changes in spending changes in income/output AE = Aggregate Expenditures = C + I + G + Xn = AD

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1 small larger changes in spending changes in income/output AE = Aggregate Expenditures = C + I + G + Xn = AD

2 The Multiplier Effect A small change in spending gives rise to a larger change in income/output (Y) --- initial spending creates additional income that results in additional spending. This also works in reverse. A small decrease in spending gives rise to much larger decreases in income and output. Spending by Alex income earned by Rosaura who spends some and saves some. Rosaura s spending leads to income for Jovan who spends some and saves some. Jovan s spending becomes income for Kara who spends some and

3 The Multiplier Effect A little change in spending gives rise to a larger change in income/output (Y) --- initial spending creates additional income that results in additional spending. Price Level LRAS SRAS PL 1 AD Y F Real GDP

4 How much spending is needed to close the GDP gap? In a recession, spending is insufficient to reach full employment The shortfall in spending is called a recessionary gap. Because there is a recessionary gap, a GDP gap exists (short fall between actual (Y1) and potential GDP (YF). Price Level PL 1 Y 1 LRAS SRAS GDP Gap AD Y F Real GDP

5 How much spending is needed to close the gap? If the GDP gap is $100 Price Level billion due to a recessionary gap in spending, should spending be increased $100 billion to close the gap? PL 1 Does a certain amount of spending result in an equal amount of GDP (income and output)? Y 1 LRAS SRAS AD Y F Real GDP Due to the multiplier effect, a $100 billion increase in spending would be far too much spending to close the GDP gap. A smaller, not equal change in AE leads to a desired larger change in GDP.)

6 How much should spending be reduced? An inflationary gap occurs if spending exceeds the amount necessary to purchase the full employment level of output (Y F ). Does a reduction in spending (AE) result in an equal decrease in GDP (income and output)? WHY? No due to the multiplier effect. Price Level PL 1 LRAS Y F Y 1 SRAS AD Real GDP Actual output > potential output

7 The Multiplier Effect A change in a component of aggregate expenditures (C, I, G, or Xn) gives rise to a LARGER change in equilibrium GDP R. A GDP R gap of $100 billion could be closed by a change in AE of less than $100 billion. Δ AE x Multiplier = Δ GDP R small Δ s in spending larger Δ s in GDP R

8 Key Assumptions of the Spending Multiplier: The economy supports repetitive, continuous flows of expenditures and income through which dollars spent by Smith are received as income by Chin, then spent by Chin and received as income by Gonzales, and so on. Any change in income will cause both consumption and saving to vary in the same direction. Yd C and S A larger disposable income means more is available to spend and save.

9 Assume that all consumers spend 80% (MPC =.80) and save 20% (MPS =.20) of any change in income. $100 expenditure Yd of $100 $80 in C and $20 in S $80 expenditure Yd of $80 $64 in C and $16 in S $64 expenditure Yd of $64 $51.20 in C and $12.80 in S $51.20 expenditure... There is an end point or maximum by which income and expenditures are generated by the initial expenditure. The amount by which the change in Yd is spent (MPC) ensures the expansion and the leakage of saving (MPS) ensures that the expansion diminishes over time.

10 Key Relationships: GDP = Yd C S APC APS MPC MPS $370 $375 -$ $ YD C S APC APS MPC and MPS are relatively stable as income increases.

11 Key Definitions and Formulas: APC = Average Propensity to Consume = (fraction of any income spent) S/Yd C/Yd APS = Average Propensity to Save = (fraction of any income that is saved) C/Yd + S/Yd = 1 If income is $100 billion and the APS is.20, then the average amount of consumption =?? $80 Billion

12 Key Definitions and Formulas: ΔC / ΔYd MPC = Marginal Propensity to Consume = (fraction of any change in income that is spent) ΔS / ΔYd MPS = Marginal Propensity to Save = (fraction of any change in income that is saved) ΔC/ ΔYd + Δ S/ ΔYd = 1 If income increases by $100 billion and the MPC is.75, then the MPS = and the change in saving =? MPS =.25 Saving = $25 billion

13 Spending Multiplier Formulas: M = 1/MPS or 1/1-MPC or ΔGDP E / ΔAE.80 5 If the MPS =.20 the MPC = M = If the MPC =.75 the MPS = M = If the MPC =.90 the MPS = M = If the change in GDP E = $20 billion and the change in AE = $5 billion, then the multiplier = 4 and the MPC =.75 and the MPS =

14 Key Formula: Δ AE x M = Δ GDP E M = 1/MPS or 1/1-MPC or ΔGDP E / ΔAE If the GDP gap is $100 billion, how much must AE (C, I, G, or Xn) increase to return the economy to Y F if the MPC =.80? M = 1/1-MPC = 1/1-.80 = 1/.20 = 5 Δ AE x M = Δ GDP E 20 X 5 = 100 Billion

15 Key Formula: Δ AE x M = Δ GDP E M = 1/MPS or 1/1-MPC or ΔGDP E / ΔAE If the GDP gap is $40 billion and the MPS =.25, what amount must AE increase to close the GDP gap? 4 M = 1/MPS = 1/.25 = Δ AE x M = Δ GDP E 10 4 X = 40 Billion

16 Key Formula: Δ AE x M = Δ GDP E M = 1/MPS or 1/1-MPC or ΔGDP E / ΔAE If the economy is experiencing an inflationary gap and actual GDP exceeds potential GDP by $50 billion, how much must government decrease G to close the inflationary gap and return to full employment, assuming an MPS of.20? 5 M = 1/MPS = 1/.20 = Δ AE x M = Δ GDP E 10 X 5 = 50 Billion

17 Does a change in G have the same effect on GDP as a change in T? No G has a greater effect! A change in G affects GDP directly by a multiple of the change in G. A change in T affects GDP by a multiple of less than the change in T. A change in T results in a change in Yd. Yd can be either spent (C) or saved (S); therefore, a change in T only affects GDP by a multiple of the change in C. The initial change in C is less than the change in T.

18 Determine the effect on GDP of an increase in G of $20 billion and the effect of a decrease in T of $20 billion. Assume the MPC =.80 Remember: Δ AE x M = Δ GDP Multiplier = 1/1-.80 = 5 ΔG Effect of the the increase in G: 20 X 5 = 100 increase Effect of the decrease in T: T of $20 billion Yd C 4 S 16 X 5 = 80 increase which is less than ΔC the increase of 100 from G.

19 What would be the effect on the economy (GDP E ) of a decrease of $100 billion in G. Assume the MPS = X 4 = $400 billion decrease in GDP What would be the effect of an increase in taxes of $100 billion? Increase T of $100 billion decreases income (Yd) by 100 billion. That means consumers will decrease spending by $75 billion (.75 x100) and decrease saving by $25 bill. The $75 billion decrease in C X the multiplier of 4 = a $300 billion decrease in GDP.

20 Effect of EQUAL increases or decreases in G and T? Effect on Budget? Effect on Economy? no change / balanced Expansionary or Contractionary depend

21 Determine the effect on GDP of equal increases (balanced budget) in both G and T of $50 billion. Assume an MPC of.80. Effect on Budget? balanced Effect on GDP (economy)? Increase by $50 billion Multiplier = 5 Δ C = $40 billion (.80x50) Effect of G: 5 x 50 = 250 billion increase in GDP Effect of T: decrease income by $50 billion; therefore, C decreases by $40 billion and S decreases by $10 billion. Therefore, $40 billion X 5 = 200 billion decrease in GDP Net effect: = $50 billion increase in GDP

22 Key Idea: The balanced budget multiplier is 1 x ΔG An increase in G and T of $50 billion would increase GDP E by how much? 50 billion A decrease in G and T of $30 billion would decrease GDP E by how much? $30 billion Conclusion: A balanced budget increase in G and T (spending and taxes are equal) has an expansionary effect on the economy. A balanced budget decrease in spending and taxes has a contractionary effect on the budget.

23 Disequilibrium in the Keynesian AE Model. Equilibrium occurs when AE = GDP E Expenditure = output decreasing If AE > GDP then inventories are and businesses will output. If AE < GDP then inventories are and businesses will output. increasing

24 AP Questions The Multiplier

25 If $500 billion in AE $1000 billion in GDP E, then how much would G have to to reach a Y F of $2000 billion? $2000B $1000B $500B $200B $100B

26 The value of the spending multiplier decreases when? A. Tax rates are decreased B. Exports decrease C. Imports decrease D. Government expenditures decrease E. The MPS increases

27 Which of the following best explains why equilibrium income will rise by more than $100 in response to a $100 increase in G? A. Incomes will taxes B. Incomes will C... C. AE PL D. AE MS I E. budget deficit AE

28 In a closed economy with no taxes in which the APC is 0.75, which of the following is true? A. If income is $100, then saving is $75 B. If income is $100, then C is $50 C. If income is $200, then saving is $50 D. If income is 200, then C is $75 E. If income is $500, then S is $100

29 Suppose that Yd is $1000, C is $700, and the MPC is If Yd increases by $100, C and S will equal which of the following? C S A B C D E

30 If at Y F, government wants to increase its spending by $100 billion without inflation in the short run, it must do which of the following? A. T by greater than $100 B B. T by $100B C. T by less than $100 B D. T by $100 B E. by less than $100 B

31 If AE from 200 to 300 solely due to a change in G which leads to a change in GDPe of 1000 to 1500, which of the following is true? A. G is 300 and the multiplier is 5 B. G is 100 and the multiplier is 5 C. G is 100 and C increases by 500 D. G and GDP increase by 500 each E. C and GDP increase by 500 each

32 The FED and Monetary Policy

33 Banks play an important role in determining changes in the money supply. a) Assume that a bank receives a cash deposit of $9000 from a customer. What is the immediate impact of this transaction on the money supply? Explain.

34 Banks play an important role in determining changes in the money supply. b) Suppose that the reserve requirement is 10% and banks voluntarily keep an additional 10% in reserves. Calculate each of the following: 1) the maximum amount by which this bank will increase its loans from the $ ) The maximum increase in the money supply that will be generated from the deposit. c) Assume that the government increases its spending by $9000, which is financed by a sale of bonds to the central bank. 1) Indicate what will happen to the money supply. 2) Explain what will happen to the money demand.

35 The FED and Monetary Policy Key Ideas

36 Banks can create money! When you deposit money in a checking account at the bank, does the bank have to keep all your money in the bank vault? The FED requires that banks keep only a certain percentage of your money in the bank vault or on deposit at the FED.

37 Reserve Ratio (Requirement) The percent that must be kept in the bank vault or on deposit at the FED is the required reserve ratio or reserve requirement. The actual amount is called the required or legal reserves. For example, if the RR is 20%, the bank must keep $200 of your $1000 deposit in the bank vault. What can the bank do with the other $800 (excess reserves)?

38 So how do banks create $? Bank Deposit RR ER Loan A $1000 $200 $800 $800 B $800 $160 $640 $640 C $640 $51.20 $ $ D $ $ $ $ E $ F Total Amount of $ created by banking system: $4000

39 Money Creation Formula A single bank can create $ by the amount of its excess reserves. The banking system as a whole can create $ by a multiple of the excess reserves. Money Multiplier = 1/RR $ created by Banking System = DM x ER Ex. If RR = 20% MM = 1/.20 = 5 If $1000 is deposited in bank, required reserves are $200; excess reserves are $800. A single bank can create money (loan) by this amount) The banking system as a whole can create: 5 X $800 = $4000.

40 To determine total change in MS: Include (add) deposit if NEW $ + banking system created $ Shortcut: New deposit X DM = Total change in money supply If initial deposit not new --- total change is ONLY banking system created money (if coins to checks --- changes composition of MS) New vs Existing $ Out of circulation into circulation Not currently counted until put into circulation (added) Bank Reserves (out) --- loans made (in/added as new) Bank Reserves (out) bonds purchased from public (in/added as new) FED reserves (out) bonds purchased from public (in/added as new) Buried treasure (out) deposited in bank checking account (new/added) In Circulation Counted as part of M1 M1 = currency + checkable deposits (demand deposits) Changing coins to checkable deposits changes only the COMPOSITION of the money supply but does not add to it.

41 Tools of the FED used to control Reserve Requirement the money supply: Percent the bank must keep of your deposit in the bank vault or on deposit at the FED Discount Rate Interest rate the FED charges banks to borrow money Open Market Operation The buying and selling of government securities (bonds) by the New York FED.

42 Reserve Requirement More money kept in bank vault less money can be loaned out Vault $ Available for Loans

43 Reserve Requirement Less money kept in bank vault More money can be loaned out $ Available for Loans Vault

44 Discount Rate Higher interest rate makes it more difficult for banks to borrow $ from the FED. FED -- High Rates Loans to banks $ for banks to loan

45 Discount Rate Lower interest rate makes it more easier for banks to borrow $ from the FED. Loans to banks $ for banks to loan FED -- Low Rates

46 Buy Bonds: Open Market Operation FED Banks Money Supply?

47 Sell Bonds: Open Market Operation FED Banks Money Supply?

48 Wednesday Those who did not show up for the MANDATORY preregistration for AP testing MUST go this PM after school. AP Macro study session (Pizza) tonight 6:00 7:30 here Please read all instructions for TAKE-HOME TEST --- NOTE DUE DATES. If you have an AP test on Tuesday, turn your take-home test in this Friday or see me personally. Reading Study Guide answers online on Unit 4. Loanable funds FR answers will be posted tonight. Today: Need Exchange Rates handout and all handouts related to the FED and Monetary Policy. Cheating is all about character and integrity. Sharing answers is cheating when testing. Do you have the integrity it takes to be proud of the person you have become?

49 Expansionary (Easy) Monetary Policy discount rate reserve requirement open market operations Money Supply Aggregate Demand

50 Contractionary (Tight) Monetary Policy discount rate reserve requirement open market operations Money Supply Aggregate Demand

51 The FED Funds Rate The interest rate banks charge each other for temporary loans. This is what the FED usually targets with its OMO. It cannot directly change an interest rate set by a bank, but by changing the reserves of the bank, it pressures the bank to change its interest rates. The FED can directly change only the DISCOUNT rate (relatively ineffective)

52 Demand for Money Transactions demand to purchase output varies directly with nominal GDP GDP N D M GDP N D M to purchase output to purchase output Asset or speculative demand varies inversely with interest rates interest rates OC of holding money balances asset demand for money interest rates OC of holding money balances asset demand for money

53 The Transmission Mechanism PL LRAS (i) SRAS S M1 PL 1 i 1 AD D M Y 1 Y F GDP R Q M1 Q M

54 The Transmission Mechanism PL LRAS SRAS (i) S M1 5th PL 1 i 1 AD D M Y F Y 1 GDP R Q M1 Q M

55 5th Bank Balance Sheets (T- Accounts) A T-account shows changes in a bank s assets (amounts owed the bank or the bank has a claim on) And a bank s liabilities (claims against the bank --- such as checking account deposits) Basic relationship: Assets liabilities = net worth. Simplified: Assets should equal liabilities (that s why they call it a balance sheet)

56 Suppose Justin deposits in Bank A $1000 in quarters he received from a relative for graduation. Bank A s balance sheet (T-Account) looks like this: Assets Liabilities actual reserves +$1000 checkable deposit Does the money supply change when Justin deposits his quarters?

57 Assuming the required reserve ratio (reserve requirement) is 10%, the bank s balance sheet should look like this: BANK A Assets + $100 required reserves + $900 excess reserves Liabilities +$1000 checkable deposit Assuming that for the sake of convenience, Bank A keeps all of its reserves (required and excess) on deposit at the FED and keeps zero in vault cash. The FED s balance sheet should look like this as a result of Justin s deposit of coins: THE FED: Assets Securities Liabilities Reserves of Bank A 6 th for Wed

58 Assume that Bank A decides to loan out its excess reserves of $900 to Sarah. The loan is deposited in Sarah s account in Bank A. New Assets Liabilities $ + $100 required reserves + $900 excess reserves + $900 loans +$1000 checkable deposit checkable deposits Assume the Sarah writes a $900 check to Allie who deposits the check in his bank (Bank B). Assume that Bank B also keeps All of its reserves on deposit at the FED. After the check clears, the Balance sheet of Bank A, should look like this Assets +100 required reserves (Justin s deposit) $0 excess reserves $900 loans (Sarah) Liabilities checkable deposit (Justin) $0 checkable deposit (Sarah)

59 Bank B (Allie s bank) Assets + $90 required reserves + $810 excess reserves Liabilities +$900 checkable deposit (Allie s) FED Bank Assets +Securities Liabilities +$100 reserves of Bank A ( ) $900 reserves of Bank B Conclusions: Reserves lost by one bank are gained by other banks. What could Bank B do with its $810 in excess reserves? If the deposit expansion continues through the banking system, what w is the potential new money the banking system could create from the quarters? What is the total change in the money supply from the deposit?

60 FED Open Market Purchase of Government Securities FED Banks Assets FED Buys Bonds from Commercial Banks Balance Sheet of Federal Reserve Bank Liabilities + Securities + reserves of commercial banks Assets - Securites +reserves Assets Balance Sheet of Commercial Banks FED Buys Bonds from the Public Balance Sheet of Federal Reserve Bank Liabilities Liabilities + Securities +reserves of commercial banks Assets Balance Sheet of Commercial Banks Liabilities + reserves +checkable deposits

61 FED Open Market Sale of Government Securities FED Banks Assets FED Sells Bonds to Commercial Banks Balance Sheet of Federal Reserve Bank Liabilities - Securities - reserves of commercial banks Assets + Securites - reserves Assets Balance Sheet of Commercial Banks FED Sells Bonds to the Public Balance Sheet of Federal Reserve Bank Liabilities Liabilities - Securities - reserves of commercial banks Assets Balance Sheet of Commercial Banks Liabilities - reserves - checkable deposits

62 In groups of two, take 5 minutes to: Use a separate answer sheet (#1-6) and answer the questions on check for understanding on balance sheets. Put both names on the answer sheet. DO NOT MARK ON Question sheet When finished, turn The Banking System and Money Creation over on the back and answer the FR question # 3 Show all work Label each part of the question. Use notes and handouts No discussion outside of your group.

63 Impact on the Economy Fed Purchase of government securities: FED Banks Sm i I, C AD 0 PL U FED Banks Sm i I, C AD 0 PL U

64 Name two factors that weaken the money (deposit) multiplier:

65 Janet Smith deposits $1000 of her cash holdings in her checking account at the bank. The reserve requirement is 20% and the bank has no excess reserves. A) what is the immediate effect of her deposit on the money supply? Explain why. B) What is the maximum amount of money the bank can initially loan out? Explain. C) What is the maximum amount of money the entire banking system can create? Explain. D) Give one reason why the money supply may not increase by the amount you identified in (C)

66 Janet Smith deposits $1000 of her cash holdings in her checking account at the bank. The reserve requirement is 20% and the bank has no excess reserves. A) what is the immediate effect of her deposit on the money supply? Explain why.

67 Janet Smith deposits $1000 of her cash holdings in her checking account at the bank. The reserve requirement is 20% and the bank has no excess reserves. B) What is the maximum amount of money the bank can initially loan out? Explain.

68 Janet Smith deposits $1000 of her cash holdings in her checking account at the bank. The reserve requirement is 20% and the bank has no excess reserves. C) What is the maximum amount of money the entire banking system can create? Explain.

69 Janet Smith deposits $1000 of her cash holdings in her checking account at the bank. The reserve requirement is 20% and the bank has no excess reserves. D) Give one reason why the money supply may not increase by the amount you identified in (C)

Using an appropriately labeled money market graph, show the effects of an open market purchase of government securities by the FED on :

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