NOTES: Unit 4 – Money & Banking / Monetary Policy 3-21-16 to 3-27-16

AP Macroeconomics Unit 4 - Part 1: Types and Functions of Money

There are 3 different types of money: Commodity Money is a good that has other purposes that also functions as money - an example would be tribes in Africa using cows as money. Representative money is whatever you are using as currency represents a specific quantity of a precious metal (gold, silver) - the drawback is when the value of the metal changes, it affects the value of your national currency. Fiat Money is not backed by a precious metal - it is money that must be accepted for transactions and is backed by the word of the government that it has value.
Functions of money include the Medium of Exchange, the Store of Value (put money away in hopes to retain its value), and the Unit of Account (Price implies Worth (quality)).

AP Macroeconomics Unit 4 - Part 3: Money Market Graphs 

When the price is high, the quantity demanded is low and when the price is low, the quantity demanded is high. When the interest rate is low, people have an incentive to borrow more for transactions, to hold assets, transaction demand, asset demand. The supply of money does not vary based on the interest rate - demand for money is tied to the interest rate, supply of money is not. The supply of money is fixed, it is set by the Fed - it doesn't move unless the Fed does something to move it. 

AP Macroeconomics Unit 4 - Part 4: The Fed's Tools of Monetary Policy 

Reserve Requirement is the percentage of the bank's total deposits that they must hang on to, either as vault cash or on reserve w/ a Fed branch. Discount Rate is the rate at which banks can borrow money from the Fed. For Expansionary Policies (easy $), the RR decreases; the DR decreases (for banks to borrow more money); and if the Fed wants to expand money supply, it buys bonds. For Contractionary Policies (tight $), the RR increases; the DR increases (to discourage banks form borrowing money); and if the Fed wants to contract or reduce the money available, it sells bonds. 

AP Macroeconomics Unit 4 - Part 7: The Loanable Funds Mar

Loanable Funds is money that is available in the banking system for people to borrow. When the interest rate is lower, people demand more money and when the interest rate is higher, people have a disincentive to borrow. Supply of Loanable Funds comes from the amount of money that people have in banks, it is dependent on savings. The more money people save, the more money banks have available to make loan. If people have an incentive to save more, then you increase the supply of loanable funds. If people have incentives to save less, you decrease the supply of loanable funds. 

AP Macroeconomics Unit 4 - Part 8: Money Creation & Multiple Deposit Expansion 

Banks create money by making loans. One of the FED's tools for monetary policy is the ability to control the Reserve Requirement (RR). 
Money Multiplier = 1/RR        RR = 20%      Loan amount = $500
What is the total money created? 1/0.2 = 5 × 500 = $2,500. We got $2,500 by using the process of Multiple Deposit Expansion.


AP Macroeconomics Unit 4 - Part 9: Relating the money Mkt., Loanable Funds Mrk., and AD - AS

In the money market, the governemnt is borrowing money from Americans. A change in the money market will carry through the loanable funds graph, and the aggregate demand and supply graph. In this case of a government deficit, the increase in demand, results in an increase in the interest in the money market applies to the loanable funds graph. The aggregate demand is an increase, causing a rise in the price level and GDP. According to the equation of exchange, MV = PQ, a change in the supply of money causes a change in price, shown as an increase in interest rates will increase the price level. All three graphs are related by the Fisher Effect, a 1:1 direct ratio. 

UNIT 4

UNIT 4: 

3/4/16

I. USES OF MONEY 
a. Medium of Exchange:

• Trade & Barter

b. Unit of Account:

• Establishes economic worth in exchange process
• Ex: Cake as payment

c. Store of Value:

• Money holds its value over a period of time whereas products may not. 

II. TYPES OF MONEY
a. Commodity Money:

• It gets its value from the type of material from which it is made.
• Ex: Gold coins made from gold

b. Representative Money: 

• Paper money that is backed up by something tangible that gives it value

c. Fiat Money:

• It is money because the government  says so and because it is the money used in the U.S.

III: CHARACTERISTICS OF MONEY

a. Portable

b. Durable

c. Uniform

d. Scarce

e. Acceptable

f. Divisible 

IV: MONEY SUPPLY

a. M1 Money:

1. Currency - broken down into cash and coins
2. Checkable Deposits
3. Travelers' Check -  2-3 signatures to actually use

• 75% most liquid ---> easy to convert to cash 

b. M2 Money:

• Consists of M1 Money + Savings Accounts and deposits held by banks outside the U.S.
• Not as liquid as M1 Money

c. M3 Money:

• Consists of M2 Money + certificates of deposits, which is known as CDs. 

3/9/16

Time Value of Money: 

• Is a dollar today worth more than a dollar tomorrow?

           - Yes.

• Why?

           - Opportunity cost & inflation

           - This is the reason for charging & paying interest 

• Let v = future value of $

               p = present value of $
               r  = real interest rate (nominal rate - inflation rate)
               n =  years
               k = number of times interest is credited per year



The Simple Interest Formula:

• Formula: v = (1 + r)n * p

The Compound Interest Formula: 

• Formula: V = (1 + r/k)nk * p

Decrease of money has an inverse relationship between nominal interest rates & quantity of money demanded. 

1. What happens to the quantity demanded of money when interest rates increase?

• Quantity demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities. 

2. What happens to the quantity demanded when interest rates decrease?

• Quantity demanded increases. No incentive to convert cash into interest earning assets. 

The Demand for Money: 
What happens if price level increases? 

Increasing the Money Supply: 

   How does this affect AD?
     - Increase money supply
     - Decreases interest rate
     - Increases investment
     - Increases AD










Decreasing Money Supply: 

How does this affect AD?
  - Decrease money supply
  - Increase interest rate
  - Decrease investment
  - Decrease AD 

Financial Sector: Financial Assets vs. Financial Liabilities 

Financial Assets:
(What you OWN) 

• f
• It benefits the owner based upon the issuer of the assets meeting certain obligations

Financial Liabilities:

(What you OWE) 

• Liabilities incurred by the issuer of a financial asset to stand behind the issued asset. 
• f

Interest Rate:

• Priced paid for the use of a financial asset

Stocks vs. Bonds 

Stocks:

• Financial assets that conveys ownership in a company
• Stock market is high risk

Bonds:

• The promise to pay a certain amount of money + interest in the future.
• Have no hold on it, they're safer. 

What Banks Do:

• A bank is a financial intermediary

            - Uses liquid assets (i.e. bank deposits) to finance the investments of borrowers

            - Process is known as Fractional Reverse Banking 

                          - A system in which depository institutions hold liquid assets less than                                       the amount of deposits 

                          - Can take the form of: 

                                 1. Currency in bank vaults

                                 2. Bank Reserves: Deposits held at the Federal Reverse. 

3/10/16

Ultimate Lenders --> Financial Intermediaries --> Ultimate Borrowers 

What Banks Do - Basic Accounting Review 
T-Account (Balance Sheet):

• Statements of assets & liabilities

Assets (Amounts owned):

• Items to which a bank holds legal claim
• The use of funds by financial intermediaries

Liabilities (Amounts owned):

• The legal claims against a bank
• The sources of funds for financial intermediaries

Federal Reserve Bank (The Fed):

• Houses the Secret Service
• 7 board members appointed by President 

  Functions: 

1. Uses paper currency
2. Sets reserve requirements & holds reserves of the banks
3. It lends money to the banks & charges them interest
4. They are check-clearing service for the banks 
5. Acts as personal bank for the government 
6. Supervises members' banks
7. It controls the money suplly in the economy 

How do banks create  money? 

  - By lending out deposits  that are used       multiple times. 

Where do the loans come from?

- They come from depositers who take cash and place it in their banks.

How are the amounts of potential loans calculated? 

- By using the balance sheet or the T-Account that consists of liabilities and assets

Bank liabilities (on the right side of T-Account)

#1 Demand Deposits or Checkable Deposits 

    - They belong to depositers and can be withdrawn by depositers 

#2 Owner's Equity 

   - Values of stock held by the public ownership  of bank shares

Bank assets (the left side of the T-Account)

#1 Required Reseves

- Percentage of demand deposirs that must be held in the vault so that some depositers have access to their money

#2 Excess Reseves 

#3 Property 

#4 Securities (Bonds)

#5 Loans

Reserve Requirement:

• The Fed requites banks to always have some money readily available to meet the consumer's demand 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 Three Types of Multiple deposit Expansion Question:

Type 1: Calculate the initial change in excess reserves the initial deposit

Type 2: Calculate the change in loans in banking system

Type 3: Calculate the change in the money supply. 

*Sometimes Type 2 & Type 3 will have the same result (i.e. NO Fed involvement)

3/21/16

#1. The Reserve Requirement:

• Only a small percent of your bank deposit is in the safe. The rest of your $ has been loaned out. 
• The reserve requirement (reserve ratio) is the % of deposits that banks must hold in reserve and NOT loan out.)

               - When the Fed increases the money supply it increases the amount of money                         held in bank deposits. 

If there is a RECESSION, what should the Fed do to the Reserve Requirement? 

- Decrease the Reserve Ratio

1. Banks hold less money & have more excess reserves
2. Banks create more money by loaning out excess
3. Money supply increases, interest rates fall, AD goes up. 

If there is INFLATION, what should the Fed do to the Reserve Requirement?

- Increase the Reserve Ratio 

1. Banks hold more money & have less excess reserves
2. Banks create less money
3. Money supply decease, interest rates up, AD goes down. 

#2. The Discount Rate:

• The Discount Rate is the interest rate that the Fed charges commercial banks.
• To INCREASE the Money Supply, the Fed should DECREASE the Discount Rate (Easy Money Policy)
• To DECREASE the Money Supply, the Fed should INCREASE the Discount Rate (Tight Money Policy)

#3. Open Market Operations:

• The Fed buys/ sells government bonds (securities).
• This is the most important and widely used monetary policy.
• To INCREASE the Money Supply, the Fed should BUY government securities.
• To DECREASE the Money Supply, the Fed should SELL government securities.

Federal Funds Rate:

• Where FDIC member banks loan each other overnight bonds. 

Prime Rate:

• The interest rate that banks give to their most credit-worthy customers. 

If the economy  goes into recession, the real GDP will decrease for at least 6 months.

If the economy suffers from too much ddemand-pull inflation  or cost inflation