Macroeconomics Unit 4 The Financial Sector, Money, and Monetary Policy

Unit 4: The Financial Sector, Money, and Monetary Policy Define Key Terms The Financial SectorThe part of the economy made up of institutions (like banks) that focus on pairing lenders and borrowers AssetsAny item of economic value that can be converted into cash. Something owned LiabilitiesA legal or financial obligation that must be paid back. Something owed LiquidityThe ease in which an asset can be converted into medium of exchange. Cash and money in checking accounts is very liquid. A car or a home is not The Demand for Money What is the transaction demand for money? People demand money to make everyday purchases. This is not affected by the interest rate What is the asset demand for money? When people demand money as a liquid asset because they prefer it to other non-liquid assets like bonds Interest rate ↑, the quantity of money demanded __↓__ Interest rate ↓, the quantity of money demanded __↑__ Shifters of Money Demand 1. Changes in price level- Inflation requires consumer to hold more cash for financial transactions. 2. Changes income- Sustained economic growth in the economy leads to a increase in the demand for money 3. Changes in taxation that affects personal investment- Government policies such as changing the capital gains tax would change the demand for money Shifters of Money Supply 1. Reserve ratio-the the percent of deposits that banks must hold in reserve (the % they can NOT loan out) -To increase money supply, decrease the reserve ratio -To decrease money supply, increase the reserve ratio 2. Discount Rate- the interest rate that the FED charges commercial banks -To increase money supply, decrease the discount rate -To decrease money supply, increase the discount rate 3. Open Market Operations- when the FED buys or sells government bonds (securities) -To increase money supply, the FED buys bonds -To decrease money supply, the FED sells bonds The Three Functions of Money 1. A Medium of Exchange- Money can easily be used to buy goods and services. DonÕt have to barter 2. A Unit of Account- Money measures the value of goods and services and measures value 3. A Store of Value-Money allows you to store purchasing power for the future Types of Money 1. Commodity Money Something that performs the function of money and has an alternative use (ex: mackerel in prison) 2. Fiat Money Something used for exchange but has no other important use (ex: $20 dollar bill) The Money Market Graph Draw the demand and supply of money and label the equilibrium nominal interest rate Nominal Interest Rate Money Supply ir Money Demand QMoney Quantity of Money Money Market Practice 1. Unexpected inflation causes the demand for money to __increase__ and the interest rate to __increase___. 2. If the supply of money increased, the interest rate will __decrease__ and investment will __increase___. True or False 3. When the interest rate is high, the opportunity cost of holding money increases so the quantity of money demanded will decrease. True 4. The money supply includes all assets like cash, demand deposits, bonds, and real estate. False 5. Monetary policy is when the central banks changes the interest rates by changing the money supply True The Federal Reserve (The Fed) Money Multiplier Equation What is the Federal Reserve and what does it do? The Fed is the central bank of the United States and it regulates commercial banks and adjusts the money supply to adjust interest rates to meet economic goals. This is called Monetary Policy. Money Multiplier Practice Shifter Practice 1. Assume the reserve requirement is .10. If the Fed 1. If the FED increases the reserve requirement the buys $10 billion worth of bonds the money supply money supply will __↓__ and interest rates ___↑___. will increase by $100 billion. 2. If the FED sells bonds the money supply will __↓__ 2. Assume the reserve requirement is .20. If the Fed interest rates __↑__, and investment ___↓___. sells $10 billion worth of bonds the money supply 3. If the FED decreases the reserve requirement the will decrease by __$50__ billion. 3. Assume the reserve requirement is .10. If the Fed money supply will __↑__ and interest rates __↓____. 4. If the FED decreases the discount rate, the money buys $5 billion worth of bonds the money supply supply will ___↑___ and interest rates ___↓___. will increase by $50 billion. 4. Assume the reserve requirement is .50. If the Fed 5. If the FED buys bonds the money supply will__↑__ sells $5 billion worth of bonds the money supply interest rates ↓ , and investment ↑ . will decrease by $10 billion. Federal Funds Rate 5. Assume the reserve requirement is .25. If the Fed Federal Funds Rate- The federal funds rate is the interest sells $2 billion worth of bonds the money supply rate that banks charge each other for loans. The Fed uses will decrease by $8 billion. open market operations to hit this target rate. Bonds Interest Rates and Inflation What is maturity? 1. If the nominal interest rate is 7% and expected A borrower issues a bond that must be paid back by a inflation is 3%, what is the real interest rate? 4% certain amount of time. That time is its maturity. A 2. If the real interest rate is -2% and the nominal bond can be sold early at an agreed upon price. interest rate was 3%, what was the inflation rate? 5% If the interest rate increases, bond prices will __↓__ Real interest rate = nominal rate - expected inflation If the interest rate decreases, bond prices will __↑__ Nominal interest rate = real rate + expected inflation Bank Balance Sheets Define Fractional Reserve BankingDefine Demand DepositsProcess where banks hold a portion of deposits in Bank deposits that can be withdrawn at any time (ex: reserve and loan the rest of the money out checking accounts) Define Excess ReservesDefine OwnerÕs EquityThe amount banks are legally free to loan out. Excess The amount of money owners have put into a reserves and required reserves make up total reserves company or bank. It doesnÕt need to be held in reserve 1. If the reserve requirement is .1 (or 10%) how Use the bank balance sheet to answer the questions much is this bankÕs required reserves and excess Assets Liabilities reserves? Req =$2,000 Excess = $3,000 Loans $15,000 Demand Deposits $20,000 2. What is the maximum possible increase in the Total Reserves $5,000 OwnerÕs Equity $10,000 money supply if the bank loaned out all its Treasury Bonds $10,000 excess reserves? $30,000 ($3,000 x 10) Total $30,000 Total $30,000 3. Assume a customer deposits $5,000 into this 5.Assume a customer withdraws $15,000. Identify three bank, what is the initial change in the money options this bank has to avoid defaulting other than asking supply? There is no initial change 4. If the $5,000 deposit is placed in reserve, how borrows to pay back loans. They can sell treasury bonds, borrow money from the Fed, much is demand deposits and excess reserves? or borrow money from another bank Demand deposits=$25,000 Excess = $7,500 Monetary Policy and AD/AS Draw and label both graphs and show the economy in a recession. Use the money market graph to show how the FED closes the recessionary gap using monetary policy Interest Rate Money Market Price Level AD and AS SM SM1 LRAS AS ir AD1 ir1 DM AD QM QM1 Quantity of Money Qe QFE Real GDP Use arrows to explain the process: SM↑ → ir↓ → I↑ and C↑ → AD↑ → Full Employment Draw and label both graphs and show the economy with an inflationary gap. Use the money market graph to show how the FED closes the inflationary gap using monetary policy Interest Rate Money Market Price Level AD and AS SM1 SM LRAS AS ir1 ir DM AD AD1 Qe Real GDP QM1 QM Quantity of Money QFE Use arrows to explain the process: SM↓ → ir↑ → I↓ and C↓ → AD↓ → Full Employment The Loanable Funds Market Draw the loanable funds market and label the Shifters of Demand for Loanable Funds equilibrium real interest rate 1. Changes in perceived business opportunities Real 2. Changes in government borrowing Interest SLoans Shifters of Supply for Loanable Funds Rate 1. Changes in private savings behavior 2. Changes in public savings 3. Changes in foreign personal investment irR 4. Changes in expected profitability Loanable Funds Practice 1. What happens to the real interest rate if the government runs a deficit? Demand increases so interest rate increase DLoans 2. If lenders decide to lend less, real interest rates ___↑__, investment __↓___, and economic growth __↓___ 3. An increase in savings would cause real interest rates to Q Quantity of Loans ___↓___, investment __↑___, and economic growth __↑__