UNIT 7

Balance of Payments

4/27/16

Balance of Payments: 
- Measure of money inflows and outflows between the United States and the Rest of the      

  World (ROW). 

• Inflows are referred to as CREDITS
• Outflows are referred to as DEBITS 

- The Balance of Payments is divided into 3 accounts:

1. Current Account
2. Capital/Financial Account
3. Official/Reserves Account

Current Account: 
• Balance of Trade or Net Exports
    - Exports of Goods/Services
    - Exports create a credit to the balance 
      of payments

• Net Foreign Income 

    - Income earned by U.S. owned foreign assets - income paid to foreign held U.S assets

• Net Transfers 

    - Foreign Aid : a debit to the current account

    - Ex: Mexican migrant worker sends money to Mexico

Capital/ Financial Account: 

• The balance of capital ownership
• Includes the purchase of both real and financial assets 
• Direct investment in the United States is a credit to the capital account

            - Ex: The Toyota Factory in San Antonio

• Direct investment by U.S. firms/individuals in a foreign country are debits to the capital account 

            - Ex: The Intel Factory in San Jose, Costa Rica.

• Purchase of foreign financial assets represents a debit to the capital account 

            - Ex: Warren Buffet buys stock in Petrochina 

• Purchase of domestic financial assets by foreigners represents a credit to the capital account 

             - Ex: The UAE sovereign wealth fund purchases a large stake in the NASDAQ

Relationship between Current Account & Capital Account:

• The Current Account and the Capital Account should zero each other out
• That is... If the Current Account has a negative balance (deficit), then the Capital Account should then have a positive balance (surplus)

Official Reserves:

• The foreign currency holdings of the U.S. Federal Reserve system
• Balance of payments surplus ---> Fed accumulates foreign currency and debits the balance of payments
• Balance of  payments deficit ---> Fed depletes its reserves of foreign currency and credits the balance of payments
• Official reserves zero out balance of payments 

Active v. Passive Official Reserves:

• The U.S. is passive in its use of official reserves. If does not seek to manipulate the dollar exchange rate. 

Formulas: 

Balance of Trade

• Goods Exports + Goods Imports 

Balance of Goods & Services 

• Goods Exports + Service Exports + Goods Imports + Service Imports

Current Account: 

• Balance of goods & services + Net Investments + Net Transfers 

Capital Account:

• Foreign Purchases + Domestic Purchases 

5/3/16

Foreign Exchange (FOREX):

• The buying and selling of currency.
• Any transition that occurs in the Balance of Payments necessitates foreign exchange.
• The exchange rate (e) is determined in the foreign currency market. 

Changes in Exchange Rates:

  - Exchange rates (e) are a function of the supply and demand for currency.

• ⬆Supply of a currency ----> ⬇in exchange rate of a currency 
• ⬇Supply of a currency ----> ⬆in exchange rate of a currency
• ⬆Demand for a currency ----> ⬆in exchange rate of a currency
• ⬇Demand for a currency ----> ⬇in exchange rate of a currency 

Appreciation & Depreciation: 

• Appreciation: When the exchange rate of that currency ⬆ (e⬆) 
• Depreciation: When the exchange rate of that currency ⬇ (e⬇) 

Exchange Rate Determinants:

• Consumer Tastes
• Relative Income
• Relative Price Level
• Speculation 

Exports and Imports: 

• Appreciation: U.S. goods --> more expensive 

                           Foreign goods --> cheaper          = Reduces exports and increasing imports

• Depreciation: U.S. goods --> cheaper 

                   Foreign goods --> more expensive     = Increasing exports and reducing imports

Flexible Rates:

• It s very sensitive to the business cycle ans it provides options for investments 

Fixed Rates: 

• It is based on a countries willingness to contribute currency and control the amount. 

Absolute Advantage: 

• Individual: Exists when a person can produce more of a certain good/service than someone else in the same amount of time (or can produce a good using the least amount of resources)
• National: Exists when a country can produce more of a good/service than another country can in the same time period. 

Comparative Advantage:

• A person or a nation has a comparative advantage in the production of a product when it can produce the product at a lower domestic opportunity cost than can a trading partner. 

Examples of Output Problems: 

1. Words per minute
2. Miles per gallons
3. Tons per acre
4. Apples per tree
5. Televisions produced per hour

Examples of Input Problems: 

1. # of hrs to do a job
2. # of acres to feed a horse
3. # of gallons of paiHbnt to paint a house

Specialization and Trade: 

• Gains from trade are based on comparative advantage, not absolute advantage. 

UNIT 5 & 6

Chapter 5: Extending the Analysis of Aggregate Supply

4/7/16

Short Run Aggregate Supply:

• The period in which wages (and other input prices) remain fixed as price level increases or decreases. 

Long Run Aggregate Supply:  

• The period of time in which wages have become fully responsive to changes in price level. 

Effects over Short Run:

• In the short run, price level changes allow for companies to exceed normal outputs and hire more workers because profits are increasing while wages remain constant. 
• In the long run, wages will adjust to the price level & previous output levels will adjust accordingly. 

Equilibrium in the Extended Model:

• The extended model means the inclusion of both the short run and long run AS curves. 
• The long AS curve is represented with a 

Demand Pull Inflation in the AS Model: 

• Demand-Pull: Prices increase based on increase in aggregate demand.
• In the short run, demand pull will drive up prices, and increase productivity. 
• In the long run, increase in aggregate demand will eventually return to previous levels. 

Cost Push & the Extended Model: 

• Cost-push arises from factors that will increase per unit costs such as increase in the price of a key resource.
• Short run shifts left. 

Dilemma for the Government:

• In an effort to fight cost-push, the government can react in two different ways. 
• Action such as spending by the government could begin an inflationary spiral,
• No action however could lead to recession by keeping production and employment levels declining. 

4/8/16

The Long-Run Phillips Curve (LRPC): 

• There is NO trade off between inflation and unemployment in the Long-Run. 
• Occurs at natural rate of unemployment.
• It is represented by a vertical line
• Will shift if the LRAs curve shifts
• The Natural rate of unemployment is equal to: Formula: Frictional + Structural + seasonal unemployment       (4-5%)
• The major LRPC assumption is that more worker benefits create higher natural rates and fewer worker benefits create lower natural rates. 

• NOTE: Natural rate of unemployment is held constant
• Because the Long-Run Phillips Curve exists at the natural rate of unemployment (Un), structural changes in the economy that affect UN will also cause the LRPC to shift. 
• Increases in Un will shift LRPC --->
• Decreases in Un will shift LRPc <---

The Short-Run Phillips Curve (SRPC):
There is a trade off between inflation and unemployment
When one goes up, the other goes down. 

Supply Shocks:

• It is a rapid and significant increase in resources which causes the SRAs curve to shift.
• Decrease in SRAS: shift to the left --->
• SRPC will shift to the right <---

Misery Index:

• It is the communication of inflation and unemployment in any given year.
• Single-digit misery is good.
• If unemployment rate is 3% and inflation rate is 1%, it is good. 

4/11/16

Inflation:

• General rise in the Price Level.

Deflation:

• General decline in the Price Level.

Disinflation:

• Decrease in the rate of inflation over time.

Stagflation:

• Where unemployment & inflation increase at the same time. 

4/13/16

Supply-Side Economics:

• Shows changes in AS and not in AD, which determines the level of inflation, unemployment rates, and economic growth.
• Supply-side economists support policies that promote GDP growth by arguing that high marginal tax rates along with current system of transfer payments, unemployment compensation, or welfare programs provide disincentives to work, invest, innovate, and undertake entrepreneurial ventures.
• Low marginal tax rates induce more work thus AS increases.
• Lower marginal tax rates also make leisure more expensive and more attractive.

Incentive to Save:

1. High Marginal Tax Rates:
         - Reduce the rewards for savings & investments.
2. Consumption:
         - Might increase, but investments depend upon saving.
3. Lower Marginal Tax Rates:

         - Encourage saving and investing. 

Laffer Curve:

• It is a theoretical relationship between tax rates and government revenue
• As tax rates increase by 0, tax revenues increase by 0 to a maximum level, then decline. 

Criticisms: 
  #1: Research suggests that the impact of the tax rates on incentives to work, save and invest are small.
  #2: Tax cut also increase demand, which can fuel inflation and demand may exceed supply. 
  #3: Where the economy is actually located on the curve, is difficult to determine. 

Chapter 6: Economic Growth & Productivity 

Economic Growth Defined:

• Sustained increase in Real GDP over time.
• Sustained increase in Real GDP per Capita over time.

Why Grow?

• Growth leads to greater prosperity for society.
• Lessens the burden of scarcity.
• Increases the general level of well-being.

Conditions for Growth:

• Rule of Law
• Sound Legal and Economic Institutions
• Economic Freedom
• Respect for Private Property
• Political & Economic Stability

         - Low Inflationary Expectations

• Willingness to sacrifice current consumption in order to grow
• Saving 
• Trade

Physical Capital:

• Tools, machinery, factories, infrastructure
• Physical Capital is the product of Investment.
• Investment is sensitive to interest rates and expected rates of return.
• It takes capital to make capital.
• Capital must be maintained.
• 
  

Technology & Productivity:

• Research and development, innovation and invention yield increases in available technology.
• More technology in the hands of workers increases productivity.
• Productivity is output per worker.
• More Productivity = Economic Growth.

Human Capital:

• People are a country’s most important resource. Therefore human capital must be developed.
• Education
• Economic Freedom
• The right to acquire private property
• Incentives
• Clean Water
• Stable Food Supply
• Access to technology

Hindrances to Growth:

• Economic and Political Instability

           - High inflationary expectations

• Absence of the rule of law
• Diminished Private Property Rights
• Negative Incentives

          - The welfare state

• Lack of Savings
• Excess current consumption
• Failure to maintain existing capital
• Crowding Out of Investment

          - Government deficits & debt increasing long term interest rates!

• Increased income inequality --> Populist policies
• Restrictions on Free International Trade

Unit 4 - Monetary policy video

https://www.youtube.com/watch?v=w5o-lVIuO40

NOTES: Unit 4 – Money & Banking / Monetary Policy 3-21-16 to 3-27-16

AP Macroeconomics Unit 4 - Part 1: Types and Functions of Money

There are 3 different types of money: Commodity Money is a good that has other purposes that also functions as money - an example would be tribes in Africa using cows as money. Representative money is whatever you are using as currency represents a specific quantity of a precious metal (gold, silver) - the drawback is when the value of the metal changes, it affects the value of your national currency. Fiat Money is not backed by a precious metal - it is money that must be accepted for transactions and is backed by the word of the government that it has value.
Functions of money include the Medium of Exchange, the Store of Value (put money away in hopes to retain its value), and the Unit of Account (Price implies Worth (quality)).

AP Macroeconomics Unit 4 - Part 3: Money Market Graphs 

When the price is high, the quantity demanded is low and when the price is low, the quantity demanded is high. When the interest rate is low, people have an incentive to borrow more for transactions, to hold assets, transaction demand, asset demand. The supply of money does not vary based on the interest rate - demand for money is tied to the interest rate, supply of money is not. The supply of money is fixed, it is set by the Fed - it doesn't move unless the Fed does something to move it. 

AP Macroeconomics Unit 4 - Part 4: The Fed's Tools of Monetary Policy 

Reserve Requirement is the percentage of the bank's total deposits that they must hang on to, either as vault cash or on reserve w/ a Fed branch. Discount Rate is the rate at which banks can borrow money from the Fed. For Expansionary Policies (easy $), the RR decreases; the DR decreases (for banks to borrow more money); and if the Fed wants to expand money supply, it buys bonds. For Contractionary Policies (tight $), the RR increases; the DR increases (to discourage banks form borrowing money); and if the Fed wants to contract or reduce the money available, it sells bonds. 

AP Macroeconomics Unit 4 - Part 7: The Loanable Funds Mar

Loanable Funds is money that is available in the banking system for people to borrow. When the interest rate is lower, people demand more money and when the interest rate is higher, people have a disincentive to borrow. Supply of Loanable Funds comes from the amount of money that people have in banks, it is dependent on savings. The more money people save, the more money banks have available to make loan. If people have an incentive to save more, then you increase the supply of loanable funds. If people have incentives to save less, you decrease the supply of loanable funds. 

AP Macroeconomics Unit 4 - Part 8: Money Creation & Multiple Deposit Expansion 

Banks create money by making loans. One of the FED's tools for monetary policy is the ability to control the Reserve Requirement (RR). 
Money Multiplier = 1/RR        RR = 20%      Loan amount = $500
What is the total money created? 1/0.2 = 5 × 500 = $2,500. We got $2,500 by using the process of Multiple Deposit Expansion.


AP Macroeconomics Unit 4 - Part 9: Relating the money Mkt., Loanable Funds Mrk., and AD - AS

In the money market, the governemnt is borrowing money from Americans. A change in the money market will carry through the loanable funds graph, and the aggregate demand and supply graph. In this case of a government deficit, the increase in demand, results in an increase in the interest in the money market applies to the loanable funds graph. The aggregate demand is an increase, causing a rise in the price level and GDP. According to the equation of exchange, MV = PQ, a change in the supply of money causes a change in price, shown as an increase in interest rates will increase the price level. All three graphs are related by the Fisher Effect, a 1:1 direct ratio. 

UNIT 4

UNIT 4: 

3/4/16

I. USES OF MONEY 
a. Medium of Exchange:

• Trade & Barter

b. Unit of Account:

• Establishes economic worth in exchange process
• Ex: Cake as payment

c. Store of Value:

• Money holds its value over a period of time whereas products may not. 

II. TYPES OF MONEY
a. Commodity Money:

• It gets its value from the type of material from which it is made.
• Ex: Gold coins made from gold

b. Representative Money: 

• Paper money that is backed up by something tangible that gives it value

c. Fiat Money:

• It is money because the government  says so and because it is the money used in the U.S.

III: CHARACTERISTICS OF MONEY

a. Portable

b. Durable

c. Uniform

d. Scarce

e. Acceptable

f. Divisible 

IV: MONEY SUPPLY

a. M1 Money:

1. Currency - broken down into cash and coins
2. Checkable Deposits
3. Travelers' Check -  2-3 signatures to actually use

• 75% most liquid ---> easy to convert to cash 

b. M2 Money:

• Consists of M1 Money + Savings Accounts and deposits held by banks outside the U.S.
• Not as liquid as M1 Money

c. M3 Money:

• Consists of M2 Money + certificates of deposits, which is known as CDs. 

3/9/16

Time Value of Money: 

• Is a dollar today worth more than a dollar tomorrow?

           - Yes.

• Why?

           - Opportunity cost & inflation

           - This is the reason for charging & paying interest 

• Let v = future value of $

               p = present value of $
               r  = real interest rate (nominal rate - inflation rate)
               n =  years
               k = number of times interest is credited per year



The Simple Interest Formula:

• Formula: v = (1 + r)n * p

The Compound Interest Formula: 

• Formula: V = (1 + r/k)nk * p

Decrease of money has an inverse relationship between nominal interest rates & quantity of money demanded. 

1. What happens to the quantity demanded of money when interest rates increase?

• Quantity demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities. 

2. What happens to the quantity demanded when interest rates decrease?

• Quantity demanded increases. No incentive to convert cash into interest earning assets. 

The Demand for Money: 
What happens if price level increases? 

Increasing the Money Supply: 

   How does this affect AD?
     - Increase money supply
     - Decreases interest rate
     - Increases investment
     - Increases AD










Decreasing Money Supply: 

How does this affect AD?
  - Decrease money supply
  - Increase interest rate
  - Decrease investment
  - Decrease AD 

Financial Sector: Financial Assets vs. Financial Liabilities 

Financial Assets:
(What you OWN) 

• f
• It benefits the owner based upon the issuer of the assets meeting certain obligations

Financial Liabilities:

(What you OWE) 

• Liabilities incurred by the issuer of a financial asset to stand behind the issued asset. 
• f

Interest Rate:

• Priced paid for the use of a financial asset

Stocks vs. Bonds 

Stocks:

• Financial assets that conveys ownership in a company
• Stock market is high risk

Bonds:

• The promise to pay a certain amount of money + interest in the future.
• Have no hold on it, they're safer. 

What Banks Do:

• A bank is a financial intermediary

            - Uses liquid assets (i.e. bank deposits) to finance the investments of borrowers

            - Process is known as Fractional Reverse Banking 

                          - A system in which depository institutions hold liquid assets less than                                       the amount of deposits 

                          - Can take the form of: 

                                 1. Currency in bank vaults

                                 2. Bank Reserves: Deposits held at the Federal Reverse. 

3/10/16

Ultimate Lenders --> Financial Intermediaries --> Ultimate Borrowers 

What Banks Do - Basic Accounting Review 
T-Account (Balance Sheet):

• Statements of assets & liabilities

Assets (Amounts owned):

• Items to which a bank holds legal claim
• The use of funds by financial intermediaries

Liabilities (Amounts owned):

• The legal claims against a bank
• The sources of funds for financial intermediaries

Federal Reserve Bank (The Fed):

• Houses the Secret Service
• 7 board members appointed by President 

  Functions: 

1. Uses paper currency
2. Sets reserve requirements & holds reserves of the banks
3. It lends money to the banks & charges them interest
4. They are check-clearing service for the banks 
5. Acts as personal bank for the government 
6. Supervises members' banks
7. It controls the money suplly in the economy 

How do banks create  money? 

  - By lending out deposits  that are used       multiple times. 

Where do the loans come from?

- They come from depositers who take cash and place it in their banks.

How are the amounts of potential loans calculated? 

- By using the balance sheet or the T-Account that consists of liabilities and assets

Bank liabilities (on the right side of T-Account)

#1 Demand Deposits or Checkable Deposits 

    - They belong to depositers and can be withdrawn by depositers 

#2 Owner's Equity 

   - Values of stock held by the public ownership  of bank shares

Bank assets (the left side of the T-Account)

#1 Required Reseves

- Percentage of demand deposirs that must be held in the vault so that some depositers have access to their money

#2 Excess Reseves 

#3 Property 

#4 Securities (Bonds)

#5 Loans

Reserve Requirement:

• The Fed requites banks to always have some money readily available to meet the consumer's demand for cash.
• The amount set by the Fed, is the Required Reserve Ratio.
• The Required Reserve Ratio is the % of demand deposits (checking account balances) that must not be loaned out
• Typically the Required Reserve Ratio = 10% 

The Three Types of Multiple deposit Expansion Question:

Type 1: Calculate the initial change in excess reserves the initial deposit

Type 2: Calculate the change in loans in banking system

Type 3: Calculate the change in the money supply. 

*Sometimes Type 2 & Type 3 will have the same result (i.e. NO Fed involvement)

3/21/16

#1. The Reserve Requirement:

• Only a small percent of your bank deposit is in the safe. The rest of your $ has been loaned out. 
• The reserve requirement (reserve ratio) is the % of deposits that banks must hold in reserve and NOT loan out.)

               - When the Fed increases the money supply it increases the amount of money                         held in bank deposits. 

If there is a RECESSION, what should the Fed do to the Reserve Requirement? 

- Decrease the Reserve Ratio

1. Banks hold less money & have more excess reserves
2. Banks create more money by loaning out excess
3. Money supply increases, interest rates fall, AD goes up. 

If there is INFLATION, what should the Fed do to the Reserve Requirement?

- Increase the Reserve Ratio 

1. Banks hold more money & have less excess reserves
2. Banks create less money
3. Money supply decease, interest rates up, AD goes down. 

#2. The Discount Rate:

• The Discount Rate is the interest rate that the Fed charges commercial banks.
• To INCREASE the Money Supply, the Fed should DECREASE the Discount Rate (Easy Money Policy)
• To DECREASE the Money Supply, the Fed should INCREASE the Discount Rate (Tight Money Policy)

#3. Open Market Operations:

• The Fed buys/ sells government bonds (securities).
• This is the most important and widely used monetary policy.
• To INCREASE the Money Supply, the Fed should BUY government securities.
• To DECREASE the Money Supply, the Fed should SELL government securities.

Federal Funds Rate:

• Where FDIC member banks loan each other overnight bonds. 

Prime Rate:

• The interest rate that banks give to their most credit-worthy customers. 

If the economy  goes into recession, the real GDP will decrease for at least 6 months.

If the economy suffers from too much ddemand-pull inflation  or cost inflation