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Cheat sheet
The economy behind your investments: cheat sheet
The summary, key terms and the trap to avoid for every lesson, in order. Print it, or read it, cover it, and say it back.
- Financial markets (bonds, stocks) let savers lend directly; intermediaries (banks, funds) stand between.
- A bond's rate depends on its term, credit risk and tax treatment.
- In a closed economy, S = I; national saving = private saving + public saving.
- A budget deficit is negative public saving.
- financial system
- the institutions that help match one person's saving with another's investment
- financial markets
- institutions through which savers can lend directly to borrowers
- financial intermediaries
- institutions through which savers lend to borrowers indirectly
- bond
- a certificate of debt
- stock (share)
- a claim to partial ownership in a firm
- mutual fund
- an institution that sells shares to the public and uses the money to buy a portfolio of stocks and bonds
- national saving
- income left after consumption and government purchases
- private saving
- income households have left after taxes and consumption
- public saving
- tax revenue the government has left after its spending
- budget deficit
- government spending greater than tax revenue
Watch out: Calling a share purchase "investment" in the macroeconomic sense. When you buy a share, you save. Only if the firm is selling new shares does it get the use of your money, and only if it spends that on new capital is there investment: the purchase of new capital goods, such as a factory or machine.
- Supply of loanable funds = saving; demand = investment; the interest rate balances them.
- Saving incentives: lower interest rate, more investment.
- Investment incentives: higher interest rate, more saving.
- Deficits: less national saving, higher interest rate, less investment (crowding out).
- market for loanable funds
- the market in which those who want to save supply funds and those who want to invest borrow
- crowding out
- a fall in investment caused by government borrowing
- investment tax credit
- a tax advantage for firms that buy new capital
- budget surplus
- tax revenue greater than government spending
Watch out: Thinking a budget deficit shifts the demand for loanable funds in this model. In Mankiw's treatment, the deficit lowers national saving, so it shifts supply to the left. The fall in investment is a movement along the demand curve.
- Fractional-reserve banks create money by lending part of each deposit.
- Money multiplier = 1 ÷ reserve ratio.
- Leverage magnifies a bank's gains and losses; capital requirements guard against it.
- Tools: open-market operations, lending to banks, reserve requirements, interest on reserves; control is imperfect.
- reserves
- deposits banks have received but not lent out
- fractional-reserve banking
- a system in which banks hold only a fraction of deposits as reserves
- reserve ratio
- the fraction of deposits banks hold as reserves
- money multiplier
- the amount of money the banking system generates with each unit of reserves
- bank capital
- the resources a bank's owners have put into it
- leverage ratio
- total assets ÷ bank capital
- capital requirement
- a regulation setting a minimum amount of bank capital
- open-market operations
- the central bank's buying and selling of government bonds
- discount rate
- the interest rate on the central bank's loans to banks
- federal funds rate
- the interest rate at which US banks make overnight loans to one another
Watch out: Thinking banks only pass on money that already exists. When a bank lends out part of a deposit, the depositor still has the full balance and the borrower has new spending power: the bank has created money. It hasn't created wealth, though: the borrower also has a new debt.
- Inflation is a fall in the value of money; over the long run it comes from money growth.
- Quantity equation: M × V = P × Y.
- Monetary neutrality holds in the long run, not over a year or two.
- Inflation tax; Fisher effect: nominal rate = real rate + inflation.
- quantity theory of money
- the theory that the quantity of money determines the price level, and money growth the inflation rate
- nominal variables
- variables measured in money units
- real variables
- variables measured in physical units
- classical dichotomy
- the separation of variables into nominal and real
- monetary neutrality
- the idea that changes in the money supply don't affect real variables
- velocity of money
- the rate at which money changes hands
- quantity equation
- M × V = P × Y
- inflation tax
- the revenue a government raises by printing money
- Fisher effect
- the one-for-one adjustment of the nominal interest rate to inflation
Watch out: Blaming inflation mainly on particular prices, such as coffee or fuel. Mankiw's point is that sustained, general inflation is about the value of money, and over the long run it comes from growth in the money supply.
- Fluctuations are irregular, quantities move together, and unemployment rises as output falls.
- Aggregate demand slopes down because of the wealth, interest-rate and exchange-rate effects.
- Changes in consumption, investment, government purchases or net exports at a given price level shift it.
- A change in the price level is a movement along it.
- recession
- a period of declining real incomes and rising unemployment
- depression
- a severe recession
- aggregate-demand curve
- the quantity of goods and services that households, firms, the government and foreigners want to buy at each price level
- wealth effect
- a lower price level raises the real value of money holdings, raising consumption
- interest-rate effect
- a lower price level lowers interest rates, raising investment
- exchange-rate effect
- a lower price level lowers interest rates and the currency's value, raising net exports
Watch out: Treating a change in the price level as a shift in aggregate demand. A change in the price level moves the economy along the curve; only changes in spending at a given price level shift it.
- Liquidity preference: the interest rate balances money supply (fixed by the central bank) and money demand.
- A higher price level raises money demand and interest rates, cutting investment: the main reason aggregate demand slopes down.
- More money means lower interest rates and higher aggregate demand.
- Central banks target an interest rate, which is the same thing as steering the money supply.
- theory of liquidity preference
- Keynes's theory that the interest rate adjusts to balance the supply of and demand for money
- money demand
- how much wealth people want to hold as money; it falls as the interest rate rises
- monetary policy
- the central bank's setting of the money supply or interest rates
- federal funds rate
- the interest rate at which US banks lend to one another overnight; the Fed's target
Watch out: Thinking the central bank sets interest rates by decree. It sets a target and then changes the money supply (through open-market operations) until the market rate reaches it.
- Long-run aggregate supply is vertical at the natural rate of output.
- Short-run supply slopes up: sticky wages, sticky prices, misperceptions.
- Fall in demand: recession now, recovery as expectations adjust.
- Fall in supply: stagflation; accommodation trades lower output for higher prices.
- long-run aggregate-supply curve
- vertical at the natural rate of output
- natural rate of output
- the production of goods and services an economy achieves in the long run, when unemployment is at its natural rate
- short-run aggregate-supply curve
- upward-sloping: a higher price level raises output for a time
- sticky-wage theory
- nominal wages adjust slowly, so unexpected price rises raise output
- sticky-price theory
- some prices adjust slowly because of menu costs
- misperceptions theory
- suppliers mistake changes in the overall price level for changes in relative prices
- stagflation
- falling output with rising prices
- accommodation
- raising aggregate demand in response to a fall in supply
Watch out: Thinking a fall in aggregate demand leaves output permanently lower. In the model, expectations and wages adjust, and output returns to its natural rate. The question for policy is how long that takes, and whether policy should speed it up.
- Multiplier = 1 ÷ (1 − MPC); a bigger MPC means a bigger multiplier.
- Crowding out works the other way, through higher interest rates.
- Tax cuts raise demand, more so if seen as permanent.
- Active stabilisation: some economists favour it; others worry about lags and forecasting. Automatic stabilisers work without decisions.
- fiscal policy
- the government's setting of spending and taxes
- marginal propensity to consume
- the share of extra income that people spend
- multiplier effect
- the extra shifts in aggregate demand when fiscal policy raises income and so raises spending
- crowding-out effect
- the offset to aggregate demand when expansionary fiscal policy raises interest rates and so reduces investment
- automatic stabilisers
- changes in taxes and spending that boost demand in a recession without deliberate action
Watch out: Thinking a government spending increase always raises demand by exactly its own size, or always by the full multiplier. The multiplier pushes the effect up; crowding out pulls it down. The final effect depends on both, and on how the central bank responds.
- The Phillips curve: a short-run trade-off between inflation and unemployment.
- It reflects movements along short-run aggregate supply.
- Friedman and Phelps: in the long run it is vertical at the natural rate.
- Expected inflation shifts the short-run curve; the 1970s confirmed the natural-rate hypothesis.
- Phillips curve
- a curve showing the short-run trade-off between inflation and unemployment
- natural rate of unemployment
- the unemployment rate the economy tends towards in the long run
- expected inflation
- how much people expect the overall price level to rise
- natural-rate hypothesis
- the claim that unemployment eventually returns to its natural rate, regardless of inflation
- long-run Phillips curve
- vertical at the natural rate of unemployment
Watch out: Treating the Phillips curve as a permanent menu. The trade-off exists in the short run, while inflation differs from what people expect. In the long run, unemployment returns to its natural rate whatever the inflation rate.
- Supply shocks shift the Phillips curve, raising both inflation and unemployment.
- Disinflation (slower inflation) is not deflation (falling prices).
- Sacrifice ratio: a typical estimate is 5% of output per point of inflation.
- Rational expectations: credibility can lower the cost; the Volcker disinflation still brought a deep recession.
- supply shock
- an event that directly changes firms' costs and prices, shifting aggregate supply and the Phillips curve
- disinflation
- a fall in the rate of inflation
- deflation
- a fall in the price level
- sacrifice ratio
- percentage points of annual output lost for each 1-point fall in inflation
- rational expectations
- the theory that people optimally use all the information they have, including about policy, when forecasting
Watch out: Thinking a central bank can cut inflation painlessly whenever it chooses. The traditional view is that disinflation costs output while expectations adjust. Rational expectations suggests credibility can reduce the cost, not that it disappears.
- Stabilise? For: recessions are costly. Against: lags and poor forecasts.
- Rules? For: limits abuse and time inconsistency. Against: rules can't foresee shocks; the problems may be hypothetical.
- Zero inflation? For: permanent benefits for a temporary cost. Against: small gains, big and unevenly shared costs.
- Inflation targeting is a common middle ground.
- stabilisation policy
- using monetary and fiscal policy to reduce economic fluctuations
- discretion
- letting policymakers decide case by case
- policy rule
- a pre-set formula or commitment that policymakers must follow
- political business cycle
- fluctuations caused by policymakers boosting the economy around elections
- time inconsistency
- the gap between what policymakers announce and what they later do
- inflation targeting
- a central bank's commitment to an announced inflation goal or range
- indexation
- automatic adjustment of taxes, contracts or bonds for inflation
Watch out: Treating any one side as "the economics answer". Mankiw presents each debate with arguments on both sides because economists genuinely disagree, partly over facts (how long lags are, how costly inflation is) and partly over values (who should bear costs).
- Spending or tax cuts? Spending works directly on demand; tax cuts also improve incentives and supply.
- Balance the budget? For: debt burdens the future and crowds out investment. Against: the burden is small relative to lifetime income; look at the whole of fiscal policy.
- Tax reform for saving? For: taxes heavily reduce the reward for saving. Against: favours the rich and may not raise saving.
- Be wary of proposals that sound too good to be true.
- budget deficit
- government spending greater than tax revenue
- government debt
- the total of past borrowing not yet repaid
- consumption tax
- a tax on spending rather than income, so saved income is not taxed until spent
- substitution effect
- here, a higher return makes saving more rewarding, encouraging it
- income effect
- here, a higher return means less saving is needed to reach a goal, discouraging it
Watch out: Taking the size of the national debt alone as proof of a problem, or dismissing it entirely. Both sides in Mankiw's debate look at more than the headline number: what the borrowing paid for, how the debt compares with income, and who bears the cost.
- Nominal exchange rate: currency for currency. Real: goods for goods, (e × P) ÷ P\*.
- Appreciation: a currency buys more foreign currency; depreciation: less.
- PPP: e = P\* ÷ P; faster inflation means a depreciating currency.
- PPP fails for non-traded goods and imperfect substitutes; it is a long-run guide.
- nominal exchange rate
- the rate at which one currency can be traded for another
- real exchange rate
- the rate at which the goods of one country can be traded for the goods of another
- appreciation
- a rise in a currency's value, measured in foreign currency
- depreciation
- a fall in a currency's value, measured in foreign currency
- purchasing-power parity
- the theory that a unit of any currency should buy the same quantity of goods in all countries
- law of one price
- the principle that a good should sell for the same price everywhere
- arbitrage
- buying where a good is cheap and selling where it is dear to profit from the difference
Watch out: Confusing the nominal and real exchange rates. A dollar buying more yen (nominal appreciation) doesn't make American goods dearer if American prices have fallen relative to Japanese ones. What matters for trade is the real exchange rate.
- Net exports = exports − imports (the trade balance).
- Net capital outflow = home purchases of foreign assets − foreign purchases of home assets.
- NX = NCO, always.
- S = I + NCO: saving finances investment at home or assets abroad.
- closed economy
- an economy that does not interact with other economies
- open economy
- an economy that interacts freely with other economies
- net exports
- the value of a country's exports minus its imports; also called the trade balance
- trade surplus
- exports greater than imports
- trade deficit
- imports greater than exports
- net capital outflow
- home residents' purchases of foreign assets minus foreigners' purchases of home assets
- foreign direct investment
- buying and actively managing a business abroad
- foreign portfolio investment
- buying shares or bonds of a foreign firm
Watch out: Treating the trade balance and capital flows as separate. They are two sides of the same transactions: a country that imports more than it exports must be paying with assets or borrowing, so its net capital outflow is negative by the same amount.
- Loanable funds: supply = saving; demand = investment + NCO; price = real interest rate.
- Foreign exchange: supply of dollars = NCO (vertical); demand = NX; price = real exchange rate.
- A higher interest rate lowers NCO.
- NCO links the markets, and NX = NCO in equilibrium.
- market for loanable funds
- here, the market where national saving meets demand from domestic investment and net capital outflow
- market for foreign-currency exchange
- the market where net capital outflow (supply of dollars) meets net exports (demand for dollars)
- real interest rate
- the price of goods today relative to goods in the future
- real exchange rate
- the price of home goods relative to foreign goods
- net capital outflow
- home purchases of foreign assets minus foreign purchases of home assets
Watch out: Thinking the supply of dollars in the foreign-exchange market depends on the exchange rate. In Mankiw's model it is set by net capital outflow, which depends on the real interest rate, so the supply curve is vertical.
- Budget deficit: interest rate up, NCO down, currency up, net exports down (twin deficits).
- Import quota: currency up, net exports unchanged.
- Capital flight: interest rate up, currency down, net exports up.
- The trade balance depends on saving and investment, not on trade policy.
- trade policy
- a government policy that directly affects the quantity of goods a country imports or exports
- import quota
- a limit on the quantity of a good produced abroad that can be sold at home
- twin deficits
- the tendency of a budget deficit and a trade deficit to move together
- capital flight
- a large and sudden movement of funds out of a country
Watch out: Expecting an import quota to cut a trade deficit. In Mankiw's model, the trade balance equals net capital outflow, which depends on saving and investment. A quota pushes up the exchange rate, so other exports fall and other imports rise, leaving net exports unchanged.