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Session 4: Multipliers, Money and Banking (1) • I. The Multiplier Model – The Basic Model • Woodsheds and Carpenters – The Basic Graphs and Approaches • Approach 1 and 2. • Impact of Higher “G” – Numerical Presentation – Tax Effect does not equal “G” Effect – Multipliers in Actions • Past Estimates • Defense Spending – Keynesian Model and AS-AD Paradigm – Some Take-Away Points Session 4: Multipliers, Money and Banking (2) • II. Money, Interest rates, and Commercial Banking – Functions of Money – Its Evolution (Barter, Commodity and Modern money) – Interest rates • What are they? • Time value of money • Array of rates (real vs. nominal) – Commercial Banking • The Goldsmiths – Chain repercussions – Modern Fractional-Reserve Banking – Final system equilibrium • The Money-Supply multiplier – Two Qualifications » Money stays at home and doesn’t go to banks » Bank holds excess reserves The Basic Model (in a “Simple” Economy World) • Q = C + I on output side (I is injection); • Q = C + S on consumption side (S is leakage). • We know that: C = a +b*(DI) or DI = Q • • • • • So: Q = a + b*Q + I, or Q(1-b) = a + I, or Q = 1/(1-b) * (a + I), or ∆ Q = 1/(1-b) * ∆ a === ∆ Q/∆ a = 1/(1-b) ∆ Q = 1/(1-b) * ∆ I === ∆ Q/∆ I = 1/(1-b) The Basic Graphs and Approaches Approach 1: GDP Determined by Intersection of Saving and Investment Schedules Approach 2: GDP Determined by TE = 45% Line Detail on the Output Multiplier The Effect of Higher G on Output Government Purchases Add On Just like Investment to Determine Equilibrium GDP Taxes Reduce Disposable Income and Shift CC Schedule to the Right and Down Expenditure Multipliers in Macroeconomic Models Keynesian Model and the AS-AD Approach Some Take-Away Points • Ideal Conditions for Multipliers – Must have unemployed or slack resources – Prices and wages are fixed in the short run – Differences in planned (or forecast) and actual is really important – Investment is exogenous (at this time) • If conditions hold, multipliers can give some insights into SR determination of how output will be determined II. Money, Interest Rates and Commercial Banking • Money • Its’ Functions, Evolution, Barter, Commodity and Modern money • Components of the Money Supply – Transaction Money – Broad Money • Interest rates • • • • What are they? Time Value of Money An array of rates Real versus Nominal • Commercial Banking • The Goldsmiths – Chain repercussions – Modern Fractional-Reserve Banking – Final system equilibrium • The Money-Supply multiplier – Two Qualifications » Money stays at home and doesn’t go to banks » Bank holds excess reserves Money • Money is “what money does”. – Money is any stock of items with widespread acceptability for the purpose of payment. – Functions: • Medium of exchange • Store of value • Measure of value – Main sources of Demand for Money • Transaction demand • Asset demand Transaction instruments, examples and some problems. Barter Actual commodities Double coincidence of wants Commodity Money Gold, silver, fullbodied monies Backed by intrinsic value Modern Money Fiat money, paper, fiduciary notes, bank notes Inflation/ Deflation Money is, what money does. Item Medium of Exchange Store of Value Unit of Account Transaction Cost Wampum, shells Yes Varies Yes Little Cigarettes in WWII POW camp Yes Varies Yes Little Large stationary object Yes Varies Yes Little Cattle, oil Yes No Yes Feed cost Commodity money Yes ~ ~ Inflation Fiat $ Gov’t strong? Yes Yes Opportunity of earning interest Casino chips Within casino. Yes Yes Exchange Conversion Yes Yes Yes Check costs/ processing For some commodities Yes Yes Depends on commodity group. Yes Yes Yes Risk from rate movements Defers payment No No Cost to user and seller Checks and bank notes Food stamps Foreign currency Credit cards Interest Rates • Especially with transaction demand, if you don’t have money, many may be willing to “rent” money at a cost. – To buy non-durables (consume this period) and durables (consumer while you are paying back). • The cost of money is the interest rate, that is the cost of borrowing, measured in $/yr/$ borrowed The rate of interest charged depends on: • Length of term (time) – Lenders are willing to give up their money to people for longer periods of time only if they can charge more. • Risk level (risk premium) – Lenders must cover the probability of possible default • Liquidity – Lenders perceive more risk and inability to quickly extract borrowers’ investment with illiquid assets • Administrative costs – Lenders with increased administrative and service costs must charge a higher interest rate. Banking and the Supply of Money • Banking as a business – How Banks developed – the Goldsmith Story – Modern Fractional-Reserve Banking – Legal Reserve requirement • The Process of Deposit Creation – – – – First-generation banks Chain repercussions Final system equilibrium Two qualifications and the Money Multiplier Some myths on what banks do. • Banks store $$ that customers deposit. • Banks lend or invest most $$ deposited. • Banks are government agencies. • Banks are businesses. • Banks aren’t concerned about/with people. • Banks serve customers or they fail. • You can not buy $$. • Most people rent $$ by paying interest. The Goldsmiths • Goldsmiths or gold holders held gold for people, gave them certificates to transact business. • In effect, they created money as long as: – Depositors would accept someone else’s gold. – Some people were coming in with gold as some gold was going out. – Some “static” amount of gold was always in the till. • Found out that they could lend out or give out a deposit slip and charge “interest” Two Qualifications of Money-Supply Multipliers • Leakage in hand-to-hand circulation • Possible excess reserves held by banks • Both actions would not allow all $$$ to be spent and create the desired circular impacts. Formula for the Session 4: Derivation of Output Multipliers • • • • • • • Using the Definition of GDP: (1) GDP = C + I from the Product Side We know that: C = a + b GDP, then insert in (1) (2) GDP = a + b*GDP + I, then GDP*(1-b) = a + I or GDP = (1/(1-b)) * (a + I), or ▲GDP = (1/(1-MPC)) * ▲a or ▲I.