AP Macroeconomics
Method 1: (from N. Gregory Mankiw text) |
M Ch. 26
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Method 2: (from Paul Krugman text) |
K Mod. 22
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a) Saving Incentives: The government may want to influence people to save more money.
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4. In response to the lower interest rate, new borrowers will
enter the aggregate market because they can afford the cost of borrowing, the interest rate, and the monthly payments. Current borrowers may decide they can afford to borrow more. So, the aggregate demand will increase, shifting right from AD 1 to AD2. |
Investment Incentives: The government may want to encourage industries to invest in capital stock, thereby increasing the capacity for economic growth.
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4. The higher interest rate in normal circumstances would
discourage demand (borrowing). However, the tax credits offset the effect of the interest rates, and industries borrow while the net cost of borrowing remains below the new equilibrium interest rate. Of course, for all other borrowers who don't qualify for the tax credit, the interest rate will be higher. 5. Tax credits could be given to other segments of the population. For instance, tax credits for buying a home. 6. In response to investment tax credits, borrowers will enter the aggregate market because they can afford the cost of borrowing, the interest rate, and the monthly payments. So, the aggregate demand will increase, shifting right from AD 1 to AD2. |
If the government spends more than it collects in taxes (T<G), the government will need to borrow money to pay for the services it provides the people. Depending upon the economics textbook or the AP preparation book you are using, two graphs are used to demonstrate the same effect in the loanable funds market. The graph at the right is the same as as the graph immediately above. The circumstances have changed. In this case,
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The graph to the left is an alternative representation of budget deficit spending by the government. The supply curve represents national savings.
National Savings = Private Savings + Public Savings S = (Y-T-C) + (T-G)
Note: This same graph can be used to show the effect of raising taxes to cover increased government spending. The net effect is to reduce private savings and reduce national savings, which leads to higher interest rates. |
Time Value of Money |
M Ch. 27
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Money and the Measurement of Money |
M Ch. 29
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Function of Money:
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Store of Value: The value of goods and services converted into money until a purchase may be made in the future. (i.e. An employee sells their services to an employer in exchange for money. The employee, as a consumer, will later spend the value of their services converted into money for goods and services they desire.
Medium of exchange: The seller will accept the money in exchange for goods and services if the money represents an equivalent value. Unit of Account (or Standard of Value): Money allows people to compare values (prices) of goods and services in relation to one another. |
Commodity Money: objects or products are used as money because they have intrinsic value (i.e. gold; salt; oil; cigarettes or condoms in prisons)
Fiat Money: Currency that has no inherent value, but is exchanged for value established by fiat or decree by the government. The money is worth what the government says it's worth. Currency: the paper bills and coins that represent fiat money |
Money Stock in the EconomyMoney Stock is the total supply of money to the economy. The Federal Reserve System breaks the supply into categories. The two broadest categories are M1 and M2 as shown in the graphic. There are other categories (i.e. M3, M4) which looks at less liquid money-like assets. For our purposes, understanding M1 and M2 will help us understand people's use of banks and the Fed's policies to manage the supply of money available for use in the economy.
The M1 money supply includes all physical currency, traveler's checks, demand deposits, and other checkable deposits. M1 is a measure of all the most liquid forms of money in an economy. The M2 money supply includes everything in M1. Also, M2 includes savings deposits, money market securities, and other time deposits which are less liquid and not as suitable as exchange mediums. However, the M2 money supply can be quickly converted into cash or checking deposits. |
The Reserves Market with Ample Reserves:
The Fed money market representation is referred to as the Reserves Market. Notice the vertical money supply curve to represent all the money in the market at a moment. The y-axis will be labeled or understood as the Policy Rate. The x-axis is the quantity of reserves. The intersection of supply of reserves on the lower horizontal area of the money demand curve exposes why a change in money supply would not be effective in altering interest rates. There is too much money in circulation for the Fed to be able to influence the interest rates banks charge the households and firms who borrow. So, the Fed created the IOR to influence the interest rate banks charge borrowers. After you watch the short 4-part video series from the St. Louis Federal Reserve Bank, we'll review the new tools for influencing the interest rates. |
Banks and the Money SupplyHouseholds and firms hold money in their pockets and in demand deposits (checking accounts) at the bank. From this supply of money they spend in the marketplace. The Central Bank influences the buying behavior of households and firms, by influencing the amount of money banks have to lend to households and firms. This is also true of the Federal Reserve System in the U.S.. So, the Circular Flow Model to the right represents the economy. Starting from the bottom, the Central Bank indirectly influences the supply of money in the circular flow by affecting the quantity of money the banks have to loan to firms and households that are participating in the circular flow of money.
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Banks and Money Supply |
M Ch. 29
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The Money Market |
M Ch. 34
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Money Demand and Equilibrium in the Money Market:
Remember that the Central Bank manages the supply of money primarily by buying and selling government bonds through open market operations (OMO). OMO affects the quantity of reserves banks hold, but more importantly, the quantity banks have available to supply the economy through loans. To the right is a Money Market Graph. Let's assume the money supplied to the market is fixed. Consequently the money supply curve is vertical and straight. The demand curve for money (MD) is sloped because there is a relationship between the quantity of money demanded and the interest rate. The demand curve can be drawn bowed as it is or with straight constant curve. Actually, the constant curve will be most often used in economics texts. |
Reasons Money Demand Increases
(MD shifts right)
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Reasons Money Demand Decreases
(MD shifts left)
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Goal: Target lower interest rates.
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Goal: Target increasing the interest rate:
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