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Transcript
Fractional Reserve Banking a. The Fractional Reserve System -banks are required to keep only a fraction of their deposits in reserves -the % (10% today) is known as the reserve requirement b. How Banks Operate -Balance Sheet -Assets are the properties, possessions and claims on others -Banks major asset is their loans to customers -Liabilities are its debts and obligations to others -Bank’s major liability is their customers’ deposits -Assets minus Liabilities = net worth (value of the bank) c. Fractional Reserves and Monetary Expansion -the system allows the money supply to grow to several times the size of the reserves the banking system keeps How does a bank create money? -Example -$100,000 deposit with a 20% reserve requirement -$20,000 must go into required reserves -$80,000 goes into Excess Reserves and can be lent out -$80,000 loan is made to Jim -$80,000 deposit made by Jim with the loan proceeds -$16,000 must go into required reserves (20% of $80,000) -$64,000 goes into Excess Reserves and can be lent out -$64,000 loan is made to Jill -$64,000 deposit made by Jill with the loan proceeds -$12,800 must go into required reserves (20% of $64,000) -$51,200 goes into Excess Reserves and can be lent out -$51,200 loan to John -$51,200 deposit made by John -$10,240 must go into required reserves (20% of $51,200) -$40,960 goes into Excess Reserves and can be lent out From the initial $100,000 deposit, the banks have created a total of $295,200 in deposits This process will continue until the total new required reserves is equal to the original deposit made (in this case $100,000) -How much in new deposits will the original $100,000 deposit create? -Oversimplified deposit creation formula Original Deposit X 1 / Reserve Requirement = New Deposits Created $100,000 X 1/.20 = $500,000 From this we can figure out how much new money supply is created Since a total of $100,000 in new required reserves were created (equal to the amount of the new deposit) we have to subtract that number from the new deposits created – because required reserves are not part of the money supply in circulation. Total New Deposits Created = -Total New Reserves Created = Total new money supply created = $500,000 $100,000 $400,000 The Process will also work the same in reverse when a withdrawal is made Why is the Deposit Creation Formula Oversimplified? 1. Every recipient of cash must redeposit the cash into another bank rather than hold it -If they don’t keep it in the bank, that is less excess reserves that the bank can lend out, therefore less expansion of deposits and the money supply 2. Every bank must hold reserves no larger than the legal minimum -Banks will for the most part always have money in excess reserves and therefore have money to lend out Fractional Reserve Banking d. The Fractional Reserve System - Banks are required to keep only a fraction of their deposits in reserves - The % (10% today) is known as the reserve requirement Making the Money Supply Grow -In order to make the money supply grow, bank’s excess reserves must grow in order for them to make more loans -How does that happen? 1) When you and I make deposits in the bank 2) When the Fed uses their tools of monetary policy to influence the levels of excess reserves - REMEMBER: Main role of FED is to control the money supply (excess reserves) Feds Tools of Monetary Policy - The Fed has 3 major tools it uses to conduct monetary policy - Each affects the amount of excess reserves in the system, which in turn affects the monetary expansion process explained above - The outcome of monetary policy is to influence the cost and availability of credit -Cost of Credit = interest rates -Availability of Credit = Money Supply Loose (easy) monetary policy - The Fed allows the money supply to grow and interest rates to fall which will normally stimulate the economy - Low interest rates encourage borrowing by consumers and businesses - Use this to fight unemployment but can lead to inflation Tight monetary policy - The Fed restricts the growth of the money supply which drives up interest rates - This slows growth in the economy by getting consumers and businesses to borrow less - This is used to fight inflation but can cause unemployment The Tools of the Fed 1). Reserve Requirement - gives the Fed control over the money supply by requiring member banks to hold a certain percentage of deposits in reserves IF Increase the Reserve Requirement - more of every deposit must go into required reserves means less money in excess reserves and less money to lend out - tight/contractionary monetary policy IF Decrease the Reserve Requirement - less of every deposit must go into required reserves means more money in excess reserves and more money to lend out - loose/expansionary monetary policies - can be a very powerful tool if used – seldom is used 2. Open Market Operations - most popular tool of the monetary policy - the buying and selling of government securities in financial markets - To increase the money supply o The Fed will buy Gov’t securities/bonds from banks o Banks give the Fed bonds in return for $$ which increases excess reserves o This means more money to lend out and an increasing money supply - To decrease the money supply o FED sells Gov’t securities to banks o Banks give the Fed $$ in return for bonds which decreases excess reserves o This means less money to lend out and a decreasing money supply 3. Discount Rate - Rate of interest paid by member banks who take loans from the Fed - By decreasing the discount rate o Banks will be more likely to take loans from the Fed o The more in loans they take, the greater their excess reserves o The greater their excess reserves, the more they have to lend o The more they have to lend, the more the money supply can grow - By increasing the discount rate o Banks will want to pay back their loans from the Fed and will use their excess reserves o This means less to lend – this means shrinking money supply Impact of Monetary Policy a. Short-Run Impact - Increases and decreases in the money supply affect interest rates - This in turn affects the cost and availability of credit b. Long-Run Impact - Changes in the supply of money affect the general levels of prices - Too much money in circulation for too long leads to inflation - Loose policies lead to inflation and intended to fight unemployment (recession) - Tight policies can lead to unemployment and intended to fight inflation (expansion) Money - M1 – represents the transactional components of the money supply o The components that most closely match money’s roles as a medium of exchange o Traveler’s checks, coins, currency, demand deposits and other checkable deposits (money you can spend NOW) - M2 – the components of the money supply that most closely conform to money’s roles as a store of value o M1 and small denomination time deposits, savings deposits and money market funds - M1 is more liquid than M2 - liquidity - the measure of how fast a financial asset can be converted into cash The Cost of Economic Instability a. Economic Costs - Stagflation- a period of stagnant growth and inflation at the same time o Recession usually brings inflation under control, but this does not always happen – Example 1970s - GDP Gap o the difference between the actual GDP and the Potential GDP o Pot. GDP – what could be produced if all resources were fully employed o measure of unemployment in terms of output not produced - Misery Index o sum of the monthly inflation and unemployment rates o measure of consumer suffering during periods of high inflation and unemployment - Uncertainty o worrying about your job in times of declining GDP o put off purchases o if a lot of people do this, less production, more lay offs b. Social Costs - Wasted resources o labor wasted because people can not find jobs o people have a feeling of uselessness and non-productive - Political instability o dissatisfied voters will vote out politicians they blame for the problems o voters may vote for radical change leading to instability - Crime o crime rates often increase o less people making money, less taxes paid, less money to pay for police and other services - Family problems - less income, more debt, inability to pay debt, bankruptcy Macroeconomic Equilibrium a. Aggregate Supply – COST OF PRODUCTION -AS curve shows the real levels of GDP that would be produced at various price levels -Figure 163 (p. 443) - a - b (horizontal range) o Can increase production by employing more resources at a relatively low cost, no need to increase price - b –c (middle range) o to increase production, employing more resources costs more, so price has to increase with additional production - c – d (vertical range) o cost to increase production high because producers competing for increasingly scarce resources o price will increase relatively more for not much increase in output Shifts in the AS curve - Costs of inputs – down, shift to the right – up, shift to the left - discovering of less expensive natural resources, increases in labor production, new technologies, lower interest rates, lower taxes, deregulation - all would shift it to the right (and vice versa) b. Aggregate Demand- SPENDING - (Figure 16.4 – p. 444) - Summary of demand for all economic units in the economy - AD curve – shows the quantity of real GDP that would be purchased at each possible price level in the economy - A change in the price level will move you along the curve o higher price level, less GDP demanded (and vice versa) Shifts in the AD curve - How much people spend instead of save o Spend more, AD shifts out to the right o expectations about the future expectations are high, may spend more, AD shifts to the right o increase in transfer payments (government spending) or reductions in taxes both will increase the amount people have to spend shifts AD out to the right c. Equilibrium (Figure 16.5 – p. 445) - Where the AD curve and the AS intersect - Macroeconomic equilibrium o The level of real GDP is consistent with a given price level o where producers are satisfied to produce at a given price level and purchasers are satisfied to purchase at a given price level Stabilization Policies - economic growth, full employment and price stability are three of the major economic goals of the American people - in order to reach these goals sound economic policy must be implemented - many ways to achieve stability 1. Demand Side Policies a. Federal policies designed to either increase or decrease aggregate demand by shifting the AD curve b. Fiscal policy – the use of government spending and taxing to influence economic activity c. Derived from Keynesian economics A. Keynesian Economics a. Basic framework b. C + I + G + F = GDP c. Of the sectors, (I) was the most unstable and most to blame for economic instability d. Government’s role was to step in and offset the changes in investment sector spending e. could lower taxes and enact other measures to stimulate spending by consumers and investors f. major drawback was the deficits that would be incurred by the government, but it was believed that the deficits could be recovered in better economic times B. Automatic Stabilizers (Government Spending) a. Another key component in fiscal policy b. Programs that automatically trigger benefits if changes in the economy threaten people’s incomes c. Created to provide for Americans but also to ensure that aggregate demand is propped up during times of low demand in the economy i. Unemployment insurance 1. Paid for through payroll deductions 2. Get paid 1/3 to ½ your weekly pay – up to 26 weeks ii. Federal entitlement programs 1. social welfare programs designed to provide minimum health 2. Ensures demand does not fall below a certain level for a selected group of people C. Fiscal Policy and Aggregate Demand a. Can shift AD with fiscal policy b. Tax cuts or increased government spending can increase AD and shift to the right c. Increase AD will increase GDP but will also increase price levels D. Limitations of Fiscal Policy a. Increasing government spending is not difficult, but decreasing government sending is b. Planning fiscal policy to offset decreases in investment spending is almost impossible c. It takes a long time from planning to implementation of fiscal policy a. It could take so long that the spending isn’t needed any more 2. Supply-Side Policies a. Economic policies designed to stimulate output and lower unemployment by increasing production b. Include a smaller role of the government (than demand-side) c. Deregulation of industries – less government involvement d. Less regulations to comply with can low costs, increase supply A. Federal tax structure a. higher income taxes make people not want to work as much as they could b. lower taxes would give people incentive to work harder and in the long run have more money to spend (more tax receipts) B. Supply Side Policies and the AS Curve a. Policies to increase AS would shift the AS curve out to the right a. Deregulation b. Lower Taxes b. The result would be an increase in GDP and a decrease in price level a. THIS IS A PERFECT WORLD! BUT…. C. Limitations a. Lack of experience with them to know how they affect the economy b. The foundation that tax receipts would eventually be recovered even after reducing tax rates was found to be weak c. Policy made more to restore economic growth rather than remedy instability IN THE SHORT RUN a. money expansion (fiscal or monetary) can be used to lower interest rates b. Lower the cost of borrowing, shift the AS curve to the right c. This can increase GDP BUT… In The Long Run a. This can lead to inflation b. how fast should the money supply be allowed to grow? Growth of The Money Supply a. Monetarists believe in slow but steady growth b. Allow the money supply to grow at a rate that is equal to the anticipated rate of GDP increase plus the rate of productivity (how much more can be produced this year from last year with same amount of resources) c. If GDP up 3% and productivity up 1% then money supply growth should be 4% d. Just enough extra money each year to buy the additional goods and services the economy produces e. With less money in circulation, inflation would slowly be reduced Monetary Policy and Unemployment a. Monetarists argue that attempts to cut unemployment by expanding the money supply provide only temporary relief b. Excessive rate of monetary growth drive up prices and interest rates c. Higher interest rates raise the cost of borrowing for business d. This will shift the AS curve in to the left e. It will also shift the AD curve in to the left f. Result will be minimal if any gains in GDP but higher price levels g. Overly expansionary monetary policy will cause inflation in the long term h. Monetary policy is not a long term solution for unemployment