Monetary Policy Video Summaries

Video 1:
This video discusses the three different types of money. The first and most basic is commodity money which can be defined as the use of goods and services that have a similar function as money.
The second, which is not in use anymore, is representative money that is used to represent a precious metal such as gold or silver. A draw back of this type of money is that when the value of the metal changes, it affects the value of the actual currency. The third type, and the one we use today, is fiat money. Fiat money is not backed by a precious metal but simply by the word of the government that it has value. Then there are also three functions of money. The first is as a medium of exchange meaning that it is through money that exchange happens. The second is store of value which is when you put money away it is expected to still have the same value when you take it back. Inflation is a disincentive of saving. The third is unit of account meaning that the price of an object implies something of its worth and quality.

Video 2:
To create a money market graph we must first label our axis. The vertical axis, as in most graphs, is price but in this case the price paid to borrow money so it will be labeled as the interest rate. The horizontal axis is quantity of money. Then we have the demand for money which slopes downward because when interest rate is high, demand for money is going to be low and vice versa; it is an inverse relationship. The only difference of the money market graph is that the supply of money is vertical because it does not vary based on interest rate, it is fixed by the FED. So to bring the interest rate down, the FED can increase money supply.

Video 3:
There are three FED tools of monetary policy which include required reserve, discount rate, and the buying and selling of bonds. The required reserve is the percentage of the banks total deposits which they must keep either as vault cash or reserve with a FED branch. The discount rate is the rate at which banks can borrow money from the FED, however, this is not guaranteed to be effective because it is only an incentive. The third tool is the buying and selling of bonds which is used the most often. During an expansionary or recession period (easy money), the required reserve will be decreased so that it becomes excess money to make more loans, the discount rate will be lowered and the FED will buy bonds to increase money supply. During a contractionary or inflation period (tight money), the required reserve and the discount rate will be raised, and the FED will sell bonds to lower the money supply. The federal funds rate is the rate at which banks borrow money from each other.

Video 4:
Loanable funds is the money available in the banking system for people to borrow. In this video we learn how to make a loanable funds graph which has interest rates in the vertical axis and quantity of loanable funds in the horizontal axis. Demand for loanable funds is downward slopping and supply of loanable funds, which comes from the amount of money people have in banks, is upward slopping. In this market, more money saved equals more money for loans so savings are a positive affect. During a government deficit, they will demand money to spend it causing a shift of the demand on a money market graph to the right (increase) and the interest rate will go up. Since the change in one graph affects the other, in the loanable funds graph, the demand for loanable funds will also increase causing the interest rate to raise. Another way to show an increase in interest rates is by decreasing the supply of loanable funds and in return increasing the interest rate.

Video 5:
Another important concept is the money creating process which involves the money multiplier, one over the required ratio, and multiple deposit expansion. Banks create money by making loans which they make from the excess reserves, so if someone deposited $500 in a bank with a required ratio of 20%, that bank will be able to loan out $400. The $400 will then be deposited at another bank which can loan out $320 dollars and so on; this is the process of multiple deposit expansion. If we add up all potential loans we come up with $2500 that were created from the initial $500 deposit. This number can be derived by multiplying the loanable amount times the money multiplier. However, this amount is not guaranteed because it is only an assumption that each bank will loan out all of their excess reserves.

Video 6:
There is a connection between the money market, loanable funds, and AD - AS graphs. An example of this can be seen by  graphing the changes that occur during a government deficit. In the money market, the demand for money will increase so it is moved to the right and the money supply stays the same. This will cause either an increase in demand of loanable funds or a decrease in supply of loanable funds so that the interest rate is equal to that in the money market. The AD - AS graph will also have an increase in aggregate demand causing an increase in both price level and GDP. With the equation of exchange, MV = PQ, we can also see how a change in money supply means a change in price just like the graphs show. The Fisher effect says that interest rate and price level are equivalent so if there is a 1% increase in the interest rate it will yield a 1% increase of inflation.

Loanable Funds Market

Markets where savers and borrowers exchange funds (Qlf) at a real rate of interest rate. The demand for loan-able funds, or borrowing comes from household, firms, government and foreign sector. The demand for loan-able funds is in fact the supply of bonds. Supply of the loan-able funds or savings comes from the households. 

*Changes in Demand for loan-able funds: Demand for loan-able funds equal borrowing, more borrowing equals more demand for loans funds (-->).  Less borrowing equals less demand for loan-able funds (<--)   Dlf --> :r%:increases

Example: Government deficit spending equals more borrowing and more demand for loan able funds

Dlf --> :r%:increases
-Less investment demand equals less borrowing and less demand for loan-able funds.
 Dlf <--: r%: decreases.

Supply of loan-able funds equals saving (i.e. demand for bonds)

-More saving equals more supply of loan-able funds (-->)

- Less saving equals less supply of loan-able funds (<--) 

Example: Government budget surpluses equals more saving and more supply of loan-able funds.
 Slf -->:r%: decreases
Decrease in consumers MPS equals less supply of loan-able funds and less savings

 Slf <---: r%: increases 

When the government does fiscal policy it will affect the loan-able funds market.

-Changes in real interest rate (r%) will affect Gross Private Investment. 

Key Principles

-A single bank can create money, through loans, by the amount of ER.

-The banking system as a whole can create money by a multiple (deposition money multiplier) of the initial ER.

	New/ Existing Money	Bank Reserves	Immediate change in Money Supply
Initial Deposit Cash (Money created in the banking system only)	Existing Money	Increase	No, because only the composition of money changes (cash to currency)
FED purchase of a bond from the public	New Money	Increase	Yes, because money coming from the FED puts new money in the circulation
Bank Purchase of a bond from the public	New Money	Increase	Yes, because money coming from reserves puts new money in circulation.

Factors that weaken the effectiveness of the deposit multiplier can be:

 1) if the banks fail to loan out all of their excess reserves.

 2) if bank customers take their loans in cash rather than in a new checking account deposits it creates a cash or currency drain

The money market (Supply and Demand for money) 

-The Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded. 

Monetary Policy

Fiscal Policy : Congress: the President, Tax on Spend.

Monetary Policy: The FED ( Federal Reserve Bank), OMO, Discount Rate, Federal Fund Rate, Reserve Requirement.

The Federal Fund Rate is the interest rate that commercial banks charge one another for an overnight loan.
-Has an indirect relationship of the Money supply.
Prime Rate is the interest rate that the banks charge their most credit worthy customers. 

Open Market Operations (OMO) -Buy or sell securities/bonds	Expansionary: recession -Easy money policy -Buy bonds which increases money supply	Contractionary: inflation -Tight money policy -Sell bonds which decreases money supply
Discount rate: the interest rate that the FED charges commercial banks for borrowing money.	-Decrease	-Increase
Reserve Requirement	-Decrease	-Increase

Creating a bank

Depositing reserves in the Federal Reserve Banks.
- required reserves
- reserve ratio

Formula:

Reserve Ratio =
          Commercial bank's required reserves                                  

 Commercial bank's checkable deposits liabilities

Excess Reserves= Actual Reserves - Required Reserves

Required Reserves= Check-able Deposits * Reserve Ratio


Assets are made up of:
- Reserves: RR %
- Required Reserves (rr) is the percentage required by the FED to keep on hand to meet the demand.
-Excess Reserves (er) is the percentage reserves over and above the amount needed to satisfy the minimum of the reserve ratio that is set by the FED.
- Loans that firm consumers and other banks earning interest.
- Loans that go to the government which are equal to treasury securities.
- Bank property- (if the banks fails, you can liquidate the building/ property.)  
Liabilities + Equities are made of :
-Demand Deposits (dd) is money that is put into the bank.
-Times deposits (Check-able Deposits)
-Loans from Federal Reserve and other banks.
-Shareholders Equity- (to set up a bank, you must invest your own money in it to have a stake in the banks successes or failures.)    

The 7 Functions of the FED

FED functions:

1. issuing paper currency
2. setting reserve requirement and holding reserves of banks
3. lending money to banks and charges them interest
4. check clearing services for banks
5. acting as personal bank for the government
6. supervises member banks
7. controls money supply in the economy. 

Three types of multiple deposit expansion:

Type 1: calculate the initial change in excess reserves. (the amount a single bank can loan from the initial deposit)

Type 2: calculate the change in loans in the banking system.

Type 3: calculate the change in money supply

Type 4: calculate the change in demand deposit

Unit 4

Definition: Money is any assets that can be used to purchase any goods or services.

There are three uses of money:

1. As a medium of exchange - determine value
2. Unit of account - to compare prices
3. Store of value - where you put your money

The three types of money are: 

1. Commodity Money - is money that has value within itself.   ex: salt, olive oil, gold 
2. Representative Money - is money that represents something of value   ex: an IOU
3.  Fiat Money - it is money because the government says so and it consists of paper currency and coins.

Six characteristics of money:

1. Durability - how long it lasts
2. Portability - you can take it anywhere or put it anywhere
3. Divisibility - can be broken down
4. Uniformity - it is the same no matter where you go
5. Limited supply
6. Acceptability - people will take it

* Money supply is the total value of financial assets available in the U.S economy*

-M1 Money involves liquid assets (easy to to convert to cash), checkable or demand deposits, and travelers checks.

-M2 Money involves M1 Money + Savings Act + Money Market account. 

Three purposes of Financial Institutions:

• Store Money 
• Save Money 
• Loan Money 

Two reasons they loan out money is for credit cards and for mortgages.

There are 4 ways to save money:

1. Through a savings account with an interest of 0.5 - 2%
2. Checking account with no interest
3. Money market account
4. Certificate of deposit which can't move money without being penalized. 

Loans - banks operate on a fractional reserve system which means they keep a fraction in the bank and lend out the rest.  

*Interest rates*
Principle is the amount of money that has been borrowed

Actual interest is a price paid for use of borrowed money.

Simple interest that are paid on the principle

Compound interest which is money paid on the principle plus accumulated interest. 

Simple Interest: I= P*R*T              P= Principal   R= Interest Rate   T= Time
                                    100
 R= I * 100           P= I*100        T= I*100
         P*T                     R*T               P*R

There are 5 types of financial institutions:

1. Commercial banks
2. Savings and loan institutions
3. Mutual savings bank
4. Credit unions
5. Finance companies. 

Investment is redirecting resources (consume now for the future).  
Financial Assets - claims on property and income of borrower 
Financial Intermediaries - institution that channels funds from savers to borrowers .

Three purposes if financial intermediaries are:

1. That they share risks like in diversification which spreading investments to reduce risk.
2. Intermediaries also provide information
3. Liquidity that returns money to an investor receives above and beyond the sum of money that initially was invested. 

Bonds you loan; Stocks you own
Bonds: are loans or IOU's that represent debt that the government or the corporation must repay to an investor. Low risk investment.

Three components:  Coupon Rate is an interest rate that an issuer will pay to bondholder. Maturity is time in which a payment bond holder is due. Par Value is the amount that an investor pays to purchase a bond
*Yield is the annual rate of return on a bond if the bond were held to maturity.*

Time value of Money: Why is a dollar today worth more than tomorrow?

-opportunity cost and inflation

-this is the reason for charging and paying

Interests:
Let v= future value of money.

 P= present value of money.

R= real interest rate (nominal interest rate - inflation rate) expressed as a decimal

 N= years.

 K= number of times interest is credited per year. 

Formulas:
Simple interest formula: v=(1+r/k)^n *p
The compound formula: v=(1+r/k)^nk +p 
 1) Calculate interest rate: r% = 1% - pi% 
2) Simple interest formula: v= (1+r)^n *p 

Monetary equation of exchange:

MV = PQ

M=money supply   V=velocity of money   P=price level   Q=quantity

Fiscal Policy

*Changes in the expenditures or tax revenues of the federal government.

-2 tools of fiscal policy: controlled by congress

• Taxes – government can increase or decrease taxes
• Spending – government can increase or decrease spending

Balanced budget

   -Revenues = Expenditures

  Budget deficit

   -Revenues < Expenditures

  Budget Surplus

   -Revenues >Expenditures

  Government Debt: Sum of all deficits – sum of all surpluses

  Government Borrows money when it runs a budget deficit from:

   -Individuals

    -Corporations

   -Financial Institutions

   -Foreign entities or foreign governments

        Discretionary Fiscal Policy (  action )

    Expansionary fiscal policy – think deficit

    Contractionary fiscal policy – think surplus

      

       Non –Discretionary Fiscal Policy ( no action )

Discretionary:	Automatic:
-Increasing or decreasing government spending and/or taxes in order to return economy to full employment. -Involves policy makers doing fiscal policy in response to an economic problem.	-Unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate effects of a recession and inflation. -Automatic fiscal policy takes place without policy makers.

   Contractionary Fiscal Policy – policy designed to decrease aggregate demand

• Strategy for controlling inflation

   Expansionary Fiscal policy – to increase aggregate demand

• Strategy for GDP combating recession and reducing unemployment

 Expansionary - Increase government spending (G increases) and decrease Taxes ( T decreases )

 Contractionary - Decrease government spending  (G decreases) and increase taxes  ( T increases )

Automatic or Built in stabilizers occur without government intervention.

1. Transfer Payments

      -Welfare Checks

      -Food Stamps

      -Unemployment Checks

      -Corporate Dividends

      -Social Security

      -Veteran’s benefits

    2. Progressive income taxes

-Automatic stabilizers take 33-50% out

   Progress Tax System

    -Average tax rate ( tax revenue/ GDP) rises with GDP

   Proportional Tax System

    -Average tax rate ( remains constant as GDP changes)

    Regressive tax System

    -Average tax rate fall with GDP 

Disposable Income

*Disposable Income*
Is what you bring home
-Income after taxes or net income
DI = Gross income - Taxes
Two choices: with disposable income, households can either...

1. Consume (spend money on goods and services)
2. Save (not spend money on goods and services)

Consumption: 
-Household spending
-the ability to consume is constrained by:
     *the amount of disposable income
     *the propensity to save
-Do households consume if DI = 0?
     -Autonomous consumption
     -Dissaving

Average Propensity to Consume
-APC = C/Di = % of DI that is spent

Saving
-Household not spending
-the ability to save is constrained by...
     *the amount of disposable income
     *the propensity to consume
-Do households save if DI = 0?
     -No

Average Propensity to Save
-APS = S/DI = % of DI that is not spent

APC and APS:
APC + APS = 1    1 - APC = APS    1 - APS = APC
APC > 1  Dissaving          -APS Dissaving

Marginal Propensity to Consume
-MPC = ΔC/ΔDI  % of every dollar earned that is spent

Marginal Propensity to Save
-MPS = ΔS/ΔDI  % of every extra dollar earned that is saved

MPC + MPS = 1     1 - MPC = MPS     1 - MPS = MPC

The Spending Multiplier Effect:
-An initial change in spending causes a larger change in aggregate spending or aggregate demand
-Multiplier = Change in AD (ΔC, Ig, G, Xn) / Change in spending

Why does this happen?
-expenditures and income flow continuously which sets off a spending increase in the economy.

Calculating the Spending Multiplier: 
-Multiplier = 1/1-MPC or 1/MPS
     *Multiplier are positive when there is an increase in spending and negative when there is a decrease.
     *Spending multiplier can be calculated from the MPC or MPS
Calculating the Tax Multiplier:
-The government taxes the multiplier works in reverse. Why?
 Because now money is leaving the circular flow

Tax Multiplier (note: it is negative)
= -MPC/ 1-MPC or –MPC/MPS
-If tax cut, multiplier is positive because now money is in the circular flow.

Aggregate Demand, Aggregate Supply, and the Investment Demand Curve

*Aggregate Demand*

Shifts in aggregate demand:there are two parts to a shift in ad
  - a change in c, Ig, and/or Xn
  - a multiplier effect that produces a greater change than the original change in the 4 components

• increase=shifts to the right
• decrease=shift to the left

Determinants of AD:

Consumption
   - household spending is affect by: 
       - consumer wealth
           . More wealth= more spending (AD shifts ->)
           . Less wealth= less spending (AD shifts <-)
       - consumer expectations
           . Positive expectations = more spending (AD ->)
           . Negative expectation = less spending (AD <-)
       - household indebtedness
           . Less debt = more spending 
           . More debt = less spending 
       - taxes 
           . Less taxes = more spending 
           . More taxes = less spending

Gross private investment 
• investment spending is a sensitive to:
      - the real interest rate 
           . Lower real interest rate = more investment (AD->)
           . Higher real interest rate = less investment (AD<-)
      - expected returns 
           . Higher expected returns = more investment
           . Lower expected returns = less investment
           . Especial returns are influenced by 
                 - expectation of future profitability 
                 - technology 
                 - degree of excess capacity (Existjng stock of capital)

Govt spending
• more govt spending (AD->)
• less govt spending (AD<-)

Net exports 
• nets exports are sensitive to:
    -exchange rate (international value of $)
        . Strong $ = more imports and fewer exports (AD<-)
        . Weak $ = fewer imports and more exports (AD->)
     - relative income 
         . Strong foreign Economies = more exports 
         . Week foreign economies = less exports

*Aggregate Supply*
-Long Run Aggregate Supply (LRAS) - the period of time where input prices are completely flexible and adjust to changes in the price level.
-the level of real GDP supplied is independent of price level.
-It marks the level of full employment in the economy. (FE, Yf, Y' = full employment)
-Analogous to PPC
-Since input prices are flexible in long run, changes in price level do not change firms real profits and therefore don't change firms level of output.
-LRAS is vertical at the economy's level of full employment. 

-Short Run Aggregate Supply (SRAS) - Period of time where input prices are sticky and don't adjust to changes in the price level
-the level o real GDP supplied is directly related to the price level.
-because input prices are sticky in the short run, the SRAS is upward slopping. 
-an increase in SRAS is seen as a shit to the right ---> and decrease to the left <---
-the key to understanding shifts in SRAS is per unit cost production
-per unit cost production = total input cost

Determinants of SRAS: (affect unit production cost)

1. Input Prices
2. Productivity
3. Legal - Institutional Environment: taxes and subsidies

• Taxes (money to government) on business increase per unit production cost, shits SRAS <----
• Subsidies (money from government) to business reduce per unit production cost, shifts SRAS ---->

Domestic Resource Prices:

-wages (75% of all business costs)

-cost of capital 

-raw materials (commodity prices)

Foreign Resource Prices:

-Strong money: lower foreign resource prices

-Weak money: higher foreign resource prices

Market Power: Monopolies and cartels that control the price of those resources.

-Increase in resource prices: SRAS <----

-Decrease in resource prices: SRAS ---->

Productivity = total output/total inputs

More productivity = lower unit production cost ---->

Lower productivity = higher unit production cost <----

Government Regulation: creates a cost o compliance = SRAS <----

Deregulation: reduces compliance cost = SRAS ---->

Full Employment – Equilibrium exists where AD interests 

SRAS and LRAS at the same point.

Recessionary Gap - exists when equilibrium occurs below full employment output.

-AD decrease shifts to the left 

Inflationary Gap- exists when equilibrium occurs                    beyond full employment output.

-AD increases shifts to the right

Interest Rates and Investments Demand

Money spent on expenditures on:

o   New plants ( factories )

o   Capital equipment ( machinery )

o   Technology ( hardware and software )

o   New homes

o   Inventories ( goods sold by producers )

·         How do a business make investment decisions?

o   Cost / Benefits Analysis

·         How does a business determine benefits?

o   Expected rate of return

·         How does a business count the cost?

o   Interest Cost

·         How does a business determine the amount of investment they undertake?

o   Compare expected rate of return to interest cost

§  If expected return > interest cost, then invest

§  If expected return < interest cost, do not invest

Real ( r% ) vs. Nominal ( i% )  (pie)inflation

What’s the difference?

·         Nominal is observable rate of interest. Real subtracts out inflation (pie%) and only known ex post facto.

How to compute the real interest rate

r%= i% - pie%

What determines cost of an investment decision?

·         Real interest rate ( r%)

What is the shape of investment demand slope?

·         Downward sloping

Why?

·         When interest rates are high, few investments are profitable. When interest rate are low, more investments are profitable.

*The Investment Demand Curve*

Cost of production 

- lower cost shifts ID ---->

-Higher cost shifts ID <----

Business Taxes

-lower business taxes shift ID ---->

-higher business taxes shift ID <----

Technological Change

• New technology ---->
• Lack of technology <----

Stock of Capital

• If an economy is low on capital then ID shifts ---->
• If it has much capital then ID shifts <----

Expectations 

• positive expectations shift ID ---->
• negative expectations shift ID <----

LRAS: represents a point on an economics production possibilities curve and it is a vertical line at an output level that represents the quantity of goods and services a nation can produce over a sustained period using all of its productive resources as efficiently as possible.

-always at full employment

-does not change as price level changes

-shifts outward if there is a change in technology, resource, or there is economic growth.