Unit 4 : Banking systems

AP MACRO

Financial Assets

Assets that can generate future income.

What is money?

anything that can be used to purchase goods and services that must meet three requirements

Medium of Exchange

Used to facilitate transactions for goods/services.

Unit of Account

Standard measurement of value for pricing.

Store of Value

Retains purchasing power over time.

Commodity Money

Has intrinsic value (e.g., gold, silver). and performs the function of money

Fiat Money

Government-issued currency with no intrinsic value.

M0

Currency in circulation and bank reserves.

M1

Most liquid money: currency, checkable deposits, travelers checking, saving accounts, Bank reserves are not included

M2

Includes M1 plus near-monies like CDs, Money market accounts, money market funds

M3

Includes larger time deposits and larger liquid assets.

Liquidity

Ease of converting an asset to cash.

Wealth

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

other financial assets?

written claims where buyers have the right to future income from sellers (loans/boonds)

-Both physical (land, homes, cars) or digitla date (total, terms, and agreements)

-lower liquidity that cash and other M1 monies

how does an asset hold value?

they allow the holder to accumulate wealth over time—storing money as assets allows for the asset to grow due to interest over time in the growth of the aggregate economy

Bonds

• loans that represent debt that the government, businesses, or individuals must repay to the lender (sometimes you!). They tend to be more secure than stocks. 

• after their term, when it comes to maturity, the bonholder gets the face value of the bond plus interest

• investors want something with a high rate of return

who issues bonds?

typically, govt to gets funding for projects, and companies sets do it

Stocks

represent ownership of a corporation and the stockholder is often entitled to a portion of the profit paid out as dividends

how is the price of a previously issued bond related to interest rates

-it is an inverse relationship

-when interest rates rise, the price of a bond bought with a lower rate of return will fall

-when interest rates fall, the price of a bond bought previously with a higher rate of return will rise b/c more attractive

speculation

consumers holding their money rather than bonds because they expect the interest rate to increase in the future

Financial Intermediaries

Institutions facilitating loans and investments.

-for a bank, a loan is an asset b/c they get money

-for a borrower, a loan is a liability b/c its smth that needs to be paid back

Opportunity Cost

Potential interest lost by holding money.
-holding money results in losing out on potential interest that could be accumulated on money in assets

Nominal Interest Rate

Rate not adjusted for inflation.

Real Interest Rate

Rate adjusted for inflation effects.

Fisher Equation

NIR = RIR + inflation relationship.

Unexpected Inflation

Inflation differing from prior expectations.

Fiat Money

holds symbolic power b/c a govt has determined it to be moeny, hence used in exchanges of goods and services

Real Value of Money

NOT determined by government, but by how many goods and services it can purchase

Medium of exchange

money is used to exchange goods and services(don’t have to find someone with which to barter); allows for easier and more convenient method for people to get G+S

Unit of Account

commonly accepted as a way to set prices

Store of value

holds purchasing power over time (not unique to money ie financial inflation)

-this is undercut by inflation which reduces the value stored over time

savings accounts or long-term savings is using money as a store of value

Banking Systems

Includes commercial and investment banks.

Fractional Reserve System

Banks hold a fraction of deposits in reserve.

Reserve Requirement

Percentage of deposits banks must retain.

• banks then will loan out money that is deposited and then pay customers interest

• deposits make checking accounts a liability for the bank. Loans are an asset for the bank

Bank Balance Sheet

Shows bank's assets and liabilities.

Commercial Banking

-changed to DD impact a bank’s reserves and the amount of new loans it can make

• must determine the MM to calculate the maximum changes in the money supply

• excess reserves are used to increase the amount of new loans a bank can make

• basis of the expansion of a money suppoly

• customers detrmine how mnay loans can be given

Demand Deposits

Customer deposits available for withdrawal.

Money Multiplier

MM = 1/reserve requirement calculation.

How to use the MM

-determine maximum changes to the banking system when deposits or withdrawals from DD occur

how does a bank’s liability change when someone w/draws money

-when customer’s withdraw money, it is w/drawn from a bank’s reserve and subtracted from a bank’s liabilities

Excess Reserves

Funds banks can loan beyond required reserves.

how to find the maximum change when adding money? when withdrawing?

-just multiply

-multiply and then subtract withdrawal

Money Market

looks at the supply and demand of money (M1)

-money is the good

-price in the money market is the NIR because the NIR is the “price of money” and an opportunity cost of holding money

what does a graph of the money market look like?

NIR v Quantity of Money

-Demand:

• downward (MD)

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

-Supply:

• the supply of money that people have access to controlled by a country’s central bank

• ind of the nominal interest rate

• vertical line

• only shifts by monetary policy

What are the types of demand?

transaction demand - buying smth

Precautionary demand - 20 bucks in case

Assets to speculative demand - essentially saving money/using stocks

what does demand for money represent

-preferences for liquidity

How demand for money when interest is different?

when interest is low - lots of money

when interest is high - less money (there is a higher opportunity cost of not having money in an asset)

How does the market adjust to different interest rates?

higher rates, the surplus drives down the interest rate

-lower rates, the shortage will drive up the interest rate

What are shifters of the Money Demand

• Aggregate Price Level: high prices require more money to make purchases

• real GDP (national income): 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 demanded. The availability and cost of using money substitutes affects money demand.

Who conducts monetary policy?

central banks

What is monetary policy?

the actions of central banks to achieve macroeconomic policy objective such as price stabilty (low and stable rate of inflation), full employment, and economic growth

How does dec nominal interst rates help an economy in recession

things are less expensive to borrow and thus more interest-sensitive spending (investment and consumption) inc in AD

how does in nominal interest rates in the short run help an economy in inflation

higher interest rates = more expensive to borrow = less interest-sensitive spending - Dec in AD

how does the money supply affect to NIR

Changing the money supply affects the NIR

How can banks change the money supply?

Required Reserve Ratio, Discount Rate, Open-Market operations (OMO)

required Reserve Ratio (and effects on NIR and MS)

The percentage of DD banks must hold in their reserve

-If the RR ratio dec, banks have more in excess reserves to lend, so MS increases (NIR falls)

-If the RR ratio Inc, banks have less in excess reserves to lend so MS dec (NIR rises)

Discount Rate

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

-IF DR dec, banks are encouraged to lend more so MS inc and NIR falls

-If DR ince, banks are encouraged to lend less so MS dec and NIR inc

Open-Market Operations (OMO)

the central bank buying and selling govt bonds

-when the central banks buys bonds (OM Purchase), bank’s excess reserves inc, so MS inc, NIR falls

-when the central banks sell bonds (OM Sale) bank’s excess reserves dec so MS dec, NIR rises

-there are changes in the reserves and thus the monetary base changes

What happens to MS in limited reserve environments as a result of OMO

the MS is greater than the effect on the monetary base because of the MM

What does an increase in Excess reserves cause?

banks will make more loans, leading to more deposits, which creates more excess reserves, which allows for more loans

-dec in excess reserves works in VV

What assumptions does the MM make?

• banks hold no excess resrves

• borrowers spend heir entire loans

• customers hold no cash

  • = 1/RR

What does the MM calculate?

the maximum possible change to the MS as a result of an open market operation

-found using OMO * MM

Limited Reserve Framework:

Recognition Lag

Impact Lag

Recognition lag

it takes central banks time to collect an analyze the data needed to recognize problems in the economy

Impact Lag

it takes time for the economy to adjust after the policy action is take

Ample reserves framework

• reserves are abundant

• required reserve rate is zero

• changint the MS no longer leads to changes in nominal interest rates

  • diferent monetary policy tools are needed

What are the monetary policy tools needed to deal with Ample reserves

Policy rate is the overnight interbank lending rate/ the U.S it is the federal fund rates

-set at the intersection of QTR and PRQ

Loanable funds market

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

• determined by expectatino of return on investment

• the real interst rate is the price of borrowing money that consumers pay for borrowing money

• Based on real prices since loans last a long time period

  • RIR = NIR + inflation

Demand: (LFM)

Number of loans deamnded (consumer, producer, govt)

Supply (LFM)

equal to national savings (public + private savings in a closed economy) or nation-national savings plus Capital inflow (open economy)

When does disequilibrium occur in LFM

interest rate (price) is too low or high

• changes in return on investment will shift demand of loanable funds

• changes in savers behavior will shift supply of loanable funds