Unit 4.6: Financial Sector

how monetary policy works in a limited reserves framework

Monetary policy works by changing the supply of excess reserves => changing the supply of money => changing the nominal interest rate

list 3 Limited Reserves monetary policy tools

1. required reserve ratio

2. discount rate

3. open market operations

how much does an OMO change a bank’s excess reserves?

by the entire amount of the purchase/sale b/c reserve requirement only applies to checkable deposits

purpose of buying bonds in an ample reserves framework

to maintain ample reserves

list 2 tools of ample reserves monetary policy

change administered interest rates:

1. Interest on reserves (IOR)

2. Discount rate

how do changes to IOR affect the reserve market model

increase IOR: move up the lower bound of demand for reserves

decrease IOR: move down the lower bound of demand for reserves

how do changes to discount rate affect the reserve market model

increase discount rate: move up the upper bound of demand for reserves

decrease discount rate: move down the upper bound of demand for reserves

explain the steps of expansionary monetary policy in ample reserves framework

1. administered interest rates decrease

2. policy rate decreases

3. other nominal interest rates decrease

4. Interest-sensitive spending increases

5. AD increases

explain the steps of restrictive/contractionary monetary policy in ample reserves framework

1. administered interest rates increase

2. policy rate increases

3. other nominal interest rates increase

4. Interest-sensitive spending decreases

5. AD decreases

Loanable Funds market

How much money in the form of loans consumers, businesses, and government are requiring, determined by expectation of return on investment

supply of loans in closed economy

Supply in closed economy = national savings

national savings equation

national savings = public + private savings

supply of loans in open economy

Supply in open economy = national savings + net capital inflow (money coming in from foreign investors)

what changes/shifts demand for loanable funds?

changes in return on investment

higher return = LD shifts right and interest rates increase

lower return = LD shifts left and interest rates decrease

what changes/shifts supply of loanable funds?

changes in savers’ behavior

saving increases = LS shifts right and interest rates decrease

saving deceases = LS shifts left and interest rates increase

What are excluded from the money supply?

1. currency (paper and coins) held by the U.S. Treasury, the Federal Reserve banks, commercial banks, and thrift institutions

2. checkable deposits of the government (specifically, the U.S. Treasury) or the Federal Reserve that are held by commercial banks or thrift institutions.

who owns each federal reserve bank?

the private commercial banks in its district

who makes up the FOMC?

• The seven members of the Board of Governors.

• The president of the New York Federal Reserve Bank.

• Four of the remaining presidents of Federal Reserve Banks on a 1-year rotating basis

transactions demand for money

The demand for money as a medium of exchange

graphed as a vertical line

what determines transactions demand for money and why

nominal GDP because households and firms will want more money for transactions if prices or real output increase

asset demand for money

The amount of money people want to hold as a store of value

varies inversely with the interest rate

total demand for money

transactions demand for money + asset demand for money

downsloping line

what changes/shifts the total demand for money

a change in nominal GDP (through transactions demand)

bond interest yield or rate

fixed annual interest paid by the bond / bond price = interest yield or rate

percentage rate of return

(future price - initial price) / initial price

Security Market Line (SML)

A line that shows the average expected rate of return of all financial investments at each level of nondiversifiable risk measured by beta.

average expected rate of return

risk-free interest rate (if) + risk premium

what determines the SML’s slope?

investors’ feelings about risk and how much compensation they require for dealing with it

The more they dislike risk, the steeper it is b/c they expect more compensation for any increase in risk

what shifts SML?

Changes in the risk free rate (if)