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 

UNIT 3

UNIT 3: Aggregate Demand and Aggregate Supply and determinants, SRAS vs. LRAS, The Spending Multiplier, The Three Great Schools of Economics, Fiscal Policy Options, Sticky Price, Sticky Wage models

February 12, 2016

Aggregate Demand Curve (AD):

• AD is the demand by consumers, businesses, government, and foreign countries.
• What definitely doesn't shift the curve? Changes in price level.

Why is AD downward sloping?

1.) Real-Balance Effect:

• Higher price levels reduce the purchasing power of money.
• This decreases the quantity of expenditures.
• Lower price levels increase purchasing power and increase expenditures.
• Ex: If the balance of your bank was $50,000, nut inflation erodes your purchasing power, you will likely reduce your spending. 

2.) Interest-Rate Effect:

• When the 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. 

3.) Foreign Trade Effect: 

• 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. (Xn decreases) 

Shifters of Aggregate Demand:

Shifts in Aggregate Demand (AD):

• There are two parts to a shift in AD:

       - A change in C, Ig, G, and/or Xn 
       - A multiplier effect that produces a greater change than the original change in the 4      
         components.

• Increases   in AD= AD ->
• Decreases in AD= AD <-

Increase in Aggregate Demand:

Decrease in Aggregate Demand:

Determinants of AD:

Consumption:
Household spending is affected by:
Consumer Wealth 

• More wealth = more spending (AD shifts ->)
• Less wealth = less spending (AD shifts <- )

Consumer Expectations

• Positive expectations = more spending (AD shifts ->)
• Negative expectations = less spending (AD shifts <-) 

Household indebtedness

• Less debt = more spending (AD shifts ->)
• More debt = less spending (AD shifts <- )

Taxes

• Less taxes = more spending (AD shifts ->)
• More taxes = less spending (AD shifts <- )

Gross Private Investment: 
Investment Spending is sensitive to:
The Real Interest Rate

• Lower Real Interest Rate = More Investment (AD ->)
• Higher Real Interest Rate = Less Investment (AD <- )

Expected Returns

• Higher Expected Returns = More Investment (AD ->)
• Lower Expected Returns = Less Investment (AD <- )
• Expected Returns are influenced by:

           - Expectations of future profitability
           - Technology
           - Degree of Excess Capacity (Existing Stock of Capital)
           - Business Taxes

Government Spending: 

• More Government Spending (AD ->)
• Less Government Spending (AD <- )

Net Exports:
Net Exports are sensitive to: 
Exchange Rates (International value of $)

• Strong $ = More imports & Fewer Exports = (AD <- )
• Weak  $ = Fewer Imports & More Exports = (AD ->)

Relative Income

• Strong Foreign Economics = More Exports = (AD ->)
• Weak Foreign Economics = Less Exports = (AD <- )

February 18, 2016

Aggregate Supply:

• The level of Real GDP (GDPR) that firms will produce at Price Level (PL). 

Long Run (Vertical):

• Period of time where input prices adjust to changes in the price level.
• The level of GDPR supplied is independent of PL.

Short Run:

• Period of time where input prices are and do not adjust to changes in PL.
• The Level of Real GDP supplied is directly related to PL.

LRAs (Long Run Aggregate Supply):

• LRAs marks level of full employment in the economy.
• Because input prices are comp. flexible in long-run, changes in PL do not change firms real profits, therefore not changing firms' level of output. this means LRAs is vertical at economy's level of full employment. 
• Formula: Full employment = FE, Yf or Y*

Changes in SRAs: 

• An increase in SRAs is seen as a shift to the right. SRAs -->
• Decrease in SRAs is seen as shift left. SRAs <--
• Key to understanding shifts in SRAs is per unit cost production,
• Formula: Per unit cost production = total input cost/ total output

Determinants of SRAs: 

• Input Prices 
• Productivity 
• Legal-Institutional Environment 

Input Prices:

- Domestic Resource Prices

• Wages (75% of all business costs)
• Cost of Capital
• Raw Materials (Commodity Prices) 

- Foreign Resource Prices
- Market Power
- Increase in Resource Prices = SRAs <--
- Decrease in Recourse Prices = SRAs --->

Productivity: 

• Formula: Productivity = Total output / Total input
• More Productivity = Lower unit production cost = SRAs -->
• Lower Productivity = higher unit production cost =  SRAs <-- 

Legal-Institutional Environment:

- Taxes & Subsidies

• Taxes ($ to govt) on business increase per unit production cost = SRAs <--
• Subsides ($ from govt) to business reduce per unit production cost = SRAs -->

- Government 

• Government regulation creates a cost of compliance = SRAs <--
• Deregulation reduces compliance costs = SRAs -->

Full Employment:

• Full Employment equilibrium exists where AD intersects SRAs & LRAs at the same point.
  

Recessionary Gap: 

• A recessionary gap exists when equilibrium occurs below full employment output.

Inflationary Gap:

• An inflationary gap exists when equilibrium occurs beyond full employment output.

February 22, 2016

(Notes on SRAs)

Nominal Wages:

• It is the amount of money received by a worker per unit of time.
• Ex: by an hour, by day, etc. 

Real Wages:

• It is the amount of goods and services a worker can purchase with their nominal wages.
• Purchasing power of nominal wages --> what you can and cannot buy 

Sticky Wages:

• The nominal wage level is set according to an initial price level and does not vary due to labor contracts or other restrictions. 

Investment:

- Money spent or expenditures on:

• New plants (factories) 
• Capital equipment (machinery) 
• Technology (hardware & 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 under take?

- Compare expected rate of return of investment cost 

• If expected return > interest cost, then invest
• If expected return < interest cost, then not invest 

Real (r%) v. Nominal (i%):
- What is the difference?

• Nominal is the observable rate of interest. 
• Real subtracts out inflation (π%) and is only known ex post facto. 

- How do you compare the real interest rate (r%)?

• r% = i% - π%

- What then, determines the cost of an investment decision?

• The real interest rate (r%)

February 23, 2016

Investment Demand Curve (ID):
What is the shape of the Investment Demand Curve?

• Downward Sloping

Why?

• When interest rate are high, fewer investments, are profitable; when interest rates are low, more investments are profitable. 

Shifts in Investment Demand (ID):

- Cost of Production

• Lower costs shift ID -->
• Higher costs shift ID <--

- Business Taxes

• Lower business taxes ID -->
• Higher business taxes shift ID <--

- Technological Change

• New technology shifts ID -->
• Lack of technological change shifts ID <--

- Stock of Capital

• If an economy is low on capital, then ID -->
• If an economy has much capital, then ID <--

- Expectations

• Positive expectations shift ID -->
• Negative expectations shift ID <--

Consumption & Savings 

Disposable Income (DI):

Income after taxes or net income
Formula: DI = Gross Income - Taxes

2 Choices:
With disposable income, households can either:

1. Consume (spend money on goods & services)
2. Save (NOT spend money on goods & services)

Consumption:

House Hold Spending
- The ability to consume is constrained by:

• the amount of disposable income
• the propensity to save

- Do households consume if DI = 0?

• autonomous
• consumption
• dis-saving

Saving:

House Hold NOT Spending

- The ability to save is constrained

• The amount of disposable income
• The propensity to consume

- Do house holds save if DI= 0? No

Average Propensity to Consume & Average Propensity to Save

APC & APS:

• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 : Dissaving
• - APS : Dissaving

Marginal Propensity to Consume (MPC):

• The fraction of any change in disposable income that is consumed.
• Formula:  MPC = Change in Consumption/ Change in Disposable Income
• MPC =  ΔC / ΔDI

Marginal Propensity to Save (MPS):

• The fraction of any change in disposable income that is saved.
• Formula:  MPS= Change in Savings / Change in Disposable Income
• MPS =  ΔS / ΔDI 

Marginal Propensities:

• MPC + MPS = 1
• MPC = 1 - MPS
• MPS = 1 - MPC
• Remember, people do two things with their disposable income. They consume it or save it. 

The Spending Multiplier Effect:

• An initial change in spending (C, IG, G, XN) causes a larger change in aggregate spending, or Aggregate Demand (AD). 
• Formula:  Multiplier = Change in AD / Change in Spending
• Formula:  Multiplier = ΔAD / Δ C, Ig, G, or Xn

Calculating The Spending Multiplier:

• The spending multiplier can be calculated  by the MPC or the MPS.
• Formula:  Multiplier = 1/1 - MPC  or  1/MPS
• Multipliers are (+) when there is an increase in spending and (-) when there is a decrease. 

Classical: 

• Competition is good.
• The invisible hand (means market will fix itself no government needed.)
• In the long run, the economy will balance at full employment. 
• Trickle down effect (help the rich first and everybody else second.)
• The economy is always close to or at full employment. 

Keynesian: 

• Competition is fraud.
• AD is the key not AS.
• Lits & Savings cause recessions.
• Ratchets effects & sticky wages blocked Say's Law.
• In the Long Run, we are all dead. 

2/29/16

Fiscal Policy:

• Changes in the expenditures or tax revenues of the federal government.

2 Tools of Fiscal Policy:

• Taxes: Government can increase or decrease taxes.
• Spending: Government can increase or decrease spending. 

Deficits, Surpluses, and Debt:

- 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 entitles or foreign government 

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 v. Automatic Fiscal policies:

- Discretionary:

• Increasing or decreasing Government Spending and/or Taxes in order the economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem. 

- Automatic:

• 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. 

Expansionary Fiscal Policy:

• ("Easy")
• Combat a recession 
• Increase government spending, Decrease taxes 

Contractionary Fiscal Policy:

• ("Tight")
• Combat inflation
• Decrease government spending, Increase taxes 

Automatic or Built-In Stabilizers: 

- Anything that increase the governments budget deficit during a recession and increases it budget surplus during inflation without requiring explicit action by policymakers.

- Economic Importance:

• Taxes reduce spending & Aggregate Demand 
• Reductions in spending are desirable when the economy is moving toward inflation. 
• Increases in spending are desirable when the economy is heading toward recession.