ECON 116 STUDY GUIDE

AGGREGATE SUPPLY CURVE (AS)

AS is an upward sloping curve (since: Y then P ) that traces out the price-quantity decision of firms in response to changes in the
economy (like P or D)
As demand/prices shift, firms face new demand and marginal revenue curves.
Firms then choose new price-quantity combinations
If D or P, then D and MR shift rightward  leading to the simultaneous increase in price level
Effect of positive cost shock: shift the AS curve to the right , which makes P and Y
Effect of a negative supply shock: stagflation, shifting the marginal cost curve to the left  and forces firms to operate at higher prices and
reduced capacity (AS  P and Y)

VERTICAL AS CURVE
If AS curve is vertical at a certain point of Y, that means the economy is at full capacity
No more can be produced in the short run, without improvements in technology of an increase in resources (a rightward shift in AS)
Full crowding out effect means that a + G is accompanied by a - I = zero net effect on Y
Remember that the multiplier model says that ∆ Y = (1 / 1-b)*∆ G
Let’s say that G=10
Then… Y  Md  r  I  Y=(1 / 1-b)*10

INTEREST RATE EFFECTS ON CONSUMPTION

SUBSTITUTION EFFECT says that a rise in the interest rate will lead you to consume less today and save more. On the other
hand, if r, then it lowers the reward to saving. The opportunity cost of spending a dollar today has fallen. You will substitute
toward current consumption because saving is not that rewarding. (r then C)
INCOME EFFECT says that, if you have positive wealth and can earn interest by saving, then interest rates will have an effect on
consumption habits. For households with positive wealth, the income effect is the opposite of substitution. Savings earns interests,
that means a decrease in the interest rate means less non-labor income. (r, C)
But for a debtor household, who is paying interests on debts, as r, then the household is better off and C.
DECREASE IN FEDERAL FUNDS RATE
This means that banks can borrow more, which increases the deposits
DEP  by the money multiplier effect MS  r  I
The opposite would hold true if there were an increase in FFR

OPEN MARKET OPERATIONS: RRR AND THE MONEY SUPPLY

RRR  commercial banks are required to hold a smaller percentage of deposits  MS, in other words money multiplier increases
If RRR = 1, then the Fed’s open market operations will not have any effect on the money supply. Any increases in money supply will not
result in “money creation”

OTHER FED OPERATIONS

The Fed may not want to alter money supply or interest rates
Can use currency sterilization
Buy foreign currency with US bonds or buy foreign currency with US$
While, selling an equivalent amount in US Treasury bonds on the domestic market

FISCAL POLICY
Many factors determine the interest rate
GDP, growth rate, unemployment rate, price level, and growth in money supply
If inflation is very high, then Bernanke may tighten the money supply by r
The Fed tightens the money supply during an inflation (so price level is important)
GDP and PM would be underlying factors
Effect on bond prices: r  bond prices  since investors would discount them in light of the new, higher yields
Effect on foreign exchange rates: r  foreign direct investment   upward pressure on the currency (appreciation)
Effect on stock market: ambiguous because in a good economy (where Y and P), dividends on stocks are expected to 
In a good economy, if r, then discount rate  and value of stock 

FISCAL V. MONETARY POLICIES

Fiscal policy has a longer implementation lag
Fiscal policy has a shorter response lag (from the moment of implementation)
Effectiveness of fiscal and monetary policies depends on the slopes of the IM and LS curves
Monetary policy has no effect with fixed exchange rates

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ECON 116 STUDY GUIDE
INVENTORY INVESTMENT
Investment is a very useful indicator for output. If inventory investment falls, it could presage a drop in output.
Firms produce less when they detect a slowdown in the economy, therefore they use stores from inventory.
This would be a leftward shift in AS.
In the short run, Y and P (accelerating the slowdown effect predicted by the firm)
Policymakers should be concerned with negative savings rates
In the long run, C in order to pay back debt. This will reduce the standard of living.
On the other hand, the negative savings rate could be a simple reflection of spiking energy costs.
In the long run, this decrease in inventory investment could mean that consumers are predicting higher levels of permanent income
and have increased their current consumption.

FIRM’S LABOR AND CAPITAL DECISIONS

Based on: technology, expectations (animal spirits and accelerator effect), excess labor/capital, desired/optimal levels of inventories, current
amount of inventories, interest rates

BALANCE OF PAYMENTS: CURRENT ACCOUNT V. CAPITAL ACCOUNT

Balance of payments is the record of country’s transactions with the rest of the world
Country’s sources (supply) and its uses (demand) of foreign exchange
Current Account is net exports of goods and services, plus net investment income, plus net transfer payments
Exports earn credit (+)
Imports are debit (–)
CA = PX * EX – PM * IM
Capital Account is sum of private US/foreign assets abroad and the US/foreign government assets
Example: Frenchman buys farm in the US
Capital account: decrease in private US assets abroad
Capital account: increase in foreign private assets in the US

J-CURVE EFFECT
Current Account = PX*EX – PM*IM and PM = 1/e*PXF
Currency depreciation: e
EX and IM (positive affect on trade balance)
PM (negative effect on trade balance)
PX changes when P changes
Short run: price of exports lags behind the price of imports. Depreciation may increase the trade deficit.
Long run: shock to import prices works its way through economy. PM   AS shifts left  P and PX. This offsets initial
revenues. CA will eventually improve.

TWIN DEFICITS refers to the government spending deficit (G + TR – T) and the trade deficit ((Sp – I) + (EX – IM))
Effect of G (with no T): government deficit will worsen. The trade deficit will also worsen because some of G will be spent on IM
Effect of Stock Market Boom: increase wealth in economy. Therefore IM, worsening the trade deficit. Increased wealth will likely T,
which may help the government deficit.
Effect of $ Depreciation: current account deficit will first worsen then improve (J-Curve Effect). American goods will look relatively cheaper
than foreign goods, so EX and IM. Depreciation is also expansionary, so GDP  T  decreasing government spending deficit.

FIXED EXCHANGE RATES

Monetary policy has no effect

FLEXIBLE EXCHANGE RATES

Monetary policy is effective
RIY
R   Capital inflows cause APPRECIATION
(which means that PM  and M  and then Y)
The appreciation of currency means Y, the same as the target change of Y

Fiscal policy is less effective

G then Y  Md  r  capital outflows cause DEPRECIATION
(which means that Px  then X and Y)
The depreciation of currency means Y, which is different from the target change

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ECON 116 STUDY GUIDE
INTEREST RATE PARITY EQUATION (1+r$) = (F/S)(1+rYen)
S is the spot rate
F is the forward rate
Example: interest rate of the US$ is 5%, Japanese interest rate is 1%, Yen/Dollar exchange rate is 100
S = 100
(1+.05) = (F/100)(1+.01)
The expected forward rate is 103.96
The difference in exchange rates could indicate relative health of the economies. High r = robust growth v. low growth = negative growth

CLOSED ECONOMY
Consumption is negatively related to the interested rate (C and r)
A fall in the interest rate lowers the reward of saving, thus the opportunity cost of spending has fallen. You consume more today.
Savings is positively related to the interest rate (S and r)
This is because S = Y – T – C. If r, then C 

GLOBAL SYSTEM
Inflation in one country can lead to inflation in another country
P  PX  one country’s exports is another country’s imports PM   P 
This depends on the fact that export/import prices are equivalent in different countries = fixed exchange rate
If the exchange rate is flexible, then one country’s price of exports would not 1-to-1 to another country’s import prices

EUROPEAN UNION
Before the EU, Spain could make its own monetary decisions. If the demand for Spanish goods , the authorities could depreciate the
currency by r or buying foreign currency. Depreciation would make P and PM look more favorably. A decrease in interest rates would also
have increased output and raise price levels (r  Y and P)

CHINA / CURRENT EVENTS IN THE CURRENT ACCOUNT

China has a large current account surplus
The Chinese central bank also would like to keep the Yuan value relatively close to the US dollar value
To make sure the Yuan does not appreciate too much relative to the dollar, the central bank must keep buying foreign currency and
inject the Yuan into the economy
If the Yuan were to appreciate, then EX, IM, and the Chinese current account would decrease

OPEN ECONOMY WITH FLEXIBLE EXCHANGE RATES

What would happen if the Chinese Yuan appreciates
Effect on output and unemployment rate: since appreciation of currency  PX, then Y
Net export (EX – IM) is part of AE… so GDP 
Therefore, by Okun’s law, unemployment rate would also  (since less people would be needed)
Effect on inflation: an appreciation in currency tends to P
This is a result from basic AS-AD. Y which shifts the AD curve to the left; and as Pm shifts the AS curve to the right
Effect on the interest rate: because Y and P, r must also 
Interest rate is a function of output/income and price levels
Effect on current account: (opposite of J-curve effect) In the short run, appreciation of currency may increase the balance of trade deficit.
Unfortunately, it takes time for the demand to respond to price changes. Once the exports/imports have time to respond, the net effect turns
negative.

OPEN ECONOMIES v. CLOSED ECONOMIES

In an open economy: if the marginal propensity to import is lower, then the import leakage is reduced – government spending is more
effective, multiplier is higher
A higher marginal propensity to consume lowers the multiplier.
In a closed economy: if the marginal propensity to consumer is higher, then the multiplier will be higher

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ECON 116 STUDY GUIDE
BALANCED BUDGET REQUIREMENT
G=T=S
Investment multiplier is: 1+bs / 1 – b
This multiplier is bigger than the first multiplier
Without the balanced budget requirement, taxes ‘leak out’ from AD
With the balanced budget requirement, all of the taxes become AD – which in turn increases the multiplier

SOLOW GROWTH MODEL

Says that consumption of worker is maximized when the savings rate equals the capital level specified by Cobbs-Douglas production function
Consumption per worker is lower for savings rates beyond the Golden Rule Rate of Savings

BEING EXOGENOUS
If monetary policy targets interest rate (r), then money supply (MS) is exogenous
If instead monetary policy targets money supply (MS), then interest rate (r) is exogenous
The exogenous variable is accepted at a certain level

IN A RECESSION
The current account is better off
AD   P  Y, which means that PX   X (directly increasing the current account)
On the other hand, AS could also shift inward, which means that P  Y, then Pm  AS shifts upward  P and Y

DEPRECIATION is expansionary and inflationary

This is because the price of exports decreases and price of imports increases
Px  X  AD  Y and P (expansionary and inflationary)
Prices are raised further (inflationary) as Pm  P and Y because the AS curve shifts inward
AS is probably relatively inelastic. This means that P  only a small Y… net effect of change in Y is still expansionary

WHY AMERICAN EXPORTS DECREASE

∆ foreign exchange rates made American goods more expensive relative to foreign goods
income in the world could have decreased, lowering the overall demand of goods

INVESTMENTS IN HOUSING will increase when people believe that the price of housing will keep on increasing (boom)

UNEMPLOYMENT RATES = (LF – E) / LF

It may not initially change as fast as a recession may be occurring
Firms could keep idle workers instead of firing them (rehiring is costly and layoffs lowers motivation)
Firms could switch from capital intensive production to labor intensive production (production , but no layoffs)
Discouraged worker effect (dropping out of LF)

OKUN’S LAW implies that the unemployment rate decreases about 1% for every 3% increase in real GDP
So firms must change their employment less than the change in output

SHREDDING CLOTHES ? AND THE GOVERNMENT DEFICIT

Shredding clothes obviously decreases the money supply
MS  r  I  Y
Government deficit = G – T
This will be affected by Y (if T is dependent on income Y)

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ECON 116 STUDY GUIDE
LIFE CYCLE CONSUMPTION
This theory is based on the premise that consumers seek to smooth consumption over time; holding it steady regardless of if he is young (net
borrower), middle-aged (net saver), or old (net dis-saver)
If there is a borrowing constraint, then you can only spend what you have plus the amount allowed
John had income flows of $1000 in the first period and $2000 in the second period.
Life cycle savers would say that John’s optimal level of consumption is $1500 in each period
But say there is a borrowing constraint of $300
Then John can only spend $1300 in the first period, not the whole $1500 (he does not have that much income in period 1)
Tax cuts or unexpected income could also temporarily increase income
John would consume $1300 in the first period, normally.
John would consume $1400 in the first period, if given this tax cut.
The tax cut increased his income by 10% in the first period ($100)
He spend 100% of his tax income ($1400-$1300 = $100)
The effect of tax cuts depend on whether the individual faces credit constraint.

CURRENT BOND PRICES depends on the interest rate.

A change in expected future inflation may/may not raise current bond prices

TRADE FEEDBACK EFFECT says that G  Y  IM = = = EX*  Y*  IM* = = = EX  Y

PRICE FEEDBACK EFFECT explains how inflation in one country leads to inflation in another country, which in turn returns to increase
inflation in the original country
If there is no such effect, then inflation in one country stays there

LUCAS SUPPLY CURVE implies that anticipated policy changes have no effect on real output
If people have rational expectations, then neither announced expansionary monetary policy nor announced expansionary fiscal
policy will affect real output

PHILLIPS CURVE shows the relationship between inflation and unemployment.

1960s: large demand shocks and relatively smaller supply shocks  shifting AD curve, AS curve unmoved. This meant a positive
relationship between the P and Y, negative relationship between P and UE. Because Y and UE have a negative relationship.
1970s: large oil shocks shifted AS curve. The AD curve also moved  Phillips Curve no longer true.
1990s: inflation and UE both low because of large rightward shifts in the AS curve  due to productivity of technology

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ECON 116 STUDY GUIDE
HOW TO FIND MULTIPLIER
Express Consumption in terms of Y
Then insert those terms into: Y = C + I + G
Reduce this until I and G have coefficients
The coefficient of I/G is its multiplier
Investment multiplier is: 1+bs / 1 – b(1 – s)

EFFECTS OF HIGHER SALES TAX (s)

If the rate of sales tax increases, then the multiplier will increase
Negative effect: s  disposable income   C  multiplier 
Positive effect: s  G  multiplier 
This positive effect dominates since s only C by b<1 … the full revenue of the G will become part of AD
AD (from G) > C (from S)

PUTTING IT ALL TOGETHER: WHAT HAPPENS TO THE GOVERNMENT SPENDING MULTIPLIER

With just the IS-model: G  Y
LM Curve is added (Investment depends on r): multiplier decreases
G, Y, Md, r. I. Y
Y increases less due to crowding out
AS Curve is added: multiplier decreases
Price level is now considered
As G, AD shifts to the right  and we get Y and P
P  Md, so r, I, and Y (crowding out effects again)
Excess Capital/Labor added: multiplier decreases
Fewer new workers are hired, so there is less of an increase in C
Inventory Investment added: multiplier decreases
Same effect as excess labor/capital
Investment is sensitive to interest rate rule: multiplier decreases
If G, Y, T, the higher taxes lead to Y
Perception that G is temporary: multiplier decreases
MPC does not change much because the is perceived to be temporary
Fed follows interest rate rule: multiplier increases
The interest rate rule says that the Fed wants to keep a certain interest rate level
MS is endogenous, it is used to counteract any crowding out
Government must pay more interest rate payments: multiplier decreases
More payments means more deficits
Increasing debt burden may G or T

QUANTITY THEORY OF MONEY assumes that the velocity of money is constant (so M x V = P x Y)
The velocity of money is the number of times a bill changes hands per year
It is a ratio of nominal GDP to stock of money (V = GDP/M)
Therefore, a MS = same nominal GDP