Monetary Policy FRQ

April 03, 2017

Loanable funds

• Is an interest rate of 50% good or bad? Bad for borrowers but good for lenders
• The loanable funds market is the private sector supply and demand of loans
• This market brings together those who want to lend money (savers) and those who want to borrow (firms with investment spending projects)
• This market shows the effect on real interest rate
• Demand - inverse relationship between real interest rate and quantity loans demanded
• Supply - direct relationship between real interest rate and quantity loans supplied
• This is NOT the same as the money market (supply is not vertical)

Prime rate

• The interest rate that banks charge their most creditworthy customers

March 31, 2017

Tools of monetary policy

• 1) reserve requirement
• 2) open market operation
• 3) discount rate

Reserve requirement

• Only a small percent of money is in the safe
• The rest is loaned out
• Set amount bank must hold for lending ability
• If there is a recession, the FED should decrease the reserve ratio
• Banks hold less money and have more excess reserves
• Banks create more money by loaning out excess
• Money supply increases, interest rates fall,  AD goes up
• If there is an inflation, the FED should increase the reserve ratio
• Banks hold more money and have less excess reserves
• Banks create less money
• Money supply decreases, interest rates rise, and AD goes down

Monetary multiplier

• Find change in money supply,

Open market operations

• When the FED buys or sells government bonds (securities)
• This is the most important and widely used monetary policy
• If the FED buys bonds - it takes bounds out of the economy and replaces them with money
• If the FED sells bonds - it takes money and gives the security to the investor
• The effect of the open market ops are enhanced by the multiplier - if banks don't loan that money or people hold the cash, it becomes ineffective

The discount rate

• There are many different interest rates, but they tend to all rise and fall together

March 24, 2017

Money creation formula

• A single bank can create money by the amount of its excess reserves
• The banking system as a whole can create money by a multiple of the excess reserves
• MM X ER = expansion of money
• Money multiplier = 1/RR

New vs existing money

• If the initial deposit in a bank comes from the FED or bank purchase of a bond or other money out of circulation (buried treasure), the deposit immediately increases the money supply
• The deposit then leads to further expansion of the money supply through the money creation process
• Total change in MS if the initial deposit is new $ = deposit + $ created by banking system
• If a deposit in a bank is existing money (already counted in M1; ex - currency or checks), depositing the amount does NOT change the MS immediately because it is already counted
• Existing currency deposit into a checking account changes only the composition of the money supply from coins/paper money to checking account deposits
• The change in the MS if deposit is existing money = banking system created money

March 23, 2017

Demand deposits

• Created through the fractional reserve system

Fractional reserve system

• Process in which banks hold a small portion of their deposits in reserves and they loan out the excess
• The cash that banks keep on hand is called quiet reserves

Total reserves (TR) or actual reserves (AR)

• Equals to required reserves (RR) or excess reserves (ER)

Excess reserves

• What you can lend out (loans)

March 22, 2017

Bonds vs Stocks

• “Bonds are loans, stocks you own”

Bonds

• How are the value of bonds determined? If a corporation issues and then sells a bond
• Is it a liability
• First: if a corporation issues and then sells a bond

Liability for corporation

Asset for the buyer

• If that corporation issues a 10k bond with a 10 yr term and a 5% interest
• Nominal interest is 5%
• If nominal interest rate falls to 3% the value of the bond increases
• If interest rises to 8% then value decreases
• Dividends- which are portions of a corporation's profits, are paid out to stockholders
• Higher the corporate profit, the higher the dividend
• Capital gain- is earned when a stockholder sells stock for more than he or she paid for it
• Capital loss- stockholder sells stock at lower price then bought
• Federal reserve bank= Fed, central bank
• Two goals
• Stabilize economy
• Full employment

The money market

• (Supply and demand for money)
• Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded
• What happens to the quantity demanded of money when interest rates increase?
• Quantity demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities
• What happens to the quantity demanded when interest rates decrease?
• Quantity demanded increases. There is no incentive to convert cash into interest earning assets
• The demand for money
• Money demand is downward slope
• Monday demand shifters
• Changes in price level
• Change in income
• Changes in taxation that affects investment
• Increasing the money supply
• If the FED increase the money supply, a temporary surplus of money will occur at 5% interest.
• The surplus will cause the interest rate to fall to 2%
• How does this affect ad?

March 20, 2017

Who is on the...

• $100 - Benjamin Franklin
• $50 - Grant
• $20 - Jackson
• $10 - Hamilton
• $5 - Lincoln
• $2 - Jefferson
• ¢50 - JFK
• ¢10 - FDR
• $1,000 - Cleveland
• $100,000 - Wilson

Why do we use money? What would happen if we didn't use money?

• The barter system: goods and services are traded directly. There is no money exchanged.

What is money?

• Money is anything that is generally accepted in payment for goods and services
• Money is not the same as wealth or income
• Wealth is the total collection of assets that store value
• Income is a flow of earnings per unit of time

Money can be used as a

• 1) medium of exchange - buy goods and services
• 2) unit of account - measuring the value of goods and services
• 3) store of value

3 types of money

• Representative money - money that represents something of value: IOU’s
• Commodity money - something that performs the function of money and has alternative uses: salt, gold, silver, cigarettes
• Fiat money - money because the government says so: paper money, coins

6 characteristics of money

• 1) durability - just wrinkles
• 2) portability
• 3) visibility- can easily break the denomination down
• 4) uniformity
• 5) limited supply
• 6) acceptability

3 types of money supply

• Liquidity - ease with which an asset can be accessed and converted into cash (liquidized)
• M1 (high liquidity) - coins, currency, and checkable deposits (personal and corporate checking accounts which are the largest component of M1). AKA demand deposits. In general, this is the money supply.
• M2 (medium liquidity) - M1 plus savings deposits (money market accounts), time deposits (CDs = (certificates of deposit), and Mutual funds
• M3 (low liquidity) - M2 plus time deposits above $100K