ECO 3223 FALL 2015 EVANS STUDY GUIDE FOR EXAM 1 INTRODUCTION PERSPECTIVES ON THE U S ECONOMY Understand the following 1 The role that the technology boom and interest rates played in the housing market bubble the financial crisis and the subsequent Great Recession In response to the Dot com bust and then the 9 11 attacks the Fed lowered interest rates to prevent a prolonged recession Fed Funds rate falls from 6 5 to 3 1 in 2001 remains low until 2004 Low interest rates led to increase in demand for housing and financing both act as catalysts for housing boom application approval processing and servicing Significant trends in the performance of the Dow Jones Industrial Average since 1990 Subprime mortgages adjustable rate mortgages and mortgage backed securities are Dot com revolution enabled financial institutions to lower costs and increase speed of loan innovations that enabled banks to increase quantity but with devastating consequences 2 o Home prices peak in 2006 by 2009 prices fell by 37 o Subprime borrowers are unable to qualify for refinancing since value of homes had o Full blown financial crisis emerges fallen below loan value foreclosure wave begins 3 4 5 Current levels in U S GDP relative to potential unemployment price levels and interest rates not actual values but trends What significant event during the 1980s is associated with former Federal Reserve Chair Paul Volker The four major ways that the Federal Reserve responded to the financial crisis that intensified after the collapse of Lehman Brothers These initiatives have been credited with preventing the complete collapse of our financial system 1 Lender of Last Resort traditional discount window Term Auction Facility TAF Primary 2 Provision of Liquidity to Financial System The Commercial Paper Funding Facility Dealer Credit Facility PDCF and Term Securities Lending Facility TSLF category and bilateral currency swap agreements with foreign central banks CPFF Asset Backed Commercial Paper Money Market Investor Funding Facility AMLF and Term Asset Backed Securities Loan Facility TALF 3 Open Market Operations conventional and unconventional expanded traditional tool of open market operations to support credit markets put downward pressure on longer term interest rates and to make broader financial conditions more accommodative through the purchase of longer term securities from the Federal Reserve s portfolio improved risk management practices improved liquidity management more appropriate compensation structures more transparency in dealing with consumers and improvements in supervisory and regulatory oversight both micro and macro prudential The term debt deflation and how it has affected recovery from the Great Recession 4 Regulatory and Supervisory improved capital structures both amount and quality 1 Debt deflation an individual s net worth before a market crash and after a market crash are completely different because assets lose value when market prices are lower than before INTRODUCTION BRIEF OVERVIEW OF AD SRAS LRAS MODEL 1 Be familiar with the structure of this model meaning of horizontal and vertical axes and the significance of the long run aggregate supply curve 2 Make sure you know the factors that will shift AD SRAS and LRAS The Price Level is not one of them Shifters of AD Shifters of SRAS Shifters of LRAS right o An increase in the money supply shifts AD to the right o Increase in spending from any of the components C I G NX will shift AD to the o Taxes increase AD shifts to the left o Increase in expected inflation shifts SRAS up to the left o Price shock increase shifts SRAS up to the left o Output gap increases SRAS shifts up to the left o Shifts to the right when there is 1 an increase in the total capital in the economy 2 an increase in the total amount of labor supplied in the economy 3 an increase in the available technology or 4 a decline in the natural rate of unemployment o An opposite movement in these variables shifts the curve to the left 3 What is the difference between short run equilibrium and long run equilibrium natural rate of output generated by the natural rate of unemployment take advantage of short run profitability when price level rises determined by amount of capital and labor and available technology vertical at the wages and prices are sticky generates an upward sloping SRAS as firms attempt to o LRAS o SRAS 4 How does the Invisible Hand the economy s self correcting mechanism work What are the components of the self correcting mechanism o Regardless of where output is initially it eventually returns to the natural rate o Slow wages are inflexible particularly downward need for active government o Rapid wages and prices are flexible less need for government intervention policy What are the long run effects of a permanent negative supply shock A permanent 5 positive supply shock 2 o Permanent negative supply shock such as an increase in ill advised regulations that causes the economy to be less efficient thereby reducing supply would decrease potential output and shift the long run aggregate supply cure to the left o Because the permanent supply shock will result in higher prices there will be an immediate rise in inflation and so the short run aggregate supply curve will shift up and to the left CHAPTER 1 Understand the following I The role that financial markets play in the economy o such as bond stock markets o crucial to promoting greater economic efficiency by channeling funds from people o key factor in producing high economic growth poorly performing financial markets o activities in financial markets also have direct effects on personal wealth behavior who do not have a productive use for them are one reason that many countries remain desperately poor of businesses and consumers and the cyclical performance of the economy 2 financial instrument a claim on issuer s future income or assets any financial debt security that promises to make payments periodically for a specified period of The interpretation of the movement of interest rates depicted in Figure 1 o security claim or piece of property subject to ownership o bond time o the bond market enables corporations and governments to borrow to finance their activities and it is where interest rates are determined o interest rate cost of borrowing or price paid for rental of funds high interest rates could deter you from buying a house car because cost of financing would be high could encourage you to save because