3/31 Monetary Policy

3/31 Monetary Policy

3 Tools of Monetary Policy used by the FED

• Reserve Requirement
• Open Market Operation - OMO
• Discount Rate

The FED sets the amount that banks must hold

Reserve Requirement Uses

1. recession; FED decreases reserve ratio
1. Banks hold less money and more ER
2. Banks create more money by loaning ER
3. MS increases, i decreases, AD increases
2. inflation; FED increases reverse ratio
1. Banks hold more money and less ER
2. Banks create less $
3. MS decreases, i increases, AD decreases

OMO - when FED buys/sells gov't bond; most important and widely used monetary policy

FED buys bonds - MS increases, FED sells bonds - MS decreases

Depends on whether the purchase or sale of bonds/securities if from bank or nonbank public entities

Discount rate - the interest rate that the FED charges commercial banks in the short-term

Federal Fund Rate - the FED Fund Rate is the interest rate that banks charge out one another for overnight loans

3/24 Money Creation Formula

3/24 Money Creation Formula

• a single bank can create $ by loaning out its ER
• the banking system can $ by a multiple of the ER
• [Money Multiplier (1/Required Reserved Ratio)] MM * ER = Expansion of money

New vs. Existing Money

• if a deposit in a bank is existing $, part of M1, depositing the $ has no immediate change in MS as it was already counted in the MS
• Existing currency deposits into a checking acct changes only in composition of the MS from coins/paper $ to checking acct deposits
• Total change in the MS of deposited is the new money created by the banking sys.
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3/23 Fractional Reserve System

3/23 Fractional Reserve System
Fractional Reserve System - process in which banks hold a small portion of their deposits in reserves and loan out the excess
Demand Deposits - checkable deposits DD - liability
Required Reserves - Banks' cash on hand RR - asset
Excess Reserves - Banks' loanable money ER - asset
Total/Actual Reserves - RR + ER
Asset - owned
Liability - owed

3/22 Money Market

3/22 Money Market

(The Supply and Demand thereof)

• Demand for money (DM) has an inverse relationship btwn nominal interest rate (i or ir) and quantity of money demanded (Qm or QD - quantity demanded)
• when ir increases, QD falls b/c individuals would prefer to have interest earning assets instead of borrowed liabilities
• when ir decreases, QD increases, no incentive to convert cash into interest earning assets

Money Demand (DM) Shifters

1. Δ in PL
2. Δ in Income
3. Δ in Taxation that affects Investment

Money Supply (MS)

• If the FED increases MS, temporary surplus of money will occur at 5% interest; surplus would cause the rate to fall to 2%

Tight Money - Contractionary - Inflation

• Sell bonds, less money, MS decreases

Easy Money - Expansionary - Recession

• Buy bonds, more money, MS increases

3/22 Bonds and Stocks

3/22 Bonds and Stocks

• Bonds - loans/ IOUs that represent debt that the gov't or corp must repay to an investor, bond holder has no ownership in company
• Stocks - owned
• If a corporation issues then sells a bond, is it a liability to the corp., since it is owed and not owned by the corp.
• The buyer who bought the bond now has it as an asset as the buyer owns it

Stockowner earns profit 2 ways

1. Dividends - portions of a corp. profits, are paid out to stockholders. Higher the corp profits, higher the dividends
2. Capital Gains - when stockholder sells stock for more he/she paid for it
3. Capital Loss - if bought high, and sold low, loss of profit

Central Bank or the FED - stabilizes the economy, maximizes employment

2/21 Lost Notes Financial Institution

Purpose of Financial Institutions

• Store$
• Save$
1. Savings Acct
2. Checking Acct
3. CD
4. Money Mrkt
• Loan $
• Interest - price paid for the use of borrowed $
• Principal - amount that was borrowed

Types of Financial Intermediaries

• Commercial banks
• Credit Unions
• Mutual Fund Companies
• Finance Companies
• Savings + Loans Institutions

Financial Systems

• Assets - what is owned                               Liability - what is owed
• Financial Asset - proper claims that entitles the buyer to future income from seller
• Physical Asset - a claim on a tangible object

5 Major Financial  Assets:

1. Loans
2. Stocks
3. Bonds
4. Loan-backed Securities
5. Bank Deposits

Money Lost from not investing it

Future Value - (FV =PV(1+i)^t)

Present Value -(PV=FV/(1+i)^N)

• Simple interest formula: v= (l+r)^n * p
• Compound interest formula v= (l+(r/k))^nh*p

3/20 Money and Monetary Policy

3/20 Money and Monetary Policy

Uses of Money

• Medium of Exchange
• Unit of account
• Store of Value

3 Types of Money

• Representative Money - represents something of value, i.e. IOU's
• Commodity Money - something that performs the functions of money and has alt. uses, i.e. salt
• Fiat Money - money b/c govt'/society says so, i.e. Paper Money, Coins

6 Characteristics of Money

1. Durability
2. Portability
3. Visibility
4. Uniformity
5. Limited Supply
6. Acceptability

Barter System - goods/services traded directly, no $ xchanged

Money - anything generally accepted in payment for goods/services

Wealth - total collection of assets that store value

Income - a flow of earnings per unit of time

Liquidity - ease w/ which an asset can be accessed and collected to cash(liquidized) - L

3 Types of Money Supply

• M1 money - High L, coins, currency, checkable deposits(checks) ( largest component)
• M2 money - Medium L, M1 + savings deposits, time deposits, certificates of deposits and mutual funds below $100K
• M3 money - Low L, M2 + time deposits above $100K

Automatic and Built-in Stabilizers(3/7)

Automatic and Built-in Stabilizers(3/7)

• anything that increases the gov't budget deficit during a recession and increases its budget surplus during inflation w/o requiring explicit action of policymakers

Transfer Payments

1. Welfare Checks
2. Food Stamps
3. Unemployment Checks
4. Corporate Dividends
5. Social Security
6. Veteran's Benefits

Fiscal Policy(3/6)

Fiscal Policy(3/6)

Gov't uses 2 options to stabilize the economy...

Fiscal Policy

• actions by Congress to stabilize the economy

• changes in expenditure or tax revenues of federal gov't

• the 2 tools are taxes(increasing or decreasing) or spending(increasing or decreasing) 

• 3 policies to promote gov't economics gov't - Full employment, Price Stability, Economic Growth

Deficits, Surpluses, and Debt

• Balanced Budget - Revenue(R) = Expenditures(E)
• Budget Surplus - R > E
• Budget Debt - R < E
• Gov't Debt = Σ deficits - Σ surpluses
• Gov't Borrows from - individuals, corporations, financial institutions, foreign entities

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Fiscal Policy Again

• Non-Discretionary Fiscal Policy(nonaction)
• Types of Taxes
  • Progressive Taxes - larger% of income from the high income groups
  • Proportional Taxes (flat rate)- same% of income from all income grps
  • Regressive Taxes - larger% from low income grps
• Discretionary Fiscal Policy

• Contractionary FP (The Brake)

• Fights Inflation

• Taxes increases, Transfers decreases, Gov't Spending decreases, Budget Surplus

• Expansionary FP (The Gas)

• Fights Recession

• Taxes decreases, Transfers increases, Gov't increases, Budget Deficit