INTRODUCTION BRIEF OVERVIEW OF AD SRAS LRAS MODEL Be familiar with the structure of this model meaning of horizontal and vertical axes and the significance of the long run aggregate supply curve AD consists of Consumers gov spending investment net exports SRAS relationship between REAL GDP and price level what economy can generate in short term LRAS what we are capable of producing long term due to our level of tech resources capital Make sure you know the factors that will shift AD SRAS and LRAS The Price Level is not one of them AD change in wealth component spending fiscal policy monetary policy SRAS Price Shock Changes in expected inflation Persistent output gap LRAS Technology Capital 3 What is the difference between short run equilibrium and long run equilibrium The long run is the period when the general price level contractual wage rates and expectations adjust fully to the state of the economy in contrast to the short run when these variables may not fully adjust 5 How does the Invisible Hand the economy s self correcting mechanism work What are the components of the self correcting mechanism The invisible hand that will restore balance of the economy naturally through supply and demand The components Change in price level Change in Interest Rates 6 How does the economy self correct following a shift in AD A shift in SRAS CHAPTER 1 Understand the following the role that financial markets play in the economy They give saved up excess funds from people who don t presently need them to those that do the structure of a balance sheet assets liabilities net worth and the problem of debt deflation 1 2 1 2 Inflation only affects your assets so if they become worth more than they should be a bubble will form and your assets will crash back down to regular prices However your liabilities wont change because that is a contractual agreement Therefore you will now be in debt because you borrowed so much money thinking that you could keep reinvesting it in assets that were consistently raising in price Assets Liabilities credit cards car loans mortgage cash stock bonds house 300 000 but drops to 100 000 due to de ation 200 000 Then you have 100 000 dollars of debt 4 3 the interpretation of the movement of interest rates depicted in Figure 1 Important to note that there is more than one type of interest rate Most important is Fed funds because all others are based on this rate which the federal reserve imposes Also note that interest rates other than the Fed Funds are based upon varying levels of risk Therefore a company that is more likely to pay your loan back will have to pay you less interest because YOU would rather loan someone your money who will pay you back than someone less likely 2 from Figure 2 the reason for the sharp rise in the DJIA between 1990 2000 the steep declines in 2001 and 2007 Dot com bubble basically internet companies became way over valued and their prices crashed 5 the relationship between money supply growth and business cycles Figure 3 Money supply will grow during business expansion because Companies will have more motivation to borrow money to invest it in possible ventures 6 the reason for the crossover of M2 and the GDP Deflator depicted in Figure 4 GDP deflator and Money supply have always been directly related However the cross over is due to the technological revolution which lowered the cost of production tremendously 7 how to calculate a growth rate real versus nominal GDP growth Nominal GDP of one year ie 2009 multiplied by the Deflator of another year 2008 Real GDP all of this divided by The deflator of the Nominal GDP in 2009 CHAPTER 2 Know the following 1 how financial markets benefit consumers how they promote economic growth They promote economic growth by moving funds from people who have saved to the people who need them to get stuff done Benefit consumers by keeping money safe and providing a means to increase their wealth through investment 2 the structure of the financial system direct versus indirect debt versus equity markets primary versus secondary markets money markets versus capital markets brokers versus dealers 3 the main disadvantage of owning stocks versus bonds holders might not be payed back If a company goes bankrupt they must pay back the bond holders before stock holders so stock 4 the flow of funds through the financial system major lenders major borrowers top two 5 two reasons that the secondary market is important to the primary market for stock in which new financial capital is provided to the borrower Fundamentally secondary markets mesh the investor s preference for liquidity i e the investor s desire not to tie up his or her money for a long period of time in case the investor needs it to deal with unforeseen circumstances with the capital user s preference to be able to use the capital for an extended period of time 6 the largest components of the money and capital markets respectively Components of the Capital market 1 Bond Market the market for debt instrument of any kind 2 Mortgage Market deals with loan or residential commercial and industrial real estate and on farmland 3 Stock Market common and preferred stocks issued by corporations are traded Money Market i The market for extremely short period loans ii Money at call and short notice iii The rate in this market is the call money rate iv The rate is deter mined by the de mand and supply of funds v Money is lent mainly to the bill brokers and stock exchange dealers 7 the three major functions benefits of financial intermediaries Through the process of nancial intermediation certain assets or liabilities are transformed into different assets or liabilities As such nancial intermediaries channel funds from people who have extra money or surplus savings to those who do not have enough money to carry out a desired activity 8 how financial intermediaries a lower transaction costs and b deal with asymmetric information between borrowers and lenders both adverse selection and moral hazard issues Adverse selection means anyone who wants to borrow is a risky individual based on the fact that they need to borrow money Therefore everyone is carefully evaluated as a borrower Moral Hazard deals with behavior after the loan A banker can write something into the contract which specifies how fast the person can spend the loan and such Lower Transaction Costs through online banking technology 9 two ways that regulation of financial markets protects investors a Requires