Supply Side of Economics

Supply side Economics/ Reaganomics:

• to stimulate active policy, to stimulate, to work save and invest
• Includes tax cuts, which increases disposable income

Laffer curve: it displays the theoretical relationship between tax rates and government revenue

Criticisms of the Laffer Curve:

1. Empirical evidence suggests that the impact of tax rates on incentives to work, save, and invest are small. 
2. Tax cuts also increase demand which can fuel inflation 
3. Where the economy is actually located on the curve is difficult to determine 9w

Phillips Curve

In the short run: the Phillips curve represents a trade-off between inflation and unemployment.

• As inflation increases, unemployment decreases 

Each point on the Phillips Curve corresponds to a different level of output.

Long run Phillips curve: 

• it occurs on the natural rate of unemployment, 
• it is represented by a vertical line. 
• There is no tradeoff between inflation and unemployment 
• the economy produces at a full ouput level 
• The LRPC (Long run phillips curve) will only shift if the LRAS curve shifts. 
• Increases in unemployment, it will shift LRPC ->
• Decreases in unemployment, it will shift LRPC <-

Video FRQ (Monetary Policy) Scenario #5

Loanable Funds Market

Is an interest rate of 50% good or bad?

• Bad for borrowers but good for lenders 

The loanable funds market is the private sector supply and demand of loans. 

This market brings together those who want to lend money (savers) and those who want to borrow (firms with investment spending projects)

• This market shows the effect on REAL INTEREST RATE 
• Demand- Inverse relationship between real interest rate and quantity loans demanded 
• Supply- Direct relationship between real interest rate and quantity loans supplied 

This is NOT the same as MONEY MARKET (supply is not vertical)

Prime Rate: it is the interest rate that banks charge their most creditworthy  customers

Click the link below for more information on loanable funds:
Loanable Funds

Monetary Policy (OMO)

3 tools of monetary policy:
1. Reserve Requirement: If you have a bank account, where is your money?
The FED sets the amount that banks must hold
The reserve requirement (reserve ratio) is the percent of deposits that banks must hold in reserve (the percent they can NOT loan out)

• bank deposits- when someone (public or private) deposits money in the bank
• banks keep some of the money in reserve and loans out their excess reserves 
• The loan eventually becomes deposits for another bank that will loan out their excess reserves 

If there is a recession:

• Decrease the Reserve Ratio
• Banks hold less money and have more excess reserves 
• Banks create more money by loaning out excess 
• Money supply increases, interest rates fall AD goes up 

If there is an inflation: 

• Increase the Reserve Ratio
• Banks hold more money and have less excess reserves 
• Banks create less money 
• Money supply decreases, interest rates up, AD down 

2. Open Market Operations (OMO): when the FED buys or sells government bonds/securities

• This is the most important and widely used monetary policy
• If the fed BUYS bonds- takes out bonds from economy and replace with money MS (up)
• IF the fed SELLS bonds - takes the money and gives the security to the investor. MS (down)

IT matters who buys/ sells the bonds and what they do with the cash!

3.  Discount Rate: MANY different interest rates, but they tend to all rise and fall together

• It is the interest rate that the FED charges commercial banks for short-term loans.

Federal Funds Rate: the interest rate that bank charges another for overnight loans 

Money Creation Formula

• A Single bank can create $ by the amount of its excess reserves. 
• The banking system as a whole can create $ by a multiple of the excess reserves. 
• MM ( Money Multiplier)  X ER = Expansion of money
• Money Multiplier (MM) = 1/RR 

New vs Existing $

• If the initial deposit in a bank comes from the FED or bank purchase of a bond or other money out of circulation, the deposit immediately increases the money supply. 
• The deposit then leads to further expansion of the money supply through the money creation process 
• Total change in MS if initial deposit is new $ = Deposit (DD) + $  created by banking system (Money Multiplier X ER) *must add the initial deposit as well

• If a deposit in a bank is existing $ (already counted in M1; ex: Currency or checks), depositing the amount does NOT change the MS immediately because it is already counted. 
• Existing currency deposited into a checking account changes only the composition of the money supply from coins/paper $ to checking account deposits
• Total change in the MS if deposit is existing $ = banking system created money only. 

Click the link below to watch a video on money multiplier:

Money and Money Multiplier Effect

Extra Notes

Demand deposit: created through the fractional reserve system
Fractional reserve system: it is the process in which banks hold a small portion of their deposits in reserves and they loan out the excess.
Required Reserves: the cash that banks keep on hand
Total Reserves/ Actual Reserves= Required Reserves + Excess Reserves