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Topics from the CED:
Financial Assets
Nominal v. Real Interest Rates
Definition, Measurement, and Functions of Money
Banking and the Expansion of the Money Supply
The Money Market
Monetary Policy
The Loanable Funds Market
Financial sector: The network of institutions that link borrowers and lenders
Includes banks, mutual funds, pension funds, and other financial intermediaries
The most liquid forms of money are cash and demand deposits (money deposited into a checking account)
The opportunity cost of money is the interest that could have been earned from holding other assets such as bonds
Other financial assets that people can hold in place of the most liquid forms of money include bonds (interest-bearing assets) and stocks (equity)
Stock represents ownership of a corporation
The stockholder is often entitled to a portion of the profit paid out as dividends
Bonds (securities) are loans, or IOUs, that represent debt that the government, business, or individual must repay to the lender
The bond holder has no ownership of the company and is paid interest
The price of previously issued bonds and interest rates on bonds are inversely related
Friendly reminder: although you can invest money into stocks and bonds, the word “investment” in economics ALWAYS refers to business spending on tools and machinery
DO NOT confuse the two
• A nominal interest rate is rate of interest paid for a loan, unadjusted for inflation
• The rate you “see” and pay for a loan
• Lenders and borrowers establish nominal interest rates as the sum of their expected real interest rate and expected inflation
• A real interest rate it is the nominal interest rate adjusted for inflation
• It can be calculated by subtracting the actual information rate from the nominal interest rate
• Real interest rate= Nominal interest rate – inflation
11
• Money is anything that is generally accepted as a means of payment for goods or services
• Money is a highly liquid financial asset —it is easily changeable into another asset or good
Commodity money: something that performs the function of money and has alternative uses
• Examples: Gold, silver, cigarettes, etc.
Fiat money: Something that serves as money but has no other important uses
• Examples: Paper money and coins
13
Medium of exchange
Money can easily be used to buy goods and services without bartering
Unit of account (measure of value)
Money measures the value of all goods and services
Store of wealth
Money allows you to store purchasing power for the future
, 14
• The money supply is measured using monetary aggregates designated as M1 and M2
• M1 consists of coins and currency plus checking accounts (checkable deposits) and traveler’s checks
–It is highly liquid
• M2 consists of M1 plus savings deposits (money market accounts), time deposits (CDs = certificates of deposit), and mutual funds
–Considered near money; less liquid than M1 (have to covenrt to cash to use it)
The monetary base (MO or MB) includes currency in circulation and bank reserves
16
• Credit cards are not money
• They are a short-term loan (usually with a higher than normal interest rate)
• A debit card is part of the monetary system because it serves the same function as a check since it allows you to spend money from your bank account
The transactions motive is the need to hold money for spending
The precautionary motive is holding money for unexpected expenses and impulse buying
The speculative motive is holding cash to avoid holding financial assets whose prices are falling
Colander, Economics
• The Federal Reserve Bank (the Fed) is the U.S. central bank
• Federal Reserve notes are liabilities of the Fed that serve as cash
• A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms
Board of Governors
7 members appointed by the president and confirmed by the
senate
FINANCIAL SECTOR GOVERNMENT
Regional Reserve Banks and Branches
12 regional Federal Reserve banks and 25 branches
Oversees
Federal Open Market Committee (FOMC)
Board of Governors plus 5 Federal Reserve bank presidents
Provides ServicesOpen Market Operations
1. Conducts monetary policy (influencing the supply of money and credit in the economy)
2. Supervises and regulates financial institutions
3. Lender of last resort to financial institutions
4. Provides banking services to the U.S. government
5. Issues coin and currency
6. Provides financial services to commercial banks, savings and loan associations, savings banks, and credit unions
Monetary policy: influencing the economy through changes in the banking system’s reserves, which in turn, influences the money supply and credit availability in the economy
If commercial banks need to borrow money, they can do so from the Fed
If there’s a financial panic and a run on banks, the central bank is there to make loans
Can we go to the Fed to get a loan?
No
Expansionary monetary policy is designed to counteract the effects of recession and return the economy to full employment
It increases the money supply
It decreases interest rates and it tends to increase both investment and output
Also called the easy money policy
M i I Y
M=money supply i=interest rate I=investment Y=output
Price level
Real GDP
AD1
P1 AD2
P2
Y1 Y2
SRAS
LRAS
Contractionary monetary policy is designed to counteract the effects of inflation and return the economy to full employment
It decreases the money supply
It increases the interest rate, and it tends to decrease both investment and output
Also called the tight money policy
M i I Y
M=money supply i=interest rate I=investment Y=output
Price level
Real GDP
AD1
P1
Y1
SRAS
AD2
Y2
P2
LRAS
1. Reserve requirement
2. Discount rate
3. Open market operations
These are the 3 shifters of the money supply
These tools are used by the Fed to regulate the amount of money in circulation
The reserve requirement is the percent of deposits that banks must hold in reserve (the percent they can NOT loan out)
• Banks keep some of the money in reserve and loan out their excess reserves
• Reserves and interest rates are inversely related
By changing the reserve requirement the Fed can increase or decrease the money supply
If the Fed increases the reserve requirement it contracts the money supply—banks have to keep more reserves and lend out less money (decreases the money multiplier)
35
• If the Fed decreases the reserve requirement it expandsthe money supply—banks have more money to lend out (increases the money multiplier)
36
If there is a recession, what should the Fed do to the reserve requirement?
It should decrease the reserve ratio
This means banks hold less money and have more excess reserves
Banks create more money by loaning out excess reserves
The money supply increases, interest rates fall, and AD increases
McGraw-Hill/IrwinColander, Economics37
If there is inflation, what should the Fed do to the reserve requirement?
• Increase the reserve ratio
• This means banks hold more money and have less excess reserves
• Banks create less money
• The money supply decreases, interest rates increase, and AD decreases
McGraw-Hill/Irwin38
Discount rate: the interest rate the Fed charges for the loans it makes to commercial banks
• To increase the money supply, the Fed should decreasethe discount rate
• To decrease the money supply, the Fed should increasethe discount rate
39
The primary way in which the Fed changes the amount of reserves in the system
• Open market operations occur when the Fed buys or sells government securities (bonds)
• To expand the money supply, the Fed buys bonds
• To decrease the money supply, the Fed sells bonds
How are you going to remember this?
Buy-BIG: Buying bonds increases the money supply
Sell-SMALL: Selling bonds decreases the money supply
There is an inverse relationship between bond prices and interest rates
When the Fed buys bonds, the price of bonds rises and interest rates fall
When the Fed sells bonds, the price of bonds falls and interest rates rise
42
An open market purchase is an expansionary monetary policy that tends to reduce interest rates and increase income
When the Fed buys bonds, it deposits money in banks’ account with the Fed
Bank reserves are then increased
When banks loan out the excess reserves, the money supply increases (it also increases the monetary base)
An open market sale is a contractionary monetary policythat tends to raise interest rates and lower income
When the Fed sells bonds, it receives checks drawn against banks
The bank’s reserves are reduced and the money supply decreases (it also decreases the monetary base)
The federal funds rate is the interest rate that banks charge one another for one-day loans of reserves
• Federal funds are loans of excess reserves that banks make to one another
• (Often asked about on the AP exam)
The Fed can increase or reduce reserves by buying or selling bonds
By selling bonds, the Fed decreases reserves
This causes the fed funds rate to increase (banks have less reserves to loan out)
By buying bonds, the Fed increases reserves
This causes the fed funds rate to decrease (banks have more reserves to loan out)
46
If the federal funds rate is above the Fed’s target range, it buys bonds to increase reserves and lower the Fed funds rate
If the federal funds rate is below the Fed’s target range, it sells bonds to decrease reserves and raise the Fed funds rate
The current federal funds rate is 1.5%
It can take as long as 12-18 months for a change in this rate to affect the entire economy
47
Quantitative easing is a monetary policy used by the Fed to buy government bonds to stimulate the economy
The Fed might decide to purchase assets from commercial banks in order to increase the price of those assets, which increases the money supply and lowersinterest rates
May be used when inflation is low and open market operations are not working
48
• Demand deposits: Money deposited in a commercial bank in a checking account
• Required reserves (or reserve ratio): The percent of a deposit that banks must hold
• Excess reserves: Reserves that a bank can loan out beyond required reserves
• Bank balance sheet: A record of a bank’s assets, liabilities, and net worth
• Owner’s equity: Money put into a business or bank; not held in reserves
• Our banking system is a fractional reserve system
• Banks must hold a portion of deposits (known as the reserve requirement, which is set by the Fed) and can loan out the rest of the money
• 1/r is the simple money multiplier
• The simple money multiplier is the measure of the amount of money ultimately created per dollar deposited in the banking system, when people hold no currency
• It tells us how much money will ultimately be created by the banking system from an initial inflow of money
• The higher the reserve ratio, the smaller the money multiplier, and the less money that will be created
A customer deposits $100 into a bank. What is the immediate impact on the money supply?
No impact—the money was already in the money supply (M1) so there is no change
54
• Remember, customer demand deposits can be withdrawn at any time
• To find the total amount of deposits that will be created, multiply the original deposit by 1/r, where r is the reserve ratio
A customer deposits $100 into the bank. The reserve ratio is 10 percent (0.1). The amount of money ultimately created from this deposit is:
$100 x 1/0.1 = $1,000
New money created = $1,000 – $100 = $900
56
Why is the amount of new money created only $900 and not $1,000?
Because the $100 deposit was already in the money supply (part of M1)
57
The Fed buys bonds equal to $10 million and the required reserve ratio is 0.2. What is the maximum change in the money supply throughout the banking system?
1/r =1/0.2=5
5 *(10 million)=50 million
Buying bonds creates money so the money supply increases by $50 million
58
The Fed buys bonds equal to $10 million and the required reserve ratio is 0.2. What is the maximum change in loans throughout the banking system?
1/r =1/0.2=5
5 *(10 million)=50 million
To loan this money out, a bank has to hold 20%
50 million*(0.2)=10 million
Total available for loans: 50 million -10 million= 40 million
59
Assets Liabilities
Loans $8,000Reserves $500Treasury bonds $1,500
Demand deposits $5,000Owner’s equity $5,000
Total: $10,000 Total: $10,000
• First, both sides of the balance sheet must equal one another• Demand deposits are always on the liability side (the bank “owes” this money to its
customers) • Loans are always on the asset side (money owed to the bank)• If the reserve requirement is not listed, you can figure it out by dividing reserves by demand
deposits (500/5,000=0.1 or 10%); **Be careful as the balance sheet can include terms such as total reserves as well as excess reserves; be sure to use the right numbers**
Assets Liabilities
Loans $15,000Total reserves $ 5,000Treasury bonds $10,000
Demand deposits $20,000Owner’s equity $10,000
Total: $30,000 Total: $30,000
61
The reserve requirement is 10%. How much is the bank’s required reserves?To answer, we will look at the demand deposits.$20,000 x .1 = $2,000
Is the bank holding excess reserves? If so, how much?Yes: $3,000 (Total reserves – required reserves)
Assets Liabilities
Loans $15,000Total reserves $ 5,000Treasury bonds $10,000
Demand deposits $20,000Owner’s equity $10,000
Total: $30,000 Total: $30,000
62
How much could the bank increase the money supply if it loaned out its excess reserves?$3,000 x 1/.1 = $30,000
Assume John deposits $1,000 into the bank. What is the initial change in the money supply?None—the $1,000 was already in the money supply
Assets Liabilities
Loans $15,000Required reserves $2,000Excess reserves $3,000Treasury bonds $5,000
Demand deposits $20,000Owner’s equity $5,000
Total: $25,000 Total: $25,000
If a customer deposits $1,000 into this bank:1. What is the required reserve ratio (before the deposit is made)? 2. Will the money supply (M1) initially increase, decrease, or stay same?3. How much is the required reserves?4. How much is the excess reserves?5. What is the maximum change in money supply from the deposit?
Assets Liabilities
Loans $15,000Required reserves $2,100Excess reserves $3,900Treasury bonds $5,000
Demand deposits $21,000Owner’s equity $5,000
Total: $26,000 Total: $26,000
If a customer deposits $1,000 into this bank:1. What is the required reserve ratio (before the deposit is made)? 10% ($2,000/$20,000)2. Will the money supply (M1) initially increase, decrease, or stay same? Stay the same3. How much is the required reserves? $2,1004. How much is the excess reserves? $3,9005. What is the maximum change in money supply from the deposit? $9,000 ($1,000 x 1/0.1= $10,000 - $1,000 (amount of initial deposit); OR $900 x 1/0.1)
The market where the Fed and the users of money interact thus determining the nominal interest rate (i%)
In the money market, equilibrium is achieved when the nominal interest rate is such that the quantity demanded and quantity supplied of money are equal
66
Money Demand (MD) comes from households, firms, government, and the foreign sector
It is downward sloping
There is an inverse relationship between nominal interest rate and the quantity of money demanded (the quantity of money people want to hold)
67
The Money Supply (MS) is determined by the Federal Reserve
The money supply curve is vertical because it is determined by the Fed’s (or central bank’s) particular monetary policy
It is also vertical because it is independent from the interest rate
68
69
NOTE:•i=nominal interest rate
•I= Investment
Be careful!
QM1
MD or DM
MS
i1
Quantity of Money or QM
Nominal Interest Rate
(ir)
What happens to the quantity demanded of money when interest rates increase?
Quantity demanded falls because individuals would prefer to have interest-earning assets instead
What happens to the quantity demanded when interest rates decrease?
Quantity demanded increases
There is no incentive to convert cash into interest-earning assets
70
1. Changes in price level
An increase in the price level leads to an increase in the demand for money
A decrease in the price level leads to an decrease in the demand for money
2. Changes in national income (GDP)
When real GDP increases there will be an increase in the demand for money (when real GDP decreases there will be a decrease in the demand for money)
3. Changes in money technology
We may decide to hold less cash as we use debit cards and credit cards more often (decreasing the demand for money)
QM1
MD1
MS
i1
QM
(billions of dollars)
Nominal Interest Rate (ir)
MD2
i2
Scenario: The price level increases.
QM1
MD2
MS
i2
QM
(billions of dollars)
Nominal Interest Rate
(ir)
MD1
i1
Scenario: The price level decreases
1. Reserve requirement
2. Discount rate
3. Open market operations
74
QM1
MD1
MS1
i1
QM
(billions of dollars)
Nominal Interest Rate
(ir)
i2
MS2
QM2
Scenario: The Fed buys bonds on the open market
QM2
MD1
MS2
i2
QM
(billions of dollars)
Nominal Interest Rate
(ir)
i1
MS1
QM1
Scenario: The Fed sells bonds on the open market
How does this affect AD?
An increase in the money supply leads to a decrease in interest rates, an increase in investment and therefore an increase in AD
77
IM I ADi
How does this affect AD?
Decreasing the money supply leads to an increase in interest rates, which decreases investment and AD
78
M i I AD
The economy is in a recession. Using the AS/AD model and the money market, demonstrate an expansionary monetary policy to move the economy out of a recession.
79
The economy is in a recession. Using the AS/AD model and the money market, demonstrate an expansionary monetary policy to move the economy out of a recession.
QM1
MD1
MS1
5%
QM(billions of dollars)
Nominal Interest Rate (ir)
2%
MS2
QM2
The economy has rising inflation. Using the AS/AD model and the money market, demonstrate a contractionary monetary policy to move the economy out of an inflationary gap.
X81
The economy has rising inflation. Using the AS/AD model and the money market, demonstrate a contractionary monetary policy to move the economy out of an inflationary gap.
82
QM2
MD1
MS2
7%
QM
(billions of dollars)
Nominal Interest Rate (ir)
5%
MS1
QM1
The loanable funds describes the behavior of savers and borrowers
This market shows the effect on the real interest rate (r)
84
Demand for loanable funds: there is an inverserelationship between the real interest rate and the quantity of loans demanded
At higher interest rates, households prefer to delay their spending and put their money in savings
Simply put, the demand for loanable funds represents borrowers and investors
85
Borrowing is the demand for loanable funds
Private investment is borrowing by businesses and consumers
Government borrowing is deficit spending when government spending is greater than tax revenue
A change that effects borrowing will shift the demand of loanable funds
For example: investment tax credits
86
Supply of loanable funds: there is a direct relationship between the real interest rate and the quantity of loans supplied
An increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out)
Simply put, the supply of loanable funds represents savers and lenders
Saving is what makes lending possible so, the supply of loanable funds is the amount of money that is saved
Private saving is the amount that households save instead of consume
Public saving is the amount that the government saves instead of spends
National savings = Public saving+ private saving
A change in public or private saving will shift the supply of loanable funds
88
Foreigners also lend money so the supply of loanable funds also depends the amount of money that enters or leaves the country
Capital inflow: the amount of money entering the country
Capital outflow: the amount of money leaving the country
Net capital inflow = Inflow - outflowA change in net capital inflow will shift the supply of loanable
funds
In a closed economy, national savings is the sum of private saving and the public saving
In an open economy, national saving is the sum of private savings, public savings, and net capital inflows
Demand Shifters
Changes in borrowing by consumers
Changes in borrowing by businesses
Changes in borrowing by the government (such as deficit spending)
Supply Shifters
Changes in private savings behavior
Changes in public savings
Changes in foreign investment (such as inflow of foreign financial capital)
Real Interest Rate
Q of Loanable FundsQ1
S1 or SLF1
r1
D1 or DLF1
S2 or SLF2
r2
Q2
Real Interest Rate
Q of Loanable FundsQ2
S1 or SLF1
r2
D1 or DLF1
S2 or SLF2
r1
Q1
Real Interest Rate
Q of Loanable FundsQ1
S1 or SLF1
r2
D1 or DLF1
r1
Q2
D2 or DLF2
Real Interest Rate
Q of Loanable FundsQ2
S1 or SLF1
r1
D1 or DLF1
r2
Q1
D2 or DLF2
The government increases deficit spending
Draw the graph that illustrates this concept
Real Interest Rate
Q of Loanable FundsQ1
S1 or SLF1
r2
D1 or DLF1
r1
Q2
D2 or DLF2
Real interest rates increase
causingcrowding out
(of investment)
Government borrows from the private sector, increasing the demand for loans
Real interest rates increase
causingcrowding out
(of investment)
Government borrows from the private sector, increasing the demand for loans
Real Interest Rate
Q of Loanable FundsQ2
S1 or SLF1
r2
D1 or DLF1
S2 or SLF2
r1
Q1
**A correct answer for this could also be a decrease in the supply of loanable funds**
If there is an expansionary monetary policy, what are the results?
AD increases
MS increases
The supply of loanable funds increases
99
If there is a contractionary monetary policy, what are the results?
AD decreases
MS decreases
The supply of loanable funds decreases
100
101
Money Market
Interest Rate
Q of Money
MS2
i1
DM
i2
MS1
Expansionary monetary policy leads to…
QM1 QM2
Interest Rate
Q of Loanable Funds
SLF2
DLF
Loanable Funds Market
SLF1
r1
r2
… an increase in loanable funds
Q1 Q2
Expansionary Monetary Policy: Increases AD
Interest Rate
Q of Loanable Funds
SLF1
DLF
Loanable Funds Market
SLF2
r2
r1
… an decrease in loanable funds
Q2 Q1
Contractionary Monetary Policy: Decreases ADMoney Market
Interest Rate
Q of Money
MS1
i2
DM
i1
MS2
Contractionary monetary policy leads to…
QM2 QM1