Wednesday, September 4, 2013
Reading and quiz for 9/5
If you are having trouble logging in to moodle, email me at travis.ormsby@gmail.com so that I can provide you with your moodle login credentials. If you continue to have trouble for any reason, the reading for 9/5 is here and the quiz is here.
Tuesday, September 3, 2013
Welcome to AP Macroeconomics
You should enroll yourself in the Moodle for this course by going to elearn.spps.org (new window). You sign in with your active directory account (the one where your username is s followed by your CIF).
Once you have logged in, find the Navigation header on the left hand side bar. Click "Courses" then "School Courses" then "Senior High Schools" then "Central" then "AP Macro"
You should see an option to enroll yourself in the course. Once you do so, you will be able to access the materials for the course. You should read the syllabus and the two readings for 9/4 and take the quiz on scarcity and opportunity cost.
If you do not know your active directory login, you may access tomorrow's reading here and the quiz for that reading here. Bring the answers to the quiz to class tomorrow. You must also email me at travis.ormsby@gmail.com so that I can get your login information to share with you.
I am delaying a vote on the various methods to allocate extra credit points until I can phrase the different options in a way that I find satisfactory. Expect more information this week.
Once you have logged in, find the Navigation header on the left hand side bar. Click "Courses" then "School Courses" then "Senior High Schools" then "Central" then "AP Macro"
You should see an option to enroll yourself in the course. Once you do so, you will be able to access the materials for the course. You should read the syllabus and the two readings for 9/4 and take the quiz on scarcity and opportunity cost.
If you do not know your active directory login, you may access tomorrow's reading here and the quiz for that reading here. Bring the answers to the quiz to class tomorrow. You must also email me at travis.ormsby@gmail.com so that I can get your login information to share with you.
I am delaying a vote on the various methods to allocate extra credit points until I can phrase the different options in a way that I find satisfactory. Expect more information this week.
Readings for 9/4
If we can land a man on the surface of the moon, make a $5 footlong sandwich, or give someone a face transplant, why can't we get everything else we want?
Our problem is that we are selfish, greedy bastards. Except for an extremely small percentage of people (who primarily live on Tibetan mountaintops), we are never going to be satisfied fully.
Don't believe me? Try this little thought experiment: I offer Bill Gates a check for $1 Million. No strings attached. Do you think he'll say no? Of course not. Even though he's got billions upon billions of dollars, he didn't get that way by turning down million dollar checks.
That's the first law of economics: everybody always wants more (as long as it's free).
This wouldn't be a problem if we had infinite resources available. Then everyone could satisfy their infinite desires and you could, in fact, get everything you wanted. Sadly, there are not infinite resources available. Our planet only has a mass of 6E+24 kilograms and most of that is boiling hot metals that people don't really want that badly.
Limited resources + Unlimited Wants = Dissatisfaction.
Economists use the word scarcity to describe the dissatisfaction we get from having insufficient resources to fulfill our wants. The fact that scarcity exists is the fundamental fact of economics. If resources weren't scare, we wouldn't care about how they were distributed, or how to make more efficient use of them, or how they change over time. For that reason, economics is sometimes referred to as the science of scarcity. This is perhaps because it sounds better than the dismal science, which is what some other, jealous, petty, and mean people like to call it in order to make us look bad.
-----------------------------------------------------------
So it's clear that you can't get everything that you want, due to the whole scarcity thing we learned about last time. You can, however, get some things you want. You have to choose. Which of the infinite things that you want do you want most? That means, of course, that there's going to be a bunch of stuff you're not going to get. Here's a little rhyme to help you remember:
When you choose, you loose.
You loose the chance to do/have/be something else. Choosing implies mutual exclusivity. Getting one means that you can't get the other one. Because if you could have both, then you wouldn't have to choose, now would you?
Economists call this lost chance your opportunity cost. Every time you do something, you are making a choice to not do something else. There's probably an infinite number of things you could have done instead, but since each choice is mutually exclusive, we only consider your next best option to be your opportunity cost.
An example would be helpful, I think:
As I write this, I could do any of the following things instead:
1) Race down the street wearing a purple sash and diamond tiara
2) Finish reading The Bride by Bapsi Sidhwa (an excellent book so far, highly recommended)
3) Go to sleep
Because each of these four options are mutually exclusive, I can only do one of them. Clearly I actually chose to write this blog post, so that must be my best choice, but what was my next best option? Running down the street at all, much less in a ridiculous get-up, doesn't sound like a particularly appealing option. I would like to find out how Zaitoon deals with her in-laws in the Pakistani hill country, but my bed is looking awfully comfortable right now and I'm getting pretty sleepy, so I think that's my next best option after writing this post.
So my opportunity cost for writing the post is going to bed. I can't both go to sleep and write this, so by choosing to write, I lose out on being able to go to sleep.
Economists care about opportunity costs, not about money costs. The following example will illustrate the difference:
Several weeks ago, I took my car in to get the timing belt replaced. I paid them $862.47. But I had other opportunity costs:
1) I lost the opportunity to be certain that no one was ripping me off.
2) I missed out on playing with my daughter for the time I had to wait
3) I burned a whole gallon of gas driving there and back
I would gladly pay 10% of the final bill ($86) for an ironclad guarantee that I wasn't being ripped off. I would have paid about $50 for someone to take my car in for me so I could use my time to be with my kid. A gallon of gas runs about $3.50. Note that these costs are not mutually exclusive. I traded all of them plus the cash for 1 timing belt. So the belt didn't cost $862.47, it really cost the equivalent of about $1,000 ($862.47 + $86 + $50 + $3.50).*
My other choice was to go without a new belt and risk having my car break down (in which case I'd still have to pay all the costs, just at a less convenient time). Since it is worth more than $1,000 to avoid that risk, it makes sense to take my car in to get it repaired.
The last important thing about opportunity cost is to understand that every action you can possibly take has one. Because scarcity exists, you have to give up some opportunity in order to do anything. This is where the saying "there's no such thing as a free lunch" comes in handy. Even if I don't charge you for the lunch, you still could have been doing something else instead of eating the lunch. If nothing else, by taking the lunch, you lose the opportunity to go on the popular (if medically insane) 24-hour Hollywood Miracle Diet. You may not value that lost opportunity very highly, but that doesn't mean you didn't lose something.
*Notice that nifty little trick I did where I gave the value of my opportunity costs in dollars? None of those extra lost opportunities actually cost me real dollars, but it's useful to be able to put their value in dollars in order to make easy comparisons. Economists use the idea of "willingness to pay" in order to help quantify the value of opportunity costs, since such costs don't always involve cash payments.
Our problem is that we are selfish, greedy bastards. Except for an extremely small percentage of people (who primarily live on Tibetan mountaintops), we are never going to be satisfied fully.
Don't believe me? Try this little thought experiment: I offer Bill Gates a check for $1 Million. No strings attached. Do you think he'll say no? Of course not. Even though he's got billions upon billions of dollars, he didn't get that way by turning down million dollar checks.
That's the first law of economics: everybody always wants more (as long as it's free).
This wouldn't be a problem if we had infinite resources available. Then everyone could satisfy their infinite desires and you could, in fact, get everything you wanted. Sadly, there are not infinite resources available. Our planet only has a mass of 6E+24 kilograms and most of that is boiling hot metals that people don't really want that badly.
Limited resources + Unlimited Wants = Dissatisfaction.
Economists use the word scarcity to describe the dissatisfaction we get from having insufficient resources to fulfill our wants. The fact that scarcity exists is the fundamental fact of economics. If resources weren't scare, we wouldn't care about how they were distributed, or how to make more efficient use of them, or how they change over time. For that reason, economics is sometimes referred to as the science of scarcity. This is perhaps because it sounds better than the dismal science, which is what some other, jealous, petty, and mean people like to call it in order to make us look bad.
-----------------------------------------------------------
So it's clear that you can't get everything that you want, due to the whole scarcity thing we learned about last time. You can, however, get some things you want. You have to choose. Which of the infinite things that you want do you want most? That means, of course, that there's going to be a bunch of stuff you're not going to get. Here's a little rhyme to help you remember:
When you choose, you loose.
You loose the chance to do/have/be something else. Choosing implies mutual exclusivity. Getting one means that you can't get the other one. Because if you could have both, then you wouldn't have to choose, now would you?
Economists call this lost chance your opportunity cost. Every time you do something, you are making a choice to not do something else. There's probably an infinite number of things you could have done instead, but since each choice is mutually exclusive, we only consider your next best option to be your opportunity cost.
An example would be helpful, I think:
As I write this, I could do any of the following things instead:
1) Race down the street wearing a purple sash and diamond tiara
2) Finish reading The Bride by Bapsi Sidhwa (an excellent book so far, highly recommended)
3) Go to sleep
Because each of these four options are mutually exclusive, I can only do one of them. Clearly I actually chose to write this blog post, so that must be my best choice, but what was my next best option? Running down the street at all, much less in a ridiculous get-up, doesn't sound like a particularly appealing option. I would like to find out how Zaitoon deals with her in-laws in the Pakistani hill country, but my bed is looking awfully comfortable right now and I'm getting pretty sleepy, so I think that's my next best option after writing this post.
So my opportunity cost for writing the post is going to bed. I can't both go to sleep and write this, so by choosing to write, I lose out on being able to go to sleep.
Economists care about opportunity costs, not about money costs. The following example will illustrate the difference:
Several weeks ago, I took my car in to get the timing belt replaced. I paid them $862.47. But I had other opportunity costs:
1) I lost the opportunity to be certain that no one was ripping me off.
2) I missed out on playing with my daughter for the time I had to wait
3) I burned a whole gallon of gas driving there and back
I would gladly pay 10% of the final bill ($86) for an ironclad guarantee that I wasn't being ripped off. I would have paid about $50 for someone to take my car in for me so I could use my time to be with my kid. A gallon of gas runs about $3.50. Note that these costs are not mutually exclusive. I traded all of them plus the cash for 1 timing belt. So the belt didn't cost $862.47, it really cost the equivalent of about $1,000 ($862.47 + $86 + $50 + $3.50).*
My other choice was to go without a new belt and risk having my car break down (in which case I'd still have to pay all the costs, just at a less convenient time). Since it is worth more than $1,000 to avoid that risk, it makes sense to take my car in to get it repaired.
The last important thing about opportunity cost is to understand that every action you can possibly take has one. Because scarcity exists, you have to give up some opportunity in order to do anything. This is where the saying "there's no such thing as a free lunch" comes in handy. Even if I don't charge you for the lunch, you still could have been doing something else instead of eating the lunch. If nothing else, by taking the lunch, you lose the opportunity to go on the popular (if medically insane) 24-hour Hollywood Miracle Diet. You may not value that lost opportunity very highly, but that doesn't mean you didn't lose something.
*Notice that nifty little trick I did where I gave the value of my opportunity costs in dollars? None of those extra lost opportunities actually cost me real dollars, but it's useful to be able to put their value in dollars in order to make easy comparisons. Economists use the idea of "willingness to pay" in order to help quantify the value of opportunity costs, since such costs don't always involve cash payments.
Wednesday, May 1, 2013
AP Macro Review Resources
You should notice a new tab for AP Macro Review Resources. Check here for access to some good review materials. I'll post more stuff here in the next week or so, so keep your eye out for new resources
Friday, April 26, 2013
Friday, March 1, 2013
Exam 3 Review Guide
**UPDATED WITH PRACTICE QUESTIONS**
Printer friendly version here.
Each title is a link to the problem set for that topic. Your complete set of problem sets is due on Thursday with the exam.
The problem sets should be your primary review aids. Below is a brief outline of the topics we have covered and the general things you need to know/be able to do for each topic.
3.1: Circular Flow Model. You need to know the circular flow model and how it can be used to calcuate GDP. You need to know and be able to use the expenditure approach formula for calculating GDP.
3.2: GDP. You need to know the difference between real and nominal GDP and how to apply the relationship between total and per capita GDP
3.3: Real v. Nominal GDP. You need to be able to convert between real and nominal GDP given a measure of inflation.
3.4: CPI. You need to be able to calculate CPI. You need to be able to use CPI to determine the changes in real values between two years.
3.5: Costs of Inflation and Deflation. You need to know the costs of both expected and unexpected inflation. You need to know why deflation is worse than inflation.
3.6: Measuring Unemployment. You need to be able to apply the relationship between population, civilian non-institutionalized population, labor force, employment, unemployment, labor force participation rate and unemployment rate. You need to be able to differentiate between the types of unemployment.
3.7: The Natural Rate of Unemployment. You need to be able to apply the relationship between overall unemployment, cyclical unemployment, and the natural rate of unemployment. You need to be able to apply the relationship between cyclical unemployment and labor market equilibrium. You need to understand how the labor market equilibriation process is different in the short term from the long term.
** UPDATE **
Here is a practice FRQ for you (it is the same as the one I gave out in class today). Below is a breakdown of the answers:
1) This is just memorization. Look at your problem set for 3.1 to know exactly how to do this
2) If unemployment is less than the natural rate, cyclical unemployment is less than 0%. This means that the current wage in the labor market is less than the equilibrium wage. You should draw a diagram of the labor market that shows a current wage below equilibrium
3) If a bunch of people leave, the labor supply will decrease (shift to the left). You diagram should start with the labor shortage from part 2 and show how the decreasing labor supply makes the shortage even worse (since wages don't change in the short run)
4) Inflation is the percent change in CPI. Application of the % change formula: (new-old)/old. (300-400)/400 = -25% or 25% deflation
5) Application of the formula to find the real value of income: (nominal income/CPI)*100 = real income. Hans' real income last year was $3/hour: ($12/400)*100. His real income this year is $6: ($18/300)*100. The percent change from $3 to $6 is 100%: ($6-$3)/$3 = 1 = 100% increase
6) Application of the formula to calculate GDP: C+I+G+(X-M)=Y. The total change in nominal GDP is -$18 billion (-$3 billion-$12 billion-$3 billion+$6 billion). To find the real change, use the same formula from above: (nominal/CPI)*100. (-$12 billion/300)*100 = -$4 billion.
Printer friendly version here.
Each title is a link to the problem set for that topic. Your complete set of problem sets is due on Thursday with the exam.
The problem sets should be your primary review aids. Below is a brief outline of the topics we have covered and the general things you need to know/be able to do for each topic.
3.1: Circular Flow Model. You need to know the circular flow model and how it can be used to calcuate GDP. You need to know and be able to use the expenditure approach formula for calculating GDP.
3.2: GDP. You need to know the difference between real and nominal GDP and how to apply the relationship between total and per capita GDP
3.3: Real v. Nominal GDP. You need to be able to convert between real and nominal GDP given a measure of inflation.
3.4: CPI. You need to be able to calculate CPI. You need to be able to use CPI to determine the changes in real values between two years.
3.5: Costs of Inflation and Deflation. You need to know the costs of both expected and unexpected inflation. You need to know why deflation is worse than inflation.
3.6: Measuring Unemployment. You need to be able to apply the relationship between population, civilian non-institutionalized population, labor force, employment, unemployment, labor force participation rate and unemployment rate. You need to be able to differentiate between the types of unemployment.
3.7: The Natural Rate of Unemployment. You need to be able to apply the relationship between overall unemployment, cyclical unemployment, and the natural rate of unemployment. You need to be able to apply the relationship between cyclical unemployment and labor market equilibrium. You need to understand how the labor market equilibriation process is different in the short term from the long term.
** UPDATE **
Here is a practice FRQ for you (it is the same as the one I gave out in class today). Below is a breakdown of the answers:
1) This is just memorization. Look at your problem set for 3.1 to know exactly how to do this
2) If unemployment is less than the natural rate, cyclical unemployment is less than 0%. This means that the current wage in the labor market is less than the equilibrium wage. You should draw a diagram of the labor market that shows a current wage below equilibrium
3) If a bunch of people leave, the labor supply will decrease (shift to the left). You diagram should start with the labor shortage from part 2 and show how the decreasing labor supply makes the shortage even worse (since wages don't change in the short run)
4) Inflation is the percent change in CPI. Application of the % change formula: (new-old)/old. (300-400)/400 = -25% or 25% deflation
5) Application of the formula to find the real value of income: (nominal income/CPI)*100 = real income. Hans' real income last year was $3/hour: ($12/400)*100. His real income this year is $6: ($18/300)*100. The percent change from $3 to $6 is 100%: ($6-$3)/$3 = 1 = 100% increase
6) Application of the formula to calculate GDP: C+I+G+(X-M)=Y. The total change in nominal GDP is -$18 billion (-$3 billion-$12 billion-$3 billion+$6 billion). To find the real change, use the same formula from above: (nominal/CPI)*100. (-$12 billion/300)*100 = -$4 billion.
Tuesday, February 19, 2013
Exam 2 Study Guide
printer friendly version here. Some practice questions are embedded at the bottom of this post. Some of the practice questions do not have answers given, these are typically questions related to definitions that you should not have too much difficulty finding the answer to.
The best resources to use if you want to know what kind of questions will be on the exam are your problem sets and the reading quizzes. If you are missing any problem sets, each one is linked below. The problem sets are due on Friday.
There are 7 main topics that you need to be familiar with.
2.1: The Definition of Money. You need to know that money is a medium of exchange, unit of account, and store of value. The better job it does at those things, the more like money it is. It has to be able to do all 3 things. Something that is an excellent medium of exchange and unit of account but doesn't store value is not very much like money at all.
2.2: Present Value. You need to understand that because people would rather have money now than money later, a future payment is worth less than its face value today. The degree to which a person values the present over the future is referred to as their discount rate. This discount rate represents the point at which a person would switch from being a borrower to being a lender - at an interest rate less than the discount rate it makes sense to borrow money, while it makes sense to lend money if the interest rate is above the discount rate. You need to be able to use the formula FV=PV(1+r)^t to calculate a missing value given the other three.
2.3: The Money Creation Process. You need to understand the process by which the banking system creates money by loaning it out. Someone deposits money in the bank and the bank keeps some of this money just in case the person wants some of it back later. The proportion they keep is the reserve ratio. Laws in the US set a minimum proportion to hold back, this is the required reserve ratio. The rest they loan out. This money is spent and makes its way back into the banking system as people deposit their earnings. Part of this is loaned out. Rinse and repeat.
Example:
A bank starts with no deposits, reserves, or loans.
Assets | Liabilities
Reserves: $0 Deposits: $0
Then someone deposits $1000 cash into the bank. The customer's deposit is a liability for the bank because the bank must pay out the money whenever the customer asks for it. But the bank has an extra $1000 in reserves from the cash, which is an asset.
Assets | Liabilities
Reserves: $1,000 Deposits: $1,000
Assume that the bank is required to keep 5% in reserves.
Assets | Liabilities
Required Reserves: $50 Deposits: $1,000
Excess Reserves: $950
Since the bank has more money in reserves than they are required to, they can loan the excess out. The loans are an asset because it is money somebody else owes to the bank.
Assets | Liabilities
Required Reserves: $50 Deposits: $1,000
Excess Reserves: $0
Loans: $950
People don't borrow money in order to keep it under their mattress, so this loan will get spent. That spending is income for somebody else, who deposits it into the bank. This increases Deposits by $950 and Reserves by the same amount.
Assets | Liabilities
Reserves: $1000 Deposits: $1,950
Loans: $950
Once again, the bank has excess reserves
Assets | Liabilities
Required Reserves: $97.50 Deposits: $1,950
Excess Reserves: $902.50
Loans: $950
So it loans them out
Assets | Liabilities
Required Reserves: $97.50 Deposits: $1,950
Excess Reserves: $0
Loans: $1,852.50
Once again, this money comes back into the system, increasing deposits and reserves
Assets | Liabilities
Reserves: $1000 Deposits: $2,852.50
Loans: $1,852.50
Excess again
Assets | Liabilities
Required Reserves: $142.63 Deposits: $2,852.50
Excess Reserves: $857.37
Loans: $1,852.50
Another Loan
Assets | Liabilities
Required Reserves: $142.63 Deposits: $2,852.50
Excess Reserves: $0
Loans: $2,709.87
Which becomes another deposit.
Assets | Liabilities
Reserves: $1000 Deposits: $3,709.87
Loans: $2,709.87
Notice how every time the money gets redeposited into the bank, the total reserves go back up to $1000, which was the initial deposit. You should also notice that the Deposits, Required Reserves, and Loans are all increasing throughout this process. You should notice that this increase is occurring at a decreasing rate, so eventually, we will get to a point where it is not possible make any new loans.
Assets | Liabilities
Required Reserves: $1000 Deposits: $20,000
Excess Reserves: $0
Loans: $19,000
The maximum total increase in loans will be equal to the size of the initial loan * 1/RRR where RRR is the required reserve ratio ($950 * 1/0.05 = $19,000). The maximum total increase in the money supply depends on the source of the initial deposit that allowed the initial loan. If the initial deposit was already in the money supply (say you found a shoebox full of cash), the maximum total money supply increase will be equal to the amount of new loans created. If the initial deposit was outside the money supply (say a wizard conjured it), the maximum total money supply increase will be equal to the initial deposit plus the amount of new loans created.
You need to be able to relate the values for an initial deposit, reserve ratio, maximum increase in loans, and maximum increase in the money supply. Given some of these values, you need to be able to calculate (without a calculator) one or more missing values.
2.4: Money Demand. You need to understand that there is an opportunity cost to holding money. Every dollar that you keep in your pocket or your checking account is a dollar that you are not earning interest on. Because holding money is not free, people will not want to hold an infinite amount of money. The higher the nominal interest rate is, the less likely people will be to hold on to their money (since the opportunity cost is higher). The inverse relationship between nominal interest rate and quantity of money demanded results in a demand curve for money that is downward sloping,
2.5 Money Market. You need to understand that the money supply is controlled by a country's central bank and is vertical. You need to be able to understand the relationship between money demand, money supply, nominal interest rates and quantity of money. Given a scenario, you need to be able to determine and correctly diagram a change in any one or more of these values.
2.6: Real Interest Rates and the Loanable Funds Market. You need to understand that when we borrow or lend money, we are not interested in the nominal rate of interest, but the real rate, which can be estimated by subtracting the rate of inflation from the nominal interest rate. If real interest rates are high, we want to loan money (by saving it), while we want to borrow money when real interest rates are low. In other words, the supply of savings is directly proportional to the real interest rate, while investment demand (the demand for borrowed money) is inversely proportional to the real interest rate. We can diagram this relationship in the loanable funds market.
You need to understand the relationship between investment demand, savings supply, real interest rates, and quantity of loanable funds. Given a scenario, you need to be able to determine and correctly diagram a change in any one or more of these values.
2.7: The Quantity Theory of Money. You need to understand the equation of exchange, MV = PY, which is an accounting identity and is true by definition. You need to understand the assumption of the quantity theory of money. You need to understand that when we make those assumptions, any increase in the money supply leads directly to an increase in the price level. You need to be able to use the equation of exchange to calculate M, V, P, or Y given the other three values. You need to be able to use the simple quantity theory of money to determine what will happen to inflation given a change in the money supply. You also need to be able to use the simple quantity theory of money to determine what policy the Federal Reserve should follow if they want a particular level of inflation.
The best resources to use if you want to know what kind of questions will be on the exam are your problem sets and the reading quizzes. If you are missing any problem sets, each one is linked below. The problem sets are due on Friday.
There are 7 main topics that you need to be familiar with.
2.1: The Definition of Money. You need to know that money is a medium of exchange, unit of account, and store of value. The better job it does at those things, the more like money it is. It has to be able to do all 3 things. Something that is an excellent medium of exchange and unit of account but doesn't store value is not very much like money at all.
2.2: Present Value. You need to understand that because people would rather have money now than money later, a future payment is worth less than its face value today. The degree to which a person values the present over the future is referred to as their discount rate. This discount rate represents the point at which a person would switch from being a borrower to being a lender - at an interest rate less than the discount rate it makes sense to borrow money, while it makes sense to lend money if the interest rate is above the discount rate. You need to be able to use the formula FV=PV(1+r)
2.3: The Money Creation Process. You need to understand the process by which the banking system creates money by loaning it out. Someone deposits money in the bank and the bank keeps some of this money just in case the person wants some of it back later. The proportion they keep is the reserve ratio. Laws in the US set a minimum proportion to hold back, this is the required reserve ratio. The rest they loan out. This money is spent and makes its way back into the banking system as people deposit their earnings. Part of this is loaned out. Rinse and repeat.
Example:
A bank starts with no deposits, reserves, or loans.
Assets | Liabilities
Reserves: $0 Deposits: $0
Then someone deposits $1000 cash into the bank. The customer's deposit is a liability for the bank because the bank must pay out the money whenever the customer asks for it. But the bank has an extra $1000 in reserves from the cash, which is an asset.
Assets | Liabilities
Reserves: $1,000 Deposits: $1,000
Assume that the bank is required to keep 5% in reserves.
Assets | Liabilities
Required Reserves: $50 Deposits: $1,000
Excess Reserves: $950
Since the bank has more money in reserves than they are required to, they can loan the excess out. The loans are an asset because it is money somebody else owes to the bank.
Assets | Liabilities
Required Reserves: $50 Deposits: $1,000
Excess Reserves: $0
Loans: $950
People don't borrow money in order to keep it under their mattress, so this loan will get spent. That spending is income for somebody else, who deposits it into the bank. This increases Deposits by $950 and Reserves by the same amount.
Assets | Liabilities
Reserves: $1000 Deposits: $1,950
Loans: $950
Once again, the bank has excess reserves
Assets | Liabilities
Required Reserves: $97.50 Deposits: $1,950
Excess Reserves: $902.50
Loans: $950
So it loans them out
Assets | Liabilities
Required Reserves: $97.50 Deposits: $1,950
Excess Reserves: $0
Loans: $1,852.50
Once again, this money comes back into the system, increasing deposits and reserves
Assets | Liabilities
Reserves: $1000 Deposits: $2,852.50
Loans: $1,852.50
Excess again
Assets | Liabilities
Required Reserves: $142.63 Deposits: $2,852.50
Excess Reserves: $857.37
Loans: $1,852.50
Another Loan
Assets | Liabilities
Required Reserves: $142.63 Deposits: $2,852.50
Excess Reserves: $0
Loans: $2,709.87
Which becomes another deposit.
Assets | Liabilities
Reserves: $1000 Deposits: $3,709.87
Loans: $2,709.87
Notice how every time the money gets redeposited into the bank, the total reserves go back up to $1000, which was the initial deposit. You should also notice that the Deposits, Required Reserves, and Loans are all increasing throughout this process. You should notice that this increase is occurring at a decreasing rate, so eventually, we will get to a point where it is not possible make any new loans.
Assets | Liabilities
Required Reserves: $1000 Deposits: $20,000
Excess Reserves: $0
Loans: $19,000
The maximum total increase in loans will be equal to the size of the initial loan * 1/RRR where RRR is the required reserve ratio ($950 * 1/0.05 = $19,000). The maximum total increase in the money supply depends on the source of the initial deposit that allowed the initial loan. If the initial deposit was already in the money supply (say you found a shoebox full of cash), the maximum total money supply increase will be equal to the amount of new loans created. If the initial deposit was outside the money supply (say a wizard conjured it), the maximum total money supply increase will be equal to the initial deposit plus the amount of new loans created.
You need to be able to relate the values for an initial deposit, reserve ratio, maximum increase in loans, and maximum increase in the money supply. Given some of these values, you need to be able to calculate (without a calculator) one or more missing values.
2.4: Money Demand. You need to understand that there is an opportunity cost to holding money. Every dollar that you keep in your pocket or your checking account is a dollar that you are not earning interest on. Because holding money is not free, people will not want to hold an infinite amount of money. The higher the nominal interest rate is, the less likely people will be to hold on to their money (since the opportunity cost is higher). The inverse relationship between nominal interest rate and quantity of money demanded results in a demand curve for money that is downward sloping,
2.5 Money Market. You need to understand that the money supply is controlled by a country's central bank and is vertical. You need to be able to understand the relationship between money demand, money supply, nominal interest rates and quantity of money. Given a scenario, you need to be able to determine and correctly diagram a change in any one or more of these values.
2.6: Real Interest Rates and the Loanable Funds Market. You need to understand that when we borrow or lend money, we are not interested in the nominal rate of interest, but the real rate, which can be estimated by subtracting the rate of inflation from the nominal interest rate. If real interest rates are high, we want to loan money (by saving it), while we want to borrow money when real interest rates are low. In other words, the supply of savings is directly proportional to the real interest rate, while investment demand (the demand for borrowed money) is inversely proportional to the real interest rate. We can diagram this relationship in the loanable funds market.
You need to understand the relationship between investment demand, savings supply, real interest rates, and quantity of loanable funds. Given a scenario, you need to be able to determine and correctly diagram a change in any one or more of these values.
2.7: The Quantity Theory of Money. You need to understand the equation of exchange, MV = PY, which is an accounting identity and is true by definition. You need to understand the assumption of the quantity theory of money. You need to understand that when we make those assumptions, any increase in the money supply leads directly to an increase in the price level. You need to be able to use the equation of exchange to calculate M, V, P, or Y given the other three values. You need to be able to use the simple quantity theory of money to determine what will happen to inflation given a change in the money supply. You also need to be able to use the simple quantity theory of money to determine what policy the Federal Reserve should follow if they want a particular level of inflation.
Thursday, January 24, 2013
How can we use a PPF to quantify opportunity costs?
Every action we take has an opportunity cost. It can sometimes be hard to see that because so many of our costs are hidden. What's the cost of talking a walk on a sunshiney day? It's free isn't it? No. Certainly you could have done something else with your time. Take a nap. Do your laundry. Study econ. Whatever. Just because you didn't pay any money doesn't mean that you didn't pay an opportunity cost.
The problem with these hidden opportunity costs is that, well, they're hidden. They are extremely difficult to measure and to compare. You might be able to tell me that you would rather talk a walk than study your econ, but how much more exactly do you prefer it?
One way to look at opportunity costs is to use a Production Possibilities Frontier (PPF). A PPF is useful precisely because it allows us to measure the size of implicit opportunity costs. The PPF shows the trade offs we face between 2 competing alternatives. The additional wrinkle is that the PPF shows us that we don't have to choose only one thing or the other. We can have some of one thing and some of another. The trade off tells us, for each value, exactly how much of one good we have to give up in order to get one more of the other.
**Warning, math concepts ahead. Put on your math brain**
**Warning, math concepts ahead. Put on your math brain**
Here's a simple PPF
This shows the trade off between making guns and making butter. If we make 100 units of butter, we can't make any guns. If we make 50 units of guns, we can't make any butter. Notice that the graph is linear, and therefore has a constant slope. The slope of the curve (we always call it a curve even if it's straight) is the trade off we make. For every quantity of guns or butter, we always trade 2 units of butter for 1 unit of guns.
We usually use a slightly more realistic model of PPF. This graph (click on it to see a larger version) shows the trade off between making DVD players and MP3 players. Notice that the graph is not linear and that therefore the slope is not constant. Because the slope of the line represents the trade off between making the two goods, the trade off depends on how many DVD or MP3 players are being produced. For example, moving from point A to point B means we give up 30 DVD players (80-50) and gain 20 (100-80) MP3 players. 30 DVD players represents the opportunity cost of 20 MP3 players. The average opportunity cost for 1 MP3 player is 30/20 = 1.5 DVD players.
Moving from point B to point C, however, we trade 30 DVD players (50-20) for just 10 MP3 players (110-100). On this region of the PPF, 30 DVD players represents the opportunity cost of 10 MP3 players. That means the average opportunity cost for a single MP3 player is 30/10 = 3 DVD players. A PPF curve like this one shows increasing costs. The more MP3 players we want to make, the more each one costs.
The graph above also shows us another nifty use for PPFs. The curve represents the most productive combinations of goods. At any point on the line, it is not possible to produce more of one good without producing less of the other. Inside the line, at point D for example, it is possible to produce both more DVD players and more MP3 players. Because we are obviously not using our resources optimally at point D, we refer to that point as inefficient. Point E, on the other hand, is outside the PPF. It is not possible to produce that combination of DVD and MP3 players.
One note about PPF's and reality. Obviously we have more choices than just the two presented in these PPFs. We could construct a more complex PPF in 3 dimensions to show the trade off between 3 options. Or an abstract n-dimensional PPF to show the trade offs between n different options. But that's way more complicated than we need to get. The simple 2 dimensional model is sufficient to illustrate the idea that the trade offs between two competing alternatives can be quantified by a PPF.
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