Economics Exam Notes

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Economics Exam Notes

Question 1. (Chapter 31, pg759)
* Impact of interest rate on spending
* Analysis of events which change interest rate in the market * Policies to manage inflation/recession

Impact of interest rate on the economy (ripple effect)

To lower interest rate| | To increase interest rate|
|  | | |  |
Central bank buy securities in open market operations and increases money supply| | Central bank sell securities in open market operations and increases money supply| |  | | |  |
Short term interest rate and exchange rate falls| | Short term interest rate and exchange rate rises| |  | | | |
Qty of money and supply of loanable funds increase| | Qty of money and supply of loanable funds decrease| |  | | |  |
Long term interest rate fall| | Long term interest rate rises| |  | | |  |
Consumption, expenditure, investment, and net export increase| | Consumption, expenditure, investment, and net exports decrease| |  | | |  |
Aggregate demand increases| | Aggregate demand decreases| |  | | |  |
Real GDP growth, employment rate and Inflation rate increases| | Real GDP growth, employment rate and Inflation rate decreases| |  | | |  |
In additional, stock and bond prices rises| | In additional, stock and bond prices falls|

Analysis of events that change interest rate in the market

Money demanded (MD) changes on 3 scenerios:
* state of economy
* average price level in the economy
* people expectation

Money supply (MS) changes only when government implements monetary policies.

Few examples of events that changes interest rate
Events| MS| MD| interest rate| graph|
Central bank buy securities/bonds| increase| no change| fall| 1| Central bank sell securites/bonds| decrease| no change| rises| 2| Recession/bad economy| no change| fall| fall| 3|

high inflation (high expectation)| no change| rise| rise| 4| higher average price level| no change| rise| rise| 5|

Draw graphs

Monetary policies to manage inflation and recession

Recessionary economy
Problem: expect lesser future income (lower disposable income) = low consumption = fall in MD = lower interest rate Solution: Expansionary monetary policies (decrease required reserve ratio/attractive discount rate/buy securities) = increase MS = fall in interest rate = encourage spending = boost economy

Draw money and AD-AS graph

Inflationary economy
Problem: high price level and expect higher future price level = higher consumption now = rise in MD = high interest rate. Solution: Contractionary monetary policy (increase required reserve ratio/unattractive discount rate/sell securities) = decrease MS = rise in interest rate = discourage spending = reduce inflation

Draw money and AD-AS graph

Question 2. (Chapter 25 & 31 Page 599 and 753)
* Money Creation
* Monetary policies (domestic and international effects)

Money Creation Process

The Money Multiplier
Money Creation (loan available) = Initial Excess Reserve x multiplier (1/required reserve ration)

Example: Calculate an increase of deposit of $10,000 with rrr. of 10%

Solution: Money created = ($10,000 – 10%) x (1/10%)
=$9,000 x 10
=$90,000

Money Creation are affected by 3 factors:
* The Monetary base i.e. the base amount that will directly affect the amount of money available for desired reserves for banks and desired currency holding for household and firms. * Desired reserves i.e. the amount that the bank plan to hold basing on their daily business requirement and financial outlook (different from rrr) * Desired currency holdings i.e. the cash amount household and firms desired to hold as liquidity (i.e. it will not be used to generate further money creation). Also known as currency drain ratio/CDR (i.e. the ration of currency to deposit).

Monetary policies (domestic and international effects)...
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