Monetary Policy

Loan-able Funds Market

Is an interest rate of 50% good or bad?
Bad for borrowers but good for lenders
The loanable funds market is the private setor supply and demand of loans.

• This market brings together those who want to lend money and those who want to borrow.

This market shows the effect on REAL INTEREST RATE

Demand - inverse relationship between real interest rate and quantity loans demanded
Supply - Direct relationship between real interest rate and quantity loans supplied
This is NOT the same as the money market. (Supply is not vertical)

Tools of Monetary Policy and 3 Shifts of Money Supply

The Fed adjusting the money supply by changing any one of the following

1. Setting reserve requirements
2. Lending Money to Banks
• Discount rate
3. Open Market Operations
• Buying and selling bonds

The reserve requirement

• Only a small percent of your money is in the safe the rest  of your money has been loaned out. This is called "fractional reserve banking"
• The FED sets the amount that banks must hold. The reserve requirement is the percent of deposits that banks must hold in reserve.

Using Reserve requirement

• If there is a recession, what should the FED do to the reserve requirement?
• Decrease the reserve ratio
1. Banks hold less money and have more excess reserve.
2. Banks create more by loaning out excess
3. Money supply increases, interest rates decrease, AD goes up
• If there is inflation, what should the FED do to the reserve requirement?
1. Increase the reserve ratio
2. Banks hold more money and have less excess reserves
3. Banks create less money
4. Money supply decreases, interest rate increases, AD decreases

Open Market Operations

• Open market operations is when the FED buys or sells govt. bonds
• This is the most important and widely used monetary policy.
• If the FED buys bonds it takes bonds out of the economy and replaces them with money.
• If the FED sells bonds it takes the money and gives the security to teh investor.

The Discount rate

• There are many different interest rates, but they tend to all rise and fall together.
• The discount rate is the interest rate that the FED charger commercial banks for short term loans.

Federal Funds Rate

• The federal funds rate is the interest rate that banks charge one another for overnight loans as reserves.

Prime rate

• It is the interest rate that banks charge their most credit worthy customers.

Money Creation Formula

A single bank can create $ by the amount of it's excess reserves.
The banking system as a whole can create $ by a multiple of the excess reserves.
Money Multiplier = 1/RR
New vs. Existing $

• If the initial deposit in a bank comes from the FED or bank purchase of a bond or other money out of circulation, the deposit immediately increases the money supply
• The deposit then leads to further expansion of the money supply through the money creation process
• Total change in MS if initial deposit is new $ = deposit + $ created by banking system
• If a deposit in a bank is existing $ deposting the amount does not change the MS immediately because it is already counted
• Existing currency deposited into a checking account changes only the composition of the money supply from coins/ paper $ to checking account deposits
• Total change in the MS if deposit is existing $ banking system created money only

Money Market

Demanded for money has an inverse relationship between nominal interest rates and the quantity of money demanded.
Quantity demanded rate: increases of money. Quantity demanded: decrease

• QD decreases interest rates
• QD increases cash

Demanded for money

• Money demanded shift
1. Change in price level
2. Change in income
3. Change in taxation that affects investment
• Nominal interest rate (IR) on y-axis
• Quantity of money on x-axis

The money demanded curve slopes down and to the right because all else being equal, higher interest rates increase the opportunity cost of holding money, they're leading public to reduce quantity of money it demanded.

Bonds vs. Stocks

Bonds are loans

Stocks are owns

Bonds are loans, or IOU's, that represent debt that the government or corporation must repay to an investor. The bond holder has NO OWNERSHIP of the company.
Bonds

• First: if a corporation issues and then sells a bond
• If that corporation issues a 10K bond with a 10yr term and a 5% interest
• Interest rate: Decreases
• Bonds: Increases
• Interest Rates: Increases
• Bond: Decreases
• Nominal interest rate: 5%
• Stock owners can earn a profit in 2 ways
1. Dividends, which are portions of a corporations profits are paid to stockholders
2. A capital gain is earned when a stockholder sells stock for more than he or she paid for it.
3. A stock holder that sells stock at a lower price than the purchase price suffers a capital loss.

Unit 4 (MONEY)

What would happen if we had no money?

• The barter system: goods and services are traded directly. No money is exchanged.
• Money is anything that is generally accepted in payment for goods and services.
• Money not the same as wealth or income
• Wealth is the total collection of assets that store value
• Income is flow of earnings per unit of time

Money can be used as a

• Medium of exchange
• buy goods and services
• Unit of account
• measuring the value of goods and services
• Store of value

3 Types of money

1. Representative
• represents something of value
• IOU's 
2. Commodity
• Something that performs the function of money and has alternative uses
• Salt, Gold and silver
3. Fiat money
• serves as money but has no other important uses
• paper money
• coins

6 characteristics of money

1. Durability
2. Portability
3. Limited supply
4. Divisibility
5. Acceptability
6. Uniformity

3 Types of money

• Liquidity - money converted to cash
• M1 - Coins, currency, and check-able deposits.
• M2 - M1 plus savings deposits, time deposits and mutual funds below $100k.
• M3 - M2 plus time deposits above $100K

Purpose of Institutions

• Store $
• Save $
• Savings acct.
• Checking acct.
• CD
• Money market acct.
• Loans $
• Interest - prices paid for the use of borrowed money
• Principle - amount that you borrow

Types of financial intermediaries

• Commercial banks
• Credit Union
• Svaing and loans institutions
• Finance companies
• Fund companies

The financial system

• Assets - anything of monetary value owned by a person or business
• Financial - a paper claim that entities the buyer to future income from the seller
• Physical - a claim on a tangible object
• Liability - is what you owe
• There are 5 major financial assets: loans, stocks, bonds, loan backed securities and bank deposits.

Interest Rates and Inflation

• The time value of money - a dollar is worth more today than it is tomorrow. You are losing money every second you are not investing it.
• RIR - Real = nominal - expected inflation
• NIR - Nominal = Real + expected inflation
• RIR - intended return on an investment for lending. True cost of borrowing

Present vs. Future value

• Future value - if you invest money to someone, it will compound according to FV = PV (1+i)^t
• Present value - is the amount of money need to invest now, in order to get some amount in the future. PV= FV/(1+r)^n

Time Value of Money

• v=(1+r)^n X p
• v=future value of $
• p= present value of $
• r=real interest rate (non-inf) decimal
• n= years
• k= number of times interest is credited per year
• v=(1+r/k)^nk X p

Fiscal Policy

How does the government stabilizes the economy?

•  The government has 2 different tool boxes it can use
• Fiscal Policy - Actions by congress to stabilize the economy

Fiscal Policy

• Changes in the expanditures or tax revenues of the federal government
• Tools of fiscal policy: taxes - government can increase or decrease taxes. Spending - govt. can increase or decrease spending
• Fiscal policy is enacted to promote our nations economic goals: full employment, price stability, economic growth

Deficit, Surpluses and Debt

• Balanced budget: revenues = expenditures
• Budget deficit: Revenues < expenditures
• Budget surplus: Revenues > expenditures
• Government debt: Sum of all deficit - sum all surpluses
• Govt. must borrow money when it runs a budget deficit
• Govt. borrows from: individuals, corporations, financial institutions, foreign entities or govt.

Fiscal Policy two options

• Discretionary fiscal policy (action)
• Expansionary - think deficit
• Contractionary - think surplus
• Non - discretionary (no action)

3 types of taxes

• Progressive tax - takes a larger % of income from high income groups
• Proportional taxes - takes the same % of income from all income groups
• Regressive taxes - takes a larger % from low income groups.

Contractionary Fiscal Policy

• Decrease govt. spending
• tax increases
• Combinations of the two

Expansionary Fiscal Policy

• Increase govt. spending
• decrease taxes on consumers
• Combinations of the two

Automatic or Built in stabilizers

• Anything that increases the govt. budget deficit during a recession and increase it's budget surplus during inflation without requiring explicit action by policy makers

Non-discretionary fiscal policy

• Corporate dividends
• social security
• veterans benefit

Transfer payments

• welfare checks
• food stamps
• unemployment checks

Expansionary is reduced with DI but recession reduce drops

Fun with MPC and MPS

MPC + MPS = 1
The spending multiplier effect

• An initial change in spending causing a larger change in aggregate spending, or agggregate demand (AD)
• Multiplier = Change in AD/Chnage in spending = AD/ C, I, G, Xn
• Why? expenditures and income flow continuously which sets off a spending ^ in the economy.

Calculating spending multiplier

• 1/1-MPC pr 1/MPS
• Multiplier is + when increase in spending but - when decrease in spending

Calculating tax multiplier

• When the government texes, the multiplier work in reverse.
• Money leaving circular flow
• Tax mulitplier = MPC/ 1- MPC or -MPC/MPS
• If there is a taxcut, then the multiplier is +, more money in circular flow

Why prices tend to be sticky

• Menu cost
• Fear of price wars
• Wage contracts
• Minimum wage
• Moral effort and productivity

Output level low, unemployment increase, GDP decrease and there is a recession.
Upward sloping, output expands as total increase
Firms cant respond in increase in demand by increase output.

What is Investment?

Money spent or expenditures on: New plants, Capital equipment, technology, new homes, inventories.
Expected rates of return

• How does business make investment decisions?
• Cost/Benifit Analysis
• How does business determine the benefits?
• Expected rate of return
• How does business count the cost?
• Interest costs
• How does business determine the amount of investment?

Real vs. Nominal

• Nominal is the observable rate of interest. Real subtracts out inflation and is only known ex post facto.
• r% = i% - pi%
• real interest rate (r%) determines the cost

Investment Demand Curve (ID)

• Downward sloping

Shifts in Investment Demand

• Cost of production, business taxes, technological change, stock of capital and expectations.

Aggregate Supply

• The level of Real GDP that firms will produce at each price level (PL)
• Long run- time where input prices are completely flexible. Always be vertical.
• Short run - time where input prices are sticky and not adjust to change in price level. Determinants.
• (LRAS) long run aggregate supply marks the level of full employment in the economy (analogous to PPC)
• Input prices are sticky in short run the SRAS is upward sloping.
• Increase in SRAS is seen as a shift to the right
• Decrease in SRAS is seen as a shift to the left
• They key to understanding shifts in SRAS is per unit cost of production
• Per unit production cost = total input/ total output

Determinants of SRAS

• Input prices, productivity, legal institutional environment.
• Input prices - made or sold in U.S. Wages, cost of capital, raw materials. Strung $ = lower foreign weaker $ = higher foreign. Market Power - monopolies and cartels that control resources control the price of those resources. Increase in resources price = SRAS <- decrease in resources  price = SRAS ->
• Productivity = output/inputs. More productivity = lower unit production cost = SRAS -> Lower = higher production cost = SRAS <-
• legal institutional environment - taxes and subsides is taxes on business increase per unit cost = SRAS <- subsides to business reduce per unit production cost = SRAS -> Govt regulation creates a cost of compliance = SRAS <- Deregulation reduces compliance costs = SRAS ->

Macroeconomics

Aggregate Demand Curve

• Ad is demanded by consumers, businesses, government, and foreign countries.
• Talks about total. Determinants will be different.
• Changes in price level cause they move along the curve not a shift of the curve.

Aggregate Demand (AD)

• Relationship between the price level and the level of real GDP is inverse.
• 3 reasons why AD is going down
1. Higher prices reduce purchasing power of $. This decreases the quantity of expenditure. Wealth Effect.
2. As price level increases, lenders need to charge higher interest rates to get a REAL return on their loans. Higher interest rates discourage consumer spending and business investment. Interest - Rate effect.
3. When U.S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods. Exports fall and imports rise causing real GDP demanded to fall. Foreign Trade effect.

Shifts in Aggregate Demand (AD)

• Two parts to a shift in AD
• A change in C, Ig, G, and Xn
• A multiplier effect that produces a greater change than the original change in the 4 components.
• Increase in AD=AD ->
• Decrease in AD=AD<-

Determinants of AD

• Consumption
• Gross Private Investment
• Government Spending
• Net Exports

Change in consumer spending

• Consumer wealth
• Consumer expectations
• Households indebtedness
• Taxes

Change in investment spending

• Real interest rates
• Future business expectations 
• Productivity and Technology
• Business Taxes

Change in government spending

• War
• Health care
• Defense

Change in Net Exports

• Exchange rates
• National income compared to abroad

AD = GDP =C+Ig+G+Xn

"if the US get a cold, Canada gets pneumonia"

Government Spending

• More govt. spending (AD ->)
• Less govt. spending (AD<-)

Disposable Income (DI)

• Income after taxes or net

2 Choices

• Consume or save
• With disposable income, households can consume or save.

Consumption

• Household spending
• The ability to consume is constrained by amount of disposable income or the propensity to save

APC=C/DI=%DI that is spent

Household consume if DI=0

• Dissaving or Autonomous consumption

Saving

• Household not spending
• Ability to save is constrained by amount of disposable income and propensity to consume
• Households save if DI=0
• NO
• APS=S/DI=%D that is not spent

APC & APS

• APC+APS=1
• 1=APC=APS

MPC and MPS

• Marginal propensity to consume
• C/DI
• % of every extra dollar earned that is spent
• S/DI
• %of every extra dollar earned that is saved
• MPC+MPS=1
• 1-MPC=MPS
• 1-MPS=MPC

Determinants of C&S

• Wealth
• Increase
• Decrease