Knowt
AP MACRO CH 26-28
AP Macroeconomics
Study Guide
Chapter 26: Finance, Saving, and Investment
26.1 Financial Institutions and Financial Markets
Capital Differences: physical v. human; Financial capital
Gross investment v. net investment; depreciation;
How do we define wealth?
Markets for financial capital: loan markets, bond markets, stock markets
What are stock, loans, and bonds?
Financial Institutions (different types)
Interest Rate (real v. nominal & how to calculate)
26.2 The Loanable Funds Market
Loanable Funds Market
X-axis = Loanable Funds; Y-Axis = Interest Rate
Demand for Loanable Funds
IR or Expected Profit;
Supply for Loanable Funds
Real IR; disposable income; wealth; expected future income; default risk;
Equilibrium:
Higher the real IR the greater amount of saving and the larger is the quantity of loanable funds supplied;
26.3 Government in the Loanable Funds Market
Gov’t Budget Surplus v. Gov’t Budget Deficit
Crowding-Out Effect
Private curve. market curve (private + govt)
Ricardo-Barro Effect
Chapter 27: The Monetary System
27.1 What is Money?
Money; commodity/token; generally accepted; means of payment;
Functions of Money:
Medium of Exchange
Unit of Account
Store of Value
Barter System
Fiat
Deposits v. currency
M1 and M2
Credit Cards (instant loans) and Checks
Checkable deposits
27.2 Banking
How do banks create money?
Bank deposits
Reserve ratio
27.3 The Federal Reserve System
Structure of the Fed (board of Governors)
Fed’s Policy Tools
Required reserve ratios; discount rate; open-market operations; extraordinary crisis measures;
FOMC – Open Market Operations
27.4 Regulating the Quantity of Money
Creating deposits by making loans;
Monetary base; desired reserves and desired currency holdings;
Fed buying securities v. Fed selling securities;
Multiplier effect & currency drain (money multiplier)
Chapter 28 Money, Interest, and Inflation
28.1 Money and the Interest Rate
Quantity of Money demanded
Holdings, opportunity cost of holding money
Real interest rate = nominal interest rate – Inflation rate
Demand for Money Schedule and Curve
x-axis = quantity of money :: y-axis = nominal IR
Changes in Demand for Money
Price level; real gdp; financial technology;
Supply of Money demanded
Supply is fixed by the Fed
28.2 Money, the Price Level, and Inflation
Long-Run; nominal IR influences money holding plans equals the real interest rate plus the inflation rate.
Value of money: quantity of goods/services unit of money will buy
Value of money = 1/P (price level)
Change in Quantity of Money (Fed increases money)
A given % change in the quantity of money brings an equal % change I the price level
“Baby-Sitting club” example
Quantity Theory of Money (QTM)
Velocity of Circulation and the equation of exchange
M x V = P x Y
P = (M x V) / Y
Inflation; corresponds with money growth rate
Hyperinflation (Germany/Zimbabwe/Venezuela)
28.3 Costs of Inflation
Inflation is a tax
Shoe-leather costs, confusion costs, uncertainty costs;
GRAPHS
Loanable Funds -
Money Supply -
Quantity Theory of Money
Theory
Quantity theory of money is the proposition that when real GDP equals potential GDP, an increase in the quantity of money brings an equal percentage increase in the price level (other things remaining the same).
Ongoing money growth brings inflation.
The quantity theory of money (QTM) states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply. For example, if the amount of money in an economy doubles, QTM predicts that price levels will also double.
First noted by Copernicus; furthered by Locke, Hume, & Bodin; and recently refined by Friedman and Fisher.
Velocity of Circulation & Equation of Exchange
Velocity of circulation is the number of times in a year that the average dollar of money gets used to buy final goods and services.
Think that multiplier effect – how often it filters through the economy.
Equation of exchange is an equation that states that the quantity of money multiplied by the velocity of circulation equals the price level multiplied by real GDP.
V = Velocity of Circulation
M = Quantity of Money
P = Price Level
Y = Real GDP
Equations
M x V = P x Y
V = (P x Y) / M
V = (1.25 x $8T) / $2T, V = 5
With $2T of money, each dollar is used (on average) 5 times during the year, so $2T x 5 = $10T of goods and services bought.
($2T x 5) = (1.25 x $8T)
Quantity Theory Prediction
The equation of exchange, M × V = P × Y, implies that
P = (M × V) ÷ Y.
On the left is the price level and on the right are all the things that influence the price level.
These influences are the quantity of money, the velocity of circulation, and real GDP.
To turn the equation into a theory of what determines the price level, we use two facts:
In the long run, real GDP equals potential GDP, which is independent of the quantity of money.
The velocity of circulation is relatively stable and does not change when the quantity of money changes.
So, in the long run, V and Y are constant and the price level P is proportional to the quantity of money M. If M increases then P must also increase! (or vice versa)
P = (M x V) / Y
P = ($2T x 5) / $8T = 1.25
Now, increase money to $2.4T (or 20%)
New PL – P = ($2.4T x 5) / $8T = 1.50
PL rises from 1.25 to 1.50, or 20%!
When the economy is at full-employment (real = potential), and the velocity of circulation is stable, the price level and the quantity of money increases by the same?
Inflation and the Quantity Theory of Money
The equation of exchange tells us the relationship between the price level, the quantity of money, the velocity of circulation, and real GDP.
This equation implies a relationship between the rates of change of these variables, which is Money growth + Velocity growth = Inflation rate + Real GDP growth
Which means that Inflation rate = Money growth + velocity growth – real GDP growth
The velocity of circulation grows at 1 percent a year and real GDP grows at 3 percent a year.
If the quantity of money grows at 2 percent a year, the inflation rate is zero.
If the quantity of money grows at 4 percent a year, the inflation rate is 2 percent a year.
If the quantity of money grows at 10 percent a year, the inflation rate is 8 percent a year.
Change in Inflation Rate
Increase in the Money Growth Rate
The inflation rate increases slowly and there is a temporary (short-run) increase in the real GDP growth rate.
Velocity speeds up as IR increases.
Faster inflation rate reduces potential GDP and slows real GDP growth, but for low IR these effects are small and dominated by money growth rate effects.
Decrease in the Money Growth Rate
Work in the opposite as above.
In the long run and other things remaining the same, a change in the growth rate of the quantity of money brings an equal change in the inflation rate.
Because, in the long run, both velocity growth and real GDP growth are independent of the growth rate of money: …
A change in the money growth rate brings an equal change in the inflation rate.
Hyperinflation is If the quantity of money grows rapidly, the inflation rate will be very high.
An inflation rate that exceeds 50 percent a month is called hyperinflation.
50 percent a month is 12,875 percent per year.
The highest inflation rate in recent times was in Zimbabwe, where inflation peaked at 231,150,888.87 percent a year in July 2008.
Inflation Costs
The income tax on nominal interest income drives a wedge between the before-tax interest rate paid by borrowers and the after-tax interest rate received by lenders.
The fall in the after-tax interest rate weakens the incentive to save and lend.
The rise in the before-tax interest rate weakens the incentive to borrow and invest.
Inflation increases the nominal interest rate, and because income taxes are paid on nominal interest income, the true income tax rate rises with inflation.
The higher the inflation rate, the higher is the true income tax rate on income from capital.
And the higher the tax rate, the higher is the interest rate paid by borrowers and the lower is the after-tax interest rate received by lenders.
With a fall in saving and investment, capital accumulation and real GDP growth slows.
The cost of inflation depends on its rate and its predictability.
The higher the inflation rate, the greater is its cost.
And the more unpredictable the inflation rate, the greater is its cost.
Low & predictable is the goal.
Inflation is costly for four reasons:
Tax costs
Government gets revenue from inflation.
Inflation Is a Tax
You have $100 and you could buy 10 DVDs ($10 each) today or hold the $100 as money.
If the inflation rate is 5 percent a year, at the end of the year the 10 DVDs will cost you $105.
If you held $100 as money for the year, you have paid a tax of $5 on your holding $100 of money.
Shoe-leather costs
So-called “shoe-leather” costs arise from an increase in the velocity of circulation of money and an increase in the amount of running around that people do to try to avoid incurring losses from the falling value of money.
When money loses value at a rapid anticipated rate, it does not function well as a store of value and people try to avoid holding it.
They spend their incomes as soon as they receive them, and firms pay out incomes—wages and dividends—as soon as they receive revenue from their sales.
The velocity of circulation increases.
During Germany’s period of hyperinflation (1921-23), merchants hired runners to bring cash to the bank in order to convert it into another more stable currency.
Confusion costs
Money is our measuring rod of value.
Unit of account & Standard of value (allows us to understand costs/benefits easily)
Make sound decisions based on marginal benefit and marginal costs…
Obfuscates opportunity cost.
Borrowers and lenders, workers and employers, all make agreements in terms of money.
Inflation makes the value of money change, so it changes the units on our measuring rod.
Does this matter? Think about time. If we were unable to keep accurate time that was off by 5-15 minutes every day, how do you show up to class on time?
Confusion might not be a big deal, but it very well could be!
Uncertainty costs
A high inflation rate brings increased uncertainty about the long-term inflation rate.
Increased uncertainty also misallocates resources. It makes long-term planning difficult, which reduces investment and thus slows economic growth.
Instead of concentrating on the activities at which they have a comparative advantage, people find it more profitable to search for ways of avoiding the losses that inflation inflicts.
CASINO! Sort of.
Gains and losses occur because of unpredictable changes in the value of money.
People do not specialize in comparative advantage and spend time focusing on ways to avoid losses or make gains.
Tossing away scarce resources (human capita). Societal loss.
Money Market
A change in the nominal interest rate is the initial effect of a change in the quantity of money, but it is not the ultimate effect.
Interest rate changes affect borrowing/lending, investment, consumption, spending… which affect production (rGDP) and prices (price level).
The long run refers to the economy at full employment or when we smooth out the effects of the business cycle.
When real GDP = potential and there is full employment. Real GDP equals potential GDP on average in the long-run. Average over the business cycle! In the short run, the interest rate adjusts to make the quantity of money demanded equals the quantity of money supplied.
In the long run, the price level does the adjusting.
The Long-Run Demand for Money
In the long run, equilibrium in the market for loanable funds determines the real interest rate.
The nominal interest rate that influences money holding plans equals the real interest rate plus the inflation rate.
Think about an economy that has NO inflation
If the inflation rate is zero, the nominal interest rate in the long run equals the real interest rate.
The interest rate is determined by real forces in the long-run.
What is the variable that adjusts to make the quantity of money that people plan to hold equal the quantity of money supplied?
The variable that adjusts in the long run is the “price” of money.
Law of demand applies to money just like any other good.
The lower the “price” of money, the greater is the quantity of money that people are willing to hold.
The “price” of money is the value of money.
Value of Money
The value of money is the quantity of goods and services that a unit of money will buy.
It is the inverse of the price level, P, which equals the GDP price index divided by 100.
Value of Money = 1/P
Say you have $100, you can buy $100 dollars worth of goods/services.
However, if PL increases by 10% you can now only buy $90 worth of goods/services. The quantity of G/S that $100 can buy has fallen.
Your $100 can only buy $100 divided by 1.1 or $91. Yesterday’s $100 is now only worth $91.
The higher the value of money the less people want to hold.
If movie tickets were 10₵ and restaurants 20₵ you’d be content with maybe holding $1. If movie tickets were $10 and meals $20 you may want $100 to hold.
The price level is lower and the value of money HIGHER in the first example, and the amount of money you would plan to hold is LOWER!
Money Market Equilibrium in the Long Run
In the long run, money market equilibrium determines the value of money.
How far does your dollar go?
If the QofM exceeds LR quantity demanded, people go out and spend their surplus money. The quantity of goods and services available is FIXED, so the extra spending drives prices up!
As PL rises, the value of money falls.
If the QofM supplied is less than the LR quantity demanded, people lower their spending to build up the quantity of money they hold. This shortage translates into a surplus of goods & services, so the spending cut-back forces prices downward.
As PL falls, the value of money rises.
When supplied = demand, the price level and value of money are at their equilibrium levels.
The long-run demand for money is determined by potential GDP and the equilibrium interest rate.
The LRMD curve shows how the quantity of money that households and firms plan to hold, in the long run, depends on the value of money.
The MS curve shows the quantity of money supplied, which is $1 trillion.
The price level adjusts to make the value of money equal to 1 and achieve long-run money market equilibrium.
A Change in the Quantity of Money
Starting from a long-run equilibrium, suppose that the Fed increases the quantity of money by 10 percent.
In the short run, the greater quantity of money lowers the nominal interest rate.
With the lower interest rate, people and firms spend more.
But with real GDP equal to potential GDP, prices start to rise.
Eventually, a new LR equilibrium is reached at which PL has increased in proportion to the increase in the QofM.
At the new long-run equilibrium, the price level will have risen by 10 percent, from 1.0 to 1.1.
A key proposition about the quantity of money and the price level is that:
In the long run and other things remaining the same, a given percentage change in the quantity of money brings an equal percentage change in the price level.
The quantity of money increases by 10 percent from $1 trillion to $1.1 trillion and the supply of money curve shifts from MS0 to MS1.
The price level rises by 10 percent and the value of money falls by 10 percent to restore long-run equilibrium in the money market.
Example
Imagine an isolated neighborhood where you only have parents and very young children (no grandparents or teenagers).
There are no baby-sitters, so they form a baby-sitting club for each other.Each time you sit for someone else you get a token, which can only be spent on a baby-sitting session from another member.
A baby-sitting club uses tokens to pay for neighbor’s baby-sitting services. One sitting costs one token.
There is inactivity in the club. People are hoarding tokens and not spending them. The organizers double the number of tokens by giving a token to each member for each token currently held.
With more tokens parents plan more nights out – everyone wants a sitter, but there aren’t enough. Anxious parents who REALLY need a sitter offer two tokens per session. At this higher price the quantity of baby-sitters demanded decreases and supply increases.
Equilibrium in this local baby-sitting market is restored when the price of it doubles to two tokens.
Nothing real has changed, but the nominal quantity of tokens and the price level have doubled.
The Banking System
Fractional Reserve Banking
The Federal Reserve “King of Banks”
Banks and other financial institutions that accept deposits and provide services that enable people and businesses to make and receive payments
The Federal Reserve regulates and influences the activities of the commercial banks, thrift institutions, and money market funds, whose deposits make up the nation's deposits.
Commercial Banks
A firm that is licensed by the comptroller of the currency in the US Treasury to accept deposits and make loans
In 2016, about 5260 commercial banks operated in the United States
Because of Mergers, this number is down from the original 15000 in the 80s and during the financial crisis in 2008-09, more than 130 banks failed
A commercial bank accepts three types of deposits
Checkable Deposits (Low IR)
Savings Deposits
Time Deposits (High IR - must stay in for set amount of time)
Profit & Risk
The goal of a commercial bank is to maximize the long-term wealth of its stockholders
To achieve this goal, banks borrow from depositors and others and lend for long-terms at high IR
Lending is risky, so a bank must be prudent in the way it uses its depositors funds and balance security for depositors and stockholders against high but risky returns
If banks incur losses, mass withdrawals might create a crisis
To trade off between risk and profit, a bank divided its assets into four parts
Reserves
Liquid Assets
Securities
Loans
Reserves
A bank reserves consists of currency in the banks vaults plus the balance on its reserve account at a federal reserve bank
The FED requires the banks and other financial institutions to hold a minimum percentage of deposits as reserves, called the Required Reserve Ratio
Currency in vault is to meet depositors withdrawal requirements
Reserve account is like the banks deposit at the FED
Banks desired reserves might exceed the required reserves, especially when the cost of borrowing reserves is high
Banks create money by making loans
Federal Reserve System
Central Bank of the United States
Public Authority that provides banking services to banks and regulates financial markets
Main task is to regulate the interest rate and quantity of money to achieve low and predictable inflation and sustained economic growth
Liquid Assets
Banks liquid assets are short term treasury bills and overnight loans to other banks
When banks have excess reserves, they can lend them to other banks that are short of reserves in an interbank loans market
The interbank loans market is called federal funds market and the interest rate on interbank loans is the federal funds rate
The FED’s policy actions target the federal funds rate
Securities & Loans
Securities held by banks are bonds issued by the US Government and by other organizations
A bank earns a moderate interest rate on securities, but it can sell them quickly if it needs cash
Loans are the funds that banks provide to business and individuals and include outstanding credit card balances
Loans earn the bank a high IR, but they are risky and cannot be called in before the agreed date
Bank Assets & Liabilities
In 2013, Checkable Deposits and Commercial Banks in the United States, included in M1, were about 9% of total commercial bank deposits
Another 46 percent of deposits were saving deposits and small time deposits, which are apart of M2
In 2016, commercial banks held:
17% of total assets as reserves
22% as securities
61% as loans
The source of funds allocated was:
75% were deposits in M1 and M2
13% Borrowing from bondholders
12% from banks stockholders–the banks net worth
Thrift Institutions
Three type of thrift institutions are savings and Loans Associations, Savings Banks, and Credit Unions
A Savings and Loans Association is a financial institution that accepts checkable deposits and savings deposits and that makes personal, commercial, and home-purchase loans
A savings bank is a financial institution that accepts savings deposits and makes mostly consumer and home-purchase loans
A credit union is a financial institution owned by a social or economic group, such as a firm's employees, that accepts savings deposits and makes mostly consumer loans
Like commercial banks, thrift institutions hold reserves and must meet minimum reserve ratios set by the FED
Money Market Funds
A money market fund is a financial institution that obtains funds by selling shares and used these funds to buy assets such as US Treasury bills
Money market fund shares act like bank deposits
Shareholders can write checks on their money market fund accounts
There are restrictions on most of these accounts
Formulas
