Transcript Interest Rate

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Always draw a graph when in doubt!!!
Answer the questions you know first and then
spend more time on the calculations or more
time-consuming ones graph/charts)
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Identify- short word or phrase (1 sentence) to
receive points (don’t write paragraphs)
Illustrate- draw or re-draw graphs (be sure to
label all axes & all points (Q & P) OR (Y & PL)
Define- definition of concept (1-2 sentences)
Indicate- state what is expected to happen
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Use the 10 minute reading period to write
notes (pre-write)- draw graphs & start
outlining your ideas
Work in order a, b, c & d (each part will ask
you to build on the prior one)
Be prepared for other graphs- Money market,
money supply, etc to bring back the AD/AS
graph
Law of Demand (inverse relationship)
As price increases, quantity demanded will
decrease.
As price decreases, quantity demanded will
increase.
 Law of Supply (direct relationship)
As price increase, the quantity supplied will
increase.
As price decrease, the quantity supplied
decreases.
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Opportunity Cost
Trade-offs
Inefficiency (inside curve) vs. efficiency (any
point on the curve)
Growth (rightward shift in curve)
Opportunity Cost
Example:
1. The opportunity cost of
moving from a to b is…
2.The opportunity cost of
moving from b to d is…
3.The opportunity cost of
moving from d to b is…
4.The opportunity cost of
moving from f to c is…
5.What can you say about point F?
6. What can you say about point G?
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Opportunity Cost
Example:
1. The opportunity cost of
moving from a to b is… 2 Bikes
2.The opportunity cost of
moving from b to d is… 7 Bikes
3.The opportunity cost of
moving from d to b is… 4 Computer
4.The opportunity cost of
moving from f to c is… 0 Computers
5.What can you say about point F?
Inefficient
6. What can you say about point G?
Unattainable
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Absolute advantage- producing a higher
quantity given the same amount of resources
 Comparative advantage- producing at a lower
opportunity cost (must do calculation)
Food
Clothing
Great Britain
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3
U.S.
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1. Which of the following statements must be true?
A.
B.
C.
D.
E.
The U.S. has both the absolute and comparative
advantage in producing food.
Japan has both the absolute and comparative
advantage in producing food.
The U.S. has both the absolute and comparative
advantage in producing clothing.
Japan has both the absolute and comparative
advantage in producing clothing.
Japan has the absolute advantage in producing
soybeans and the comparative advantage in
producing clothing.
2. In the Japan, the opportunity cost of the first
unit of
A.
B.
C.
D.
E.
Food is 1/3 units of clothing.
Food is ¼ units of clothing.
Clothing is 3 units of food.
Clothing is 4 units of food.
Clothing is 5 units of food.
GDP = C + I + G + Nx
(net exports = exports (goods going out of
U.S.)- imports (goods coming into U.S.)
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For all countries there are three major
economic goals:
1. Promote Economic Growth
2. Limit Unemployment
3. Keep Prices Stable (Limit Inflation)
In this unit we will analyze how each
of these are measured.
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Economists collect statistics on production,
income, investment, and savings.
This is called national income accounting.
The most important measure of growth is GDP.
Gross Domestic Product (GDP) is the dollar value of all
final goods and services produced within a country’s
borders in one year.
• Dollar value- GDP is measured in dollars.
• Final Goods-GDP does not include the value of
intermediate goods. Intermediate goods are goods
used in the production of final goods and services.
• One Year-GDP measures annual economic
performance.
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What is NOT included in GDP?
1. Intermediate Goods
• No Multiple Counting, Only Final Goods
• EX: Price of finished car, not the
radio, tire, etc.
2. Nonproduction Transactions
•Financial Transactions (nothing produced)
•Ex: Stocks, bonds, Real estate
•Used Goods
•Ex: Old cars, used clothes
3. Non-Market (Illegal) Activities
•Ex: Illegal drugs, unpaid work
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Calculating GDP
Two Ways of calculating GDP:
1. Expenditures Approach-Add up all the
spending on final goods and services
produced in a given year.
2. Income Approach-Add up all the income
that resulted from selling all final goods and
services produced in a given year.
Both ways generate the same amount since
every dollar spent is a dollar of income.
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NRU- natural rate of unemployment (4-6%)
Frictional and cyclical unemp. is normal
Labor force = # ppl employed/# actively
seeking work within last 6 weeks
Unemp rate = # ppl unemployed/# actively
seeking work within last 6 weeks
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Nominal prices- are actual prices for that
calendar year
Real prices- prices adjusted for inflation
real interest rate = inflation + nominal
Consumer Price Index (CPI)
The most commonly used measurement inflation for
consumers is the Consumer Price Index
Here is how it works:
• The base year is given an index of 100
• To compare, each year is given an index # as well
CPI =
Price of market basket
Price of market
basket in base year
x 100
1997 Market Basket: Movie is $6 & Pizza is $14
Total = $20 (Index of Base Year = 100)
2009 Market Basket: Movie is $8 & Pizza is $17
Total = $25 (Index of 125)
•This means inflation increased 25% b/w ’97 & ‘09
•Items that cost $100 in ’97 cost $125 in ‘09
Problems with the CPI
1. Substitution Bias- As prices increase for the fixed
market basket, consumers buy less of these products
and more substitutes that may not be part of the
market basket. (Result: CPI may be higher than
what consumers are really paying)
2. New Products- The CPI market basket may not
include the newest consumer products. (Result: CPI
measures prices but not the increase in choices)
3. Product Quality- The CPI ignores both
improvements and decline in product quality.
(Result: CPI may suggest that prices stay the same
though the economic well being has improved
significantly)
Aggregate- the sum of the entire economy’s demand or supply
Aggregate Demand & Supply
Shifters of Aggregate Demand
AD = C + I + G + X
Change in Consumer Spending
Change in Government Spending
Change in Investment Spending
Net EXport Spending
Shifters of Aggregate Supply
AS = P + A + I + R
Change in
Change in
Change in
Change in
Productivity (Investment)
Actions of the Government
Inflationary Expectations
Resource Prices
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Shifters of Aggregate Demand
1. Change in Consumer Spending
Consumer Wealth (Boom in the stock market…)
Consumer Expectations (People fear a recession…)
Household Indebtedness (More consumer debt…)
Taxes (Decrease in income taxes…)
2. Change in Investment Spending
Real Interest Rates (Price of borrowing $)
(If interest rates increase…)
(If interest rates decrease…)
Future Business Expectations (High expectations…)
Productivity and Technology (New robots…)
Business Taxes (Higher corporate taxes means…)
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Shifters of Aggregate Demand
3. Change in Government Spending
(War…)
(Nationalized Heath Care…)
(Decrease in defense spending…)
4. Change in Net Exports (X-M)
Exchange Rates
(If the us dollar depreciates relative to the euro…)
National Income Compared to Abroad
(If a major importer has a recession…)
(If the US has a recession…)
“If the US get a cold, Canada gets Pneumonia”
AD = GDP = C + I + G + Xn
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Why is AD downward sloping?
1. Real-Balance Effect• Higher price levels reduce the purchasing
power of money
• This decreases the quantity of expenditures
• Lower price levels increase purchasing power
and increase expenditures
Example:
• If the balance in your bank was $50,000, but inflation
erodes your purchasing power, you will likely reduce
your spending.
• So…Price Level goes up, GDP demanded goes down.
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Why is AD downward sloping?
2. Interest-Rate Effect
• When the price level increases, lenders
need to charge higher interest rates to
get a REAL return on their loans.
• Higher interest rates discourage
consumer spending and business
investment. WHY?
• Example: An increase in prices leads to an increase
in the interest rate from 5% to 25%. You are less
likely to take out loans to improve your business.
• Result…Price Level goes up, GDP demanded goes
down (and Vice Versa).
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Why is AD downward sloping?
3. Foreign Trade Effect
• When U.S. price level rises, foreign buyers
purchase fewer U.S. goods and Americans
buy more foreign goods
• Exports fall and imports rise causing real
GDP demanded to fall. (XN Decreases)
• Example: If prices triple in the US, Canada will no
longer buy US goods causing quantity demanded of
US products to fall.
• Again, Price Level goes up, GDP demanded goes
down (and Vice Versa).
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Answer and identify shifter:
C.I.G.X
or
P. A.I. R.
A major increase in productivity.
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Answer and identify shifter:
C.I.G.X
or
P. A.I. R.
B
A
D
A
D
B
A
A
C
A
A major increase in productivity.
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Inflationary Gap
Output is high and unemployment is less than NRU
LRAS
Price
Level
AS
Actual GDP
above
potential GDP
PL1
AD1
QY Q1
GDPR
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Recessionary Gap
Output low and unemployment is more than NRU
LRAS AS1
Price
Level
Actual GDP
below
potential GDP
PL1
AD
Q1 QY
GDPR
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Short Run Phillips Curve
What happens when AS falls causing stagflation?
Increase in unemployment and inflation
Inflation
5%
SRPC1
1%
SRPC
2%
9%
Unemployment
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Short Run vs. Long Run
What happens when AD falls?
What happens in the long run?
Inflation
Long Run
Phillips Curve
5%
In the long run wages
fall and there is no
tradeoff between
inflation and
unemployment
3%
1%
2%
5%
SRPC
SRPC1
Unemployment
9%
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AD/AS and the Phillips Curve
Show what happens on both graphs if AD increase
Price
Level
LRAS
Inflation
LRPC
AS
PLe
AD1
AD
QY
GDPR
SRPC
UY
Unemployment
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AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC with the
recessionary gap. What happens when AD falls?
Price
Level
LRAS
Inflation LRPC
AS
PLe
AD
AD1
QY GDPR
SRPC
UY
Unemployment
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AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC at full
employment. What happens when AS falls?
Price
Level
LRAS
Inflation
LRPC
AS1
AS
PLe
SRPC1
AD
QY
GDPR
SRPC
UY
Unemployment
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AD/AS and the Phillips Curve
Correctly draw the LRPC and SRPC with an
recessionary gap. What happens when AS goes up?
Price
Level
LRAS
AS
Inflation
LRPC
AS1
PLe
SRPC
AD
QY
GDPR
SRPC1
UY
Unemployment
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How does the Government Stabilizes the
Economy?
The Government has
two different tool
boxes it can use:
1. Fiscal PolicyActions by Congress to
stabilize the economy.
OR
2. Monetary PolicyActions by the
Federal Reserve Bank
to stabilize the
economy.
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Two Types of Fiscal Policy
Discretionary Fiscal Policy-
• Congress creates a new bill that is designed to
change AD through government spending or
taxation.
•Problem is time lags due to bureaucracy.
•Takes time for Congress to act.
•Ex: In a recession, Congress increase spending.
Non-Discretionary Fiscal Policy
•AKA: Automatic Stabilizers
•Permanent spending or taxation laws enacted to
work counter cyclically to stabilize the economy
•Ex: Welfare, Unemployment, Min. Wage, etc.
•When there is high unemployment, unemployment
benefits to citizens increase consumer spending.
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Contractionary Fiscal Policy (The BRAKE)
Laws that reduce inflation, decrease GDP
(Close a Inflationary Gap)
• Decrease Government Spending
• Tax Increases
• Combinations of the Two
Expansionary Fiscal Policy (The GAS)
Laws that reduce unemployment and increase
GDP (Close a Recessionary Gap)
• Increase Government Spending
• Decrease Taxes on consumers
• Combinations of the Two
How much should the Government Spend?
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
Money multiplier= 1/MPS
1/.2= 1/1/5= 5
Increasing the Money Supply
Interest
Rate (ir)
SM SM1
10%
5%
If the FED increases the
money supply, a temporary
surplus of money will
occur at 5% interest.
The surplus will cause the
interest rate to fall to 2%
2%
DM
200
Increase
money supply
250
How does this
affect AD?
Quantity of Money
(billions of dollars)
Decreases
interest rate
Increases
investment
Increases
AD 43
Decreasing the Money Supply
Interest
Rate (ir)
SM1 SM
10%
5%
2%
If the FED decreases the
money supply, a temporary
shortage of money will occur
at 5% interest.
The shortage will cause the
interest rate to rise to 10%
How does this
affect
AD?
D
M
150
Decrease
money supply
200
Quantity of Money
(billions of dollars)
Increase
interest rate
Decrease Decrease AD
investment
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Showing the Effects of
Monetary Policy Graphically
Three Related Graphs:
• Money Market
• Investment Demand
• AD/AS
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Interest
Rate (i)
Interest
Rate (i)
S&D of Money
SM SM1
10%
10%
5%
5%
2%
2%
DM
200
PL
250
QuantityM
AD/AS
PL1
PLe
Qe
Q1
DI
Quantity of Investment
The FED increases the
money supply to
stimulate the economy…
AS
AD
Investment Demand
AD1
GDPR
1. Interest Rates Decreases
2. Investment Increases
3. AD, GDP and PL Increases
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Interest
Rate (i)
Interest
Rate (i)
S&D of Money
SM1 SM
10%
10%
5%
5%
2%
2%
DM
175
PL
200
QuantityM
AD/AS
PLe
Quantity of Investment
1. Interest Rates increase
2. Investment decreases
3. AD, GDP and PL decrease
PL1
AD
AD1
Qe
DI
The FED decreases the
money supply to slow
down the economy…
AS
Q1
Investment Demand
GDPR
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Loanable Funds Market
At the equilibrium real interest rate the amount
borrowers want to borrow equals the amount lenders
want to lend.
Real Interest
Rate
SLenders
re
DBorrowers
QLoans
Quantity of Loans
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Loanable Funds Market
Example: The Gov’t increases deficit spending?
Government borrows from private sector
Increasing the demand for loans
Real Interest
Rate
SLenders
Real interest
rates increase
causing
crowding out!!
r1
re
D1
DBorrowers
QLoans Q1
Quantity of Loans
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Loanable Funds Market
Demand Shifters
Supply Shifters
1. Changes in perceived
business opportunities
2. Changes in
government
borrowing
• Budget Deficit
• Budget Surplus
1. Changes in private
savings behavior
2. Changes in public
savings
3. Changes in foreign
investment
4. Changes in expected
profitability
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The Money Multiplier
Example: Assume the reserve ratio in the US is 10%
You deposit $1000 in the bank
The bank must hold $100 (required reserves)
The bank lends $900 out to Bob (excess reserves)
Bob deposits the $900 in his bank
Bob’s bank must hold $90. It loans out $810 to Jill
Jill deposits $810 in her bank
SO FAR, the initial deposit of $1000 caused the
CREATION of another $1710 (Bob’s $900 + Jill’s $810)
Money
Multiplier
1
= Reserve Requirement (ratio)
Example:
• If the reserve ratio is .20 and the money supply increases
2 Billion dollars. How much the money supply increase?51
Using Reserve Requirement
1. If there is a recession, what should the FED do to
the reserve requirement? (Explain the steps.)
Decrease the Reserve Ratio
1.
2.
3.
Banks hold less money and have more excess reserves
Banks create more money by loaning out excess
Money supply increases, interest rates fall, AD goes up
2. If there is inflation, what should the FED do to the
reserve requirement? (Explain the steps.)
Increase the Reserve Ratio
1. Banks hold more money and have less excess reserves
2. Banks create less money
3. Money supply decreases, interest rates up, AD down
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Practice
Don’t forget the Monetary Multiplier!!!!
1. If the reserve requirement is .5 and the FED
sells $10 million of bonds, what will happen
to the money supply?
2. If the reserve requirement is .1 and the FED
buys $10 million bonds, what will happen to
the money supply?
3. If the FED decreases the reserve requirement
from .50 to .20 what will happen to the
money multiplier?
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FOREIGN EXCHANGE
FOREX Supply and Demand
Simplified
Imagine a huge table with all the different
currencies from every country
This is the Foreign Exchange Market!
Just like at a product market, you can’t take
things without paying.
If you demand one currency, you must supply
your currency.
Ex: If Canadians what Russian Rubles.
The demand for Rubles in the FOREX
market will increase and the supply of
Canadian Dollars will increase.
What happens if Europeans prefer
vacationing in the United States?
€
$
Dollars
$
€
S
er1
Euros
S
S1
ere
D1
D
Quantity of Dollars
ere
er1
D
Quantity of Euros
The Dollar APPRECIATES The Euro DEPRECIATES
1. Changes in TastesEx: British tourists flock to the U.S…
Demand for U.S. dollars increases (shifts right)
Supply of British pounds increases (shifts right)
Pound-depreciates
Dollar-appreciates
2. Changes in Relative Incomes (Resulting
in more imports)Ex: US growth increase US incomes….
U.S. buys more imports…
U.S. Demand for pounds increases
Supply of U.S. dollars increases
Pound- appreciates
Dollar- depreciates
3. Changes in Relative Price Level
(Resulting in more imports)-
Ex: US prices increase relative to Britain….
U.S. demand for cheaper imports increases…
U.S. demand for pounds increases
Supply of U.S. dollars increases
Pound- appreciates
Dollar- depreciates
4. Changes in relative Interest RatesEx: US has a higher interest rate than Britain.
British people want to put money in US banks
Capital Flow increase towards the US
British demand for U.S. dollars increases…
British supply more pounds
Pound-depreciates
Dollar- appreciates
What will happen to the international value of the
Mexican peso if there is high inflation in Mexico?
Pesos
The peso DEPRECIATES
The demand for pesos
will decrease since
Mexico's trading
partners will not want
to purchase higher
priced Mexican
products.
The supply will
increase as Mexicans
look to buy lower
priced imports.
Practice
For each of the following examples, identify what will
happen to the value of US Dollars and Japanese Yen.
1. American tourists increase visits to Japan.
2. The US government significantly decreases
personal income tax.
3. Inflation in the Japan rises significantly faster
than in the US.
4. Japan has a large budget deficit that increases
Japanese interest rates.
5. Japan places high tariffs on all US imports.
6. The US suffers a larger recession.
7. The US Federal Reserve sells bonds at high
interest rates.
How do these scenarios affect exports and imports?
Practice
For each of the following examples, identify what will
happen to the value of US Dollars and Japanese Yen.
1.
2.
3.
4.
5.
USD depreciates and Yen appreciates
USD depreciates and Yen appreciates
USD appreciates and Yen depreciates
USD depreciates and Yen appreciates
USD depreciates (Demand Falls) and Yen
appreciates (Supply Falls)
6. USD appreciates (Supply Falls) and Yen
depreciates (Demand Falls)
7. USD appreciates and Yen depreciates
Scenarios 1, 2, and 4 will increase US exports because
US products are now relatively “cheaper”