ECO 202 Test 2

Money

Assets that people are generally willing to accept in exchange for goods, services, or payment of debts

Why was money invented?

To make facilitating exchanges more efficient

Self-Fulfilling Valuation

Money is not backed by bullion, rather it is backed by the fact that we are confident in other accepting the money.

Money, Income, Wealth

Any currency that represents a barter value, the total amount of money someone receives, the total amount of money someone is worth

The Central Bank

Controls the quantity of money, which affects interest rates and spending

M1

Currency in Circulation + checking account deposits + savings account deposits

M2

M1 + other things

Bank's Balance Sheet Assets

Reserves, Loans, Securities

Bank Reserves

The sum of deposits kept as Vault Cash and deposits the bank has with the Federal Reserve

Bank Profit?

Banks make a profit by loaning out money at a higher interest rate than they paid for their deposits

Banks creating money

Making loans from their excess reserves, because that technically generates a deposit entry.

Primary Goal of a Bank

Make a profit, although the Fed may rely on them

Fractional Reserve Banking System

A system in which banks keep less than 100 percent of deposits in reserves

Bank Run

Many depositors simultaneously deciding to withdraw money from a bank

Bank Panic

Many banks simultaneously experiencing runs at the same time

Central Bank as Lender of Last Resort

Makes loans to banks that cannot borrow funds elsewhere, allowing the smaller banks to pay off depositors.

Federal Reserve Act

Gave the Federal Reserve the authority to make "discount" loans to banks, with the hope of putting an end to bank panics

Federal Deposit Insurance Corporation (FDIC)

Designed to insure deposits in most banks up to a limit, allowing them to refund money lost in checking accounts that go out of business, reassuring most depositors that their deposits are safe.

How many Federal Reserve Districts are there?

12, each with its own Federal Reserve bank

Board of Governors info

In Washington DC, 7 members, appointed by President, approved by Congress, 14-year nonrenewable terms, chair serves 4-year renewable term.

Securitization

A process that creates a secondary market in which loans are bundled together and sold in financial markets

Shadow Banking System

Investment Banks, Hedge Funds, other nonbank financial firms that function like commercial banks

Difference of Shadow Banking

Weren't regulated by federal government agencies, more highly relied on borrowed money, don't have FDIC (MORE RUNS)

Maturity Mismatch

When short-term lenders refused to renew their loans forcing shadow banks to get their money from banks, the banks couldn't get it as it had been invested long-term

Monetary Policy

The actions the Federal Reserve takes to manage the money supply and interest rates

Fiscal vs Monetary

Executive Branch vs Fed

Monetary Policy Tools

1. Open Market Operations
2. Discount Policy
3. Reserve Requirements
4. Interest on Reserves

Federal Open Market Committee (FOMC)

A committee of the Fed that sets their interest rate policies

Makeup of FOMC

Meet 8 times a year, 12 members: 7 Board of Governors, President of Fed bank of New York, 4 of 11 other Federal Reserve Banks

Open Market Operations

The buying and selling of Treasury Securities by the Federal Reserve to control the money supply

Treasury Securities

Bills, Notes, Bonds sold and issued by US treasury to borrow money in order to fund the budget deficit

Maturity of Bills

Maturity of Notes

2-10 years

Maturity of Bonds

>30 years

Purchase/Sale of Treasury Securities

Purchase increases reserves, increases money supply and vice versa.

Money Supply and Interest Rates

A decrease in the interest rate on reserves generally causes the money supply to increase, as it increases the amount of loans banks make

Quantity Equation

Money Supply (M) x Velocity of Money (V) = Price Level (P) x Real Output (Y)

Quantity Theory of Money

Quantity Equation with constant velocity, Irving Fisher argued because the number of times a dollar is spent is based on factors that don't change often

Inflation Rate (not constant V)

Delta M + Delta V - Delta Y = Delta P

How can governments be careful of inflation

By only issuing bonds in amounts that private investors will buy

ADAS model

Determines real GDP and Price Level

Variables that shift AD

Government purchases (GP,R), Income taxes (C,L), Interest Rates (C-I-NX,L), Business Taxes (I, L), Expectation of Future Incomes (C-I, right), Net Exports (NX, L), Real GDP differences (NX, L)

What determines the long-run real GDP?

Number of workers, capital stock, and the available technology

What is Real GDP in LRAS model?

Potential GDP, meaning Full Employment (only structural or frictional unemployment present)

What determines the LRAS

Potential GDP increases (number of workers in the economy, more machinery/equipment, technological changes)

SRAS slope

Positive, because as price level increases, prices of inputs rise more slowly (higher prices = higher profits)

What shifts both LRAS and SRAS?

Change in Potential GDP, cost of production, supply restrictions

Variables that only shift SRAS

Increases in LABOR CAPITAL (R), technological change (R), inflationary expectations (L), unexpected changes in the price of an important natural resource (L)

Long-run Macroeconomic Equilibrium

Real GDP = LRAS = Potential GDP, natural rate of unemployment

What effects does a change in short-run equilibrium have?

Below potential = Recession, below price level = deflation, vice versa

How does an economy return to long-run equilibrium

People adjust to the change in price level, leading SRAS to shift to meet the AD or vice versa

Unemployment in the ADAS graph

Below potential is unemployment increases, vice versa

Short run effect of supply shock

Increase in prices shifts SRAS to the left, below potential GDP and above price level

Long run effect of supply shock

Falling wages and prices caused by recession shifts SRAS back to its original position

If the Fed buys Treasury Securities, then...

Bank reserves increase, encouraging banks to make more loans, increasing the money supply

Unemployment rate is the natural rate of unemployment along

The LRAS

An increase in the interest rate b the Fed in the short run

Decreases the unemployment rate, and increases the price level

An increase in interest rates

Shifts the Aggregate Demand curve to the left

The automatic adjustment from real > potential to long-run potential GDP

The SRAS curve shifts to the left