MacroEconomic - Unit 3

Financial Assets

• Money is anything that can be used to purchase goods and services.

• Wealth is an accumulation of savings through the purchase of assets (with money) that occurs over time.

Financial Assets

Written claims where buyers have the right to future income from sellers.

Ex: Cash, demand deposits (checking accounts), loans, stocks, and bonds.

Can be physical assets, like land, homes, or cars

• An asset is anything that holds value, that the owner has a written claim to future income from the seller

Liquidity

How easily the asset can be turned into cash

• Cash is the most liquid financial asset (Checking accounts, demand deposits are also liquid)

How easily can each of these items be converted into cash depends on time and energy

• Some harder assets to turn into cash are bonds and saving accounts

How do assets old value

Assets allow the holder to accumulate wealth over time (storing money in assets allows for the asset to grow due to interest over time in the growth of the aggregate economy) and they are both an asset and a liability

Loans

Borrowing money

Loans are critical in the growth of the aggregate economy (Both an asset and a liability)

Bonds

A bond has a term - the number of years the holder can earn interest. After a bond comes to maturity (Date you must pay the amount back) the bond holder gets the face value of the bond plus the interest it earned over its term.

• Bonds are most commonly issued by governments in order to take money for government projects and pay the loan back with interest

• Investors are attracted to financial assets that have higher rates of return than other assets

• Bonds are key to understanding the role of financial institution in creating and regulating our money supply

• The price of previously issued bonds and interest rates have an inverse relationship (Current interest rate on bonds falls, previously issued bonds increase, vice versa)

The interest rate of previously issued bonds is much more attractive now, driving demand for those bonds up (When the demand for previously issued bonds rises, the price rises, vice versa)

(Rate of return = Real interest rate)

Opportunity Cost of Holding Money

When individuals hold money, there is an opportunity cost to the decision.

The cost is the interest the money could be earning in an interest-bearing asset (Includes bonds)

If consumers hold money rather than bonds because they expect the interest rate to increase in the future this is a speculation

Nominal Vs. Real Interest Rates

Nominal Interest Rates

Nominal interest rates are rates that you see when doing business with a financial institution.

These are rates that are paid on a loan, and it is not adjusted for inflation

Real Interest rates

Real interest rates are the real rate of return earned on financial assets or paid back on loans

These are rates that are adjusted for inflation

The Fisher Effect

An equation that helps us calculate the real rate of return on investments, financial assets, and loans (Impact of inflation on nominal and real interest rates)

Nominal Interest rate = Real interest rate + inflation

Inflation = Nominal interest rate - Real interest rate

Real interest rate = Nominal - inflation

• (mostly algebra)

* The opportunity cost of holding money is the interest you could be earning on a financial asset

* When people choose to purchase financial assets, they take into account their expected Real rate of return, which is based on expected or anticipated inflation

Expected vs. Unexpected Inflation

If inflation is higher than expected, the REAL rate of return on the financial asset falls or REAL value of the financial asset falls (Vise versa)

When a question says fixed interest rates the new nominal interest rate doesn’t change

When a question says flexible interest rates the new real interest rate doesn’t change because the nominal interest rate is flexible, banks or individuals still trying to maintain their real rate of return .

• Expected inflation is what banks use to set a nominal interest rate for:

- Terms of a customer loan

- Savings vehicles

• Actual inflation is calculated after the term of the loan is over.

Impacts on Unanticipated Inflation on Borrowers and Lenders

Lenders, borrowers, and savers make decisions about loaning, borrowing, or saving based on what they expect or anticipate inflation to be over the term of their loan or saving

• When expectations on inflation isn’t met then its unexpected or unanticipated inflation.

• When what is expected happens that is expected or anticipated inflation

Scenarios with higher unanticipated inflation

Borrowers are better off - They pay back loans with dollars of less value

Lenders are worse off - They expected higher rates of return on their loans, but only because of anticipated inflation. When unanticipated inflation hits, it reduces the real interest rate

• Higher unexpected inflation makes the real rate of return on fixed savings and loans lower

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Definition, Measurement, and Functions of Money

Money is:

• Any asset that is accepted as a means of payment

• US dollars as fiat (paper) money

• Real value of money is not set by governments — It’s set by the numbers of goods and services it can purchase

Three Major Functions of Money

Unit of Account

A unit of account means people commonly accept money as a way to set prices

Store of Value

A store of value means money holds purchasing power over time

Other assets also hold value, so it is not unique to money, just a characteristic

Inflation undercuts the store of value

• Inflation can decrease money’s ability to store value over time because you need more dollars over the course of time to purchase the same good you purchased in the past

• When people save their money in savings accounts or long-term savings, this is using money as a store of value

Medium of Exchange

A medium of exchange means money is used to exchange goods and services

Money’s use as a medium of exchange has helped economies grow faster

Money Supply

M0 = Monetary Base: Currency in circulation (Cash) and Bank reserves

M1 = M0 + demand deposits, physical currency, travelers check, other checkable deposits

M2 = M1 + denomination time deposits (CD - Certificate of Deposit) + retail money market funds, money market deposit account

M3 = M1 + M2 + larger time deposits + larger liquid assets

Banking and The Expansions of Money Supply

Banking System

Made up of many different banks, including commercial and investment banks

In most countries the banking system is regulated by the nation’s central bank.

Commercial Banks

• Store money and pay an individual to store money

When customers store their money in checking or savings accounts, the bank owes the individual the money back (On a bank balance sheet, it shows up under bank liabilities)

• Loan out money and earn interest

Banks use a portion/fraction of a customer demand deposits to make loans to individuals and businesses and earn interest, so that banks can make money back (On a bank balance sheet, it shows up under bank assets)

Fractional Reserve Banking

The central bank sets the percent of customer demand deposits that a bank must hold in reserves (no loan out) - known as reserve requirement

The rest of the demand deposits may be loaned out to individuals or customers - Known as fractional reserve banking and this is how banks make money.

Bank Balance Sheets

Shows the amount of bank assets and bank liabilities each individual bank has, and both sides are equal to each other:

Changes in demand deposits affect the size of the bank’s required and excess reserves

• Required Reserve - The percent of demand deposits bank must hold in reserves

• Excess reserve - The percent of demand deposits banks choose to hold on to. These can be loaned out to individuals and businesses

The Money Multiplier

The money multiplier is used to determine maximum changes to the banking system when deposits or withdrawals from demand deposits occur.

Money Multiplier (MM) = 1 / Reserve Requirement ratio (rr)

The money multiplier is based on the central bank’s setting of the reserve requirement (rr), the percentage

Customer Withdrawals is when a customer withdraws money, it is withdrawn from a bank’s reserves (Banks’s assets), and it is subtracted from a bank’s demand deposits (Bank’s liabilities)

The Money Market

• The good and services being supplied and demanded is money (M1)

• The money market is also know as the liquidity preference model of the interest rate

• The money market deals with nominal interest rates. The nominal interest rate is the price in the money market because its the opportunity cost of holding money

Money Demand (MD)

Represents the relationship between the nominal interest rate and the quantity of money (M1) people want to hold:

• Transactions (Money needed to buy goods/services) demand

• Precautionary (Money needed in case of unexpected or unplanned expenses) demand

• Assets or speculative (The use of money as a way to hold wealth) demand

There is an inverse relationship between nominal interest rate and the quantity of money demanded

When nominal interest rate is high, the quantity of money demanded is low

When nominal interest rate is low, the quantity of money demanded is high

Money Supply (MS) (Monetary Policy)

• The amount of money that people have access to

• Controlled by a country’s central bank

• Is independent of the nominal interest rate

• Vertical supply curve

Market Equilibrium

Occurs when the nominal interest rate is set where the current supply of money (MS) intersects the current demand for money (MD). Money demanded equals the quantity of money supplied

Market Adjustment

At higher interest rates, the surplus will drive down the interest rate.

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

Factors that Shifts Money Demand

1. Aggregate Price Level (Inflation)

Higher prices require more money to make purchases (Transaction demand)

PL increases, money demanded increases. PL decreases, money demanded decreases

2. Real GDP (National Income)

When national income increases, spending increases, so more money is needed.

Real GDP increases, money demanded increases. Real GDP decreases, money demanded decreases

3. Technology

The easier it is to convert less liquid assets (Things that are harder to turn into cash) into money, the less money is demanded (Vise versa)

The availability and cost of using money substitutes (E.g., credit cards) affects money demanded.

Factors that Shifts Money supply

• Related to monetary policy, as conducted by central banks

Monetary Policy

A central bank’s policies of influencing nominal interest rates to help achieve macroeconomics objectives:

• Price stability (Low and stable rate of inflation)

• Full employment

Interest rates changes impacts the price level, real output, and unemployment through shifts of aggregate demand

Monetary Policy’s Target Interest Rate

Background:

When banks are unable to meet the reserve requirements, they can:

• Call in loans

• Sell assets

• Borrow from the central bank (discount rate)

• Borrow from other commercial banks (policy rate)

Policy Rate:

Referred to as the overnight interbank lending rate. The bank that is paid in between banks, from one commercial bank to another

Also called the federal funds rate in the US

* Central banks often set a target range for the policy rate to guide monetary policy

How Does Monetary Policy Work

Expansionary Monetary Policy:

When the central bank decreases nominal interest rates in the short run to help get an economy out of a recessionary gap (Negative output gap)

Lower interest rates = less expensive to borrow = more interest-sensitive spending (Investment and consumption) = increase in aggregate demand

Contractionary Monetary Policy:

When the central bank increases nominal interest rates in the short run to help get an economy out of an inflationary gap (Positive output gap)

Higher interest rate = more expensive to borrow = less interest-sensitive spending (Investment and consumption) = decrease in aggregate demand

Monetary Policy Lags

• Recognition lag - it takes central banks time to collect and 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 taken

Limited Reserves Framework

* In a limited reserves framework, interest rate changes are brought about through shifts of the money supply

A banking system in which:

• Reserves are not overly abundant (Limited)

• There is non-zero reserve requirement (Required reserves)

• Commercial banks hold required reserves and possibly also some excess reserves

• Monetary policy works by changing the supply of excess reserves and, therefore, the supply of money

* Central banks use monetary policy tools to influence the money supply

Monetary Policy Tools

1. Required reserve ratio

The percentage of demand deposits bank must hold in their reserves

If the required reserve ratio decreases, banks have more in excess reserves to lend, so MS increases (Nominal interest rates falls - expansionary)

If the required reserve ratio increases, banks have less in excess reserves to lend, so MS decreases (Nominal interest rates rises - contractionary)

2. Discount rate

The interest rate commercial banks must pay to borrow from the central bank

If the discount rate decreases, banks are encouraged to lend more, so MS increases (Nominal interest rate falls - expansionary)

If the discount rate increases, banks are encouraged to lend less, so MS decreases (Nominal interest rate rises - Contractionary)

3. Open-Market Operations (OMO)

Central banks buying and selling of government bonds (securities)

When the central bank buys bonds (OM purchase), banks excess reserve increases, so MS increases (Nominal interest rate falls - expansionary)

When the central bank sells bonds (OM purchase), banks excess reserve decrease, so MS decreases (Nominal interest rate rises - contractionary)
* A policy that increases MS is expansionary and one that decreases it is contractionary.

The Money Multiplier

• OMO causes changes in reserves, so monetary base changes

• In limited reserves environment, the effect of an OMO on the MS is greater than the effect on the monetary base because of the money multiplier

• An increase in excess reserves (OM purchase) leads banks to make more loans, which leads to more deposits, which creates more excess reserves, which allows for more loans

• A decrease in excess reserves (OM sale) works in the opposite way.

The maximum possible value of the money multiplier is

Money multiplier (MM) = 1 / required reserve ratio

This is based on the assumptions that:

• Banks hold no excess reserves

• Borrowers spend their entire loans

• Customers hold no cash

The maximum possible change to the MS as a result of an OMO can be calculated as:

Change to MS = (OMO amount) * (MM)

Ample Reserves

* In an ample reserves framework, interest rate changes are brought about through changes to administered interest rates.

A banking system in which:

• Reserves are abundant

• The required ratio is zero

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

• Different monetary policy tools are needed

In an ample reserve market graph the policy rate is set at the intersection of supply and demand (The lower horizontal portion of demand - straight line)

• OMO (Buying bonds) are used in the context of ample reserves in order to maintain ample reserves (Increases supply of reserves - vertical line).The monetary base increases, but there is no impact on interest rate

* Along the horizontal line of demand is where ample (unlimited) reserves is, and along the downward slopping line is where limited reserves are.

Monetary Policy Tools (Ample Reserves)

The Federal reserves influence NIR by using monetary policy tools

Administered Interest Rates:

1. Interest on reserves

The interest rate on reserves is the interest rate commercial banks earn on the funds in their reserve balance accounts with the Fed

This is the Fed’s primary monetary policy tool

When the Fed makes changes on interest on reserves, it will change the lower bound on the reserve market graph (Increase or decrease)

1. Discount rate

The interest rate commercial banks must pay to borrow from the Fed

Typically adjusted in the same manner as interest on reserves.

When the Fed makes changes to the discount rate the upper bound on the reserve market graph is changed (Increases or decreases)

Ample reserves: Lowering Interest Rates

A decrease in administered interest rated (Interest on reserves and the discount rate) leads to a decrease in the policy rate and a decrease in other nominal interest rates (This is an expansionary policy because interest-sensitive spending and aggregate demand will increase)

A increase in administered interest rated (Interest on reserves and the discount rate) leads to a increase in the policy rate and a increase in other nominal interest rates (This is an contractionary policy because interest-sensitive spending and aggregate demand will decrease)

Formulas

1. Nominal Interest rate = Real interest rate + inflation

2. Inflation = Nominal interest rate - Real interest rate

3. Real interest rate = Nominal - inflation

4. Money Multiplier (MM) = 1 / Reserve Requirement ratio (rr)

5. The maximum possible value of money (Maximum money supply created) = Initial deposit x (1 / Reserve Requirement ratio)

6. Change to MS = (OMO amount) * (MM)

7. Required Reserve (RR) = Reserve Ratio x Demand Deposits

8. Excess Reserves (ER) = Total Reserves - Required Reserve

9. Total Money Created / loan creation = Excess Reserve x Money Multiplier

10. Quantity Theory of Money = (M)(V) = (P)(Q)

M = Money Supply

V = Velocity of Money (How often money is spent)

P = Price Level

Q = Real GDP

11. Time Value of Money

Present Value: Dollars today

Future Value: Dollars in the Future

FV = PV x (1 +interest rate)^# Years

PV = FV / (1+interest rate)^# Years