AP Macro Unit 4
The central bank can adjust the money supply by changing (Money Supply Shifters)
The Reserve Requirements (Ratios), The Discount Rate, Open Market Operations
Interest Rate
The amount a lender charges borrowers for borrowing money. It's the "price" of a loan
When there are ample reserves, what happens if the central bank buys bonds?
The interest rate doesn't change OMO doesn't work
interest on reserves
The interest rate that the Federal Reserve pays commercial banks to hold reserves
What is the opportunity cost of holding money in your pocket or checking account?
The interest you could be earning from other financial assets like stocks, bonds, and real estate.
1. Stay the same 2. $1700 3. $300 4. 1/.1 = 10 -> 3000(10) = 30,000
Use Image If Bob withdrawals $3000 from this bank: 1. Will M1 money supply initially ↑, ↓, stay same? 2. How much is the required reserves? 3. How much is the excess reserves? 4. Assume Bob burned the money, what is the maximum change in money supply?
Demand Deposits
$ deposited in a commercial bank in a checking account
In the short run, an expansionary monetary policy would most likely result in which of the following changes in the price level and real gross domestic product (GDP) ?
Price Level: Increase; Real GDP: Increase
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
Which federal reserve action can shift the aggregate demand curve to the left
Raising the discount rate
Draw the Investment Demand Graph
See image
What is the relationship between interest rate and quantity of money demanded
inverse
Federal Funds Rate
is the interest rate that banks charge one another for one-day loans of reserves
What will a low interest rate do to investment
it will increase investment
In the short run, which of the following would occur to bond prices and interest rates if a central bank bought bonds through OMO's
Bond Prices: Increase; Interest Rates: Decrease
To increase the Money supply, the central bank can _________ government securities
Buy
The transaction demand for money is very closely associated with money's use as a
medium of exchange
Which of the following sequence of events would occur if the Federal Reserve implemented contractionary monetary policy
Interest rates increase, investment and consumption spending decrease, aggregate demand decreases, and output prices decrease
Administered rates
Interest rates set by the Fed rather than determined in a market
Suppose that all banks keep only the minimum reserves required by law and that there are no currency drains. The legal reserve requirement is 10%. If Maggie deposits the $100 dollar bill she has into her checking account, the maximum increase in the total money supply would be
$900
What will happen to the demand and supply for loanable funds if there is political instability?
-Demand will decrease as worried consumers and businesses borrow/invest less -Supply will decrease as worried foreigners take money out of the country (This is called "capital flight")
Money Multiplier Equation
1 / Reserve Requirement (Ratio)
how can the fed decrease the reserve ratio
1. Banks hold less money and have more excess reserves. 2. Banks create more money by loaning out excess. 3. Money supply increases, interest rates fall, AD up.
How can the fed increase the reserve ratio
1. Banks hold more money and have fewer excess reserves. 2. Banks create less money. 3. Money supply decreases, interest rates up, AD down.
Loanable funds market demand shifters
1. Changes in borrowing by consumers 2. Changes in borrowing by businesses (investment spending) 3. Changes in borrowing by the government (ex: deficit spending)
If the reserve requirement is .1 and the Fed buys $10 million bonds, what will happen to the money supply?
1/.1 = 10 -> 10M(10) = 100M increase
If the reserve requirement is .5 and the Fed sells $10 million of bonds, what will happen to the money supply?
1/.5 = 2 -> 10M(2) = 20 million decrease
Which of the following is most likely to occur if the federal reserve engages in open market operations to reduce inflation
A decrease in reserves in the banking system
A) Calculate required reserve ratio B) Fed purchases $5,000 of bonds from swell bank. What will be the change in the dollar value of each of the following immediately after the purchase? i) Excess Reserves ii) demand deposits C) Maximum amount the money supply can change because of this purchase D) When the fed purchases bonds, what will happen to the price of bonds in the open market? E) Instead of the purchase of bonds, someone deposits $5,000 cash into their checking account. What is the immediate effect on M1.
A) 20% B) i) 5,000 ii) 0 C) 1/.2 = 5 -> 5,000(5) = 25,000 D) The price of bonds will increase because the purchase of bonds increases the money supply, decreasing the interest rate E) No change
Assets
Anything tangible or intangible that has value.
Interest-Bearing Assets
Assets that earn interest over time. e.g. bonds
When there are ample reserves
Banks deposit a lot of reserves with the central bank • Changing the money supply has little or no effect on interest rates • The central bank conducts monetary policy by changing its administered rates (IOR or discount rate)
When there are limited reserves, what happens if the central bank buys bonds from banks?
Banks will have more reserves The supply of reserves will shift to the right and the interest rate will decrease
1. 10% 2a. decrease by $5,000 2b. No effect - cash and demand deposits both in M1 2c. $500 3. They can borrow from the federal reserve or another bank
Based on Image 1. What is the reserve requirement 2. Luis withdraws $5,000 in cash from his checking account 2a) how much will the banks reserve change by? 2b) What is the initial effect of the withdrawal on M1. Explain 2c) What is the new value of excess reserves? 3. Assume the next day John withdraws an amount that exceeds the excess reserves. No loans are called in, how can the bank cover its required reserves?
Bank B can increase its loans by $40
Based on the balance sheet for three different banks, which of the following is true if the reserve requirement is 10%
Money Demand Shifters
Changes in price level, Changes in income, Changes in technology
Loanable funds market supply shifters
Changes in private savings behavior 2. Changes in public savings 3. Changes in foreign investment (ex: more inflow of foreign financial capital)
To increase the Money supply, the central bank can _________ the Discount Rate
Decrease (Easy Money Policy)
What can the central bank do to decrease rates?
Decrease interest on reserves and the discount rate
How does a decrease in the money supply affect AD?
Decrease money supply -> Increase interest rate -> Decrease investment -> Decrease AD
If there is a recession, what could the central bank do to the reserve requirement?
Decrease the reserve ratio
To decrease the Money supply, the central bank can _________ the Discount Rate
Increase (Tight Money Policy)
What can the central bank do to increase rates?
Increase interest on reserves and the discount rate
How does an increase in the money supply affect AD?
Increase money supply -> Decreases interest rate -> Increases investment -> Increases AD
If there is inflation, what could the central bank do to the reserve requirement?
Increase the reserve ratio
With a constant money supply, if the demand for money decreases, the equilibrium interest rate and quantity of money will change in which of the following ways?
Interest Rate: decrease; quantity of Money: not change
If the Fed decreases the reserve requirement from .50 to .20 what will happen to the money multiplier?
It will go from 2 to 5
What is included in M2
M1 plus savings deposits (including money market deposit accounts), small time deposits under $100,000, and shares in retail money market mutual funds
What is the financial sector
Network of institutions that link borrowers and lenders. Includes banks, mutual funds, pension funds, and other financial intermediaries.
When an economy is operating below the full-employment level of output, an appropriate monetary policy would be to increase which of the following
Open market purchase of government bonds
Transaction Demand for Money
People hold money for everyday transactions
Asset Demand for Money
People hold money since it is less risky than other assets
The purchase of bonds by the federal reserve will have the greatest effect on real gross domestic product if which of the following situations exists in the economy
The required reserve ratio is low, and the interest rate has a large effect on investment spending
Two reasons people demand money
Transaction Demand for Money & Asset Demand for Money
1. 10% 2. Stays the same 3. it will increase by $100, making it $2,100 4. It will increase by $900, making it $3900 5. $900 6. 1/.1 = 10 -> 900(10) = $9,000
Use pictured graph to answer questions If Bob deposits $1000 into this bank: 1. What is the required reserve ratio? 2. Will M1 money supply initially ↑, ↓, stay same? 3. How much is the required reserves? 4. How much is the excess reserves? 5. How much more can the bank initially lend out? 6. Maximum change in money supply from deposit?
What is fractional reserve banking
When banks hold a portion of deposits to cover potential withdrawals and then loans the rest of the money out
Balance Sheet
a record of a bank's assets, liabilities, and net worth
What is included in M1
all physical currency, traveler's checks, demand deposits, and other checkable deposits
Excess Reserves
amount that the bank can loan out
Which of the following will lead to a decrease in a nation's money supply
an increase in reserve requirements
Private Investment
borrowing by businesses and consumers
To counteract a recession the federal reserve should
buy securities on the open market and lower the discount rate
The federal reserve decreases the federal funds rate by
buying government bonds on the open market
Bond & Interest Rate relationship
inverse
the amount of money that the public wants to hold in the form of cash will
decrease if interests rates increase
If the reserve requirement is 25% and banks hold no excess reserves, an open market sale of $400,000 of government securities by the Federal Reserve will
decrease the money supply by up to 1.6M
Government Borrowing
deficit spending when government spending is greater than tax revenue
Bonds
e loans, or IOUs, that represent debt that the government, business, or individual must repay to the lender. The bond holder has NO OWNERSHIP of the company and is paid interest (securities)
net capital inflow
inflow - outflow
Required Reserves
percent that banks must hold by law
Stocks
represent ownership of a corporation and the stockholder is often entitled to a portion of the profit paid out as dividends (equities)
Draw the Money Market graph
see image
Draw the Reserve Market Model
see image
Draw the loanable funds market
see image
To decrease the Money supply, the central bank can _________ government securities
sell
Loanable funds market
shows the supply and demand of loans and shows the equilibrium real interest rate
what will the net capital inflow effect
supply of loanable funds
capital inflow
the amount of money entering the country
capital outflow
the amount of money leaving the country
Liquidity
the ease with which an asset can be converted to a medium of exchange. In general, the higher the liquidity the lower the rate of return
The Discount Rate
the interest rate that the central bank charges commercial banks
The supply of money will only change when...
there is action by the FED
What must be the same about the assets and liabilities side in a balance sheet
they have to equal the same amount
Why would the FED want to slow down the economy
to fight inflation
Open Market Operations
when the central bank buys or sells government bonds
When there are limited reserves:
• Banks deposit few reserves with the central bank • Small changes in the money supply can affect interest rates • The central bank conducts monetary policy by changing the reserve requirement or the discount rate or by using open market operations
