ECO 3223 SPRING 2016 EVANS STUDY GUIDE FOR EXAM 1 Note This is intended to direct you to the relevant topics that will be covered on the exam Questions will be worded differently so don t MEMORIZE this content use it to help you understand the concepts Understand the definitions of all terms at the end of each chapter 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 cri sis 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 Dot com revolution enabled financial institutions to lower costs and increase speed of loan application approval processing and servicing People then began to default on their mortgages leading to the collapse and recession 2 significant trends in the performance of the Dow Jones Industrial Average since 1990 Subprime mortgages adjustable rate mortgages and mortgage backed securities are innovations that enabled banks to increase quantity but with devastating consequences Home prices peak in 2006 by 2009 prices fell by 37 Subprime borrowers are unable to qualify for refinancing since value of homes had fallen below loan value foreclosure wave begins Full Blown financial crisis begins 3 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 4 the term debt deflation and how it has affected recovery from the Great Recession Debt Deflation People that once had a high worth of assets and low liabilities are now experiencing a lower worth of as as market value of goods decreases asset worth decreases sets while the liabilities remain the same 5 Models a Macroecon signifi Price Level LRA SRA omy LRAS SRAS ADBe familiar with the structure of this model meaning of cance of the long run aggregate supply curve horizontal and vertical axes and the 1 AD LONG RUN EQ What is the differ Q equilibrium ence between short run equilibrium and long run Short Run Equilibrium Long Run Equilibrium cannot be maintained in the long run desired level of output and demand Be able to demonstrate and explain the impact upon output unemployment and the price level of expansionary or contractionary monetary policy Expansionary Policy Contractionary Policy demand increases unemployment decreases price level increases demand decreases unemployment increases price level decreases How does the Invisible Hand the economy s self correcting mechanism work What are the components of the self correcting mechanism How does the economy self correct following implementation of monetary policy b Foreign Exchange Understand the construction of the model and Why do we hold the Supply curve as fixed in the short run What factors shift short run Demand in the foreign exchange market How do shifts in Demand affect currency appreciation or depreciation CHAPTER 1 Understand the following 1 the role that financial markets play in the economy Financial markets transfer money from people with excess funds to those that have a shortage Bond and stock markets promote greater economic efficiency by channeling funds from people who do not have a productive use for them to those that do Well functioning financial markets are crucial to economic growth and poorly functioning markets are the reason many countries remain desperately poor Have a direct effect on personal wealth business and consumer behaviors and performance in economy 2 the interpretation of the movement of interest rates depicted in Figure 1 2 Although interest tend to move in unison they often differ substantially and the spreads between them fluctuate Most interest rates peaked around 1981 and then declined mostly until around 2010 Three month treasury interest rates fluctuate more than others and is usually lower 3 from Figure 2 the reason for the sharp rise in the DJIA between 1990 2000 the steep declines in 2001 and 2007 Rose sharply between 1990 2000 due to technology boom Fell sharply in 2001 due to the collapse of tech bubble Fell again in 2007 due to housing bubble 4 the relationship between money supply growth and business cycles Figure 3 Money may influence the business cycle A steep drop in money growth could indicate a recession Monetary Theory ties changes in the money supply to changes in aggregate economic activity and the price level 5 the reason for the crossover of M2 and the GDP Deflator depicted in Figure 4 CHAPTER 1 Understand the following 6 how to calculate a growth rate real versus nominal GDP growth 7 why countries with highly independent central banks experience low rates of inflation CHAPTER 2 Know the following 3 1 how financial markets benefit consumers how they promote economic growth Financial markets make funds available to those that need to borrow and provide interest opportunities to those that lend Allows consumers to time purchases better Provide funds to those that have investment opportunities Proficient allocation of capital increasing production 2 the structure of the financial system direct versus indirect debt versus equity markets primary versus sec ondary markets money markets versus capital markets brokers versus dealers Direct Finance Indirect Finance lender Debts Equities Primary Markets Secondary Markets Money Market market Capital Market Brokers Dealers borrowers borrow funds directly from lenders by selling them securities borrowers borrow money through financial intermediaries and not directly from the borrower pays lender fixed dollar amounts at regular intervals until a specified date borrower gives lender claims on the assets and income of the business stock new issues of securities are sold to initial buyers by the corporation or government agency that is borrowing funds securities that have been previously issued can be resold market in which only short term debt instruments are traded more liquid than capital market in which longer term debt and equity instruments are traded agents of investors who match buyers with sellers of securities link buyers and sellers by buying and selling securities at stated prices 3 the term