Download Unit 4 Notes1 - Phoenix Union High School District

• $9.2 T - The total amount of all bank deposits in the United States. The FDIC
has just 25 billion dollars in the deposit insurance fund that is supposed to
"guarantee" those deposits.
• $10 T - The total amount of mortgage debt in the United States.
• $10.4 T - The M2 money supply in the United States.
• $15 T - U.S. GDP. It is a measure of all economic activity in the United States
for a single year.
• $16 T - The size of the U.S. national debt.
• $32 T - The total amount of money that the global elite have stashed in
offshore banks .
• $50 T - The total amount of government debt in the world.
• $56 T - The total amount of debt (government, corporate, consumer, etc.) in
the U.S. financial system.
• $61 T - The combined total assets of the 50 largest banks in the world.
• $70 T - The approximate size of total world GDP.
• $190 T - The approximate size of the total amount of debt in the entire
world.
Unit 4 Notes
Money, Banking and
Monetary Policy
Money
 Money
is anything used to facilitate the
exchange of goods between buyers and
sellers.
 Financial assets are purchases made by
firms and households who expect to see a
rate of return:
 Stock – A claim of ownership of a firm.
 Bonds – A certificate of indebtedness
used by firms or government to raise
money.
Functions of Money
 Our
money is fiat money in that it has no intrinsic
value (gold) or value as a commodity.
 Our money serves 3 functions:
1. Medium of exchange – Allows us to exchange
our resources for goods.
2. Unit of Account – Measures the relative worth of
goods and services.
3. Store of value – Allows us to receive value for
our resources to be used at a later time.
Time Value of Money
 Money
loses value over time due to the
natural occurrence of inflation.
 If you gave out a $100 loan today, you
would want to receive your payment back
as soon as possible.
 Time value of money is the reason we
receive interest on savings and charge
interest on borrowing.
Present Value and Future Value
 Assume
you have lent $100 at 10% interest
for one year that has no inflation (for
simplicity).
 FV - Future Value, PV - Present Value
 FV = PV×(1+r) or FV = $100×(1.10) = $110
 PV = FV/(1+r) or PV = $110/(1.10) = $100
PV vs. FV
 Money
today is more valuable than the
same amount of money in the future.
 The present value of $1 received one year
from now is $1/(1+ r)
 The future value of $1 invested today is
$1×(1 + r)
Classwork: Money
Read
Pages 229 – 232
Answer Questions 1, 3, and 4 on
pages 242 – 243
Money
Market
Supply of Money
 Monetary
policy - The actions of the central bank,
that determines the size and rate of growth of the
money supply, which in turn affects interest rates.
 Stabilizing MS guarantees the value of money
which is measured by the US central bank as M1,
M2 and M3.
 The components of MS are defined by their
liquidity (how easily they can be converted to
cash:)
Components of MS
 M1
= cash + coins + checkable deposits
 M2 = M1 + savings deposits + small time deposits
(CDs) + money market deposits + Money market
mutual funds
 M3 = M2 + large (over $100,000) time deposits +
Institutional money market mutual funds
 At any given point MS is constant so the current
MS curve is vertical.
Demand for Money
 Transaction
Demand – As nominal GDP
increases, consumers demand more $ to buy
goods and services. As PL increases more $ is
demanded to pay for more expensive goods.
 Asset Demand – At higher i % for bonds,
people will invest more, and the D for $
decreases. At lower i % for bonds, people
invest less and asset Demand for money
increases.
 Total Demand: MD = Transaction Demand +
Asset Demand
The Money Market
 The
money market
compares the quantity of
money supplied and
demanded based on
nominal interest rates.
 If NIR is set below E, a
shortage occurs and the
NIR will rise. If NIR is set
above E, a surplus occurs
and the NIR will fall.
NIR
MS
i%
MD
Q$
Money
Money Market vs. Loanable
Funds Market
 The
S of loanable funds comes from national
savings. The S of the money market includes
currency and checking deposits.
 The D for loanable funds comes from Investment.
The D of the money market includes I, and also C,
and asset demand.
 The loanable funds market graphs the real i %, while
the money market uses the nominal i %
 Δ in the money market are short term, where
expected inflation is negligible. Δ to loanable funds
focus on long-term decisions so the real i % is used.
Changes to
MS
Increase in the MS





Original MS = $1000, Original
Bond Price = $100, Original
i % = 10%, Interest = $10
When the Fed increases MS
NIR
to $1500, a surplus of money
occurs.
With this money people buy
assets, like bonds and the D
for those assets h,
10 %
increasing the P of bonds.
8%
New MS = $1500, New Bond
Price = $125, New i % = 8%,
Interest = $10
Increasing MS decreases i %
MS
MS1
MD
$1000 $1500
Q$
Decreasing the MS
 Fed
decreases MS from
$1000 to $500 leaving a
shortage of money.
Bondholders sell their
bonds, causing a
decrease in D and price
for bonds.
 The decrease in P to $90
with the same interest
amount - $10, brings the
i % up to 11.1%. Higher i
% causes MD to fall until
the i % rises to the point
of Q$ = $500
NIR
MS1
MS
11.1 %
10 %
MD
$500 $1000
Q$
Decreasing the MS
 Fed
decreases MS from
$1000 to $500 leaving a
shortage of money.
Bondholders sell their bonds,
NIR
causing a decrease in D
and price for bonds.
11.1 %
 The decrease in P to $90
with the same interest
amount - $10, brings the i % 10 %
up to 11.1%. Higher i %
causes MD to fall until the i %
rises to the point of Q$ =
$500
MS
MS
MD
$500 $1000
Q$
Fractional
Reserve
Banking &
Money
Creation
Fractional Reserve Banking
 When
people deposit money into a bank only
a fraction is reserved by the banks for
withdrawals.
 Very little of the $7 Trillion in savings is ever
withdrawn by savers.
 Banks loan out most of that money and give
some of the interest from those loans to savers.
 The fraction of deposits kept on reserve is
called the reserve ratio.
Money Creation
 Assume

the reserve ratio is 10%
Reserve ratio (rr) = required reserves/total deposits = .10
 To
see how loans turn into new money create a TAccount or balance sheet.
 Total assets must always equal total liabilities
 Asset – Anything owned by the bank or owed to
the bank. Cash on reserve and loans to citizens are
assets
 Liability – Anything owned by depositors or lenders
to the bank. Checking deposits of citizens or loans
to the bank.
Jen deposits $1000 in Chase Bank.
Assets
Liabilities
Required Reserves $100 Checking Deposits $1000
Excess Reserves $900
Total Assets $1000
Total Liabilities $1000
Chase Bank lends out the $900 in
excess reserves to Bob the farmer.
Assets
Liabilities
Required Reserves $100 Checking Deposits $1000
Excess Reserves $0
Loans $900
Total Assets $1000
Total Liabilities $1000
Bob uses the $900 at Tractor Supply, which has an
account at Chase. Chase must keep $90 and $810
become excess reserves.
Assets
Liabilities
Required Reserves $190 Checking Deposits $1900
Excess Reserves $810
Loans $900
Total Assets $1900
Total Liabilities $1900
Chase makes an $810 loan to Bill who buys a couch from
Couch World, who also has an account with Chase. The
$810 goes back to Chase who must keep $81.
Assets
Liabilities
Required Reserves $271 Checking Deposits $2710
Excess Reserves $729
Loans $1710
Total Assets $2710
Total Liabilities $2710
Danskin Rules!
The Money Multiplier
 An
initial deposit of $1000 creates, after only two
loans are made, $2710 of checking deposits.
 This process continues until there are no more
excess reserves, when $10,000 will have been
created.
 This process is known as the money multiplier
which is identical to the spending multiplier from
Unit 3
 M = 1/(reserve ratio) = 1/rr (=1/.10 = 10 in our
example)
 This process works in reverse when withdrawals
are made (money destruction)
Tools of
Monetary
Policy
Fed’s Actions
 Expansionary
Policy – When unemployment
and declining GDP is a problem, the Fed buys
bonds, ↓ the discount rate, or ↓ the reserve
requirement which ↑ MS.
 Contractionary policy – When inflation is a
problem, the Fed sells bonds, ↑ the discount
rate, or ↑ the reserve requirement which ↓ MS.
Open Market Operations
 Through
the FOMC, the Fed buys and sells US
bonds on the open market. Of the three tools,
OMO is used the most because it causes the
least disruption to the markets.
 Buying securities – Commercial banks hold
Treasury bonds rather than excess cash reserves.
If the Fed buys those securities, the banks would
receive excess cash, which they would then
loan out, creating money and causing interest
rates to fall.
 Selling
securities – If the Fed sells bonds
to commercial banks, excess reserves
would fall. Money destruction begins,
MS declines and interest rates rise.
 Buying Bonds = Bigger Bucks
 Selling Bonds = Smaller Bucks
Discount Rate
 The
discount rate is the i % the Fed charges banks
for short term loans.
 Lowering the discount rate (or FFR) increases
excess reserves in commercial banks and expands
the MS.
 Raising the discount rate (or FFR) decreases excess
reserves in commercial banks and shrinks the MS.
Required Reserve Ratio
 Lowering
the rrr increases MS
 Increasing the rrr decreases MS
Problem:
Unemployment
Problem:
High Inflation
Monetary tool could
be…
Buy bonds in an OMO Sell bonds in an OMO
Or…
↓ the discount rate
↑ the discount rate
Or…
↓ the reserve
requirement
↑ the reserve
requirement
Possible effect would
be…
↑MS, ↓i %, ↑I, ↑AD,
↑ real GDP,
↓ unemployment
↓MS, ↑ i %, ↓I, ↓AD,
↓ real GDP,
↓ price level
Federal Funds Rate
 FFR
– The interest rate that banks charge for short
term loans.
 The FFR is set as a target rate and the FOMC then
proceeds to engage in OMOs to hit that target
rate.
 The analysis of monetary policy is the same
whether talking about Δ to MS or the FFR
Monetary Policy
 Read
pages 261-267
 Answer questions 4, 6, and 8 on page 281
Monetary
Policy, Real
GDP and Price
Level
Expansionary
Policy
When the Federal Reserve
encourages banks to
make loans, the MS will
increase, lowering interest
rates.
 As interest rates decrease,
businesses will be more
likely to increase I. As I
increases so too does AD.
 As AD and Real GDP
increases, unemployment
decreases.
NIR
MS
MS1

5%
4%
MD
Q$
PL
LRAS
AD
SRAS
AD1
Real GDP
Contractionary
Policy
NIR
When the Fed discourages
banks from making loans, 6 %
the MS will decrease,
5%
raising interest rates.
 As interest rates increase,
businesses will be more
PL
likely to decrease I. As I
decreases so too does AD.
 As AD and Price Level
decreases, inflation
decreases.
MS1 MS

MD
Q$
LRAS
SRAS
AD
AD1
Real GDP
The Federal Reserve & Monetary Policy
 Structure
of The Federal Reserve (pg. 235)
 Makeup of the FOMC (pg. 236)
 Purpose of the FOMC (236)
 7 Fed Functions and the Money Supply (237)

(Provide explanations when necessary)
 Reasons
the Fed is Independent of Govt. (238)
 Reasons for Using Expansionary Monetary Policy
and Its Effects (268)
 Reasons for Using Restrictive/Contractionary
Monetary Policy and Its Effects (268)
Quantity Theory
of Money
Monetary Policy and Real GDP
 The
link between monetary policy and real
GDP is the relationship between changes in MS,
i %, and the level of private investment.
 IF MS ↑, and there is no ↑ in I, expansionary
monetary policy would have no effect on real
GDP and unemployment.
 Some economists, called monetarists, have
become proponents of the quantity theory of
money.
Quantity Theory of Money
 This
theory states that increasing MS has no
effect on real GDP, but only serves to increase
the price level
 This theory uses the equation of exchange:
 MV = PQ
 V = PQ/M
 GDP = (P × Q)
 Quantity of money = M
 Velocity
= V = the number of times each dollar
is spent in a year.
 If in a given year the money supply is $100 and
nominal GDP is $1000, then each dollar must
be spent 10 times; V = 10
 If the money supply (M) increases, this must be
reflected in the other 3 variables.



Velocity must fall
Price level must rise
Output must increase
 Historically
velocity has remained stable and
constant
 Many economists believe that output is a
function of technology and supply of
resources
 Therefore, the increase in M will only lead to
an increase in price level (P) – inflation
 The quantity theory of money ignores the
effects of MS on AD, which is why it is
controversial.