Nominal Interest Rate (R)
rate at which you can exchange dollars today for dollars tomorrow. the interest rate that you earn (or pay) on a loan
The nominal rate is often set by: real interest rate + expected inflation.
Real Interest Rate (r)
rate at which goods today can be traded for goods tomorrow. the nominal interest rate adjusted for inflation.
Fisher Effect
the idea that an increase in expected inflation drives up the nominal interest rate, which leaves the expected real interest rate unchanged
Fisher Equation (Finding Interest Rates)
Liquidity
refers to the ease with which an asset can be used to purchase a good or service
Consumer Price Index (CPI)
cost of a basket of goods purchased by an average urban consumer (likely overestimates inflation)
Problems with CPI
- changes in quality of goods and services
- introduction of new goods and services
- CPI tells you the cost to but the same things, not the cost to achieve the same utility
Consumption Deflator
reflects the average price for the goods and services that indiviudals actually buy (likely underestimates inflation)
Inflation π
refers to increases in the overall level of prices in the economy
Inflation Formula
CPIt+1 - CPIt / CPIt
Inflation: Country Comparisons
- inflation almost always positive
- varies across countries
- strong correlation between inflation and increase rate of money supply
- Inflation rate typically less than growth rate of money supply
Employment: Steady State
employment is in steady state when unemployed find work at the same rate the employed are losing jobs.
u* = σ/(σ+ φ)
Job Finding Rate (φ)
probablility that a given unemployed individual will be employed next period.
φ is dominant source of changes in unemployment. Responsible for 2/3 of increases in unemployment. D
Average duration of unemployment 1/φ
Job Loss Rate (σ)
probability that a given employed individual will be unemployed
Average duration of employment 1/σ
Is job creation and loss good for productivity?
Yes, job creation and destruction serve to reallocate jobs from less to more productive establishments.
As much as half of overall productivity growth in the economy comes from the reallocation of jobs across establishments
Labor Force
Unemployed + Employed
Employment Statistics: Total Population
U+E+N
N= not in labor force
Participation Rate
(E+U)/Pop x 100
Unemployment Rate
U/(U+E) x 100
or
U/LF x 100
Labor Supply Effects: Wages Decrease
It depends on the individual
incomes effect is -, substitution effect is +
On average the two effects cancel each other out. In the last 50 years real wages have doubles and hours are the same
Labor Supply Effects: Increase in Z/Investments
If non-earned income increases labor supply decreases.
Implications of labor supply model
using taxes to pay for something that everyone consumes has negative effects on overall labor supply.
Labor Supply Effects: Changing Taxes
the same as changing wages. If the assumption holds, them the income and sub effect cancel out and the end result is no effect.
Labor Supply
(P)rice x (C)onsumption = (W)ages x (L)abor + (I)nvestments
PC = WL+I
Demand for real money supply
Md = (P)rice x L(R-,Y+,TC+)
L (real money balances) is a function of the Rate, Income (Y), and Transaction Costs.
As rate increase L decreases, as Y increases L Increases, as TC increases L increases.
Transaction Costs
How easy it is to turn interest bearing assets into cash. Higher TC increase demand for cash. If ATMs and Credit Cards disappeared I would want to have more cash on hand.
Open Market Operations
transactions in which the Fed exchanges money for government securities, specifically treasury bills.
Fed: Increasing Money Supply
Fed buys treasuries, injecting money nto the economy
Fed: Decreasing Money Supply
Sells treasuries, extracting money from the economy
Buying Treasuries is like printing money
If the Fed buys government treasuries, then it pays interest on those treasuries directly to the treasury department. Thus it’s like creating new money.
Money Supply Measure used by the Fed
- Currency: the volume of currency held by the public (households and …rms.)
- M1: currency held by the public in addition to demand deposits and travellers checks.
- M2: M1 plus saving deposits, money market accounts and some time
- deposits.
Currency Ratio (cr)
currency/deposits
I have $20 in my wallet and $1000 in a bank.
Reserve Ratio (rr)
Reserves/deposits
Fed sets minimum but banks can choose to keep more reserves
A individual deposits $1000 in the bank. The bank keeps $100 as reserves and lends the other $900. rr=100/1000
Monetary Base (B)
Currency + Deposits
Fed controls both of these through monetary policy.
Money Multiplier to Determine M1
M1 = ((cr+1)/cr+rr))xB
B is controlled by the Fed and the money multiplier is determined by the actions of individuals.
Money Multiplier
(cr+1)/(cr+rr)
Determined by the preferences of banks and individuals
the larger rr, the lower the multiplier
the larger cr, the lower the multiplier
if people prefer more cash, then they have less in banks which means less lending, which means lower multiplier.
IS-LM Comparative Statics: Increase in R
Income (Y) and (I)nvestment decrease
IS-LM Comparative Statics: Decrease in R
(I)nvestment and (Y) Income Increase
Firms have less incentive to save and borrowing becomes cheaper so they start more new projects.
IS-LM Comparative Statics: Increase in Y
the level of savings increases so R decreases.
More supply than demand.
IS-LM Comparative Statics: Decrease in Y
level of savings decreases reducing the supply of money (via the multiplier) so R goes up.
Seignorage
the real revenue gained from printing money
Limits of Seignorage
After a certain point printing money decreases the amount a government can buy.
The slice of the pie you get is bigger but the size of the pie gets smaller. So there is a golden rule.
It acts as a regressive tax, it raises the price of all goods on the economy, and hurts those who are more cash dependent (low income).
Cost of inflation
- shoe leather costs: transaction costs increase because you need more frequent purchases or trips to the bank to avoid costs
- menu costs: costs to producers of changing prices (reprinting menus)
- Costs from lack of indexing: minimum wage is not indexed to inflation so each year is a pay cut for these workers.
Benefits of Inflation
- positive π helps the labor market function better
- it’s more difficult to directly cut a workers pay. With inflation no raise is equal to a pay cut.
Hyperinflation
monthly inflation over 50%.
Causes of Hyperinflation
- Fiscal shortfalls drive hyperinflation. Deficits need to be paid.
- Fiscal policy is the only way to fix it.
- Can be caused by huge shocks to the budget.
- drastic reduction in revenues
- natural disasters
- huge payment increases
- Germany had to make large payments after WWI.
- Can be caused by huge shocks to the budget.
Importance of Stable Inflation Rates
Unstable inflation rates will actually affect todays inflation.
If the Fed does a temporary change in inflation to make paying its debts easier, it will lose trust when it tells banks that is will keep it stable after. Then banks will not trust the Fed and the expected inflation will be different from the Fed target.
IS-LM: What happens to C if Investment decreases?
Theoretically ambiguous, because a decrease in I ⇒decrease in Output (Y) ⇒ decrease in C. But decrease in investment leads to a decrease in R, which increase C.
In real life the first effect dominates, so C decreases.
Short run vs Long run changes in Money Supply
Short run: M increases ⇒ R decreases and Y increases
Long Run: M increases ⇒ P increases ⇒π increasing ⇒R increasing.
IS-LM: Investment and Savings
Investment (r drives Y), Savings (Y drives r)
r increases ⇒ I decreases ⇒Y decreases
more expensive for firms to borrow and better to save money then spend
r decreases ⇒I increases ⇒ Y increases
