increase the amount of excess reserves member banks have to lend to the general public. Contractionary open market operations involves the Fed selling bonds and securities to member banks thereby decreasing the amount of excess reserves member banks have to loan out to the general public. Open-market operations directly affects the federal funds rate which is the interest rate member banks charge each other for short term and overnight loans. Expansionary open market operations lowers the federal funds rate whereas contractionary open market operations raises this key interest rate.

Discount rate – the interest rate that the Fed charges its member banks when member banks borrow money directly from the Fed. Contractionary monetary policy involves the Fed raising the discount rate, making it more expensive for its member banks to borrow money from the Fed. Expansionary use of the discount rate would involved the Fed lowering the discount rate thereby making it less expensive for its member banks to borrow from the Fed.

Reserve requirement – the percentage of a banks reserves that must be kept in reserve rather than its excess reserves which are those moneys that can be loaned out to the general public. For example, if a bank possessed overall reserves of one billion dollars and the reserve requirement was twenty percent, this member bank would have to hold two hundred billion dollars in reserve and would be able to loan out eight hundred billion dollars. Contractionary use of this tool would involved the Fed raising this reserve requirement thereby lowering the amount of excess reserves this member bank would have to loan out to the general public. Expansionary use of this tool would involved the fed lowering the reserve requirement to increase the amount of excess reserves this member bank could loan out.

Monetary Policy July 14, 2010

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Measures of Money

Medium of exchange means money must be accepted by people when they buy and sell goods and services. Standard of value or unit of account means money must be useful for quoting prices. Store of value means money must be durable so it can be kept for future use.

M1 includes paper currency and coin, demand deposits, and other checkable deposits and travelers checks. (Primarily used as a medium of exchange.)

M2 is everything included in M1 plus the amount held in savings and small time deposits, money market deposit accounts, and non-institutional money market mutual funds and certain other short-term money market assets. (M2 includes items that are used as a store of value.)

M3 includes everything in M2 plus a number of financial assets and instruments generally employed by large businesses and financial institutions. (M3 includes items that serve as a unit of account.)

Monetary Equation of Exchange

MV = PQ

  • M = the amount or stock of  money in circulation
  • V = the income velocity of circulation the average number of times a dollar is spent on final goods and services per time period (usually one year)
  • P = the average price level of final goods and services in GDP (the GDP deflator)
  • Q = real output which is the quantity of goods and services in GDP
Milton Friedman
Milton Friedman

Monetarists such as Milton Friedman believe that the rate of increase in the money supply has a big impact on inflation and growth in the economy.

Phillips Curve July 14, 2010

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The economist A.W. Phillips created the short-run Phillips curve to show what is often an inverse relationship that exists between the inflation rate on the vertical axis and the unemployment rate which is shown on the horizontal axis. When shifts of the aggregate demand curve take place the Phillips curve model holds true. An AD shift to the right causes inflation to increase and the unemployment rate to drop as output increases. An AD shift to the left causes the inflation rate to decrease and the unemployment rate to increase as output decreases.

When the short-run aggregate supply curve shifts, it will shift the entire Phillips curve. For example, if SRAS shifts to the right, inflation will decrease and the unemployment rate will decrease as output increases, shifting the entire Phillips curve inward toward the origin. If the SRAS curve shifts to the left, inflation will increase and the unemployment rate will increase simultaneously, causing the Phillips curve to shift outward away from the origin. The best example of this is the stagflationary period at the end of the 1970s and early 1980s. The cause of this stagflation was the large increase in the vital input resource of oil.

The Crowding Out Effect July 14, 2010

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When the government runs deficits meaning that its incoming revenues are less than total government spending, the government must borrow this money in the same loanable funds market used byt he private sector. This government borrowing drives up real interest rates which will reduce the amount of loanable funds borrowed by the private sector.

Monetary and Fiscal Policy Interaction July 14, 2010

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Monetary Policies

Expansionary Monetary Policy

  • reserve requirement decrease
  • discount rate decrease
  • buying bonds and securities from member banks

Contractionary Monetary Policy

  • increase reserve requirement
  • increase discount rate
  • selling bonds and securities to member banks

Fiscal Policies

Expansionary Fiscal Policy

  • cutting taxes
  • increase government spending

Contractionary Fiscal Policy

  • raising taxes
  • decrease government spending

John Maynard Keynes

Policy Combinations

Expansionary Monetary / Expansionary Fiscal

  • interest rates in-determinant
  • investment in-determinant
  • real GDP increase
  • price level increase
  • unemployment rate decrease

Contractionary Monetary / Contractionary Fiscal

  • interest rates in-determinant
  • investment in-determinant
  • real GDP decrease
  • price level decrease
  • unemployment rate increase

Contractionary Monetary / Expansionary Fiscal

  • interest rates increase
  • investment decrease
  • real GDP in-determinant
  • price level in-determinant
  • unemployment rate in-determinant
  • The greatest example of this combination is the early nineteen eighties when Reaganomics and Paul Volcker’s tight money policies were practiced at the same time.

Currency Exchange July 14, 2010

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Current Account and Capital Account

The current account and capital account measure the balance of payments between imports and exports. When incurring a current account deficit, the capital account must  balance this deficit off with a combination of capital inflows and official reserves to cause the balance of payments to revert back to zero.

For more on this, see Reffonomics: U.S. Balance of Payments.

Currency Exchange

When a citizen or company of one country wants to purchase goods in another country, it must make an exchange of their own currency for the currency of the other country. For example, if an American consumer wishes to purchase a Japanese automobile, said consumer must exchange dollars for yen. Currency exchange rates play a large role in affecting the affordability of goods traded across national boundaries for how exchange rates work.

For more info on this, see Reffonomics: Currency Exchange Interactive, Currency Exchange Multiple Choice Quiz, Exchange Rates

Strengths and Weaknesses of Currency

A strong currency:

  • will increase imports and decrease exports
  • will make foreign travel and the purchase of foreign assets much cheaper

A weak currency:

  • will decrease imports and increase exports
  • will make foreign travel and the purchase of foreign assets more expensive

Comparative Advantage & Barriers to Trade July 14, 2010

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Comparative Advantage Theory

David Ricardo’s comparative advantage theory states that even if two producers face the situation where one producer has the absolute advantage over the other producer in both products of perspective trade it is still useful for the superior producer to specialize in the product in which he has the lower opportunity cost of the two and trade for the other good. In doing so, he is specializing in the product in which he has a comparative advantage while the other producer specializes in the other good. The two producers then trade with each other at terms of trade that benefit both. In this way, both producers can achieve a level of production greater than they could just producing what they’re capable of producing on their own.

Barrier to Trade

Barriers to trade: Quotas, tariffs, and export subsidies

  • Quotas – an agreed upon limit on imports with a trading partner. Real world example: Early 1980s quota on Japanese cars coming into the United States
  • Tariffs – a tax on imported goods
  • Export subsidies – a choice by one country to assist its domestic industries by providing subsidies to them which make it difficult for its overseas competitors.

Effects of barriers to trade:

  • All three of the barriers to trade above will decrease the supply of goods available to consumers thus increasing the price of consumer goods.
  • The only winners when barriers to trade are increased are domestic producers in the affected industry.
  • Retaliatory barriers are often erected in response to the initial barriers to trade.
  • The overall effect of barriers to trade is a net decrease in the overall level of production in global markets. Yet strong domestic interests such as domestic producers and domestic trade unions have vested interests that cause them to advocate for barriers to trade.

Income Inequity July 14, 2010

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Another market failure is income inequity which is massive differences in incomes realized by different types of labor. Government tries to lessen income inequity through various tax systems.

  • Proportional tax system – A proportional tax taxes an equal percentage of income from all tax payers. For example, two tax payers of different income will each pay ten percent of their income in taxes. A person who earns $100,000 will pay $10,000 while a person who earns $50,000 will pay $5,000 in taxes.
  • Regressive tax system – A regressive tax will tax a higher percentage of income from the lower income earner while at the same time taxing a lower percentage of income of the higher income earner. For example, a person who earns $100,000 will pay $9,000 (9%) in taxes while the person who earns $50,000 pays $5,000 (10%) in taxes.
  • Progressive tax system – A progressive tax system taxes higher income earners at a higher percentage of their income than it does of lower income earners. For example, a person who earns $100,000 will pay $10,000 (10%) in taxes while the person who earns $50,000 pays $4,000 (8%) in taxes.

A progressive tax system such as the one used in the United States is a way of government lessening the income inequities produced by the market economy.

For  more information, see Reffonomics: Lorenz Curve and Gini Coefficient Lesson, Multiple Choice Questions.

Positive and Negative Externalities July 14, 2010

Posted by petrarcanomics in Role of Government.
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Positive externalities or external benefits or spillover benefits are goods and services that have beneficial effects for third parties who are not directly involved in the transaction for those goods. Classic examples of positive externalities are:

  • education
  • vaccine shots
  • home renovations
  • use of alternative energy

Markets tend to underproduce positive externalities because the benefits to third parties not involved in the transaction are  not typically realized and understood by those third parties who benefit from them. Government solution to this under production is to subsidize aether consumers, producers, or some amount of both to cause society to produce the most efficient and optimum level of production.

Negative externalities are goods and services that dump costs onto third parties that are not directly involved in the transaction. Classic examples of negative externalities are:

  • pollution
  • smoking
  • drinking and driving
  • failure to maintain a  home

Markets generally over produce negative externalities because direct costs to the producer are artificially low because the producer is getting away with dumping costs onto third parties not involved in the transaction. Government solves the market failure of negative externalities by internalizing the costs of production to producers through taxes, fines, and civil court settlements which drive the societal costs of production back onto the producers.

See Reffonomics for more on these topics: Negative Externality, Positive Externality, Externalities.