Chapter 21 Saving and Capital FormationECON 3 - Principle.docx

Chapter 21: Saving and Capital Formation
ECON 3 - Principles of Macroeconomics
University of California San Diego
Christopher Gibson
Monday, April 20th
Saving
Let’s first get some definitions out of the way.
• saving - current income minus spending on current needs
• saving rate - saving divided by income
• assets - anything of value that one owns
• liabilities - the debts one owes
• wealth (or net worth) - the value of assets minus liabilities
• balance sheet - a list of an economic unit’s assets and
liabilities on a specific date
For example:
Year-end balance sheet
Assets Liabilities
Cash $ 100 Car loan $ 10,000

Checking account 500 Credit card balance 450
Savings account 2,000 Insurance bill 150
Stock 900
Car 15,000
Total $18,500 $10,600
Net worth $7,900
Capital gains and losses
• capital gains - increases in the value of existing assets
• capital losses - decreases in the value of existing assets
1
For example, what if in the balance sheet above, the stock price
increased in value to $1,000
and car decreased to $14,950? Then change in wealth is
∆(wealth) = savings + capital gains − capital losses
Assuming no additional savings, we have a capital gain of $100
and a capital loss of $50, so the
change in wealth is an increase of $50 to $7,950.
Stocks versus flows
• flow - a measure that is defined per unit of time
• stock - a measure that is defined at a point in time
Think about stocks and flows as water filling a bathtub. The
stock is the total amount of water

in the tub at any given time, while the flow is the net inflow
(inflows minus outflows) during
any period of time.
If, for example, 2 gallons of water flow in and 1 gallon of water
flows out every minute, then
the net inflow would be 1 gallon of water per minute. If we start
with an empty tub, this rate
of flow tells us that in 10 minutes, the stock in the tub will be
10 gallons.
Why do people save?
Some of the reasons that people save include the following.
• life-cycle saving - saving to meet long-term objectives such as
retirement, college at-
tendance, or the purchase of a home
• precautionary saving - saving for protection against
unexpected setbacks such as the
loss of a job or a medical emergency
• bequest saving - saving done for the purpose of leaving an
inheritance
2
Savings: An example
The two families the Thrifts and the Spends are alike in all but
one way. The Thrifts save 20%
of their income per year while the Spends only save 5%. Both
families make income of $40,000

per year as well as any interest income from saving, with an 8%
rate of return.
For example, since the Thrifts save 20% of income, in the first
year their income is $40,000
and their savings is $8,000. In the second year, income is
$40,000 plus 8% of their total savings
of $8,000, giving total income
40, 000 + 0.08 · 8, 000 = 40, 640
The Thrifts will save 20% of this income ($8,128) and consume
the rest ($32,512). Total saving
will be $8,000 plus the $8,128 from the current year, giving
$16,128. In 1987, income will
be $40, 000 + 0.08 · $16, 128 = $41, 290.24. They will save
20% of this income, adding to their
existing savings of $16,128. This process continues. The table
below shows the paths of income,
savings, and consumption for several years.
Thrifts Spends
Year Income Savings (total) Consumption Income Savings
(total) Consumption
1985 $40,000 $8,000 $32,000 $40,000 $2,000 $38,000
1986 40,640 16,128 32,512 40,160 4,008 38,152
1987 41,290.24 24,386.05 33,032.19 40,320.64 6,024.03
38,304.61
...
...
...
...
...

...
...
2000 50,753.45 144,568.88 40,602.76 42,468.38 32,978.16
40,344.96
...
...
...
...
...
...
...
2010 59,484.35 255,451.19 47,587.48 44,198.02 54,685.15
41,988.12
While the Thrifts initially do not consume as much as the
Spends, by 2000 their consumption
catches up, as their interest income on savings more than
compensates for their lower rate of
consumption, 80%.
Moreover, in 2000, total savings by the Thrifts reaches
$144,568.88, while the Spends have
only saved $32,978.16. Then by 2000, the Spends had saved less
than the Thrifts had by
1987! This difference in savings only increases as the years go
on, attributable to the power of
compound interest.
The figure below shows the consumption path of both the
Thrifts and the Spends. What the
figure does not show is the wild disparity in their total savings

that the Thrifts have available
for retirement over the Spends!
3
Why don’t people save?
We have seen why people do save (and, arguably, why they
should save), but why do people
not always save as much as they should?
• self-control - people prefer consumption today to consumption
tomorrow
�
called present bias or discounting future consumption
• demonstration effects - effects on the behavior of individuals
caused by observation of
the actions of others and their consequences
�
E.g., you want to keep up with neighbors so you get a summer
house in the Hamptons
�
Then, when you summer in the Hamptons, all of your neighbors
talk about their
chateaus in France! (should you then buy a French chateau?)
• capital gains grow wealth in other ways

4
As the above figure shows, there seems to be a tendency for
household savings to decrease as
capital gains (on housing and stock market assets) increase.
Households may be more concerned
with achieving wealth establishment goals instead of particular
savings goals.
National saving
Recall that saving is current income minus spending on current
needs. On a national level,
it is tricky to determine what should be included in spending on
current needs and what is
not. Investment should not be in spending on current needs
(mostly), since most of investment
involves the accumulation of long-term capital. It is more
difficult to determine the role of
consumption and government expenditure, since these
categories can include spending on long-
lived durable goods, or short-lived nondurable goods. For
simplicity, we will make the following
assumptions.
1. All Consumption and Government expenditures are on
current needs.
2. All Investment spending is on future needs.
3. The economy is closed, so that there is no international trade:
M = X = NX = 0.
If we consider a closed economy, net exports are zero and

Y = C + I + G
We will define national saving as income minus spending: S =
Y − C − G. Let T = Taxes −
transfers− interest, net taxes. Savings becomes
S = (Y −T −C) + (T −G)
If we define Sprivate = Y −T −C and Spublic = T −G, then
savings can be rewritten as
S = Sprivate + Spublic
So national saving is the sum of private saving plus public
saving.
Government saving
Public saving, Spublic = T − G, is the government’s savings,
which can be positive or negative.
Notice the following.
Spublic > 0 =⇒ T > G =⇒ budget surplus
Spublic < 0 =⇒ T < G =⇒ budget deficit
Here is data from the federal as well as state and local
governments in 2015 and 2016.
Government savings in 2015 and 2016
Federal government State and local governments
Year Receipts Expenditures Surplus Receipts Expenditures
Surplus
2015 2,063.2 1,906.6 156.6 1,303.1 1,293.2 9.9
2016 3,452.1 4,149.4 -697.3 2,416.3 2,583.7 -167.4

5
As the table makes clear, the federal and state/local
governments ran a budget surplus in 2015,
but ran a deficit in 2016.
As the figure above shows, business saving has increased over
the time horizon between 1960
and 2017, while household saving has decreased. Government
saving is typically negative, so
the government is typically a borrower.
Investment and capital formation
Like all economic decisions, capital projects will be undertaken
if the benefits exceed the costs.
Investment and capital formation: An example
Carol is considering starting a junk disposal business and
anticipates she can earn $49,000 per
year. She must rent hauling truck for $8,500 per year, and she
can earn 10% on investment
funds. Alternatively, she can earn $40,000 per year if she keeps
her current job. Will she start
the business?
1. If she starts her own business, Carol will make revenues of
$49,000 and incur costs of
$8,500, yielding profit $49, 000 − $8, 500 = $40, 500
2. If she keeps her current job, Carol will make her salary of
$40,000, but she can also

invest her $8,500 she would have paid to rent the hauling truck
at a rate of 10%. At the
beginning of the year, this will be an outflow of the $8,500
investment, and at the end of
they year she will be returned her investment with 10% interest,
yielding total profit
40, 000 + 8, 500 · (1 + 0.01) − 8, 500 = 40, 850
So Carol would make $40,850 by keeping her current job.
Since Carol will earn more by keeping her current job ($40,850)
than starting her business
($40,500), Carol will keep her current job.
Suppose instead that investment funds yield 5%. Would Carol’s
decision change?
6
1. If she starts her own business, Carol will still make $40,500
since this did not depend on
the interest rate.
2. If Carol keeps her current job, she will make only 5% on her
investment of $8,500, yielding
total profit
40, 000 + 8, 500 · (1 + 0.005) − 8, 500 = 40, 425
So Carol would make $40,425 by keeping her current job.
Now, since Carol will earn more by starting her business
($40,500) than by keeping her current
job ($40,425), Carol will keep start her own business.

Factors that affect investment include
As the previous example illustrates, there are many factors that
influence the decision of whether
or not to invest funds.
1. A decline in the price of new capital goods
• Imagine if Carol paid less to rent the junk hauling truck.
2. A decline in the real interest rate
• We saw this change Carol’s decision of whether to invest.
3. Technological improvement that raises the marginal product
of capital
• This could increase Carol’s productivity and lead to revenue
greater than the pro-
jected $49,000.
4. A higher relative price for the firm’s output
• Like higher productivity, a higher relative price would lead to
revenue greater than
the projected $49,000.
5. Lower taxes on the revenues generated by capital
• While not addressed in our example above, any additional
expense discourages in-
vestment spending.
The supply and demand of loanable funds

• Who supplies loanable funds?
– Households are typically the suppliers of loanable funds, as
they put money into
savings, retirement accounts, and the stock market.
• Who demands loanable funds?
– Firms typically demand loanable funds, borrowing in order to
finance long-term
capital projects.
– Governments can be net borrowers or net lenders, but since
the government typically
runs a budget deficit it is more likely a net borrower, so it
demands funds.
7
What is the price of loanable funds?
The price of loanable funds is the real interest rate. This is the
reward to supplying loanable
funds (lending) and the cost of demanding loanable funds
(borrowing).
Notice that the market for loanable funds reaches equilibrium
just like any other market of
supply and demand.
• If the real interest rate is too high, the supply of savings
exceeds demand so savers are
willing to take lower rates.

• If the real interest is too low, there is not enough lending
(saving) in the market so firms
will bid real interest rate up.
Changes in any of the above factors that affect the demand for
loanable funds (except changes
in the real interest rate) result in shifts in the demand for
loanable funds. After a shift in
loanable funds, the market is forced out of equilibrium. The
market regains equilibrium at a
higher/lower real interest rate through the forces described
above.
8
Chapter 19: Economic Growth, Productivity, and Living
Standards
Christopher Gibson
Wednesday, April 15th - Monday, April 20th
Intro to growth and living standards
Growth and increases in productivity and living standards have
been quite impressive. Take
the following examples.
1. Information Transmission from Coast to Coast U.S.

• 1848: 4 - 6 months to deliver message via boat across the
country
• 1861: Coast-to-coast telegraph; nearly instantaneous between
stations
• 1915: First coast-to-coast telephone service
• Today: Cell phones are portable, relatively inexpensive, and
instantaneous
2. History of Travel Across the U.S.
• 18th-19th century: Covered wagon takes more than 7 months
to cross the U.S.
• 1869: Transcontinental railroad, takes 84 hours to cross the
U.S. on express train
• Start of 20th century: Automobiles allow point-to-point travel
• Mid-20th century: Jet airplanes allow cross-country travel in
5-6 hours
1
The figure above shows the remarkable increase in GDP per
capita in the United States. What
factors explain this incredible growth?
Compound interest
The difference between simple and compound interest is that
• with simple interest, you earn interest only on your principal
• with compound interest, you earn interest on your principal
and your interest
For example, suppose you invest $100 at a rate of 4%. After 1

year, you have $100 · (1 + 0.04) =
104. After 2 years, with simple interest you have 104 + 0.04 ·
100 = 108. With compound
interest you have 104 · (1 + 0.04)2 = 104 + 0.04 · 104 = 108.16.
As the years go on, this difference
widens.
Years 1 2 3 10 50 n
Simple 104 108 112 140 300 100 + 100 · 0.4 · n
Compound 104 108.16 112.49 148.02 710.67 100(1.04)n
Moreover, the differences between growth rates becomes
increasingly apparent as the time
horizon increases.
50 years 100 years
Interest Simple Compound Simple Compound
2% $200 $269.19 $300 $724.46
4% 300 710.67 500 5,050.49
6% 400 1,842.02 700 33,930.21
Growth of a country
As we saw above, small differences in growth rates matter!
Consider two countries whose only
difference in growth is one percent per year.
12 years 24 years 36 years 72 years
Country A (2%) 1.27 1.61 2.04 4.16
Country B (3%) 1.43 2.03 2.90 8.40
After 72 years, a one percent difference in growth rates leads
country B to be twice as advanced
as country A!
The figures below show different rates of growth for a few

countries over varying time periods.
2
Rule of 72
A shortcut to estimate the number of years it takes a country to
grow at a growth rate g% is
years to double =
72
g
As above, it takes 72
2
= 36 years to grow at a rate of 2%, and 24 years at a rate of 3%.
This
means that
(1.02)36 ≈ 2 (actually 2.04 as above)
(1.03)24 ≈ 2 (actually 2.03 as above)
So for small interest rates, this shortcut is pretty accurate! As
you can show, the approximation
becomes more precise as the rate increases to g = 7%, and then
begins to become increasingly
less accurate.
3

Real GDP per capita
Real GDP per person is Y
POP
, which can be broken down into
Y
POP
=
Y
N
·
N
POP
where Y is total real GDP, N is the number of employed
workers, and POP is the total
population. Then GDP per person is
GDP per person = (Average labor productivity) · (share of
population employed)
The benefit of writing RGDP per capita in this way is that it
allows us to isolate two factors
relevant to its growth. As the first figure below shows, RGDP
per worker and RGDP per person
move together. In addition, as the second figure below shows,
the share of the population with
jobs increases until the early 1980s as more women enter the
workforce, but then tends to level

out. If this is true, then we can focus on average labor
productivity as the driving factor of
RGDP per capita growth.
4
Determinants of average labor productivity
Since it seems that average labor productivity drives economic
growth, it is useful to consider
what determines average labor productivity.
1. Human capital - talents, education, skills, and training of
workers
2. Physical capital - factories, machines, and equipment
• Diminishing returns to capital limits extent to which capital
can spur growth
Pizza Pizzas Marginal
ovens per hour return
0 1 1
1 10 9
2 15 5
3 15 0
3. Land and other natural resources - land, raw materials,
energy
• E.g. land for farming (like natural capital!)
4. Technological advancement is probably the most important
determinant of growth

• This is not just new capital, but improvements on existing
capital
• Cars, computers, mobile phones
5. Entrepreneurship and management
• Entrepreneurs are people who create new economic enterprises
• Managers arrange inputs to maximize efficiency
6. Political and legal environment
• For example, laws that ensure property rights encourage
development of property
• Sharing of idea allows specialization and spread of knowledge
Costs of economic growth
The costs of economic growth are
• Deferred consumption today to create capital for the future
• Deferred consumption today to research and innovate
technological progress
• Forgone leisure in possibly dangerous jobs
We also mentioned some other potential costs in class,
including
• Pollution as a result of carbon-based energy
• Issues with rising inequality
5

Promoting growth
In order to promote growth of real GDP per person, we can
target any of our determinants
described above.
1. Human capital - most countries provide free public education
(at least through high
school)
2. Physical capital - Saving and investment incentives
• Favorable tax treatment for investment in physical capital
• Low interest rates to encourage investment
• Subsidies
3. Technological progress - promoting research (public funding
like National Science Foun-
dation)
4. Entrepreneurship and management - small business loans to
promote new businesses
5. Legal and political framework - Implement policies to
promote innovation
• Well-defined property rights
• Patents
This is only a partial list of examples. Feel free to fill this in
with some of your own ideas!
6

Chapter 22: Money, Prices, and the Federal Reserve
Christopher Gibson
Wednesday, April 29th - Monday, May 4th
What is money?
Without money, how would people obtain goods and services?
• barter - the direct trade of goods or services for other goods or
services
�
Animal pelts used to be a common item used for barter
Barter depends on a double coincidence of wants, a phenomenon
where two parties each hold
an item the other wants, so they exchange these items directly
without any monetary medium.
Instead, we might prefer something that is universally agreed
upon to be valuable, avoiding
the double coincidence of wants.
• money - any asset that can be used in making purchases
�

Animal pelts served as early forms of money, but their
effectiveness depended on a
shared belief in their value.
Money and its properties
We would like money to be widely agreed to be valuable. What
are the other key roles does
money serves?
1. medium of exchange - an asset used in purchasing goods and
services
�
Basically it has to satisfy the definition of money
2. unit of account - a basic measure of economic value
�
Enables the value of different goods to be compared, even if
rates of exchange between
two goods cannot be directly observed
3. store of value - an asset that serves as a means of holding
wealth
�
Imagine if you were paid every two weeks with a box full of
food; your “payment”
would spoil before you could consume it all!
1

Measuring money
We will focus on two measures of money called M1 and M2.
1. M1 - the sum of currency outstanding and balances held in
checking accounts
2. M2 - all assets in M1 plus some additional assets that are
usable in making payments
but at a greater cost or inconvenience
Notice that the difference between assets only in M2 and those
in M1 is liquidity.
• Liquidity is the ability to quickly convert an asset into
spendable currency without losing
its value
�
the less value that is lost, the more liquid is the asset
Money and commercial banks
Before banks, people would store all of their money at home
(under their mattresses, for exam-
ple). Then people wanted to put their money into banks for at
least two reasons.
1. It is risky to carry large amounts of cash, for fear of losing it
2. Banks may incentivize households to lend them their cash in
exchange for paying interest

3. Making payments is easier when money is held in a bank.
Banks like taking customer’s cash
• Banks can lend out borrowed cash at a higher rate than they
pay to borrow it!
But how much do they decide to lend out? Banks face
competing incentives:
(i) The more cash banks lend out, the more they can make in
terms of interest on these loans.
(ii) If banks lend out too much cash, they may not have enough
to satisfy the demands of their
clients, who may either withdraw cash or transfer it directly in
order to make a payment
(e.g. by writing a check)
Let us formalize the bank’s decision with a few definitions.
• bank reserves - cash or similar assets held by commercial
banks for the purpose of
meeting depositor withdrawals and payments
• 100 percent reserve banking - a situation in which banks’
reserves equal 100 percent
of their deposits
�
This is one extreme of reserve banking
2

Again, it is in the bank’s interest to hold fewer than 100 percent
of deposits in reserve since
they would like to earn interest by issuing loans. In fact, a 100
percent reserve banking system
could not be sustainable, because banks have expenses (interest
payments on deposits, storage
for customers’ cash), and without income banks would go out of
business!
Then as banks lend out their reserves and deposits remain,
deposits exceed reserves! It is
useful to introduce terminology to measure this.
• reserve-deposit ratio - bank reserves divided by deposits
• fractional-reserve banking system - a banking system in which
bank reserves are less
than deposits so that the reserve-deposit ratio is less than 100
percent
�
As the definition implies, if reserves equal deposits, the reserve
ratio is 100 percent
and we have 100 percent reserve banking, as above.
• excess reserves - reserves that exceed the amount of reserves a
bank would like to hold
to satisfy their reserve-deposit ratio.
�
If the bank would like to satisfy Reserves
Deposits

= rr, then excess reserves are given by
Excess reserves = Reserves − rr · Deposits
Let’s look at how this results in money creation.
The creation of money
How is money created? The obvious answer is that the
government prints it! But there is a
more subtle means of money creation that we will explore here.
Money is created through:
1. The government issuing (e.g. printing) new currency; and
2. The process of deposit creation through a fractional-reserve
banking system
Let’s look at an example.
An example of money creation: No currency held
Suppose the central bank in the new economy of Wynneweld
issues 1000 notes of its new
currency, the baskin. Not wanting to hold currency, the public
brings this new currency to the
only bank in town, Bank Exotic. In order to protect against
running out of reserves to satisfy
their clients’ demand for their deposits, the bank keeps 10% of
deposits on reserve. These
assumptions are summarized as follows.
• The government of Wynneweld distributes 1000 baskins to the
public.

• The public does not want to hold any currency as cash, and
will always deposit it into
the bank
3
• Bank Exotic is the only bank in town and it keeps 10% of its
deposits as reserves.
If this were a 100 percent reserve banking system, the bank
would keep all of these deposits
and the total amount of money created in the economy would
remain 1000 baskins. We know,
however, that the bank will loan out 90% of its deposits.
In Step 1, the public deposits the 1000b currency into the bank,
increasing reserves and deposits.
Step 1
Assets Liabilities
Reserves 1000b Deposits 1000b
→
Step 2
Assets Liabilities
Loans 900b
In Step 2, the bank loans out its 900b excess reserves, leaving it
with reserve ratio Reserves
Deposits

=
100b
1000b
= 0.1, as desired.
In Step 3, the public deposits the 900b loan since they do not
wish to hold any cash, increasing
reserves back to 1000b and deposits to 1900b.
Step 3
Assets Liabilities
Loans 900b
→
Step 4
Assets Liabilities
Loans 2710b
In Step 4, given that banks have 1900b in deposits and would
like to hold only 10% of this
in reserves, Bank Exotic finds that it has 1000b − 190b = 810b
in excess reserves. The bank
will then loan out an additional 810b, increasing loans to 2710b
and decreasing reserves to 190b.
In Step 5 and beyond, any loans issued will come back as
deposits. Since reserves in Bank
Exotic will always be 1000b after the public deposits their cash,
this process will continue until
deposits satisfy

Reserves
Deposits
= 0.1 =⇒ Deposits =
Reserves
0.1
=
1, 000b
0.1
= 10, 000b
The final balance sheet after this process will look as follows.
Assets Liabilities
Reserves 1,000b Deposits 10,000b
Loans 9,000b
So the central bank printing 1000b resulted in the creation of
10,000b in deposits. This increases
the money supply M1 by 10,000b
�
The currency as reserves does not count in M1 because it is not
currency in circulation.
4
The money multiplier

This increase in deposits as a result of an influx of currency can
also be found using the money
multiplier. The money multiplier is the inverse of the reserve
ratio. In particular, for a
reserve ratio rr, the money multiplier is
MM =
1
rr
In our example, with rr = 0.1, MM = 1
0.1
= 10, so a 1000b increase in currency led to a
10 · 1000b = 10, 000b increase in deposits.
An example of money creation: Half of currency held
Consider the previous example, but suppose instead that the
public will deposit only half of
new currency issues. These new assumptions are summarized as
follows.
• The government of Wynneweld distributes 1000 baskins to the
public.
• The public deposit half on initial currency issues into the bank
• Bank Exotic is the only bank in town and it keeps 10% of its
deposits as reserves.
Then if 500b is held in currency and 500b is deposited, using
the money multiplier, total deposits
increase by 10 · 500b = 5000b, so deposits increase to 5000b.

The total money change in the
money supply is the increase in currency in circulation (500b)
and total deposits (5000b). The
increase in the money supply is thus 5,500b.
Clearly then, monetary policy (how the government changes the
money supply) is affected
by at least two factors:
1. What percentage of deposits banks hold in reserves
�
This will be referred to as the effective reserve ratio
2. How much money the public wishes to hold as currency
�
This will be referred to as the demand for money
The federal reserve system
The Federal Reserve System (or the Fed) is the central bank of
the United States
�
Other central banks include the Bank of Canada (BoC), the
Bank of Mexico (BdeM), the
People’s Bank of China (PBoC), the European Central Bank
(ECB)
The Fed’s key responsibilities include:
• Monetary policy - the determination of the nation’s money

supply
• Supervision and regulation of financial markets
• Intervention in times of financial crisis (it’s more likely than
you think).
5
�
e.g. the Fed can loan directly to banks
�
the Fed can change the reserve requirement, a much more
extreme tool than mone-
tary policy (in fact as of March 15th, 2020, the Fed decreased
all reserve requirements
to zero!
https://www.federalreserve.gov/monetarypolicy/reservereq.htm)
The history of the Fed
Federal Reserve Act passed in 1913 and the Federal Reserve
System started operations in 1914
in response to particularly severe banking panic in 1907.
In forming the Federal Reserve System, two competing forces
needed to be balanced.
1. A central bank should be able to affect the money supply of
the entire country, and should
thus be centralized.

2. The culture of the United States is U.S. culture is averse to
centralized power, having been
founded as a country by fighting against the subjugation of the
centralized government
of Great Britain
The compromise to address these competing forces led to the
following structure of the Federal
Reserve System.
1. There are 12 regional Federal Reserve banks, each associated
with a geographical area
called a Federal Reserve district.
�
Each bank is able to give input into the Fed’s decision making
with knowledge of their
district’s needs that is more accessible at the local level.
�
San Diego is in district 12, whose main branch is in San
Francisco.
• Board of governors - the leadership of the Fed, consisting of
seven governors appointed
by the president to staggered 14-year terms
�
Terms are staggered so there is an appointment every two years
(only one full term
may be served by each governor).

6
https://www.federalreserve.gov/monetarypolicy/reservereq.htm
�
There are currently two vacant seats on the board.
• Federal Open Market Committee (FOMC) - the committee that
makes decisions
concerning monetary policy
– The FOMC consists of the seven Fed governors, the president
of the Federal Reserve
Bank of New York, and 4 rotating members of other regional
Federal Reserve banks.
�
The FRBNY president is always on the FOMC because
monetary policy goes
through the trading desk in the New York Fed.
�
If there are un-appointed governors, those vacant seats on the
board stay vacant
on the FOMC.
• open-market operations - the buying and selling of government
bonds to affect the
money supply
• open-market purchase - the purchase of government bonds
from the public by the Fed

for the purpose of increasing the supply of bank reserves and
the money supply
�
The Fed executes open-market purchases in order to increase
the money supply
• open-market sale - the sale by the Fed of government bonds to
the public for the
purpose of reducing bank reserves and the money supply
�
The Fed executes open-market sales in order to decrease the
money supply
Contractionary monetary policy: An example
Consider the example above, where the central bank’s addition
of 1000 baskins in currency led
to 10,000 baskins worth of deposits being created.
Assets Liabilities
Loans 9,000b
What if, for whatever reason, the central bank decides that there
should only be 9,000b worth
of deposits in the economy? Given the money multiplier is 10,
the government would need to
remove 100b from the bank’s reserves. This would entail the
open market sale of 100b worth
of bonds, leading to a decrease of 10 · 100b = 1000b in
deposits, and a final balance sheet as
follows.

Assets Liabilities
Reserves 900b Deposits 9,000b
Loans 8,100b
Expansionary monetary policy: An example
What if instead the central bank instead decides to increase the
money supply to 15,000b?
Then it would execute an open market purchase of 500b worth
of bonds, leading to an increase
of 10 · 500b = 5000b in deposits, and a final balance sheet as
follows.
Assets Liabilities
Loans 13,500b
7
How to stop a banking panic
• banking panic - a situation in which news or rumors of the
imminent bankruptcy of one
or more banks leads to bank depositors to rush to withdraw their
funds
�
If you think your bank is going to run out of money, it is
rational to want to withdraw
your deposits while the bank still has reserves to honor them!
In order to prevent this sort of “run” on banks, it is essential

that customers believe that their
deposits will remain accessible, even if the bank goes bankrupt!
This is why in addition to
the Federal Reserve System being created in 1913, the Federal
Deposit Insurance Corporation
(FDIC) was created in 1933 to stop banking panics.
• deposit insurance - a system under which the government
guarantees that depositors
will not lose any money, even if their bank goes bankrupt
– The Federal Deposit Insurance Corporation (FDIC) is the
deposit insurance for the
United States, created during the Great Depression by the 1933
Banking Act.
�
Up to $100,000 worth of deposits were insured until 2008, when
this limit was
increased to $250,000 of deposits
The velocity of money
The velocity of money is a measure of how often money
changes hands on average. It is defined
as follows
velocity =
value of transactions
money stock
In order to value transactions, we will take the nominal GDP,
which is real GDP Y , scaled by
the current price level P . Then velocity of money can be

written as M ·V = P ·Y .
While this equation in itself is not so informative (V can take
whatever value ensures that it
holds), if we assume that velocity and real GDP are constant (at
least in the short-term, then
we have the following relationship.
M ·V = P ·Y
This implies that increases in the money supply lead to
inflation. As the following graph shows,
there is empirical support for this result.
8
Midterm 1 (Practice)
Solution
s
ECON 3 − Principles of Macroeconomics
Christopher Gibson

Monday, April 27th
Multiple choice
1 2 3 4 5 6 7 8 9 10
B A E F E B D B B D
For the following questions, choose the best answer. Choose
only one. Multiple choice questions
are worth 3 points each.
1. If real GDP increases, we know for certain that
(a) the price of some goods in the economy decreased.
(b) the production of some goods in the economy increased.
(c) the price of some goods in the economy increased.
(d) the production of some goods in the economy decreased.
2. If CPI decreases, we know for certain that
(a) the price of some goods in the economy decreased.

(b) the production of some goods in the economy increased.
(c) the price of some goods in the economy increased.
(d) the production of some goods in the economy decreased.
3. Unemployment may suffer from underestimation as a result
of
(a) retired workers.
(b) unreliable workers.
(c) voluntary part-time workers.
(d) disabled workers
1
(e) discouraged workers.
(f) temporary workers.

4. The labor force participation rate is
(a) the fraction of the population that is of working-age.
(b) the fraction of the working-age population that is actively
seeking employment.
(c) the fraction of the population that is employed.
(d) the fraction of the population that is employed or actively
seeking employment.
(e) the fraction of the working-age population that is not a
student, retired, or disabled.
(f) the fraction of the working-age population that is employed
or actively seeking em-
ployment.
5. The Fisher effect predicts that
(a) nominal interest rates and real interest rates move together.
(b) real interest rates and GDP move together.

(c) real interest rates and inflation move together.
(d) GDP and inflation move together.
(e) nominal interest rates and inflation move together.
(f) nominal interest rates and GDP move together.
6. Which of the following contributes to GDP?
(a) You buy a bond from the Federal Reserve.
(b) You buy stock in Facebook from a broker who charges
commission.
(c) Your sister-in-law sells you a house that she has lived in for
3 years before it is on
the market to the public.
(d) You pay your hairdresser to watch your dog, knowing full
well that she will not
report the income on her taxes.
7. If nominal interest is 8% and inflation is 2%, the exact real

interest rate (not the approx-
imate rate) would be
(a) 8%
(b) 6%
(c) Between 6% and 8%
(d) Less than 6%
8. One reason the CPI might not measure the true price level is
(a) the income effect.
(b) the substitution effect.
(c) the output effect.
2
(d) the conglomeration effect.

9. If CPI rises more than GDP deflator, there is
(a) unemployment in the economy.
(b) inflation in the economy.
(c) deflation in the economy.
(d) a looming recession.
10. Workers who would like a job but have not looked recently
enough to be counted as
unemployed are referred to as
(a) abandoned workers.
(b) berated workers.
(c) condemned workers.
(d) discouraged workers.
(e) excluded workers.
(f) frustrated workers.

3
Short answer
1. (25 points total)
(a) (5 points) Name three “costs of inflation” and provide an
example for each
i. Price as a signal of scarcity
• For example: Have prices of rice increased because rice is
becoming harder
to grow or is it just inflation?
ii. Distortions caused by taxes
• For example: Not all taxes are indexed to inflation, such as the
deduction
from capital depreciation.
iii. Increases in the cost of cash

• For example: The cost of having to reprint menus to reflect
higher prices
iv. Unexpected redistribution of wealth
• For example: Inflation decreases the real interest rate, hurting
lenders but
benefiting borrowers.
v. Interference with long-term planning
• For example: Inability to predict prices will limit your ability
to know how
much to save.
(b) (15 points total) Suppose an economy produces the
following three goods
Year
Groceries Clothing Industrial equipment
Quantity Price Quantity Price Quantity Price
2029 15 $1.00 20 $3.00 3 $10.50
2030 16 $1.50 25 $2.00 3 $9.50

2031 17 $2.00 19 $2.50 2 $9.00
i. (5 points) Which of the three does not belong in consumer
price index and why?
Industrial equipment since it is not a consumer good.
ii. (10 points) Calculate CPI with the two most appropriate
consumer goods, using
2029 as the base year.
CPI2029 = 100
CPI2030 = 83.33
CPI2031 = 106
4
(c) (5 points) From 2030 to 2031 is the real interest rate higher
or lower than the nominal
interest rate?

Since there is inflation between 2030 and 2031 the real interest
rate is lower than the
nominal rate, given that
r ≈ i − π
Note that it does not matter if you use the exact formula or the
approximation. The
direction will be the same, as (1 + π) > 0.
2. (25 points total)
(a) (5 points) Name three sources of growth and provide an
example for each
i. Increase of physical capital
• For example: More machines per worker.
ii. Increase of human capital
• For example: Training in Microsoft Office.
iii. Land and other natural resources
• For example: Finding new places to drill for oil.
iv. Technological advances

• For example: Inventing a new way to extract previously
unattainable shale
oil (fracking)
v. Entrepreneurship and management
• For example: Allocating employees to the tasks where they
would be most
productive. Incentivizing small business ownership through
low-interest
loans.
vi. Legal systems
• For example: A system that protects property rights.
(b) (10 points) If after three years, RUC has only grown at an
annual rate of 1% per
year while RES has enjoyed a steady annual growth of 5% per
year, one dollar would
have grown as shown in the table below.
Time passed RUC RES
3 years 1.03 1.16

By investing in RES, after three years your savings would be
higher by(
1.16 − 1.03
1.03
)
· 100% ≈ 12.36%
(c) (10 points) If over the next three years RUC grew by 10%
per year while RES
maintained a 5% growth rate, one dollar would have grown as
shown in the table
below.
Time passed RUC RES
3 years 1.03 1.16
6 years 1.37 1.34
5
Thus you would not have preferred to invest in RES, as your

total return over 6
years with RUC would be 37% whereas your return with RES
would be 34%.
3. (20 points total) Suppose that in 2023, you have entered the
labor force and, as a successful
UCSD student, you secure a job with a starting salary of
$100,000 per year. With your
new salary, you rent an amazing apartment for $2,000 per
month.
(a) (10 points total) In one year you are given a 5% raise. You
are confused, however,
because after paying your new rent of $2,200, you find that you
are able to afford
fewer goods and services than you were the year before.
i. (4 points) Given this information alone, what explains your
reduced purchasing
power?
With this information alone, it seems that prices have increased
by 10%, since
the change in rent is (

2200 − 2000
2000
)
· 100% = 10%
Thus, a 5% increase in nominal income results in a decrease in
real income and
hence purchasing power.
ii. (6 points) If all prices in the economy move identically, what
is the percentage
change in your real income?
If inflation is 10% and nominal income increases by 5%, the
approximation tells
us that real income is approximately 5% − 10% = −5%. Thus, a
5% increase in
nominal income results in a decrease in real income and hence
purchasing power.
Using the exact formula, purchasing power changes from 100,
000/P to 105, 000/(1.1)P ,
so that the change in real income is(

105000
(1.1)P
− 100000
P
100000
P
)
· 100% = −
(
0.05
1.1
)
· 100% ≈ −4.55%
(b) (10 points) Suppose instead that inflation is 6% per year.
What must be your income
in 2024 in order to assure a 5% increase in real income?
In order to guarantee a 5% increase in real income, a income of

$100,000 must be
increased not only by 5%, but by an additional 6% to
compensate for inflation, giving
income
$100, 000 · (1.05) · (1.06) = $111, 300
Income in 2024 must then be $111,300.
6
Problem Set 1

Chapter 21 Saving and Capital FormationECON 3 - Principle.docx

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