unit 3

functions of money

functions of money

A good that is widely accepted for purposes of exchange in the repayment of debt, medium of exchange, unit of account, and store of value

characteristics of money

divisible, portable, acceptable, scarce, durable, and stable

using money over barter

Avoids the Coincidence of Wants (In order to trade, each party must have something that the other party wants), Firms can focus on producing one thing and getting paid with money. Then using that money to purchase the goods and services they want

fractional reserve banking

A banking arrangement in which banks hold only a fraction of their deposits and lend out the remainder

how banks create money

created each time a loan is made and is destroyed each time a loan is repaid

financial intermediaries

banks connect savers who deposit money with borrowers who receive a loan

depository institutions

accept money deposits and use them to make loans

balance sheets

help them keep track of their assets and liabilities

assets

something of value that you own

liabilities

a debt or something you owe

net worth

value of assets - value of liabilities

t-account

a balance sheet with a two-column format, with the T-shape formed by the vertical line down the middle and the horizontal line under the column headings for “Assets” (left) and “Liabilities” (right)

federal funds rate

the interest rate at which one bank lends funds to another bank overnight

prime rate

the interest rate commercial banks charge their most creditworthy customers

excess reserves

the amount above required reserves

medium of exchange

Anything that is generally acceptable in exchange for goods and services

unit of account

A common measurement used to express value

store of value

Something with the ability to hold value over time

federal reserve

Central bank of the United States to ensure a stable economy for the nation

financial services role

Operate a nationwide payments system and distribute the nation’s currency and coin

banking supervision role

regulate member banks and bank holding companies and serve as a banker for the U.S. Treasury

goals of monetary policy

stable price, full employment, sustainable economic growth

monetary policy

The changes the Fed makes to the money supply

expansionary monetary policy

an increase in the money supply by the fed(M2) by decreasing interest rates. Used when unemployment is rising. More money is associated with greater total spending in the economy. Increased spending in the economy leads firms to produce and sell more products. As firms sell and produce more products they hire more workers, lowering the unemployment rate. Shifts Aggregate Demand to the right

contractionary monetary policy

A decrease in the money supply by the fed (M2) by increasing interest rates. A smaller money supply will lower total spending in the economy. As spending decreases, firms begin to sell less.As firms sell fewer products, inventories increase (surplus of goods). To get rid of the surplus firms reduce prices, reducing inflation.

discount rate

The interest rate charged by the Federal Reserves to banks that borrow on a short-term (usually overnight) basis

reserve requirements (discontinued)

The amount of money banks must keep on reserve

open market operations (omo)

The buying and selling of Treasury securities between the Fed and selected financial institutions in the open market, directed by the Federal Open Market Committee (FOMC), Auxiliary tool

interest on reserve balances (iorb)

Rate at which the Federal Reserve pay banks interest on reserve balances, which are balances held by banks at their local Federal Reserve Bank

overnight reverse repurchase agreement (on rrp)

Rate the Federal Reserve pays banks on short-term overnight deposits. Used to set a floor on interest rates. Banks buy a security from the Fed and simultaneously agree to sell it back the next day

discount window primary rate

The interest rate the Fed charges a bank for a loan. Typically set at 1 percentage point above the Federal Funds Rate.

money supply (M2) falls

Sell Securities, raise the discount rate, Raise the IORB

money supply (M2) rises

Buy Securities, lower the discount rate, Lower the IORB

demand

borrowers

supply

lenders

arbitrage

The simultaneous purchase and sale of a good in order to profit from a difference in price, ensures the federal funds rate moves up, used to borrow in the Federal Funds market and then deposit those funds at the Fed at the IORB rate and make a profit on the difference so FFR doesn’t fall too far below the IORB rate.

old tools

helped the Fed manipulate the amount of reserves the banks have available to lend - Discount Rate (tied to the Federal Funds Rate), Open Market Operations (OMO), Reserve Requirements

new tools

used by the Fed to influence consumers and businesses willingness and ability to borrow (demand) loans - Interest on Reserve Balances (IORB), Overnight Reverse Repurchase Agreement (ON RRP)

effects increasing the money supply

If inflation is in check, more money stimulates economic activity, thus boosting economic growth, Consumers buy cars and houses, Businesses expand, buy equipment

effects of decreasing the money supply

An effective way to fight inflation, Consumers pay more to borrow money, dampening spending, Businesses have difficulty borrowing; unemployment rises

how monetary policy works

The Federal Reserve is using the Law of Demand to influence the quantity of money demanded by changing the price (interest rates) - High interest rates (higher prices), lower quantity of money demanded - Lower interest rates (lower prices), higher quantity of money demanded

countercyclically

the Fed uses Expansionary Monetary policy during contractions and Contractionary Monetary Policy during expansions. Ultimate goal, help the economy stay on track with our goals - Maximum Employment, Stable Prices, and Sustainable Economic Growth

keynes “big idea”

“Paradox of Thrift” – consumers and businesses save money in uncertain times. When businesses and consumers aren’t spending during an economic downturn, government should increase its spending to make up the difference, fund their spending during a recession through selling government securities (bonds), run a temporary deficit, when federal expenditures are greater than tax revenues, during a downturn and then increase taxes and lower spending during an expansionary period to balance out the government’s books

fiscal policy

Changes government makes in spending or taxation to achieve particular economic goals

expansionary fiscal policy

Increase in Federal spending Decrease in Federal taxes Objective is to reduce the unemployment rate

The Government increases spending and/or reduces taxes means more spending in the economy means firms are selling and producing more goods meaning they will hire more workers and then the unemployment rate falls

Shifts Aggregate Demand to the right

contractionary fiscal policy

Decrease in Federal spending Increase in Federal taxes Objective is to reduce inflationary pressures

Government decreases spending and/or increases taxes. This leads to less overall spending in the economy, which means that firms will sell fewer goods so then firms will have a surplus and prices will go down, so inflation is reduced.

Shifts Aggregate Demand to the left

automatic stabilizers

Fiscal policies that, without any new action by Congress or the President, change gov’t spending and taxes. Ex: Unemployment compensation, Progressive Income Tax

discretionary fiscal policy

the government passes a new law that explicitly changes overall tax or spending levels with the intent of influencing the level or overall economic activity

recognition lag

The time it takes policymakers to recognize a problem in the economy

legislative lag

The time it takes to change fiscal policy

implementation lag

The time between adopting new policies and the policies having an effect

crowding out

Government borrowing during expansionary fiscal policy results in higher interest rates, which reduces business investment and household consumption

politics

politicians use expansionary when they should use contractionary

barter

trading one good or service for another, without using money

M1 money supply

currency and checking accounts in banks, and to a lesser degree, traveler’s checks

M2 money supply

everything in M1, but also adds savings deposits, money market funds, and certificates of deposit

money multiplier formula

total money in the economy divided by the original quantity of money, or change in the total money in the economy divided by a change in the original quantity of money

money multiplier

the quantity of money that the banking system can generate from each $1 of bank reserves.

lender of last resort

an institution that provides short-term emergency loans in conditions of financial crisis

velocity

the speed with which money circulates through the economy; calculated as the nominal GDP divided by the money supply

quantity equation of money

M (money supply) x V (velocity) = P (price level) x Q (real gdp)

budget deficit

when the federal government spends more money than it receives in taxes in a given year

budget surplus

when the government receives more money in taxes than it spends in a year

individual income tax

a tax based on the income, of all forms, received by individuals

payroll tax

a tax based on the pay received from employers; the taxes provide funds for Social Security and Medicare

progressive tax

a tax that collects a greater share of income from those with high incomes than from those with lower incomes

national debt

the total accumulated amount the government has borrowed, over time, and not yet paid back

mandatory spending

government spending on certain programs that are required by law

total savings

Private savings (S) + Foreign Savings (M - X)

total demand

Private sector investment (I) + Gov’t borrowing (G-T)

private investment

Private savings + Public savings + Trade deficit

budget deficits increase outcomes

Domestic investment to decrease Private savings to increase; OR Trade deficit to increase

trade balance

the gap between a nation’s exports and imports (X-M)

current account balance

the international flows of income and foreign aid

large budget deficits can mean

Less investment in physical and human capital Increase in interest rates

crowding out of physcial capital

Large budget deficits increase demand for financial capital Drives up interest rates Private firms invest in less physical capital

debt

total amount of money the government owes. It has been accumulating since the beginning of our nation’s history

public choice economics

applies the theories and methods of economics to the analysis of political behavior. Assumes that people are guided chiefly by their own self-interests Voters “vote their pocketbooks” supporting candidates and ballot propositions they think will make them personally better off Bureaucrats strive to advance their own careers Politicians seek election or reelection to office

fed’s dual mandate

stable price & full employment