Unit 5: Balance of Payments

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 are divided into three accounts 

• Current Account
• Capital/Financial Account
• Official Reserves account

Current Account 

• Balance of Trade or Net Exports
• Exports of Good/Services - Import of Goods/Services
• Exports create a credit to the balance of payments
• imports create a debit to the balance of payments

Net Foreign Income

• Income earned by the U.S. owned foreign assets - income paid to foreign held U.S. assets.
• Ex: Interest payments on U.S. owned Brazilian bonds - interest payments on German owned U.S. Treasury bonds

Net Transfers

• Foreign Aid --> a debit to the current account
• Ex: Mexican immigrant workers send money to family in Mexico.

Capital/Financial Account

• the balance of capital ownership
• includes the purchase of both real and financial assets.
• Direct investment in the U.S. is a credit to the capital account. Ex: The Toyota Factory in San Antonio .
• Direct investments 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 United Arab Emirates sovereign wealth fund purchases a large stake in the NASDAQ.

Relationship between current and capital account

• Should ZERO each other out. 

If the current account has a negative balance (deficit), then the capital account should have a positive balance (surplus).

Official Reserves

• The foreign currency holdings of the U.S. Federal Reserve System.
• When there is a balance of payments surplus the Fed accumulates foreign currency and debits the balance of payments.
• When there is a balance of payments deficit the Fed depletes its reserves of foreign currency and credits the balance of payments.
• Official Reserves ZERO out the balance of payments.

Active v. Passive Official Reserves 

• The United States is passive in its use of official reserves. It does not seek to manipulate the dollar exchange rate.

Balance of Trade:

• Goods Exports + Good Imports

Balance on Goods and Services:

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

Current Account 

• Balance on goods and services + Net Investment + Net Transfers

Capital Account 

• Foreign Purchases + Domestic Purchases

Unit 5: Short Run Phillips Curve and Long Run Phillips Curve

SRPC

• There is an inverse relationship between unemployment and inflation.

LRPC 

• it occurs at the long rate of unemployment
• it is always represented by a vertical line
• there is no trade off between unemployment and inflation
• it will only shift if LRAS shifts
• if the NRU shifts or changes so does the LRPC
• (Natural Rate of Unemployment) Un = Frictional + Seasonal Unemployment (4-5%)
• The major LRPC assumption is that more worker benefits create higher natural rates and a few worker benefits create lower natural rates.

Misery Index 

• Where you have a combination of inflation and unemployment in any given year.
• Single digit misery is good.

Supply Shocks 

• Rapid & significant increase in resource cost, due to many things.

Disinflation

• Long Run Phillips Curve

Deflation

• General decline in prices

Supply side economists 

•  support policies that promote GDP growth by arguing that high marginal tax rates along with the current system of transfer payments such as unemployment compensation or welfare programs provide disincentives to work, invest, innovate, and undertake entrepreneur ventures. 

Incentives to save and invest

1. High marginal tax rates reduce the rewards for savements and investment.
2. Consumption might increase but investments depend on savings.
3. Lower marginal tax rates encourage saving and investment.

Laffer Curve 

•  It is a theoretical relationship between tax rates and tax revenues. As tax rates increase from zero to some maximum level and then decline. 

3 criticisms of the Laffer Curve

1. Evidence suggests that the impact of tax rates in incentives to work, save and invest are small.
2. Tax cuts 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.

Unit 5: Phillips Curve

Original SR Phillips Curve

• Inflation and unemployment are inverse of each other
• Inflation increases as the economy expands
• Recession- unemployment increases as the economy slows down 

Stagflation

• Is an increase in inflation and unemployment at the same time.

A New Phillips Approach 

• New Range - The SRPC can move outward and inward
• Cost Push Inflation is when there is more stress on resources, wages and input cost.
• Supply Shocks -  A rapid loss of resources or rapid increase in resource cost.
• The SRPC Curve moves outward during these shocks
• The SRPC moves back inward as the society increases productivity and/or regains resources.

Long Run Phillips Curve

• Inflation- Society will adjust for a cost/wage increases with new prices.
• LRPC is the efficient PPF
• Natural Rate of Unemployment becomes the equivalent of the full employment rate

Phillips and AD/AS Curves

• Change points on SRPC - Along the curve
• Move the SRPC - Shift the curve on the SRPC

Unit 5: Long Run Phillips Curve

• Because the Long-Run Phillips curve exists at the natural rate of unemployment( Un) structural changes in the economy that affect unemployment will also cause the LRPC to shift.
• Increase in the Natural Rate of Unemployment will shift LRPC to shift to the right
• Decrease in the Natural Rate of Unemployment will shift LRPC to shift to the left.
• X axis: Inflation rate
• Y axis Unemployment rate

Unit 5: Short Run and Long Run AS

Short Run Aggregate Supply 

• In macroeconomics this is the period in which wages (and other input prices) remain fixed as price level increases or decreases.

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 and previous output levels will adjust accordingly.

Equilibrium in the Extended Model

• The extended model means the inclusion of both the short and long run AS curves.

Demand Pull Inflation in the AS 

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

Cost Push

• Arises from factors that will increase per unit costs such as increase in the price of a key resource.

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 unemployment levels declining.



Unit 4: Withdrawals and the Banking System

• When a customer deposits cash or withdraws cash from their demand deposit, it has NO EFFECT on Money Supply.

It only changes

• The composition of money
• Excess reserves
• Required reserves 

Single bank (Ex: Chase) 
Can only loan money from excess reserves 

Banking system (Ex: Chase, Wells Fargo)  

Formulas:

ER x Multiplier =  Total Money Supply

•  When the FED buys or sells bonds, ER is created. Take the number that was bought or sold and multiply it by the multiplier

Unit 4

What Do Banks Do?

• A bank is a financial intermediary 
• Uses liquid assets (i.e. bank deposits) to finance the investments of borrowers
• Process known as Fractional Reserve Banking 

• A system in which depository institutions hold liquid assets > the amount of deposits 

• Can take form of:  
• currency in bank vaults 
• bank reserves: deposits held at federal reserves  

 What Banks Do-Basic Accounting Review

• T-account (balance sheet): 
• statements of assets and liabilities 

• Assets(amounts owned): 
• items to which a bank holds legal claim 
• uses of funds by financial intermediaries

• Liabilities(amounts owed): 
• legal claims against a bank
• sources of funds for financial intermediaries  

Federal Reserve Bank :

Functions:

• Uses paper currency
• Holds reserves of the banks
• Lends money and charges interests 
• Check clearing service for the bank
• Personal bank for the government  
• Supervises members  of banks  
• Control money supply in economy  

Reserve Requirement: 

• federal requires bank to always have some money readily available to meet consumer's demand for cash 
• amount set by the federal is required reserve
• the required reserve ratio is the % of demand deposits (checking account balance) that must not be loaned out 
• typically it is 10% 

Three types of multiple deposit expansion question:

1. Calculate the initial change in excess reserves
2. Calculate the change in the money supply
3. Calculate the change in the money supply: sometime type 2 and type 3 will have the same result  (if no Fed involvement)

1) The Reserve Requirement:

• only a small % of your bank deposit is in the safe the rest of your money has been loaned out
• this is called "Fractional Reserve Banking"
• the FED sets the amount that banks must hold
• 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  

1. If there is a recession, what should the FED do to the reserve requirement?  

               decrease the RR 

1. Banks hold less money and have more ER
2. Banks create more money by loaning out excess 
3. Money increase, interest rates fall, AD goes up  

1.  If there is inflation what should the FED do to the reserve requirement, what should the FED do to the reserve requirement?  

 decrease the RR 

1.  Banks hold more  money and have less ER 
2. Banks create less money 
3. Money Supply decrease, interest rates rise, AD goes down   

 2) The Discount Rate:

• Discount Rate is  the interest rate that the FED charges commercial banks 
•  Ex: If the banks of America needs $10 million, they borrow it from the U.S Treasury (which the FED controls, but they must pay it back with interest)
•  To increase the Money Supply, 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:

• FED buys/sell government bonds (securities)
• This is the most important and widely used monetary policy
• -To increase the MS, the FED should BUY government securities
• To decrease the MS, the FED should SELL government securities  

Monetary policy:

• Expansionary: buy bonds, decrease discount rate, decrease RR = increase in loan, AD increases, GDP increase, MS increases. interest rate decreases 
• Contractionary: sell bonds, increase discount rate, increase RR= loans decrease, AD decrease. GDP decrease, MS decrease, interest rate increases   

Federal Fund Rate: 
Where FDIC member bank loans each other overnight funds


Prime Rate: 
Interest rate that banks give to their most credit- worthy customers  

Unit 4: Money

Uses of Money: 

• Medium of exchange: Trade or barter
• Unit of account: Establishes economic worth in the exchange process 
• Store of value: Money has its value over a period of time, where products may not  

Types of Money: 

• Commodity money: Gets it value from the type of material from which it is made
• Representative money: Paper money backed up by something tangible that it gives it value 
• Fiat Money: Money because government says it is money and that is used in the U,S 

Characteristics of money: 

• portable 
• durable
• uniform
• scarce
• acceptable 
• divisible  

Money Supply:

• M1 money: Currency Examples: cash, coins, checkable deposits/ checking account, traveler's checks, and demand deposits) 
• M2 money: consists of M1 money  + savings accounts and deposits held by banks held outside of the U.S
• M3 money: consists of M2 money + certificates of deposits, known as CD's 
• 75% of money in circulation and it mostly liquid because it easy to convert to cash  

Time value of money:

1. Is a dollar today worth more than a dollar tomorrow?  Yes 
2. Why? Opportunity cost and inflation. This is the reason for changing and paying interest.

Formulas:

Simple interest formula: v=  (1+r)^n * p 

Compound interest formula: v= (1+r/k)^nk *p 

• V= future value of money
• P= present value of  money
• R= real interest rate (nominal rate- inflation rate) expressed as a decimal  
• N= years
• K= # of times interest is credited per year

1. What happened to the quantity demanded of money when interest rates increase? Quantity demanded falls because individuals would prefer to have interest rate assets instead of borrowed liabilities
2. What happens to the quantity demanded when interest rates decrease? Quantity demanded increase, there is no incentive to convert cash into interest earning assets
3. What happens if price levels increase? 

   Money demand shifters:

   • Change in price level
   • Change in income 
   • Change in taxation that effects investments
4. How does money supply affect AD? 

money supply increases= decrease in interest rates, increase in investments, and decrease in AD

money supply decreases = increase in interest rate, decrease in investment, decrease in AD

Financial Assets vs Financial Liabilities 

• FA: assets such as stocks and bonds provide expected future benefits 
• FA:it benefits the owner, based upon the issue of the asset meeting certain obligations
• FL: liabilities incurred by financial asset to stand behind the issued asset  

Interest rate:

• price paid for a financial asset 

Stocks vs Bonds: 

Stocks: assets that convey ownership in a company(shareholder)

Bonds: promise to pay a certain amount of money + interest in the future

Monetary Policy

Unit 3: Automatic or Built-In Satabilizers

Automatic or Built-In Stabilizers

• Anything that increases the government’s budget deficit during a recession and increases its budget  surplus during inflation WITHOUT REQUIRING EXPLICIT ACTION BY POLICY MAKERS
• Economic Importance:
• Taxes reduce spending and aggregate demand
• Reductions in spending are desirable when the economy is moving toward inflation
• Increases in spending are desirable when the economy is heading toward recession.

• Progressive Tax System
• Average tax rate (tax revenue/GDP) rises with GDP
• Proportional Tax System
• Average tax rate remains constant as GDP changes
• Regressive Tax System
• Average tax rate falls with GDP
• The more progressive the tax system, the greater the economy’s built-in stability.

Unit 3: Fiscal Policy

Fiscal Policy

Definition: Changes in the expenditures or tax revenues of the federal government.

• 2 tools of Fiscal Policy:
• Taxes - government can increase order or decrease taxes
• Spending - Government can increase or decrease spending
• Inverse relationship

Deficits, Surpluses, and Debt

• Balanced Budget
• Revenues = Expenditures
• Budget Deficit
• Revenues < Expenditures
• Budget Surplus
• Revenues > Expenditures
• Government Debt
• Sum of all deficits - Sum of all Surpluses
• Government must borrow money when it runs a budget deficit. They borrow from:
• Individuals
• Corporations
• Financial Institutions
• Foreign Entities or Foreign Governments

Fiscal Policy (Two Options)

• Discretionary Fiscal Policy (action)
• Expansionary fiscal policy - think deficit
• Contractionary fiscal policy - think surplus
• Non - Discretionary Fiscal Policy (no action)

Discretionary vs. Automatic Fiscal Policies

• Discretionary
• Increasing or Decreasing Government Spending and/or Taxes in order to return the economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem.
• Example: Recession and Inflation
• Automatic
• Unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems.
• Example: Medicare and Medicaid

“Easy” Expansionary Fiscal Policy	“Tight” Contractionary Fiscal Policy
Combats Recession	Combats Inflation
Increases Government Spending Decreases Taxes	Decrease in Government Spending Increase in Taxes

Unit 3: Marginal Propensity to Consume (MPC)

Marginal Propensity to Consume (MPC)

Definition: The fraction of any change in disposable income that is consumed.

• MPC = Change in Consumption / Change in Disposable Income
• MPC = Change in Savings / Change in Disposable Income

Marginal Propensities

• MPC + MPS = 1
• .: MPC = 1 - MPC
• .: MPS = 1 - MPC
• Remember that people do two things with their disposable income, consume it or save it !

The Spending Multiplier Effect

Definition: An initial change in spending (C, IG, G, Xn) causes a larger change in any aggregate  Spending, or Aggregate Demand (AD).

• Multiplier = Change in AD / Change in Spending
• Multiplier = Change in AD / Change in C, I, G, or Xn

Calculating the Spending Multiplier

Definition: The Spending Multiplier can be calculated from the MPC or the MPS.

• Spending Multiplier = 1 / 1 - MPC or 1 / MPS
• Spending Multipliers are (+) when there is an increase spending and (-) when there is a decrease in spending.

Calculating the Tax Multiplier

Definition: When the government taxes, the multiplier works increase

• Why?
• Because now $ is leaving the circular flow.
• Tax Multiplier ( note: it’s negative)
• Tax Multiplier = -MPC / 1 - MPC or -MPC / MPS
• If there is a tax -CUT, then the multiplier is (+), because there is now more $ in the circular flow.