Download Chapters 13 14 15

AP Macro Outline – 2005-2006
I.
A.
B.
C.
D.
E.
8 – 12 %
Basic economic concepts
Chapters 1, 2, 3, 4, 5 & parts of 20
Scarcity, choice and opportunity costs
Production possibilities curve
Comparative advantage, specialization and exchange
Demand, supply, and market equilibrium
Macroeconomic issues: business cycle, unemployment, inflation, growth
II. Measurement of economic performance
Chapters 4, 5, 7, 8
A. National Income Accounts (4-6%)
1. Circular flow
2. Gross Domestic Product
3. Components of GDP
4. Real versus Nominal GDP
B. Inflation measurement and adjustment (4-5%)
1. Price indices
2. Nominal versus real values
3. Costs of inflation
C. Unemployment (4-5%)
1. Definition and measurement
2. Types of unemployment
3. Natural rate of unemployment
12 – 16 %
III. National income and price determination
Chapters 9, 10, 11, 12
A. Aggregate Demand (5-8 %)
1.
Determinants of AD
2.
Multiplier and crowding-out effects
B. Aggregate Supply (5-8%)
1.
Short run and long run analyses
2.
Sticky versus flexible wages and prices
3.
Determinants of AS
C. Macroeconomic equilibrium (5-8%)
1.
Real output and price level
2. Short run and long run
3. Actual versus full-employment output
4.
Economic fluctuations
IV. Financial Sector
Chapters 13, 14, 15
A. Money, banking and financial markets (7-15%)
1.
Definition of financial assets: money, stocks, bonds
2. Time values of money
3.
Measures of money supply
4.
Banks and creation of money
5.
Money demand
6.
Money market
7.
Loanable funds market
B.
1.
2.
3.
Central bank and control of the money supply (3-5%)
Tools of central bank policy
Quantity theory of money
Real versus nominal interest rates
15 – 25 %
10 – 20 %
20 – 30%
V. Inflation, Unemployment and Stabilization Policies
Chapters 11, 12, 16, 17, 18, 19
A. Fiscal and Monetary policies (15-20%)
1. Demand side effects
2. Supply side effects
3. Policy mix
4. Government deficits and debt
B. Inflation and unemployment (5-10%)
1. Types of inflation
a)
Demand-pull
b) Cost-push
2. The Phillips Curve: short run versus long run
3. Role of expectations
VI. Economic Growth and Productivity
Mix of all chapters
A.
Investment in Human capital
B.
Investment in physical capital
C.
Research and development and technological progress
D.
Growth policy
VII. Open economy: International Trade and Finance
Chapters 6, 37, 38
A. Balance of payment accounts
1. Balance of trade
2. Current account
3. Capital account
B. Foreign exchange market
1. Demand for and supply of foreign exchange
2. Exchange rate determination
3. Currency appreciation and depreciation
C. Net Exports and Capital flows
D. Links to financial and goods markets.
4 – 6%
10 – 12%
Money and Banking 2005
• Chapters 13-14-15
• An easy but important conclusion
to Macro – 20+ AP Questions
• Bonus work chapter 13-14-15
• By February 10 Chapter 13
• Quiz Monday, February 13
Chapter 13
• By February 17 Chapter 14
• By week of February 20 Chapter
15.
• Test Day: Thursday 2/23/06
FUNCTIONS OF MONEY
SUPPLY OF MONEY
DEMAND FOR MONEY
MONEY MARKET
U.S. FINANCIAL SYSTEM
CHAPTER THIRTEEN
The Historical Development of $
From Barter to Electronic Fund
Transfers (EFT’s)!
Barter
• The oldest system of
exchange!
• Problem with the
“double coincidence
of wants”.
Commodity Money
• Money that is valuable
in and of itself.
• Cows, salt, shells,
tobacco, camels,
cigarettes, bullets, tea,
anything that is
mutually acceptable.
• On Mocha it was clam
shells!!
Problems with
Commodity Money
•
•
•
•
Storage
Making change
Carrying it to market
Consistent Value
Precious Metals
• A decided advantage
in making change and
storage.
• Problems of limited
supply and over
supply.
Bimetallic Systems
• With gold in short
supply and not enough
money in circulation,
Gresham, Chancellor
of the Exchequer in
England in the 1800’s
introduced silver to
the money supply!
• A disaster ensued!
Gresham’s Rule:
Cheap money drives out expensive!
What happens when gold and silver
are used together?
Fiat Money
Paper Money - Currency
• Fiat money’s value is based
on FAITH!
• Introduced by the Chinese as
soon as paper was invented.
• Printing too much money
can induce hyperinflation.
• Today’s Federal Reserve
Notes are legal tender –
valuable by law!
Hyper inflation grew to 1 dollar=4 trillion marks
• Original 5% interest on $10
billion war debt to U.S.
• High U.S. tariff of 1922
prevented Europe debt
repayment
• Germany unable to pay
$32 billion reparations but
Coolidge demanded
payments: "They hired the
money, didn't they?"
• Congress passed 1930
Hawley-Smoot "tariff wall"
and Hoover refused veto
despite appeal of 38 nations
and 1028 American economists
Inflation 1923/24: a woman feeds her tiled stove with money.
Hyperinflation was rare before the 20th century; older economies
would revert to either specie metals or barter once inflation
reached a certain level. The widespread use of fiat money created
the possibility of hyperinflation as governments often tended to
print larger amounts of money to finance their expenses. Inflation
results where such an increase in money supply occurs without
regard for the actual market demand.
Rates of inflation of several hundred percent per month are often
seen. Extreme examples include Germany in the early 1920s when
the rate of inflation hit 3.25 million percent per month; Greece in
the mid-1940s with 8.55 billion percent per month; and Hungary
during the same approximate time period at 4.19 quintillion percent
per month. Other more moderate examples include Eastern
European countries in the period of economic transition in the
early 1990s and in Bolivia and Peru in 1985 and 1988,
respectively.
Nations such as Ghana in North Western Africa continue to this day
to have inflation in the order of 30% per annum.
Hyperinflation!
Various workers also had to be paid by the Weimar
Government, additional currency was printed,
which fuelled a period of hyperinflation. The
value of the Mark declined from 4.2 per US dollar
to 1,000,000 per dollar by August 1923 and
4,200,000,000,000 per dollar on November 20. On
December 1, a new currency was established at
the rate of 1,000,000,000,000 old marks for 1 new
mark, the Rentenmark.
Demand Deposits, Share Drafts,
NOW Accounts: Checks!
• Created by medieval
goldsmiths, today
checks and checkbook
deposits cover 90% of
all business
transactions.
• Most people are paid
by check or by direct
deposit to a checking
account.
Electronic Fund Transfer
• Increasingly money is
merely transferred from one
account to another by
computer terminals and
cash registers.
• Debit or check cards
automatically transfer funds
from a purchasers account
to a stores account!
• Better than cash because it
is faster and a record is kept
of transactions.
What about credit cards?
The most profitable portion
of many bank’s business!
Because of suckers who use it
as an expensive loan at up to 35%.
Characteristics of Money
• Acceptable
•
•
•
•
•
Portable
Durable
Divisible
Recognizable
Stable in valueHomogeneous
• Stable in time
Functions of Money
• Medium of Exchange
Socially acceptable and allows geographic and human specialization.
Functions of Money
• Medium of Exchange
• Unit of Account,
Measure of Value
It is a “yardstick” for measuring the relative worth of a variety of goods.
Functions of Money
• Medium of Exchange
• Unit of Account,
Measure of Value
• Store of Value
A convenient way to store wealth, cash is the most liquid.
Functions of Money
• Medium of Exchange
• Unit of Account, Price
Measure of Value
• Store of Value
• Standard for deferred
Payment
Can count on its worth in the future.
Money Definition
Money Definition
Coins & Currency
Coins , 2- 3 % of M1
Paper Money, 37 % of M1
Money Definition
Coins & Currency
Federal Reserve Notes
Money Definition
Coins & Currency
Checkable Deposits 60% of M1
•Commercial Banks
•Thrift Institutions
•Savings & Loan Associations
Money Definition
M1 = C + C + C + TLC
Currency
•Token Money
•Intrinsic
Value
Coins, Currency, Checks
Checkable
Deposits
Things like Checks!
•Commercial Banks
•Thrift Institutions
•Savings & Loan Associations
Money Definition
=
Plus...
Money Definition
=
Plus...
Near-monies
Money Definition
=
Plus...
Near-monies
1. Noncheckable Savings
Accounts
Money Definition
=
Plus...
Near-monies
1. Noncheckable Savings
Accounts
2. Money Market Deposit
Accounts
Money Definition
=
Plus...
Near-monies
1. Noncheckable Savings
Accounts
2. Money Market Deposit
Accounts
3. Time Deposits
Money Definition
=
Plus...
Near-monies
M2 = M1 + <$100,000
Most Watched!
1. Noncheckable Savings
Accounts
2. Money Market Deposit
Accounts
3. Time Deposits
4. Money Market Mutual Funds
Money Definition
=
Plus...
Large Time Deposits
M3 = M2 + >$100,000
Measuring the Money Supply
M1 = C + C + C + TLC
M2 = M1 + <$100,000
M3 = M2 + >$100,000
• M1 smallest and most
liquid
• M3 largest and least liquid
• M2 tracked most closely by
the FED
• M2 that portion of the
money supply controlled
by consumers
Money Supply impacts i which impacts both C & I
in C + I + G + (X – M) = AD!
Monetary Control
The Federal Reserve
vs
Allen Greenspan
Expansionary/Contractionary
Pure Monetarists
Milton Friedman
Conservative/Growth
The Federal Reserve
Allen Greenspan
vs
Pure Monetarists
Milton Friedman
3 Economic Common Goals:
3-5% RGDP Growth
Stable Prices
Full Employment
Counter Cyclical Money
Supply Manipulation!
MS
i
I GDP
Money Supply Growth
At 3-5% Annually no matter
The Cycle of the Economy
Recession
MS
MS
i
I GDP
Inflation
* V = NGDP
Grow Money Supply at
3-5% no matter economic
conditions.
The Future?!?
• Ben Bernanke has
replaced Alan
Greenspan.
• Greenspan’s last day
was Friday, February
3, 2006
• Bernanke replaced on
Monday, February 6,
2006!
The Supply of Money
Currency (coins & paper money)
plus Checkable deposits
1997 Data
(billions of dollars)
The Supply of Money
Currency (coins & paper money)
plus Checkable deposits
M1
equals M1
$1057
1997 Data
(billions of dollars)
The Supply of Money
Currency (coins & paper money)
plus Checkable deposits
M1
equals M1
$1057
plus Noncheckable savings deposits,
including MMDA’s
plus Small time deposits
plus Money market mutual fund
balances (MMMF’s)
1997 Data
(billions of dollars)
The Supply of Money
Currency (coins & paper money)
plus Checkable deposits
M1 M2
equals M1
$1057
plus Noncheckable savings deposits,
including MMDA’s
plus Small time deposits
plus Money market mutual fund
balances (MMMF’s)
equals M2
$3964
1997 Data
(billions of dollars)
The Supply of Money
Currency (coins & paper money)
plus Checkable deposits
M1 M2
equals M1
$1057
plus Noncheckable savings deposits,
including MMDA’s
plus Small time deposits
plus Money market mutual fund
balances (MMMF’s)
equals M2
plus Large time deposits
$3964
1997 Data
(billions of dollars)
The Supply of Money
Currency (coins & paper money)
plus Checkable deposits
M1 M2 M3
equals M1
$1057
plus Noncheckable savings deposits,
including MMDA’s
plus Small time deposits
plus Money market mutual fund
balances (MMMF’s)
equals M2
plus Large time deposits
equals M3
$3964
1997 Data
(billions of dollars) $5205
MONEY SUPPLY
Currency (coins & paper money)
plus Checkable deposits
M1 M2 M3
equals M1
plus Savings deposits,
including MMDA’s
plus Small time deposits
plus Money market mutual
fund
(MMMF) balances
equals M2
plus Large time deposits
equals M3
$1101
$4827
2000 Data
(billions of dollars)
$6853
What Backs the Money Supply?
What Backs the Money Supply?
• Money as Debt
Paper money and checks are promises to pay. In other words,
issued money to be used in financial transactions. Monetary authorities
attempt to provide the amount of $ needed for a level of business
activity that will promote full employment.
What Backs the Money Supply?
• Money as Debt
• Value of Money
What Backs the Money Supply?
• Money as Debt
• Value of Money
• Acceptability
Society accepts it as a medium of exchange.
What Backs the Money Supply?
• Money as Debt
• Value of Money
• Acceptability
• Legal Tender
By law creditors must accept money as a form of payment.
What Backs the Money Supply?
• Money as Debt
• Value of Money
• Acceptability
• Legal Tender
•Fiat Money
$ backed by the faith that the government will keep it stable.
What Backs the Money Supply?
• Money as Debt
• Value of Money
• Acceptability
• Legal Tender
• Relative Scarcity
When demand stays constant, the supply of money will determine
its purchasing power.
What Backs the Money Supply?
• Money as Debt
• Value of Money
• Acceptability
• Legal Tender
• Relative Scarcity
• Money and Prices
What Backs the Money Supply?
• Money as Debt
• Value of Money
• Acceptability
• Legal Tender
• Relative Scarcity
• Money and Prices
• Value of the Dollar
The 50 cent dollar – “Ya sure can’t buy what you used to for a buck”
What Backs the Money Supply?
• Money as Debt
• Value NOTES:
of Money
Reciprocal relationship
• Acceptability
between the price level
and Tender
the value of the
• Legal
dollar.
• Relative Scarcity
1
• Money and
Prices
D =
P
• Value of the Dollar
What Backs the Money Supply?
• Money as Debt
• Value of Money
• Acceptability
• Legal Tender
• Relative Scarcity
• Money and Prices
• Value of the Dollar
• Inflation and Acceptability
If rampant inflation, society will not accept, value is gone!
Maintaining Money’s Value
What backs the money supply?
Maintaining Money’s Value
What backs the money supply?
Stable Value!
through....
Maintaining Money’s Value
What backs the money supply?
Stable Value!
through....
• Appropriate fiscal policy
Maintaining Money’s Value
What backs the money supply?
Stable Value!
through....
• Appropriate fiscal policy
• Intelligent management of
the money supply
Fiscal Policy = Congress + President Money Supply = The FED
The Demand For Money
The Demand For Money
Transactions Demand, D1
varies directly with nominal GDP
Primary function – Medium of exchange
The Demand For Money
Transactions Demand, D1
varies directly with nominal GDP
Asset Demand, D2
varies inversely with the interest rate
Primary function store of value
illustrated....
AP Essay
The Demand For Money
Rate of interest, i (percent)
Transactions
Demand, Dt
+
10
7.5
5
2.5
Dt
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
The Demand For Money
10
7.5
5
2.5
Dt
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
+
Rate of interest, i (percent)
Rate of interest, i (percent)
Transactions
Demand, Dt
Asset
Demand, Da
=
10
7.5
5
2.5
Da
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
The Demand For Money
7.5
5
2.5
Dt
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Asset
Demand, Da
=
10
7.5
5
2.5
Da
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
Total demand
for money, Dm
Rate of interest, i (percent)
10
+
Rate of interest, i (percent)
Rate of interest, i (percent)
Transactions
Demand, Dt
10
7.5
5
2.5
0
Dm
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
The Demand For Money
7.5
5
2.5
Dt
0
Asset
Demand, Da
=
Total demand
for money, Dm
Rate of interest, i (percent)
10
+
Rate of interest, i (percent)
Rate of interest, i (percent)
Transactions
Demand, Dt
10
ADD THE
7.5
7.5
MONEY SUPPLY
5
TO
FIND THE 5
2.5
2.5
EQUILIBRIUM
RATE
Da
0
OF
INTEREST 0 0
250 300
0 50 100 150 200 250 300
0 50 100 150 200
Amount of money
demanded (billions
of dollars)
10
Amount of money
demanded (billions
of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
Dm
50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
The Demand For Money
7.5
5
2.5
Dt
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Asset
Demand, Da
=
10
7.5
5
2.5
Da
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Total demand
for money, Dm
Rate of interest, i (percent)
10
+
Rate of interest, i (percent)
Rate of interest, i (percent)
Transactions
Demand, Dt
Sm
10
7.5
ie
5
2.5
0
Dm
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Equilibrium
Interest Rate
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
Rate of interest, i (percent)
The Money Market
Sm
10
7.5
ie
5
Suppose the money
supply is decreased
from $200 billion, Sm,
to $150 billion Sm1.
Dm
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
Rate of interest, i (percent)
The Money Market
Sm1
Sm
A temporary shortage
of money will require
the sale of some assets
to meet the need.
10
7.5
ie
5
Dm
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
Rate of interest, i (percent)
The Money Market
Sm1
Sm
A temporary shortage
of money will require
Bonds are assumed
the sale of some assets
7.5
as a typical asset with
to meet the need.
10
ie
lower
prices
associated
5
with higher
2.5
interest rates
Dm
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
Rate of interest, i (percent)
The Money Market
Sm1
After adjustments to
asset holdings, a new
equilibrium will be
seen at a higher level
of interest.
10
ie
7.5
5
Dm
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Rate of interest, i (percent)
The Money Market
Sm
10
7.5
ie
5
Suppose the money
supply is increased
from $200 billion, Sm,
to $250 billion Sm2.
Dm
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Rate of interest, i (percent)
The Money Market
Sm Sm2
10
7.5
ie
5
A temporary surplus
of money will require
the purchase of some
assets to meet the desired level of liquidity.
Dm
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Rate of interest, i (percent)
The Money Market
Sm2
After adjustments to
asset holdings, a new
equilibrium will be
seen at a lower level
of interest.
10
7.5
5
2.5
ie
0
0
50
100
150
200
Dm
250 300
Amount of money demanded
(billions of dollars)
The United States Financial System
The United States Financial System
The Federal Reserve System
The United States Financial System
The Federal Reserve System
• Board of Governors
The United States Financial System
The Federal Reserve System
• Board of Governors
• Assistance & Advice
The United States Financial System
The Federal Reserve System
• Board of Governors
• Assistance & Advice
• Federal Open Market Committee
The United States Financial System
The Federal Reserve System
• Board of Governors
• Assistance & Advice
• Federal Open Market Committee
• Three Advisory Councils
The United States Financial System
The Federal Reserve System
• Board of Governors
• Assistance & Advice
• Federal Open Market Committee
• Three Advisory Councils
• The Twelve Federal Reserve Banks
The United States Financial System
The Federal Reserve System
• Board of Governors
• Assistance & Advice
• Federal Open Market Committee
• Three Advisory Councils
• The Twelve Federal Reserve Banks
• Central Bank Role
The United States Financial System
The Federal Reserve System
• Board of Governors
• Assistance & Advice
• Federal Open Market Committee
• Three Advisory Councils
• The Twelve Federal Reserve Banks
• Central Bank Role
• Quasipublic Banks
The United States Financial System
The Federal Reserve System
• Board of Governors
• Assistance & Advice
• Federal Open Market Committee
• Three Advisory Councils
• The Twelve Federal Reserve Banks
• Central Bank Role
• Quasipublic Banks
• Banker’s Banks
The United States Financial System
The Federal Reserve System
• Board of Governors
• Assistance & Advice
• Federal Open Market Committee
• Three Advisory Councils
• The Twelve Federal Reserve Banks
• Central Bank Role
• Quasipublic Banks
• Banker’s Banks
• Commercial Banks & Thrifts
FED Functions and the Money Supply
FED Functions and the Money Supply
• Issuing Currency
FED Functions and the Money Supply
• Issuing Currency
• Setting Reserve Requirements &
Holds Reserves
FED Functions and the Money Supply
• Issuing Currency
• Setting Reserve Requirements &
Holds Reserves
• Lending Money to Banks & Thrifts
FED Functions and the Money Supply
• Issuing Currency
• Setting Reserve Requirements &
Holds Reserves
• Lending Money to Banks & Thrifts
• Check Collection
FED Functions and the Money Supply
• Issuing Currency
• Setting Reserve Requirements &
Holds Reserves
• Lending Money to Banks & Thrifts
• Check Collection
• Fiscal Agents for the Federal
Government
FED Functions and the Money Supply
• Issuing Currency
• Setting Reserve Requirements &
Holds Reserves
• Lending Money to Banks & Thrifts
• Check Collection
• Fiscal Agents for the Federal
Government
• Supervision of Member Banks
FED Functions and the Money Supply
• Issuing Currency
• Setting Reserve Requirements &
Holds Reserves
• Lending Money to Banks & Thrifts
• Check Collection
• Fiscal Agents for the Federal
Government
• Supervision of Member Banks
• Control of the Money Supply
FED Functions and the Money Supply
• Issuing Currency
NOTES:
• Setting Reserve
Requirements &
Reserve
HoldsFederal
Reserves
from & Thrifts
• LendingIndependence
Money to Banks
Federal Government
• Check Collection
• Fiscal Agents for the Federal
Government
• Supervision of Member Banks
• Control of the Money Supply
Recent Developments
• Relative Decline of Banks & Thrifts
Recent Developments
• Relative Decline of Banks & Thrifts
• Expansion of Services
Recent Developments
• Relative Decline of Banks & Thrifts
• Expansion of Services
• Mergers
Recent Developments
• Relative Decline of Banks & Thrifts
• Expansion of Services
• Mergers
• Regulatory Reform
Recent Developments
• Relative Decline of Banks & Thrifts
• Expansion of Services
• Mergers
• Regulatory Reform
• Market Globalization
Recent Developments
• Relative Decline of Banks & Thrifts
• Expansion of Services
• Mergers
• Regulatory Reform
• Market Globalization
• Electronic Money
Recent Developments
• Relative Decline of Banks & Thrifts
• Expansion of Services
• Mergers
• Regulatory Reform
• Market Globalization
• Electronic Money
• E-Cash
Recent Developments
• Relative Decline of Banks & Thrifts
• Expansion of Services
• Mergers
• Regulatory Reform
• Market Globalization
• Electronic Money
• E-Cash
• Smart Cards
Recent Developments
• Relative Decline of Banks & Thrifts
• Expansion of Services
Questions
• Mergers
• Regulatory Reform
and
• Market Globalization
Discussion
• Electronic Money
• E-Cash
• Smart Cards
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
medium of exchange
unit of account
store of value
M1, M2, M3
token money
intrinsic value
Federal Reserve Notes
checkable deposits
thrift (savings) institutions
savings & loan associations
mutual savings banks
credit unions
near-monies
noncheckable deposits
money market deposit account
Copyright McGraw-Hill, Inc.
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
time deposits
money market mutual fund
legal tender
fiat money
transactions demand
asset demand
total demand for money
money market
Federal Reserve System
Board of Governors
Federal Open Market Committee
Advisory Councils
Federal Reserve Banks
commercial banks
E-cash
smart cards
The Demand For Money
The Demand For Money
Transactions Demand, D1
varies directly with nominal GDP
The Demand For Money
Transactions Demand, D1
varies directly with nominal GDP
Asset Demand, D2
varies inversely with the interest rate
illustrated....
AP Essay 04
The Demand For Money
Rate of interest, i (percent)
Transactions
Demand, Dt
+
10
7.5
5
2.5
Dt
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
The Demand For Money
10
7.5
5
2.5
Dt
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
+
Rate of interest, i (percent)
Rate of interest, i (percent)
Transactions
Demand, Dt
Asset
Demand, Da
=
10
7.5
5
2.5
Da
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
The Demand For Money
7.5
5
2.5
Dt
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Asset
Demand, Da
=
10
7.5
5
2.5
Da
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
Total demand
for money, Dm
Rate of interest, i (percent)
10
+
Rate of interest, i (percent)
Rate of interest, i (percent)
Transactions
Demand, Dt
10
7.5
5
2.5
0
Dm
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
The Demand For Money
7.5
5
2.5
Dt
0
Asset
Demand, Da
=
Total demand
for money, Dm
Rate of interest, i (percent)
10
+
Rate of interest, i (percent)
Rate of interest, i (percent)
Transactions
Demand, Dt
10
ADD THE
7.5
7.5
MONEY SUPPLY
5
TO
FIND THE 5
2.5
2.5
EQUILIBRIUM
RATE
Da
0
OF
INTEREST 0 0
250 300
0 50 100 150 200 250 300
0 50 100 150 200
Amount of money
demanded (billions
of dollars)
10
Amount of money
demanded (billions
of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
Dm
50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
The Demand For Money
7.5
5
2.5
Dt
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Asset
Demand, Da
=
10
7.5
5
2.5
Da
0
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Total demand
for money, Dm
Rate of interest, i (percent)
10
+
Rate of interest, i (percent)
Rate of interest, i (percent)
Transactions
Demand, Dt
Sm
10
7.5
ie
5
2.5
0
Dm
0 50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Equilibrium
Interest Rate
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
Rate of interest, i (percent)
The Money Market
Sm
10
7.5
ie
5
Suppose the money
supply is decreased
from $200 billion, Sm,
to $150 billion Sm1.
Dm
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
Rate of interest, i (percent)
The Money Market
Sm1
Sm
A temporary shortage
of money will require
the sale of some assets
to meet the need.
10
7.5
ie
5
Dm
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
Rate of interest, i (percent)
The Money Market
Sm1
Sm
A temporary shortage
of money will require
Bonds are assumed
the sale of some assets
7.5
as a typical asset with
to meet the need.
10
ie
lower
prices
associated
5
with higher
2.5
interest rates
Dm
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Copyright McGraw-Hill, Inc. 1999 in your text book before AP Curriculum
Rate of interest, i (percent)
The Money Market
Sm1
After adjustments to
asset holdings, a new
equilibrium will be
seen at a higher level
of interest.
10
ie
7.5
5
Dm
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Rate of interest, i (percent)
The Money Market
Sm
10
7.5
ie
5
Suppose the money
supply is increased
from $200 billion, Sm,
to $250 billion Sm2.
Dm
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Rate of interest, i (percent)
The Money Market
Sm Sm2
10
7.5
ie
5
A temporary surplus
of money will require
the purchase of some
assets to meet the desired level of liquidity.
Dm
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Rate of interest, i (percent)
The Money Market
Sm2
After adjustments to
asset holdings, a new
equilibrium will be
seen at a lower level
of interest.
10
7.5
5
2.5
ie
0
0
50
100
150
200
Dm
250 300
Amount of money demanded
(billions of dollars)
Coming up next...
How Banks Create Money
Chapter 14
Banks begin in Medieval Europe
• Goldsmiths would
hold peoples coins in
their safes!
• Rather than take their
coins on a trip which
was unsafe.
• Goldsmiths issued
script based on a
person’s deposits
Fractional Reserves
• An enterprising goldsmith
realized that at anyone time
only a portion of money on
deposit circulated.
• Taking a risk the goldsmith
was able to loan out someone
else’s deposit at interest and
make a profit.
• In so doing, the banking
industry was born!
• But there were risks—Panics
caused banks to fail!
FDIC & FSLIC
How Banks Create Money
• Total Reserves,
Reserves, or Deposits
• Excess Reserves
• Required Reserves
• Loan able Funds
• Required Reserve
Ratio (RRR)
New Deposit = $100,000 with a
Required Reserve Ration of 20%
Required Reserves
$20,000
Required reserves the
amount of money a bank
must keep for safe
operation. The % is
under the control of the
Federal Reserve!
Excess Reserves
$80,000
Excess reserves may be
loaned out. The
difference between the
interest it receives on
this money loaned and
what it pays depositors
determines a banks
profitability.
How Banks Create Money
• Banks create money
by making loans,
receiving deposits, and
reloaning that money
until all new deposits
become required
reserves.
• With no required
reserves, how much
money could be
created?
Multiple Deposit Expansion Process
Bank
Acquired reserves
and deposits
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.22
H
20.98
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks
21.97
Copyright McGraw-Hill,
Inc.
Total amount
Required
reserves
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
Excess
reserves
Amount bank
can lend - New
money created
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
of money created by the banking system
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Multiple Deposit Expansion Process
Bank
Acquired reserves
and deposits
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.22
H
20.98
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks
21.97
Copyright McGraw-Hill,
Inc.
Total amount
Required
reserves
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
Excess
reserves
Amount bank
can lend - New
money created
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
of money created by the banking system
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Multiple Deposit Expansion Process
Bank
Acquired reserves
and deposits
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.22
H
20.98
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks
21.97
Copyright McGraw-Hill,
Inc.
Total amount
Required
reserves
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
Excess
reserves
Amount bank
can lend - New
money created
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
of money created by the banking system
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Multiple Deposit Expansion Process
Bank
Acquired reserves
and deposits
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.22
H
20.98
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks
21.97
Copyright McGraw-Hill,
Inc.
Total amount
Required
reserves
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
Excess
reserves
Amount bank
can lend - New
money created
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
of money created by the banking system
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Multiple Deposit Expansion Process
Bank
Acquired reserves
and deposits
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.22
H
20.98
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks
21.97
Copyright McGraw-Hill,
Inc.
Total amount
Required
reserves
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
Excess
reserves
Amount bank
can lend - New
money created
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
of money created by the banking system
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Multiple Deposit Expansion Process
Bank
Acquired reserves
and deposits
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.22
H
20.98
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks
21.97
Copyright McGraw-Hill,
Inc.
Total amount
Required
reserves
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
Excess
reserves
Amount bank
can lend - New
money created
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
of money created by the banking system
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Multiple Deposit Expansion Process
Bank
Acquired reserves
and deposits
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.22
H
20.98
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks
21.97
Copyright McGraw-Hill,
Inc.
Total amount
Required
reserves
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
Excess
reserves
Amount bank
can lend - New
money created
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
of money created by the banking system
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Multiple Deposit Expansion Process
Bank
Acquired reserves
and deposits
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.22
H
20.98
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks
21.97
Copyright McGraw-Hill, Inc.
Required
reserves
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
Excess
reserves
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Amount bank
can lend - New
money created
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Multiple Deposit Expansion Process
Bank
Acquired reserves
and deposits
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.22
H
20.98
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks
21.97
Required
reserves
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
Excess
reserves
Amount bank
can lend - New
money created
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Total amount of money created by the banking system
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
$400.00
Multiple Deposit Expansion Process
Bank
Acquired reserves
and deposits
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.22
H
20.98
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks
21.97
Required
reserves
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
Excess
reserves
Amount bank
can lend - New
money created
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Money
Destruction when
Money is held and
not reloaned!
Total amount of money created by the banking system
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
$400.00
The Monetary Multiplier
Monetary
Multiplier
=
1
Required reserve ratio
The Monetary Multiplier
Monetary
Multiplier
=
Maximum
Demand-deposit
expansion
=
1
Required reserve ratio
Excess
reserves
x
Monetary
Multiplier
Outcome of Money Expansion
$100
New reserves
$80
Excess
reserves
$400
Bank system lending
Copyright McGraw-Hill, Inc.
Money Created
$20
Required
reserves
$100
Initial
Deposit
Outcome of Money Expansion
$100
New reserves
$80
Excess
reserves
$20
Required
reserves
Leakages exist...
Currency Drains
People hold on to cash.
Excess Reserves
Bank does $400
not give out loan.$100
Initial
People
not wanting
Bank system
lendingloans. Deposit
Copyright McGraw-Hill, Inc.
Money Created
TI –ers and
Ritger’s Formula
TR – (TR x RRR)
RRR
=
Potential Change in
Money Supply!
Knowing this formula is dangerous and may harm your ability
to pass the AP Test in May????????????
AP Essay Questions
From the 1993 Exam:
The reserve requirement for the banking system is
20%. Currently, Third National Bank has no
excess reserves. Then Behroz deposits $100 in her
checking account at Third National.
A. Explain, without using mathematical formula,
why Behroz' deposit can lead to greater increase in
the money supply.
B. Discuss two limitations on this process.
From the 1995 Exam: What are the excess reserves
and required in the third round with an initial
deposit of $100 and a RRR of 20%?
Multiple Deposit Expansion Process
Bank
Acquired reserves
and deposits
A
$100.00
B
80.00
C
64.00
D
51.20
E
40.96
F
32.77
G
26.22
H
20.98
I
16.78
J
13.42
K
10.74
L
8.59
M
6.87
N
5.50
Other banks
21.97
Required
reserves
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
Excess
reserves
Amount bank
can lend - New
money created
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
Total amount of money created by the banking system
$80.00
64.00
51.20
40.96
32.77
26.22
20.98
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.57
$400.00
All money creation and
destruction is only a potential
change in the money supply???
• Money held as cash
and not redeposited
diminishes money
creation or
destruction.
• Banks holding excess
reserves and not
making new loans also
diminishes the
process.
Transmission Graphs
Ready to run in circles!
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1
8
R 10
i
R 8
6
6
10
Dm
0
Quantity of money demanded and supplied
MEI
Investment
Demand
0
Amount of planned
investment, I
Price level
AS
MEI – Marginal Efficiency of Investment
As interest falls more Investment becomes
Possible and Profitable!
P1
AD1
Real domestic output, GDP
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1
8
R 10
i
R 8
6
6
10
Dm
0
Quantity of money demanded and supplied
MEI
Investment
Demand
0
Amount of planned investment, I
Price level
AS
P1
AD1
Real domestic output, GDP
If the money supply
increases to
stimulate the
economy....
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1 Sm2
8
R 10
i
R 8
6
6
10
Dm
0
Quantity of money demanded and supplied
Price level
AS
P2
P1
AD1
AD2
Real domestic output, GDP
MEI
Investment
Demand
0
Amount of planned investment, I
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1 Sm2
8
R 10
i
R 8
6
6
10
Dm
0
Quantity of money demanded and supplied
MEI
Investment
Demand
0
Amount of planned investment, I
Price level
AS
P2
P1
If the money
supply increases
again....
AD1
AD2
Real domestic output, GDP
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1 Sm2 Sm3
8
R 10
i
R 8
6
6
10
Dm
0
MEI
Investment
Demand
0
Quantity of money demanded and supplied
Amount of planned investment, I
Price level
AS
P3
P2
P1
AD1
AD2
Real domestic output, GDP
AD3
Long Run Effects:
1. Increased planned investment
will lead to increased AS
2. i down = international $ down,
PL up = X down
3. Canceling effect: AD up, MD up,
i up, and I down, = AD down
Real rate of interest, i
Fiscal Policy and Equilibrium GDP
Sm1
Price level
10
AD1
AD2
Real domestic output, GDP
R 10
i
8
R
6
0
PI2
MEI
PI1
Amount of planned investment, I
8
6
0
Dm2
Dm1
Quantity of money demanded and supplied
Long Run Effects:
1. Decreased planned investment
will lead to decreased AS
2. Canceling effect: I down, AD down,
MD down, and i down, = AD up
3. i up = international $ up, PL down = X up
• Money Supply Effects
interest rate
• Interest rate effects
Investment
• Investment effects AD
and AS
• AD and AS effect price
level
• Price Level effects
exports and imports
CHAPTER FIFTEEN
Monetary
Policy
FEDERAL RESERVE BANK OF NEW YORK
Fiscal and Monetary
Goals are identical in
that both seek to
prevent wild
inflationary and
recessionary swings
while guiding the
economy on a path of
steady economic
growth, with full
employment and
stable prices!
Tools of the Fed!!!
• Required Reserve
Ratio
• Open Market
Operation
• Discount Rate
• Federal Funds Rate
• Moral Suasion*
*For an extended period of time!
Federal
Funds Rate
Federal Funds Rate
• Over night lending
rate
• Set by the Fed
• Used to direct Banks
and Money Supply
• Most often used
between banks
– Less costs
– Less oversight
Allan Greenspan
Dr. Greenspan took office June 20, 2000, as
Chairman of the Board of Governors of the
Federal Reserve System for a fourth four-year
term ending June 20, 2004. Dr. Greenspan also
serves as Chairman of the Federal Open
Market Committee, the System's principal
monetary policymaking body. He originally
took office as Chairman and to fill an
unexpired term as a member of the Board on
August 11, 1987. Dr. Greenspan was
reappointed to the Board to a full 14-year term
which began February 1, 1992. He has been
designated Chairman by Presidents Reagan,
Bush and Clinton.
Ben Bernanke
•
•
•
Before his appointment as Chairman, Dr.
Bernanke was Chairman of the President's
Council of Economic Advisers, from June
2005 to January 2006.
Dr. Bernanke has already served the Federal
Reserve System in several roles. He was a
member of the Board of Governors of the
Federal Reserve System from 2002 to 2005; a
visiting scholar at the Federal Reserve Banks
of Philadelphia (1987-89), Boston (1989-90),
and New York (1990-91, 1994-96); and a
member of the Academic Advisory Panel at
the Federal Reserve Bank of New York (19902002).
From 1994 to 1996, Dr. Bernanke was the
Professor of Economics and Public Affairs at
Princeton University. He was the Howard
Harrison and Gabrielle Snyder Beck Professor
of Economics and Public Affairs and Chair of
the Economics Department at the university
from 1996 to 2002. Dr. Bernanke had been a
Professor of Economics and Public Affairs at
Princeton since 1985.
Organization of the Fed!!
• Fed Chairman – Ben
Bernanke!
• Board of Governors
• Federal Open Market
Committee (FOMC)
• Federal Reserve Banks
Organization of the FED
7 Board of
Governors
RRR
7
FOMC
Ben+11
DR & FFR
5
12 Federal
Reserve
Banks
OMO
GOALS OF MONETARY POLICY
to assist the economy
in achieving a fullemployment,
noninflationary level
of total output....
Consolidated Balance Sheet of
the Federal Reserve Banks
ASSETS
Consolidated Balance Sheet of
the Federal Reserve Banks
ASSETS
• Securities T-bills and T-bonds
Consolidated Balance Sheet of
the Federal Reserve Banks
ASSETS
• Securities
• Loans to Commercial Banks
Consolidated Balance Sheet of
the Federal Reserve Banks
ASSETS
• Securities
• Loans to Commercial Banks
LIABILITIES
Consolidated Balance Sheet of
the Federal Reserve Banks
ASSETS
• Securities
• Loans to Commercial Banks
LIABILITIES
• Reserves of Commercial Banks
Consolidated Balance Sheet of
the Federal Reserve Banks
ASSETS
• Securities
• Loans to Commercial Banks
LIABILITIES
• Reserves of Commercial Banks
• Treasury Deposits
Consolidated Balance Sheet of
the Federal Reserve Banks
ASSETS
• Securities
• Loans to Commercial Banks
LIABILITIES
• Reserves of Commercial Banks
• Treasury Deposits
• Federal Reserve Notes
TOOLS OF MONETARY POLICY
The FED can influence the $ creating abilities of commercial banks.
Open Market Operations
TOOLS OF MONETARY POLICY
Open Market Operations
Buying Securities
TOOLS OF MONETARY POLICY
Open Market Operations
Buying Securities
From commercial banks...
TOOLS OF MONETARY POLICY
Open Market Operations
Buying Securities
From commercial banks...
• Bank gives up securities
TOOLS OF MONETARY POLICY
Open Market Operations
Buying Securities
From commercial banks...
• Bank gives up securities
• FED pays bank
TOOLS OF MONETARY POLICY
Open Market Operations
Buying Securities
From commercial banks...
• Bank gives up securities
• FED pays bank
• Banks have increased reserves
TOOLS OF MONETARY POLICY
Open Market Operations
Buying Securities
From commercial banks...
• Bank gives up securities
• FED pays bank
• Banks have increased reserves
From individuals...
TOOLS OF MONETARY POLICY
Open Market Operations
Buying Securities
From commercial banks...
• Bank gives up securities
• FED pays bank
• Banks have increased reserves
From individuals...
• Individual gives up securities
TOOLS OF MONETARY POLICY
Open Market Operations
Buying Securities
From commercial banks...
• Bank gives up securities
• FED pays bank
• Banks have increased reserves
From individuals...
• Individual gives up securities
• Individual deposits check in bank
TOOLS OF MONETARY POLICY
Open Market Operations
Buying Securities
From commercial banks...
• Bank gives up securities
• FED pays bank
• Banks have increased reserves
From individuals...
• Individual gives up securities
• Individual deposits check in bank
• Banks have increased reserves
Federal Reserve Bond Purchase of Bonds
Purchase of a New reserves
$1000
$1000 bond
Excess
Reserves
from a bank...
$5000
Bank System Lending
Money Created
Federal Reserve Bond Purchase of Bonds
Purchase of a New reserves
$800
$1000 bond
Excess
Reserves
From the public...
$4000
Bank System Lending
$200
Required
reserves
$1000
Initial
Deposit
Total Increase in Money Supply ($5000)
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
Raising the Reserve Ratio
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
Raising the Reserve Ratio
• Banks must hold more reserves
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
Raising the Reserve Ratio
• Banks must hold more reserves
• Banks decrease lending
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
Raising the Reserve Ratio
• Banks must hold more reserves
• Banks decrease lending
• Money supply decreases
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
Raising the Reserve Ratio
• Banks must hold more reserves
• Banks decrease lending
• Money supply decreases
Lowering the Reserve Ratio
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
Raising the Reserve Ratio
• Banks must hold more reserves
• Banks decrease lending
• Money supply decreases
Lowering the Reserve Ratio
• Banks may hold less reserves
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
Raising the Reserve Ratio
• Banks must hold more reserves
• Banks decrease lending
• Money supply decreases
Lowering the Reserve Ratio
• Banks may hold less reserves
• Banks increase lending
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
Raising the Reserve Ratio
• Banks must hold more reserves
• Banks decrease lending
• Money supply decreases
Lowering the Reserve Ratio
• Banks may hold less reserves
• Banks increase lending
• Money supply increases
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
The Discount Rate
This differs from the Federal Funds Rate and the prime interest rate.
Discount Rate – the rate the FED charges banks to borrow.
Federal Funds Rate – the rate commercial banks charge each other.
Prime Interest Rate – the rate banks charge their best customers.
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
The Discount Rate
Easy Money Policy
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
The Discount Rate
Easy Money Policy
• Buy Securities
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
The Discount Rate
Easy Money Policy
• Buy Securities
• Decrease Reserve Ratio
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
The Discount Rate
Easy Money Policy
• Buy Securities
• Decrease Reserve Ratio
• Lower Discount Rate
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
The Discount Rate
Easy Money Policy
Tight Money Policy
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
The Discount Rate
Easy Money Policy
Tight Money Policy
• Sell Securities
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
The Discount Rate
Easy Money Policy
Tight Money Policy
• Sell Securities
• Increase Reserve Ratio
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
The Discount Rate
Easy Money Policy
Tight Money Policy
• Sell Securities
• Increase Reserve Ratio
• Raise Discount Rate
TOOLS OF MONETARY POLICY
Open Market Operations
The Reserve Ratio
Discuss
relative
The Discount
Rate
Easy Money
Policy
Importance
Tight Money Policy
of each control
• Sell securities
• Increase Reserve Ratio
• Raise Discount Rate
MONETARY POLICY, REAL GDP
AND THE PRICE LEVEL
Cause-Effect Chain
MONETARY POLICY, REAL GDP
AND THE PRICE LEVEL
Cause-Effect Chain
• Money supply impacts interest rates
MONETARY POLICY, REAL GDP
AND THE PRICE LEVEL
Cause-Effect Chain
• Money supply impacts interest rates
• Interest rates affect investment
MONETARY POLICY, REAL GDP
AND THE PRICE LEVEL
Cause-Effect Chain
• Money supply impacts interest rates
• Interest rates affect investment
• Investment is a component of AD
MONETARY POLICY, REAL GDP
AND THE PRICE LEVEL
Cause-Effect Chain
• Money supply impacts interest rates
• Interest rates affect investment
• Investment is a component of AD
• Equilibrium GDP is changed
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1
10
10
8
8
6
6
Dm
0
Investment
Demand
0
Quantity of money demanded and supplied
Amount of investment, i
Price level
AS
P1
AD1
Real domestic output, GDP
Copyright McGraw-Hill, Inc. 1999
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1
10
10
8
8
6
6
Dm
0
Investment
Demand
0
Quantity of money demanded and supplied
Amount of investment, i
Price level
AS
P1
AD1
Real domestic output, GDP
If the money supply
increases to
stimulate the
economy....
Copyright McGraw-Hill, Inc. 1999
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1 Sm2
10
10
8
8
6
6
Dm
0
Investment
Demand
0
Quantity of money demanded and supplied
Amount of investment, i
Price level
AS
P2
P1
AD1
AD2
Real domestic output, GDP
Copyright McGraw-Hill, Inc. 1999
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1 Sm2
10
10
8
8
6
6
Dm
0
Investment
Demand
0
Quantity of money demanded and supplied
Amount of investment, i
Price level
AS
P2
P1
If the money
supply increases
again....
AD1
AD2
Real domestic output, GDP
Copyright McGraw-Hill, Inc. 1999
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1 Sm2 Sm3
10
10
8
8
6
6
Dm
0
Investment
Demand
0
Quantity of money demanded and supplied
Amount of investment, i
Price level
AS
P3
P2
P1
AD1
AD2
Real domestic output, GDP
AD3
Copyright McGraw-Hill, Inc. 1999
Transmission Graphs
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1
8
R 10
i
R 8
6
6
10
Dm
0
Quantity of money demanded and supplied
MEI
Investment
Demand
0
Amount of planned
investment, I
Price level
AS
MEI – Marginal Efficiency of Investment
As interest falls more Investment becomes
Possible and Profitable!
P1
AD1
Real domestic output, GDP
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1
8
R 10
i
R 8
6
6
10
Dm
0
Quantity of money demanded and supplied
MEI
Investment
Demand
0
Amount of planned investment, I
Price level
AS
P1
AD1
Real domestic output, GDP
If the money supply
increases to
stimulate the
economy....
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1 Sm2
8
R 10
i
R 8
6
6
10
Dm
0
Quantity of money demanded and supplied
Price level
AS
P2
P1
AD1
AD2
Real domestic output, GDP
MEI
Investment
Demand
0
Amount of planned investment, I
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1 Sm2
8
R 10
i
R 8
6
6
10
Dm
0
Quantity of money demanded and supplied
MEI
Investment
Demand
0
Amount of planned investment, I
Price level
AS
P2
P1
If the money
supply increases
again....
AD1
AD2
Real domestic output, GDP
Real rate of interest, i
Monetary Policy and Equilibrium GDP
Sm1 Sm2 Sm3
8
R 10
i
R 8
6
6
10
Dm
0
0
Quantity of money demanded and supplied
Amount of planned investment, I
Price level
AS
P3
P2
P1
AD1
AD2
Real domestic output, GDP
MEI
Investment
Demand
AD3
Long Run Effects:
1. Increased planned investment
will lead to increased AS
2. i down = international $ down,
X up
3. Canceling effect: AD up, MD up,
i up, and I down, = AD down
4. Secondary effects – PL up, X down
Real rate of interest, i
Fiscal Policy and Equilibrium GDP
Sm1
Price level
10
AD1
AD2
Real domestic output, GDP
R 10
i
8
R
6
0
PI2
MEI
PI1
Amount of planned investment, I
8
6
0
Dm2
Dm1
Quantity of money demanded and supplied
Long Run Effects:
1. Decreased planned investment
will lead to decreased AS
2. i up = international $ up, X down
3. Canceling effect: I down, AD down,
MD down, and i down, = AD up,
4. Secondary effects – PL down = X up
MONETARY POLICY, REAL GDP
AND THE PRICE LEVEL
Effects of an easy money policy
Decrease i, Increase I, Increase AD, RGDP Increases
MONETARY POLICY, REAL GDP
AND THE PRICE LEVEL
Effects of an easy money policy
Effects of a tight money policy
Increase i, Decrease I, Decrease AD, Inflation declines
MONETARY POLICY, REAL GDP
AND THE PRICE LEVEL
Effects of an easy money policy
Effects of a tight money policy
Policy effectiveness
An increase in I will cause an increase in money demand.
That will offset the reduction in interest rates.
MONETARY POLICY, REAL GDP
AND THE PRICE LEVEL
Effects of an easy money policy
Effects of a tight money policy
Policy effectiveness
Monetary policy & aggregate supply
Where should monetary policy be employed?
Effectiveness of Monetary Policy
Effectiveness of Monetary Policy
Strengths of monetary policy
Effectiveness of Monetary Policy
Strengths of monetary policy
• Speed and flexibility
Effectiveness of Monetary Policy
Strengths of monetary policy
• Speed and flexibility
• Isolation from political pressure
Effectiveness of Monetary Policy
Strengths of monetary policy
• Speed and flexibility
• Isolation from political pressure
• Recent successes
Effectiveness of Monetary Policy
Strengths of monetary policy
• Speed and flexibility
• Isolation from political pressure
• Recent successes
Shortcomings and problems
Effectiveness of Monetary Policy
Strengths of monetary policy
• Speed and flexibility
• Isolation from political pressure
• Recent successes
Shortcomings and problems
• Less control?
Effectiveness of Monetary Policy
Strengths of monetary policy
• Speed and flexibility
• Isolation from political pressure
• Recent successes
Shortcomings and problems
• Less control?
• Cyclical asymmetry
Effectiveness of Monetary Policy
Strengths of monetary policy
• Speed and flexibility
• Isolation from political pressure
• Recent successes
Shortcomings and problems
• Less control?
• Cyclical asymmetry
• Changes in velocity of money
Effectiveness of Monetary Policy
Strengths of monetary policy
• Speed and flexibility
• Isolation from political pressure
• Recent successes
Shortcomings and problems
• Less control?
• Cyclical asymmetry
• Changes in velocity of money
• The investment impact
Effectiveness of Monetary Policy
Strengths of monetary policy
• Speed and flexibility
• Isolation from political pressure
• Recent successes
Shortcomings and problems
• Less control?
• Cyclical asymmetry
• Changes in velocity of money
• The investment impact
• Interest as income
Monetary Policy and the
International Economy
• Net export effect
Interest rates affect the demand for the $, increased i rates,
increased demand for $, $ appreciates, lower exports.
Monetary Policy and the
International Economy
• Net export effect
• Macro stability and
the trade balance
Monetary Policy and the
International Economy
• Net export effect
• Macro stability and
the trade balance
Discussion...
•
•
•
•
•
•
•
•
monetary policy
open-market committee
reserve ratio
discount rate
easy money policy
tight money policy
velocity of money
prime interest rate
Extending the Analysis
of Aggregate Supply
Next
Chapter 16