macro unit 4

4.1

FINANCIAL ASSETS

Financial assets

Places where people can house their wealth

stocks

• Represent ownership in a corporation

• You buy shares hoping that their value will increase over time

• Type of equity (ownership in the value of an asset or business)

• Privately-held companies are entitled to all of their profit, but public companies allow people to buy stocks that entitle them to a portion of the company’s profit

• People who own stocks are shareholders

• Shareholders get a higher rate of return from stocks than bonds offer

  • Rate of return is the percentage of the initial amount gained or lost

  • Owning a stock of a company is riskier than owning a bond in it bc the amount you’ll get back from a stock isn’t as upfront as the amount you have to be paid back from a bond

  • Higher return and higher risk than bonds

shares

• Increase in value as company increases in value

interest rate

• Price (as a percentage) that lenders charge borrowers for borrowing their savings

• Opportunity cost of holding money and not putting it in bonds or buying stock or sum

bond

• A loan to a corporation or government 

• They pay back original investment in addition to interest

• When equilibrium interest rate increases, purchasing power decreases, as does real value of interest

• You earn interest when you hold your assets in bonds

• Default: the risk that the bond issuer might fail to make the payments they promised per the bond contract

• If a company files bankruptcy, its bondholders get paid back before shareholders who usually get nothing

liquidity

• Ability to purchase goods and services with your assets

• Stocks and bonds are not immediately liquid – but still liquid, and stocks moreso

• Money is liquid

• An asset is liquid if it can be quickly converted into cash without much loss of value

money

• Checking and savings along with currency

• Most liquid of all assets

• Doesn’t earn interest

  • You lose the interest you could’ve gotten through a bond – opportunity cost

currency

• Cash and/or coins

Bond Price Relationship with Interest

• Interest increases, bond price decreases

wealth

• Value of a household’s accumulated savings

Financial asset

• Non-physical asset that entitles a buyer to future income from a seller

  • Like a stock or bond

Physical asset

• Tangible object that an owner has the right to use or dispose of freely

  • Like money, a house, or a car or sum

liability

• Requirement to pay money in the future

  • A loan can be a financial asset to the bank, but it’s a liability to you

Financial system/market

• Where households invest current savings and accumulated savings (wealth) by purchasing financial assets

Financial risk

• Uncertainty about whether you’ll gain or lose in the future

Financial intermediaries

• Institutions that transform funds gathered from many individuals into financial assets

• Two examples are mutual funds and banks

Top five categories of financial assets

1. Cash

2. Stocks

3. Bonds

4. Bank deposits

5. Mutual funds

Diversified portfolio of stocks 

• a group of stocks in which risks are unrelated to (offset from) one another

• Holding assets in stock, bonds, real estate, and cash ofc

• High transaction costs for those who don’t invest a ton of money (like $1M or more)

Mutual funds

• Financial intermediaries that create stock portfolios by buying and holding shares in companies 

banks

• Financial intermediaries that provide liquid assets in the form of bank deposits to its lenders and loans those funds to borrowers to spend on illiquid assets 

• Resolve the conflict between lenders’  need liquidity and borrowers who don’t wanna use stock or bond markets

• Depositors lend money to banks

• Banks loan most of their deposits

deposits

• Demand deposits are when the bank gives you your money immediately when you ask for it

4.2

NOMINAL VS. REAL INTEREST RATES

Fisher formula

i: nominal interest rate

r: real interest rate

𝞹: inflation rate

1+i = (1+r)(1+𝞹)

• Banks charge real interest rate they desire in addition to inflation rate

• Lower-than-expected inflation helps lenders and hurts borrowers

Nominal interest rage

• Interest actually paid for the loan

• Expected real interest rate + expected inflation rate

• Has historically always been greater than real interest rate

Real interest wage

• Interest rate value adjusted for inflation

• Equal to (nominal interest rate - inflation rate)

• Opportunity cost of loaning funds

• Expected interest rate = nominal interest rate - expected inflation rate

• Holders of fixed-value assets are hurt by inflation because it decreases the real value of the money available to them in the future

COLA

• Cost-of-living adjustment

4.3

MONEY

money

• an asset that can easily be used to purchase goods and services

• Things like cars, houses, and stocks don’t count as money

• Durable, uniform, in limited supply, divisible into smaller units

• Think of anything you can use to pay for groceries

  • Cash, debit, pay app, checks

4/4

In a fractional reserve banking system, only a fraction of bank deposits are backed by cash on hand and available for withdrawal

Bank reserves are the currency that banks hold in their vaults plus their deposits in the central bank

T-Account for a bank has assets and liabilities/bank capital (normal business would have owners equity instead of bc)

The reserve ratio is the fraction of bank deposits that a bank holds as reserves

The required reserve ratio is the smallest fraction of deposits that the central bank requires banks to hold

Bank runs → bank failure (unable to pay off its depositors in full)

Bank regulation

• Deposit insurance → all banks members of FDIC (max = 250k)

• Capital requirements  → to keep risk taking incentive, make so banks must hold more than deposits so losses won’t be too bad and bank capital / equity (need 7%)

• Reserve requirements are rules set by the central bank that determine the required reserve ratio for banks

• Discount window → central bank id ready to lend money to banks via dw

Determining money supply → banks “create money” manes they increase the amount recorded in depositors accounts, they don’t print more currency (only treasury does that)

Banks create money by… 

• Initial deposit has no impact on the money supply, they keep some in deposit but loan some of the cash from a given deposit out to others, put money back into circulation and increase

• Currency in circulation becomes checkable deposit and currency in circulation bc reloaned and then it keeps happening and keeps increasing money supply

• Money multiplier (like expenditure)

Required reserves are the reserves that banks must hold, as mandated by the central bank

Excess reserves are a bank’s reserves over and above its required reserves

Money multiplier=1rr

• rr is reserve ratio

• Simplified version above

Banks control monetary base

• Venn diagram: one circle = bank reserves aka monetary base and overlaps with a much larger circle of checkable bank deposits aka money supply, overlap = currency in circulation

The money multiplier is the ratio of the money supply to the monetary base, is indicated the total number of dollars created in the banking system by each $1 addition to the monetary base

4.1

• The interest rate is the price calculated as a percentage of the amount borrowed, charged by lenders to borrowers for the use of their savings. 

• A household’s wealth is the value of its accumulated savings.

• A financial asset is a nonphysical asset that entitles the buyer to future income from the seller

• A physical asset is a tangible object that the owner has the right to use or dispose of as they wish

• A liability is a requirement to pay money in the future.

• Financial risk is uncertainty about future outcomes that involve financial losses and gains

• An asset is liquid if it can be quickly converted into cash without much loss of value

• An asset is illiquid if it cannot be quickly converted into cash without much loss of value.

• A loan is a lending agreement between an individual lender and an individual borrower. 

• A bond is an interest-bearing asset that represents a loan to a company or government.

• A stock is a type of equity that represents ownership of a company

• A bank deposit is a claim on a bank that obliges the bank to give the depositor their cash

• A bank is a financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance borrowers’ investment spending on illiquid assets. 

4.2

• The nominal interest rate is the interest rate actually paid for a loan

• The real-interest rate is the nominal interest rate adjusted for inflation

4.3a

• Money is any asset that can easily be used to purchase goods and services

• The money supply is the total value of financial assets in the economy that are considered money.

• A medium of exchange is an asset that individuals acquire for the purpose of trading for goods and services rather than for their own consumption.

• A store of value is a means of holding purchasing power over time.

• A unit of account is measure used to set prices and make economic calculations

• Commodity money is a good used as a medium of exchange that has intrinsic value in other uses

• commodity -backed money is a medium of exchange with no intrinsic value, but whose ultimate value is guaranteed by a promise that it can be converted into valuable goods.

• Flat money is a medium of exchange whose value derives entirely from its official status as a means of payment

• A monetary aggregate is an overall measure of the money supply

• The monetary base (also known as M0 or MB) is the total amount of currency (cash) in circulation or kept on reserve by commercial banks

• The M1 monetary aggregate includes currency in circulation, checkable bank deposits, and other liquid deposits

• The M2 monetary aggregate includes M1 plus less liquid “near monies” (financial assets that can be readily converted into cash).

4.3b

• A central bank is a government institution that issues currency, oversees and regulates the banking system, controls the monetary base, and implements monetary policy.

• An open market operation (OMO) is a purchase or sale of government debt (bond) by the Fed.

4.4

• In a fractional reserve banking system, only a fraction of bank deposits are backed by cash on hand and available for withdrawal

• Bank reserves are the currency that bands hold in their vaults plus their deposits at the central bank

• The reserve ratio is the fraction of bank deposits that a bank holds as reserves.

• The required Reserve ratio is the smallest fraction of deposits that the Central Bank requires banks to hold 

• Reserve requirements are rules set by the central bank that determine the required reserve ratio for banks

• Required reserves are the reserves that banks must hold, as mandated by the central bank.

• Excess reserves are a bank's reserves over and above its required reserves

• The money multiplier is the ratio of the money supply to the monetary base. It indicates the total number of dollars created in the banking system by each $1 addition to the monetary base

4.5

Money market – supply and demand for equilibrium price of money, borrowers and lenders agree to short-term loans

M1 is used as definition of money supply (currency in circulation and liquid deposits) M2 = broader

Demand → hold money because convenience (fast) but opportunity cost because no interest earned

• opportunity cost cost depends on interest rates (directly related)

We assume only on interest rate (short run i) however

• Long term interest rates reflect average market expectations

• Short term rates affect the money demand (short term is normally under a year)

The money demand curve shows the relationship between the quantity of money demanded and the nominal interest rate

 → decreasing and concave up (y axis i / nominal interest rate and x axis quantity of money)

Shifts!!!

• Changes in agg PL → higher prices increase demand for money (right), lower prices = left, *proportional to the price level (movement from M1 to M2) 

• Changes in rGDP → larger quantity of GDP (goods and services to buy), the larger want to hold at any given interest rate

• Changes in technology → decrease demand for money / ie now we have venmo vs going to bank in person

• Changes in regulation → ie allowing banks to pay interest on checking account funds, demand for money rose and shifted the money demand curve to the right

• An increase in money demand shifts right / quantity of money demanded rises at any given interest rate

• A decrease in money demanded shifts left / quantity of money demanded decreases at any given interest rate

Supply → set by central bank (control of currency and reserve / open market operations)

Money supply is independent of the nominal interest rates

The money supply curve (MS) shows the relationship between the quantity of money supplied and the nominal interest rate – the money supply curve is independent of the nominal interest rate

*vertical line

Equilibrium interest rate /// Ei

• MD and MS (MD curve intersects vertical M line at E interest rate)

• Is nominal equilibrium, in disequilibrium

  • Quantity demanded greater than supplied, shortage

  • Quantity demanded less than supplied, surplus

• Changes = change in money demand or money supply

**central banks ability to affect eh eq nominal interest rate through control of money supply shows how monetary policy can be used to affect the macroeconomy

• Increases when, MS decrease or MD increase / decrease when MASS increase or MD decrease

Loanable funds model – the real interest rate matches the quantity of loanable funds supplied by savers with the quantity of loanable funds demanded for investment spending

4.6

4.6 MONETARY POLICY

Central banks conduct monetary policy via their influence on amount of money and credit in the economy (increase of decrease interest rates based on economy)

Primary goal monetary policy = price stability (no dilation or high inflation rates)

Inflation targets and monetary policy to do so and hit

Inflationary targeting occurs when the central bank sets an explicit target for the inflation rate and adjusts monetary policy in order to hit that target

Monetary policy in response to inflationary or recessionary gap, it shifts the AD curve via effect on interest rate

Expansionary monetary policy is monetary policy that increases aggregate demand

Lower interest rate → high investment spending raises income → higher consumer spending (via multiplier) → increase in aggregate demand and AD curve shifts to the right

Contractionary monetary policy is monetary policy that reduces aggregate demand

Higher interest rate → lower investment spending reduces income → lower consumer spending (via multiplier) → decrease in aggregate demand and AD curve shifts to the left

Can lead recessionary gap to return to full employment and in inflation is can close output gap and restore price stability

right for expansionary and left for contrasty

OILR = target IR from central bank

The overnight interbank lending rate is the interest rate that banks charge other banks for overnight loans. The central bank’s policy rate is its target range for an overnight interbank lending rate

In the US, banks make overnight loans to each other in the federal funds market, and the federal funds rate is the interest rate in that market

• Allows bank that need/want liquidity to borrow from each other (lending excess reserve), IR for this is determined by S/D but influence by central bank actions

The policy rate is the central bank's target for the overnight interbank lending rate, which of the Fed is known as the federal funds raise – the interest rate that the US commercial banks charge each other for overnight loans

How a central bank's implements monetary policy depends on limited or ample reserves

• In an economy with limited reserves, reserves are scarce and therefore relatively small changes in the supply of reserves shifts the money supply curve and changes the interest rate

  • Three policy tools: reserve requirements, discount rate, open market operations (OMO)

• In an economy with ample reserves, banks hold high levels for excess reserves and therefore changes in thes supply of reserves does not change the interest rate significantly

  • Policy of change is harder so interest rate paid on reserve balances (IORB), and quantitative easy, etc

Monetary policy transmission mechanism

• Central bank sets policy rate target range → (implementation regime) → aggests current and expected short-term interest rates → affects longer-term interest rates and overall financial conditions → influences consumers and producers spending decisions → progress made toward full employment and stable prices

LIMITED RESERVES implementing monetary policy

The reserve requirement

• Minimum required reserve ratio if they fail to meet must borrow in the interbank overnight lending market

• Increase in reserve requirement leads to more increase in demand for overnight market, high interest rate they are inclined to charge their documents higher interest rate

• So decrease in rr would reduce amount of borrowing, decreasing demand for reserves and the EQ of the overnight market – and charge consumers lower interest rates

• When rr decreased, allowed to lend larger percentage so supply more loans and increase money supply (money multiplier) and leads to lower interest rates and higher GDP

• When rr increased, reduce lending, fall in money supply, higher interest rates, lower GDP

The discount rate is the interest rate the central bank charges on loans to banks

• Set by federal reserve, normally set just above federal funds rate and move with short-term interest rates

• Extend length of discount window to encourage borrowing from the fed (2020)

Open market operations (OMOs) include the purchase or sale of government debt (eg bond) by a central bank

Open market operation and the interest rate

• How centra banke gan buy or sell go bonds to affect interest rate in limited reserves

• When money supply increases, money supply curve shifts to the right and EQ IR galls (increase in money supply drives interest rates down)

• Push interest rate down to try by increasing money supply (an open market purchase drives the interest rate down)

• Push interest rate up to target by decreasing money supply (an open market sale drives the interest rate up)

Modern monetary policy tools

• A central bank is up against the zero bound when the short-term interest rate has already been lowered to zero. Further economic stimulus, if needed, requires the central bank to use nontraditional policy tools.

• Quantitative easing (QE) is an expansionary monetary policy that involves central banks purchasing longer-term government bonds and other private financial assets

• The interest on reserve balances (IORB) is the amount the central bank pays in interest to banks for their balances held in reserve

  • Interest of reevers (IOR) ist her ate the ventral banks pays in interest to banks for their reserve balances

Administered interest rates – fed sets two overnight IRs, IR paid on bank's reserves balances and the rate on feds repurchase agreements, together keep the federal funds rate → used to create range

• With ample reserves, federal funds rate will move with the interest rate the fed pays on reserves / banks version of buy low sell high aka arbitrage (assures federal fund rates will not go synch below the IR on reserves)

AMPLE RESERVES implement monetary policy

Administered interest rates / the market for reserves

• Demand curve for market reserves had three parts, horizontal at low levels of reserves, downward sloping middle (relationship between policy rate and quantity of reserves demand), horizontal very slow to the interest rate on reserves / vertical supply

Demand and supply changes in market for reserves

• IOR will shift the demand curve / increase in IOR will shift lower horizontal section upward, decrease will shift to downward as abrigate ascites policy rate moves with the IOR,,, EQ for market is in that horizontal section it will change discount rate

• Adjustments to reserve are shown on supply curve (right for increase, left for decrease)

Monetary v fiscal

• Monetary policy lags result from the time it takes to recognize a problem in the economy and the time it takes for a monetary policy action to take effect in the economy

• Monetary policy is more often used to stabilize economy (subject to lag like fiscal policy)

Monetary policy refers to the actions of central banks, including the Federal Reserve, to achieve macroeconomic policy objectives such as price stability, full employment, and stable economic growth. Fiscal policy refers to the tax and spending policies of a national government. – from the fed

4.6

Definitions: 

Inflation Targeting → occurs when the central bank sets an explicit target for the inflation rate and adjusts monetary policy in order to hit that target

Expansionary Monetary Policy → is monetary policy that increases aggregate demand.

Contractionary Monetary Policy → is monetary policy that reduces aggregate demand

The overnight interbank lending rate is the interest rate that banks charge other banks for overnight loans. The central bank’s policy rate is its target range for an overnight interbank lending rate. 

In the US, banks make overnight loans to each other in the federal funds market, and the federal funds rate is the interest rate in that market.

In an economy with limited reserves, reserves are scarce and therefore relatively small changes in the supply of reserves shifts the money supply curve and changes the interest rate.

In an economy with ample reserves, banks hold high levels of excess reserves and therefore changes in the supply of reserves does not change the interest rate significantly.

The discount rate is the interest rate the central bank charges on loans to banks

Open market operations (OMOs) include the purchase or sale of gov’t debt (eg. a bond) by a central bank.

A central bank is up against the zero bound when the short-term interest rate has already been lowered to zero. Further economic stimulus, if needed, requires the central bank to use nontraditional policy tools.

Quantitative easing (QE) is an expansionary monetary policy that involves central banks purchasing longer-term government bonds and other private financial assets.

The interest on reserve balances (IORB) → is the amount the central bank pays in interest to banks for their balances held in reserve

Monetary policy lags result from the time it takes to recognize a problem in the economy and the time it takes for a  monetary policy action to take effect in the economy.

4.7

4.7 THE LOANABLE FUNDS MARKET

Circular-flow model callback → closed economy (no international sector) = savings are equal to national savings, in an open economy = savings equal national savings plus capital inflow from private sector

• Basically closed economy = not international, open economy = international

Savers and borrowers matched up through markets controlled by supply and demand (same way producers and consumers are matched up)

Financial markets channel savings of households to business that want to borrow in order to purchase capital equipment

How financial markets work = theme

Economic growth = human capital (increase in skill/knowledge of the workforce) and physical capital (goods used to make other goods, mostly through private spending)

Private investment spending is people/corporations – modern times they do it with other people's money (if they borrow, charged an interest rate)

Savings-investment spending identity - saving and investment spending are always equal

POV imaginary economy

Total income = total spending

Total income = consumer spending + savings

Total spending = consumer spending + investment spending

Consumer spending + savings = consumer spending + investment spending

Savings = investment spending

In a more realistic economy…

• Households are not the only parties that can save in an economy

  • The budget surplus is the difference between tax revenue and government spending when tax revenue exceeds government spending

  • The budget deficit is the difference between tax revenue and government spending when government spending exceeds tax revenue

  • National savings, the sum of private savings and the budget balance, is the total amount of savings generated within the economy

• Any one country is a part of a wider world economy so savings can be spent on on physical capital in a different country (savings generated in one country, spent in another)

  • Inflow of funds and outflows of funds

Net capital inflow is equal to the total inflow of foreign funds minus the total outflow of domestic funds to other countries

Investment = national savings + net capital inflows

The loanable funds market is a hypothetical market that brings together those who want to lend money and those who want to borrow money (real interest rate = r)

Graph for demand for loanable funds

• Horizontal axis quantity demanded, vertical axis real interest rate, demand curve slopes downwards

Rate of return=Revenue from project - Cost of projectCost of project 100

• Supply - supply is upward sloping

Equilibrium in the loanable funds market

• To the left

  • Supply = offers accepted from lenders willing to lend out a lower interest rate

  • Demand = projects with a rate of return of higher (funded)

• To the right

  • Supply = offers not accepted from lenders who demand an interest rate of more than

  • Demand = projects with a rate of return less than (not funded)

Disequilibrium in the loanable funds market occurs when real interest rates are not equal to the equilibrium interest rate (higher, surplus of loanable funds that drive back down / lower, shortage drives real interest rate back up)

Shifts in demand

• Changes in perceived business opportunities 

  • Change in beliefs about the rate of return can impact desired dispensing at any given interest rate

  • An investment tax credit is an amount that firms are allowed by law to deduct from their taxes based on their investment spending (changes rate of return, changes demand, shifting curve)

• Changes in the government’s borrowing

  • Gloves that run budget deficits = source of the demand for loanable funds

  • Crowding out occurs when a government deficit drives up the interest rate and leads to reduced investment spending

Shift in supply

• Changes in private saving behavior (many factors, ie housing costs)

• Changes in capital inflows (change investors perceptions of the country)

Recal: real interest rate = nominal interest rate - inflation rate

*Even though the real interest rate is equal to the nominal minus the inflation rate, simply knowing two of the values will not necessarily tell you the third. For example, an increase in nominal and a decrease in the inflation rate will both lead to an increase in the real interest rate / but if change in opp directions than it is impossible to know