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AP Macroeconomics Unit 4 Unit 4 Lesson 1 Money hw: read ch 16 I. Money 3 Functions of Money: Medium of exchange: use it to buy stuff Unit of measure: use it to measure worth Store of value: use it to hold value I. Money Money in Early Societies: Barter requires double coincidence of wants. Compressed tea leaves & gold schillings are commodity money. Fiat money is made valuable by gov’t decree. I. Money Characteristics of: Portable Durable Divisible Limited Supply (to retain value) Some islanders in Micronesia used these carved stones called “Vai” as currency . Morton I. Money A monetary standard is a system that makes sure currency has the characteristics of money. The Constitution gave the federal gov’t the power to coin money, not the states. But, private banks could issue paper money (bank notes). This resulted in counterfeiting problems. Remember 4 Char. Of $: -Portable -Durable -Divisible -Limited Supply I. Money The Inconvertible Fiat Money Standard Since 1934. Money supply is managed by gov’t. Tangible component: coins/bills Intangible component: checks/bank accounts. I. Money Measures of the Money Supply: M1: Currency + Checkable Deposits Checkable deposits make up +/- 70% of M1 M2: M1 + Savings Deposits + Small Time Deposits + Money Market Mutual Funds + Money Mkt Deposit Accounts M3: M1 + M2 + large time deposits (>$100k) I. Money The velocity of money (V) is the number of times in a year that a typical dollar bill is used to pay for a new good/service. V = (PY)/M, Note** V=GDP/M so, MV = PY This quantity equation relates the quantity of money (M) to the value of output (PY). Usually, velocity is relatively stable. I. Money MV = money spent PQ = money received by sellers I. Money The Federal Reserve System Nation’s central bank. Lends $ to private banks. Is set up like a corporation, but banks are stockholders. Privately owned, but publicly controlled. The president appoints board of governors. I. Money FDIC Federal Deposit Insurance Corporation Insures customer deposits in event of bank failure. Coverage has historically been $100,000 per account type, per owner. I. Money Other Financial Institutions Savings & Loan Association – invests majority of its funds in home mortgages. Credit Union – nonprofit cooperative, owned by & operated for the benefit of its members. II. Financial Assets & Balance Sheets/ T-Accounts Assets are claims on a borrower. Liabilities are obligations/ things borrowed One entity’s asset is another entity’s liability. Balance sheets, or T-Accounts must balance. II. Financial Assets & Balance Sheets/ T-Accounts Banks assets include accounts at the Federal Reserve District Bank Treasury securities owned by the bank loans to customers Liabilities are deposits Net Worth=assets minus liabilities II. Financial Assets & Balance Sheets/ T-Accounts Let’s start a bank. We will sell $250k in stock. How should this be entered in our T-Account? II. Financial Assets & Balance Sheets/ T-Accounts Now, we need a building. We decide to build a $220k building and buy $20k in equipment. What does our balance sheet look like now? II. Financial Assets & Balance Sheets/ T-Accounts For simplicity’s sake, ignore our last balance sheet. We’ll go back to having $250k cash assets & $250k stock liability. Let’s start taking deposits. We take in $100k in deposits. Implications for M1? What should we do with this money? II. Financial Assets & Balance Sheets/ T-Accounts Reserves = money in the vault + money deposited at the Fed Required reserves = dollar amount banks must have in vault cash & Fed account. Reserve ratio = % of deposits banks are required to hold in reserve. Excess reserves = actual reserves - required reserves II. Financial Assets & Balance Sheets/ T-Accounts Clearing a check. One of our customers writes a check for $50,000 to someone. II. Financial Assets & Balance Sheets/ T-Accounts Let’s make some loans. This is a Fractional Reserve Banking System b/c reserves < deposits. The Fed currently mandates a reserve ratio of 10%, so we can loan out… ...90% of our reserves. We decide to loan someone $50k. II. Financial Assets & Balance Sheets/ T-Accounts How could a bank find itself holding less in reserves than the reserve ratio specifies? How does the bank correct for this? The bank borrows money from either the Fed or other banks. II. Financial Assets & Balance Sheets/ T-Accounts What does the TAccount look like if the loan recipient pays the $50k to a contractor who deposits the $ into our bank? The bank has just created $50k of new money. What is the most we could loan out? II. Financial Assets & Balance Sheets/ T-Accounts What does the TAccount look like if the loan proceeds go to another bank? What if the recipient come in the next day and pays off the loan in full? Hw: ch 16 pa 2,4,5 III. Saving & Capital Formation Saving money makes economic growth possible. One person’s savings is another person’s loan. Savings make investments possible. III. Saving & Capital Formation PPF: consumer goods, capital goods IV. Financial Assets & the Financial System Financial assets (savings accounts, bonds…) are claims on a borrower. Intermediaries bring savers and borrowers together. The interest a bank pays on its savings accounts is always lower than the interest it earns from loans. The difference is called the SPREAD. IV. Financial Assets & the Financial System A bank pays 5% interest on its savings account. The bank takes some of the money deposited in savings accounts, & loans that money out in the form of mortgages, car loans, consolidation loans, etc. On average, the bank charges 10% on its loans. What’s the spread? Why does the bank do this? IV. Financial Assets & the Financial System The Money Multiplier: The Fractional Reserve System allows banks to “create” money, but how much is created? Remember the multiplier effect on AD: 1/(1-MPC) or 1/MPS The money multiplier = 1/reserve requirement IV. Financial Assets & the Financial System The money multiplier = 1/reserve requirement This gives you the maximum size the money supply could reach as a result of the deposit. Note the difference between size of money supply and the amount of new money created. IV. Financial Assets & the Financial System Leakages prevent the money supply from reaching levels indicated by multiplier: Currency Drain-$ that leaves the banking system Excess Reserves-Banks don’t always loan out all available reserves IV. Financial Assets & the Financial System The money multiplier can also be used to determine amount of new loans or additional $. Instead of multiplying initial deposit by multiplier, multiply excess reserves by multiplier. Ch16pa 7,8,9 Read ch 13 V. Money, the Interest Rate & Loanable Funds Money Demand The value of money is determined by the forces of supply and demand. The Quantity Theory of Money states that, quote, “Mo’ money equals... mo’ inflation… in the long-run.” Value of Money Quantity of Money V. Money, the Interest Rate & Loanable Funds Money Market The (nominal) interest rate adjusts to balance the supply of and demand for money. Interest Rate (i) Quantity of Money V. Money, the Interest Rate & Loanable Funds Loanable Funds Market The real interest rate adjusts to bring the S & D of loanable funds to equilibrium. Real Interest Rate (r) Q of Loanable Funds V. Money, the Interest Rate & Loanable Funds Lower i and/or r chiefly spurs I, which increases AD. VI. Nonbank Financial Intermediaries Life insurance companies invest the premiums they charge. Finance companies: -make (usually high interest) loans to customers -offer loans through businesses (boat, furniture, & jewelry stores) VI. Nonbank Financial Intermediaries Mutual funds are corporations that buy stock in other corporations. Employers put $ in pension funds that invest in stocks & provide retirement income. Real estate investment trusts borrow $ from banks & lend to construction companies. VII. Basic Investment Considerations Low-risk investments pay low returns. Consistent investing can yield large returns because of compound interest. Investors should avoid complex investments they don’t understand. The Time Value of Money value of money with a given interest rate over a given time FV = PV + (r * PV) PV = FV / (1 + r) Remember: r = i - π VII. Basic Investment Considerations r=i-π What happens to r if: i increases & π decreases? i decreases & π increases? i increases & π increases? i decreases & π decreases? The Fisher Effect In the long-run, an increase in Sm will result in an increase in π and i, but r is unaffected. VII. Basic Investment Considerations The Relationship Between Risk & Return Stocks Bonds Stock Based Mutual Funds Bond Based Mutual Funds Risk CD’s Savings Accounts Return VIII. Insurance You pay a premium to receive coverage. Types: Life: upon your death, beneficiary receives a check Health: pays some or all of your medical expenses Property: compensates you for loss of property through fire, theft, etc. as specified Car: Liability covers damage you cause to someone else. Full also covers damage to you/your car. Unemployment, Disability, Vacation, Dental IX. Looking At a Budget Variable expenses can change (food, entertainment). Fixed expenses-same every mo. (water bill). Subtract expenses & deductions from income, to determine what’s left over. X. Simple vs Compound Interest Simple interest is a flat percentage. If you’re paying 10% simple interest on a $1,000 loan, you’ll pay $100 in interest. If you’re paying 10% compound interest, you pay more. XI. Loans Longer time = higher interest rate The minimum most banks will loan is $3$5k. XI. Loans - Continued Interest Rates Charged Lowest Highest Credit Union- Bank- Finance Co.- Credit Card- Payday Advance XI. How Do I Get Credit? 3 criteria for credit: 1) Income 2) Debt 3) Repayment History (Credit Score/Report) -To build credit: take small loans & repay them on time XII. Financial Assets & their Characteristics 2 Types of markets: Primary market: only purchaser can redeem Secondary market: asset can be resold to new owner Note: financial assets that can be bought on the secondary market have (2nd) by them. Certificates of deposit: purchaser agrees to leave $ in the “CD” for certain period of time. Individual Retirement Accounts & 401(k) Plans are tax-sheltered investment plans. XII. Financial Assets & their Characteristics Stocks: claims to partial ownership of a corporation (2nd) Mutual Funds: Corporations whose only function is to invest in other corporations (2nd) Money Market Deposit Account: a highbalance (min. $1k) savings account that you can write checks from Money Market Mutual Fund: mutual funds that invest in short-term debt (2nd) XII. Financial Assets & their Characteristics Corporate bonds: loans to corps. (2nd) Municipal bonds: issued by state/local gov’ts, and are safe & tax-exempt (2nd). Savings bonds are small loans to fed. gov’t Treasury bills, notes, & bonds are loans to fed. gov’t & are the safest financial asset (2nd). XIII. Bond Characteristics Ratings are based on financial health of company. D (lowest) to AAA (highest) XIII. Bond Characteristics Term Credit Risk Tax Treatment Face Amount Issue Price Maturity Date Coupon, Yield $50 (annual) interest payment on an $800 bond = 50/800 = 6.25% yield (annual) XIII. Bond Characteristics The lower the price of a bond, the higher the yield (interest earned). When bond yields rise, interest rates in general rise. Yield = interest payment/price Ch13pa 1 XIV. Market Efficiency Efficient Market Hypothesis: it’s not possible to “beat the market” regularly Instead, investors should diversify (hold many different stocks) XV. Organized Stock Exchanges New York Stock Exchange (NYSE): oldest U.S. stock exchange, 2,800 corporations, 1,400 seats American Stock Exchange (AMEX): 750 corporations, smaller Smaller regional stock exchanges are found in Boston, Memphis, Philly, etc. XVI. The Over-the-Counter Market Most stocks are traded electronically on the OTC Market. NASDAQ is the biggest OTC market (lists 4,000 corp’s). XVII. Measures of Stock Performance Dow-Jones Industrial Average is an index of 30 stocks S&P 500 is an index of 500 stocks In a bull market, prices are rising. In a bear market, prices are falling. XVIII. Short Selling Short selling is: selling a stock… that you don’t own... but have borrowed. You expect P to go down. When it’s time to return borrowed stock… buy it at new P, then return it. XIX. Trading in the Future In the spot market, transactions are made instantly. In the futures market, futures contracts are bought/sold. Futures contracts are agreements to buy/sell something at a certain P on a certain day. XIX. Trading in the Future Options markets are markets where people buy the option to buy or sell a stock at a certain P in the future. Call option gives you the right to buy Current Price Price Next Week $45 Put option gives you the right to sell XX. The Structure of the Fed The Federal Reserve (Fed for short) is the nation’s central bank. It’s a bank for banks. The Fed’s 12 district banks serve these functions. The Fed and it’s district banks are quasipublic; they’re owned by member banks but run by appointees of the president XX. The Structure of the Fed The Board of Governors supervise/regulate the Fed (7 members) The Fed has 12 district banks. They’re banks for banks. The Federal Open Market Committee (FOMC) controls the money supply through sale/purchase of gov’t bonds. XX. The Structure of the Fed Responsibilities-The Fed: prints money monitors/holds bank reserves approves bank mergers is gov’ts fiscal agent clears checks regulates money supply is “lender of last resort” The current reserve requirement in the U.S. is 10% (in Rincon) The FedAtlanta District Think of a dam… A dam controls the flow of water downriver. Releasing too much water would cause flooding. Too little water would cause a drought. XXI. The Fed is like a dam... & the river is the $ supply. If the gov’t releases too much $, this causes inflation. Too little $ slows economy & could cause a recession. Federal Reserve Money Supply XXI. Tools of Monetary Policy Monetary policy is increasing or decreasing the money supply. Easy money policy stimulates the economy but causes inflation. (i ) XXI. Tools of Monetary Policy Tight money policy slows economy but fights inflation. (i ) XXI. Tools of Monetary Policy A bigger $ supply causes interest rates to fall. People start borrowing more so they can get things they want now. This can cause GDP to rise. XXI. Tools of Monetary Policy The Fed affects the money supply by: A) changing the reserve requirement affects excess reserves changes money multiplier rarely changed by Fed XXI. Tools of Monetary Policy B) Open Market Operations: buying & selling bonds the Fed’s main tool the Fed uses this to target the Federal Funds Rate: the rate at which banks lend money to each other “I Am The Fed” XXI. Tools of Monetary Policy Continued C) changing the discount rate (the rate at which the Fed loans $ to banks) To Get the Economy Going... Bu.L.L. So you want to run the Fed? Extra Credit What kind of money policy is taking place if the government buys bonds? What does this do to interest rates? What happens to the money supply if: the Fed increases the reserve requirement? the Fed sells bonds in open market operations? the Fed lowers the discount rate? XXI. Tools of Monetary Policy Q: How does the Fed stimulate the economy? A: BLL XXI. Tools of Monetary Policy Cyclical Asymmetry: tight money policy can force GDP contraction, but easy money policy won’t necessarily result in expansion. The Politics of Interest Rates The Fed is independent from gov’t, but faces political pressure (usually to lower interest rates) The president affects Fed by appointing new members when terms expire. Fiscal vs. Monetary Generally, monetary policy is considered superior to fiscal policy in the following respects: speed flexibility political acceptance Fiscal vs. Monetary Easy Monetary goes with Expansionary Fiscal Tight Monetary goes with Contractionary Fiscal Ch 16pa 11, 12, 13 Fun Stuff What happens if: Sm falls? XXII. Net Exports& the Economy 3 things cause Nx to change: Relative Price Level Exchange Rate if π increases, X decrease, M increase if $ appreciates, X decrease, M increase Relative Interest Rates if i rises on $, $ appreciates, X decrease, M increase XXIII. Aggregate Variables & the Money Market The money market influences Aggregate Supply & Demand (& RGDP & π): & vice versa: Anything that causes AD to increase causes Dm to increase too (remember crowding-out effect). XXIV. Establishing the Federal Budget Steps to adopting the budget: Step 1: Executive formulation-president drafts budget Step 2: House tweaks budget and votes on it Step 3: Senate may approve House bill or write its own. If they draft their own, HouseSenate work out a compromise bill Step 4: Congress sends their bill back to President for his approval or veto XXIV. Establishing the Federal Budget – Continued Don’t write this: What happens if the President is of a different political party than the majority of the House or Senate? In 1995, President Clinton and a Republican led Congress could not come to an agreement on a budget, forcing several federal agencies to temporarily shut down. Among other costs, $800 million was eventually paid to government employees on furlough at the time. XXV. Major Spending Categories Mandatory Spending: Social Security, Medicare, interest on debt, veterans’ benefits, etc. Discretionary Spending: defense, education, justice system, NASA, EPA, etc. XXV. Major Spending Categories The biggest categories of federal spending: 1st-National Defense 4th-Income Security 2nd-Social Security 5th-Health 3rd-Medicare 6th-Net Interest XXVI. From the Deficit to the Debt Deficit- expenditures in excess of revenues in 1 yr. Surplus- revenues in excess of expenditures in 1 yr. Federal debt- grand total owed KNOW THE DIFFERENCE BETWEEN DEFICIT & DEBT! XXVI. From the Deficit to the Debt Federal gov’t has practiced deficit spending since 1776. But, deficit spending was low until WWII. After 1947, there were low deficits or surpluses until the 80s. In the 80s, taxes were cut & defense spending increased. XXVI. From the Deficit to the Debt Continued There is a “debt ceiling”. Congress raised it in ‘08 to $11.3 trillion. When there’s a deficit, the Treasury Dept. can: sell bonds (borrow) print money (called monetizing the debt) How Much Does the Government Owe? As of Friday 3/13/09, the federal debt was in excess of $10.9 trillion. That’s over $35 thousand per capita. XXVII. Impact of the National Debt 2 ways the debt hurts the economy: More debt = more interest owed. This causes more tax $ to go to interest payments. When gov’t borrows, interest rates rise, which slows economic growth. XXVII. Impact of the National Debt 50% of the national debt is owed to the Fed. Rest is held by individuals, corporations, states, & foreign gov’ts. XXVII. Impact of the National Debt China, Japan and the UK are the biggest foreign holders of our debt. XXVII. Impact of the National Debt Social Security, Medicare, & Medicaid spending is growing faster as the population gets older. Under current law, around 2035 mandatory spending will exceed tax revenue. XXIX. Fiscal Policy - is the gov’ts attempt to stabilize the economy through taxing and spending. XXIX. Fiscal Policy Economic Impact of Taxes Taxes affect the FOP, & how resources are distributed. A tax placed on a good raises production costs, & P goes up. Taxes encourage or discourage certain activities. XXIX. Fiscal Policy A sin tax raises revenue while reducing consumption of a socially undesirable product. Taxes change our incentives to save, invest, and work. The incidence of a tax is the final burden of the tax. It is easier for a producer to shift the incidence to the consumer if the demand is inelastic. XXIX. Fiscal Policy This could show the effect of a tax on prescription medicine. This might be the effect of a tax on candy bars. How much of the tax did the producer absorb? How much of the tax did the producer pass on to the consumer? XXIX. Fiscal Policy Criteria for Effective Taxes Taxes should be equitable, simple, and efficient. Equitable = fewer loopholes Simple = easy to understand. Efficient = easy to administer and successful at generating revenue. XXIX. Fiscal Policy Two Principles of Taxation: The benefit principle says people should be taxed according to the benefits they get. But, most benefits go to those who can least afford to pay. Also, some gov’t benefits are hard to measure. The ability-to-pay principle - people should be taxed according to their ability to pay. XXIX. Fiscal Policy Types of Taxes Proportional tax - same percentage regardless of income (Social Security: 6.2% up to 87k/yr). Progressive tax - higher percentage tax on people with higher incomes (income tax). Regressive tax - higher percentage on low incomes than on high incomes (sales tax). XXIX. Fiscal Policy 2 ways to increase real GDP: Supply-Side Policies include cutting business taxes & regulations. Demand-Side Policies include cutting income taxes or increasing gov’t spending. RGDP RGDP XXIX. Fiscal Policy The crowding-out effect revisited: When G increases, this causes i to increase, which results in a decrease in i-sensitive I & C. GDP = C + I + G + Nx XXIX. Fiscal Policy The crowding-out effect revisited: When G increases, this causes i to increase, which results in a decrease in i-sensitive I & C. GDP = C + I + G + Nx XXIX. Fiscal Policy The crowding-out effect revisited: When G increases, this causes i to increase, which results in a decrease in i-sensitive I & C. GDP = C + I + G + Nx Extra Credit Fiscal Policy Or Monetary Policy? To slow inflation, the Fed sells bonds. The economy has begun to recover, & the gov’t cuts subsidies to farmers. The discount rate is lowered, in an effort to stimulate the economy. The gov’t raises taxes back to their pre-recession rates. XXX. Fiscal & Monetary Policies-Uses Of The Fed & the federal gov’t use fiscal and monetary policies for several reasons: to fight inflation to fight unemployment to make the business cycle more stable Fiscal & monetary policies are often used in tandem. XXXI. Loanable Funds Market What makes up S? D? Why r & not i? Changes in G could affect S or D, depending on how you look at it. Either way, the same thing happens to r. XXXI. Loanable Funds Market What happens if taxes decrease? latest jobs report causes producers to expect recession to drag on? Money Market or Loanable Funds Market: What’s the Difference? Money Market: Short term Money Supply controlled by Fed (perfectly inelastic) Interest rates are nominal Demand for money affected by economy Loanable Funds Market: Long term Quantity supplied of loanable funds affected by real interest rate Interest rates are real. Supply and Demand for loanable funds affected by economy: Households save more or less Fed monetary policy Demand for money XXXII. Inflation & Unemployment In the short run,... when AD increases, what happens to π? Unemployment? In the short run, high π & low U usually occur together. ITSR, low π & high U usually occur together. XXXIII. The Phillips Curve The Phillips curve shows the short-run trade-off between π & U. Q: How would you show stagflation on this Phillips curve? XXXIII. The Phillips Curve A: Stagflation can be shown by shifting the Phillips curve to the right. Changes in AS shift the Phillips curve. XXXIV. The Long Run **In the long-run, an economy’s level of production depends on it’s quantities of productive resources (i.e. capital, labor, etc.).** In the long-run, Real GDP will hover around full employment. Inflation has no effect on production in the long-run. Q: What does the Phillips curve look like in the long-run? A: It is vertical. XXXIV. The Long Run Short Run Long Run Full Employment +/- 4% XXXIV. The Long Run As you recall, in the long-run, AS is vertical. Q: Implications for fiscal & monetary policies? A: Economy naturally selfcorrects, ... The Phillips Curve The faster AD grows, the faster inflation will grow. When output grows, unemployment falls. High inflation goes hand-in-hand with low unemployment. The Phillips Curve Shows the inverse relationship between PL and U. Implies that it’s impossible to reach FE without inflation. What about stagflation?? The Phillips Curve We must shift the Phillips curve to explain stagflation. Phillips Curve is derived from AD. A change in AS shifts the curve. The Phillips Curve RGDP always hovers around the FE level of output. This point is shown here as LRAS. Since there is a FE level of output, it stands to reason that there is a natural rate of unemployment. The Phillips Curve So, in the longrun, the Phillips Curve is vertical. What could cause the LRPC to shift? XXXV. Economic Growth Economic growth is best measured using real GDP per capita The percent change in this figure shows us economic growth. Per capita means per person. Real GDP per capita has grown slower than real GDP. What does this mean? XXXV. Economic Growth Determinants Quantities of the four factors of production (especially labor and capital). Investment in physical capital must exceed depreciated-capital replacement levels. Public Policy-provide incentives for capital investment Labor Productivity Advances in technology (often resulting from investment in R&D) provide more productive physical capital, which results in higher labor productivity. Education and training increases human capital & also labor productivity. Rate of productivity growth has compounding effects on economy over time (U.S. vs Great Britain). XXXV. Economic Growth Over long periods of time, small differences in rates of productivity growth compound like interest in a bank account and can make enormous difference to a society’s prosperity. Nothing contributes more to reduction of poverty, to increases in leisure, and to the country’s ability to finance education, public health, environmental improvement, and the arts. XXXV. Economic Growth Increases in AD does not equate economic growth. The LRAS shifts right. Sources of Economic Growth (1934-1984) Source of Growth % of Total growth Increase in Quantity of labor 32 Increase in labor productivity 68 Technology 28 Quality of capital 19 Education and training 14 Economies of scale 9 Improved resource allocation 8 XXXV. Economic Growth Capital investment, a closer look: Capital investment, required for economic growth, itself requires that people save some of their money. But there can be too much saving. If MPS is 1, what good is that? Diminishing MPK (marginal product of capital) results eventually, as capital per worker increases. XXXV. Economic Growth Economic growth increases: standard of living. tax base. U.S. demand for imports. incentive for other countries to become market economies. XXXVI. Growth Policy Countries benefit from foreign investment, but poor countries really benefit from it. Developing economies will usually benefit from policies that encourage investment from abroad. Education (human capital)is at least as important as physical-capital investment to a country’s long-run economic success. Gov’t policies should help provide good schools & encourage the population to take advantage of them. XXXVI. Growth Policy Healthier workers are more productive. Gov’t’s should adopt policies that increase the health of the population. Protecting property rights and promoting political stability can foster economic growth. Free trade promotes economic growth. Policies (provision of grants, patents, etc.) that promote R&D foster economic growth. XXXVI. Growth Policy Population growth increases a country’s supply some of the factors of production (labor, human capital, entrepreneurship). Gov’t policies that encourage population growth can contribute to economic growth. XXXVI. Economic Growth "The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger - but recognize the opportunity." Speech in Indianapolis, April 12, 1959