Chapter 29

The Aggregate Expenditures

Model
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Assumptions and Simplifications

Use the Keynesian aggregate
expenditures model
Prices are fixed
GDP = DI
Begin with private, closed economy
Consumption spending
Investment spending
LO1

29-2

Consumption and Investment

Investment
demand
curve
8

20

ID
20

Investment
(billions of dollars)
(a)
Investment demand curve

LO2

Investment Schedule
Investment (billions of dollars)

r and i (percent)

Investment Demand Curve

Investment
schedule

Ig

20

20

Real domestic product, GDP

(billions of dollars)
(b)
Investment schedule

29-3

Equilibrium GDP
Determination of the Equilibrium Levels of Employment, Output, and Income: A Private Closed Economy
(2)
Real
Domestic
Output
(and
Income)
(GDP =
DI),*Billion
s

(3)
Consumption
(C),
Billions

(4)
Saving
(S),
Billions

(5)
Investment
(Ig),
Billions

(6)
Aggregate
Expenditure
(C+Ig),
Billions

(7)
Unplanned
Changes in
Inventories,
(+ or -)

(1) 40

$370

$375

$-5

$20

$395

$-25

Increase

(2) 45

390

390

20

410

-20

Increase

(3) 50

410

405

20

425

-15

Increase

(4) 55

430

420

10

20

440

-10

Increase

(5) 60

450

435

15

20

455

-5

Increase

(6) 65

470

450

20

20

470

(7) 70

490

465

25

20

485

+5

Decrease

(8) 75

510

480

30

20

500

+10

Decrease

(9) 80

530

495

35

20

515

+15

Decrease

(10) 85

550

510

40

20

530

+20

Decrease

(1)
Possible
Levels of
Employment,
Millions

(8)
Tendency of
Employment,
Output, and
Income

Equilibrium

* If depreciation and net foreign factor income are zero, government is ignored and it is assumed that all saving occurs in the household sector of the
economy, then GDP as a measure of domestic output is equal to NI,PI, and DI. Household income = GDP

LO3

29-4

Equilibrium GDP
(C + Ig = GDP)
Equilibrium
point
Aggregate
expenditures

C + Ig
C

Ig = $20 billion

C = $450 billion

LO3

29-5

Changes in Equilibrium GDP

(C + Ig)1
(C + Ig)0
(C + Ig)2

Increase in
investment
Decrease in
investment

LO5

29-6

Adding International Trade

Include net exports spending in
aggregate expenditures
Private, open economy
Exports create production,
employment, and income
Subtract spending on imports
Xn can be positive or negative
LO6

29-7

The Net Export Schedule

Two Net Export Schedules (in Billions)

LO6

(1)
Level of GDP

(2)
Net Exports,
Xn1 (X > M)

(3)
Net Exports,
Xn2 (X < M)

$370

$+5

$-5

390

+5

-5

410

+5

-5

430

+5

-5

450

+5

-5

470

+5

-5

490

+5

-5

510

+5

-5

530

+5

-5

550

+5

-5
29-8

Net Exports and Equilibrium GDP

C + Ig+Xn1
C + Ig
C + Ig+Xn2

Aggregate expenditures
with positive
net exports

Aggregate expenditures
with negative net
exports

Positive net exports

450
470
Negative net exports
LO6

Xn1
490

Xn2
29-9

International Economic Linkages

Prosperity abroad
Can increase U.S. exports
Exchange rates
Depreciate the dollar to increase
exports
A caution on tariffs and devaluations
Other countries may retaliate
Lower GDP for all
LO6

29-10

Adding the Public Sector

Government purchases and
equilibrium GDP
Government spending is subject to
the multiplier
Taxation and equilibrium GDP
Lump sum tax
Taxes are subject to the multiplier
DI = GDP
LO7

29-11

Government Purchases and Eq.

GDP
The Impact of Government Purchases on Equilibrium GDP
(5)
Net Exports
(Xn), Billions
Imports
(M)

(6)
Government
Purchases
(G), Billions

(7)
Aggregate
Expenditures
(C+Ig+Xn+G),
Billions
(2)+(4)+(5)+(6)

$10

$10

$20

$415

20

10

10

20

430

20

10

10

20

445

420

10

20

10

10

20

460

(5) 450

435

15

20

10

10

20

475

(6) 470

450

20

20

10

10

20

490

(7) 490

465

25

20

10

10

20

505

(8) 510

480

30

20

10

10

20

520

(9) 530

495

35

20

10

10

20

535

(10) 550

510

40

20

10

10

20

550

(1)
Real Domestic
Output and
Income
(GDP=DI),
Billions

(2)
Consumption
(C),
Billions

(3)
Saving (S),
Billions

(4)
Investment
(Ig),
Billions

Exports
(X)

(1) $370

$375

$-5

$20

(2) 390

390

(3) 410

405

(4) 430

LO7

29-12

Government Purchases and Eq.

GDP
C + Ig + X n + G
C + Ig + X n
C

Government spending
of $20 billion

LO7

29-13

Taxation and Equilibrium GDP

Determination of the Equilibrium Levels of Employment, Output, and Income: Private and Public Sectors
(1)
Real
Domestic
Output
and
Income
(GDP=DI),
Billions

(7)
Net Exports
(Xn), Billions

(9)
Aggregate
Expenditures
(C+Ig+Xn
+G),
Billions
(4)+(6)+(7)+(
8)

(2)
Taxes
(T),
Billions

(3)
Disposable
Income (DI),
Billions, (1)(2)

(4)
Consumption (C),
Billions

(5)
Saving
(S),
Billions

(6)
Investment (Ig),
Billions

Exports
(X)

Imports
(M)

(8)
Government Purchases
(G),
Billions

(1) $370

$20

$350

$360

$-10

$20

$10

$10

$20

$400

(2) 390

20

370

375

-5

20

10

10

20

415

(3) 410

20

390

390

20

10

10

20

430

(4) 430

20

410

405

20

10

10

20

445

(5) 450

20

430

420

10

20

10

10

20

460

(6) 470

20

450

435

15

20

10

10

20

475

(7) 490

20

470

450

20

20

10

10

20

490

(8) 510

20

490

465

25

20

10

10

20

505

(9) 530

20

510

480

30

20

10

10

20

520

(10) 550

20

530

495

35

20

10

10

20

535

LO7

29-14

Aggregate expenditures (billions of dollars)

Taxation and Equilibrium GDP

C + I g + Xn + G
Ca + Ig + Xn + G

$15 billion
decrease in
consumption
from a
$20 billion
increase
in taxes

45
490

LO7

550

Real domestic product, GDP (billions of dollars)

29-15

Equilibrium versus FullEmployment

LO8

Recessionary expenditure gap

Insufficient aggregate spending
Spending below full-employment GDP
Increase G and/or decrease T
Inflationary expenditure gap
Too much aggregate spending
Spending exceeds full-employment
GDP
Decrease G and/or increase T
29-16

Aggregate expenditures
(billions of dollars)

Equilibrium versus FullEmployment

AE0
AE1
530

510

Recessionary
expenditure
gap = $5 billion

490

Full
employment
45
490

510

530

Real GDP
(a)
Recessionary expenditure gap
LO8

29-17

Equilibrium versus FullEmployment

AE2
Inflationary
expenditure
gap = $5 billion

AE0

Full
employment

LO8

29-18

Says Law, Great Depression,

Keynes
Classical economics
Says Law
Economy will automatically adjust
Laissez-faire
Keynesian economics
Cyclical unemployment can occur
Economy will not correct itself
Government should actively manage
macroeconomic instability

29-19

Chapter 30
Aggregate Demand and
Aggregate Supply
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Aggregate Demand
Real GDP desired at each price level
Inverse relationship
Real balances effect
Interest effect
Foreign purchases effect

LO1

29-21

Changes in Aggregate Demand

Determinants of aggregate demand
Shift factors affecting C, I, G, Xn
2 components involved
Change in one of the determinants
Multiplier effect

LO2

29-22

Consumer Spending

LO2

Consumer wealth
Household borrowing
Consumer expectations
Personal taxes

29-23

Investment Spending
Real interest rates
Expected returns
Expectations about future business
conditions
Technology
Degree of excess capacity
Business taxes
LO2

29-24

Government Spending
Government spending increases
Aggregate demand increases (as
long as interest rates and tax rates
do not change)
More transportation projects
Government spending decreases
Aggregate demand decreases
Less military spending
LO2

29-25

Net Export Spending

National income abroad
Exchange rates
Dollar depreciation
Dollar appreciation

LO2

29-26

Aggregate Supply
Total real output produced at each
price level
Relationship depends on time horizon
Immediate short run
Short run
Long run

LO3

29-27

AS: Immediate Short Run

Price level

Immediate-short-run
aggregate supply
P1

0
LO3

ASISR

Qf

Real domestic output, GDP

29-28

Aggregate Supply: Short Run

AS

Price level

Aggregate supply
(short run)

Qf

Real domestic output, GDP

LO3

29-29

Aggregate Supply: Long Run

Price level

ASLR

Long-run
aggregate
supply

Qf

Real domestic output, GDP

LO3

29-30

Changes in Aggregate Supply

Determinants of aggregate supply
Shift factors
Collectively position the AS curve
Changes raise or lower per-unit
production costs

LO4

29-31

Input Prices
Domestic resource prices
Labor
Capital
Land
Prices of imported resources
Imported oil
Exchange rates
LO4

29-32

Productivity
Real output per unit of input
Increases in productivity reduce
costs
Decreases in productivity increase
costs
total output
Productivity =
total inputs
Per-unit production cost
LO4

total input cost

total output
29-33

Legal-Institutional Environment
Legal changes alter per-unit costs of
output
Taxes and subsidies
Extent of government regulation

LO4

29-34

Price level (index numbers)

Equilibrium
AS

100

92

Real
Output
Demanded
(Billions)

Price Level
(Index
Number)

Real
Output
Supplied
(Billions)

$506

108

$513

508

104

512

510

100

510

512

96

507

514

92

502

AD
0

502

510 514

Real domestic output, GDP

(billions of dollars)

LO5

29-35

Changes in Equilibrium

Price level

AS

P2
P1

AD2
AD1
0
LO6

Qf

Q1 Q2

Real domestic output, GDP

29-36

Decreases in AD: Recession

Prices are downwardly inflexible
Fear of price wars
Menu costs
Wage contracts
Efficiency wages
Minimum wage law

LO6

29-37

Decreases in AS: Cost-Push

Inflation

Price level

AS2

P2
P1

AS1

b
a

AD
0
LO6

Q1 Qf
Real domestic output, GDP

29-38

Increases in AS: Full-Employment

Price level

AS1

P3
P2
P1

AS2

b
a

AD2
AD1
0

Q1

Q 2 Q3

Real domestic output, GDP

LO6

29-39

Stimulus and the Great Recession

Housing collapse triggers bank
failures which leads to recession
Federal Reserve intervenes
Lowers short-term interest rates
Federal Government begins largest
peacetime program of spending

29-40

Stimulus and the Great Recession

GDP growth has been disappointing
High debt load due to low interest
rates
High rate of savings
Unequal impact
Price increases rather than output
gains
29-41

Chapter 31
Fiscal Policy, Deficits, and
Debt
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Fiscal Policy
Deliberate changes in:
Government spending
Taxes
Designed to:
Achieve full-employment
Control inflation
Encourage economic growth
LO1

29-43

Expansionary Fiscal Policy

Use during a recession
Increase government spending
Decrease taxes
Combination of both
Create a deficit

LO1

29-44

Contractionary Fiscal Policy

Use during demand-pull inflation
Decrease government spending
Increase taxes
Combination of both
Create a surplus

LO1

29-45

Policy Options: G or T?
To expand the size of government
If recession, then increase
government spending
If inflation, then increase taxes
To reduce the size of government
If recession, then decrease taxes
If inflation, then decrease
government spending
LO1

29-46

Built-In Stability
Automatic stabilizers
Taxes vary directly with GDP
Transfers vary inversely with GDP
Reduces severity of business
fluctuations
Tax progressivity
Progressive tax system
Proportional tax system
Regressive tax system
29-47

Evaluating Fiscal Policy

Is the fiscal policy
Expansionary?
Neutral?
Contractionary?
Use the cyclically adjusted budget to
evaluate

LO3

29-48

Government expenditures, G, and

tax revenues, T (billions)

Cyclically Adjusted Budgets

T

b
$500
450

GDP2

(year 2)
LO3

GDP1

(year 1)

Real domestic output, GDP

29-49

Government expenditures, G, and

tax revenues, T (billions)

Cyclically Adjusted Budgets

T1
T2

$500

475
450
425

h
f
g

GDP4

(year 4)
LO3

GDP3

(year 3)

Real domestic output, GDP

29-50

Fiscal Policy: The Great Recession

Financial market problems began in
2007
Credit market freeze
Pessimism spreads to the overall
economy
Recession officially began
December 2007 and lasted 18
months
LO4

29-51

Problems, Criticisms, &

Complications
Problems of Timing
Recognition lag
Administrative lag
Operational lag
Political business cycles
Future policy reversals
Off-setting state and local finance
Crowding-out effect
LO5

29-52

Current Thinking on Fiscal Policy

Let the Federal Reserve handle shortterm fluctuations
Fiscal policy should be evaluated in
terms of long-term effects
Use tax cuts to enhance work effort,
investment, and innovation
Use government spending on public
capital projects
LO5

29-53

The U.S. Public Debt

$16.4 trillion in 2012
The accumulation of years of
federal deficits and surpluses
Owed to the holders of U.S. securities
Treasury bills
Treasury notes
Treasury bonds
U.S. savings bonds
LO5

29-54

The U.S. Public Debt

LO5

29-55

The U.S. Public Debt

Interest charges on debt
Largest burden of the debt
2.3% of GDP in 2012
False Concerns
Bankruptcy
Refinancing
Taxation
Burdening future generations
LO5

29-56

Substantive Issues

LO6

Income distribution
Incentives
Foreign-owned public debt
Crowding-out effect revisited
Future generations
Public investment

29-57

Crowding-Out Effect
Real interest rate (percent)

16
14
12
b

10
8

Crowding-out
effect

4
2

ID1
0

LO6

Increase in
investment
demand

5
10 15 20 25 30 35
Investment (billions of dollars)

ID2
40

29-58

Social Security, Medicare

Shortfalls
More Americans will be receiving
benefits as they age
Social security shortfalls
Income during retirement
Funds will be depleted by 2033
Medicare shortfalls
Medical care during retirement
Funds will be depleted by 2024
29-59

Social Security, Medicare

Shortfalls
Possible options to fix include:
Increasing the retirement age
Increasing the portion of earnings
subject to the social security tax
Disqualifying wealthy individuals
Redirecting low-skilled immigrants to
higher-skilled, higher paying work
Defined contribution plans owned by
individuals
29-60

Chapter 32
Money, Banking, and Financial
Institutions
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Functions of Money
Medium of exchange
Used to buy/sell goods
Unit of account
Goods valued in dollars
Store of value
Hold some wealth in money form
Money is liquid
LO1

29-62

Money Definition M1
M1
Currency
Checkable deposits
Institutions offering checkable deposits
Commercial banks
Savings and loan associations
Mutual savings banks
Credit unions
LO2

29-63

Money Definition M2
M2
M1 plus near-monies
Savings deposits including money
market deposit accounts (MMDA)
Small-denominated time deposits
Money market mutual funds
(MMMF)
LO2

29-64

What Backs the Money

Supply?
Guaranteed by governments ability
to keep value stable
Money as debt
Why is money valuable?
Acceptability
Legal tender
Relative scarcity
LO3

29-65

What Backs the Money

Supply?
Prices affect purchasing power of
money
Hyperinflation renders money
unacceptable
Stabilizing moneys purchasing power
Intelligent management of the
money supply monetary policy
Appropriate fiscal policy
LO3

29-66

Federal Reserve - Banking

System
Historical background
Board of Governors
12 Federal Reserve Banks
Serve as the central bank
Quasi-public banks
Bankers bank

LO4

29-67

Federal Reserve Banking

System
Federal Open Market Committee
Aids Board of Governors in setting
monetary policy
Conducts open market operations
Commercial banks and thrifts
6,000 commercial banks
8,500 thrifts
LO4

29-68

Federal Reserve Functions

Issue currency
Set reserve requirements
Lend money to banks
Collect checks
Act as a fiscal agent for U.S.
government
Supervise banks
Control the money supply
LO5

29-69

Federal Reserve Independence

Established by Congress as an
independent agency
Protects the Fed from political
pressures
Enables the Fed to take actions to
increase interest rates in order to
stem inflation as needed

LO5

29-70

The Financial Crisis of 2007 and

2008
Mortgage Default Crisis
Many causes
Government programs that
encouraged home ownership
Declining real estate values
Bad incentives provided by
mortgage-backed bonds

LO6

29-71

The Financial Crisis of 2007 and

2008
Securitization- the process of slicing
up and bundling groups of loans into
new securities
As loans defaulted, the system
collapsed
Underwater homeowners
abandoned homes and mortgages

LO6

29-72

The Financial Crisis of 2007 and

2008
Failures and near-failures of financial
firms
Countrywide: second largest lender
Washington Mutual: largest lender
Wachovia
Other firms came close

LO6

29-73

The Financial Crisis of 2007 and

2008
Troubled Asset Relief Program (TARP)
Allocated $700 billion to make
emergency loans
Saved several institutions from
failure

LO7

29-74

The Financial Crisis of 2007 and

2008
The Feds lender-of-last-resort
activities
Primary Dealer Credit Facility
Term Securities Lending Facility
Asset-Backed Commercial Paper
Money Market Mutual Fund
Liquidity Facility
Commercial Paper Funding Facility
LO7

29-75

The Financial Crisis of 2007 and

2008
Money Market Investor Funding
Facility
Term Asset-Backed Securities Loan
Facility
Interest Payments on Reserves

LO7

29-76

Post-Crisis U.S. Financial

Services
Major Categories of Financial Institutions
Commercial Banks
Thrifts
Insurance Companies
Mutual Fund Companies
Pension Funds
Securities Firms
Investment Banks
LO8

29-77

Post-Crisis U.S. Financial

Services
Wall Street Reform and Consumer
Protection Act
Passed to help prevent many of the
practices that led to the crisis
Critics say it adds heavy regulatory
costs

LO8

29-78

Too Big to Fail

Wall Street Reform and Consumer

Protection Act of 2010
Decision made not to criminally
prosecute HSBC bank because of
economic effect

29-79

Chapter 33
Money Creation
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Fractional Reserve System

The Goldsmiths
Stored gold and gave a receipt
Receipts used as money by public
Made loans by issuing receipts
Characteristics:
Banks create money through
lending
Banks are subject to panics
LO1

29-81

Fractional Reserve System

Balance sheet
Assets = Liabilities + Net Worth
Both sides balance
Necessary transactions
Create a bank
Accept deposits
Lend excess reserves

LO1

29-82

A Single Commercial Bank

Transaction #1
Vault cash: cash held by the bank
Creating a Bank

Balance Sheet 1: Wahoo Bank

Assets
Cash

LO2

Liabilities and Net Worth

$250,000 Stock Shares

$250,000

29-83

A Single Commercial Bank

Transaction #2
Acquiring property and equipment
Acquiring Property and Equipment
Balance Sheet 2: Wahoo Bank

Assets
Cash
Property

LO2

Liabilities and Net Worth

$10,000 Stock Shares
240,000

$250,000

29-84
33-84

A Single Commercial Bank

Transaction #3
Commercial bank functions
Accepting deposits
Making loans

Accepting Deposits

Balance Sheet 3: Wahoo Bank

Assets
Cash
Property

LO2

Liabilities and Net Worth

Checkable
$110,000
Deposits
$100,000
240,000
Stock Shares
250,000

29-85
33-85

A Single Commercial Bank

Transaction #4
Depositing reserves in a Federal
Reserve bank
Required reserves
Reserve ratio
Reserve
ratio

LO2

Commercial banks
Required reserves
Commercial banks
Checkable-deposit liabilities
29-86

A Single Commercial Bank

Type of Deposit

Current
Requirement

Statutory
Limits

Checkable deposits:
$0-$12.4 Million
$12.4 - $79.5 Million
Over $79.5 Million
Noncheckable nonpersonal
savings and time deposits

LO2

0%
3
10

3%
3
8-14

0-9

The Fed can establish and vary the

reserve ratio within limits set by
Congress
Required reserves help the Fed control
lending abilities of commercial banks

29-87

A Single Commercial Bank

Transaction #4
Assume the bank deposits all cash
on reserve at the Fed
Depositing Reserves at the Fed
Balance Sheet 4: Wahoo Bank

Assets

Liabilities and Net Worth

Cash
Reserves

$0 Checkable
110,000
Deposits

$100,000

Property

240,000 Stock Shares

250,000

29-88

A Single Commercial Bank

Excess reserves
Actual reserves - required reserves
Required reserves
Checkable deposits x reserve ratio
Example:
Checkable deposits $100,000
Reserve ratio 20%
LO2

29-89

A Single Commercial Bank

Transaction #5
Clearing a check
$50,000 check reduces reserves and
checkable deposits
Clearing a Check

Balance Sheet 5: Wahoo Bank

Assets
Reserves
Property

LO2

Liabilities and Net Worth

Checkable
$60,000
Deposits
240,000 Stock Shares

$50,000
250,000

29-90

Money Creating Transactions

Transaction #6a
Granting a loan
$50,000 loan deposited to
checking
When a Loan is Negotiated
Balance Sheet 6a: Wahoo Bank

Assets
Reserves
Loans
Property

LO3

Liabilities and Net Worth

$60,000 Checkable
Deposits
50,000
240,000 Stock Shares

$100,000
250,000

29-91

Money Creating Transactions

Transaction #6b
Using the loan
$50,000 loan cashed

After a Check is Drawn on the Loan

Balance Sheet 6b: Wahoo Bank

Assets
Reserves
Loans
Property

Liabilities and Net Worth

$10,000 Checkable
Deposits
50,000

$50,000

240,000 Stock Shares

250,000

A single bank can only lend an amount

equal to its preloan excess reserves
LO3

29-92

Money Creating Transactions

Transaction #7
Bank buys government securities
from a dealer
Deposits payment into checking
Buying Government Securities
Balance Sheet 7: Wahoo Bank

Assets
Reserves
Securities
Property

Liabilities and Net Worth

$60,000 Checkable
Deposits
50,000
240,000 Stock Shares

New money is created

LO3

$100,000
250,000

29-93

Profits, Liquidity, and the Fed

Funds Market
Conflicting goals
Earn profit
Make loans to earn interest
Buy securities to earn interest
Maintain liquidity
Alternative?
Overnight bank loans
Federal funds rate
LO3

29-94

The Banking System

Multiple-deposit expansion
Assumptions:
20% required reserves
All banks loaned up
Banks lend all of their excess
reserves
A $100 bill is found and deposited
Multiple deposits can be created
LO4

29-95

The Monetary Multiplier

Monetary
multiplier

LO5

1
required reserve ratio

1
R

29-96

The Monetary Multiplier

Maximum amount of new money
created by a single dollar of excess
reserves
Higher R, lower m
Reversibility
Making loans creates money
Loan repayment destroys money
29-97

Banking, Leverage, and

Financial Instability
Leverage is the use of borrowed
money to magnify profits and losses
Modern banks use lots of leverage
Thus small losses can drive banks
into insolvency

29-98

Chapter 34
Interest Rates and Monetary
Policy
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Interest Rates

LO1

The price paid for the use of money

Many different interest rates
Speak as if only one interest rate
Determined by the money supply
and money demand

29-100

Demand for Money

LO1

Why hold money?

Transactions demand, Dt
Determined by nominal GDP
Independent of the interest rate
Asset demand, Da
Money as a store of value
Varies inversely with the interest
rate
Total money demand, Dm

29-101

Interest Rates
Equilibrium interest rate
Changes with shifts in money supply
and money demand
Interest rates and bond prices
Inversely related
Bond pays fixed annual interest
payment
Lower bond price will raise the
interest rate
LO1

29-102

Federal Reserve Balance Sheet

Assets
Securities
Loans to commercial banks
Liabilities
Reserves of commercial banks
Treasury deposits
Federal Reserve Notes
outstanding

29-103

Tools of Monetary Policy

Open market operations
Buying and selling of government
securities (or bonds)
Commercial banks and the general
public
Used to influence the money supply
When the Fed sells securities,
commercial bank reserves are
reduced
LO3

29-104

Tools of Monetary Policy

Fed buys bonds from commercial
banks
Federal Reserve Banks
Assets

Liabilities and Net Worth

+ Securities

+ Reserves of Commercial
Banks

(a) Securities

Assets

(b) Reserves
Commercial Banks
Liabilities and Net Worth

-Securities (a)
+Reserves (b)
LO3

29-105

Tools of Monetary Policy

Fed sells bonds to commercial banks
Federal Reserve Banks
Assets

Liabilities and Net Worth

- Securities

- Reserves of Commercial
Banks

(a) Securities

Assets

(b) Reserves
Commercial Banks
Liabilities and Net Worth

+ Securities (a)
- Reserves (b)
LO3

29-106

Open Market Operations

Fed buys $1,000 bond from a

commercial bank

New Reserves
$1000
Excess
Reserves

$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)
LO3

29-107

Open Market Operations

Fed buys $1,000 bond from the

public

Check is Deposited
New Reserves
$1000

$800
Excess
Reserves

$4000
Bank System Lending

$200
Required
Reserves

$1000
Initial
Checkable
Deposit

Total Increase in the Money Supply, ($5000)

LO3

29-108

Tools of Monetary Policy

LO3

The reserve ratio

Changes the money multiplier
The discount rate
The Fed as lender of last resort
Short term loans
Term auction facility
Introduced December 2007
Banks bid for the right to borrow
reserves

29-109

Tools of Monetary Policy

Open market operations are the most
important
Reserve ratio last changed in 1992
Discount rate was a passive tool
Interest on reserves

LO3

29-110

The Federal Funds Rate

Rate charged by banks on

overnight loans
Targeted by the Federal Reserve
FOMC conducts open market
operations to achieve the target
Demand curve for Federal funds
Supply curve for Federal funds
29-111

Monetary Policy
Expansionary monetary policy
Economy faces a recession
Lower target for Federal funds rate
Fed buys securities
Expanded money supply
Downward pressure on other
interest rates
LO4

29-112

Monetary Policy
Restrictive monetary policy
Periods of rising inflation
Increases Federal funds rate
Increases money supply
Increases other interest rates

LO4

29-113

Taylor Rule
Rule of thumb for tracking actual
monetary policy
Fed has 2% target inflation rate
If real GDP = potential GDP and
inflation is 2%, then targeted Federal
funds rate is 4%
Target varies as inflation and real
GDP vary
LO4

29-114

Monetary Policy, Real GDP,

Price Level
Affect on real GDP and price level
Cause-effect chain
Market for money
Investment and the interest rate
Investment and aggregate demand
Real GDP and prices
Expansionary monetary policy
Restrictive monetary policy
LO5

29-115

(a)
The market
for money
Sm1

Sm2

Sm3

AS

10

P3

P2

Dm

ID

0
$125

$150

$175

Amount of money
demanded and
supplied
(billions of dollars)

LO5

(c)
Equilibrium real
GDP and the
Price level

(b)
Investment
demand

Price Level

Rate of Interest, i (Percent)

Monetary Policy and

Equilibrium GDP

$15

$20

$25

Amount of investment
(billions of dollars)

Q1

Qf Q3

AD3
I=$25
AD2
I=$20
AD1
I=$15

Real GDP
(billions of dollars)

29-116

Monetary Policy and Equilibrium

GDP
(d)
Equilibrium real
GDP and the
Price level

(c)
Equilibrium real
GDP and the
Price level

AS

AS

Q1

Qf Q3

AD3
I=$25
AD2
I=$20
AD1
I=$15

Real GDP
(billions of dollars)

Price Level

Price Level

P2

LO5

P3

P3

P2

Q1

Qf Q3

AD3
I=$25
AD4
I=$22.5
AD2
I=$20
AD1
I=$15

Real GDP
(billions of dollars)

29-117

Expansionary Monetary Policy

CAUSE-EFFECT CHAIN

Problem: Unemployment and Recession

LO5

Fed buys bonds, lowers reserve ratio, lowers the

discount rate, or increases reserve auctions
Excess reserves increase
Federal funds rate falls
Money supply rises
Interest rate falls
Investment spending increases
Aggregate demand increases
Real GDP rises

29-118

Restrictive Monetary Policy

CAUSE-EFFECT CHAIN

Problem: Inflation

LO5

Fed sells bonds, increases reserve ratio, increases

the discount rate, or decreases reserve auctions
Excess reserves decrease
Federal funds rate rises
Money supply falls
Interest rate rises
Investment spending decreases
Aggregate demand decreases
Inflation declines

29-119

Evaluation and Issues

Advantages over fiscal policy
Speed and flexibility
Isolation from political pressure
Monetary policy is more subtle
than fiscal policy

LO6

29-120

Recent U.S. Monetary Policy

Highly active in recent decades
Responded with quick and innovative
actions during the recent financial
crisis and the severe recession
Critics contend the Fed contributed
to the crisis by keeping the Federal
funds rate too low for too long

LO6

29-121

After the Great Recession

Slow recovery especially in terms of
employment
Zero interest rate policy
Zero lower bound problem
Quantitative easing
Forward commitment
Operation Twist
LO6

29-122

The Big Picture

Input
Resources
With Prices

Productivity
Sources

LegalInstitutional
Environment

LO6

Consumption
(Ca)

Aggregate
Supply

Levels of
Output,
Employment,
Income, and
Prices

Aggregate
Demand

Investment
(Ig)

Net Export
Spending
(Xn)
Government
Spending
(G)
29-123

Chapter 35
Financial Economics
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Financial Investment
Economic investment
New additions or replacements to
the capital stock
Financial investment
Broader than economic investment
Buying or building an asset for
financial gain
New or old asset
Financial or real asset
LO1

29-125

Present Value

LO2

Present day value of future returns or

costs
Compound interest
Earn interest on the interest
X dollars today=(1+i)tX dollars
in t years
$100 today at 8% is worth:
$108 in one year
$116.64 in two years
$125.97 in three years

29-126

Present Value Model

Calculate what you should pay for an
asset today
Asset yields future payments
Assets price should equal total
present value of future payments
The formula:

( 1 + i)
LO2

dollars today = X dollars in t years

29-127

Applications
Take the money and run
Lottery jackpot paid over a number
of years
Calculating the lump sum value
Salary caps and deferred
compensation
Calculating the value of deferred
salary payments
LO2

29-128

Popular Investments
Wide variety available to investors
Three features
Must pay to acquire
Chance to receive future payment
Some risk in future payments

LO3

29-129

Stocks
Represents ownership in a
company
Bankruptcy possible
Limited liability rule
Capital gains
Dividends

LO3

29-130

Bonds
Debt contracts issued by government
and corporations
Possibility of default
Investor receives interest

LO3

29-131

Mutual Funds
Company that maintains a portfolio
of either stocks or bonds
Currently more than 8,000 mutual
funds
Index funds
Actively managed funds
Passively managed funds
LO3

29-132

Calculating Investment
Returns
Gain or loss stated as percentage
rate of return
Difference between selling price and
purchase price divided by purchase
price
Future series of payments also
considered into return
Rate of return inversely related to
price
LO4

29-133

Arbitrage
Buying and selling process to
equalize average expected returns
Sell asset with low return and buy
asset with higher return at same
time
Both assets will eventually have
same rate of return

LO5

29-134

Risk
Future payments are uncertain
Diversification
Diversifiable risk
Specific to a given investment
Nondiversifiable risk
Business cycle effects
Comparing risky investments
Average expected rate of return
Beta
LO6

29-135

Risk
Risk and average expected rates of
return
Positively related
The risk-free rate of return
Short-term U.S. government bonds
Greater than zero
Time preference
Risk-free interest rate
LO6

29-136

The Security Market Line

Compensate investors for:
Time preference
Nondiversifiable risk

LO8

Average
expected
rate of return

Average
expected
rate of return

Rate that
compensates
for time
preference

if

Rate that
compensates
for risk

risk premium

29-137

SML: Applications
Feds expansionary monetary policy
led to lower interest rates
SML shifted downward
Slope of SML increased due to
increased investor risk-aversion
Stocks fell

LO8

29-138

Index Funds Versus Actively

Managed Funds

Choice of actively or passively

managed mutual funds
After costs, index funds outperform
actively managed by 1% per year
Role of arbitrage
Management costs are significant
Index funds are boring no chance
to exceed average rates of return
29-139

Chapter 36
Extending the Analysis of Aggregate
Supply
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

From Short Run to Long Run

Short run
Input prices inflexible
Upsloping aggregate supply
Long run
Input prices fully flexible
Vertical aggregate supply
The transition?
LO1

29-141

From Short Run to Long Run

Production above potential output:
High demand for inputs
Input prices rise
Short run aggregate supply shifts
left
Return to potential output
Production below potential output
Graphical examples
LO1

29-142

Extended AD-AS Model

Demand-Pull Inflation

Price Level

ASLR

P3

AS1

c
b

P2
P1

AS2

a
AD2
AD1

Qf Q2
Real Domestic Output
LO2

29-143

Extended AD-AS Model

Cost-Push Inflation
AS2

Price Level

ASLR

P3
P2

AS1

b
a

P1

AD2
AD1

Q2 Qf
Real Domestic Output
LO2

29-144

Extended AD-AS Model

Recession

Price Level

ASLR

AS2

P1
P2

AS1

b
c

P3

AD1
AD2

Q 1 Qf
Real Domestic Output
LO2

29-145

Extended AD-AS Model

Explaining ongoing inflation
Ongoing economic growth shifts
aggregate supply
Ongoing increases in money supply
shift aggregate demand
Small positive rate of inflation

LO2

29-146

Economic Growth, Ongoing

Inflation

Consumer Goods

LO2

Long Run
Aggregate
Supply

Price Level

Capital Goods

Productions
Possibilities

Increase in
production
possibilities

Real GDP

Increase in long-run
aggregate supply
29-147

U.S. Growth
ASLR1

ASLR2
AS2

Price level

AS1

P2
P1
AD2

AD1
0

Q1

Q2

Real GDP
LO2

29-148

Inflation and Unemployment

Low inflation and low unemployment
rates
Feds major goals
Compatible or conflicting?
Short-run tradeoff
Aggregate supply shocks cause
both rates to rise
No long-run tradeoff
LO3

29-149

The Phillips Curve

Price Level

AS

P3
P2

AD3

P1
P0

AD2
AD1
AD0

Q0

Q1 Q2 Q3

Real Domestic Output

LO3

29-150

The Phillips Curve

Demonstrates short-run tradeoff
between inflation and unemployment
Concept

Empirical Data
Annual Rate of Inflation (Percent)

Annual Rate of Inflation (Percent)

Data for the 1960s

Unemployment Rate (Percent)

LO3

69
68
66
67
65
64

63
62

61

Unemployment Rate (Percent)

29-151

The Phillips Curve

1960s economists believed in stable,
predictable tradeoff
Phillips curve shifts over time
Adverse supply shocks 1970s
OPEC oil price shock
Stagflation
Stagflations demise 1980s
LO3

29-152

The Phillips Curve

No long-run tradeoff between
inflation and unemployment
Short-run Phillips curve
Role of expected inflation
Long-run vertical Phillips curve
Disinflation

LO4

29-153

The Phillips Curve

Annual rate of inflation (percent)

14
13
12
11
10
9
8
7
6
5
4
3
2
1

Unemployment rate (percent)

LO4

29-154

The Phillips Curve

The Misery Index, Selected Nations, 2001-2012

LO4

29-155

Annual Rate of Inflation (Percent)

The Long-Run Phillips Curve

PCLR

15

PC3
12

b3
PC2

a3
b2

PC1
6

c3

a1

c2

b1

a2

Unemployment Rate (Percent)

LO4

29-156

Taxes and Aggregate Supply

Supply-side economics
Tax and incentives to work
Incentives to save and invest
The Laffer curve
Tax Rate (Percent)

100
n
m

LO5

m
l

Laffer Curve

Maximum
Tax Revenue

Tax Revenue (Dollars)

29-157

Taxes and Aggregate Supply

Criticisms of the Laffer curve
Taxes, incentives, and time
Inflation or higher real interest
rates
Position on the curve
Rebuttal and evaluation

LO5

29-158

Chapter 37
Current Issues in Macro
Theory and Policy
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Causes of Macro Instability

Mainstream view
Held by most economists
Price stickiness
Unexpected demand shocks
Variable investment spending
Unexpected supply shocks

LO1

29-160

Causes of Macro Instability

Monetarist view
Government interference is the
problem
Equation of exchange MV = PQ
Stable velocity
Monetary causes of instability
Inappropriate monetary policy
LO1

29-161

Causes of Macro Instability

Real-business-cycle view
Shifts in long-run aggregate supply

Price Level

ASLR2 ASLR1

P1

AD1
AD2
Q2
LO1

Q1

Real Domestic Output

29-162

Causes of Macro Instability

Coordination failures
Fail to reach equilibrium because of
lack of coordination mechanism
Limited information
Expectations and self-fulfilling
prophecy
Unemployment equilibrium
Inflation equilibrium
LO1

29-163

Chapter 37
Current Issues in Macro
Theory and Policy
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Does the Economy Self Correct?

New classical view
Rational expectations theory
Monetarists
Automatic correction will occur
Speed of adjustment
Unanticipated price-level
changes
Fully anticipated price-level
changes
LO2

29-165

Does the Economy Self

Correct?
Mainstream view
Downward wage inflexibility
Efficiency wage theory
Greater work effort
Lower supervision costs
Reduced job turnover
Insider-outsider relationships

LO2

29-166

Rules or Discretion?
In support of policy rules
Reduce macro instability
Monetary rule
Shift AD to keep up with AS
Price stability achieved
Inflation targeting
Balanced budget
LO3

29-167

Rules or Discretion?
Defense of discretionary stabilization
policy
Discretionary monetary policy
Velocity is not stable
Discretionary fiscal policy
Useful during recession
Policy successes
LO3

29-168

Rules or Discretion?

LO4

29-169

The Taylor Rule

Rules: Passive monetary policy
Discretion: Active monetary policy
Hybrid policy rule to dictate Fed
actions
Policy responds to changes in real
GDP and inflation
Fed explains deviations from the rule
Increase Fed credibility and reduce
uncertainty
29-170

Chapter 38
International Trade
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Some Key Trade Facts

U.S. trade deficit in goods
$735 billion in 2012
U.S. trade surplus in services
$196 billion in 2012
Canada largest U.S. trade partner
Trade deficit with China
$315 billion in 2012
Exports are 14% U.S. output
Dependence on oil
LO1

29-172

Some Key Trade Facts

Principal U.S. exports
include:
Chemicals
Agricultural products
Consumer durables
Semiconductors
Aircraft
U.S. provides about
8.1% of worlds
exports

LO1

Principal U.S.
imports include:
Petroleum
Automobiles
Metals
Household
appliances
Computers

29-173

Economic Basis for Trade

Nations have different resource
endowments
Labor-intensive goods
Land-intensive goods
Capital-intensive goods

LO2

29-174

Comparative Advantage
Assumptions
Two nations
Same size labor force
Constant costs in each country
Different costs between countries
U.S. absolute advantage in both
Opportunity cost ratio
Slope of the curve
Vegetables sacrificed per ton of beef
LO2

29-175

Comparative Advantage
Self-sufficiency output mix
Specialization and trade
Produce the good with the lowest
domestic opportunity cost
Opportunity cost of 1 ton of beef:
1 pound of vegetables in U.S.
2 pounds of vegetables in Mexico
29-176

Comparative Advantage
Terms of trade
U.S. 1V = 1B
U.S. will sell 1B for more than 1V
Mexico 2V = 1B
Mexico will pay less than 2V for 1B
Settle between the two
Depends on supply/demand factors
Assume 1B = 1.5V
LO2

29-177

Comparative Advantage
Gains from trade
Trading possibilities line
Slope equals terms of trade
Improved options
Complete specialization
More of both goods
More efficient resource allocation
LO2

29-178

Comparative Advantage
Trade with increasing costs
Concave production curve
Resources not perfectly
substitutable
Incomplete specialization
Case for free trade
Promote efficiency
Promote competition
LO2

29-179

Supply and Demand Analysis

World price
Domestic price with no trade
World price > domestic price
Export surplus
Export supply curve
World price < domestic price
Import shortage
Import supply curve
LO3

29-180

Trade Barriers and Export

Subsidies
Tariffs
Revenue tariff
Protective tariff
Import quota
Nontariff barrier (NTB)
Voluntary export restriction
(VER)
Export subsidy
LO4

29-181

Economic Impact of Tariffs

Direct effects
Decline in consumption
Increase in domestic production
Decline in imports
Tariff revenue
Indirect effects

LO4

29-182

Economic Impact of Quotas

LO4

Decline in consumption
Increase in domestic production
Decline in imports
Quotas do not provide for any
government revenue but instead
transfer it to foreign producers

29-183

The Case for Protection

LO5

Military self-sufficiency
Diversification for stability
Infant industry
Protection against dumping
Increased domestic employment
Cheap foreign labor

29-184

Multilateral Trade Agreements

General Agreement on Tariffs and
Trade (GATT)
World Trade Organization (WTO)
European Union (EU)
North American Free Trade
Agreement (NAFTA)

LO6

29-185

GATT
Three principles:
Equal, nondiscriminatory trade
between member nations
Reduction in tariffs
Elimination of import quotas

LO6

29-186

WTO
Established by Uruguay Round of
GATT
153 member nations in 2010
Oversees trade agreements and
rules on disputes
Critics argue that it may allow
nations to circumvent environmental
and worker-protection laws
LO6

29-187

European Union
Initiated in 1958 as Common Market
Abolished tariffs and import quotas
between member nations
Established common tariff with
nations outside the EU
Created Euro Zone with one currency

LO6

29-188

NAFTA
Agreement between U.S., Canada,
and Mexico
Established a free trade zone
between the countries
Trade has increased in all countries
Enhanced standard of living

LO6

29-189

Trade Adjustment and

Offshoring
Trade Adjustment Assistance Act
Designed to help individuals hurt
by international trade
Offshoring of jobs
Shifting of work previously done by
American workers to workers
abroad

LO6

29-190

Petition of the Candlemakers

Petition of candlemakers asking for
protection from natural light
producers such as the sun
Tongue-in-cheek argument
supporting the idea of free trade

29-191

Chapter 39
The Balance of Payments,
Exchange Rates, and Trade
Copyright 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

International Transactions
International trade
Buy/sell current goods or services
Imports and exports
International asset transactions
Buy/sell real or financial assets
Buy stock
Sell your house to a foreigner
Requires currency exchange
LO1

29-193

Balance of Payments
Sum of international financial
transactions
Current account
Balance on goods and services
Net investment income
Net transfers
Balance on current account
LO2

29-194

Balance of Payments
Capital and financial account
Capital account
Financial account
Balance of payments accounts sum
to zero
Current account deficits generate
asset transfers to foreigners
Official reserves
LO2

29-195

Official Reserves
Foreign currencies, certain reserves
with the IMF, and stocks of gold
Owned by government or central
bank
Used as balancing mechanism in
balance of payments

LO2

29-196

Flexible Exchange Rates

The Market for Foreign Currency

(Pounds)

Dollar Price of 1 Pound

S1
$3

$2

$1

Dollar
Depreciates
(Pound
Appreciates)

Exchange
Rate: $2 = 1

Dollar
Appreciates
(Pound
Depreciates)

D1
0

Q1

Quantity of Pounds
LO3

Q
29-197

Flexible Exchange Rates

Determinants of exchange rates
Factors that shift demand/supply
Changes in tastes
Relative income changes
Relative price-level changes
Purchasing-power-parity theory
Relative interest rates
Relative expected returns on assets
Speculation
LO3

29-198

Flexible Exchange Rates

The Market for Foreign Currency

(Pounds)

Dollar Price of 1 Pound

S1
c

$3

$2

Balance
Of Payments
Deficit

b D
2

Exchange
Rate:
$2 = 1

$1

Exchange
Rate:
$3 = 1

D1
0
LO3

Q1

Quantity of Pounds

Q2

Q
29-199

Flexible Exchange Rates

Eliminate balance of payments
deficit or surplus
Disadvantages of flexible exchange
rates
Volatility
Uncertainty and diminished trade
Terms-of-trade changes
Instability
LO3

29-200

Fixed Exchange Rates

Government intervention
Use of reserves
Trade policies
Exchange controls and rationing
Distorted trade
Favoritism
Restricted choice
Black markets
Macroeconomic adjustments
LO4

29-201

The Managed Float

Gold standard 1879-1934
Fixed exchange rate system
Bretton Woods 1944-1971
Fixed exchange rate system
indirectly tied to gold
Managed float 1971-present

LO5

29-202

The Managed Float

Dependence on foreign exchange
markets
Occasional intervention
In support of managed float
Concerns with managed float

LO5

29-203

U.S. Trade Deficit

Large and persistent
Causes of trade deficits
High U.S. growth (relatively)
China
Price of oil
Low U.S. saving rate
Implications of trade deficits
Increased current consumption
Increased indebtedness
LO6

29-204

Speculation in Currency Markets

Positive or negative influence?
Contributes to currency market
fluctuations
Self-fulfilling expectations
Smoothing short-term fluctuations
Absorbing risk
Futures market at work
Positive role played overall
29-205