UNIT 4

financial markets...

channel private savings into investment spending and government borrowing

investment spending

spending on new productive physical capital, such as machinery and structures, and on changes in inventories

government borrowing

the amount of funds borrowed by the government in the financial markets

financial intermediaries

financial institutions through which savers can indirectly provide funds to borrowers
-ex: banks are financial intermediaries for savers and borrowers

what is the source of money for loans

money saved in banks

assets

money and other valuables belonging to an individual or business

liquidity

the ease with which an asset can be converted into cash

risk

Degree of uncertainty of return on an asset; in business, the likelihood of loss or reduced profit.

money

cash and demand deposits
-most liquid
-no risk but the opportunity cost is the lost potential return from holding other financial assets

bond

a loan (IOU) to the government or business must be repaid to the lender
-somewhat liquid
-risk varies depends on the issue/borrower

stock

certificate representing equity (ownership) in a company
-liquidity varies
-risk varies based on the company

personal finance

the way individuals and families budget, save, and spend

demand deposits

balances in bank accounts that depositors can access on demand by writing a check

rate of return

percentage of increase in the value of savings from earned interest

relationship between price of bonds and interest rates

inverse relationship

What are nominal interest rates?

% increase in money that the borrower pays not adjusting for inflation

What is the formula for nominal interest rates?

Nominal interest rate = Real interest rate (RIR) + expected inflation

What are real interest rates?

% increase in purchasing power that a borrower pays (adjusted for inflation)

What do real interest rates indicate?

The amount of goods and services a unit of money can buy

How are real interest rates calculated?

Real interest rate = nominal interest rate - expected inflation

any asset that is accepted as a means of payment

money

is money the same as wealth and income

NO

wealth

collection of assets

income

flow of earnings per unit of time

3 functions of money

1. medium of exchange
2. unit of account
3. store of value

medium of exchange

Any item sellers generally accept and buyers generally use to pay for a good or service; money; a convenient means of exchanging goods and services without engaging in barter.
-accepted as a transaction payment
-eliminates the complications of barter

barter

Exchange goods without involving money.

unit of account

a measurement of value
-allows comparison of prices

store of value

store purchasing for future use

money aggregates

overall measures of the money supply

M0 (or MB)

-the monetary base
-currency in circulation and bank reserves

M1

-currency in circulation
-checkable bank deposits (aka demand deposits)
-saving deposits/other liquid deposits

M2

M1 plus savings accounts, certificates of deposit, and other liquid assets
-M1 plus the following:
-money market accounts
-time deposits
-mutual funds

fractional reserve banking

a banking system in which banks hold only a fraction of deposits as reserves

deposits are a...

liability for the bank and an asset for the depositor

banks use excess reserves to..

make loans

excess reserves

a bank's reserves over and above its required reserves

loans are..

assets for the bank and liabilities for the borrower

bank balance sheets (T accounts)

banks record their assets, liabilities, and net worth with these

asset

items of ownership

liabilities

claims of the non owners. you have to give it back to someone if asked

net worth

the claims of the owners against the firm's assets
-if you sell all your assets and use the money to pay off the liabilities, what is left over is net worth

for balance sheets, assets =

liabilities + net worth

the reserve requirement

the percentage of deposits that banking institutions must hold in reserve

reserve ratio

the fraction of deposits that banks hold as reserves
-set by the federal reserve

excess reserves =

actual - required
-the amount by which the banks actual reserves exceed its required

T or F: a bank can only loan an amount equal to its excess reserves

true. this means it can only create money equal to its excess reserves

What is the simply money multiplier?

It is the ratio of the money supply (M1) to the monetary base (M0).

What does the simply money multiplier indicate?

It tells us the change in M1 (amount of new money generated) from the new excess reserves created by new deposits.

What is a limitation of the simply money multiplier?

It may overstate the predicted amount because it doesn't consider banks' desire to hold excess reserves or the public holding more currency.

How is the simply money multiplier calculated?

It is calculated as (1)/(RR ratio).

at any given time, people demand a certain amount of liquid assets (money) for two different reasons

1. transaction demand for money
2. asset demand for money

transaction demand for money

the demand for money based on the desire to facilitate transactions

asset demand for money

The amount of money people want to hold as a store of value; this amount varies inversely with the interest rate.

opportunity cost of holding money in your pocket or checking account

the interest you could be earning from other finances like stocks, bonds, and real estate

relationship between interest and the quantity of money demanded

inverse

Image: relationship between interest and the quantity of money demanded

3 shifters of money demanded

1. changes in PL
2. changes in RGDP: increase in RGDP = increase in money demanded
3. changes in technology

the money supply curve

shows how the quantity of money supplied varies with the interest rate
-vertical because its a fixed amount determined by the central bank

Image: the money supply curve

monetary policy

the actions of a nations central bank to stabilize its economy by managing the MS to promote full employment, control inflation, and promote moderate long term interest rates

the money market graph

at the equilibrium in money market:
-Qm = MS
-the nominal interest rate is determined by MS = MD

Image: the money market graph

relationship between interest rate and asset rate

positive

the federal reserve

the central bank of the US.
-regulates the banking industry and implements monetary policy

Why does the Fed use monetary policy?

-to counter SR output gaps
-by influencing the nominal interest rate in the SR...
-which in turn affects AD through investment and interest sensitive consumption, and returns the aggregate output (RGDP) to full employment

effective monetary policy must be

counter cyclical

how can the fed manipulate the MS and change IR?

change the reserve requirement, conduct open market operations, and target a specific discount rate

open market operations

the purchase and sale of U.S. government bonds by the Fed

recessionary output gap

requires expansionary cyclical policy
-inc MS
-dec NIR
-inc I and C
-inc AD
-inc Y

inflationary output gap

contractionary monetary policy
-dec MS
-inc NIR
-dec I and C
-dec AD
-dec Y

changing the reserve requirement in a recession

-DECREASE the reserve ratio
1. banks have more excess reserves to make loans
2. the MM increases so loans create more money
3. MS inc, IR dec, AD inc

changing the reserve requirement when there is inflation

-INCREASE the reserve ratio
1. banks have fewer excess reserves to make loans
2. the MM decreases so loans create less money
3. MS dec, IR inc, AD dec

relationship between reserve ratio and MS

inverse

the discount rate

the interest rate that the fed charges commercial banks to borrow money
-to inc the MS, the def should dec the discount rate
-inverse relationship between discount rate and MS

when the fed buys securities from banks

it directly increases the reserves of the commercial bank

when the fed buys securities from individuals

they end up putting the money in their banks which increases the bank reserves

when the fed buys securities from the gov

it is just like making a loan to the gov. in doing so they r creating money because as the gov spends the money it ends up back in the bank

federal funds

the balances that banks maintain in their accounts at the fed

federal funds rate

the target interest rate set by the fed at which banks borrow and lend their extra reserves to one another over night

ample reserves system

a Federal Reserve policy that keeps enough reserves in the banking system to control interest rates and stabilize the economy.

under an ample reserves system

changing the MS has little to no effect on interest rates. the fed now conducts monetary policy by changing its administered rates

administered rates

interest rates set by the Fed rather than determined in a market

interest on reserve balances (IORB)

interest rate paid by the fed on funds held in the banks reserve balance accounts

do reserves at the fed have a risk

no, so banks have no incentive to loan at an interest rate lower than the IORB

under contractionary policy

the fed will increase the IORB, which increases the FFR, which discourages interest sensitive spending

interest sensitive spending

consumer spending on goods and services that are significantly impacted by changes in interest rates,

under expansionary policy

the fed will decrease the IORB, which decreases the FFR, which encourages interest sensitive spending

the reserve market model

- There is an inverse relationship between the Federal Funds Rate and the quantity of reserves demanded
- when FFR is high --> banks want to hold less in reserves
- when FFR is low --> banks want to hold more in reserves
-

Image: the reserve market model

what happens if the fed buys bonds from banks when there are limited reserves?

-banks will have more reserves
-the supply of reserves will shift to the right and the IR will decrease

what happens if the fed buys bonds from banks when there are ample reserves?

the IR does not change
-OMO does not work

what can the CB do to change IR when there are ample reserves

decrease the IR on reserves and the discount rate or increase interest on reserves and the discount rate

when the fed increases the MS to stimulate the economy

interest rates decrease, investment increases, AD GDP and PL increases

when the fed decreases the MS to stimulate the economy

interest rates increase, investment decreases, AD GDP and PL decreases

who demands loanable funds and who supplies them

borrowers demand, savers supply

loanable funds market

a hypothetical market that illustrates the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders
-inverse relationship between RIR and quanitity of loans demanded (borrowing)

Image: loanable funds market

demand for loanable funds shifters

1. Changes in perceived business opportunities
2. Changes in government borrowing

supply of loanable funds shifters

1. changes in public and private saving behavior
2. changes in foreign investment
3. changes in expected profitability

closed economy

national savings = public savings + private savings
-no trade

open economy

investment = national savings + net capital inflow