Economic Principles: Market Dynamics and Policy Effects

Posted on Mar 9, 2025 in Economics

Key Economic Concepts and Applications

Market Dynamics

If the price of good B rises, the supply curve for good A (a production substitute) shifts left.

If the price of good B falls, the demand for good A (a demand-side complement) decreases.

If the price of sugar (a supply-side substitute) increases, the most reasonable new equilibrium for good A would be a higher price (supply curve shifts left) and quantity demanded (demand curve shifts right).

If the price of eggs (a demand-side complement with good A) rises, the new equilibrium will be a lower price and quantity.

If a price ceiling is introduced at 220 (equilibrium at 200), the number bought/sold stays at equilibrium. If lowered to 180, the equilibrium is lower.

Price Elasticity

Greater price elasticity: A higher number of substitutes available and a more narrowly-defined market.

Good K price elasticity of demand: |-3.2| > 1, so elastic demand. A 1% price increase leads to a 3.2% decrease in quantity demanded (inverse relationship, so it’s a normal good – demand increases when income rises).

When NS Shack lowered coffee prices from $4 to $2, sales went from 700 to 1000. Price elasticity of demand = -1.235. If the price elasticity of demand for carrots is -2, and prices rise by 18%, then the quantity demanded will likely decrease by 36%, and the total revenue impact will be a decrease of 6%. Given price elasticity of socks is -0.6 and tees is -0.7: socks and tees have inelastic demand. If a firm wanted to increase total revenue, it would increase the price of both socks and tees. If the price of tees increases by 25%, total revenue will increase by 4.2%.

Inventory and Equilibrium

Inventory changes are a real-world mechanism that causes firms to adjust prices to the equilibrium price.

Exchange Rates

The Euro depreciated from 2010-2020. In October 2004: 1.25 USD = 0.8 euro; 1.25 euro = 1 USD.

According to the Fed, the exchange rate was 1 USD to 5 yen. If a toaster sold for 500 yen at the time, the USD price was $100. If next year the rate is 1 USD to 2 yen, the yen appreciated over this year.

Kiki can exchange 1 USD to 5 yen; 0.5 euros with 1 USD. Therefore, 1 yen is equal to 0.1 euro (1/5 x 0.5/1 = 0.1).

Macroeconomic Concepts

Many are predicting a fall in stock prices. If US household MPC=0.9, a decrease in consumption by 100M will decrease RGDP/TS by 1000M.

Interest rates are affected by Fed actions. If household MPC=0.6, a decrease in consumption and investment by 100B will decrease RDGP/TS by 500B, shifting AD left by 500B.

In Figure 2, starting at A, an increase in the price level will result in a move to D.

NVD stock price went from 800 to 900+/share this week. Assuming constant shares outstanding, the earnings (profits) of the company remained constant.

Circular flow diagram: Economy’s money flows from firms to factor markets to households.

Bull market: Increasing average stock prices lead to an increase in the USD value. As the USD value rises, US exports decrease (less attractive to other countries).

Comparative Advantage

Kikiland: 250 fries (opportunity cost of 1 fry/day = 0.8 nuggets); 200 nuggets (opportunity cost of 1 nugget=1.25 fries). Kikiland trades with Guacland. Kikiland has a comparative advantage in fry production because the opportunity cost of producing fries is lower there. A logical term of trade: 1 fry = 0.9 nuggets.

Real vs. Nominal Values

Macroland: Value for A (real value of weekly income constant 2024$s) is approximately 15,625; B is approximately 11,125.

If RGDP is 150B, Y1 TS=150B. Y2 equilibrium RGDP & TS: 600B (multiplier=3).

Demand and Supply

Demand and Supply curves for bagels sold in NJ: Qd=50-1.15x; Qs=-10+3.46x. Equilibrium price: $13. If bagel supply doubles at any given price, the new equilibrium price is 13/2 = $6.67. With widely shared health information, the most likely equations are: Qd intercept rises: 150-1.15x and Qs has no effect.

If the BMW buyer population increases, BMW demand goes up, leading to an initial BMW shortage until the price goes up.

Interest Rates and Economic Indicators

If interest rates rise: Stock prices (firm value) fall; move along the SRAS to lower GDP and shift AD left (no effect on C or I functions vertically).

CPI: Comes out monthly.

Investment Spending Category: Physical capital spending (new machines, tools, factories, new homes); NOT stocks/bonds commonly bought by households/firms.

If investment increases by 200B, total output (eventually) increases by $600B because of the Multiplier (SS multiplier = 7 in Figure 1).

MPC and Economic Policy

If MPC changes from 0.8 to 0.6: The consumption function rotates clockwise.

If Congress lowers taxes by 40B and MPC is 0.7: AD shifts right by 93B. If housing prices rise and MPC is 0.8: Consumption increases by 20B and the AD curve shifts right by 100B. If Congress increases transfer payments by 500B and MPC is 0.95: RGDP/TS equilibrium increases by 9500B and AD shifts right. If average prices fall and MPC is 0.8: Consumption increases by +50, RGDP/TS equilibrium increases by 250B, and the AD curve shifts right by 250B.

TS1-TS2: Increasing Transfer Payments. If TS were greater than RGDP, inventories would be falling.

Physical Capital

Physical capital: Tangible assets used to produce goods and services.

Disposable Income and Consumption

An increase in disposable income: Movement along the consumption function up and to the right. If Yd=50B, MPC=0.9, T=50B, Tr=100B: C=$365B.

Economic Data

Table 1 Ecoland: A(4230B), E(2.7%), D(6.9%), B(3645). LVland: 2016NIP(305,000), TEP(110,000), LFPR(39.2%).

1949: Burgers cost 10 cents & CPI was 23.8. 2023: CPI is 312.3, burger: $1.31 (actually $1.39, price risen about the same rate as average prices in the economy). Compound annual inflation: 3.5%. Today coffee is $1.55; 1921 (CPI 17.9): 9 cents.

Ricardian Trade

Ricardian trade: Two trading partners with different opportunity costs (comparative advantage) have one or more terms of trade where both parties are made at least as well off by specializing and trading. This increases consumption possibilities (standard of living). It is not a zero-sum game (one gains at the other’s expense) or division of labor (workers focus on one task).

Opportunity Cost: With a $10 budget, the opportunity cost of 1 beer ($3) is the amount of wine ($5) forgone to buy 1 additional beer = 3/5 = 0.6 glass of wine.

The Federal Reserve (Fed)

The Fed: “The bankers’ bank;” founded in 1913 by Congress as the US Central Bank.

Only the Fed can write a check/payment drawn on themselves, but banks have the most control over the money supply. In a fractional reserve system, most of the money supply increase comes from banks creating money by issuing new loans.

There are 12 Fed banks (San Francisco is the only one on the West Coast) = corporation; member banks = stockholders.

Fed funds rate: The interest rate banks charge each other for overnight loans (target 5.25%).

Three monetary policy instruments: Open Market Operations (OMO) (purchase/sales), Required Reserve Ratio (RRR), Discount Rate (DR) (direct control).

Three fiscal policy instruments: Government purchases, Transfer payments, Taxes.

Spending on unemployment benefits = Transfer Payments, not Government purchases.

Currently, the US is on 100% fiat money (cannot be converted into commodity money; has no inherent value, indirect link to implicit value).

1946-1971: Full-bodied fiat (backed by units of equal value held in the issuer’s vault, gold standard).

Demand for US dollars comes from: Imports (internal) and exports (economic conditions abroad).

• The 12 Federal Reserve Banks: Boston, New York, Philadelphia, Richmond, Atlanta, Cleveland, Chicago, St. Louis, Kansas City, Minneapolis, Dallas.
  • Washington, DC: The Fed’s Board of Governors is located here.
    • Seven Board of Governors (BOGs) run the Fed.
    • The chairman is appointed from the BOG by the US President for a 4-year term. (Jerome Powell: joined BOG in 2012 filling an unexpired term, then his own started in 2014; became chair in Dec 2017 & his term goes through 2028).
      • The BOG chair is also the FOMC chair.
    • BOGs serve 14-year terms, appointed by the President and approved by the Senate (can serve an unexpired portion of someone else’s term too).
  • Private/commercial banks: More like clients; the most important economic role is to accept funds from depositors and lend to borrowers.
• FOMC: Group within the Fed that meets 8 times/year in DC; decisions on open market operations largely affect money supply and interest rates.
  • 12 voting members: 7 BOGs + NY Fed Reserve Bank President + 4/11 of the other district bank presidents.

• Fed’s Purpose:
  • Conduct the nation’s monetary policy.
  • Supervise/regulate banking institutions and protect consumers’ credit rights.
  • Maintain the stability of the financial system (original 1913 mandate).
  • Provide certain financial services to the US government, the public, financial institutions (including serving as a clearinghouse for checks), and foreign official institutions.

• Fed Dual Mandate: Maximum Employment and Stable Prices (MESP):
  • Federal Reserve Act: Mandates the Fed conduct monetary policy to “promote efficiently the goals of maximum employment, stable prices, and moderate long-term interest rates.”
  • Monetary policy targets: Variables the Fed directly affects to change RGDP, price level, and employment.
    • Two main targets: money supply and interest rate (used most).
  • How Fed monetary policy affects the state of the economy:
    • At least in the short run: by affecting interest rates and aggregate demand.
    • Lower interest rates lead to increased consumption and investment (so increased total spending and aggregate demand shifts to the right), leading to an increase in the equilibrium price level, RGDP, and a decrease in the unemployment rate.
      • Potentially impact aggregate supply through the cost of capital being affected, but this takes longer and is harder to measure.
• Traditional monetary policy instruments:
  • Open market operations: (**OMO) Most common monetary policy method; the Fed buys (to increase the money supply) or sells (to decrease the money supply) treasury securities to change the money supply (& hence interest rates).
    • OMOs: Affect excess reserves of member banks, hence influencing the demand for reserves.
      • Example: Buying bonds means increasing excess bank reserves, reducing the likelihood of banks borrowing from other banks to cover their deposits (inter-bank loans), driving down the interest rates they charge each other.
    • Three reasons the Fed traditionally conducts monetary policy through OMOs: Because the Fed initiates open market operations, it completely controls the volume; OMOs are easily reversible; the Fed can implement its operations quickly without delay.
    • The Fed increases the money supply mainly by buying T-secs; to reduce it, it sells.
  • Required reserve ratio: (RRR) The Fed can lower (to increase the money supply) or raise (to decrease the money supply) the RRR to change the money supply (& hence interest rates).
  • Discount rate: (DR) The rate the Fed charges member banks for overnight loans.
    • The Fed can lower (to increase the money supply) or raise (to decrease the money supply) the discount rate to change the money supply (& hence interest rates).
    • DR changes: Each commercial bank has to ensure it has enough reserves to cover their deposits (make their RRR); however, this isn’t an exact thing, and they want to get close to maximizing their loans as possible without going over.
      • When they go over, they can borrow reserves from other banks (Fed Funds rate) or the Fed (Discount rate).
      • If the Fed lowers this rate it charges member banks for overnight loans to cover their reserves, making it less costly to “go over,” & banks get closer to the maximum allowable amount lent out, which will increase the money supply as banks increase marginal loans as it becomes less costly to borrow.
• 2008-on New monetary policy instruments: Interest on reserve balances, overnight reverse repurchase agreement facility, term deposit facility, central bank liquidity swaps, foreign and international monetary authorities (FIMA) repo facility, central bank liquidity swaps, expired policy tools, quantitative easing (QE).
  • QE: The Fed’s purchasing of long-term bonds to increase liquidity at the long end of the bond market to lower long-term interest rates (not just short-term rates as they normally do with more typical OMOs).
• Real interest rate: Subtracting inflation from the nominal interest rate.
• How monetary policy affects interest rates:
  • Directly (in the bond market) when the Fed purchases many bonds, this can drive up the price of bonds, reducing their yield (interest rates).
  • Indirectly: (in the banking system) when the Fed purchases bonds, it increases the commercial banks’ ability to loan, & banks lower interest rates to induce more customers to borrow.
  • March 24 rates: consumer loan/credit card (24.66), bank prime loan (8.5), discount rate (window borrowing, 5.5), federal funds rate (5.33).

• (Debt-financed) Stimulus out of a recession and capital expenditures for projects (infrastructure that will be paid off by those who benefit from them).
• But: Spending beyond your means year after year to finance high levels of current consumption is not a good long-run strategy for anyone.

US economy: Point A (F on the study guide); high capital goods, low unemployment rate = Point B (make A on the study guide).

Move from E to PPC to C: Increased economic efficiency; A point above B&C is feasible if both increase in the amount of capital and technology in the economy.

Decrease in the price of apples leads to a decreased apple quantity supplied and demand for bananas (a demand-side substitute).

PPF shifts right: Increase in resources/technology/AI.

Most efficient feasible points = along the PPF curve line.

Autarkic economy: No trade; largest expected increase in PPF at A through.

Examples

1. Unemployment rate is 3%, fiscal policy: Increase taxes, decrease transfer payments/government purchases.
2. Consumption increases by 100B, Investment falls by 200B, Government purchases increase by 100B, Net Exports increase by 200B, Total Spending net impact: 100-100+100+200=+300B (Increase in Total Spending vertically).
3. MPC is 0.60 and taxes increase by 200B, Change in Consumption: -0.8(0)+0.8(-50B) = -$40B fall in consumption spending.
4. MPC is 0.8 and taxes decrease by 100B, Government purchases increase by 100B, Total Spending net impact: b=0.8(-100B), C=-0.8(-100B)+0.8(0)=+80B (Increase in Consumption by $80B) =180B.
5. If MPC rises from 0.7 to 0.8, what happens to the graph of the consumption function: The slope becomes steeper (rotate counterclockwise), an increase in MPC increases consumption and total spending.
6. MPC = 160/200 = 0.8, then multiplier = 1 / (1-0.8) = 5

7 & 8.

• Example: At a price level of P = 120 (AS = 9000) > (AD = 4000).

The amount that suppliers are willing and able to sell exceeds the amount buyers are willing and able to buy at that price level, leading to rising inventories (surplus). Firms will decrease their output and lower prices until at: P = 108 & AS = AD = $7000B. Firms are operating at a normal level of capacity; everyone wanting a job has one (except structurally and frictionally unemployed).

• Example: At a price level of P = 100 (AD = 9000) > (AS = 6500).

The amount that buyers are willing and able to buy exceeds what sellers are willing and able to sell at that level of prices, leading to falling inventories (a shortage). Firms will increase their output and raise prices until at: P = 108, AS = AD = $7000B.

9 & 10. Multiplier effect on AD & AS:

:

• • • When the Fed increases the money supply, the ST interest rate must fall until it reaches a level where HHs/firms are wiling to hold additional money
      • Fed increases money supply  HHs/firms hold more money than they want relative to other financial assets (so will buy treasury bills & make deposits in interest-paying bank accounts)  supply curve shift to the right & equilibrium interest rate will fall

• • • When Fed decreases money supply, HHs/firms initially will hold less money than they want  sell Treasury bills and withdraw money from interest-paying bank accounts  increased interest rates

• • • Show in a T-account you deposit $1000 in currency into your BoA account:

  • Depositing cash into banks: RRR = 0.50 and Bank of LV has $12,000 in deposits. What would happen if Rick deposited his $1000 in cash into his demand deposit account at the bank?
    • Deposits increase by 1000 but reserves also increase by 1000. The bank doesn’t need to keep all the deposits in the form of reserves. The bank of LV could lend out:
      • Since RRR = RR/DD  (0.50)($13,000) = $6500
      • How much of TR are ER: ER = TR – RR = $7000 – 6500 = +$500
      • What is the MPINL: = (1/RRR)(initial ER increase) = (1/0.5)(+$500) = +$1000
      • Say the bank of LV makes a loan to Susan to buy a car from USD. Demonstrate what happens on the T accounts.
    • What happens to the MS?
      • From Rick’s depositing $1000 to create a 1000 increase in DDs: nothing, since cash outside banks declines by $1000 but DDs increase by $1000
      • From banks providing a new loan: $1000 increase in DDs occurred as a result of a new loan so M1 increases by $1000
• Banks changing ERs: if banking system had initial ERs of $160 and RRR = 0.20, then how much in new loans could banks create? What would happen to the MS?
  • MPINL = 1/0.2 x (+160) = +$800
  • Implies money supply would increase by $800 since these new loans would increase DDs by $800 and DDs are a part of M1
• If RRR = 0.10 and initial ER = $300
  • MPINL = 1/0.10 x (+300) = +$3000 MS increase since new loans would increase DDs by $3000
• Effect of Fed lowering RRR: what happens if Fed drops RRR from 0.50 to 0.30.
  • RR = 0.3($12,000) = $3600
  • ER = $6000-$3600 = $2400
  • MPINL = (1/0.3)(+$2400) = +$8000
  • Say the bank of LV makes a $8000 loan to Susan for her to buy Rick’s boat. Demonstrate what happens on T accounts. What happens to the MS?
    • Notice M1 will increase by $8000 since the loan is provided by making a DD for that amount. Notice the connection between banks making new loans & the MS
  • Now say Fed lowers the RRR even further from 0.3 to 0.2. By how much could the bank of LV increase its loan portfolio?
    • How much do they need to have in the form of RR? (realize DDs have now climbed to $20,000)
      • RR = (0.2)($20,000) = $4000
    • How much of TR are ER: ER = $6000-$4000 = $2000
    • MPINL: = (1/0.20)(+$2000) = +$10,000
  • Say the bank of LV makes a $10,000 loan to Conroy for him to buy Rick’s car.
  • What happens to the MS?
    • M1 will increase by $10,000 since the loan is provided by making a DD for that amount. Notice again the connection between banks’ making new loans and the MS
    • Why does the bank keep ER at 0? Because banks are the ones able to “create money” through the issuance of new loans – a fractional reserve banking system

• 

• RR = 0.25 & DD = $20,000: how much is bank required to have on hand in the form of reserves? RR = 5,000 (0.25 x 20,000)

• • • • If bank has $2000 in vault cash & $10,000 in reserves at Fed, are they compliant: yes
        • ER = $12,000-$5000 = 7000
      • What is the MPINL bank could make: 1/0.25 x (7000) = $28,000
      • What would be the ultimate impact on the MS: M1 increase by a maximum of $28,000 because DDs increased by $28,000
    • Bank’s ER = $1000 & RRR = 0.20: assuming it doesn’t wish to hold any ER, what is the MPINL?
      • 1/0.2 x 1000 = $5000
      • Ultimate impact on MS: increase by. $5000 because DDs increased by $5000
      • If asking about the money supply, you think: what is in that?
        • Currency & coin outside of banks
        • Demand Deposits – important to know banks created money because they loan money in the form of DDs
    • Assume banks must be compliant with RRR = 0.20 & hold no positive ERs; assume banks make any new loans to individuals not listed here:

      • Ricardo finds $100 bill (event1), deposits into checking acct (event 2): demonstrate changes in T-accounts:

        • Change in RR = 0.2(100) = $20
        • Change in ER = 100-20 = 80
        • Bank MPINL = 1/0.2 x 100 = $400
        • Event 1
          • Currency + coin outside banks: -100
          • DDs: +100
          • Total impact: $0 to MS
        • Event 2:
          • Currency & coin: nothing
          • DDs: +400
          • Total impact: +$400 on MS
        • Ultimate impact on MS: +$900 (R1: C&C outside banks -100, DDs +100; R2: C&C outside banks +0, DDs +400)
    •  

      • Rose withdraws $1000 from checking acct: demonstrate changes in T-accounts:

        • Round 1:
          • C+C: +$1000
          • DDs: -$1000
          • Total impact on MS: $0
        • Round 2:
          • Change in RR = RRR(change in DD) = 0.2(-1000) = -$200
          • Change in ER = change in TR – change in RR =

-1000 + 200 = -$800

MPINL = 1/0.2 x (-800) = -$4000

• • • • • • C+C: 0
          • DDs: -$4000
          • Total net impact on MS: -$4000
        • Ultimate impact on MS: -$4000 (R1: C&C outside banks +1000, DDs -1000; R2: C&C +0, DDs -4000)
    • 
    • Point C: inflationary gap
      • Fiscal policy: increase T, decrease Tr & G  decreased C  decreased TS  lower equil. of RGDP & TS by a multiplier  lower AD (shift left)
      • Monetary policy: open market sale, increase RRR & DR  lower ER  less loans  less DDs  lower MS  increased r (interest rates)  decreased C & I spending  lower TS  lower RGDP & TS equil. by a multiplier  lower AD (shift left)
    • Point A: recessionary gap
      • Fiscal policy: decrease T (MPC), increase G (higher TS) & Tr (MPC)  increased C  greater TS  higher RGDP/TS equil. by multiplier  increased AD (shift right)
      • Monetary policy: open market purchase, lower RRR, & lower DR (DR causes increased loans) increase ER  more loans  more DDs  greater MS  lower r  increased C & I spending  greater TS  higher RGDP/TS equil. by multiplier  increased AD (shift right)
    • Point B: steady state full employment equilibrium
      • Policy is to maintain status quo (don’t make any changes to MS or budget unless AD is swinging steadily one way or the other)
    • Examples
      • Open Market purchase (money creation), say Fed buys a T-sec on the OMO for $1000; what happens to MS? (assume RRR = 0.20, so bank of LV begins compliant) ~ T-Account template 2
        • When Fed buys T-sec, bank of LV’s reserves increase by $1000 and their deposits increase by the same amount:
          • Round 1: M1 increases by $1000, now bank of LV checks its reserve positions ot see if they can lend out anymore
            • How much does bank of LV need to have in form of RR:
              • RR = RRR(DD)  (0.20)($31,000) = $6200
            • how much of TR are ER
              • ER = TR – RR  $7000-6200 = +$800
            • What is max amount bank can make in form of new loans: max possible increase in new loans = (1/RRR)(initial increase in ER)  (1/0.20)(+$800) = +$4000
          • Say bank of LV makes $4000 loan to USD for campus beautification projects; demonstrate what happens on T accounts
            • What happens to MS: M1 will increase by $4000 since loan is provided by making a demand deposit for that account
          • Round 2: M1 increases by $4000
            • Total increase in money supply is $5000
            • (using new T acct template 2 now)
      • Money contraction (destruction)
        • Fed sells $1000 on the open market to Richard
        • When Fed sells T-sec to Richard for $1000 on open market, Richard gives Fed a check drawn on B of LV for $1000; the Fed deficits the B of LV $1000; then B of LV makes twin entry and debits Richard by $1000
          • Round 1: money supply falls by $1000 since DDs fell by $1000
            • But reserves at bank also fell by $1000 so now bank must review whether it has enough reserves
            • Step 1: how much does bank of LV need to have in form of RR:
              • Notice DDs have fallen to $11,000 and TR fallen to $5000
              • RR = RRR(DD)  (0.20)($29,000) = $5800
            • Step 2: how much of TR are ER:
              • ER = TR-RR  $5000-$5800 = -=$800
            • Step 3: what is max amount bank can make in new loans
              • MPINL: (1/RRR)(initial increase in ER)  (1/0.20)(-$800) = -$4000
            • Say bank of LV calls in USD’s loan for $4000; USD pays them with a check, so their DDs fall by $4000 and outstanding loans also fall by $4000
            • Step 4: what happens to MS
              • M1 will decrease by $4000 since calling in the loan means reducing DDs by $4000
          • Round 2: M1 falls by $4000 since DDs fell by $4000
            • Total of round 1 & 2: M1 falls by $5000
        • In sum: notice that if Fed wishes to increase MS, they purchase a T-sec; if they wish to decrease MS, they sell a T-Sec; they must be careful, though since the money multiplier implies that the MS will change by more than the initial purchase/sale as long as RRR

    Exam review questions:

    • Given the recent increases in US immigration, we would expect this trend to result in shifting the aggregate supply curve to the right in the coming years as the number of workers increases
      • Increase in labor  increase in AS (shift right)
      • With more workers, the economy could potentially supply more goods/service, which is why AS shifts to the right
    • A decrease in the cost of energy prices (a major input to production and delivery of goods) would shift the AS curve to the right
      • Decrease in input costs shifts AS curve: lower cost of inputs at any givne price level, means the amount that sellers would be willing and able to supply would go up  shift AS to the right
    • Supply chain: the chain of inputs that firms are purchasing to produce their output
      • As a result of the pandemic, all the supply chains (which are synced up together and linked), when one of them goes down the whole system breaks down
      • Supply chain breaks down  firms had to pay up to find inputs into their production process to try to fill the gaps
      • The suppliers also knew these disruptions were occurring and started raising their prices
      • Cost of inputs  up  shift AS to the left  stagflation (have a stagnating economy; RGDP falling in this case & prices going up  pressure is heading current economy into potential stagflation by shifting AS to the left)
    • You want an economy where AS shifts to the right because average price levels are falling or because labor or capital or natural resources are rising in terms of their quantity (NOT in terms of their price), or technology is improving, allowing firms to be able to produce more with less (as we are seeing with AI: will be a driver like the 90s computer market and Internet drove a lot of AS shift, low inflation, and massive increase in RGDP)
      • Similar thing happening in post-Great Recession years leading up to the Pandemic
      • AI: expect technological increase to have this effect
      • But we still have some disruption, China (major supplier) just opened up a little over a year ago, so some of the supply chain is still hung up, but the increase in tech will help to move AS to the right and put downward pressure on the average level of prices and shifting out AS & RGDP in the long-run
      • In the short run: stickiness on costs
    • Inflation reduction act: last one under Biden; almost fully funded by increases in taxes
    • Soft landing = about moving into a recession; if at equilibrium of inflationary gap, the Fed is going to increase interest rates & AD is going to shift back to the left, moving equil. towards point B
      • Soft landing means it happens gradually & slowly
      • Landing = likely will see RGDP falling
    • Hard landing: quick shift back in AD; if interest rate really did discourage consumption and investment spending in a major way right away
    • Right now, there is no evidence of any landing at all, just staying at point C
    • Average growth of the economy is 3.0% (+/- 0.2%)
    • Supply-side economic policies: attractive in that they result in higher growth of the economy & lower prices (ie inflation) by shifting the AS curve to the right
    • • Became popular in the 1980s when the US/world was experiencing very high inflation
      • Today, there is still an increase in the average level of prices (inflation), but the rate of increase is declining
      • Win-win because there doesn’t seem to be any trade-off (lower prices and more output)
      • Pros: not inflationary (in theory); good long-term strategy
      • Cons: these policies take effect slowly; magnitude hard to measure/increase budget deficits; major demand-side effects as a byproduct
    • If need to have a quick impact on the macroeconomy, what do we do:
      • Increase Transfer payments
        • Best thing in a pinch  seen in the pandemic (they focused on people earning less than 175,000)
        • Lower-income people have higher MPCs, so government knows giving them checks they will spend more quickly
      • Could reduce taxes, but there is a lag effect with this
      • Increase Government purchases, but it takes a while to see effect with this as well

    Supply side policy examples:

    • Reduction in capital gains tax
    • Reduction in personal income tax
    • Cut taxes on labor-hours (wages & salaries)
    • Reduction in dividends tax
      • These will reduce the cost in inputs ^
    • Increase in R&D spending by the government promoting R&D
      • Esp. in general technology because will  increased technology & shift AS to the right
    • A decrease in technology would shift the AS curve to the left
    • Higher value of the USD = means our dollar is strong
      • Buying imports in the US  are going to appear cheaper to use & bring about an increase in import spending
      • Our goods will appear more expensive to foreigners (as the USD appears stronger than other currencies)  decreased exports from the US  NX becomes more negative
    • If the Fed increases interest rates:
      • bond yields would increase (Fed is going to sell bonds, meaning the supply of bonds is going to increase  the price of bonds falls & there is an inverse relationship between the price of bonds and their implied yields or interest rates)
      • increasing the value of the dollar: if interest rates go up, investments and particular bonds or interest denominated assets become more attractive  demand for USD goes up  increase the value of the USD
        • this refers to the foreign exchange markets
      • so net export spending would become even more negative
    • even though there are 3 tools of monetary policy, the main way monetary policy is carried out these days in the US is through OPEN MARKET OPERATIONS
    • if the Fed buys bonds, this decreases the corresponding bond yields (interest rates) & would thus decrease the demand for USD  decreasing the value of the dollar
      • because: increase in the price of bonds  decrease in interest rates
    • at an inflationary gap, an appropriate fiscal policy response would be to: increase T (taxes), decrease Tr (transfer payments) or decrease G (government purchases)
    • the tools of fiscal policymakers include the use of: taxes (T), transfer payments (Tr) and government purchases (G) to steer AD in some direction
    • in a recessionary gap, an appropriate monetary policy would be to:
      • buy treasury securities
      • lower the required reserve ratio
      • lower the discount rate (interest rate the Fed charges its member banks, the rate the Fed actually does control)
• The purchase of a treasury security by the Fed on the open market, will increase the excess reserve of banks, and hence, decrease interest rates
• When the FOMC says it is going to raise the target Federal Funds rate, it is able to do this because the Fed Funds rate is the interest rate
  • Fed funds rate is a target that they can influence, but not directly change because at the end of the day it’s a free market rate that banks charge each other based on demand and supply forces on the market
  • Has done it 12x by 5.25 % points since March of 2022
• The yield curve: as time to maturity increases, interest rates generally increase
  • Flipped/inverted yield curve: what we have been experiencing; means that short-term bond yields are higher than long-term bond yields
• Fiscal policy measures: have to do with the President
  • Raise/lower taxes
  • Raise/lower transfer payments & government purchases
• Monetary policy: has to do with the Federal Reserve
  • President only power here is appointing the chair
• If UR has fallen to 3.5% and CPI, C spending, & I spending are rising, what would you advice the Fed BOG’s chairman Jerome Powell to do in monetary policy:
  • Economy is in an inflationary gap
  • You want to discourage aggregate demand & shift it back slowly to the left to the full-employment level of output
  • So raise interest rates: because this lowers C, I spending which will lower TS & decrease equilibrium by a multiplier and decrease AD (shifting it to the left)
  • What would be the most appropriate way to administer your policy recommendation?
    • Decrease the money supply by selling treasury securities (and this leads to higher interest rates)
    • Best way: sell treasury securities because then excess reserves of banks are going to fall  banks in tough situation where they must raise interest rates because banks want to discourage people borrowing from them
    • When Fed sells directly in the bond market, this increases the supply of bonds & drop the price of bonds & interest rates go up
• How would your recommendation change if the report said the UR was 7% and the CPI was falling?
  • This is a recessionary gap: in AD/AS recessionary gap equilibrium point
  • Would now recommend: increase the money supply by buying treasury securities (reserves of banks go up, they make more loans, and money supply is increasing)
• Immediately following the Bretton Woods (1944) conference, the:
  • USD was directly linked to gold
  • Western currencies were linked to the US currency (which was linked to gold)
• • **the banking system caused an increase to the money supply by making new loans (because when they made those new loans demand deposits went up by that amount)
  So the banking system increased the money supply as a result of the Federal Reserve’s initial actions (the Fed lowered the RRR)

RGDP + TS (AE) equil = TS crosses 45deg line

What are the policies that coincide with Recessionary and Rising inflationary problems?

demand-side policies: direct/take effect quickly; poss inflationary (AD ^ can put upward pressure on prices) & contribute significantly to budget deficits

C, I, G, NX –> (AE aka TS)/RGDP equil. (by multiplier x initial change in TS) –> changes in AD:

AD slopes down bc ^ prices decrease real purchasing power of assets ppl hold & ^ interest rates –> vHH C (firms produce less in response)

always shift AD left: +T, -Tr, -I spending

movement along AD: avg PL falls/changes

(2/3 of TS) C changes: (-T or +Tr –> MPC); +W -i -P* +E (shift C ^ veritcally: +HH wealth, -real interest rates, -avg PL, +exp future income)

*changes in price levels shift C & TS but also movement along AD curve

change in C = -b(change in T) + b(change in Tr)

C = C0 + b(Y-T+Tr)

multiplier effect: change in RGDP/TS equil = 1/(1-MPC) x inital change in TS

changes in I: -i, +c (interest rates + consumer confidence); As interest rates rise or confidence falls, investment declines (now more costly to do so)  I fx shift down

changes in Gov spending (G): president’s agenda, congressional/state/local budgets

changes in Xport: strong economic conditions outside US, weak USD

changes in Nport: strong US economy/USD

– stimulate economy from recessionary gap: +Tr/G, -T –> +I –> AD shifts right & equil PL rise above potential GDP (firms operating beyond normal capacity level, those normally not working are) –> LR: adjust to higher PL

-brake economy from inflationary gap: +T, -Tr/G –> AD shift left & recession in SR (workers/firms accept lower wages/prices)–> LR: decline in PL 

AS: amt sellers willing/able to supply @ each PL

LRAS curve: vertical line relationship of PL & quantity of RGDP supplied; LR, economy self-corrects back to FE

A: flat (excess capacity, small price level ^ –> firms ^ output without having big impact on input prices; UR>4.5%) recessionary gap: AD/AS equil left of FE RGDP level

B: steeper/more inelastic; firms nearing capacity -> ^ output & ^ input costs of prodn/final prices due to decreasing returns & some upward pressure on input prices; firms need larger ^ prices to be willing/able to produce more output; UR = 4.5%

C: AS very steep/inelastic; firms’ severe scarcity of inputs/diminishing returns; small output^ drive large input costs/final prices; inflationary gap: US

supply-side policies: designed to +AS (not inflationary, good LT strategies in cap formation; bad demand-side effects as byproduct, decreasing income tax may ^ #L hours worked, ^C; hard to measure magnitude of effect; ^ budget deficits from tax cuts)

changes in AS: tech, FOP (land,labor,cap,natl resources,entrep), input prices (^AS shift left), R&D (grants/tax breaks to improve tech)

1. movement along = changes in avg PL

2. shift out curve: decrease: pers income taxes (+L); savings, capital gains, dividends, corp income taxes (+K)

1. interest rates ^: ^cost of capital/land inputs –>^cost of prodn –> shift AS left @ any given PL

2. wages fall: v cost of labor input –> v cost of prodn –> shift AS right @ any given PL

3. gasoline prices^: ^cost of energy input –> ^ cost of prodn –> shift AS left @ any given PL

4. increase tech-> v cost of prodn –> firms supply more @ any PL -> shift AS right @ any given PL

5. increased LF: ^labor, ^prodn capacity & v wages –> shift AS right @ any given PL

6. iron ore price falls (input in prodn): v FOP costs –> v cost of prodn –> shift AS right @ any given PL

terms:

banks: profit-making private businesses; important role in economy by accepting deposits & making loans; Banks fulfill key MS process fx; central banks control the MS

Money: standard object medium of exchange used in exchanging goods/service in nonbarter economies

commodity money: good used as money also has nonmonetary values (ie gold)

Full-bodied fiat money: fiat money backed by units of equal value held in issuer’s vault

Fiat money: money decreed by gov with no inherent value in & of itself (USD today); Maintains its value by faith and trust that the issuer will stand behind the money & limit its production

medium of exchange – passed from person to person for 2+ transactions without itself being consumed; Sellers willing to accept in exchange for good/service; economies more efficient when people accept a single good as medium of exchange

store of value – item used to store wealth from one period to the next ie nonperishable pearls; any asset you can hold for use in the future

unit of account – standard unit for quoting prices; way of measuring value in economy; in terms of money when one good used as money

cash: highest liquid asset 

portability: ability to be carried around easily without breakage/spoilage 

Gresham’s law: bad money (fiat – no inherent value) drives out good money due to lower transactions (carrying) costs

asset: anything of value owned by a person/firm (to avoid costs, ppl willing to hold some wealth in the form of money)

wealth: assets minus debts 

income: equal to one’s earnings per year 

liquidity: ease with which people can convert an asset into a medium of exchange

Double coincidence of wants: for a barter trade to take place between 2 people, each person must want what the other has

5 criteria make assets suitable for use as medium of exchange: acceptable to/usable by most people; standardized quality so any 2 units are identical; durable so value isn’t lost quickly by wearing out; valuable relative to its weight so amounts large enough to be useful in trade can be easily transported; divisible so can be used in low/high price purchases

inflation: causes decline in purchasing power (with rising prices, given amount of money can buy less goods/services)

stagflation: inflation/recession combo usually from supply shock

factor inputs: wages, price of capital (interest rates, raw material, energy, gas prices)

GDP: $value of all final g/s produced in domestic economy during specified period of time

Total budget: on-budget; defense/highways, HH/corp taxes as “revenue” & off-budget, nonregular spending like Social Security

Deficits: annual shortfall of gov revenues (surplus is opposite

Debt: stock of gov debt instruments (bonds) still outstanding from previous deficits, net of any surpluses

Gross federal debt: (GFD) total amount of borrowing by a country from having deficits; over time an economy with a series of budget deficits will accumulate debt

fiscal policy: use of taxes, transfers, G purchases to steer AD in some desired direction “budgetary”

contractionary fiscal policy: decrease G, increase taxes T to reduce AD increases that seem likely to lead to inflation (causes Pl to rise by less than it would have without policy) 

expansionary fiscal policy: when in recession, increase G + Tr, decrease T (increases AD by Gov ^ own purchases directly, cutting income taxes to increase HH disposable income

multiplier effect: process by which chance in autonomous expenditure -> larger change in RGDP
crowding out: ^ Gov spending -> decrease in private spending on C, I, or NX & limits policy effectiness in boosting AD beyond initial increase in G spending

stats:

1873 US Coinage Act: US joined UK by adopting a gold standard

1980s inflation: 50%

1999: first on-budget surplus since 1960 (T>Tr + G)

last 50years: US avg UR 6% & growth rate 3%; US experienced at least some inflation + potential GDP ^ every year since 1930s

2017-21: budget deficit $600+B; 2023 on/off budget deficit: $1.6T

4/2020: UR = 14.8%

2022: 3.36% payroll tax; 66M benefits (51m retired, 15m deceased/disabled)

US Q4 2023 nom GDP: $28T

early24: GFD = $34.5T (27.4T public, 7.1T interagency); UR=3.9%

2033: OASDI/SS reserves will be completely depleted; only will receive 75% (unless ^payroll tax 4.15% or -25% benefits)

formulas:

TS(AE) = C + PI + G + (X-N)

C = C0 + bYd

ΔC=C0+b(Y-T+Tr)

C0: (C if disposable income were zero) = income – taxes + transfer payments

multiplier: 1/(1-MPC)

MPC (b) = ΔC/ΔYd

MPC+MPS=1

inflation rate = MS growth rate minus RGDP growth rate

Tax multiplier: negative because changes in taxes & RGDP move in opposite directions; increase T reduced disposable income, C, RGDP Ex: -1.6 = +200B/change in taxes  change in taxes = -$125B

Government purchases multiplier:

Ex: 2 = 200B/change in gov. purchases  change in G = $100B

extra

when Susan pays for her tuition, she writes a check for $2000 to USD; USD then deposits this check in a checking account (& the checking account balance for Susan declines & for USD increases by $2000) Then when USD pays Conroy his annual salary of $2000, USD writes him a check; when Conroy deposits his check, his checking account balances increase by $2000 for Conroy & fall for the same amount for USD What has passed from Susan to USD to prof without itself being consumed? Checking account balances If money supply grows at a faster rate than RGDP, there will be inflationIf money supply grows at a slower rate than RGDP, there will be deflation (decline in the price level)If MS grows at same rate as RGDP, price level is stableWestern civilization’s money development: began with gold & silver; heavy weight & difficulty assaying its purity each transaction made it more convenient for people to leave gold deposits at bank and carry around a receipt or “note” from bank; people began trading bank receipts & paper money began

How did DDs go up R1? Because the Fed paid for this treasury security with a check drawn on themselves