Running head: KEY CONCEPTS IN MACROECONOMICS Key Concepts in Macroeconomics Robert Hicks Post University 1 Running head: KEY CONCEPTS IN MACROECONOMICS 2 Key Concepts in Macroeconomics Money; is an officially-issued legal tender which consist of coin and currency. Money is normally synonymous with cash, including negotiable instruments such as checks. It is the medium of exchange that facilitates trade. Medium of exchange: Money is used in the buying and selling of goods and services. In absence of money, goods would be exchanged via barter trade i.e. goods being traded for other goods in transactions. Barter trade is arranged on the basis of mutual need. Such arrangements are almost impossible. Money eliminates the need of double coincidence of wants. Unit of account; Money is as a yardstick to measure value of products in economic transactions. Money helps in attaching prices on goods and services. it is easy to assign value to goods using prices. Store of value; If you work today and earn 50 dollars, you can hold on to the money before you spend it because its value will hold until the next day, week or month. Holding money is a more effective way of storing value than holding perishable items which might rot. Money is not an effective storage of value though; inflation erodes the value of money. Liquidity; is the ease at which an asset can be converted to cash without incurring extra cost. Liquid assets are easily converted into cash for example government treasury bills and short term loans. Illiquid assets are not easily converted to cash and include long term bonds. Commodity money; is a type of money that derives its value from a commodity it is made of. It consists of objects which have value in them as well as the value in their use as money. For example options. Running head: KEY CONCEPTS IN MACROECONOMICS 3 Fiat money; refers to money that a government has declared to be legal tender. It is money issued by the state and it's neither fixed in value in terms of any objective standard nor convertible to any other thing by law. It's used as money because of government decree but it has no intrinsic value. Currency: A form of money that is generally accepted issued by a government and circulated in an economy. It consists of coins and notes. It's the basis of trade. Mainly used as a medium of exchange for goods and services. Examples of currencies include the dollar and the euro. Demand deposit; refers to an account with a financial institution that allows depositors to withdraw their funds from the account without warning or any time they feel the need. These deposits are a key component of the M1 money supply. An example of a demand deposit is a checking account. Federal Reserve; the fed is the central bank of the United States. It is the most powerful financial institution in the world. It was founded by the U.S. Congress in early 1990s to provide the country with a stable, flexible, safe financial and monetary system. The fed is considered as the mother of central banks. [ CITATION Ham12 \\l 1033 ] Central bank; is a supreme bank that regulates other banks of a nation and is charged with the mandate of ensuring economic stability of a nation. It formulates monetary policy to regulate the money supply in the economy. Uses tools such as reserve ratio and discount rates to stabilize the economy Running head: KEY CONCEPTS IN MACROECONOMICS 4 Money supply; is the process by which money circulates in an economy. Money supply in an economy is mainly controlled by the central bank. When the money supply is high the central bank formulates contractionary monetary policy to bring it down and expansionary policies when the supply is low. Monetary policy; refers to the guidelines set by the central bank to control money supply in an economy. The central bank uses three types of tools in monetary policy; they include open market operations, discount loans and reserve requirements. Open market operations are preferred because they are more liquid. [ CITATION Ham12 \\l 1033 ] Reserves; are currencies set aside by the central bank or any other commercial banks to cushion the bank against liquidity risk. These funds are not lend out to customers in case of banks but instead preserved to meet future needs. The central requires banks to keep a proportion of their capital with the central bank. Fractional Reserve Banking; is a banking system where only a proportion of bank deposits are backed by actual cash on hand and are available for withdrawal. This system aims at expanding the economy by freeing up capital which can be loaned to other parties. [ CITATION Ham12 \\l 1033 ] Reserve Ratio'; is the percentage of depositors' balances that banks should have at hand as cash. It is a requirement set by central bank of country. The higher the reserve ratio the lower the money supply consequently the lower the reserve ratio the higher the money supply. Running head: KEY CONCEPTS IN MACROECONOMICS 5 Money multiplier ; is a ratio of commercial bank money to central bank money under a system of fractional-reserve banking which measures the maximum amount of commercial bank money that a given unit of central bank money can be create. The multiplier effect size depends on the proportion of deposits which banks are to hold as reserves. Bank capital; It represents the net worth of the bank. It's the difference between the value of a assets of a bank and the value of its liabilities. The assets a bank includes; government securities, cash and loans like letters of credit, inter-bank loans and mortgages. The liabilities include customer deposits. Leverage; is the use of debt to finance operations of a bank. Used when the bank or a firm has insufficient capital to finance its operations as a result of low equity capital. Represents the amount of funds borrowed from other financial institutions at a cost. Leverage magnifies gains. [ CITATION Adr10 \\l 1033 ] Leverage ratio; is the ratio of debt to equity financing in a financial institutions. Measures the percentage of total capital raised through debt. Low leverage ratio is recommended since it implies that the financial institution is self sustained. Capital requirement; is the minimum amount of capital required of commercial banks by the central bank. The aim is to regulate the capacity of central banks. These requirements are often adjusted to suit the prevailing economic conditions Open market operations; activities performed by a central bank that involves buying or selling government securities especially bonds on the open market. Used as a primary monetary policy. The government buys bonds when money supply is low and sells when there is high money supply. Running head: KEY CONCEPTS IN MACROECONOMICS 6 Discount rate; is the interest rate that the central bank charges commercial banks and other financial institutions on the loans it issues to them disc. High discount rate discourages borrowing of commercial banks and reduces money supply in the economy. Reserve requirement; is also called cash reserve ratio. It is a central bank regulation, that sets the minimum percentage of customer notes and deposits that each commercial bank must hold as reserves instead of lending out. Increasing reserve requirement reduces money supply while reducing the reserve requirement increases money supply in the economy. Federal funds rate; refers to the rate of interest at which depository financial institutions actively trade federal funds (balances held at the Federal Reserve) with each other, on an uncollateralized basis usually overnight. Quantity Theory of Money; is an economic theory which advocates for a positive relationship between the long-term price of goods and changes the supply of money. The theory states that an increase in money supply in the economy will eventually lead to a proportionate increase in the prices of goods and services. Nominal variable; It is sometimes referred to as a categorical variable. This is a variable that has two or more categories with no intrinsic ordering to the categories. You can't rank the categories. An example is gender which has two categories; female and male but there is no intrinsic ranking of the categories. Real variable; refers to a function which takes as input a real number, normally represented by the variable x, to produce another real number, the value of the function, normally denoted f(x). Running head: KEY CONCEPTS IN MACROECONOMICS 7 Classical dichotomy; refers to an idea of analyzing separately both the nominal and real variables. It is attributed to pre-Keynesian and classical economics. An economy exhibits the classical dichotomy if real variables can be analyzed without considering their nominal counterparts, the interest rate and the money value of output. It means that real variables can be obtained without the knowledge of the level of the nominal money supply . Neutrality of money; is an economic theory which states that the changes in aggregate money supply affect nominal variables only; thus an increase in the supply of money will increase all wages and prices proportionately, but would not affect real economic output , unemployment levels or real prices. This theory is based on the idea that varying the money supply won't change the aggregate supply and demand of goods. Velocity of money; is the rate at which money changes hands, circulates or turns over in an economy in a particular period of time. High velocity of money means the same amount of money is used to facilitate a large number of transactions. It's given by the ratio of GNP to a stock of money. Quantity equation; is an equation that is used to describe the relationship between the stock of money and aggregate expenditure: Given by MV = PY. Where p represents the price level and Y represents real GDP. Change in money stock equals change in nominal transactions. [ CITATION Fri05 \\l 1033 ] Running head: KEY CONCEPTS IN MACROECONOMICS 8 Inflation tax; is the loss of value suffered by holders of cash and fixed income as well as on fixed-rate bonds as a results of the inflation effects; or tax on capital gains resulting from inflation. Fisher Effect; is a theory proposed by an economist by the name Irving Fisher which describes the relationship between inflation and interest rates (real and nominal). It states that real interest rate is equal to nominal interest rate less expected inflation rate. [ CITATION Fri05 \\l 1033 ] Shoe leather cost; Is the cost of effort and time ( i.e. the energy and opportunity cost of time )that people spend in an attempt to counter-act the negative impacts of inflation, such as making additional trips to the bank and holding less cash. Menu cost; is the cost a firm incurs as a result of changing the prices of its goods. The name originates from the cost of printing new menus by restaurants, although economists use it to mean the costs of changing nominal prices in general