the financial sector and the...
TRANSCRIPT
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The Financial Sector and
the Economy
The peculiar essence of our banking system
is an unprecedented trust between man and
man; and when that trust is much weakened
by hidden causes, a small accident may
greatly hurt it, and a great accident for a
moment may almost destroy it.
— Walter Bagehot
CHAPTER 30
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
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Monetary Policy
There have been three great inventions since the beginning of
time: fire, the wheel and central banking.
— Will Rogers
CHAPTER 31
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin
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The Financial Sector andthe Economy 30
Money
McGraw-Hill/Irwin Colander, Economics 3
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The Financial Sector andthe Economy 30
The Definition and Functions of Money
• Money is anything that is generally accepted as payment for goods or services
• Money is a highly liquid financial asset —it is easily changeable into another asset or good
30-4
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The Financial Sector andthe Economy 30
The Definition and Functions of Money
• Commodity money: something that performs the function of money and has alternative uses
• Examples: Gold, silver, cigarettes, etc.
• Fiat money: Something that serves as money but has no other important uses
• Examples: Paper money and coins
McGraw-Hill/Irwin Colander, Economics 5
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The Financial Sector andthe Economy 30
The 3 Functions of Money• Medium of exchange
• Money can easily be used to buy goods and services without bartering
• Unit of account (measure of value)
• Money measures the value of all goods and services
• Store of wealth
• Money allows you to store purchasing power for the future
McGraw-Hill/Irwin Colander, Economics 6
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The Financial Sector andthe Economy 30
Alternative Measures of Money
• M1 and M2
• M1: consists of coins and currency plus checking accounts (checkable deposits) and traveler’s checks
30-7
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The Financial Sector andthe Economy 30
Alternative Measures of Money
• M2 consists of M1 plus savings deposits (money market accounts), time deposits (CDs = certificates of deposit), and mutual funds
McGraw-Hill/Irwin Colander, Economics 8
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The Financial Sector andthe Economy 30
Money and Credit
• Credit cards are not money
• They are a short-term loan (usually with a higher than normal interest rate)
• A debit card is part of the monetary system because it serves the same function as a check since it allows you to spend money from your bank account
30-9
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The Financial Sector andthe Economy 30
Why People Hold Money
• The transactions motive is the need to hold money for spending
• The precautionary motive is holding money for unexpected expenses and impulse buying
• The speculative motive is holding cash to avoid holding financial assets whose prices are falling
30-10
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The Financial Sector andthe Economy 30
Time Value of Money
• The future value of money is:
• P (1 + r)n
• P = principal or amount of money
• R = interest rate
• n = number of years
McGraw-Hill/Irwin Colander, Economics 11
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The Financial Sector andthe Economy 30
Time Value of Money
• Calculate the future value of $100 with 5% interest, 10 years from now
• P (1 + r)n
• 100 (1 + 0.05)10
• = $162.89
McGraw-Hill/Irwin Colander, Economics 12
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The Financial Sector andthe Economy 30
Present Value of Money
• The present value of money is:
Amount of money
(1 + r)n
• Present value of $100 a year from now
100
(1+0.10)1
See Mr. Clifford Video
McGraw-Hill/Irwin Colander, Economics 13
= $90.91
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The Financial Sector andthe Economy 30
INTEREST RATES
McGraw-Hill/Irwin Colander, Economics 14
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The Financial Sector andthe Economy 30
Interest Rates
• Interest rate: the price paid for use of a financial asset
• The long-term interest rate is the price paid for financial assets with long maturities, such as mortgages
• The market for long-term financial assets is called the loanable funds market
30-15
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The Financial Sector andthe Economy 30
Interest Rates
• The short-term interest rate is the price paid for financial assets with short maturities
• Short-term financial assets are called money
McGraw-Hill/Irwin Colander, Economics 16
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The Financial Sector andthe Economy 30
Interest Rates and Inflation
• Real Interest Rate
• The percentage increase in purchasing power that a borrower pays (adjusted for inflation)
• Real interest rate = nominal interest rate -expected inflation
McGraw-Hill/Irwin Colander, Economics 17
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The Financial Sector andthe Economy 30
Interest Rates and Inflation
• Nominal Interest Rate
• The percentage increase in money that the borrower pays not adjusting for inflation
• Nominal interest rate = Real interest rate + expected inflation
McGraw-Hill/Irwin Colander, Economics 18
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The Financial Sector andthe Economy 30
Interest Rates and Inflation
Example #1: You lend out $100 with 20% interest. Inflation is 15%.
• A year later you get paid back $120.
• What is the nominal and what is the real interest rate?
• The nominal interest rate is 20%. The real interest rate was 5%.
• In reality, you get paid back an amount with less purchasing power.
McGraw-Hill/Irwin Colander, Economics 19
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The Financial Sector andthe Economy 30
Interest Rates and Inflation
Example #2: You lend out $100 with 10% interest. Prices are expected to increase 20%. In a year you get paid back $110.
• What is the nominal and what is the real interest rate?
• The nominal interest rate is 10%. The real rate was –10%
• In reality, you get paid back an amount with less purchasing power
McGraw-Hill/Irwin Colander, Economics 20
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The Financial Sector andthe Economy 30
Loanable Funds
McGraw-Hill/Irwin Colander, Economics 21
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The Financial Sector andthe Economy 30
Loanable Funds Market
• The loanable funds market is the private sector supply and demand of loans
• It represents the money in commercial banks and lending institutions that is available to lend out to firms and households to finance expenditures (investment or consumption)
• This market shows the effect on the real interest rate (r)
McGraw-Hill/Irwin Colander, Economics 22
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The Financial Sector andthe Economy 30
Loanable Funds Market
• Demand for loanable funds: there is an inverse relationship between the real interest rate and the quantity of loans demanded
• At higher interest rates, households prefer to delay their spending and put their money in savings
McGraw-Hill/Irwin Colander, Economics 23
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The Financial Sector andthe Economy 30
Loanable Funds Market
• Supply of loanable funds: there is a directrelationship between the real interest rate and the quantity of loans supplied
• An increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out)
McGraw-Hill/Irwin Colander, Economics 24
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The Financial Sector andthe Economy 30
Loanable Funds Market
Demand Shifters
1. Changes in perceived business opportunities
2. Changes in government borrowing
3. Budget deficit
4. Budget surplus
Supply Shifters
1. Changes in private savings behavior
2. Changes in public savings
3. Changes in foreign investment
4. Changes in expected profitability
McGraw-Hill/Irwin Colander, Economics 25
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The Financial Sector andthe Economy 30
Draw the Graph: Increase in the Supply of Loanable Funds
Real Interest Rate
Q of Loanable FundsQ1
S1 or SLF1
r1
D1 or DLF1
30-26
S2 or SLF2
r2
Q2
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The Financial Sector andthe Economy 30
Draw the Graph: Decrease in the Supply of Loanable Funds
Real Interest Rate
Q of Loanable FundsQ2
S1 or SLF1
r2
D1 or DLF1
30-27
S2 or SLF2
r1
Q1
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The Financial Sector andthe Economy 30
Draw the Graph: Increase in the Demand for Loanable Funds
Real Interest Rate
Q of Loanable FundsQ1
S1 or SLF1
r2
D1 or DLF1
30-28
r1
Q2
D2 or DLF2
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The Financial Sector andthe Economy 30
Draw the Graph: Decrease in the Demand for Loanable Funds
Real Interest Rate
Q of Loanable FundsQ2
S1 or SLF1
r1
D1 or DLF1
30-29
r2
Q1
D2 or DLF2
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The Financial Sector andthe Economy 30
Loanable Funds Example
• The government increases deficit spending
• Draw the graph that illustrates this concept
30-30
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The Financial Sector andthe Economy 30
Loanable Funds Example Government borrows from the private sector, increasing the
demand for loansReal Interest Rate
Q of Loanable FundsQ1
S1 or SLF1
r2
D1 or DLF1
30-31
r1
Q2
D2 or DLF2
Real interest rates increase
causingcrowding out
(of investment)
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The Financial Sector andthe Economy 30
The Fed and Monetary Policy
McGraw-Hill/Irwin Colander, Economics 32
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The Financial Sector andthe Economy 30
The Fed
• The Federal Reserve Bank (the Fed) is the U.S. central bank
• Federal Reserve notes are liabilities of the Fed that serve as cash
• A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms
30-33
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The Financial Sector andthe Economy 30
Structure of the Fed
Board of Governors
7 members appointed by the president and confirmed by the
senate
FINANCIAL SECTOR GOVERNMENT
Regional Reserve Banks and Branches
12 regional Federal Reserve banks and 25 branches
Oversees
Federal Open Market Committee (FOMC)
Board of Governors plus 5 Federal Reserve bank presidents
Provides ServicesOpen Market Operations
31-34
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The Financial Sector andthe Economy 30
Six Duties of the Fed
1. Conducts monetary policy (influencing the supply of money and credit in the economy)
2. Supervises and regulates financial institutions
3. Lender of last resort to financial institutions
31-35
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The Financial Sector andthe Economy 30
Six Duties of the Fed
4. Provides banking services to the U.S. government
5. Issues coin and currency
6. Provides financial services to commercial banks, savings and loan associations, savings banks, and credit unions
McGraw-Hill/Irwin Colander, Economics 36
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The Financial Sector andthe Economy 30
Monetary Policy
• Monetary policy: influencing the economy through changes in the banking system’s reserves, which in turn, influences the money supply and credit availability in the economy
31-37
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The Financial Sector andthe Economy 30
Monetary Policy
• If commercial banks need to borrow money, they can do so from the Fed
• If there’s a financial panic and a run on banks, the central bank is there to make loans
• Can we go to the Fed to get a loan?
• No
31-38
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The Financial Sector andthe Economy 30
Expansionary Monetary Policy
• Expansionary monetary policy is designed to counteract the effects of recession and return the economy to full employment
• It increases the money supply
• It decreases interest rates and it tends to increase both investment and output
• Also called the easy money policy
M i I Y
31-39M=money supply i=interest rate I=investment Y=output
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The Financial Sector andthe Economy 30
Draw the AS/AD Graph: Expansionary Monetary Policy
31-40
Price level
Real GDP
AD1
P1 AD2
P2
Y1 Y2
SRAS
LRAS
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The Financial Sector andthe Economy 30
Contractionary Monetary Policy
• Contractionary monetary policy is designed to counteract the effects of inflation and return the economy to full employment
• It decreases the money supply
• It increases the interest rate, and it tends to decrease both investment and output
• Also called the tight money policy
M i I Y
31-41
M=money supply i=interest rate I=investment Y=output
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The Financial Sector andthe Economy 30
Draw the AS/AD Graph: Contractionary Monetary Policy
31-42
Price level
Real GDP
AD1
P1
Y1
SRAS
AD2
Y2
P2
LRAS
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The Financial Sector andthe Economy 30
Tools of Monetary Policy
• 1. Reserve requirement
• 2. Discount rate
• 3. Open market operations
• These are the 3 shifters of the money supply
• These tools are used by the Fed to regulate the amount of money in circulation
McGraw-Hill/Irwin Colander, Economics 43
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The Financial Sector andthe Economy 30
The Reserve Requirement
• The reserve requirement is the percent of deposits that banks must hold in reserve (the percent they can NOT loan out)
• Banks keep some of the money in reserve and loan out their excess reserves
• Reserves and interest rates are inversely related
31-44
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The Financial Sector andthe Economy 30
Reserve Requirement
• By changing the reserve requirement the Fed can increase or decrease the money supply
– If the Fed increases the reserve requirement it contracts the money supply—banks have to keep more reservesand lend out less money (decreases the money multiplier)
McGraw-Hill/Irwin Colander, Economics 45
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The Financial Sector andthe Economy 30
Reserve Requirement
• If the Fed decreases the reserve requirement it expands the money supply—banks have more money to lend out (increases the money multiplier)
McGraw-Hill/Irwin Colander, Economics 46
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The Financial Sector andthe Economy 30
Reserve Requirement
• If there is a recession, what should the Fed do to the reserve requirement?
• It should decrease the reserve ratio
• This means banks hold less money and have more excess reserves
• Banks create more money by loaning out excess reserves
• The money supply increases, interest rates fall, and AD increases
McGraw-Hill/Irwin Colander, Economics 47
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The Financial Sector andthe Economy 30
Reserve Requirement
• If there is inflation, what should the Fed do to the reserve requirement?
• Increase the reserve ratio
• This means banks hold more money and have less excess reserves
• Banks create less money
• The money supply decreases, interest rates go up, and AD decreases
McGraw-Hill/Irwin Colander, Economics 48
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The Financial Sector andthe Economy 30
The Discount Rate
• Discount rate: the interest rate the Fed charges for the loans it makes to commercial banks
• To increase the money supply, the Fed should decrease the discount rate
• To decrease the money supply, the Fed should increase the discount rate
McGraw-Hill/Irwin Colander, Economics 49
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The Financial Sector andthe Economy 30
Open Market Operations
• The primary way in which the Fed changes the amount of reserves in the system
• Open market operations occur when the Fed buys or sells government securities (bonds)
• To expand the money supply, the Fed buys bonds
• To decrease the money supply, the Fed sells bonds
31-50
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The Financial Sector andthe Economy 30
Open Market Operations
• How are you going to remember this?
• Buy-BIG: Buying bonds increases the money supply
• Sell-SMALL: Selling bonds decreases the money supply
McGraw-Hill/Irwin Colander, Economics 51
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The Financial Sector andthe Economy 30
Open Market Operations
• There is an inverse relationship between bond prices and interest rates
• When the Fed buys bonds, the price of bonds rises and interest rates fall
• When the Fed sells bonds, the price of bonds falls and interest rates rise
McGraw-Hill/Irwin Colander, Economics 52
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The Financial Sector andthe Economy 30
Open Market Purchases
• An open market purchase is an expansionary monetary policy that tends to reduce interest rates and increase income
• When the Fed buys bonds, it deposits money in banks’ account with the Fed
• Bank reserves are then increased
• When banks loan out the excess reserves, the money supply increases
31-53
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The Financial Sector andthe Economy 30
Open Market Sales
• An open market sale is a contractionary monetary policy that tends to raise interest rates and lower income
• When the Fed sells bonds, it receives checks drawn against banks
• The bank’s reserves are reduced and the money supply decreases
31-54
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The Financial Sector andthe Economy 30
The Federal Funds Market
• The federal funds rate is the interest rate that banks charge one another for one-day loans of reserves
• Fed funds are loans of excess reserves banks make to one another
• (Often asked about on the AP exam)
31-55
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The Financial Sector andthe Economy 30
The Federal Funds Market
• The Fed can increase or reduce reserves by buying or selling bonds
• By selling bonds, the Fed decreasesreserves
• This causes the fed funds rate to increase
• By buying bonds, the Fed increases reserves
• This causes the fed funds rate to decrease
McGraw-Hill/Irwin Colander, Economics 56
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The Financial Sector andthe Economy 30
The Fed Funds Rate as an Operating Target
• If the Fed funds rate is above the Fed’s target range, it buys bonds to increase reserves and lower the Fed funds rate
• If the Fed funds rate is below the Fed’s target range, it sells bonds to decrease reserves and raise the Fed funds rate
McGraw-Hill/Irwin Colander, Economics 57
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The Financial Sector andthe Economy 30
Quantitative Easing
• Quantitative easing is a monetary policy used by the Fed to buy government bonds to stimulate the economy
• The Fed might decide to purchase assetsfrom commercial banks in order to increasethe price of those assets, which increasesthe money supply and lowers interest rates
• May be used when inflation is low and open market operations are not working
McGraw-Hill/Irwin Colander, Economics 58
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The Financial Sector andthe Economy 30
The Money Market
McGraw-Hill/Irwin Colander, Economics 59
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The Financial Sector andthe Economy 30
The Money Market
• The market where the Fed and the users of money interact thus determining the nominal interest rate (i%)
McGraw-Hill/Irwin Colander, Economics 60
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The Financial Sector andthe Economy 30
The Money Market
• Money Demand (MD) comes from households, firms, government and the foreign sector
• The demand for money shows an inverserelationship between nominal interest rates and the quantity of money demanded
McGraw-Hill/Irwin Colander, Economics 61
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The Financial Sector andthe Economy 30
The Money Market
• The Money Supply (MS) is determined only by the Federal Reserve
• The money supply curve is verticalbecause it is determined by the Fed’s (or central bank’s) particular monetary policy
McGraw-Hill/Irwin Colander, Economics 62
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The Financial Sector andthe Economy 30
Draw the Graph: The Money Market
McGraw-Hill/Irwin Colander, Economics 6363
NOTE:•i=nominal interest rate•I= InvestmentBe careful!
QM1
MD or DM
MS
i1
Quantity of Money or QM
Nominal Interest Rate
(ir)
-
The Financial Sector andthe Economy 30
The Demand for Money
• 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
• What happens to the quantity demanded when interest rates decrease?
• Quantity demanded increases
• There is no incentive to convert cash into interest earning assets
McGraw-Hill/Irwin Colander, Economics 64
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The Financial Sector andthe Economy 30
1. Changes in price level
2. Changes in income
3. Changes in taxation that affects personal investment
McGraw-Hill/Irwin Colander, Economics 65 65
Shifters of Money Demand
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The Financial Sector andthe Economy 30
McGraw-Hill/Irwin Colander, Economics 66 66
Draw the Graph: Increase in Money Demand
QM1
MD1
MS
i1
QM(billions of dollars)
Nominal Interest Rate
(ir)
MD2
i2
Scenario: The price level increases.
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The Financial Sector andthe Economy 30
McGraw-Hill/Irwin Colander, Economics 67 67
Draw the Graph: Decrease in Money Demand
QM1
MD2
MS
i2
QM(billions of dollars)
Nominal Interest Rate
(ir)
MD1
i1
Scenario: The price level decreases.
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The Financial Sector andthe Economy 30
Shifters of the Money Supply
• 1. Reserve requirement
• 2. Discount rate
• 3. Open market operations
McGraw-Hill/Irwin Colander, Economics 68
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The Financial Sector andthe Economy 30
McGraw-Hill/Irwin Colander, Economics 69 69
Draw the Graph: Increase in Money Supply
QM1
MD1
MS1
i1
QM(billions of dollars)
Nominal Interest Rate
(ir)
i2
MS2
QM2
Scenario: The Fed buys bonds on the open market.
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The Financial Sector andthe Economy 30
McGraw-Hill/Irwin Colander, Economics 70 70
Draw the Graph: Decrease in Money Supply
QM2
MD1
MS2
i2
QM(billions of dollars)
Nominal Interest Rate
(ir)
i1
MS1
QM1
Scenario: The Fed sells bonds on the open market.
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The Financial Sector andthe Economy 30
The Money Supply and AD
• How does this affect AD?
• An increase in the money supply leads to a decrease in interest rates, an increase in investment and therefore an increase in AD
McGraw-Hill/Irwin Colander, Economics 71
IM I ADi
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The Financial Sector andthe Economy 30
The Money Supply and AD
• How does this affect AD?
• Decreasing the money supply leads to an increase in interest rates, which decreasesinvestment and AD
McGraw-Hill/Irwin Colander, Economics 72
M i I AD
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The Financial Sector andthe Economy 30
Draw the Graphs: The Money Supply and AD
• The economy is in a recession. Using the AS/AD model and the money market, demonstrate an expansionary monetary policy to move the economy out of a recession.
McGraw-Hill/Irwin Colander, Economics 73
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The Financial Sector andthe Economy 30
Draw the Graphs: The Money Supply and AD
• The economy is in a recession. Using the AS/AD model and the money market, demonstrate an expansionary monetary policy to move the economy out of a recession.
McGraw-Hill/Irwin Colander, Economics 74
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The Financial Sector andthe Economy 30
Draw the Graphs: The Money Supply and AD
• The economy has rising inflation. Using the AS/AD model and the money market, demonstrate a contractionary monetary policy to move the economy out of an inflationary gap.
McGraw-Hill/Irwin Colander, Economics 75
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The Financial Sector andthe Economy 30
Draw the Graphs: The Money Supply and AD
• The economy has rising inflation. Using the AS/AD model and the money market, demonstrate a contractionary monetary policy to move the economy out of an inflationary gap.
McGraw-Hill/Irwin Colander, Economics 76
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The Financial Sector andthe Economy 30
How are AS/AD, Loanable Funds, and the Money Market Connected?
• If there is an expansionary monetary policy, what are the results?
• AD increases
• MS increases
• The supply of loanable funds increases
McGraw-Hill/Irwin Colander, Economics 77
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The Financial Sector andthe Economy 30
How are AS/AD, Loanable Funds, and the Money Market Connected?
• If there is a contractionary monetary policy, what are the results?
• AD decreases
• MS decreases
• The supply of loanable funds decreases
McGraw-Hill/Irwin Colander, Economics 78
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The Financial Sector andthe Economy 30
Putting it all Together: AS/AD, The Money Market, & Loanable Funds Market
McGraw-Hill/Irwin Colander, Economics 79
Money Market
Interest Rate
Q of Money
MS2
i1
DM
i2
MS1
Expansionary monetary policy leads to…
QM1 QM2
Interest Rate
Q of Loanable Funds
SLF2
DLF
Loanable Funds Market
SLF1
r1
r2
… an increase in loanable funds
Q1 Q2
Expansionary Monetary Policy: Increases AD
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The Financial Sector andthe Economy 30
Putting it all Together: AS/AD, The Money Market, & Loanable Funds Market
McGraw-Hill/Irwin Colander, Economics 80
Money Market
Interest Rate
Q of Money
MS1
i2
DM
i1
MS2
Contractionary monetary policy leads to…
QM2 QM1
Interest Rate
Q of Loanable Funds
SLF1
DLF
Loanable Funds Market
SLF2
r2
r1
… an decrease in loanable funds
Q2 Q1
Contractionary Monetary Policy: Decreases AD
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The Financial Sector andthe Economy 30
The Fed and the Creation of Money
McGraw-Hill/Irwin Colander, Economics 81
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The Financial Sector andthe Economy 30
Banks and the Creation of Money• The first step in the creation of money:
• The Fed creates money by simply printing currency
• Currency is a financial asset to the bearer and a liability to the Fed
• The bearer deposits the currency in a checking account at the bank
• The form of money has changed from currency to a bank deposit
30-82
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The Financial Sector andthe Economy 30
Banks and the Creation of Money
• The second step in the creation of money:
• The bank lends a fraction of the deposit
• The amount of money has expanded:
• Initial deposit + new loan
• The amount of money is multiplied
30-83
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The Financial Sector andthe Economy 30
Reserves
• Reserves: currency and deposits a bank keeps on hand or at the Fed or central bank, to manage the normal cash inflows and outflows
• The required reserve ratio (RRR) is the percentage that banks are required to hold (set by the Fed)
30-84
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The Financial Sector andthe Economy 30
Reserves
• The reserve ratio is the ratio of reserves to deposits a bank keeps and does not loan out (can include excess reserves)
• Reserve ratio = required reserve ratio + excess reserve ratio
McGraw-Hill/Irwin Colander, Economics 85
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The Financial Sector andthe Economy 30
Calculating the Money Multiplier
• 1/r is the simple money multiplier
• The simple money multiplier is the measure of the amount of money ultimately created per dollar deposited in the banking system, when people hold no currency
30-86
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The Financial Sector andthe Economy 30
Calculating the Money Multiplier
• It tells us how much money will ultimately be created by the banking system from an initial inflow of money
• The higher the reserve ratio, the smaller the money multiplier, and the less money that will be created
McGraw-Hill/Irwin Colander, Economics 87
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The Financial Sector andthe Economy 30
Calculating the Money Multiplier When People Hold Currency
• The simple money multiplier reflects the assumption that only banks hold currency
• When firms and individuals hold currency, the money multiplier in the economy is:
(1 + c)(r + c)
30-88
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The Financial Sector andthe Economy 30
Calculating the Money Multiplier when People Hold Currency
• Where r is the percentage of deposits banks hold in reserve and c is the ratio of money people hold in currency to the money they hold as deposits
McGraw-Hill/Irwin Colander, Economics 89
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The Financial Sector andthe Economy 30
Determining How Many Demand Deposits Will Be Created
• Demand deposits: bank deposits that can be withdrawn at any time
• To find the total amount of deposits that will be created, multiply the original deposit by 1/r, where r is the reserve ratio
30-90
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The Financial Sector andthe Economy 30
Determining How Many Demand DepositsWill Be Created
• A customer deposits $100 into a bank. What is the immediate impact on the money supply?
• No impact—the money was already in the money supply so there is no change
McGraw-Hill/Irwin Colander, Economics 91
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The Financial Sector andthe Economy 30
Determining How Many Demand DepositsWill Be Created
• A customer deposits $100 into the bank. The reserve ratio is 10 percent (0.1). The amount of money ultimately created is:
• $100 x 1/0.1 = $1,000
• New money created = $1,000 – $100 = $900
McGraw-Hill/Irwin Colander, Economics 92
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The Financial Sector andthe Economy 30
Determining How Many Demand DepositsWill Be Created
• New money created = $1,000 – $100 = $900
• Why is the new money created only $900 and not $1,000?
• Because the $100 deposit was already in the money supply
• This is due to our fractional reserve banking system: banks hold a portion of deposits and loan out the rest of the money
• If the Fed had created money this number would have been different ($1,000)
McGraw-Hill/Irwin Colander, Economics 93
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The Financial Sector andthe Economy 30
Change in Money Supply vs. Change in Loans
• The Fed buys bonds equal to $10 million and that the required reserve ratio is 0.2. What is the maximum change in loans throughout the banking system?
• 1/r =1/0.2=5
• 5 *(10 million)=50 million
• Fed has to hold 20% though
• 50 million*(0.2)=10 million
• Total available for loans: 50 million -10 million =40 million
McGraw-Hill/Irwin Colander, Economics 94
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The Financial Sector andthe Economy 30
Change in Money Supply vs. Change in Loans
• The Fed buys bonds equal to $10 million and that the required reserve ratio is 0.2. What is the maximum change in the money supply throughout the banking system?
• 1/r =1/0.2=5
• 5 *(10 million)=50 million
McGraw-Hill/Irwin Colander, Economics 95
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The Financial Sector andthe Economy 30
Sample Question: Bank Balance Sheet
Assets Liabilities
Loans $15,000
Total reserves $ 5,000
Treasury bonds $10,000
Demand deposits $20,000
Owner’s equity $10,000
Total: $30,000 Total: $30,000
McGraw-Hill/Irwin Colander, Economics 96
Owner’s equity: money put into a business or bank; not held in reserves
(This concept often shows up in the FRQs)
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The Financial Sector andthe Economy 30
Sample Question: Bank Balance Sheet
Assets Liabilities
Loans $15,000
Total reserves $ 5,000
Treasury bonds $10,000
Demand deposits $20,000
Owner’s equity $10,000
Total: $30,000 Total: $30,000
McGraw-Hill/Irwin Colander, Economics 97
The reserve requirement is 10%. How much is the bank’s required reserves?To answer, we will look at the demand deposits.$20,000 x .1 = $2,000
Is the bank holding excess reserves? If so, how much?Yes: $3,000 (Total reserves – required reserves)
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The Financial Sector andthe Economy 30
Sample Question: Bank Balance Sheet
Assets Liabilities
Loans $15,000
Total reserves $ 5,000
Treasury bonds $10,000
Demand deposits $20,000
Owner’s equity $10,000
Total: $30,000 Total: $30,000
McGraw-Hill/Irwin Colander, Economics 98
How much could the bank increase the money supply if it loaned out its excess reserves?$3,000 x 1/.1 = $30,000
Assume John deposits $1,000 into the bank. What is the initial change in the money supply?None—the $1,000 was already in the money supply
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The Financial Sector andthe Economy 30
Chapter Summary • The financial sector is the market where financial
assets are created and exchanged
• The financial sector channels flows out of the circular flow and back into the circular flow
• Every financial asset has a corresponding financial liability
• The economy has many interest rates
• The long-term rate is determined in the market for loanable funds, while the short-term rate is determined in the money market
30-99
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The Financial Sector andthe Economy 30
Chapter Summary • Money is a highly liquid financial asset that serves as
a unit of account, a medium of exchange, and a store of wealth
• The measures of money are:
• M1 is currency in the hands of the public, checking account balances, and traveler’s checks
• M2 is M1 plus savings deposits, small-denomination time deposits, and money market mutual fund shares
• Banks create money by loaning out deposits30-100
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The Financial Sector andthe Economy 30
Chapter Summary • The simple money multiplier is 1/r
• The money multiplier tells you the amount of money ultimately created per dollar deposited in the banking system
• The money multiplier when people hold cash is (1+c)/(r+c)
• People hold money for the transactions motive, the precautionary motive, and the speculative motive
30-101
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Monetary Policy 31
Chapter Summary
• Monetary policy influences the economy through changes in the banking system’s reserves that affect the money supply and credit availability
• Expansionary monetary policy works as follows:
↑M → i↓ → ↑I → ↑Y
• Contractionary monetary policy works as follows:
↓ M → ↑i → ↓I → ↓Y
• The Federal Open Market Committee (FOMC) makes the actual decisions about monetary policy
31-102
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Monetary Policy 31
Chapter Summary
• When the Fed buys bonds, the price of bonds rises and interest rates fall. When the Fed sells bonds, the price of bonds falls and interest rates rise.
• A change in reserves changes the money supply by the change in reserves times the money multiplier
• The Federal funds rate is the rate at which one bank lends reserves to another bank
• It is the Fed’s primary operating target
31-103