ap macroeconomics unit 4

money

anything that can be used to purchase goods and services

wealth

accumulation of savings through the purchase of assets (with money) that occurs over time

financial assets

written claims where buyers have the right to future income from sellers

examples of financial assets

1. loans 

2. bonds

3. stocks 

4. physical assets 

5. demand deposits 

liquidity

how easily assets turn into cash

comparison of liquidity

how easily demand deposits, savings accounts, and bonds can be turned into cash

assets

valuable because they allow holder to accumulate wealth over time - interest makes assets grow over time - leads to growth in the aggregate economy 

types of assets investors are attracted to

financial assets that have higher rates of return

speculation

when consumers hold money rather than bonds because they expect the interest rate to increase in the future 

bond

number of years a holder can earn interests

after a bond comes to maturity, the bondholder gets the total face value of bond _ interest it earned overtime

relationship between bond prices and interest rates

inverse relationship between bond prices and the interest rates 

nominal interest rate

rates you see when doing business with a financial institution

rates paid on loan that are not adjusted for inflation levels 

real interest rates

real rate of return earned on financial assets or paid back on loans 

rates that ARE ADJUSTED for inflation

fisher effect

NIR = RIR + Inflation

calculates the real rate of return

effects of when unexpected inflation occurs

real value of return on financial assets falls and the real value of financial assets falls 

fiat money

a currency issued by a government that is not tied to any physical commodity like gold or silver but rather to the government's authority

example: US Dollar

real value of money isn’t set by government

set by number of goods and services it can purchase 

store of value

money has purchasing power over time

other assets can also hold value 

inflation decreases money’s ability to store value

result: we need to print more money 

medium of exchange

money used to exchange goods and services to help economies grow faster

unit of account

a function of money that provides a standard monetary unit to measure and compare the value of different goods, services, and assets

M0 = monetary base

currency and bank reserves

M1

currency in circulation, demand deposits, and savings accounts 

M2

M1 + small denomination time deposits + retail money market $

M3

M1 + M2 + larger time deposits + larger liquid assets

banking system

made of many different banks (commercial and investment) 

properties of commercial banks

• store your money and pay you interest

• customers store money in checkings accounts - become bank’s liability

• loan money and earn interest 

• banks use portion of customer demand deposits to make loans to individuals and businesses - bank assets  

fractional reserve banking

central bank sets the percentage of customer demand deposits that a bank must hold in reserves (not loan out) - known as the reserve requirement 

essentially how banks make money

bank balance sheets

show amounts of bank assets and bank liabilities each individual bank has and both sides are equal to each other 

examples of assets

reserves and loans

example of liability

demand deposits

effects of changes in demand deposits

size of the bank’s required and excess reserves

required reserves

percentage of demand deposits that the banks must hold in reserves

excess reserves

percentage of demand deposits that banks choose to hold onto. these can be loaned out to individuals and businesses 

commercial banks with non-zero reserve requirement can create money through

lending excess reserves to customers

individual banks can make new loans or fewer loans based on

behavior of their customers

when customer deposits $1000, there’s a change in the

demand deposits, required reserves, and amount of new loans

money multiplier

determines maximum changes to the banking system when deposits or withdrawals from demand deposits occur

formula for money multiplier

1 / (reserve requirement)

effects of customers’ withdrawing money

withdrawn from bank’s reserve (bank’s assets) and subtracted from bank’s demand deposits (bank’s liabilities)

demand deposits = liabilities

represent money owed to the depositor that can be withdrawn on demand 

money market

competitive market where the good being supplied and demanded is money (M1) 

also known as the liquidity preference model because of the interest rate 

price in the money market =

nominal interest rates because NIR is opportunity cost of holding money 

demand in the money market

represents relationship between nominal interest rate and the quantity of money demanded 

3 types of demand in money market 

1. transactions of demand 

2. speculative/asset demand 

3. precautionary demand 

type of relationship between nominal interest rate and the quantity of money demanded

an inverse relationship 

when nominal interest rate is high

the quantity of money demanded is low

when nominal interest rate is low

the quantity of money demanded is high

graph for the demand of money

downward sloping line

supply in the money market

amount of money that people have access to

controlled by a country’s central bank 

independent of nominal interest rate 

supply of money graph

look at the graph here 

market equilibrium on money market graph

occurs when the nominal interest rate is set where the current supply of money intersects the current demand for money 

in terms of supply, at higher interest rates 

the surplus will drive down the interest

in terms of supply, at lower interest rates

the shortage will drive up the interest

shifters of the money demand

aggregate price level, real GDP (national income), and technology

aggregate price level

higher prices require more money to make purchases

real GDP

when national income increases, spending increases, so more money is needed 

technology

the easier it is to convert less liquid assets into money, the less money is needed/demanded

availability/cost of using money substitutes (such as credit cards) affect the money demand too 

factors that shift money supply

related to monetary policy as conducted by the central bank

monetary policy

central bank’s policies of influencing the nominal interest rates to help achieve macroeconomic objectives

• price stability (low/stable rate of inflation) 

• full employment levels

interest rate changes impact

price level, real output, and unemployment through shifts in the AD

monetary policy’s target interest rate BG

when banks are unable to meet the reserve requirement they can call in loans, sell assets, borrow from central bank, and borrow from commercial banks (policy rate) 

policy rate

overnight interbank lending rate 

called federal funds rate in the USA 

central banks often set a target range from the policy rate as a way to 

guide monetary policy 

expansionary monetary policy

when the central bank decreases nominal interest rates in the short run to help an economy out of a recessionary gap

lower interest rates - less expensive to borrow - more interest sensitive spending (I & C) - increase in aggregate demand 

contractionary monetary policy

when central bank increases nominal interest rates in the short run to get the economy out of an inflationary gap

higher interest rates - more expensive to borrow - less interest sensitive spending - decrease in the AD 

recognition lag

takes central bank time to collect and analyze the data needed to recognize problems in the economy

impact lag

takes time for economy to adjust after the policy action is taken

limited reserves framework

banking system in which reserves are not overly abundant

qualities of limited reserves framework

• non-zero reserve requirement

• commercial banks hold required reserves and possibly also some excess reserves 

• monetary policy works by changing supply of excess money/reserves - ultimately the supply of money 

changing money supply results in changes to the nominal interest rate

lower NIR - expansionary because there will be no more interest sensitive spending - AD will decrease

higher NIR - contractionary because there will be less interest sensitive spending so AD decreases

central banks use their monetary policy tools

required reserve ratio - percentage of demand deposits banks MUST hold in their reserves 

discount rate - interest rate commercial banks must pay to borrow from the central bank 

open market operations - central bank buying and selling of government bonds (securities)

required reserve ratio

• percentage of demand deposits banks must hold in their reserves

• if RRR decreases, banks have more in excess reserves to lend so the MS increases (NIR falls) 

• if RRR increases, banks have less in excess reserves to lend to the MS decreases (NIR rises) 

discount rate

• interest rate commercial banks must pay to borrow from the central bank 

• if DR increases, banks are encouraged to lend less so MS decreases 

• if DR decreases, banks are encourages to lend more so MS increases 

open market operations

• central bank buying and selling of govt bonds known as securities 

• when central bank buys goods (OM purchase), banks’ excess reserves increase so MS increases 

• when central bank sells bonds (OM sale) banks’ reserves decrease so MS decreases 

money multiplier and OMO

OMO causes changes in reserves so monetary base is also going to change

• in limited reserves environment, effect of an OMO on the MS is greater than the effect on monetary base because of the MM 

increases and decreases in excess reserves

• increase - leads to banks making more loans - more deposits - more excess reserves - more loans 

• decrease - leads to banks making less loans - less deposits - less excess reserves - less loans

maximum possible value of money = 1 / RRR based on the assumptions that

• banks hold no excess reserves

• borrowers spend entire loans 

• customers hold no form of cash with them 

equation for maximum change as a result of OMO

OMO amount (money multiplier)

in ample reserves framework

interest rate changes are brought about through changes to administered interest rates 

ample reserves framework quality

• banking system in which reserves are abundant 

• required reserves ratio is 0 

• diff monetary policy tools needed - central banks often set target ranges for their policy rates

• changing MS doesn’t lead to changes in the NIR

reserve market model graph

policy rate set at the intersection of SR and DR - overnight interbank lending rate

intersection in ample reserves

SR intersects lower horizontal portion of DR

maintaining ample reserves

maintained through buying bonds 

monetary base increases, but there’s no real impact on the interest rates 

monetary policy tools - ample reserves

• interest on reserves

  • interest rate commercial banks earn on the funds in their reserve balance accounts with the Fed 

  • serves a the Fed’s primary monetary policy tool

  • increases/decreases to IOR move up/down the lower bound on RMM graph 

• discount rate

  • interest rate commerical banks must pay to borrow from the fed 

  • adjusted in the same manner as interest on reserves 

  • increases/decreases to the discount rate move up/down the upper bound on reserve model graph 

when will the DR move down

decrease in administered interest rates - decrease in policy rate - decrease in nominal interest rates 

expansionary policy because int spending and AD will increase now 

when will the DR move up

increase in administered interest rates - increase in the policy rate - increase in other nominal interest rates 

contractionary policy because int spending and AD will decrease now 

loanable funds market

how much money in the form of a loan consumers, businesses, and the government are requiring 

• determined by expectation of return on investment 

real interest rate equals price of borrowing money 

• how much consumers pay for borrowing money 

• real interest rate = nominal interest rate - inflation 

graph for demand for loans

• follows law of demand

• represents amount of loans demanded by consumers (mortgages),  producers (business loans), government (bonds)

graph for supply of loans 

• follows law of supply 

• closed economy = supply equal to national savings (public + private) 

• open economy = supply equal to national savings + net capital flow 

when economy is in a negative (recessionary) or positive (inflationary) output gap

combo of expansionary/contractionary fiscal or monetary policy will be used to restore full employment 

combo of fiscal/monetary policy influences

aggregate demand, real output, price level, and interest rates 

fiscal policy

manipulate AD by changing spending + taxes

monetary policy

manipulate AD by changing interest rates

recessionary gap

fiscal policy - increase spending, lower taxes - shift AD right - unemployment down 

monetary policy - decrease interest rates - shift AD right - unemployment down 

inflationary gap 

fiscal policy - decrease spending, increase taxes - shift AD left - price level down 

monetary policy - increase interest rates - shift AD left - price level down 

when economy is at full employment

changes in the money supply have no effect on real output in the long run

causes of inflation/deflation

increasing/decreasing money supply at too rapid for a rate for a sustained period of time

quantity theory of money 

in long run, growth rate of the money supply determines the growth rate of price level (inflation rate)