Tools of Monetary Policy

3-31-17

Tools of Monetary Policy

3 tools

1. Setting RR
2. lending $ to banks and thrifts
• Discount rate
3. Open Market Operations
• Buying and selling bonds

RR

• "fractional reserve system"
• The Fed sets the amount that bank must hold
• RR is % of deposit that banks must hold in reserve
• loan eventually becomes deposits for another bank that will loan out ER 
• If there is a recession fed actions on RR
• decrease reserve ratio
• Banks hold decrease money and have more ER
• Banks create more $ by loaning out excess
• money supply increases, interest falls, AD increases, RR decreases, MS increases, i increases, I increases, and AD increases
• If there is inflation fed actions on RR
• Increases reserve ratio
• Banks hold more money and have less excess reserve
• banks create less money
• RR increases, MS decreases, i increases, I decreases, AD increases
• OMO is when fed. buy or sell govt bonds
• this is most important and widely used monetary olicy
• of fed buys bonds it takes bonds out of the eco and replaces them with $
• If fed sell bonds it takes $ and give the security to the investor
• To increase MS fed should BUY govt securities
• to decrease MS fed should sell govt securities
• If fed buys bonds the DD X MM

Discount Rate

• interest rate that fed charges commercial banks for short term loans
• DD generally not used by the fed to affect monetary supply

Money creation formula

3-27-17

Money creation formula

• A single bank can create $ by amount of its ER
• banking system as a whole can create $ by a multiple of excess reserves
• MM X ER = Expansion of $
• Money multiplier= 1/RR

News vs Existing $

• Initial deposit in a bank comes from the FED/bank purchase of a bond or other $ out of circulation (buried treasure), the deposit immediately increases the $ supply
• deposit then leads to further expansion of $ supply through the $ creation process
• Total change in MS if initial deposit is new $ = Deposit + $ created by banking system 
• if deposit in a bank is existing $ (already counted in M1), depositing the amount does NOT change the MS immediately cs it already counted
• Existing currency deposited into a checking account changes only the composition of the $ supply from coins.paper $ to checking account depositing
• total change in the MS if deposit is existing $ = banking system created $ only

Bond and stocks

3-22-17

Bonds and Stocks

• bonds are loans, or IOUs, that represent debt that the govt or corporation must repay to investor
• bond holder has no ownership of company

Bonds

• First if a corporation issues and then sells a bond
• liability or asset is corporation
• assets  or liability are buyers
• If that corporation issues a lok bond with a 10 yr. term and a 5% interest
• nominal interest rate = 5%
• nominal interest falls 3% = value of bond increases
• nominal interest rate rises 8 = value of bond decreases

Stock owners

• earn profit in two ways:
• Dividends, portions of corporations profit are paid out to stock holders
• higher corporate profit, the higher the divided
• Capital gain: earned when stockholders sell stock at lower price than purchase price suffers a capital loss

The money market

• Demand fir $ has inverse relationship between nominal interest rates and quantity of $ demanded
• What happen when demand of $ when in. rates increases?
• Quantity demand falls because of individuals would prefer to have interest earning assets instead of borrowed liabilities
• What happens when quantity demanded when in. rates decreases
• quantity demand increases no incentive to convert cash

Money Demand Shifters

1. Changes in price lvl
2. changes in income
3. changes in taxation that affect investment

• Money demand curve slopes decreases and to the shifts because all else being equal higher interest rates increase the opportunity cost of holding $, thus leading public to reduce quantity of $ it demands

Fractional Reserve system

• Demand deposits/checks
• process by which banks hold a small portion of their deposits in reserves and loan out the excess
• banks keep cash on hand which is (RR) to meet depositor's needs 
• MS only moves by bond or loans 

Unit 4 Money Exchange

3-20-17

Unit 4 Money Exchange

Barter System

• good and services are traded directly
• no money exchange

Money

• anything generally accepted in payment for goods and services
• money does not equal wealth and income
• wealth equals total collection of assets that store value 
• Income equals flow of earnings per unit of time
• can be used as

1. Medium of exchange: buys goods and services
2. Unit of account: measuring value of goods and services
3. Store value

Types of Money

• Representatives $
• something of value
• ex: IOU
• Commodity $
• something that preforms function of money and has alternative uses
• ex: Gold, salt, silver
• Flat $
• $ cause govt says so
• ex: paper, coin

Characteristics $

• durability, portability, divisibility, limited supply, uniformity, acceptability

3 Types of Money

• liquidity- ease with which an asset can be accessed and converted into cash

1. M1 (High Liquidity)- coins, currency, and checkable deposits (personal and corporate checking accounts which are largest compent of M1). AKA demand deposits. Generally money supply
2. M2 (Medium Liquidity)- M1 and savings deposits ($ market accounts), time deposits (CDs: certificates of deposit), and mutual funds below $100k
3. M3 (Low Liquidity)- M2 plus time deposits above $100k

Financial institutions

1. store money
2. save money

• savings acct., checking acct., CD, money market acct.

      3. loan money

• Interest- price paid for the use of borrowed money
• Principal- amount that you borrow

Types of Financial Intermediaries

• Commercial Banks
• savings and loans institution
• Credit Union
• Mutual Funds Companies
• Finance Companies

Financial System

• Assets- anything of monetary value owned by a person or business.
• Financial Asset- a paper claim that entitles the buyer to future income from the sellers.
• Physical Asset- claim on tangible object (Ex: car, house)
• If you go to your bank and take out loan 
• bank created Financial Asset, you have created a Liability
• Liability- requirement to pay money in the future (usually with interest)
• there are 5 major financial assets: loans, stocks, bonds, loan-backed securities, and bank deposits

Interest rates and Inflation

• The time value of money- A dollar is worth more today that it is tomorrow. You are losing money every second you are not investing.

Present vs. Future Value

• Future Value: If you invest (or lend) money to someone, it will compond (grow) according to the following equation: FV=PV(1+i)^t
• Present Value: amount of $ I need to invest new, in order to get some amount (FVS known) in the future. PV=FV/ (1+i)^N

Simple Interest Formula

• Let v= future value of $
• p= present value of $
• r= real interest rate (nominal-inflation rate) expressed as a decimal
• n= years
• k= # of times interest is credited per year
• simple interest formula
• v=(1+r) ^n X P

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Unit 3

3-7-17

Fiscal Policy

How govt stabilize eco.

• Actions by congress to stabilize economy

Fiscal Policy

• changes in expenditures or tax revenues of federal govt
• 2 tools of fiscal polic
• taxes govt can increase or decrease taxes 
• spending govt can increase or decrease spending
• Fiscal policy is encoded to promote our nations economic goals: full employment, price stability, economic growth

Deficit, Surplus, Dept

• Balanced budget
• revenues = expenditures
• Budget deficit
• revenues< expenditures
• Budget Surplus
• revenue> expenditures
• govt debt
• sum of all deficits - sum of all surpluses
• Govt must borrow money when it runs a budget deficit
• Govt borrows from
• individuals, corporations, financial institution, foreign entities of foreign

Fiscal policy 2 options

• Discretionary Fiscal Policy(action)
• expansionary fiscal policy- think deficit
• constractionary fiscal policy- think surplus
• Non Discretionary Fiscal Policy (no action)

3 types of taxes

• 1- progressive taxes- takes a larger percent of income from high income group
• ex: current federal income tax system
• 2- proportional taxes (flat rate)- takes same % of income from all income groups
• 3- Regressive tax- takes larger percentage from low income groups

Contractionary Fiscal Policy

• laws that reduce inflation, decrease GDP
• decrease govt spending
• tax increase
• combinations of the two

Expansionary FP

• law that reduce unemployment and increases GDP
• increase govt spending
• decrease tax on consumers
• combinations of the two

Automatic/Built in stabilizer

• Anything that increases govt budget deficit during recession and increases its budget surplus during inflation without requiring explicit action by policymakers
• 1- transfer payments
• welfare checks, food stamps, unemployment checks
• 2- progressive income tax
• automatic stabilizers take 33-50% out 

Unit 3

2-26-17

MPC and MPS

Spending Multiplier effect

• initial change in spending (C,Ig,G,Xn) causes larger change in aggregate spending/ (AD)
• multiplier = Δin AD/Δin spending or ΔAD/ΔGDP
• why does this happen?
• expenditures and income flow continuously which set off spending increase in economy

Calculating spending multiplier

• multiplier = 1/(1-MPC) or 1/MPS
• Multilier are (+) when there is an increase in spending and (-) when there is a decrease

Calculate tax multiplier

• when govt taxes, the multiplier works in reverse
• bc now money is leaving circular flow
• Tax multiplier (note: it's negative)
• formula = -MPC/(1-MPC) or -MPC/MPS
• If there tax - cut, multiplier is positive bc there now more money in circular flow 
• Range 1- employment is high, roduction is low
• Range 2- unemployment is medium out put is high
• Range 3 - output high unemployment   

Unit 3

2-23-17

Consumption and savings

Disposable income (DI)

• income after taxes/ net income
• DI= gross income - taxes
• 2 choices, 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 consume is contained by
• amount of disposable income
• propensity to save
• Do households consume if DI = 0?
• autonomous consumption
• Dissavings
• APC = C/DI % DI that is spent

Savings

• Household not spending
• ability to save is constrained by
• amount of disposable income
• propensity to consume
• Do households save if DI = 0? - No
• APS = S/DI% DI that not spent

APC and APS

• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 Dis-savings 
• -APS dis-savings

MPC and MPS

• Marginal Propensity to consume
• ΔC/Δ DI
• % of every extra dollar earned that is spent
• Marginal Propensity to save 
• ΔS/ΔDI
• % of every extra dollar earned that is saved
• MPC + MPS = 1
• 1- MPC = MPS
• 1- MPS = MPC

Determinants of C and S

• Wealth
• Expectations
• Household debt
• Taxes