Econ 252 Exam 3 Latest Update Graded A

Econ 252 Exam 3 Latest Update Graded A Recession episodes of negative economic growth lasting at least two quarters Expansion a period of positive growth. Expansions are periods between recessions. Co-movement Many aggregate macroeconomic variables grow or contract together during booms and busts, exhibiting a pattern of positive or negative co-movement. Variables such as real consumption, real investment, and employment move positively with real GDP: Pro-cyclical. Variables such as unemployment move negatively real GDP: Counter-cyclical Limited Predictability Recessions and expansions do not follow a repetitive, easily predictable pattern. As a result, it is impossible to forecast during an expansion when the expansion will end. Similarly, it is impossible to forecast during a recession when the recession will end. Persistence Even though the beginnings and ends of recessions are somewhat unpredictable, economic growth is not random but persistent. When the economy is growing, it will probably keep growing the following quarter. Likewise, when the economy is contracting, the economy will probably keep contracting the following quarter. Shocks Unexpected shifts to labor demand Multipliers can amplify the effects of any economic shock, regardless of its source At the beginning of a recession, the Labor Demand Curve shifts to the left due to: ⎯ A fall in output prices ⎯ A decrease in output demand ⎯ A decrease in labor productivity ⎯ A rise in other input prices ⎯ A rise in the federal funds rate In the case of a recession, if wages are flexible, the leftward shift in the labor demand curve will lead to... a fall in wages and a decrease in the quantity of labor. As a result, real GDP will decrease If wages are downward rigid, the leftward shift in the labor demand curve will lead to... no change in the wage rate and a larger decrease in the quantity of labor. As a result, output will decrease more under downward rigid wages than under flexible wages. Okun's Law: Changes in unemployment rate= -0.5(g-3%) Where g is the annual growth rate of real GDP Real Business Cycle Theory emphasizes changes in productivity and technology: Both growth and business cycles are caused by supply shocks Technological advances and other productivity-enhancing innovation cause expansions An increase in input prices like oil causes recessions Business cycles are an outcome of market mechanism No role for government in changing the nature of business cycles Keynesian Theory focuses on changes in expectations of the future: Sentiments (Animal spirits): o Expectations about future economic activities. o Business and consumer mood or sentiment. Changes in sentiments affect household consumption and firms' investment Recessions caused by low demand for goods and services Expansions caused by increases in spending. Government must step in to shore up demand ... policy can alter the business cycle. Financial And Monetary Theory whose main proponent is Milton Friedman—looks at changes in prices and interest rates: A fall in the price level will reduce employment because of downward wage rigidity A decrease in the money supply (M2) will also cause an increase in the real interest rate Higher real interest rates will reduce investment spending by firms and consumption by households multipliers can reduce labor demand further by A fall in asset prices A rise in mortgage defaults A rise in household and firm bankruptcies Downward Wage Rigidity An initial shock shifts the labor demand curve to the left Downward wage rigidity leads to greater reductions in employment Multipliers cause the labor demand curve to shift leftward even more Expansionary monetary policy in economic recovery in the medium run will: Lower interest rates and raise inflation Lower interest rates will raise spending, which shifts the labor demand curve to the right Higher inflation will lower real wages, which shifts the labor supply curve to the left the leftward shift in labor supply has an impact only if the new market-clearing wage is above the original wage rate Countercyclical Policies attempt to reduce the intensity of economic fluctuations and smooth the growth rate of employment, GDP and prices. Expansionary Policy aims to reduce the severity of an economic recession by shifting labor demand curve to the right and "expanding" economic activity (GDP). It is meant to "heat up" the economy. Contractionary Policy is used to slow down the economy when it grows too fast, or "overheats." Countercyclical Monetary Policy is conducted by the central bank. In the U.S. that is the Federal Reserve, or Fed. The primary tool of monetary policy is the Fed's control of the federal funds rate. The Fed influences the federal funds rate through open market operations. The Fed can increase the supply of bank reserves through open market purchases of treasury bonds, thereby decreasing the federal funds rate. The Fed can increase the supply of bank reserves through open market purchases of treasury bonds, thereby decreasing the federal funds rate. The Fed can decrease the supply of bank reserves through an open market sale of treasury bonds, thereby increasing the federal funds rate. Expansionary Monetary Policy lowers short-term interest rates to increase economic activity What happens if the central bank pushes the policy rate to the "zero lower bound"? "liquidity trap" Expected real interest rate = Nominal interest rate - Expected inflation rate Expected real interest rate The Fed has other tools available to impact bank reserves: Changing the reserve requirement Changing the interest rate paid on reserves deposited at the Fed Lending from the discount window Quantitative easing The Discount Window Interest rate on loans the Fed makes to banks. The discount window is an alternative to the federal funds market. When banks are low on reserves, they may borrow reserves from the Fed. This occurs most often during financial crises, when financial institutions are in trouble, e.g. after the Oct. 1987 stock market crash. If there is no crisis, fed rarely uses discount lending - Fed is a "lender of last resort." Quantitative Easing Occurs when the Fed buys long term bonds. This simultaneously increases the supply of bank reserves and pushes the price of the long term bonds up, which lowers their interest rate. The coupon the bond pays is constant. When the FED increases the demand for long term bonds, all else constant, the price of the bonds increases thereby lowering the interest rate on the bonds, Affects the interest rates for longer maturities. In general, these interest rates affect investment, mortgages and long term decisions. The effectiveness of monetary policy depends on expectations about interest rates and inflation Long-term expected real interest rate = Long-term nominal interest rate - Long-term expected inflation rate For the Fed to lower the long-term expected real interest rate, it has to either lower the long-term nominal interest rate or raise long-term expectations of the inflation rate (or both). Contractionary Monetary Policy: It is the opposite of expansionary policy: Contractionary monetary policy... slows down growth in bank reserves raises interest rates, reduces borrowing slows growth in the money supply reduces the rate of inflation The Taylor Rule Federal funds rate = Long-run federal funds rate target + 1.5(Inflation rate - Inflation rate target) + 0.5(Output gap in % points) where Output gap = 100(GDP - Trend GDP)/Trend GDP Expansionary Fiscal Policy uses higher government expenditure and lower taxes to increase the growth rate of real GDP. Contractionary Fiscal Policy uses lower government expenditure and higher taxes to reduce the growth rate of real GDP. Automatic Countercyclical Components are aspects of fiscal policy that automatically partially offset economic fluctuation Discretionary Countercyclical Components are aspects of fiscal policy that policymakers deliberately enact in response to economic fluctuations. The government expenditure multiplier is the change in GDP resulting from a $1 change in government expenditures. Higher government spending leads to higher demand for goods and services. Firms respond by increasing production, thereby shifting the demand for labor to the right with the usual multiplier effects. Crowding Out occurs when rising government expenditures partially or even fully displace expenditures by households and firms. Examples: If the Government raises expenditures, it needs to find the money to pay for it: Taxes, Debt, Printing Money If the government uses debt to pay the bills. (Government deficit increases) The extra debt shifts the demand for credit to the right in the credit market thereby raising the equilibrium interest rates. The higher interest rates and presence of more government debt produces lower private investment by firms (crowding out of I) The Government Taxation Multiplier the change in GDP resulting from a $1 decrease in government taxation. Lower government taxes leads to higher demand for goods and services. Firms respond by increasing production, thereby shifting the demand for labor to the right with the usual multiplier effects. A few specific fiscal policies that are directly targeted at the labor market: 1. Unemployment insurance 2. Wage subsidies Absolute Advantage the producer can produce more units per hour compared to other producers. Comparative Advantage the producer has a lower opportunity cost compared to that of other producers. Trade Deficit When exports imports Income-Based Payments from Foreigners: 1. Exports: Payments from the sale of goods and services to foreigners. 2. Factor Payments from Foreigners: Income from assets that domestic residents own in foreign countries. 3. Transfers from Foreigners: Transfers from individuals who reside abroad or from foreign governments. Income-Based Payments to Foreigners: 1. Imports: Payments to foreigners in return for their goods and services. 2. Factor Payments to Foreigners: Paying income on assets that foreign residents own in the domestic economy. 3. Transfers to Foreigners: Transfers to individuals who reside abroad or to foreign governments. Net Factor Payments from Foreigners = (Factor payments from foreigners) - (Factor payments to foreigners) Net transfers from Foreigners = (Transfers from Foreigners) - (Transfers to foreigners) Current account = (Net exports) + (Net factor payments from foreigners) + (Net transfers from foreigners) The Financial Account the increase in domestic assets held by foreigners minus the increase in foreign assets held domestically. Foreign Direct Investment refers to investments by foreign individuals and companies in domestic firms and businesses. To qualify as foreign direct investment, this capital flow must generate a large ownership stake in a local firm for the foreign investors. Foreign direct investment is a major conduit for technology transfer.