Money: Definitions, Measures, Time value + Introduction to ...

Money: Definitions, Measures, Time value + Introduction to ...

Money, Banking, The Fed, Fiscal and Monetary Policy AP Macro Chapters 12, 13, 14 and 15 Loanable Funds-Chapter 29 Mechanics of Fiscal Policy AP Macro Fiscal Policy Government efforts to promote full employment and Increase government spending (G

price stability by changing government spending (G) and/or taxes (T). Recession is countered with expansionary policy. ) Decrease taxes (T ) Inflation is countered with contractionary policy Decrease government spending (G ) Increase Taxes (T ) Expansionary Fiscal Policy In order to combat recession, the government engages

in expansionary policy. causing PL and GDP ,which causes u% Notice that the PL increased: this means expansionary fiscal policy creates some inflation. or T ,then AD shifts

If G Expansionary Fiscal Policy LRAS PL P1 P SRAS AD1 AD

Y YF GDPR IF RECESSION, THEN G.: AD .: GDPR & PL .: u% & % OR T .: DI .: C.: AD .: GDPR & PL .: u% & % Contractionary Fiscal Policy In order to combat inflation, the government engages in contractionary policy.

causing PL and GDP , which causes u% or T ,then AD shifts If G Notice that the u% increased: this means contractionary fiscal policy creates some unemployment.

Contractionary Fiscal Policy LRAS PL SRAS P P1 AD AD1 YF Y

GDPR IF INFLATION, THEN G .: AD .: GDPR & PL .: u% & % OR T .: DI .: C .: AD .: GDPR & PL .: u% & % Discretionary v. Automatic Fiscal Policies Discretionary Increasing or Decreasing Government Spending and/or Taxes in order to return the economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem

Automatic Unemployment compensation & marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems. Weaknesses of Fiscal Policy Lags Inside lag it takes time to recognize economic problems and to promote solutions to those problems Outside lag it takes time to implement solutions to problems

Political Motivation Politicians face re-election and are more likely to support expansionary rather than contractionary fiscal policy. Increased government spending and decreased taxes are almost always more popular with voters than increased taxes and decreased spending. Government Lags Recognition-Aware a recession is happening? Administrative-democracy is slow to move. Operational-time between actual and efforts occur with output, employment or price level. Political business cycle-fiscal policy is political, election years, etc. Expansionary Fiscal Policy Side-effect: Crowdingout of Investment and Net Exports

A possible side-effect of increased government spending and reduced taxes is a budget deficit which may lead to the crowding-out of Gross Private Investment (I G) and Net Exports (XN) When G or T , then government must borrow in order to continue spending. This leads to an increase in the demand for loanable funds or a decrease in the supply of loanable funds, which results in r % . This change in r % leads to IG . In addition, the increase in r% causes D and/or S as investors seek higher returns in the U.S. This leads to $

$ $ which leads to X and M , so XN . Because IG and XN are direct components of AD, these decreases offset some of the increase in AD. Expansionary Fiscal Policy Side-effect: Crowding-out r% SLF

r% r1 r DLF 1 ID DLF q q1 QLF I1

I G and/or T .: Government deficit spends .: D LF .: r% .: IG (Crowding-Out Effect) IG Contractionary Fiscal Policy Side-effect: Crowdingin of Investment and Net Exports A possible side-effect of decreased government spending and increased taxes is a budget surplus which may lead to the crowding-in of Gross Private Investment (I G) and Net Exports (XN) When G or T , then government develops a budget surplus This leads to a decrease in the demand for loanable funds

or an increase in the supply of loanable funds, which results in r % . This change in r % leads to IG . In addition, the decrease in r% causes D$ and/or S$ as investors seek higher returns abroad. This leads to $ which leads to X and M , so XN . Because IG and XN are direct components of AD, these increases offset some of the decrease in AD.

Stabilizers Built in stabilizers are anything that government budget deficit or a budget surplus during a recession or a surplus or deficit during inflation without requiring any action by policy makers (Congress). Government Spending Govt $ Taxes C

A=deficit B=balanced T&G B G C=Surplus A GDP Taxes Progressive Taxes as GDP Proportional Taxes= as GDP The more progressive the tax, the more built in stability Regressive Taxes as GDP Budget

The Full Employment or Standardized budget adjusts to actual deficits or surpluses to eliminate automatic changes in tax revenues. Compare actual government expenditures to those that would have occurred if the economy reached full employment. Cyclical deficit is a by product of the economys slide into a recession. Money: Definitions, Measures, Time value + introduction to Quantity Theory AP Macro Money Defined Money is anything that can be used as:

A medium of exchange A store of value A unit of account/standard of value Money works best when it meets these criteria: Portable Durable Divisible Acceptable stable Money Facts What backs the dollar and makes it valuable? Gold? No!!!!!!!The dollar is legal tender because the government says its money and people willingly accepted it. The dollar is backed by the Full FAITH and credit of the US Govt.

This is referred to as an inconvertible fiat standard. The Supply of Money In the United States, the Federal Reserve System is the sole issuer of currency. This means the Fed has monopoly control over the money supply. There are two important measures of the money supply today: M1 M2 M1 M1 serves primarily as a

medium of exchange. It includes: Currency and Coin Demand Deposits M2 M2 serves as a store of value. It includes: The M1 Time Deposits Money Market Mutual Funds Overnight Eurodollars Savings Accounts

Certificates of Depos M1 and M2 As we go from M1 to M2 The measure becomes larger Money becomes less liquid As we go from M2 to M1 The measure becomes smaller

Money becomes more liquid Time Value of Money Is a dollar today worth more than a dollar tomorrow? Yes!!!!! Why?? Opportunity Cost and inflation This is the reason for charging and paying interest Time Value of Money Let v = future value of $ p = present value of $

r = real interest rate (nominal rate inflation rate) expressed as a decimal n = years k = number of times interest is credited per year The Simple Interest Formula v = ( 1 + r )n * p The Compound Interest Formula Time Value of Money Illustrated Assume that inflation is expected to be 3% and that the nominal interest rate on simple interest savings is 1%. Calculate the future value of $1 after 1 year. Step 1: Calculate the real interest rate r% = i% - p% r% = 1% - 3% = -2% or -.02

Step 2: Use the simple interest formula to calculate the future value of $1 v = ( 1 + r )n * p v = ( 1 + (-.02))1 * $1 v = (.98) $1 Time Value of Money Illustrated Assume that inflation is still expected to be 3% but that the nominal interest rate on simple interest savings is 4%. Calculate the future value of $1 after 1 year. Step 1: Calculate the real interest rate r% = i% - p% r% = 4% - 3% = 1% or .01

Step 2: Use the simple interest formula to calculate the future value of $1 v = ( 1 + r )n * p v = ( 1 + .01)1 * $1 v = $1.01 Time Value of Money FUN!!! Assume that annual inflation is expected to be 2.5% and that the annual nominal interest rate on a 10 year certificate of deposit is 5% compounded monthly. Calculate the future value of $1,000 after 10 years. Step 1: Calculate the real interest rate r% = i% - p% r% = 5% - 2.5% = 2.5% or .025 Step 2: Use the compound interest formula to

value of $1,000 v = ( 1 + r/k )nk * p v = ( 1 + .025/12)10*12 * $1,000 v = ( 1 + 0.002083)120 * $1,000 v = $1,283.69 calculate the future Relating Money to GDP Economist Irving Fisher Postulated that: Nominal GDP=The money supply * Moneys velocity

The Monetary Equation of Exchange MV=PQ M=money supply (M1 or M2) V=moneys velocity (M1 or M2) P=price level (PL on the AD/AS graph) Q=real GDP (sometimes labeled as Y on the AD/AS diagram) P*Q or PQ=Nominal GDP The Monetary Equation of Exchange MV=PQ M1=$2 trillion V of M1 = 7 PL LRAS

SRAS PQ = $14 trillion P AD QF GDPR The Money Market AP Macro The Money Market The market where the Fed and the users of money interact thus determining the nominal interest rate (i%).

Money Demand (MD) comes from households, firms, government and the foreign sector. The Money Supply (MS) is determined only by the Federal Reserve. Money Demand Transaction Demand demand for money as a medium of exchange (independent of the interest rate). Asset Demand demand for money as a store of value (dependent on the interest rate). Total Money Demand (MD) is downward sloping because at high interest rates people are less inclined to hold money and more inclined to hold stocks & bonds. At lower interest rates people sacrifice less when they hold money. Money Supply The money supply is determined by the Federal Reserve

because the Fed has monopoly control over the supply of money. The Money Market i% MS i MD Q QM The equilibrium of MS & MD determines the nominal interest rate (i%). MD is downward sloping because the nominal interest rate is the opportunity cost of

holding money. MS is vertical because it is independent of the interest rate. Changes in Money Demand Money Demand is dependent on both the Price Level and Real GDP which together comprise the Nominal GDP Nominal GDP .: MD .: i% Nominal GDP .: MD .: i% i% In MD MS

i1 MD1 i MD Q MD .: i% QM i% in MD

MS i MD i1 MD1 Q MD .: i%

QM Changes in the Money Supply Only the Fed determines the money supply Expansionary Monetary Policy MS .: i% Contractionary Monetary Policy MS .: i% Changes in the Money Supply Only the Fed determines the money supply Expansionary Monetary Policy MS .: i% Contractionary Monetary Policy MS .: i%

i% MS in MS MS1 i i1

MD Q Q1 MS .: i% QM i% MS1 in MS MS

i1 i MD Q1 Q MS .: i% QM

Multiple Deposit Expansion AP Macro Banking Banks are a business and therefore want to make a profit. Profit=spread (difference between money earned in loans- money paid out in interest). Banks loan money to make money Where does the money come from? People/businesses put money into banks Time deposits-savings accounts Demand deposits-checking accounts Reserve Requirement The Fed requires banks to always have money readily

available to meet consumers demands for cash. The amount, set by the Fed, is the Required Reserve Ratio. The Required Reserve Ratio is the % of demand deposits (checking account balances) that must not be loaned out. Typically the Required Reserve Ratio =10% The Money Multiplier Similar to the spending multiplier, the money multiplier shows us the impact of a change in demand deposits on loans and eventually the money supply. To calculate the money multiplier, divide 1 by the required reserve ratio. Money Multiplier=1/reserve ratio Example: If the reserve ratio is 25%, then the multiplier is 4.

Why????????? 1/.25=4 The Three Types of Multiple Deposit Expansion Questions Type 1: Calculate the initial change in excess reserves. The amount a single bank can loan from the initial deposit. Type 2: Calculate the change in loans in the banking system. Type 3: Calculate the change in the money supply. Sometimes type 2 and 3 will have the same result (no Fed involvement. Read these types of questions carefully to avoid confusion!!! Example 1 Given a required reserve ratio of 20%, assume the Federal

Reserve purchases $100 million worth of US Treasury Securities on the open market from a primary security dealer. Determine that amount that a single bank can lend from this Federal Reserve purchase of bonds. The amount of new demand deposits (dd)-required reserve (rr)=initial change in excess reserves(er) $100 million- (20% * $100 million) $100 million-$20 million=$80 million in ER Example 2 Given a required reserve ratio of 20%, assume the Federal Reserve purchases $100 million worth of US Treasury Securities on the open market from a primary security dealer. Determine the maximum total changes in loans in the banking system from this Federal Reserve purchase of bonds.

The initial change in excess reserves * the money multiplier=maximum change in loans $80 million * (1/20%) $80 * 5=$400 million maximum in new loans Example 3 Given a required reserve ratio of 20%, assume that the Federal Reserve purchases $100 million worth of US Treasury Securities on the open market from a primary security dealer. Determine the maximum total changes in the money supply from this Federal Reserve purchase of bonds. The maximum change in loans + $ amount of Fed action $100 * 20%=$20 $80* 1/.20 $100-$20=$80 $80*5=$400

$400 million + $100 million=$500 million max change in the money supply Monetary Policy AP Macro Monetary Policy Central Bank (The Fed, Bank of England, ECB, Bank of Japan) efforts to promote full employment, maintain price stability, and encourage long run economic goals through control of the money supply and interest rates. Monetary Policy Analogy

The Fed is to a Capitalist Economy as a Driving Instructor is to a hormonal 15 year old student driver. Types of Monetary Policy Expansionary Easy Money Monetary policy designed to counteract the effects of recession and return the economy to full employment. Contractionary Tight Money Monetary policy designed to

counteract the effects of inflation and return the economy to full employment. Tools of Monetary Policy Required Reserve Ratio (+Contractual Clearing Balances) The discount rate Open Market Operations (OMO) (New) Term Auction Facility (TAF) The Required Reserve Ratio The % of demand deposits that must be stored as vault cash or kept on reserve as Federal Funds in the banks account with the Federal Reserve.

The Required Reserve Ratio determines the money multiplier (1/rr). the rr the rate of money creation in the banking system and is expansionary. the rr the rate of money creation in the banking system and is contractionary. Changing the required reserve ratio is the least used tool of monetary policy and is usually held constant at 10%. Contractual Clearing Balance Even though some deposits are not subject to the reserve requirement, banks may contract with the fed to maintain a clearing balance in order to have funds necessary to clear transactions at the end of the day.

Contractual Clearing Balances provide the Fed with information to better conduct monetary policy. The Discount Rate The interest % banks pay the Fed for overnight loans in order to meet the required reserve. the discount rate the cost of borrowing for banks, thus creating an incentive for banks to loan more of their ER and borrow from the Fed in order to meet their RR or contractual clearing balance. This effect is to the money supply and is expansionary. the discount rate the cost of borrowing for banks, thus creating an incentive for banks to loan less of their excess reserves. The effect is to the money supply and is contractionary. The discount rate is a secondary tool of monetary policy. It functions as a

substitute to the Fed Funds Market, providing banks with necessary liquidity when they are unable to access Fed Funds from other private sector banks. However, banks are often reluctant to utilize the discount window. The discount rate is usually higher than the fed funds rate. Open Market Operations The purchase and sale of government securities by the Fed in order to increase or decrease the banks excess reserves. OMO determines the Fed Funds rate which is the interest % banks pay each other for overnight loans of Federal Funds. When the Fed buys bonds, excess reserves , and is expansionary. When the Fed sells bonds, excess reserves and is contractionary.

OMO is the primary tool of monetary policy. Term Auction Facility (TAF) Instituted in Dec. 2007 in response to a crisis in the Fed Funds market and a reluctance of banks to utilize the Feds discount window. Under the TAF, banks can competitively bid against each other on collateralized 28 day loans from the Fed in incremental amounts of $10 M to $3B. The total amount of funds available for auction are determined prior to the auction by the Fed. The purpose of the TAF is to ensure bank liquidity without the perceived downsides of using the discount window. The TAF is a tool of expansionary monetary policy. The interest rate on a TAF loan (stop-out rate) is most likely between the Federal Funds rate and the discount rate. Why do banks need

overnight loans? Banks are like any other business in that they seek to maximize profits. Banks make a profit by loaning out as much of their excess reserves as possible and charging interest to the borrower. If in the course of business, they have loaned out all excess reserves and do not have enough money to satisfy the required reserve ratio or their contractual clearing balance, then they must either borrow from the Feds discount window, borrow from the Fed through the TAF, or most likely borrow from each other in the Fed. Funds market. Expansionary Monetary Policy to Counteract a Recession w/ reinforcing effect on Net Exports

= Res. Ratio ER ,therefore MS causing i% which leads to I G

Disc. Rate Buy so AD ,resulting in PL and GDPR ,making u% Bonds ow! S$ which causes $ making U.S. goods TAFBecause i% either D$ or

cheaper and foreign goods relativelymore causing X expensive hich means XN thereby reinforcing the increase in AD already caused b vely crease in IG. ER = Excess Reserves MS = Money Supply i% = Nominal Interest Rate

IG = Gross Private Investment D$= Demand for dollars in FOREX X = Exports AD = Aggregate Demand PL = Price Level GDPR = Real Gross Domestic Product u% = Unemployment Rate S$ = Supply of Dollars in MS MS1 i% i% Graphing

Expansionary Monetary Policy i i i1 MD

i1 Q Q1 QM Fed buys bonds, TAF loan, .: ER .: MS .: i% .: IG I I1 IG LRAS PL

SRAS P1 P Lower discount rate ID .: AD.: GDPR & PL .: u% & %

Y YF AD AD1 GDPR Contractionary Monetary Policy to Counteract Inflation w/ reinforcing effect on Net Exports

or S$ which causes $ making U.S. goods cheaper more expensiveand foreign goods relatively

causing vely either D$ ow! Because i% =

Res. Ratio ER ,therefore MS causing i% which leads to I G Disc. Rate Sell so AD ,resulting in PL and GDPR ,making u% Bonds hich means XN thereby reinforcing the decrease in AD already caused b ecrease in IG.

ER = Excess Reserves MS = Money Supply i% = Nominal Interest Rate IG = Gross Private Investment D$= Demand for dollars in FOREX X = Exports AD = Aggregate Demand PL = Price Level GDPR = Real Gross Domestic Product u% = Unemployment Rate S$ = Supply of Dollars in Loanable Funds AP Macro Loanable Funds Market

The market where savers and borrowers exchange funds (QLF) at the real rate of interest (r%). The demand for loanable funds, or borrowing comes from households, firms, government and the foreign sector. The demand for loanable funds is in fact the supply of bonds. The supply of loanable funds, or savings comes from households, firms, government and the foreign sector. The supply of loanable funds is also the demand for bonds. Loanable Funds Market in Equilibrium r% SLF & DBonds r

DLF & SBonds q QLF Changes in the Demand for Loanable Funds Remember that demand for loanable funds = borrowing (i.e. supplying bonds) More borrowing = more demand for loanable funds () Less borrowing = less demand for loanable funds () Examples Government deficit spending = more borrowing = more demand for loanable funds .: DLF .: r%

Less investment demand = less borrowing = less demand for loanable funds .: DLF .: r% Increase in the Demand for Loanable Funds r% SL F r1 r DLF q

q1 QL F DLF .: r% & QLF DLF 1 Decrease in the Demand for Loanable Funds r% SL F

r r1 DLF 1 q1 q DLF .: r% & QLF QLF DL F Changes in the Supply of Loanable Funds

Remember that supply of loanable funds = saving (i.e. demand for bonds) More saving = more supply of loanable funds() Less saving = less supply of loanable funds () Examples Government budget surplus = more saving = more supply of loanable funds .: SLF .: r% Decrease in consumers MPS = less saving = less supply of loanable funds .: SLF .: r% Increase in the Supply of Loanable Funds

r% SL SLF 1 F r r1 DLF q q1 QL F SLF .: r% & QLF

Decrease in the Supply of Loanable Funds S r% LF 1 SL F r1 r DL F q1

q QL F SLF .: r% & QLF Final thoughts on Loanable Funds Loanable funds market determines the real interest rate (r %). Loanable funds market relates saving and borrowing. Changes in saving and borrowing create changes in loanable funds and therefore the r% changes. When government does fiscal policy it will affect the loanable funds market. Changes in the real interest rate (r%) will affect Gross

Private Investment ffect of Expansionary Fiscal Polic on Loanable Funds & Investment SLF r% r% r1 r DLF DLF q q1

ID 1 QL I1 I IG G and/or T .: Government deficit Fspends .: D LF .: r% .: IG (Crowding-Out Effect)

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