Unit 4

I. Uses of Money
A. Medium of exchange - to barter (trade)
B. Unit of account - establish worth
C. Store of money- money holding value over a period of time
II. Types of Money
A. Fiat money - Money because the government says so (It is the reason why a $1 bill is valued at a dollar)
B. Commodity money - Gold and silver coins; it is goods (no physical money)
C. Representative Moneys - I.O.U. These are backed by something tangible
III. Characteristics of Money
A. Durability - If u wash a dollar, it is still good
B. Portability - Carry money multiple of ways
C. Divisibility - Multiple ways to make a change for $20
D. Uniformity - Doesn't change from state to state
E. Scarcity - Can't find $2 bills everyday, can you?
F. Acceptability - Accepted everywhere.
IV. Money Supply
A. M1 money (25% of the time) - Consists of currency in circulation ($1, $5, $10...coins)

• Checkable Deposits (demand deposits)
• Traveler's Checks

B. M2 Money (75% of the time) - Consists of M1 money + savings account (which may need a start up) + money market accounts (which may need $100,000 to start up) + deposits held by banks outside the U.S.

Fractional Reserve System

• A process by banks of holding a small portion of their deposits in reserve and loaning out the excess

1. Banks keep cash on hand (required reserves) to meet depositor's needs
2. Banks must jeep reserve deposits in their vaults or at the Federal Reserve Bank
3. Total Reserves are total funds held by a bank TR (total reserves) = RR (required reserves) + ER (excess reserves)
4. Banks can legally lend out to the extent of their excess reserves
5. Reserve Ratio = RR/TR

Significance of a Fractional Reserve System
1. Banks can create money by lending more than their reserves
2. Required Reserves don't prevent bank panics because banks must keep their required reserves (FDIC)
3. Reserve requirements gives the fed control over how much money banks can create

Functions of the FED (Federal Reserve Bank)
1. Control the nation's money supply through monetary policy
2. Issue paper currency
3. Same as a clearinghouse for checks
4. Regulates banking activities
5. Serves as a bank for banks (issue out loans)

Balance Sheet

• A statement of assets and claims summarixing the financial position of a firm or a bank at some point in time
• It must balance (Assets = Liabilities)

Assets vs. Liabilities
Assets
-What you own

• Reserves
• Required Reserves (rr) - %required by Fed to keep on hand to meet demand
• Excess Reserves (er) - %reserves over an above the amount needed to satisfy the minimum reserve ratio set by Fed

• Loans to firms, consumers, and other banks (earns interest)
• Loan to government = treasury securities
• Bank Property (If bank fails, you'd liquidate the building/ property

Liabilities
-What you owe
-Networth is a claim of the owners against the firms assets (like a house or car)

• Demand Deposits ($ put into bank)
• Timed Deposits (CD's)
• Loans from: Federal Reserve & other banks
• Shareholder's Equity - to set up a bank, you must invest your own money in it to have a stake in the banks success or failure

Reserve Requirement

• The amount, set by the Fed, is the Required Ratio
• Typically the Required Reserve Ratio = 10%
• 100% Reserve Banking has no impact on size of money supply
• Ratio is the % of demand deposits (checking account balances) that must not be loaned out

Example: The reserve ratio is 5%. You deposit $1000 into a bank. How much is the bank required to add to its reserves?
.05 x $1000 = $50

How much money can the bank now loan out?
1000(deposit) - 50(reserve ration) = $950 that can be loaned out to the next borrower.

Fraction - Reserve Banking

• Suppose banks hold 20% of deposits in reserve, making loans with the rest.
• First bank will make $800 in loans
• The money supply now equals $1800: The depositor still has $1000 in demand deposits, but now the borrower holds $800 in currency
• Thus in a fractional - reserve banking system, banks create money

Required Reserve Ratio

• The % demand deposits that must be stored as vault cash or kept on reserve as Federal Funds in the bank's account with the Federal Reserve.
• The required Reserve Ration determines the money multiplier (1/reserve ratio)
• Decreasing the reserve ration increases the rate of money creation in the banking system and is expansionary
• Increasing the reserve ratio decreases the rate of money creation in the banking system and is contractionary
• Changing the required reserve ratio is the least used tool of monetary policy and is ususally held constant at 10%

The Money Multiplier

• The money multiplier shows us the impact of a change in demand deposits on loans and eventually the money supply
• The money multiplier indicates the total number of dollars created in the banking system by each $1 addition to the monetary base (bank reserves and currency in circulation)
• To calculate the money multiplier, divide by the required reserve ration
• Money Multiplier = 1/reserve ratio
• Ex. If the reserve ratio is 25%, then the multiplier = 4

Four Types of Multiple Deposit Expansion Question

• Type 1: Calculate the initial change in excess reserves a.k.a. the amount a single bank can loan from the initial deposit
• Type 2: Calculate the change in loans in the banking system
• Type 3: Calculate the change in the money supply
• Sometimes type 2 and type 3 will have the same result (i.e. no fed involvement)
• Type 4: Calculate the change in demand deposits

Example

Given a required reserve ratio of 20%, assure the Fed Reserve purchases $100 million worth of US Treasury Securities on the open market from a primary security dealer.

• Type 1: Determine the amount that a single bank can lend from this Fed Reserve purchase of bonds
• (the amount of new demand deposits) - (required reserve) = The initial change in excess reserves
• $100 million - (20% x 100 million) = $80 million in ER
• Type 2: Determine the maximum change in loans in the banking system from this Federal Reserve purchase of bonds
• (initial change in excess reserves) x (the money multiplier) = max change in loans
• $80 million x (1/20%)
• $80 million x 5 = $400 million max in new loans

*Use money multiplier because changing whole money supply

*Changing how much Fed whole system can loan out

• Type 3: Determine the maximum change in the money supply from this Fed Reserve purchase in bonds
• (the max change in loans) + ($ amount of Federal Reserve action)
• $400 million +$100 million = $500 million max change in the money supply
• Type 4: Determine the maximum change in demand deposits from this Federal Reserve purchase of bonds
• (the max change in loans) + ($ amount of initial deposit)
• $400 million + $100 million = $500 million max change in demand deposits

Managing the Money Supply
The Fed has several tools to manage the money supply by manipulating the excess reserves held by banks, a practice known as monetary policy.

Monetary Policy Option:

• Open Market Operation (OMO)
• Expansionary--Buy Bonds from the public
• Contractionary--Sell Bonds to the public
• Required Reserves
• Expansionary--Decrease the Reserve Ration
• Contractionary--Increase the Reserve Ratio
• Discount Rate
• Expansionary--Decrease the Discount Rate
• Contractionary--Increase the Discount Rate
• Federal Funds Rate
• Expansionary--Decrease Federal Fund Rate
• Contractionary--Increase Federal Fund Rate

Fiscal Policy vs. Monetary Policy

Fiscal Policy

• Involves Congress
• Only two options are tax or spend

Monetary Policy

• Involves Fed
• OMO (Open Market Operations) buy or sell bonds (securities)
• Required Reserves
• Discount Rate--Interest Rate changed by the Fed for overnight loans to commercial banks. Does not change the money supply directly
• Federal Funds Rate - it is the interest rate charged by one commercial bank for overnight loans to another commercial bank. FOMC sets a federal fund rate, then uses Open Market Operations to guide the effective rate to the targetrate.
• Commercial to commercial borrowing is better

Loanable Funds Market

• The market where savers and borrowers exchange funds (Qlf) at the real rate of interest (r%)
• *note: nominal (current), real (prediction)

• The demand for loanable funds, or borrowing comes from households, firms, government and the foreign sector. The demand for loanable funds is in fact the supply of bonds
• The supply of loanable funds, or savings comes from households, firms, government and the foreign sector. the supply of loanable funds is also the demand for bonds.

Changes in the Demand for Loanable Funds

• Remember that demand for loanable funds borrowing (i.e. supplying bonds)
• More borrowing = more demand for loanable funds (-->)
• Less borrowing = less demand for loanable funds (<--)
• Examples
• Government deficit spending = more borrowing = more demand for loanable funds
• Dlf --> so r% increases
• Less investment demand = less borrowing = less demand for loanable funds
• Dlf <-- so r% decreases

Changes in the Supply of Loanable Funds

• Remember that supply of loanable funds = saving (i.e. demand for bonds)
• More saving = more supply of loanable funds -->
• Less saving = less supply of loanable funds <--
• Examples
• Government budget surplus = more saving = more supply of loanable funds
• Slf --> so r% decreases

• Decrease in consumer's MPS = less saving = less supply of loanable funds
• Slf <-- r% increases

Review

• Required Reserves = (Amount of Deposit) x (Required Reserve Ratio)
• Excess Reserves = (Total Reserves) - (Required Reserves)
• Maximum amount a single bank can loan = the change in excess reserves caused by a deposit
• The money multiplier = 1/required reserve ration
• Total Change in Loans = (amount single bank can lend) x (money multiplier)
• Total Change in the money supply = (total change in loans) + ($ amount of Fed action)
• Total change in demand deposits = (total change in loans) + (any cash deposited)

Unit 3

Aggregate Demand (AD)

·         Price level in Real GDP

·         Shows the amount in Real GDP that the private, public and foreign sector collectively desire to purchase at each possible price level

·         Relationship between price level and the level of Real GDP is inverse

 

3 Reasons why AD is Downward Sloping

- Real-Balances Effect

·         When the price-level is high, households and businesses cannot afford to purchase as much output

·         When the price-level is low, households and businesses can afford to purchase more output

- Interest Rate Effect

·         A higher price-level increases the interest rate which tends to discourage investment

·         A lower price-level decreases the interest rate which tends to encourage investment

- Foreign Purchases Effect

·         A higher price-level increases the demand for relatively cheaper imports

·         A lower price-level increases the foreign demand for relatively cheaper U.S. exports

Shifts in Aggregate Demand (AD)

·         There are 2 parts to a shift in AD

o    A change in C , Ig , G , and/or Xn

o    A multiplier effect that produces a greater change than the original change in the 4 components

·         Increases in AD = AD goes Right

·         Decreases in AD = AD goes Left

 

 

 

 

 

Aggregate Supply (AS)

·         Level of Real GDP that firms will produce at each price-level (PL)

Long Run Vs. Short Run

- Long Run

·         Period of time where input prices are completely flexible and adjust to changes in the price-level

·         In the long-run, the level of Real GDP supplied is independent of the price-level

- Short Run

·         Period of time where input prices are sticky and do not adjust to changes in the price-level

·         In the short run, the level of real GDP supplied is directly related to the price level

 

 

Long Run Aggregate Supply (LRAS)

·         LRAS marks the level of full employment in the economy (analogous to PPC)

·         ALWAYS VERTICLE

 

 

- What Causes LRAS to Shift

·         Increase in capital

·         Technology

·         Economic growth

·         Entrepreneurship

·         Resources available

Short Run Aggregate Supply (SRAS)

·         SRAS is upward sloping

 

 

- Changes in SRAS

·         Increase in SRAS is seen as a shift to the right. SRAS -->

·         Decrease in SRAS is seen as a shift to the left. SRAS <--

·         The key to understanding shifts in SRAS is per unit cost of production

·         Per-Unit Production Cost = total input cost / total output

- Determinants of SRAS

·         (All of the following affect unit production cost)

·         Input Prices

o    Increase in resource prices = SRAS <--

o    Decrease in resource prices = SRAS -->

·         Productivity

o    = total output / total inputs

o    more productivity = lower unit production cost = SRAS -->

o    lower productivity = higher unit production cost = SRAS <--

·         Legal - institutional environment

 

 

 

 

What is Investment?

·         Money spent or expenditures on:

o    New plants (factories)

o    Capital equipment (machinery)

o    Technology (hardware & software)

o    New homes

o    Inventories (goods sold by producers)

Expected Rates of Return

- How does business make investment decisions?

·         Cost/benefit analysis

- How does business determine the benefits?

·         Expected rate of return

- How does business count the cost?

·         Interest costs

- How does business determine the amount of investment they undertake

·         Compare expected rate of return to interest cost

o    If expected return > interest cost, then invest

o    If expected return < interest cost, then do not invest

Real (r%) vs. Nominal (i%)

- What's the difference?

·         Nominal is the observance rate of interest. Real subtracts out inflation (pi%) and is only known ex post facto.

- How do you compute the real interest rate? (r%)

·         r% = i% - pi%

- What determines cost of an investment decision?

·         The real interest rate (r%)

Investment Demand Curve (ID)

- What is the shape of the investment demand curve?

·         Downward sloping

- Why?

·         When interest rates are high, fewer investments are profitable, when interest rates are low, more investments are profitable

·         Conversely, there are few investments that yield high rates of return, and many that yield low rates of return

Shifts in Investment Demand (ID)

·         Cost of production

·         Business taxes

·         Technological demand

·         Stock of capital

·         Expectations

Consumption and Savings

Disposable Income

·         Income after taxes or net income

2 Choices:

·         With disposable income, households can either

o    Consume (spend money on goods and services)

o    Save (not spend money on goods and services)

Consumption

·         Household spending

·         The ability to consume is constrained by

o    Amount to disposable income

o    Propensity to save

- Do households consume in (decreasing)DI = 0?

·         Autonomous consumption

·         Dissaving

Savings

·         Household not spending

·         Ability to save is constrained by

o    The amounts of disposable income

o    Propensity to consume

- Do households save if DI = 0?

·         NO

APC/APS

·         APC - average propensity to consume

·         APS - average propensity to save

- Formulas

·         APC + APS = 1

·         1 - APC = APS

·         1 - APS = APC

·         APC>1 = Dissavings

·         - APS = Dissavings

MPC/MPS

·         MPC = marginal propensity to consume

o    ΔC / ΔDI

o    Percent of every extra dollar earned that is spent

·         MPS = marginal propensity to save

o    ΔS / ΔDI

o    Percent of every extra dollar earned that is saved

- Formulas

·         MPC + MPS = 1

·         1 - MPC = MPS

·         1 - MPS = MPC

Determinants of C & S

·         wealth

·         expectations

·         household debt

·         taxes

The Spending Multiplier Effect

·         An initial change in spending (C, Ig, G, Xn) causes a larger change in aggregate spending, or aggregate demand (AD)

Multiplier = change in AD / change in spending
Multiplier = ΔAD / Δ C,I,G, or X

- Why does this happen?

·         Expenditures and income flow continuously which sets off a spending increase in the economy

Calculating the Spending Multiplier

·         The spending multiplier can be calculated from the MPC or the MPS

Multiplier = 1 / 1 - MPC [or] 1 / MPS

·         Multipliers are (+) when there is an increase in spending and (-) when there is a decrease

Calculating the Tax Multiplier

·         When the government taxes, the multiplier works in reverse

- Why?

·         Because now money is leaving the circular flow

Tax Multiplier = -MPC / 1 - MPC [or] -MPC / MPS

·         If there is a tax- CUT, then the multiplier is (+), because there is now more money in the circular flow

MPS, MPC and Multiplier Examples

1. Assume the U.S. citizens spend 90cents for every extra $1 they earn. Further assume that the real interest rate (r%) decreases, causing a $50 billion increase in gross private investment. Calculate the effect of a $50 billion increase in Ig on U.S. Aggregate Demand (AD).

1.       Calculate the MPC & MPS

o    MPC = ΔC / ΔDI = .9/1 = .9

o    MPS = 1 - MPC = .10

2.       Determine which multiplier to use, whether its (+) or (-)

o    The problem mentions an increase in ^IG .: use a (+) spending multiplier

3.       Calculate the spending and/or tax multiplier

o    1 / MPS = 1 / .10 = 10

4.       Calculate the change in AD

o    (ΔC, Ig, G, or Xn) * spending multiplier

o    ($50 billion ^Ig) * (10) = $500 billion ^AD

2. Assume Germany raise taxes on its citizens by 200 billion. Furthermore, assume that Germans save 25% of the change in their disposable income. Calculate the effect the 200 billion change in taxes on the German economy

1.       Calculate the MPC & MPS

o    MPS 25% = .25

o    MPS = 1 - MPS = 1 - .25 = .75

2.       Determine which multiplier to use, whether its (+) or (-)

o    Tax multiplier because it said change in taxes

3.       Calculate the spending and/or tax multiplier

o    -MPC / MPS = -.75 / .25 = -3

4.       Calculate the change in AD

o    (ΔTax) * tax multiplier

o    (200 billion ΔT) * (-3) = -600 billionΔAD

 

 

 

Fiscal Policy

·         Changes in the expenditures or tax revenues of the federal government

- 2 Tools of Fiscal Policy:

·         Taxes - government can increase or decrease taxes

·         Spending - government can increase or decrease spending

Deficits, Surpluses, and Debt

·         Balanced Budget

o    Revenues = Expenditures

·         Budget Deficit

o    Revenues < Expenditures

·         Budget Surplus

o    Revenues > Expenditures

·         Government Debt

o    Sum of all deficits - Sum of all surpluses

·         Government must borrow money when it runs a budget deficit

·         Government borrows from:

§  individuals

§  corporations

§  financial institutions

§  foreign entities or foreign government

Fiscal Policy Two Options

1.       Discretionary Fiscal Policy (action)

o    Expansionary fiscal policy - think deficit

o    Contractionary fiscal policy - think surplus

2.       Non - Discretionary Fiscal Policy (no action)

Discretionary VS. Automatic Fiscal Policy

- Discretionary

·         Increasing or decreasing government spending and/or taxes in order to return the economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem

- Automatic

·         Unemployment compensation and marginal tax rates are examples of automatic polices that help mitigate the effects of recession and inflation. Automatic fiscal police takes place without policy makers having to respond to current economic problems.

Contractionary VS Expansionary Fiscal Policy

- Contractionary Fiscal Policy

·         Policy designed to decrease aggregate demand

·         Strategy for controlling inflation

- Expansionary Fiscal Policy

·         Policy designed to increase aggregate demand

·         Stategy for increasing GDP, combating a recession, and reducing unemployment

Expansionary Fiscal Policy

·         Recession is countered with expansionary policy

o    Increase government spending

o    Decrease taxes

Contractionary Fiscal Policy

·         Inflation is countered with contractionary policy

o    Decrease government spending

o    Increase taxes

·         Progressive Tax Rate

o    Average tax rate (tax revenue/GDP) rises with GDP

·         Proportional Tax System

o    Average tax rate remains constant as GDP changes

·         Regressive Tax system

o    Average tax rate falls with GDP

·         The more progressive the tax system, the greater the economies built in stability