Notes from YouTube videos- AP MACRO ECONOMICS: UNIT 4

Part 1: Types and functions of money.

Three types of money are : Commodity money (for example some parts of Africa where cows are used as money), Representative money (gold money), FIAT money (backed by the word of the govt. if the government says it has value then it has value). functions of money include ; medium of exchange, store of value and unit of account (price implies worth; which isn't always true).

Part 3: Money market graphs.

When price is high quantity demanded is low and when the price is low quantity demanded is high. the supply of money on the graph is vertical because it does not vary based on the interest rate and it is controlled by the FED. Demand of money is tied into the interest rate while supply of money is not. Supply of money moves only when the FED does something to move it. Also, shifting money supply to the right stabilizes interest rate.

Part 4: The FEDs tools of Monetary Policy.

Reserve requirement: is the percentage of bank total deposit that they must hang on to (vault cash).
Discount rate: is the rate at which banks can borrow money from the FED . the FED is a "lender of last resort".
FED funds rate: this has nothing to do with the FED. it is the rate at which banks borrow from each other.

Expansionary (easy money):
 RR- decreased in order to increase money supply.
 DR- decreased
 buy/sell/bonds/seurities: buy bonds to increase money supply.

Contractionary (tight money):
 RR - increased
 DD- increased
 Bonds- sell bonds to decrease Money supply.

Part 5: The equation of exchange.

MV=PQ
M= Money supply
V= Velocity (how fast its moving)
Q= Total Quantity (volume of goods).
when talking about price and quantity then we are talking about the GDP income approach. If velocity is stable, changes in money supply will lead to change in prices.

Part 6: Costs of Inflation.

1. Inflation fallacy: when inflation occurs money power isn't lost because wages will adjust and you get payed more money, therefore there is no real impact of inflation. In the "long run" this is true.
2. Shoe Leather cost.
3. Menu cost: cost of changing prices and communicating those price to customers.
4. Tax Distortions: does not tax your real income but nominal income, it is not adjusted for inflation.
5. Confusion (tied to in adequate information): people do not have a better understanding on the real concept of inflation and so they get misinformed from the media.
6. Redistribution of wealth.

Part 7: The Loanable funds market.

This is the money available in the banking system for people to borrow. Supply of loan-able funds comes from the amount of money people have in banks, this means that it is dependent on savings. In this market, the more money people save, the more money banks have to give out loans. If people have an incentive to save, then we increase the supply of loanable funds. if people have the incentive to save less we decrease the supply of loanable funds. Shifting the supply of loanable funds goes left and to the right and not up and down on the graph.

Part 8: Money creation and multiple deposit expansion.

Banks create money by making loans. One of the FED tools for monetary policy is the ability to control the reserve requirement.
- Money multiplier = 1/RR
RR= 20%, loan amount = $500
What is the total money created? 1/0.2 = 5 * 500 = $2500.
we got $2500 using the process of Multiple deposit expansion.

Part 9: Relating the money market, loanable funds market, and aggregate demand-aggregate supply model.

In the money market the govt is borrowing money from Americans. Whenever someone buys a govt bond thats you loaning your money to the government. In the Money Market, we have an increase in the demand of money  because the govt is borrowing it. So this means that the demand of money Shifts to the right and there is an increase in the interest rate. In loan-able funds, demand shifts to the right and there is an increase in the interest rate when there is an increase in govt spending. There is an increase in price level, AD and GDP.

All three graphs are all closely related.
Fisher Effect: 1% increase in interest rate will lead to a 1% increase in inflation (price level).

UNIT 4: THREE TOOLS OF MONETARY POLICY

                                     THREE TOOLS OF MONETARY POLICY

1.      The Reserve Requirement:

-          Only a small percentage of your bank deposit 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 (reserve ratio) is the percentage 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? Steps:

Decrease the Reserve ratio

1.      Banks hold less money and 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?

Funds Increase the Reserve ratio

1.      Banks hold more money and have less excess reserves.

2.      Banks create less money.

3.      Money supply decreases, interest rates go up, AD down.

2.      The Discount Rate

-          The discount rate is the interest rate that the FED charges commercial banks. For example, if bank of America needs $10 million, they borrow it from the US treasury (which the FED controls) but they must pay it back with interest. 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 (bonds).

-           

Ø  Federal funds rate.

This is where FDIC member banks, loan each other overnight loans.

Ø  Prime rate

Interest rate that banks give to their most credit worthy customers.

Reserve Requirement

                                                       Reserve requirement

·         The Fed requires banks to always have some money readily available to meet consumers demand for cash.

·         The amount, set by the Fed, Is the required reserve ratio.

·         The required reserve rate is the percentage 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.

-          A.k.a. 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 type 3 will have the same result (i.e. no Fed involvement).

They both equal

RR and DD cannot be loaned out money stretches.

UNIT 4: Money, Time value of money, What banks do and Functions of FED.

                                                                    Money

1.      Uses of money

-          Medium of exchange (trade/barter).

-          Units of accounts: establishes economic worth in the exchange process for example: giving something to someone in order to reduce price.

-          Store of value: money holds its value over a period of time whereas products may not.

2.      Types of money

-          Commodity money: it gets its value from the type of material from which it was made. An example would be gold coins and silver coins.

-          Representative money: paper money backed by something tangible, that gives it value. Example would be(“I owe you”)

-          Fiat money: it is money because the government says so. “used in the united states”.

3.      Characteristics of money

·         There are six characteristics of money:

-          Durable- paper money and coins both last.

-          Portable

-          Divisible (can be broken down in many ways)

-          Uniform (identical)

-          Scarce

-          Acceptable (Everywhere you go)

                                         Money supply

1.      M1 money supply: consists of currency (coins and cash), it also consists of checkable deposits (demand deposits) and travelers checks.

    75% of the money we use comes from M1 money. Out of all three money supply it is the “liquid” (easy to break down).

2.      M2 money: consists of M1 money + savings + deposits built by banks outside of the United States. Saving accounts are not “liquid” (not easy to break down).

3.      M3 money: consists of M2 money + certificates of deposit that are held by private institutions

                              (Pay bank penalty for withdrawing money)

                                                      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.

                                     How to calculate time value of money

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= (i+r)^n * p

The compound interest formula: v= (i+r/k)^nk * p

            Demand for money has an INVERSE relationship between nominal interest rates and the quantity of money demanded.

1.      What happens to the quantity demanded of money when interest rates increases? – Quantity demanded decreases because individuals would prefer to have interest earning assets instead of borrowed liabilities.

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

Quantity demanded increases. There is no incentive to convert cash into interest earning assets.

            Slope of demand is always downward sloping. Money supply is upward sloping.

Increasing money supply

Increasing price level

                                         Decreasing money supply

Decrease>increase>decrease>decrease money supply interest rate investment AD

                                               Financial assets

Examples are stocks and bonds. They provide an expected future benefit. It is what you own.

                                             Financial liabilities

                                        It is simply what you owe.

                                                  Interest rate

                                It is the cost of borrowing money.

                                                     Stocks

             They are financial assets that convey ownership in a company.

                                                      Bonds

    It is a promise to pay a certain amount of money or interest in the future.

                                                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 reserve 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 reserve: deposits held at the Federal Reserve.

What banks do-

Basic accounting review

·         T account (balance sheet)

-          Statements of assets and liabilities.

·         Assets (amounts owned)

-          Items to which a bank holds legal claim.

-          The uses of funds by financial intermediates.

·         Liabilities (amounts owed)

-          The legal claims against a bank.

-          The sources of funds for financial intermediaries.

 

                                                     Functions of FED

1.      To issue currency.

2.      Set reserve requirement and hold reserves of banks.

3.      To lend money to banks and charge them interest.

4.      They are a check clearing servings for banks.

5.      Acts as a personal bank to the Government.

6.      Supervises member banks.

7.      Controls money supply in the economy.