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Unit-4 Macro Review Money, Money Supply, Bank Accounting, & Fiscal and Monetary Policy Fed vs. Government • The Federal Reserve creates money – By buying bonds in open market operations – Too much money can lead to inflation • The Government creates debt – By borrowing money for deficit spending – Too much debt can lead to crowding out Money Market = Fed Loanable Funds = Gov’t Real Interest Rate -------------- ------------- R1 S1 Q1 E1 D1 Qty Loanable Funds Money Market Loanable Funds Real Interest Rate -------------- ------------- R1 S1 Q1 Private + Public Savings E1 D1 Qty Loanable Funds Use for Gov’t Debt questions Illustrates Fed’s Monetary Policy Supply of Money is fixed by Fed Fed buys/sell bonds to shift MS which changes short term interest rates (federal funds rate) Model of National Savings & Private Investment => (I) in GDP Supply = National Savings Demand = Investment (borrow $) • The Fed has 3-tools to implement monetary policy: 2 Types of Monetary Policy Expansionary Contractionary Contractionary Policy Nominal Interest Rate – reserve requirement – discount rate – open-market operations (currently 10.0%) (currently Currently6.25%) 0.75% Currently5.25% 0.0%target) target (currently => Sell Bonds, ↑ discount rate & ↑ reserve requirement MS2 MS1 LRAS1 Price Level SRAS1 Affects AD -----------------P2 -------------- -------------- P1 i2 ----------i1 --------------MD Qty of $ Y* MS ↓ => ↑ interest rate => C↓ & I ↓ => AD ↓ E1 Y1 AD2 Real GDP AD1 MONEY Types of Money Commodity money Fiat money 3 Functions of Money • Medium of exchange (Std. of value) • Unit of account • Store of value Measuring Money Supply M1 - most liquid M2 - slightly less liquid M3 = least liquid (cash, checking deposits, travelers checks, etc…) (M1 + savings acct., money markets,…) (M2 + large time deposits (over $100,000) ) Fractional Reserve Banking System Banks Create Money by lending Example: – $100 Deposit – 10% Reserve Ratio 1st Bank Balance Sheet Assets Required Reserves $10 Excess Loans Reserves $90 Total Assets $100 Liabilities Deposits This loan causes money creation $100 . First National Bank Total Liabilities $100 Assets Reserves $10.00 Liabilities Deposits $100.00 Loans Excess Reserves can Second National Bank Assets Reserves $9.00 Liabilities Deposits $90.00 Loans $90.00 $81.00 be lent out by bank Total Assets Total Liabilities $100.00 $100.00 Total Assets $90.00 Total Liabilities $90.00 Money Multiplier = 1/R First National Bank Assets Reserves $10.00 Liabilities Deposits $100.00 Loans Second National Bank Assets Reserves $9.00 Liabilities Deposits $90.00 Reserve Requirement = 10% Money Multiplier = 1/10% = 10 Loans $90.00 Total Assets Total Liabilities $100.00 $100.00 $81.00 Total Assets $90.00 Total Liabilities $90.00 Money Supply Change = Money Multiplier X Initial Excess Reserves $90 * 10 = $900 increase Money Supply Quantity Theory of Money Monetarists economists believe that money is neutral! That is changes in Money Supply (MS) have affect on real GDP in long run Qty Theory of Money Equation MV = PQ where: V = velocity P = the price level Q = real GDP M = the quantity of money Velocity of money is relatively constant Real GDP is fixed in short run ↑ MS only will ↑Price Level CROWDING OUT Loanable Funds S2 Real Interest Rate 1) Government Borrowing reduces Supply of Loanable Funds -------------- ------------- R1 S1 Q1 2) Real Interest Rates rise E1 3) Private Investor is “crowded out” of debt market D1 Qty Loanable Funds Review • Practice Questions • Practice Free Response 1 D 14 A 2 B 15 D 3 D 16 D 4 E 17 A 5 D 18 D 6 B 19 B 7 C 20 E 8 B 9 D 10 D 11 A 12 C 13 E
