Financial Sector and Monetary Policy

BIG PICTURE IDEAS

  • Financial Sector: Focuses on financial assets, such as money and bonds, and institutions (like banks) that facilitate lending and borrowing.
  • Bank Balance Sheet: Reports the assets and liabilities of an individual bank.
  • Central Banks: Use monetary policy to adjust money supply and interest rates to achieve full employment and price stability.
  • Traditional Tools of Monetary Policy: The three tools are reserve requirements, discount rates, and open market operations.
  • Effectiveness of Monetary Policy: Depends on the reserves in the banking system.

Topic 4.1 - Financial Assets

  1. Vocabulary Definitions:

    • Liquidity: The ease of converting an asset into a medium of exchange.
    • Bonds (Securities): Interest-bearing assets issued by businesses/governments.
    • Demand Deposits: Funds in a bank account that can be withdrawn anytime without penalty.
    • Interest Rate: The charge by a lender to a borrower for the use of money.

  2. Interest Rates and Bond Prices: Inverse relationship. Higher interest rates on new bonds make existing bonds less desirable, decreasing their price.

Topic 4.2 - Nominal vs. Real Interest Rates

  1. Real Interest Rate Calculation:
    ext{Real Interest Rate} = ext{Nominal Interest Rate} - ext{Expected Inflation}

  2. Chart Completion Examples:

    Nominal Interest RateReal Interest RateActual Inflation
    7%4%3%
    4%-1%5%
    6%8%-2%
    2%-3%5%

  3. Inflation Effects: When actual inflation exceeds expected inflation, the real interest rate decreases.

Topic 4.3 - Functions of Money

  1. Functions of Money:

    • Medium of exchange
    • Store of value
    • Unit of account

  2. Money vs. Non-Money Assets: Cash/checkable deposits are included as money, while bonds and real estate are not, as they cannot be used directly for transactions.

Topic 4.4 - Banking and the Expansion of the Money Supply

  1. Money Supply Definitions:

    • M1: Cash, currency, checkable deposits, and savings deposits.
    • M2: M1 plus near monies (like time deposits).

  2. Fractional Reserve Banking: Banks hold a fraction of deposits as reserves and lend out the remainder.

  3. Reserves:

    • Required Reserves: Legally mandated deposits that banks cannot loan out.
    • Excess Reserves: Funds available for banks to loan out.

  4. Money Multiplier Equation:
    ext{Money Multiplier} = rac{1}{ ext{Reserve Requirement}}

  5. Effect of Excess Reserves: If banks hold more excess reserves, the money multiplier decreases.

Banking Exercises

  1. Bank Balance Sheet Example:

    • Assets: Total Reserves ($5,000), Loans ($10,000), Treasury Bonds ($20,000).
    • Liabilities: Demand Deposits ($15,000), Owner's Equity ($10,000).

  2. Required and Excess Reserves for Bank X:

    • Required Reserves at 10%: 2,000
    • Excess Reserves: 3,000

  3. Maximum Money Supply Increase: If Bank X loans out all excess reserves: 30,000 (calculated as 3,000 imes 10).

  4. Deposits Effect: A $5,000 deposit does not immediately increase money supply.

  5. New Demand Deposits and Excess Reserves: Demand Deposits = 25,000, Excess Reserves = 7,500.

  6. Money Supply Increase from New Deposit: Maximally 45,000 from the $5,000 deposit (initial loan calculation).

Topic 4.5 - The Money Market

  1. Money Market Graph: Displays supply and demand for money, determining equilibrium nominal interest rate.

  2. Transaction vs. Asset Demand for Money:

    • Transaction demand: Used for daily purchases, independent of interest rate.
    • Asset demand: Money held for its liquidity, compared to other non-liquid assets.

  3. Vertical Supply Curve for Money: Money supply set by the central bank, not influenced by nominal interest rates.

Topic 4.6 - Monetary Policy

  1. Policy Definitions:

    • Monetary Policy: Adjusts money supply by the central bank.
    • Fiscal Policy: Involves government spending and taxation.

  2. Discount Rate vs. Federal Funds Rate:

    • Discount Rate: Fed's rate charged to banks.
    • Federal Funds Rate: Rate banks charge each other.

  3. Effects of Central Bank Actions:

    • Increase reserve requirement = Decrease in money supply
    • Central bank buys bonds = Increase in money supply
    • Decrease the reserve requirement = Increase in money supply

  4. Tool Usage: Open market operations are the most frequently used tool in monetary policy.

  5. Closing the Output Gap: Money Supply ↑ → ir ↓ → C ↑ → AD ↑ → Full Employment

  6. Impact of Decrease in Interest on Reserves:

    • Overall increase in aggregate demand due to lower interest rates encouraging spending.

Topic 4.7 - The Loanable Funds Market

  1. Loanable Funds Market: Connects borrowers (demand) and lenders (supply).

  2. Demand for Loanable Funds Shifters: Business opportunities and government borrowing changes.

  3. Supply for Loanable Funds Shifters: Changes in savings and profitability of loans.

  4. Real vs. Nominal Interest Rates: Real rates are preferred as they adjust for inflation.

  5. Government Borrowing: Increases demand for loanable funds, causing real interest rates to rise.

  6. Business Investment Decrease: Leads to lower real interest rates as demand for funds diminishes.

  7. Private Savings Increase: Increases supply, reducing real interest rates.