Monetary Policy- Determination of nation's money supply including interest rates.Fiscal Policy- Determination of gov't budget.Structural policy- Aimed at changing underlying structure, or institutionsPositive Statement- Testable AssertionNormative- Judges desirability.3 WAYS TO FIND GDP1. Add up the market values of all the final g/s produced. Avoid double counting by summing value added at each stage of production.2. Add up all expenditures on the output of all final g/s. (Consumer Expenditures, Gov't Purchases, Investments, Net Xports).3. Add up income, which is generated by the production of output. CPI- Measure of average prices paid by average consumers for a fixed market basket of consumer g/s relative to its cost in abase period. Used to eliminte effects of inflation. Equals 100 for ref period. Inflation Rate- (CPI in current year – CPI in prev year)/CPI in prev yearDeflation- IR is negative. Disinflation- IR is slower than normal.Nominal- Measured in Current price. Real- Measured in dollars of base year.Deflating- Process of dividing a nominal quantity by a price index to express in real terms. Real Wage (2000) = (Nominal Wage (2000) / CPI (2000)) * 100RGDP = (NGDP / P) * 100 <----- P is called GDP deflatorFinding P for our Shmoo Economy-1997 output at a rate of 50 shmoos / year. Sold at $10 each-1998 output at a rate of 75 shmoos / year. Sold at $20 each-1997 NGDP = $500 / year; 1998 NGDP = $1500 / year-1998 RGDP = $750 / year (measured in 1997 prices)P = (1998 NGDP / 1998 RGDP) * 100 ….. or ….. ($1500 / $750) * 100 = 200P has doubled from 1997 to 1998.CPI VS. GDP Deflator-Prices of Capital Goods are included in GDP deflator if produced domestically, but excluded from CPI-Prices of Imports included in CPI, but excluded from GDP Deflator.-CPI has fixed basket of goods, GDP Deflator changes every year.Indexing- Practice of increasing nominal quantity each period by an amount equal to the percentage increase in a specified price index. Prevents the purchasing power of a nominal quantity from being eroded by inflation. Study shows that the CPI overstates inflation by 1-2 % each year. Underestimates true standard of living. Main reasons for this overstatement Quality Adjustment Bias- Statistics do not adequately account for the fact that the quality of g/s changes over time and new goods appear. Substitution Bias- CPI uses a fixed basket of goods, but consumers seek out cheaper substitutes when prices rise.Magnitude of the Bias- about 1.1 % per year. To reduce bias, the BLS has decided to increase frequency of its survey and revise basket every 2 years.Price Level- Measure of overall pricesRelative Price- Price of a specific g/s in comparison with the prices of other g/s.Costs of Inflation- 1. Shoe leather cost. 2. Confusion costs (we measure value with $ but the value of $ changes all the time). 3. Distortions of tax systems. 4. Unexpected redistribution of wealth (With inflation, set wage earners are hurt tothe benefit of employers).REAL AND NOMINAL INTEREST RATESNominal- the annual percent increase in nominal value of a financial asset.Real- annual percentage increase in the purchasing power of a financial asset or return on loan. -Assume you have $1000 to put into a bank account yielding 50% annually.-During the same year, the price of a shmoo rises from $10 to $12. Nominal Value... $1000 * (1 + 0.50) = $1500Purchasing power went from: $1000 / $10 = 100 Shmoos to: $1500 / $12 = 125 Shmoos. Therefore real interest rate, r,which is the percent change in purchasing power, equals:(125 Shmoos – 100 Shmoos) / 100 Shmoos, or r = 25%Symbolsr = real interest rate. i = nominal, market, interest rate. p = inflation rateFisher Effect- As inflation rates increase, so do the nominal interest rates and vise versa. (on loans)BOND PRICES AND INTEREST RATES- January 1, 2000 – Tanya purchases a newly issued 2-year government bond with principal amount of $1,000 and with a coupon rate of 5% paid annually u If Tanya decides to sell her bond on January 1, 2001 (after receipt of $50) and if new one- year bonds at that time pay 6%, how much will people pay for Tanya’s old bond?People will not pay a price more than that which provides a 6% return if new one-year bonds pay 6% P * (1 + .06) = $1050 Where P is the price to be paid for the bond P = ($1050/1.06) = $990.57Measuring Money-M1- Sum of currency outstanding and balances in checking accounts and travelers checks.M2- Savings accounts, small time deposits, money markets + M1.Determination of the Money Supply- Consists of: money in the hands of the public and deposit balances held by banks (not their reserves)MONEY CREATION-Suppose there is $12 million of cash in the economy with 1/3 of it held in bank vaults as reserves. If the required reserve to deposit ratio is 20%, how large will the money supply be if banks hold no excess reserves? -Banks hold $4 million of reserves: Since (Reserve/Deposit) must be exactly 20%, deposits will be $20 million -Money Supply will be $8 million + $20 million or $28 million since the money supply is the total ofcash in the hands of the public plus deposits Open Market Operations- Open market purchases and sales is the Fed’s most used tool Open market purchase -Buying government bonds from the public (Increasing the supply of bank reserves and the money supply)Open market sale - Selling government bonds to the public (Reducing bank reserves and the money