Unit 4

Uses of Money

• medium of exchange (barter or trade)
• unit of account, hives money its economic worth
• store of value

Types of Money

1. Representative Money- paper money backed by a tangible product
2. Commodity Money- gold and silver coins, gets its value form materials made
3. Fiat Money- it is money b/c the government says so (US)

Characteristics of Money 

1. Durability - how long is money good for 
2. Portability - can carry it anywhere
3. Divisibility - can be broken into smaller units
4. Scarcity
5. Acceptability

M1 Money

• consists of currency in circulation (paper and coins) (travelers check)
• Checkable deposits- checking accounts, demand deposits (DD)
• Account for 75% of $ in circulation

M2 Money 

• Includes
• savings accounts
• money- market accounts
• accounts held by banks outside the U.S
• adding M1 money as well
• money market account- accounts interests; large money account

ASSETS = LIABILITIES + NET WORTH 

RESERVE RATIO = (commercial banks required reserves/ commercial banks checkable deposit liabilities)

3 Important Issues

1. Excess Reserves = actual reserves - required reserves
2. control of lending ability
3. asset or liability to which bank

- Banks create money by lending excess reserves and destroy it by loan repayment. Purchasing bonds from the public also creates money

-Monetary Multiplier = 1 / (required reserve ratio)

- Maximum checkable deposit creation = excess reserves x monetary multiplier

Reserve Requirement

• the Fed. requires banks to always have some money readily available to meet condumers 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 
• Typical Reserve Ratio = 10%

The Monetary Policy

• shows us the impact of a change in demand deposits on loans and eventually the money supply

Monetary Policy

• ·         Controlled by the FED(Federal Reserve Bank)
• ·         Influencing the economy through changes in reserves, which influences the money supply and available credit

4 Options of Monetary Policy

1. 1.       Reserve Requirement- the % that is set by the FED of the minimum reserves that a bank must keep; decrease -> expansionary monetary policy; increase -> contractionary monetary policy
2. 2.       Discount Rate- the rate of interest that the FED charges for overnight loans to banks; decrease    -> expansionary monetary policy; increase -> contractionary monetary policy
3. 3.       Federal Fund Rate- the rate that FDIC members charge each other for overnight loans; decrease    -> expansionary monetary policy; increase -> contractionary monetary policy
4. 4.       OMO (Open Market Operation):

a.       Buy or sell securities (bonds) – “FED”

b.      FED buys bonds -> expand money supply (expansionary)

c.       FED sells bonds -> decreases money supply (contractionary)

Prime Rate- the interest rate that banks charge their most credit worthy borrowers

	Expansionary Or Easy Money (Recession) (Increase MS)	Contractionary or Tight Money (Inflation) (Decrease MS)
OMO	Buy Bonds	Sell Bonds
Discount Rate	Decrease	Increase
Federal Fund Rate	Decrease	Increase
Required Reserve Ration	Decrease	Increase

·         Tight money has a higher interest rate

·         Easy money is depreciating

Single Bank:

•  amount of money single bank cant create (loan out) = ER
• AR-RR=ER

Banking System

• Can create money by a multiple of its initial ER
• Deposit Multiplier = 1/RR

System New $

• Deposit Multiplier x Initial ER
• Total change in the money supply as a result of the deposit

Money Market

Loanable Funds or Bond Market

Crowding Out 

Video Notes

Video 1: Types and Functions of Money

3 types of money

• ·         Commodity – goods that act as money
• ·         Representative – coins and dollars
• ·         Flat money – government’s word

3 main functions

• ·         Medium of exchange
• ·         Storage of value
• ·         Unit of account

Video 2: Money Market Graphs

Money supply

• ·         Constant, controlled by the interest rates and government.
• ·         Vertical, not based off of interest rates
• ·         Increase demand = increase interest rates

The law of demand – if the price is high quantity demanded is low, if price is low quantity demanded is high

Video 3: The Fed’s tools of monetary policy

The gov’t uses two options regarding changes in the money supply

• ·         Contractionary (tight money)
• ·         Expansionary (easy money)

Contractionary fiscal policy

• ·         Reserve rate will ↑
• ·         Discount rate will ↑
• ·         Gov’t will sell bonds and securities

Expansionary fiscal policy

• ·         Reserve rate will ↓
• ·         Discount rate will ↓
• ·         Gov’t will buy bonds and securities

Video 4: The Loanable funds Market

Loadable funds graph

• ·         Supply curve is completely dependent on saving
• ·         If more people save, then more loans are available
• ·         If gov’t is in a deficit then demand for loans will increase, which leads to a decrease in supply of loans
•  

Video 5: Money creation and multiple deposit expansion

Money is created when banks make loans

To find how much money a loan creates you must:

• ·         Find the multiplier – (1/RR)
• ·         Multiply by the loan amount = multiple deposit expansion

Example

·         RR = 20%

·         (1/.2)=5

·         5(500) = 2500

Video 6: Relating Money market, loanable funds market, AD/AS model

Exchange – MV = PQ

·         Increase in demand for money increases price level

·         Increase in demand for money increases interest rate, which causes the demand curve to increase resulting in the price levels to increase as well as GDP_r  in AD/AS graphs 

Unit 3

Aggregate Demand

• shows the amount of RGDP that the private, public and foreign sector collectively desire to purchase at each positive price
• relationship between price and RGDP is inverse
• price on Y
• Quantity of X

Three Reasons why AD is Downward Sloping

• Real Balancing Effect
• price is high; businesses and households cannot afford to buy as much output 
• vise versa
• Interest-Rate Effect
• high price level increases interest rate, discouraging investment
• vise versa
• Foreign Purchases Effect
• higher price level increases the demand for relatively cheaper imports
• vise versa

Shifts in AD

• a change in C, Ig, G and Xn
• a multiplier effect that produces a greater change that the original change in the 4 compenents

Consumption

• Household is affected by:
• consumer wealth
• more wealth, AD increases
• vise versa 
• Consumer Expectations
• positive, AD increases
• vise versa
• Household indebtedness
• less debt, AD increases
• vise versa
• Taxes
• Less Taxes, AD increases
• vise versa

Gross Private Investment

• Sensitive to:
• The real interest rate
• low interest rate, AD increases
• vise versa
• Expected Returns
• Higher Expected Returns, AD increases
• vise versa
• Influenced by
• expectations of future profitability
• technology
• degree of excess capability
• business taxes

Government Spending

• More, AD increases
• vise versa

Net Exports

• Sensitive to:
• Exchange Rate
• strong $= more imports fewer exports, AD decreases
• weak $= fewer imports and more exports AD increases
• Relative Income
• Strong Foreign Economy = increase in exports, AD increases
• Weak Foreign Economy = decrease in exports, AD decreases

Aggregate Supply

• Long Run 
• input prices are completely flexible and adjust to changes in the price level
• level of RGDP supplied is independent of the Price Level
• Short Run
• input prices are sticky and do not adjust to changes in the PL
• level of RGDP supplied is directly related to the PL

Long Run AS

• marks the level of full employment in the economy (analogous to PPC)
• Verticle

Changes in SRAS

• Increase in SRAS seen as shift to right: SRAS →
• Decreases in SRAS shift to left: SRAS ←
• Key to understanding shifts in SRAS in per unit of production:
• (Per Unit Production Cost = Total Input Cost / Total Output)

Determinants of SRAS

• Input Prices
• Domestic Resource Prices
• Wages (75% of all business costs)
• Cost of capital
• Raw materials (commodity prices)
• Foreign Resource Prices
• Strong $ = Lower Foreign Resource Prices
• Weak $ = Higher Foreign Resource Prices
• Productivity
• (Productivity = Total Output / Total Input)
• More Productivity = Lower Unit Production Costs = SRAS →
• Lower Productivity = Higher Unit Production Costs = SRAS ←
• Legal-Institutional Environment
• Taxes and Subsidies
• Taxes ($ to government) on businesses increase per unit production costs = SRAS ←
• Subsidies ($ from government) on businesses reduce per unit production cost = SRAS →
• Government Regulation
• Government regulation creates a cost of compliance = SRAS ←
• Deregulation reduces compliance costs = SRAS →

The AS/AD Model

• the equilibrium of AS & AD determined where AD intersects SRAS & LRAS at the same point

Recessionary Gap

• exists when equilibrium occurs below Full Employment output

Inflationary Gap

• exists when equilibrium occurs beyond full employment output

3 Ranges

• Horizontal or Keynesian Range
• It includes only levels of real output that are less than the FE output.
• It implies that the economy is in recession.
• Vertical or Classical Range
• The economy reaches its full capacity real output.
• Increase in PL = constant production
• Intermediate
• Expansion of real output and price level

Consumption and Saving 

• Disposable Income (▵DI)
• income after taxes, net income
• DI= gross income - taxes
• households cane either consume or save
• Consumption - household spending
• the ability to consume is constrained by:
• the amount of DI
• the propensity to save
• Do household consume if DI=0?
• Yes; autonomous consumption 
• Average Propensity to Consume (APC) = C/DI = % of DI that is spent
• Saving - household NOT spending
• the ability to save is constrained by:
• the amount of DI
• the propensity to consume
• Do household save if DI=0?
• No
• Average Propensity to Save (APS) = S/DI = % of DI that is saved
• Equations
• APC+APS=1
• 1-APC=APS
• 1-APS=APC
• APC>1, dissaving
• -APS, dissavings
• Marginal Propensity to Consume (MPC) = ▵C/▵DI = % of every extra dollar earned that is spent
• Marginal Propensity to Save (MPS) = ▵S/▵DI = % of every extra dollar earned that is saved
• MPC+MPS=1
• 1-MPC=MPS
• 1-MPS=MPC

Determinants of C & S

• wealth, expectations, household debt, taxes

Spending Multiplier Effect

• an initial change in spending (C, Ig, G, Xn) causes a larger change in AS or AD
• ▵AD/(▵ in C, Ig, G, Xn)
• Why does this happen?
• expectations and income flow continuously which sets off a spending increase in the economy
• = 1/(1-MPC) or 1/MPS
• (+) when increase in spending
• (-) when decrease in spending

Tax Multiplier

• when the government taxes, the multiplier works in reverse because money is leaving circular flow
• = -MPC/(1-MPC) or -MPC/MPS
• if tax is cut, then multiplier is positive because there is more money in the circular flow

Interest Rates and Investment Demands

Investment

• Money spent on expenditures on:
• New plants or factories
• Capital equipment (machinery)
• Technology (hardware and software)
• New homes
• Inventories (Goods sold by producers)

Expected Rates of Return

• investment decisions
• Cost/Benefit analysis
• determine the benefits
• Expected rate of return
• count the cost
• Interest cost
• determine the amount of investment they undertake
• Compared expected rate of return to interest cost
• If expected return > interest cost, then invest.
• If expected return > interest cost, then do not cost.

Real (r%) v. Nominal (i%)

• Nominal is the observable rate of interest. Real subtracts out inflation (π%), and is only known ex post facto.
• Computing r%: (r% = i% - π%)
• determining the cost of an investment decision
• Real interest rate (r%)

Investment Demand (ID)

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

Shifts in ID

• Cost of production
• Business taxes
• Technological change
• Stock of capital
• Expectations

Fiscal Policy

• Fiscal policy is the 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
• it is enacted to promote our nation's economic goals: full employment, price stability, economic growth

Deficits, Surpluses, and Debt

• Balanced budget: Revenues = Budget
• Budget Deficit: Revenues < Budget
• Budget Surplus: Revenues > Budget
• Government Debt: sum go all deficits - sum of all surpluses
• Government must borrow money when it runs a budget deficit from:
• individuals, corporations, financial institutions, and foreign entities/governments

Fiscal Policy (FP): Two Options

• Discretionary FP (actions)
• Expansionary FP - think deficit
• to increase RGDP, combat recession, and reducing unemployment
• Government Spending -->, Taxes <--
• creates inflation
• Contractionary FP - think surplus
• strategy for controlling inflation
• Government Spending <--, Taxes -->
• Non-Discretionary FP (no action) - AUTOMATIC
• Discretionary increases or decreases taxes
• Automatic - takes in unemployment compensation, social security, etc, that help eases the effects of recession and inflation

Tax Systems

• Progressive Tax System
• Average tax rate that rises with GDP
• Proportional Tax System
• Average tax rate remains constant as GDp changes
• Regressive Tax System
• Average tax rate falls with GDP

Graphs: