Chapter 9 Loanable funds market The market that coordinates the borrowing and lending decisions of business firms and households Demand for loanable funds Firms demand loanable funds investment Downward sloping curve because as the interest rate decreases Increase in investment demand curve will shift right Decrease in investment demand curve will shift left Supply of loanable funds Individuals supply loanable funds through savings Upward sloping because as the interest rate increases people will want to save more Increase in savings supply curve will shift right Decrease in savings supply curve will shift left Nominal interest rate the percentage of the amount borrowed that must be paid to the lender in addition to the repayment of the principle Real interest rate the interest rate adjusted for inflation real cost of borrowing and lending money How inflation affects borrowers and lenders 1 Actual Inflation Anticipated Inflation borrowers gain lenders lose 2 Actual Inflation Anticipated Inflation borrowers lose lenders gain Inflation does not help borrowers or lenders in a systematic manner 3 Know that there is an inverse relationship between interest rates and bond prices 1 When the interest rate rises the market value of previously issued bonds will fall 2 When the interest rate falls the market value of previously issued bonds will rise The foreign exchange market the market in which the currencies of different countries are bought and sold The demand curve for foreign currency is downward sloping because as the dollar appreciates we can import more and invest more in other countries Capital outflows domestic money invested abroad The supply curve is upward sloping because as the dollar depreciates foreign countries invest domestically Equilibrium occurs when the supply of foreign currency equals the demand for foreign currency Capital inflows foreign money invested domestically Trade deficit imports exports Trade surplus exports imports Aggregate Demand AD The relationship between the price level and the quantity of domestically produced goods and services all households business firms governments and foreigners are willing to purchase Downward sloping because as price level goes down quantity demanded of all goods will increase Short Run Aggregate Supply SRAS Upward sloping because an increase in the price level will improve the profitability of the firms and cause them to increase output Long Run Aggregate Supply LRAS Vertical because in the long run people have had time to adjust and so a higher price level will increase costs as much as it increases revenues Short run Equilibrium Occurs at the intersection of the aggregate demand AD and short run aggregate supply curve SRAS Long run equilibrium Occurs where aggregate demand AD short run aggregate supply SRAS and long run aggregate supply LRAS all intersect at a single point In long run equilibrium We have correctly anticipated the price level There is no expansion or recession Actual rate of unemployment is equal to the natural rate of unemployment Changes in the real interest rate The interest rate is inversely related to how much households Changes in the expectations of businesses and households about the future Shifters of Aggregate Demand AD Changes in real wealth Increase in real wealth shifts AD curve right Decrease in real wealth shifts AD curve left Chapter 10 consume and businesses invest Interest rate falls shifts AD curve right Interest rate rises shifts AD curve left Optimism shifts AD curve right Pessimism shifts AD curve left Changes in the expected rate of inflation Expected increase in inflation spend more now AD curve shifts right Expected decrease in inflation spend less now AD curve shifts left Changes in income abroad Foreign income increases AD curve shifts right Foreign income decreases AD curve shifts left Changes in exchange rates Dollar depreciates AD curve shifts right Dollar appreciates AD curve shifts left Shifters of Long Run Aggregate Supply LRAS Change in resource base Change in level of technology Change in institutional arrangements that affect productivity Shifters of Short Run Aggregate Supply SRAS Changes in resource prices Changes in the expected rate of inflation Supply shocks Know how to shift the aggregate demand aggregate supply graph and how to identify the shift s affect on equilibrium price level and output in both the short run and the long run Know the causes of recessions and expansions and how the economy can correct itself Permanent income hypothesis Peoples consumption depends on their long run expected permanent income rather than their current income People will save during expansions spending increases only slightly spend savings during recessions spending decreases only slightly Changes in real interest rates stabilize the economy Recession less investment low interest rates higher consumption and investment offsets Expansion more investment high interest rates lower consumption and investment recession offsets expansion Changes in real resource prices stabilize the economy Recession low demand resource prices SRAS to Expansion high demand resource prices SRAS to Chapter 11 Basic differences between Classical and Keynesian Economics Classical Economics believes that market and resource prices are flexible and allow the economy to Keynesian Economics believe that market and resource prices are inflexible and therefore the market self correct fairly quickly will not be able to quickly correct itself Marginal propensity to consume MPC The amount of additional income that is consumed MPC additional consumption additional income The Expenditure Multiplier M A change in expenditures will have a greater impact than the initial change M 1 1 MPC Budget deficits and surpluses o Balanced budget government revenues taxes is equal to government expenditures o Budget deficit government spending is greater than government revenues o Budget surplus government revenue is greater than government spending T G T G T G Fiscal Policy Deliberate changes in tax policy and or government expenditures designed to affect the budget deficit or surplus o Keynesian idea of using counter cyclical fiscal policy to stabilize the economy During recessions use expansionary fiscal policy increase government spending reduce taxes During expansions use restrictive fiscal policy decrease government spending increase taxes Timing problems associated with fiscal policy Recognition lag Our ability to
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