Download Section 5 REVIEW Saving-Investment Identity (Remember: One

Section 5
REVIEW
Saving-Investment Identity
(Remember: One persons spending is another person’s income)
Closed Economy = no government & no interaction with other countries.

Total income = Total spending
People have two chooses: Spend or Save

Total income = Consumer spending + Savings
Spending consists of either: consumer spending or investment spending

Total spending = Consumer spending + Investment spending
Putting these together:

Consumer spending + Savings = Consumer spending + Investment spending
Subtract consumer spending from both sides:

Savings = Investment spending
(*Taxes is a component of spending)
Functions of Money
Medium of Exchange: a asset that individuals acquire for the purpose of trading for goods and
services rather than for their own consumption
 Your employer exchanges dollars for an hour of your labor.
 You exchange those dollars for a grocer’s pound of apples.
Unit of Account: a measure used to set prices and make economic calculations Units of currency
(dollars, euro, yen, etc.) measure the relative worth of goods and services
 The value of a pound of cheese in a barter economy is measured in dozen eggs, or a half
pound of sausage, etc.
Store of Value – an asset that is a means of holding purchasing power
 So long as prices are not rapidly increasing, money is a decent way to store value.
T-Accounts
Asset – Anything owned by the bank or owed to the bank (Cash on reserve and loans made to
citizens)
Liability – Anything owned by depositors and lenders to the bank. (Checking deposits of citizens or
loans made to the bank)
Reserve Ratio (rr) = cash reserves/total deposits
Money Multiplier = 1/rr
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Chart all the following examples:
Situation 1: Katie takes $1,000 from under her mattress, deposits it at ECB, and opens a checking
account. ECB must put 10% in required reserves, but the remaining amount are excess
reserves and can be either kept on reserve or lent.
Balance Sheet EGB (Situation 1)
ASSETS
LIABILITIES
Required Reserves
$ 100
Checking Deposits
$ 1,000
Excess Reserves
$ 900
Total Assets
$ 1,000
Total Liabilities
$ 1,000
Situation 2: ECB lends out all of the above “Excess Reserves” to Bob, a local farmer.
Balance Sheet EGB (Situation 2)
ASSETS
LIABILITIES
Required Reserves
$ 100
Checking Deposits
$ 1,000
Excess Reserves
$
0
Loans
$ 900
Total Assets
$ 1,000
Total Liabilities
$ 1,000
Situation 3: Bob uses his money at the Tractor Supply store, which has a checking account with ECB.
The Tractor Supply Store deposits all the money into ECB where they bank
Balance Sheet EGB (Situation 3)
ASSETS
LIABILITIES
Required Reserves
$ 190
Checking Deposits
$ 1,900
Excess Reserves
$ 810
Loans
$ 900
Total Assets
$ 1,900
Total Liabilities
$ 1,900
Situation 4: ECB takes the entire excess reserves from Situation 3 and makes a loan to Brent, who is
looking to buy some furniture. Brent spends the entire amount at Furniture Factory,
which also banks with ECB, increasing checking deposits by the entire amount.
Balance Sheet EGB (Situation 4)
ASSETS
LIABILITIES
Required Reserves
$ 271
Checking Deposits
$ 2,710
Excess Reserves
$ 729
Loans
$ 1,710
Total Assets
$ 2,710
Total Liabilities
$ 2,710
Supply of Money
M1 = cash + coins + checking deposits + traveler’s checks
M2 = M1 + savings deposits + small time deposits (CD ‘s --under $100,000) + money market deposits
+ money market mutual funds
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M3 = M2 + large time deposits (CD’s -- over $100,000)
Example 1: What happens when a waitress deposits her cash tips into her savings account?
M1 decreases (Cash is already a category of M2 & M3. So, only M1 is affected, the
money was taken from M1 and shifted into M2.)
Example 2: Suppose you find a $50 bill you put in a coat pocket last winter. What effect will it have
on the M’s, if you deposit it in your checking account?
There is no change to any of the M’s. (Cash was already calculated into M1, so it
was just transferred from one category of M1 to another category of M1.)
Defining Present Value
•
Let FV = future value of $
PV = present value of $
r = real interest rate
n = # of years
•
The Simple Interest Formula
FV = PV( 1 + r )n
PV = FV / (1 + r)n
Example: You are going to lend your friend $100 at 10 percent interest.
Calculate what the repayment would be for one year:
$100 + $100*.10 = $100*(1+.10)
What if you were going to lend your friend the money for two years?
$100(1.10)*(1.10) = $121
If I put my $10,000 in an alternative investment earning 8%:
FV = 10,000*(1.08)10 = $21,589.25
What is the $20,000 in 10 years worth today?
PV = 20,000/(1.08)10 = $9263.87
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What would you have to invest in order to make $20,000 at the listed year at each rate of interest?
PV = FV/(1+r)ᶰ (round to the nearest penny)
Interest
(r)
Years
10
20
30
40
5
$ 12,278.27
$ 7,537.79
$ 8,643.85
$ 2,840.91
8
$ 9,263.87
$ 4,290.96
$ 1,987.55
$ 920.62
10
$ 7,710.87
$ 2,972.87
$ 1,146.17
$ 441.90
If I invested $20,000 at each rate of interest, what would it be worth in each year?
FV = PV*(1+r)ᶰ (round to the nearest penny)
Interest
(r)
Years
1
2
3
4
5
$ 21,000
$ 22,050
$ 23,152.50
$ 24,310.13
10
$ 22,000
$ 24,200
$ 26,620
$ 29,282
15
$ 23,000
$ 26,450
$ 30,417.50
$ 34,980.13
Expansionary Monetary Policy
 Designed to fix a recession and increase AD, lower the unemployment rate and increase real
GDP.
o By increasing the money supply, the interest rate is ↓ (Money Market model)
o A lower rate of interest ↑both private C & I
o Shifts AD (R) (AD-AS model)
MS
MS1
LRAS
r
PL
SRAS
r
p1
p
r1
AD1
MD
M*
M1
AD
Money
Y*
4
Y1
Real GDP
Contractionary Monetary Policy
 Opposite effect of expansionary
 Designed to avoid inflation by decreasing AD, which lowers the PL and decreases GDP back
to full employment level
o By decreasing the money supply, the interest rate ↑(Money Market model)
o A higher rate of interest ↓ private C & I
o Shifts AD (L) (AD-AS model)
MS1
MS
LRAS
r
PL
r1
SRAS
p
p1
r
AD
MD
M1
Monetary tool could
be…
Or…
Or…Effect would
be…
Effect would be….
M*
AD1
Money
Y1
Problem:
High Unemployment
Problem:
High Inflation
Buy bonds in an OMO
Sell bonds in an OMO
Lower the discount rate
Raise the discount rate
Lower the reserve ratio
↑MS, ↓r%, ↑I,
↑AD(R), ↑GDPr,
↓unemp
Raise the reserve ratio
↓MS, ↑r%, ↓I, ↓AD (L),
↓GDPr, ↓PL
Y*
Real GDP
* Deep recessionary gap → expansionary monetary policy could be used to assist expansionary fiscal
policy to quickly move to full employment. RISK = a burst of inflation
* Mild recessionary gap → contractionary monetary policy could be used to offset expansionary fiscal
policy to gradually move to full employment. RISK = rising interest rates
* Inflationary gap → contractionary monetary policy could be used to assist contractionary fiscal policy
to put downward pressure on the PL. RISK = rising unemployment rate
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The Problem
Deep
recessionary
gap and high
unemployment
Mild
recessionary
gap and
moderate
unemployment
Inflationary
gap
Fiscal Policy
Solution
Tax cuts and
increased
spending to
rapidly
increase AD
and real GDP
Tax cuts or
increased
spending to
gradually
increase AD
and real GDP
Tax hikes
and/or
decreased
spending to
rapidly
decrease AD
and real GDP
Budget
Impact
Potential
Consequence
Higher interest
rates, crowding
out private
investment,
lower net
exports and even
weaker AD
Large
Deficit
Moderate
Deficit
Rising prices.
Mild crowding
out and lower
net exports,
weakening AD
Lower interest
rates "crowding
in"{ private
investment,
higher net
exports and even
stronger AD
Surplus
Monetary
Policy
Complement
expand MS
to keep
interest
rates from
rising,
Increases AD
to assist
fiscal policy.
Contract MS
to keep
inflation
from rising.
Decreases
AD,
offsetting
fiscal policy.
contract MS
to keep
interest
rates from
falling.
Decreases
AD to assist
fiscal policy.
Keep An
Eye On…
Higher
Inflation
Rising
Interest
Rates
Higher
Unemployment
Practice Graphing:
1. The following figure illustrates the relationship between the nominal quantity of money, M, and
the interest rate, r.
Interest
rate
MD
Nominal quantity
of Money
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For each of the following situations, use the previous graph for reference.
a. Holding everything else constant, the interest rate increases from r1 to r2. Graph this in the
following figure.
Interest
rate
r1
r
MD
M1
M
Nominal quantity
of Money
b. Holding everything else constant, the level of aggregate real income decreases. Graph this in
the following figure.
Interest
rate
MD1
MD
Nominal quantity
of Money
(As the level of aggregate real income decreases, this causes the money demand to curve to
shift (L) as individuals demand less money at every interest rate.
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c. Holding everything else constant, there is an increase in the aggregate price level. Graph this in
the following figure.
Interest
rate
MD
MD1
Nominal quantity
of Money
(An increase in the aggregate price level causes the money demand curve to shift (R), as
individuals demand more money at every interest rate to facilitate making their transactions
at the new higher price levels. )
d. Holding everything else constant, individuals in a community are now able to use Internet
banking for their money and financial assets accounts. Graph this in the following figure.
Interest
rate
MD1
MD
Nominal quantity
of Money
(With new technology for managing money and financial assets, people will decrease their
demand for money at every interest rate. This will cause money demand to shift (L).)
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2. Use the following figure of the nominal money demand and money supply curves to answer this
question. Assume this market is initially in equilibrium with the nominal quantity of money
equal to “M” and the interest rate equal to “r”.
Interest
rate
MS
r
MD
M
Nominal quantity
of Money
a. Suppose the FOMC engages in an open-market purchase of Treasury bills. Holding everything
else constant, what happens to the equilibrium quantity of money and the equilibrium interest
rate? Sketch a graph illustrating these changes.
Interest
rate
MS
MS1
r
r1
MD
M
M1
Nominal quantity
of Money
When the Fed increases the MS through an OMO purchase of T-bills, this shifts the MS (R) to
MS1 Resulting in… ↓r to r1 ↑M to M1
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b. Suppose the FOMC engages in an open-market sale of Treasury bills. Holding everything else
constant, what happens to the equilibrium quantity of money and the equilibrium interest rate?
Sketch a graph illustrating these changes.
Interest
MS1 MS
rate
r1
r
MD
M1
M
Nominal quantity
of Money
When the FOMC decreases the money supply through an OMO sale of T-bills, the MS shifts (L)
from M to M1 Resulting in…. ↑r to r1
↓ M to M1
c. Suppose the aggregate price level increases. Holding everything else constant, what happens to
the equilibrium quantity of money and the equilibrium interest rate? Sketch a graph illustrating
these changes.
Interest
rate
MS
r1
r
MD1
MD
M
Nominal quantity
of Money
An increase in the aggregate PL shifts the MD (R) from MD to MD1.
Results = ↑r to r1 MS (-) unchanged
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3. Use the AS-AD model to answer the following questions.
(I) Scenario 1: The economy of Macroland is initially in long-run equilibrium. Then the FOMC of
Macroland decides to reduce interest rates through an open-market operation. (Expansionary
Policy)
a. Draw a graph representing the initial situation in Macroland. In your graph, be sure to
include the short-run aggregate supply curve (SRAS), the long-run aggregate supply
curve (LRAS), and the aggregate demand curve (AD), on your graph mark the
equilibrium aggregate price level and the aggregate output level as well as potential
output.
PL
LRAS
SRAS
p
AD
Y
Real GDP
b. Draw a graph of the money market showing its initial situation before the FOMC of
Macroland engages in monetary policy and showing as well as the effect of the FOMC’s
monetary policy actions. Be sure to indicate the initial equilibrium as well as the
equilibrium after the monetary policy.
Interest
rate
MS
MS1
r
r1
MD
M
M1
Nominal quantity
of Money
11
c. How well does this monetary policy action affect the aggregate economy in the short
run? Explain your answer verbally while also including a graph of the AS-AD model to
illustrate your answer
PL
LRAS
SRAS
p1
p
AD1
AD
Y
Y1
Real GDP
When the FOMC reduces interest rates through an OMO by purchasing T-bills it results
in…. ↑in AD (R) shift to AD1 In the Short-Run = Output ↑ from Y to Y1 PL to ↑
from p to p1 (unemployment to ↓)
d. Illustrate and explain how this monetary policy action affect the aggregate economy in
the long run?
PL
LRAS
SRAS1
SRAS
P2
p1
p
AD1
AD
Y
Y1
Real GDP
Long Run: Economy must return to LRAS – adjusting the economy
SRAS shifts (L) to SRAS1 as nominal wages rise --- eliminates the inflationary gap &
restores the economy to its potential output level
Result = ↑PL to p2
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(II) Scenario 2: Econoland is currently operating with a recessionary gap.
e. Draw a graph representing Econoland’s economic situation using AS-AD model. Be sure
to indicate in your graph: SRAS, LRAS, AD, the short-run equilibrium aggregate PL (p1)
the short-run equilibrium aggregate output level (Y1), and the potential output level (YE).
PL
LRAS
SRAS
p
AD
Y1 Y
f.
Real GDP
Illustrate and explain what monetary policy you would suggest the FOMC of Econoland
pursue if its only goal is to restore production in Econoland to the potential output level.
PL
LRAS
SRAS
P1
p
AD1
AD
Y1 Y
Real GDP
If the FOMC expands the money supply through OMO purchases ↓r and stimulates
spending: AD shifts (R) to AD1 Real GDP ↑ to Y
PL ↑ to p1
13
g. Is there a potential drawback to the implementation of this particular monetary policy?
Explain.
If the FOMC engages in activist monetary policy, this will cause the aggregate PL to ↑.
Alternatively, policymakers could do nothing and wait for the SRAS to shift (R) as
nominal wages fall. In the Long-run, aggregate output would return to Y, and the PL
would fall below the initial level of p.
PL
LRAS
SRAS
SRAS1
P1
p
P2
AD1
AD
Y1 Y
Real GDP
(III) Scenario 3: Upland is currently operating with an inflationary gap.
h. Draw a graph representing Upland’s economic situation using an AS-AD model. Be sure
to indicate in your graph SRAS, LRAS, AD, the short-run equilibrium aggregate price level
(P1), the short0run equilibrium aggregate output level (Y1), and the potential output
level (YE).
PL
LRAS
SRAS
p
AD
Y
Y1
Real GDP
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i.
What monetary policy would you suggest the FOMC of Upland pursue if its only goal is
to restore production in Upland to the potential output level? Explain how this
monetary policy would achieve this goal.
The FOMC should ↓ money supply = ↑r through OMO sales of T-bills. Causing AD
shift (L) ; restoring the economy to potential output level at a ↓PL than p
j.
Is there a potential drawback to the implementation of this particular monetary policy?
Explain your answer.
No, this policy restores the economy to its long-run position without raising the PL
4. Suppose that when the FOMC reduces the interest rate by 1 percentage point it increases the
level of investment spending by $500 million in Macroland. If the marginal propensity to save
equals .25, what will be the total rise in real GDP, assuming the aggregate price level is held
constant? Explain your answer.
Causes real GDP to increase due to the multiplier process 1/(1-MPC) or 1/MPS
1/.25 = 4
4 x $500 million = $2 billion
15