Unit 4-Monetary Policy Video Notes

Link 1: http://www.youtube.com/watch?v=YLsrkvHo_HA&feature=results_video&playnext=1&list=PL2CB281D126F65E26

• There are three types of money which is: commodity money, representative money, and fiat money. Commodity money is commodities that also function as money, so goods with some other purpose. Representative money means that a represents a quantity of a precious metal. Fiat money does not represent anything except it has value because the government says so. 

Link 2: https://www.youtube.com/watch?v=gzFdeM6lUno&feature=bf_prev&list=PL2CB281D126F65E26&lf=results_video

• To label a Money Market graph, the y-axis is labeled "i" which stands for interest rate and the x-axis is labeled "Qm" which stands for the quantity of money. Demand for money is always going to slope downward. It slopes downward because when the price is high, the quantity of demand is low; when the price is low, the quantity for demand is high. The supply of money is vertical is because it does not vary based on the interest rate and is fixed by the Fed, unless the Fed moves it. An increase for the demand for money will shift to the right and a decrease will be a shift to the left. If the Fed increase the money supply, it will bring the interest rate down and stabilize it. 

Link 3: https://www.youtube.com/watch?v=XJFrPI8lLzQ&feature=bf_next&list=PL2CB281D126F65E26&lf=results_video

• The tools of monetary policy can be divided into two categories: expansionary (easy money) and contractionary (tight money). For expansionary policy, the Fed lowers the reserve requirement and discount rate and buys bonds to increase money supply. For contractionary policy, The Fed will raise their required reserves and discount rate an sells bonds to decrease money supply. The discount rate is the rate at which banks can borrow money from the Fed. The Federal Funds Rate is the rate at which banks borrow money from each other. 

Link 4: https://www.youtube.com/watch?v=rdM44CC0ELY&feature=bf_next&list=PL2CB281D126F65E26&lf=results_video

• To label the Loanable Funds graph, the y-axis is labeled, "i" which stands for interest rate or price. The x-acis is labeled "Qlf" which stands for quantity of loanable funds. Demand for loanable funds is downward sloping. Supply for loanable funds is upward sloping. Supply of loanable funds comes from the amount of money that people have in banks, which means that people are dependent on savings. An increase in demand for money also increases the demand for loanable funds, because both changes increase the interest rate. More demand for money reduces the supply of money, because the government is demanding more, which causes them to buy more which leaves less in terms of supply. 

Link 5: https://www.youtube.com/watch?v=1tUC59pz95I&feature=bf_next&list=PL2CB281D126F65E26&lf=results_video

• Banks create money by making loans. The reserve requirement is the percentage of the banks total deposits that they have to keep in reserves. The money multiplier is 1 divided by the reserve ratio. Then you take this multiplier and multiply it by the amount of the initial deposit in order to find out how much money the bank can loan. Its due to the process of multiple deposit expansion. It is not guaranteed that this amount of money will be created because we would assume that none of the banks hold excess reserves. 

Link 6: http://http//www.youtube.com/watch?v=YLsrkvHo_HA&feature=results_video&playnext=1&list=PL2CB281D126F65E26%20%20http://

• The relationship between the money market, loanable funds market, and the AD/AS model is integral to macroeconomics. For example, government deficit spending; there will be an increase in the demand for money in the money market, which shifts to the right. This will also cause the demand for loanable funds to increase and the supply of loanable funds to decrease, and then an increase in AD. An increase in the interest rate will also be an increase in the price level, and this is known as the "Fisher Effect". 

Banks

How do Banks "create" money?

• By lending out deposits that are used multiple times

Where do the  loans come from?

• From depositors  who take cash and place it in their banks

How are amounts of potential loans calculated? 

• using their bank balance sheet, or T-accounts that consist of assets and liabilities for banks

Bank Assets (left side of T-account sheet)

1. Required Reserves (RR)

• These are the percentages of DD that must be held in the vault so that some depositors have access to their money.

2. Excess Reserves (ER)

• Sources of new loans. These amounts are applied  to the Monetary Multiplier/Reserve Multiplier (DD = RR + ER)

3. Bank Property Holdings (buildings and fixtures)

4. Securities (Federal Bonds)

• Bonds purchased by the bank, or new bonds sold to the bank by the Federal Reserve. These bonds can be purchased from the bank, turned into cash that immediately become available as ER.

5. Customer Loans

• Amount held by banks from previous transactions, owed to the bank by prior customers

Bank Liabilities (right side of the T-account sheet)

1. Demand deposits (DD) or checkable deposits

• Cash deposits from the public
• They are liabilities because they belong to depositors

2. Owner's Equity (stock shares)

• There are values of stock held by public ownership of bank shares

Key concepts for AP concerning Liabilities:

• If demand deposits come from someone's cash holdings, then the DD is already part of money supply
• If  DD comes in from purchase of bonds (by the FED), this creates new cash and therefore creates M1 (new money supply)

Money Creation (using excess reserves)

-Banks want to create profit, they generate it by lending the excess reserves and collecting interest. Since each loan will go out into customer's and business accounts, more loans are created in decreasing amounts (because of reserve requirement). Rough estimate of # of loan amounts created by any first loan is the money multiplier.

The Monetary Multiplier (AKA)

• Checkable Deposits Multiplier
• Reserve Multiplier
• Loan Multiplier
• Multiplier = 1/RR
• Excess reserves are multiplied by the monetary multiplier to create new loans for the entire banking system and this creates new money supply

Loanable funds

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

Changes in 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 (⬅️)
-ex: goverbment deficit spending = more borrowing = more demand for loanable funds .:Dlf ➡️ r%⬆️
-less investment demand = less borrowing = less demand for loanable finds .:Dlf⬅️r%⬇️

Changes in 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 (⬅️)
-ex: government budget surplus = more saving = more supply of loanable finds .:Slf ➡️.:r%⬇️
-decrease in consumers' MPS = less saving = less supply of loanable funds .:Slf ⬅️ .:r%⬆️

Final thoughts on loanable funds
-when government does fiscal policy it will affect the loanable funds market
-changes in the real interest rate (r%) will affect Gross Private Investment

LINK FOR MORE INFO:
https://www.youtube.com/watch?v=hucfTz4sPfU&spfreload=10 

Reserves

Type 1: calculate the initial change in excess reserves

-aka the amount a single bank cab 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 type 3 will have the same result (i.e. no FED involvement)

Type 4: calculate the change in demand deposits

Vault Cash: Cash held by the bank

Reserve ratio=commericial bank's required reserves/commercial bank's checkable deposit liabilities

Excess reserves: actual reserves-required reserves

Required reserves: checkable deposits x reserve ratio

Factors that weaken the effectiveness of the deposit  multiplier

1. If banks fail to loan out all of their excess reserves
2. if bank customers take their loans in cash rather than in new checking account deposits, it creates a cash or currency drain

Demand for money has an inverse relationship between nominal interest rate and the quality of money demanded

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Money

Money: any asset that can be used to purchase goods and services

3 uses of money:

1. as a medium of exchange (used to determine value)
2. unit of account (used to compare prices)
3. store of value (some people choose to hide their money vs the bank

3 types of money:

1. commodity money: has value within itself
2. representative money: represent something of value
3. Fiat money: is money because the government says so (paper currency, coins)

6 characteristics of money:

1. Durability (how long it lasts)
2. Portability (put it anywhere)
3. Divisibility (broken down)
4. Uniformity (money is the same)
5. Limited supply
6. Acceptability

Money supply: total value of financial assets available in the us economy 

M1 money:

-liquid assets (easily to convert to cash)

• coins
• currency (paper)
• checkable deposits or demand deposits (checks)
• traveler's checks

M2 money:

-M1 money + savings account + money market account

3 purposes of financial institutions:

1. Store money
2. Save money
3. Loan money (credit cards, mortgages)

4 ways to save money

1. savings account
2. checking account
3. money market account (higher interest rate)
4. certificate of deposit (CD) (get you a higher interest rate)

Loans: banks operate on a fractional reserve system which means they keep a fraction of the funds and they loan out the rest

Interest rates:
-Principal
-actual interest
  ▪️simple interest : paid on the principal
  ▫️formula: I = P x R x T/100
      ▫️I: simple interest
      ▫️P: principal
      ▫️R: interest rate
      ▫️T: time
▫️P= I x100/ R x T
▫️T=I x 100/ P x R
▫️R=I x 100/ P x T
  ▪️compound interest: paid on the principal + the accumulated interest
Interest: price paid for the use of borrowed money

Types of financial institutions
1. Commercial bank
2. Savings and loans institutions
3. Mutual savings banks
4. Credit unions
5. Finance companies

Investment: redirecting resources you would consume now for the future

Financial assets: claims on property and income of borrower

Financial intermediaries: institution that channel funds from savers to borrowers
3 purposes:
1. To share risk (diversification) spreading out investments to reduce risks
2. To provide information
3. Liquidity (returns) money an investor receives above and beyond the sum of money that was initially invested

Bonds you loan
Stocks you own

Bonds: are loans, Ious, that represent debt that the government or a corporation must repay to an investor
-generally long risk investment

3 components of a bond
1. Coupon rate (interest rate that a bond insured will be repaid to a bond
2. Maturity (time at which payment to a bond holder is due
3. Par value: amount that an investor pays to

Yield: annual rate of return on a bond if the bond were held to maturity

Time value of money: is a dollar today worth more than a dollar tomorrow?
Yes
Why?
-inflation and opportunity cost
-this is the reason for charging and paying interest

Time value of mont
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

Simple interest formula
V=(1+r)^n x p

Compound interest formula
V=(1 + r/k)^nk x p

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
Step 2: use the simple interest formula to calculate the future value of $1
=98 cents

Monetary equation of exchange
Formula: MV=PQ
M-money supply (m1/m2)
V-velocity of money (m1/m2)
P-price level (pl on the as/AD diagram)
Q-real GDP (sometimes labeled y on the as/AD graph


Functions of the FED
1. It issues paper currency
2. Sets reserve requirements and holds reserves of banks
3. It lends money to banks and charges them interest
4. They are a check clearing service for banks
5. It acts as personal bank for the government
6. Supervised member banks
7. Controls the money supply in the economy 

Fiscal Policy

Fiscal policy: changes in the expenditures or tax revenues of the federal government
-2 tools of fiscal policy:

1. Taxes: government can increase or decrease
2. Spending: government can increase or decreasing

Balanced budget:

revenues = expenditures

Budget deficit

revenues < expenditures

Budget surplus:

revenues > expenditures

Government debt:

sum of all deficits - sum of all surpluses

Government must borrow money when it runs a budget deficit

Government borrows from:

• individuals
• corporations
• financial institutions
• foreign entities or foreign governments

Fiscal policy two options:

-discretionary fiscal policy (action)

Expansionary fiscal policy- think deficit

Contractionary fiscal policy- think surplus

-non discretionary fiscal policy (no action)

Discretionary fiscal policy: 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 fiscal policy: Unemployment compensation and 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

Contractionary fiscal policy: policy designed to decrease aggregate demand
-strategy for controlling inflation
-decrease government spending
-increase taxes

Expansionary fiscal policy: policy designed to increase aggregate demand
-strategy for increasing GDP,  combatting a recession and reducing unemployment
-increase government spending
-decreases taxes

Automatic or built in stabilizers: anything that increases the government's budget deficit during a recession and increases its budget surplus during inflation without requiring explicit action by policy makers
-taxes reduce spending and aggregate demand
-reductions in spending are desirable when the economy is moving toward inflation

Progressive tax system: avg tax rate (tax revenue/GDP) rises with GDP

Proportional tax system: avg tax rate remains constant as GDP changes

Regressive tax system: avg tax rate falls with GDP

Disposable Income (DI)

Disposable income (DI): income after taxes or net income
-DI = gross income - taxes

2 choices
with disposable income, households can either
-consume (spend money on goods and services)
-save (not spend money on goods and services)

Consumption:
-household spending
-ability to consumer is constrained by

• the amount of disposable income
• the propensity to save

-do households consumer if DI=0?

-autonomous consumption

-did saving

-APC = C/DI = % DI that is spent 

Savings
Household NOT spending
The ability to save is constrained by 

• the amount of disposable income
• the propensity to consume

-do households consumer if DI=0? No

-APS = S/DI = DI that is not spent 

Formulas

• APC + APS = 1
• 1 - APC + APS
• 1 - APS + APC
• APC > 1 .: dissaving 

MPC: Marginal propensity to consume

-🔼C/🔼DI
-% of every extra dollar earned that is spent

Marginal propensity to save
-🔼S/🔼DI
-% of every extra dollar earned that is saved
-MPC + MPS = 1
-1 - MPC = MPS
-1 - MPS = MPC

The spending multiplier effect: an initial change in spending (c, ig, g, Xn) causes a larger change in aggregate spending or aggregate demand (AD)
-multiplier = change in AD/change in spending
-multiplier = 🔼AD/🔼 c, I, g, or x

Why does this happen?
Expenditures and income flow continuously which sets off a spending increase in the economy

Calculating the Spending multiplier
-formula: multiplier = 1/1- MPC or 1/MPS
-multipliers are + when there is an increase in spending and -when there is a decrease

Calculating the tax multiplier
When the government taxes the multiplier works in reverse why?
-because now money is leaving the circular glow

Tax multiplier (not it's negative)
=-MPC/1-MPC or -MPC/MPS
- if there is a tax cut then the multiplier is +, because there is now more money in the circular flow 

Investment Demand (ID)

Investment demand curve (ID)
What is the shape of the investment demand curve?
downward sloping

Why?

-when interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable

Shifts in investment demand (ID)

1. Cost of production

-lower costs shift right

-higher costs shift left

2. Business taxes

-lower business taxes shift right

-higher business taxes shift left

3. Technological change

-new technology shifts right

-lack of technological change shifts left

4. Stock of capital

-if an economy has much capital, then shift left

5. Expectations

-positive expectations shift right

-negative expectations shift left

LRAS: represents a point on a economy's production possibilities curve

-vertical line at an output level that represents the quantity of goods and services a nation can produce over a sustained period using all of it's productive resources as efficiently as possible 

-always at full employment

-it does not change as the price level changes

-shifts outward if there's a change in technology, change in resource, or if there is some economic growth

Full Employment

Full employment equilibrium exists where AD intersects SRAS and LRAS at the same point

A recessionary gap exists when equilibrium occurs below full employment output
-any time you are in a recession AD will shift left which is decreasing

Inflationary gap: exists when equilibrium occurs beyond full employment output
-shifts to the right which increase

Investment?
Money spent or expenditures on:
-new plants (factories)
-capital equipment (machinery)
-technology (hardware and software)
-new homes
-inventories (goods sold by producers)

Expected rates of return
How does business make investment decisions?
-cost/benefit 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 they undertake?
-compare expected rate of return to interest cost
-if expected return > interest cost, then invest
-if expected return < interest cost, then do not invest

Real (r%) v Nominal (i%)
What's the difference?
-nominal is the observable rate of interest. Real subtracts inflation (pi%) and is only known ex post facto

How do you compute the real interest rate (r%)?
r% = i% - pi%

What then, determines the cost of an investment decision?
the real interest rate (r%)

Aggregate Supply (AS)

Aggregate Supply (AS): the level of real GDP (GDPr) that firms will produce at each price level (PL)

Long Run:
-a period of time where input prices are completely flexible and adjust to changes in the price level
- in the long run, the level of real GDP supplied is independent of the price level

Short run:
-period of time where input prices are sticky and do not adjust to changes in the price level
-in the short run,  the level of real GDP supplied us directly related to the price level

Long run aggregate supply (LRAS): marks the level  of full employment in the economy (analogous to PPC)
-because input prices are completely flexible in the long run, changes in price level do not change firms' real profits and therefore do not change firms' level of output. This means that the LRAS is vertical at the economy's level of full employment

Short run aggregate supply (SRAS): Because input prices are sticky in the short run, the SRAS is upward sloping

Changes in SRAS
-an increase is seen as a shift to the right
-an decrease is seen as a shift to the left
-the key to understanding shifts in SRAS is per unit cost of production
-per unit production cost = total input cost/total output

Determinants of SRAS (all of the following affect unit production cost)
1. Input prices
-domestic resource prices

• wages (75% of all business costs)
• cost of capital
• raw materials (commodity prices)

-foreign resource prices

• strong $ = lower foreign resource prices
• weak $ = higher foreign resource prices

-market power

• monopolies and cartels that control resources control the price of those resources

-increase in resource prices = shift left

-decrease in resource prices = shift right

2. Productivity: total output/total input

-more productivity = lower unit production cost = shift right

-lower productivity = higher unit production cost = shift left

3. Legal insitutional environment 

-taxes and subsidies

• taxes ($ to govt) on business increase per unit production cost = shift left
• subsidies ($ from govt) to business reduce per unit production cost = shift right

-government regulation 

• government regulation created a cost of compliance = shift left 
• deregulation reduces complainants costs = shift right 

Aggregate Demand (AD)

Aggregate demand (AD): shows the amount of real GDP that the private, public and foreign sector collectively desire to purchase in each possible price level
-the relationship between the price level and the level of real GDP is inverse

3 reasons AD is downward sloping

1. Real balanced effect

-when the price level is high, households and businesses cannot afford to purchase as much output

-when the price level is low, households and businesses can afford to purchase more output

2. Interest rate effect

-a higher price level increased the interest rate which tends to discourage investment

-a lower price level decreased the interest rate which tends to encourage investment

3. Foreign purchases effect

-a higher price level increased the demand for relatively cheaper imports

-a lower price level increases the foreign demand got relatively cheaper U.S exports

Shifts in aggregate demand (AD)

There are two parts to a shift in AD:

1. a change in C, Ig, G, and/or Xn

2.a multiplier effect that produces a greater change than the original change in the 4 components

-increase in AD, AD shifts right

-decrease in AD, AD shifts left

Determinants of AD:

1. Consumption

household spending is affected by:

-Consumer wealth

  -more wealth = more spending (AD shifts right)

  -less wealth = less spending (AD shifts left)

-Consumer expectations 

  -positive expectations = more spending (AD shifts right)

  -negative expectations = less spending (AD shifts left)

-Household indebtedness

  -less debt = more spending (AD shifts right)

  -more debt = less spending (AD shifts left)

  -less taxes = more spending (AD shifts right)

  -more taxes = less spending (AD shifts left)

2. Gross private investment 

investment spending is sensitive to:

-The real interest rate

  -lower real interest rate = more investment (AD shifts right)

  -higher real interest rate = less investment (AD shifts left)

-expected returns

  -higher expected returns = more investment (AD shifts right)

  -lower expected returns = less investment (AD shifts left)

-expected returns are influenced by 

  -expectations of future profitability

  -technology

  -degree of excess capacity (existing stock of capital)

  -business taxes

3. Government spending 

-more government spending (AD shifts right)

-less government spending (AD shifts left)

4. Net exports

net exports are sensitive to:

-exchange rate (int'l value of $1)

  -strong $- more imports and fewer exports (AD goes left)

  -weak $- fewer imports and more exports (AD goes right)

-relative income 

  -strong foreign economies = more exports (AD shifts right)

  -weak foreign economies - less exports (AD shifts left)