Unit Four: Countercyclical Polices

Fiscal Policy v. Monetary Policy

Notes from 3/29/16

1. In the early 21st century, here in the USA:

An efficient, "full employment" economy  will probably have:

-An annual unemployment rate of 4-5%.

-An annual inflation rate of 2-3%.

2. If the economy goes into recession:

-The real GDP decrease for at least 6 months.

-The unemployment rate will go to 6% or more.

-The inflation rate will probably go to 2% or less.

3. If Congress enacts Keynesian Fiscal Policies to attempt to slow/stop the recession, then:

- The policy will try to improve C or G (parts of AD)

-Congress will cut federal taxes.

-Congress will increase job and spending programs.

-The federal budget will probably create a deficit.

-Due to changes in Money Demand, interest rates will increase.

(Crowding Out may occur)

4. If the Federal Reserve employs Monetary Policy options to slow/stop the recession, then:

-The policy will target improvement in Ig (part of AD).

-The Fed will target a lower federal funds rate.

-The Fed can decrease the discount rate.

-The Fed can buy bonds.

-The Fed can lower the reserve requirement.

-The Fed policies will decrease the interest rates through changes in the Money Supply.

-These options should increase Ig.

5. If the economy suffers from too much demand-pull inflation or cost-push inflation, then:

-The unemployment rate will go to 4% or less.

-The inflation rate will probably go to 4% or more.

6. If Congress enacts Keynesian Fiscal Policies to attempt slow/stop the inflation problems, then:

-The policy will try to decrease C or G (parts of AD)

-Congress will increase federal taxes.

-Congress will decrease job and spending programs.

-The federal budget will probably create a surplus.

-Due to changes in Money Demand, interest rates will decrease.

7. If the Federal Reserve employs Monetary Policy options to slow/stop the inflation problems, then:

-The policy will target decreases in Ig (part of AD).

-The Fed will target a higher federal funds rate.

-The Fed increase discount rate.

-The Fed can sell bonds.

-The Fed can raise the reserve requirement, but probably won't because it is too complex for the banks. 

-The Fed policies will increase the interest rates through changes in the Money Supply.

-These options should decrease Ig. 

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Unit Four: Monetary Policies

Three Tools of Monetary Policy 

Notes 3/21/16

1. Reserve Requirement

-Only a small percentage of your bank deposit is in the safe. Rest of money has been loaned out.

   *Called Fractional Reserve Banking

-Fed sets amount banks must hold

-RR= Percent 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

2. Discount Rate

-Interest Rate the Fed charges commercial banks

-To INCREASE the Money Supply, DECREASE the Discount Rate (Easy Money Policy)

-To DECREASE the Money Supply, INCREASE the Discount Rate (Tight Money Policy)

3. Open Market Operations (OMO)

-Fed is buying/selling bonds (securities)

  *Most widely and often used*

-To INCREASE the Money Supply, BUY bonds

-To DECREASE the Money Supply, SELL bonds

RECESSION?--> Expansionary Policy

-OMO: BUY bonds

-Reserve Requirement: Decrease

-Discount Rate: Decrease

* Money Supply INCREASES, AD INCREASES, GDP INCREASES, iR DECREASES, Loans INCREASES 

INFLATION?--> Contractionary Policy

-OMO: SELL bonds

-Reserve Requirement: Increase

-Discount Rate: Increase

* Money Supply DECREASES, AD DECREASES, GDP DECREASES, iR INCREASES, Loans DECREASES

+Federal Funds Rate: FDIC member banks make overnight loans to other banks

+Prime Rate: Interest rate that the banks charge to their most credit worthy customers

-When a customer deposits cash or withdraw cash from their demand deposit account, it doesn't change the Money Supply. It changes:

   *The Composition of Money

   *Excess Reserves

   *Required Reserves

-Single Bank- Can only loan money from excess reserves

-Banking System- (ER)(Multiplier)= Total Money Supply

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Unit Four: Banks and the Creation of Money

Bank Balance Sheets

Notes 3/10/16

How do banks "create" money?

-By lending out deposits that are used multiple times

Where do the loans come from?

-Depositors who take cash and place it in the bank

How are the amounts of potential loans calculated?

-By using the bank balance sheet or T-account that consists of assets and liabilities for the bank

Bank Liabilities (Right Side of T-Account Sheet)

-Demand Deposits (DD) or Checkable Deposits (CD): Cash deposits from the public, They belong to the depositors, makes them liabilites

-Owners Equity: The value of stocks held by the public ownership of bank shares

Key Concepts:

-If DD comes from someone's cash holdings, then the DD's already part of the money supply, the cash is simply being placed in a bank account

- If DD comes in from the purchase of bonds (by the FED), then this creates new cash and therefore creates new money supply

Bank Assets (Left Side of T-Account Sheet)

-Required Reserves (RR)- Percentages of DD that must be held in the vault so that some depositors have access to the money, usually between 5-20%, In real time it will never be higher than 10%

-Excess Reserves (ER)- The source of new loans, DD= ER + RR

-Property 

-Securities/Bonds- Bonds purchased by the banks or new bonds sold to the bank by the Federal Reserve, These bonds can be purchased from the bank and turned into cash that immediately becomes available as ER

-Loans

*The FED requires banks to always have some money readily available to meet consumer's demand for cash

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Unit Four: Money (Part Four)

Money

Notes from 3/9-10/16

Financial Sector

Financial Assets- Stocks or bonds that provide expected future benefits

   +Benefits the owner only if the issuer of the asset meets certain obligations

Financial Liabilities- Is incurred by the issuer of a financial asset to stand behind the issued asset.

   +Liabilites: OWED Assets: OWN

Interest Rate- The price paid for the use of a financial asset 

Stocks- Financial assets that convey ownership in a corporation

Bonds- The promise to pay a certain amount of money plus interest in the future

What Banks Do?

-A bank is a financial intermediary

   +Uses liquid assets to finance the investments of borrowers

   +Process known as Fractional Reserve Banking 

     -System where depository institutions (banks) hold liquid assets less than the amount of deposits

     -Takes forms of:

       *Currency of bank vaults

       *Bank reserves: Deposits held at the Federal Reserve

Basic Accounting Review

-T-Account (Balance Sheet)

  +Statement of assets of liabilities

  +Assets = Liabilities

- Assets (Amount Owned)

  +Items to which a bank holds legal claim

    *Examples: Capitol Stock, Owner's Equity

-Liabilities  (Amounts Owed)

  +The legal claims against a bank

Functions of the Federal Reserve Bank (FED)

1. Issue paper money

2. Sets reserve requirement and holds reserves of the bank

3. Lends money to banks and charges them interest

4. A check-clearing service for banks

5. Acts as a personal bank for the government

6. Supervises member banks

7. Control the money supply

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Unit Four: Money (Part Three)

Money

Notes from 3/9/16

Money Demand and Supply

-Demand for Money has an inverse relationship between nominal interest rates and the quantity of money demanded

-What happens to quantity of money when interest rates decrease?

   +Quantity Demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities

-What happens to Quantity Demanded when interest rates decrease?

   +Quantity Demanded decreases because there is no incentive to convert cash into interest earning assets

Increasing Money Supply

-If the FED increases money supply, a temporary surplus of money will occur at i. The surplus will cause interest rate to fall to i'. 

Supply of Money Increases ---> Interest Rates Decrease ---> Investment Increases --->        Aggregate Demand Increases

Decreasing Money Supply

-If the Fed decreases money supply, a temporary shortage of money occurs.

Supply of Money Decreases ---> Interest Rates Increase ---> Investment Decreases --->         Aggregate Demand Decreases

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Unit Four: Money (Part Two)

Money

Notes from 3/9/16

QUESTION: Is a dollar today worth more than a dollar tomorrow?

ANSWER: YES

WHY: Inflation and Opportunity Cost

VARIABLES:

v= future value of money

p= present value of money

r= real interest rate (nominal interest rate - inflation, expressed as a decimal)

n= years

k= # 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

Example: Inflation is expected to be at 3% and nominal interest rate on simple interest savings is 1%. Calculate the future value of $ after one year.

r%= i% - ∏%

r%= 1 - 3 

r%= -2% or -0.02

v= (1 + r)^n x p

v= (1 + -0.02)^1 x 1

v= (.98)^1 x 1

v= $0.98

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Unit Four: Money

Money

Notes from 3/4/16

Uses of Money

-Medium of Exchange: To trade or barter

-Unit of Account: Establishes economic worth in the exchange process

-Store of Value: Money holds its value over a period of time, whereas products do not

Types of Money

-Commodity $: Gets its value from the type of material from which it is made

    -Example: Gold and Silver Coins

-Representative $: Paper money backed by something tangible that gives it value

-Fiat $: It is money because the government said so

    -Used in the United States

Characteristics of Money

a. Portable- Can fold, move, etc.

b. Durable-Can leave money in your pocket, wash clothes, and the money will be fine

c. Scarce- Only having cash is rare

d. Divisible- How many ways can you break a dollar?.....A LOT

e. Acceptable- No where cash is not allowed

f. Uniform- Dollar is same no matter where you go

Money Supply

a. M1 $

   -Consists of currency

   -Currency:

    +Cash and Coins

    +Checkable Deposits/Demand Deposits (Checking Accounts)

    +Travelers Checks

   -75% of money currently in circulation

   -Most liquid- Easy to convert to cash

b. M2 $

   -Consists of M1 $ along with savings accounts, money market accounts, and deposits held by private institutions

   -Not as liquid

   -Money Market: Earn interest while in checking account

c. M3 $

   -Consists of M2 $ plus certificates of deposits (CDs) held by private institutions

   -If money here is withdrawn early, there is a penalty 

    +Example: Taking money out of your 401k plan

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