Macroeconomics Exam 3

Financial Initiations

move funds from savers to borrowers

Financial markets:

∗ Bond market

∗ Stock market

Financial intermediaries:

∗ Banks

∗ Mutual funds

Two big problems enter when we try to connect savers to investors:

time and risk

Present and Future Value

The Time Value of Money

The Time Value of Money

Money today is more valuable than the same amount in the future.

Present Value (PV)

the amount of money needed today to produce a future amount of money, given the interest rate.

Future Value (FV)

the amount of money in the future that an amount today will yield, given the interest rate.

Compounding

accumulation of a sum of money where interest earned remains in the account to earn additional interest.

Formula examples

Future value of $100 at 5% for 10 years: (1.05)10 × 100 = 163

Present value of $200 received in 10 years at 5%: 200 (1.05)10 = 123

General formulas

FV =PV ×(1+r)N

PV = FV (1 +r)N

More Info on Present Value

The higher the interest rate, the more valuable money today becomes.

The concept of present value helps explain why investment is inversely related to the interest rate.

Even if investment today is juicy, there is still a risk being taken

Risk and Risk Aversion

Most people are risk averse meaning they dislike uncertainty

Definition: Risk Aversion

a dislike of uncertainty.

Utility theory helps explain this:

∗ Utility: a person's subjective satisfaction or well-being.

∗ Diminishing marginal utility: the more wealth a person has, the less extra satisfaction they get from an additional dollar.

- Therefore, the utility loss from losing $1,000 exceeds the utility gain from winning $1,000.

Diversification:

reducing risk by holding many unrelated assets. This is basically like ensuring yourself in financial markets.

Market risk:

affects all companies

Firm-specific risk

affects only one company.

The price of a share of stock is determined by

supply and demand

Fundamental Analysis:

studying a company's accounting statements and future prospects to determine its value.

Fundamental Analysis Breakdown

∗ Undervalued: price < value

∗ Overvalued: price > value

∗ Fairly valued: price = value

Ways to apply fundamental analysis:

1. Do your own research

2. Rely on Wall Street analysts

3. Buy mutual funds

Efficient Markets Hypothesis (EMH)

asset prices reflect all publicly available information about value.

Informational efficiency

prices rationally reflect all available information.

At equilibrium, buyers and sellers' beliefs balance

stocks are fairly valued on average.

Behavioral evidence suggests prices also reflect psychological forces:

∗ John Maynard Keynes: "animal spirits" drive markets.

∗ Alan Greenspan: warned of "irrational exuberance" during market booms.

Market Irrationality

EMH assumes investors process all information rationally.

Debate among economists:

∗ Believers in irrationality: markets often move in ways hard to explain by fundamentals. Sometimes people just make the wrong choices.

∗ Believers in EMH: true value is unknowable, so who are we to say that something is overvalued or undervalued. The market determines the value.

Overconfidence

leads to excessive trading

Fidelity study:

female investors earned 0.4% more per year than men due to trading less frequently and paying fewer fees.

Testosterone

reduces fear and increases risk-taking

Money

is the set of assets in an economy that people regularly use to buy goods and services.

Bartering system

without money requires coincidence of wants

Money serves three main functions:

1. Medium of exchange: an item buyers give to sellers to purchase goods and services.

2. Unit of account: a yardstick used to post prices and record debts.

3. Store of value: an item that can transfer purchasing power from the present to the future.

Liquidity

the ease with which an asset can be converted into the economy's medium of exchange.

What is the most liquid assest?

money

stocks, bonds, real estate

vary in liquidity

Commodity money

money with intrinsic value

Fiat money

money without intrinsic value, used because of government decree.

Cryptocurrencies

exist only electronically, volatile, and not widely accepted, so excluded from standard money measures.

intrinsic money

the item would have value even if it were not used as money

The money stock includes

currency, demand deposits, and other monetary assets.

Currency

paper bills and coins held by the public

Demand deposits:

bank account balances accessible on demand (e.g., checks, debit cards).

Key measures of money

M1: more liquid forms of money (currency, demand deposits, other checks).

M2: less liquid, like savings accounts and all of M1 — similar in practice; composed mainly of currency and spendable deposits.

Are credit cards money?

Credit cards are not money — they defer payment. Debit cards are included in the money supply

In 2021, there was estimated to be $2.1 T of currency outstanding. That's $8,000 per adult. Where is it all?

Outside the U.S. (people in other countries hold U.S. dollars)

Stored away (in safes, drawers, banks, etc.)

Held by banks and businesses

Kept as savings, not spent

Federal Reserve (Fed):

central bank of the U.S.

Central bank

institution overseeing the banking system and regulating the money supply.

The Federal Reserve System

-Created in 1913 after bank failures, independent from Congress.

- Board of Governors: up to 7 members, 14-year terms; Chair (currently Jerome Powell) serves 4 years.

- 12 regional Federal Reserve Banks; students can locate these cities on dollar bills

Dual Mandate from Congress:

1. Regulate banks and ensure financial stability (check conditions, clear checks, make loans as lender of last resort)

2. Control the money supply via monetary policy

Money supply:

the quantity of money available in the economy.

Monetary policy:

setting the money supply, closely related to interest rates but we'll talk about that later with the Federal Funds Rate.

The Federal Open Market Committee (FOMC)

-Composed of the Board of Governors + 5 regional bank presidents. (all presidents attend but only 5 vote, but that 5 rotates, but NY always gets a vote)

- Primary tool historically: open-market operations (buying/selling U.S. government bonds).

Increasing money supply

Fed buys bonds → creates dollars

Decreasing money supply

Fed sells bonds → removes dollars.

100% Reserve Banking:

∗ Bank holds all deposits in reserve.

∗ Money supply is unchanged; deposits are simply a more liquid form of currency.

∗ Example T-account: Assets Liabilities Reserves $100 Deposits $100

Fractional-Reserve Banking:

∗ Banks hold only a fraction of deposits as reserves.

∗ Reserve ratio: fraction of deposits banks hold.

∗ Example: reserve ratio = 10%, loans = 90% of deposits. Assets Liabilities Reserves $10 Deposits $100 Loans $90

∗ Money supply increases when loans are made; new money is matched by new debt.

The Money Multiplier:

∗ Money multiplier = 1/reserve ratio

∗ Inverse of the reserve ratio: R=10%=10/100 → 100/10 = 10 ∗ Example: reserve ratio 10% → multiplier 10 → $100 of reserves is multiplied by 10 → $1,000 total money supply. ∗ Multiplier depends on reserve ratio; the lower the ratio, the larger the money supply expan sion.

Bank Runs and the Money Supply

∗ Bank runs occur when depositors withdraw simultaneously.

∗ Fractional reserves make banks vulnerable.

∗ FDIC insurance and Fed liquidity provision help to prevent modern bank runs

Open-Market Operations:

buy/sell government bonds to influence reserves and money supply → buy bonds, higher money supply

Discount Rate

interest rate the Fed charges banks → lower interest rate, higher money supply

Reserve Requirements:

minimum reserves banks must hold; affects money multiplier (effectively zero after 2020) → lower reserve requirement, higher money supply.

Interest on Reserves

paying interest encourages banks to hold reserves → lower interest rate on reserves, higher money supply.

The Fed's Tools of Monetary Control

Open-Market Operations

Discount Rate

Interest on Reserves

Reserve Requirements

Problems in Controlling the Money Supply

- The Fed cannot fully control deposits or lending decisions.

- Depositor behavior and bank lending choices affect the money supply.

The Federal Funds Rate

Modern monetary policy focuses on interest rate targets rather than strict money supply control.

- Short-term interest rate banks charge each other for overnight loa

If the money supply increases

the federal funds rate decreases

If the money supply decreases

the federal funds rate increases

Fed sets a target and adjusts reserve interest to hit the target

∗ Lower reserve interest → banks lend more → fed funds rate decreases → money supply rises.

∗ Higher reserve interest → banks hold more reserves → fed funds rate rises → money supply falls.

Inflation

the rise in the overall price level

Inflation is a sustained increase or decrease in the overall level of prices in the economy.

increase

Inflation refers to a rise in the overall price level, not just the price of individual goods.

Changes in single good prices can happen due to supply and demand, but inflation occurs only when the average of all prices in the economy increases

When the price level rises, the value of money falls;

each dollar buys fewer goods and services.

The inflation rate measures

how quickly the price level is rising

In the long run, inflation is primarily

caused by growth in the money supply exceeding growth in output.

The classical theory of inflation

Explains the relationship between money supply, money demand, and the price level.

Money supply is determined by

the central bank; money demand reflects how much wealth people want to hold in liquid form.

In equilibrium, the quantity of money demanded equals the quantity supplied.

∗ An increase in the money supply creates an excess supply of money.

∗ People adjust by spending or lending the extra money, which increases the demand for goods and services.

∗ In the short run, this might increase output

∗ In the long-run, workers might demand more pay to make up for the increase in costs, this decreases the supply curve and decreases output.

∗ Persistent growth in the money supply leads to ongoing inflation.

Classical dichotomy

Economic variables can be divided into nominal variables (measured in money) and real variables (measured in goods and services).

monetary neutrality

Changes in the money supply affect nominal variables, like the price level, but do not affect real variables, like output or employment, in the long run.

Velocity of money:

the rate at which money changes hands.

V=(P×Y)/M

Ex: 100 pizzas per year, 10 bucks per pizza, 50 dollars floating around

Quantity equation

M × V = P × Y

M = money supply

V = velocity

P = price level

Y = real GDP (real output)

If velocity is stable and output is fixed

an increase in M leads to a proportional increase in P.

The quantity theory of money links money growth directly to

inflation

Inflation acts as a

tax because it reduces the real value of money held by the public.

When governments rely heavily on this method, it can lead to

hyperinflation (typically defined as >50% per month).

Hyperinflations destroy

savings, distort prices, and destabilize the economy.

Real interest rate =

nominal interest rate- inflation rate

The Fisher effect

when expected inflation rises, the nominal interest rate rises by the same amount, leaving the real interest rate unchanged.

-This means borrowers and lenders maintain the same purchasing power over time if inflation is perfectly anticipated.

If inflation is unanticipated

the real value of debt and savings can change, redistributing wealth between borrowers and lenders. 6

- Example: if expected inflation increases from 2% to 4% and the real interest rate is 3%, the nominal interest rate rises from 5% to 7%.

Costs of inflation

Inflation fallacy

Shoe leather cost

Menu costs

Relative price variability

Tax distortions

Confusion and inconvenience

Arbitrary redistributions of wealth

Inflation fallacy

people often think inflation reduces their purchasing power, but nominal incomes also rise, so real purchasing power may be unchanged.

THIS ISN'T ALWAYS TRUE, especially not in the short-run. But, it does hold in the long-run usually.

Shoe leather costs

resources wasted when people reduce money holdings and make more frequent trips to the bank.

Menu costs

costs incurred by firms when they must change prices more frequently

Relative price variability

inflation can distort relative prices, leading to misallocation of resources.

Tax distortions

non-indexed taxes on nominal income and capital gains reduce the after-tax real return on savings, discouraging saving and investment

Confusion and inconvenience

changing price levels make accounting and economic calculation more difficult.

Arbitrary redistributions of wealth

unexpected inflation benefits debtors at the expense of cred itors, while deflation does the opposite.