ECON 122

The Federal Reserve System (Functions and Objectives/Goals)

(Major) Functions of the Federal Reserve System: 1) Determine the Legal Reserve Requirement 2) Determine the CA Ratio (Requirement) 3) Determine Federal Reserve Notes (currency, bills...determine how much to have outstanding? my note) 4) Clear Checks from One Bank to Another 5) Supervises All the Subsidiaries of Foreign Banks in the US (and audits them, etc...) 6) Also Audits and Supervises the Bank Holding Companies (most big banks have holding companies, have banks and other companies/function, eg investment banks, mortgage banks, etc...banks have to keep these operations separate from the commercial bank operation, (but they have holding companies for all of these functions? My note) 7) The Federal Reserve System is the Fiscal Agent of the US Government (the government deposits money and writes checks from the Federal Reserve, tax money goes to US Treasury account in the Federal Reserve System) -When the Treasury Reserve Account increases, the Reserves of the System decrease, and vice versa? (Figure out/Review if necessary 8) In conjunction with the FDIC, decides if they want to audit (who/when they want to audit, which banks? my note), and the Federal Reserve System determines/is in charge of the Stress Test 9) In Charge of All Antitrust Activities for All of the Banks (so if banks want to merge, they must have the permission of the Fed Reserve, regardless of if they are state or national, when a state bank is sold to a national, or even selling a branch, for all of these things banks need the permission of the Federal Reserve) -Fed Reserve is antitrust authority for banks 10) Collects and Publishes A Multitude of Economic Data (eg Industrial Production, Money Supply, Loans Data, etc) -Fed Reserve Bank of St. Louis publishes (this? my note) data weekly -So those are the major functions of the Fed Reserve System Major Goals of the Federal Reserves System (Objectives according to charter, given by Congress when created, the objectives or goals the FED was created to accomplish): 1) Monetary Stability (Maximum Price Stability): -The Federal Reserve System is in charge of the monetary stability of the country, trying to keep prices as stable as possible -Trying to keep inflation down, also avoiding/fighting deflation (which is worse than inflation -Current goal is to keep inflation around 2% 2) Economic Stability (Minimum Unemployment): -The Federal Reserve System is in charge of economic stability, keeping/changing things so the economy can achieve the optimal employment rate or the potential rate of growth of the US economy 3) Avoid Financial Crises (Avoid Financial Panics): -Have not been very good at this? -Crises in 1997, 2001 (after 9/11), people tried to take money out of banks, and banks did not have much cash in there -So after 9/11, for example, the Federal Reserve put $50 billion into banks, to avoid panics

Exchange Rate Systems, Sterilization

(Three or Four Different Types?) 1) Freely Fluctuating Exchange Rate: -Exchange rate determined by the market (SUPPLY AND DEMAND FOR THE CURRENCY, MY NOTE, BUT SEEMS RIGHT, FIGURE THIS OUT AND VERIFY) -Basically what the US has been using since off the gold standard -US is one of the only major countries to not intervene -When supply of the currency > demand for the currency, the value of the currency decreases, and vice versa (IMPORTANT CONCEPT) 2) Freely Fluctuating Exchange Rate With Some Government Intervention ("Dirty Float"): -Government mainly comes into the market and tries to keep the value of their currency from going up, or tries to push it down...that's mainly the kind of intervention, keep or make exchange rate low -He doesn't remember anyone intervening to make it high -Japan, China have done -Why keep it low? 1) Keep exports from going down (or make them higher, if pushing exchange rate down? my note) 2) To reduce interest rates (if you want to reduce the value of your currency, how do they do it? Have to buy foreign currency (selling your own currency? FIGURE THIS OUT) Eg, buy dollar, sell Yuan, purchase $ using Yuan, supply more Yuan to the market (which reduces the value of the currency, reduces the exchange rate, MY NOTE, verify)...what is the limit to this/the problem? The limit is INFLATION...Country, eg China, that is doing this, is putting a lot of currency in the market, mostly banks do (buy the Yuan, I think), so more reserves, more loans, leads to MORE MONEY SUPPLY AND MORE INFLATION...so they don't do it continuously)...Increasing reserves of banking system when you put Yuan out there? by purchasing $s? (IMPORTANT LOGIC, MAKES SENSE BUT VERIFY AND FIGURE IT OUT) -Fed cannot reduce the value of the currency, but treasury can? (Central Bank vs Treasury, but Treasury doesn't do it for the US, US free float right? IMPORTANT, FIGURE THIS OUT, MY NOTE) -Japan has been doing this, but has not experienced that much inflation, why? Japan's people are big savers, A PLACE WHERE THE LIQUIDITY PREFERENCE WITH INTEREST RATE VERY LOW (REVIEW THE GRAPH AND MAKE SURE THIS MAKES SENSE, GOOD REVIEW/LOGIC OPPORTUNITY, IMPORTANT) -Japanese absorb a lot of the money supply, not spending it, IMPORTANT IF NET EXPORTER, CURRENCY APPRECIATES, AND VICE VERSA, IMPORTANT POINT...AND IF VALUE OF CURRENCY IS 10% LESS, VALUE OF EXPORTS GOES DOWN BY (ABOUT, I THINK, MY NOTE) 10% "STERILIZATION": Japan and China? (IMPORTANT CONCEPT FOR EXAM) -Reduces negative aspects of government decisions to reduce the value of their currency, want to sterilize the amount of reserves that goes into the system -So government SELLS BONDS, you mop op some of those Yen you're putting into the market, so prevent inflation, banks forced to buy these bonds? (FIGURE OUT STERILIZATION AND LOGIC HERE) Treasury selling bonds and banks forced to buy? Lots of banks in China/Japan owned by the government -IMF was established to try to control exchange rates around the world, government would devalue, then someone else would devalue, made it impossible for countries to devalue their currency unless have permission of the IMF, other country cannot do just because you did...(at that time or is this still how it works, my note...this might not be an important point, might be too detailed) When Is The Devaluation of Currency Effective? (IMPORTANT CONCEPT) -If demand for exports is inelastic, and you devalue currency, revenue decreases (FIGURE OUT THE LOGIC HERE) -Or if imports have inelastic demand, and you devalue your currency, you just pay more for imports, so imports increase (FIGURE OUT LOGIC) -Also if supply is inelastic, you cannot supply more if you devalue, so that would be another problem with devaluation? (IMPORTANT TO FIGURE OUT LOGIC) -So want elastic supply and demand of exports? (IMPORTANT TO FIGURE OUT LOGIC I THINK THIS WAS MY NOTE SO VERIFY) Discussion of ECB monetary policy changes (MIGHT BE AN IMPORTANT POINT IN HERE, REVIEW, WHERE HE TALKS ABOUT NOT EXPECTING FED TO INTRODUCE A NEGATIVE INTEREST RATE AND WHAT THE FED COULD DO INSTEAD/OTHER THAN THAT) ANY TIME A CENTRAL BANK BUYS ANYTHING, IT INCREASES RESERVES AND THE MONETARY BASE (IMPORTANT CONCEPT) IN 3 MONTHS IBM REVENUE WOULD HAVE BEEN $7 BILLION HIGHER IF IT WASN'T FOR THE EURO GOING DOWN, IBM DOES NOT USE FUTURE MARKETS TO PROTECT (HE SAID INSURES ITSELF BY THINKING SOME OTHER EXCHANGE RATES WILL GO DOWN AROUND THE WORLD OR SOMETHING) (IMPORTANT CONCEPT, REVIEW CORPORATE PROFITS WITH CHANGES IN VALUE OF CURRENCY AND ALSO FUTURE MARKETS) Talked about government intervention in exchange rate market, want to keep their currency value down, to keep exports up...the freely fluctuating exchange rate but with intervention if the exchange rate changes too much the way they do not want it too..."dirty float" 3) (I added the number) Some countries use multiple exchange rates (eg for exports (and/or) imports): -Country may decide that some goods from abroad are necessary, and wants to keep exchange rate for those goods low (SO VALUE OF CURRENCY FOR THESE GOODS UP SO THEY ARE CHEAPER, MY NOTE, MAKES SENSE BUT VERIFY LOGIC) -Might want high exchange rate for luxury goods (BECAUSE PEOPLE BUY THEM ANYWAYS, WEALTHIER PEOPLE, WANT THEM TO BE MORE EXPENSIVE IF THEY AREN'T AS NECESSARY? MY LOGIC BUT I THINK HE SAID SOMETHING SIMILAR SO VERIFY) -More common on imports than exports I think he said, my note, but VERIFY -Chile has been doing that -Some countries might use different taxes on goods...eg Argentina producing/exporting a lot of soy beans...Argentina put a tax on exports, eg pay a tax (export tax) on each certain amount of goods you export...(WHY? FIGURE OUT LOGIC AND EFFECTS OF THIS HERE) 4) Some countries peg their currency to another currency (WHAT ARE THE EFFECTS OF THIS IS IT SIMILAR TO GIVING UP CURRENCY? PROBABLY DO NOT LOSE MONETARY POLICY COULD BREAK THE PEG OR WHATEVER, MY NOTE, FIGURE THIS OUT, IMPORTANT) 5) Some countries give up their own currency and use the currency of other countries...eg Ecuador and Zimbabwe use the US dollar...(is this what the European countries did with the Euro? FIGURE OUT, IMPORTANT) -Let's say the countries that use the dollar right now...why do they make the switch? -TO CONTROL INFLATION, mainly to control inflation if they failed to control their inflation, so they switch to a more stable currency, if used dollar, can't issue it, so their inflation is close to the inflation of the US, they get the dollar from their exports or borrow it internationally to make the change? (minor detail probably not important for final exam, just this last bit about where they get the currency to make the change, my note) What Are The Consequences of Using Another Country's Currency? 1) Giving up your monetary policy (control of inflation, inflation policy, but more stable by using, that's why? etc...my note I think, mostly) 2) Also giving up exchange rate policy (can't devalue or appreciate the currency...eg European countries could not issue the Euro or devalue it...can't devalue or appreciate (but mainly would devalue, my note)...etc...) 3) Also give up "SEIGNORAGE": represents the difference between the monetary value of the currency and the cost of producing that currency...Lots goes to the US Treasury in form of seignorage...it costs like $.04 to print a $100 bill and the government sells it to you for $100, so the difference is called seignorage, and you lose that if you are not producing your own currency (IMPORTANT CONCEPT/WORD FOR THE EXAM) -This is why it was easy to be a king or whatever, if you could create your own currency?...if use gold, then it is almost even (very little or no seignorage? MY NOTE) -If on gold standard, less seignorage, or if you use gold or silver coins, etc...MAKES SENSE -People would cut off pieces of gold coin...worth less than before...old coins? (probably not important) -So remember why a country might use another currency...he thinks losses are bigger than gains...IMPORTANT -To conclude this part, just keep in mind that changes in fiscal/monetary policy could change the exchange rate and reduce effectiveness of that policy/goal you want to achieve (REVIEW THE ECB EXAMPLE, IMPORTANT EXAMPLE OF THIS)

How Countries (Especially Developing Countries) Can Use Central Bank to Achieve Certain Social Objectives

-Most developing countries have specialized government agencies, eg government owned agricultural bank, so if the government wants to increase agricultural production this helps, most governments also have a housing bank to improve number of/amount of housing being built -Most countries, including the US, also have an Import-Export Bank to improve exports -All set up by gov to achieve a certain objective -Agricultural Bank T-Accounts Example -Eg with Import-Export bank, give loans to exporters from import-export bank -Works the same with housing, etc -So countries create agencies to achieve certain objectives -We do not do this as much in the US really, do not do this (except for Export Import, right?)...we do have agricultural and housing banks/agencies, but each of these agencies in the US are INDEPENDENT, they provide their own funding by selling their own paper/bonds/bills on the market directly, so they do not need to go to the FED (OR CENTRAL BANK AS IN EXAMPLE) to get the money, do not need to go to the central bank and that is how it is different This ends the discussion of the relationship between the Federal Reserve System, the Treasury, and the Economy

Inverse/Negative Yield Curve

-People know when the Fed starts increasing ST rates, economic activity decreases, and this will lead to a decrease in int rate (IMPORTANT LOGIC, THESE THINGS SEEM TO CAUSE BOTH WAYS, IMPORTANT RELATIONSHIPS) -SO YIELD CURVE BECOMES NEGATIVE? INVERSE? -As economy slows down, demand for funds diminishes, and int rates start going down, leading to an INVERSE YIELD CURVE -Then people start buying LT securities, they increase the value of these LT securities, and LT Rates decrease?, FIGURE THIS OUT -Purchase Bond when int rate high, because yield (return) is high, and expectation is for int rates to decrease, which increases value of your bond, so make money two ways (IMPORTANT LOGIC) -So with inverse curve (Negative Yield Curve, my note), now have less or no inflationary expectation, just have expectation that economy will slow down because of what Fed does (inverse relationship between int rates (ST? only? or all?) and economic activity) -As economy slows down, LR int rates decrease, so negative yield curve -3 to 4 months after yield curve is negative, going to have a recession (after it starts becoming negative), IMPORTANT -So remember how the yield curve behaves, as it changes the economy is changing -Eventually with negative yield curve, with decreasing interest rates, economic activity picks back up again? FIGURE ALL OF THESE YIELD CURVES OUT USING THE INTERNET, REMEMBER VARIOUS YIELD CURVES AND CONDITIONS FOR THE FINAL EXAM

T Accounts, Dollar we lose when we have a trade deficit stays in the US

-REMEMBER HOW WE SAID WE HAD DEFICIT BUT NOT CROWDING OUT EFFECT BECAUSE FOREIGNERS PUTTING MONEY IN, REVIEW IN THE CONTEXT OF DEFICIT FINANCING METHODS, MAKES SENSE...(FIGURE IT OUT MORE) 1) American Importer buys $1 million of goods from German Exporter and writes a check from their deposits with Bank of NY to pay -Foreign/European Bank takes the dollars, German Exporter could change that, but say it stays in dollars -So Frankfurt bank has $1 million deposited in the Bank of NY (WHY DOES IT STAY THERE? DEPOSIT THERE? FIGURE IT OUT)...what is it going to do with that? 1) They can sell that $ 1 million to a German Importer (somebody from Germany who wants to buy $ 1 million of US goods) ($ value stays the same, interest rate stays the same, Economic activity stays the same in the US, because $ 1million goes out and comes in? FIGURE OUT THE LOGIC AND CHANGES HERE) 2) Could sell the $ 1million to a German Investor who wants to invest in the US (EG PORTFOLIO OR DIRECT INVESTMENT) ($ value stays the same again, supply and demand of $ remains the same, provide by buying goods in US, and they use the same $ to invest in the US, but interest rates in the US go down and investment in the US goes up (FIGURE OUT THE LOGIC HERE, VERY IMPORTANT)...these changes take large amounts, but conceptually...and we've seen before that even though we had a high deficit, low interest rates, because of foreign investment (supply funds to the US, reducing the interest rate, increasing investment and economic activity (VERY IMPORTANT REVIEW IN THE CONTEXT OF THE CROWDING OUT EFFECT GRAPH AND FIGURE THIS OUT)) 3) The Frankfurt Bank could sell the $1 million to someone who wants to invest some place else, wants to change the currency (ONLY IN THIS CASE DOES THE VALUE OF THE DOLLAR GO DOWN, have to sell the dollar and buy other country currency, so the supply of dollar increases, reduces the value of the dollar, and as the value of the dollar decreases, interest rates in the US increase (HOW, FIGURE OUT THE LOGIC) and as interest rates increase, the level of investment and economic activity decrease (FIGURE THIS OUT BETTER) -Important thing is when we buy from abroad, foreigners get dollars, $, and how they use it is important for what happens in the US (VERY IMPORTANT POINT) 4) The Frankfurt Bank could sell those dollars, $, in the Eurodollar market in London (LIBOR rate down, so our banks could borrow from the Eurodollar market, A SOURCE OF SHORT TERM FUNDS...cheaper? my note)...value of $ not affected in US, but sometimes borrowing interest rates are linked to the LIBOR rate, so that borrowing would be cheaper...(FIGURE THIS OUT, FIGURE OUT THE EURODOLLAR MARKET WHAT IT IS AND HOW IT WORKS, VERY IMPORTANT) -So what they decide to do affects the value of the dollar, $, interest rates, investment and therefore economic activity -So even though dollars, $s, may come back to the US, they belong to foreigners and what they do with it matters (IMPORTANT)

Steeper Upward Sloping Yield Curve (Steep Yield Curve)

-Steeper upward sloping...Inflationary expectations pushed up? SEE GRAPHS -Economic activity: now above optimum capacity, above optimum unemployment, wages up, capacity constrained, IMPORTANT -Stock market prices go down when you have inflationary expectations like that, bond prices go down too (both of these because market rate of int rise, IMPORTANT...real rate of int + inflationary expectation = market rate of int) IMPORTANT, determined by supply and demand of funds? the market rate of int? (WHAT ARE FUNDS? BONDS INCLUDED IN THIS? FIGURE THESE THINGS OUT) -Remember inverse relationships for these things, IMPORTANT -If you see yield curve going up or know inflationary expectations going up, what do you do with bonds in your portfolio? you start selling, protect yourself, know interest rate going to go up with inflationary expectations, so sell bonds, increases supply of bonds in the market, so value of bonds goes down and int rates go up, (SUPPLY OF FUNDS RELATED?, MY NOTE, BONDS? INVESTIGATE) -Rule of thumb, if interest rates go up 1.0%, value of bonds decreases 10% (long term, 20, 30 years bonds) -So start selling, and as you sell, the value of the bonds in the market goes down and interest rates go up (as everyone is selling, IMPORTANT) -Why is it that the ST rate not going up? short part of the curve does not move, people that sell LT bonds use those funds to shift to ST bonds, so demand for ST up, so the value will go up a little? or not down as much? (so this keeps int rates from going up? my note), FIGURE THIS STUFF OUT -For ST, if interest rates up 1.0%, bond value down just 1.0%?, shorter the maturity, the less you lose when interest rates go up, IMPORTANT -So people switch from LT to ST -Fed looks at this curve everyday, and what does the Fed do when the curve steepens (due to increased inflationary expectation?))...Takes some action, STARTS INCREASING ST RATES BY SELLING SECURITIES (FED FUNDS RATE, SEE GRAPH FOR THAT, REVIEW, MY NOTE) -Do this to prevent high inflation -As they increase ST rates, market gets concerned...? (Side note: remember the best way to find inflationary expectations...two places: 1) Compare yield of regular bond and yield of TIP bond, 2) U of Michigan Consumer Sentiment Index? Survey?, IMPORTANT, REVIEW THIS) -Study of yield curve is the study of the structure of interest rates -So talking about the steep yield curve...IT STEEPENS AS INFLATIONARY EXPECTATIONS INCREASE -People protect their portfolio by selling some bonds and as they sell, supply of bonds in market increase, and the value of those bonds start falling, so int rates increase...(so that's how it steepens?, IMPORTANT, FIGURE THIS OUT) -When inflationary expectations increase, the Fed moves to keep those expectations from occurring, or to decrease inflationary expectations, SO FED INCREASES THE SHORT TERM INTEREST RATE...HOW DOES THI AFFECT THE LT RATE? -When they start increasing int rates, they do it until inflationary expectations diminish...(YOU NEED TO FIGURE OUT HOW INTEREST RATES ARE RELATED TO INFLATION...AND HOW INFLATIONARY EXPECTATIONS DON'T PUSH UP ST INT RATES TOO? VERY IMPORTANT TO FIGURE THIS OUT) -Stock prices? Bond prices? Not understanding what he is saying here...FIGURE THIS OUT IMPORTANT, USE THE INTERNET -Fed and CBs generally buy/sell ST securities/notes, so they cahnge ST rate? only? MY NOTE, how does this affect LT rates, inflation, etc? -People know when the Fed starts increasing ST rates, economic activity decreases, and this will lead to a decrease in int rate (IMPORTANT LOGIC, THESE THINGS SEEM TO CAUSE BOTH WAYS, IMPORTANT RELATIONSHIPS) -SO YIELD CURVE BECOMES NEGATIVE? INVERSE?

How the Federal Reserve Changes/Controls the Federal Funds Rate (GRAPH #1)

-The Federal Reserve controls the Federal Funds Rate (which affects other interest rates, my note) -The Federal Funds Rate is determined by Supply/Demand, on open market, but Fed sets a target rate and tries to keep it close to that target rate, and here's how they do it: Y Axis is Fed Funds Rate, X Axis is Quantity of Fed Funds -This changes daily -Every Wednesday is Settlement Day, where banks have to show they had enough reserves to cover average deposits for the previous two weeks. So on Wednesdays, may borrow FF to make up requirement, so FF demand could increase on Wednesday, or just could change by larger amount on Wednesdays, maybe not go up?...but say demand causes the Fed Funds Rate to rise, how does the Fed Reduce the rate back to the target? -They supply more Fed Funds to the market, increase the supply of funds to the market, and how do they supply Fed Funds, THEY BUY GOVERNMENT SECURITIES (to give excess reserves to bank which they then loan out to each other, IMPORTANT LOGIC, MY NOTE) -Fed Reserve can purchase enough securities to keep near target on a daily basis... -(Or, my note, could sell to reduce supply of FF to increase the rate, IMPORTANT LOGIC) -By controlling the Fed Funds rate, the Federal Reserve controls almost all other interest rates, (seems like pretty much all rates for our purposes, my note) -All rates change by the same amount and in the same direction as the Fed Funds Rate -Prime Rate, etc, remember/review that part -If Fed Funds Rate is below target, do the opposite, sell government security, increase supply of federal funds -So fed has almost complete control over interest rates (BY BUYING AND SELLING GOVERNMENT SECURITIES) -IMPORTANT, DO NOT MIX UP ON EXAM: Increase supply by buying, decrease by selling

Interest Rate Theories

1) Classical(/neoclassical?) Interest Rate Theory 2) Wicksell Interest Rate Theory 3) Keynes Interest Rate Theory 4) Hicks and Hansen Integration of Classical and Keynes Theories 5) Monetarism 6) Rational Expectation(s) Theory HE GENERALLY ASKS A COUPLE OF THESE ON THE FINAL EXAM

(Commercial) Bank Regulators

1) Federal Deposit Insurance Corporation (FDIC): -Audits the banks at least once a year (more if the bank is doing poorly?) -To be a bank, have to be a member of the FDIC (otherwise people will not deposit) -Government agency created during the Great Depression 2) Controller of the Currency (Part of the US Treasury): -Audits and controls National Banks -Charters, regulates, and supervises national banks; (also supervises the federal branches and agencies of foreign banks? seems to contradict) 3) Superintendent of Banks (State Superintendent of Banking): -Controls/Regulates local/state banks, closest to here is in San Francisco 4) Federal Reserve System: -Audits all subsidiaries of foreign banks in the US, which have to act the same as US banks -Sets rules about dividends banks can pay, shares they can buy back, etc... Other Agencies: -Securities and Exchange Commission (SEC): Regulates banks like/as it regulates other corporations -Etc, others...

4 Variables You Want to Look At In Order to Date A Recession

1) Industrial Production (has been decreasing) 2) Payroll Employment (has been rising) 3) Personal Income (has been rising) 4) Business Sales (has been slowing but not completely negative yet) So pretty well off All 4 have to be negative in a particular month to indicate a recession has started

T-Accounts #2: How Banks Create Money

1) Person A borrows $1,000,000 from Bank of America Loans (Assets) + 1,000,000 and Demand Deposits (Liabilities) +1,000,000 This $1,000,000 is real money because the person can go buy things...so the Demand Deposits went up by the amount of the loan ($1,000,000), and Money Supply (M1 and therefore M2) increases by the same amount, $1,000,000 (Are they crediting the person's account here? why Demand Deposits + 1mil?) So, effects: Total Reserves Unchanged, Required Reserves Increases by .10 x $1,000,000 = $100,000, and Excess Reserves Decreases by $100,000 Every Time Required Reserves Increase, Excess Reserves Decrease Every Time a bank increases Demand Deposits, it automatically increases its Legal Reserve Requirement (Required Reserves) by 10% of the loan, which decreases Excess Reserves by that same amount Every time the bank makes a loan, assets increase (Loans), and Liabilities increase (Demand Deposits), but Capital/Equity/Net Worth is unchanged, so the Capital Asset Ratio decreases, and the bank has to maintain the minimum ratio So this process of creating money affects Required Reserves and the Capital Asset Ratio, two important bank regulations

T-Accounts #8: US Treasury Sells Government Securities to the Public (Includes Banks), and GRAPH #3: The Crowding Out EFFECT

1) and 2), IMPORTANT, LEAST INFLATIONARY WAY, DRAW IT OUT...CROWDING OUT EFFECT...READ/WRITE ALL NOTES/EFFECTS OF THIS TOO, ON TWO DAYS' NOTES...LOSE EXCESS RESERVES, SO CAN'T CREATE AS MUCH MONEY...(WHAT IS EFFECT ON MONEY SUPPLY THOUGH)

T-Accounts #3: The Federal Reserve System Clearing Checks, Adverse Clearing Balance (Works against a particular bank)

2) Person A uses the funds they borrowed ($1,000,000) in 1) and writes a $1,000,000 check to Person B, and Person B deposits the check in Wells Fargo Bank Bank of America: Demand Deposits decrease by $1,000,000. Deposits with FED decrease by $1,000,000 Federal Reserve Bank: Member Bank Deposits (Liability) decrease by $1,000,000 (For Bank of America). Member Bank Deposits (Liability) Increase by $1,000,000 (For Wells Fargo) Wells Fargo: Deposits with FED increase by $1,000,000. Demand Deposits increase by $1,000,000 So Wells Fargo deposits that check at the Fed Reserve Bank of that district, and the Fed Reserve system clears the check This is an Adverse Clearing Balance for Bank of America Effects: Bank of America: Total Reserves: - $1,000,000 Required Reserves: - .10 x 1,000,000 = - $100,000 Excess Reserves: -1,000,000 - -100,000 = - $900,000 (Make sure this calculation is correct/makes sense for Excess Reserves) So Bank of America's Total, Required, and Excess Reserves decrease, so this is an Adverse Clearing Balance for Bank of America. Reserves go from one bank to another, they do not disappear (they go to Wells Fargo in this example): Wells Fargo: Total Reserves: + $1,000,000 Required Reserves: + .10 x 1,000,000 = + $100,000 Excess Reserves: +1,000,000 - + 100,000 = + $900,000 (So this is exactly the opposite of Bank of America) When the check went from one bank to the other, Money Supply stayed the same (Demand Deposits just from 1 bank to another, my note)

Types of Government Securities, More on Monetary Base/Open Market Operations

3 Types of Government Securities: 1) US Treasury Bills (Short-Term Securities) (3 months, 6 months, 1 year maturities) 2) US Treasury Notes (Medium Term Securities) (2 years, 5 years, 7 years, 10 years maturities) 3) US Treasury Bonds (Long Term) (30 Years Maturity) -All of these are sold on a bidding system on Mondays -Or can buy at average bid from local Fed bank? -About 20 financial houses that are approved by the Fed/Treasury to bid/buy -Gov takes bid that gives it the lowest interest rate -Notes once a month (on Monday?) -T Bonds quarterly -(So Bills Weekly? MY NOTE) -All $40/50/60 billion at a time -Partially issued to cover other government debts coming due, selling new debt to pay off debt coming due -20 houses that bid then sell to other banks -This is Open Market Operations, when the Fed buy/sells these things on the OPEN MARKET...(BUT DOES FED ISSUE THIS INITIALLY OR AFTER? FED VS TREASURY, I THINK TREASURY ISSUES THESE, MY NOTE, SO FED COULD NOT BUY FROM TREASURY RIGHT? HAS TO BUY ON OPEN MARKET, VERY IMPORTANT) -Consolidated debt, European example, no maturity, perpetual debt, never pays back initial investment but determine value using interest rate, so has a value because of guaranteed int payment -Also US Gov 40, 100 year securities, all sold to foreigners, our long term security max is 30 years -When Fed buys, does not print cash, just credits in the Balance Sheet -Every time the Fed purchases these securities it increases reserves to banks in the system (JUST INCREASES THE FED'S GOV SEC ACCOUNT, AND INCREASES THE FED'S MEMBER BANK DEPOSITS ACCOUNT, BUYING IS LIKE QE EXAMPLE ABOVE, THAT'S WHAT QE IS DOING, WHAT IS THE DIFFERENCE IF ANY?) -Member bank deposits for Fed is part of reserves for banks -$3 trillion purchases leads to $3 trillion more reserves (Total and Excess, my note, I think this makes sense, but not required, because Demand Deposits stay constant, my note) -So when banks buy securities, it increases the MONETARY BASE, NOT MONEY SUPPLY, BANKS INCREASE THE MONEY SUPPLY, NOT THE FED, VERY IMPORTANT (DIFFERENTIATE), (because Money Supply includes Demand Deposits, whereas Monetary Base includes Reserves? VERY IMPORTANT TO DIFFERENTIATE, MY NOTE) Monetary Base = Total Bank Reserves (TOTAL RESERVES) + Currency in Circulation (MOSTLY BANK RESERVES) -So when the Fed bought securities (QE) to keep interest rates low, value of securities increase and interest rates stay down, decrease, OPPOSITE FOR SELLING, WORK THIS OUT/PRACTICE -Banks had more reserves, with which they made more loans, which increased money supply (kept int rates lower, and all of the corresponding effects of that, my note, but seems to make sense) -More reserves leads to more loans and more money -The Fed is paying an interest rate on money (reserves) kept with the Fed, now .50%, so not all new reserves go to new loans (banks keep some with FED, makes sense) -More loans leads to more money, which leads to more inflation, so how does the Fed keep all of these reserves from becoming loans if economic activity goes up? 1) Can increase the Legal Reserve Requirements to up to 25% 2) Can wait until securities they bought become due, let it run out slowly, let reserves go away without repurchasing/rolling over debt (reduces reserves?) 3) Gov deficit has been going down (so the US Treasury needs to sell fewer securities) (Part of what the Treasury does is finance the deficit), if Treasury issues fewer, Fed can sell theirs they bought and reduce securities, reduce reserves, without hurting int rate? (Fed makes up difference in Treasury decrease in sales, MAKES SENSE, THINK ABOUT IT)

T-Accounts #9: Treasury Sells Bonds/Government Securities to the Central Bank

3) and 4), IMPORTANT, MOST INFLATIONARY WAY OF FINANCING THE CURRENT DEFICIT, READ/WRITE/INVESTIGATE ALL NOTES/EFFECTS OF THIS TOO...MOST INFLATIONARY BECAUSE

The Role of Financial Markets in the Economy

A well organized financial system/markets provides four major functions in the economy: 1) Allocates financial resources from surplus units to deficit units (people with extra money/income, etc...to people/organizations who/that borrow?) 2) Provide a large variety of financial instruments for both borrowers and savers (vary in time period, size, amount, risk level, etc, and these tend to satisfy the desires of savers/investors and borrowers (eg Kenya had no ST bills to invest in, etc?) 3) Provide orderly transfer of financial assets from one party to another (eg buying/selling stocks, bonds, etc) 4) Financial markets provide the framework for the workings of monetary policy (markets stopped working, panic, people didn't lend in 2008, Great Recession, so first thing they (Fed?) did was to get financial market working so monetary policy could work, to do this they bought billions of commercial paper, eg GE had paper outstanding, coming due, and nobody would buy new paper to finance their debt? because people were afraid they wouldn't be paid back, so Fed and Treasury worked to get financial markets working, bailouts?

Any Changes In One Economic Variable Creates Changes In Other Economic Variables

After these numbers (more jobs) came out, we saw: 1) Stock market/stock prices we go up 2) Bond prices go down (increase in economic activity means require higher lending from banks, which generally means higher interest rates, expect interest rates to go up, which means bond prices go down) (Inverse relationship between interest rate changes and bond prices) 3) Value of the dollar went up (economy doing well, foreigners invest more money here, they need to buy dollars to do this, which increases demand, pushes the value of the dollar up)

T-Accounts #10: Agricultural Bank/Government Agency to Achieve Certain Objective

Agricultural Bank, Cooperative, and Central Bank

5) Monetarism

Background: -A school of economics, introduced by Milton Friedman -From the University of Chicago Arguments/Key Points: -Monetarism argues that the most important factor that affects economic activity is CHANGES IN THE MONEY SUPPLY (IMPORTANT) -So policy conclusion is that the Fed should allow the money supply to expand at an almost fixed rate -Also, Fed should not get involved with interest rates, the market should determine the interest rate, not the Fed -Changes (increases right? my note) in money supply larger than the potential rate of growth of the economy will create inflation -Changes (decreases right? my note) in the money supply less than the potential rate of growth of the economy prevents the economy from reaching its potential rate of growth -Start from a position of optimum employment, like others (WHICH OTHERS? FIGURE THIS OUT, VERY IMPORTANT), so everyone is happy with the amount of cash balances they have -If the Fed increases the money supply, then somebody in the economy has more money than they want, and they spend it (businesses spend for investment, consumers for goods, I THINK, FIGURE THIS OUT, BUT THIS IS WHAT I WROTE) -That's the transmission mechanism between changes in money supply and economic activity -Also leads to inflation if you start at optimal employment -For monetarists, INFLATION IS ALWAY A MONETARY PHENOMENON Some of Their Arguments: 1) An increase in money supply (they use M2, not M1) will give rise to an increase in economic activity with a lag of 6-9 months (after 6-9 months) 2) An increase in M above the potential rate of growth of the economy will give rise to inflation after a lag of 12-15 months...and this is only a monetary phenomenon...let's see how they explain that -Suppose the price of petroleum increases because of OPEC cutting supply -Isn't that creating inflation? used to produce other things, affects those prices -Monetarists say no, the reason is that the Fed increases M to accommodate for the change in petroleum prices -Argue if they didn't increase M to accommodate, Money Income will remain the same, people will have less money for other things, so other prices have to go down (kind of what we're saying with gas prices down and other prices up today) (price of something else decreases because demand decreases, FIGURE THIS LOGIC OUT) -So a RELATIVE PRICE CHANGE, not an ABSOLUTE PRICE CHANGE...one price up, another price down -Another argument: When unions fight for a wage above productivity, they do not cause inflation, will cause UNEMPLOYMENT, if wages up, price of good up, then relative price change thing again, OR PEOPLE COULD BUY LESS, so union loses jobs...(ONLY WOULD BE INFLATION IF MONEY SUPPLY INCREASED TO ACCOMMODATE AND THEN JOBS AREN'T LOST? MY NOTE BUT THINK IT MAKES SENSE, REVIEW AND FIGURE THIS OUT, WRITE DOWN ALL OF THESE EXAMPLES AND MEMORIZE, LOOK UP ALL OF THESE THINGS ON INTERNET TOO, THESE THEORIES/FRAMEWORKS) So Monetarism: -Argues changes in money supply is the most important factor affecting the economy (For Keynes, it was spending, consumer and investment? REVIEW, FIGURE THIS OUT, BE ABLE TO COMPARE) -There is a direct relationship between changes in money supply and changes in economic activity (ASSUMING WE START WITH OPTIMAL EMPLOYMENT SO EVERYONE HAS AN AMOUNT OF CASH BALANCES THEY ARE SATISFIED WITH) -So if Fed increases money supply more than whatever is needed to make up the (potential? my note here) rate of growth in the economy, then people get more cash balances than they want, and they spend (consumer and investment) -Lag of 6-9 months before they spend the money -And if increase above economic growth, 12-15 months then inflation? -(If they increase above what is needed to satisfy the demand for money, for optimal employment and potential economic growth, VERY IMPORTANT LOGIC/POINT HERE, FIGURE OUT AND UNDERSTAND AND REVIEW) -Inflation is ALWAYS AND ONLY A MONETARY PHENOMENON -Eg petroleum price increase decided by OPEC, cartel, restrict supply (see notes from last class) -Monetarists say this won't cause inflation unless the Fed increases money supply to meet demand (higher) due to higher prices, if not, prices of something else will go down, so a relative rather than absolute price change (WRITTEN BETTER HERE, MAKES SENSE) -Labor union example too from last class, does not create inflation but rather unemployment (REVIEW/FIGURE OUT) -ANOTHER: Government by increasing deficit spending does not create inflation, gives rise to a change in the interest rate, which leads to a change in resources (a certain amount) of resources will go from private to government sector because of the increase in the interest rate (FIGURE THIS OUT? THIS ONE NEEDS WORK DOES NOT MAKE SENSE YET) -And works the other way too: if petroleum prices go down, should it create deflation? As long as money supply stays the same (SAME RATE, not necessarily the same right? just a relatively fixed rate, MY NOTE) things do not create deflation, consumers now have more cash balances, and will spend what they save on something else...(so demand for something else increases or for petroleum or what? maybe both? FIGURE OUT THE LOGIC HERE)...a lot of people have been saying this -Consumers have been spending more money, economy doing better, so it works when prices going up or down 3) Besides those 2 things? (FIGURE OUT/NUMBER THE ARGUMENTS) monetarists argue that external shocks to the economy (eg OPEC gets together and decides to increase petroleum prices, or bad weather, not internally created by internal economic forces, hurricanes, war, etc) will work out in the economy in a fairly long period of time, monetary authority does not need to increase/change money supply to accommodate for the external shocks (FIGURE OUT THE LOGIC HERE) 4) Given all these things, the monetarists argue that the Fed Reserve System should expand the money supply at a fairly fixed rate, so everybody will know how much it is going to expand, and if everybody knows, then everybody will make their projects, purchases, etc...know how to plan (WHAT IS THE LOGIC HERE? FIGURE IT OUT) -Finally, because of all this, monetarists argue that the Fed Reserve System should use a basic rule as opposed to authority to make decision/changes whenever they want to, want to take the authority away from the Fed and give them a rule to follow (IMPORTANT, DO NOT LEAVE THIS ONE OUT) -WHy have we never really accepted this as a monetary policy? even though some chairmen/presidents are/know monetarism...QUANTITY THEORY OF MONEY IS KIND OF A PRODUCT OF MONETARISM EVEN IF THE FED MAY NOT FOLLOW IT THAT WAY, ESPECIALLY IN THE SR -Most important reason is that when Congress established the Fed, it gave the Fed two objectives: 1) Low inflation 2) Low/optimal unemployment -Sometimes these two goals conflict, eg increase interest rates to decrease inflation (IMPORTANT LOGIC), cut down economic activity, so balance those two goals (VERY IMPORTANT LOGIC ON HOW THIS WORKS...THINK ABOUT WHAT DOING WITH OPEN MARKET TO CAUSE INCREASE IN INT RATES, DECREASING RESERVES, SO DECREASING MONEY SUPPLY, SO LOWER SUPPLY OF FUNDS AND HIGHER INT RATE? MAKES SENSE BUT VERIFY, MAKE SURE THIS IS THE RIGHT WAY TO THINK ABOUT IT) -Union example, causes unemployment somewhere (COULD BE SOMEWHERE OTHER THAN THE ONE FIRM? FIGURE THIS OUT BUT MAKES SENSE IF OTHER FIRMS WAGES DON'T GO UP TO KEEP PEOPLE THERE OR SOMETHING? FIGURE THIS OUT VERY IMPORTANT LOGIC TO UNDERSTAND/FIGURE OUT)...so Fed intervenes, may lower the interest rate if unemployment going up (to increase economic activity and therefore the need for more employees, MY NOTE BUT SEEMS TO MAKE SENSE, FIGURE THIS OUT) -Monetarists say the interest rate should be determined by the market and the Fed should only take care of the Money Supply (IMPORTANT, BUT WHAT DOES THIS MEAN? NO OPEN MARKET STUFF? THINK ABOUT THIS) -Lags a problem too, during lags other things could happen, so difficult to just work on a rule and take away other authority (IMPORTANT) -Even though monetarism did bring some order -End of Monetarism discussion

Rational Expectation Theory

Background: -Also from the University of Chicago (like Monetarism) Arguments/Key Points: -Let's say unemployment increases, (and) economic activity decreases, what do people expect? -Government will start some fiscal policy, spend more money, Fed will decrease interest rates -By rational expectation, people know/expect this before these things happen, and if you expect it (eg what the government/Fed are going to do) you start buying bonds, buying stocks, and this reduces the interest rate without the Fed needing to (HOW? DEMAND SHIFTS OUT?), so under rational expectation, people act before the Fed/government acts, and do whatever the Fed/government was going to do (was expected to do, my note) so the Fed/government don't need to do it anymore -Do people behave that way? Some do, but not really enough to prevent the need for monetary/fiscal policy, or whatever...

2) Wicksell Interest Rate Theory

Background: -Swedish Economist, Knüte Wicksell, wrote Lectures in Political Economy book...in 1890 -Wicksell concerned with why countries had bouts of inflation -Concerned about finding a way to reduce inflation -Because of this writing we created the Fed Reserve in the US -Before Wicksell, no Legal Reserve Requirements, banks made own decisions -Wicksell's work helped Congress establish the Fed in 1913...the result of the Aldridge? Commission? Arguments/Key Points: -Argued at any one time in the economy we have two interest rates: 1) Natural Rate of Interest (Technologically determined, what does this mean?) 2) Market Rate (What banks charge you) -In the LR, the two are equal -In the SR, they are different, and that difference is why we have inflation -Friday Week 8 Economic Data discussion...CPI etc...price index for quantity theory of money...bank reserves for loan losses, oil prices...GDP variables and percentages... -Not a whole lot different from classical in the LR, but in the SR, two interest rate, one which is the market rate, and one which is the natural rate GRAPH -Market rate is determined by institutional factors -Natural rate is determined by technological factors -In the LR, have to be equal, because if natural rate higher everyone rush to invest to put up, and if lower, would postpone investment? (FIGURE OUT THE LOGIC HERE) -The difference in the SR between the natural rate and the market rate causes inflation -So in the graph above, then let's assume a technological change increases the MEI (expected rate of return on new investment, WHAT KIND OF INVESTMENT? SEEMS LIKE WOULD BE BUSINESS OR ANYTHING? BUT NOT STOCKS RIGHT? WHO KNOWS? (NOT SURE FIGURE THIS OUT, VERY IMPORTANT))...so at the same interest rate you invest more, MEI to MEI1 -According to classical model, savings increases -r0 to r1...natural rate up (which is determined by supply and demand? my note) -Back then no LRR, so banks loan out more to be used for investment -If have excess reserves, can lend money at the same market rate as before? -So keep providing loans at the same rate as before -F0 to F1 -What supplies funds from F0 to F1 is an increase in money supply, the increase in funds from F0 to F1 does not come from savings (as in classical), but banks keep same market rate, VERY IMPORTANT LOGIC -So that change in funds available as banks loan more (increase in money supply, delta M), leads to ST? delta M, which keeps market rate the same -So money supply important here, and had nothing to do with interest rates in the classical mode, VERY IMPORTANT -Assume optimum employment at start, when MEI increases, firms need to hire more, but already at optimum, have to take workers from other firms, so pay them more, so wages go up -Firms that did not experience the change also have to increase wages to keep employees from leaving -So if start from optimal unemployment, increase wages, and when wages increase, prices increase or else you lose profits, VERY IMPORTANT, SO THIS IS INFLATION -So at the end of this is the natural rate back to r0? Don't know? Don't think so? Seems like it if it depends on supply and demand? I THINK I ASKED HIM AND HE SAID NO, but probably irrelevant -So starting with r0, r0 same at optimal employment, then technological change (positive, increases productivity), savings doesn't increase, change is from delta M? -In this case, bank is acting passively -But banks could act actively and create the same problem, if they have excess reserves, they can buy government securities, an alternative to loaning it out (if not technological change where the money supply increases from tech change)...so banks can create the same problem just by having excess reserves they don't need?...IMPORTANT...(AND WOULD THIS INCLUDE LIKE FED FUNDS LENDING OR WHAT? FIGURE OUT THIS THEORY) GRAPH -Banks have excess, buy securities, D0 to D1, Po to P1, so interest rates decrease (inverse relationship) -Now have lower int rates, increase in economic activity, Consumption up, Investment up, and if you start at a position of optimum employment, AGGREGATE DEMAND (WHAT IS THIS? DEFINE) increases, but supply not increased because start at optimum employment?...so prices go up, inflation -Lower interest rates, higher demand (C and I up), prices up, prices up means inflation -So those are two arguments Wicksell made to explain inflation, VERY IMPORTANT TO WRITE DOWN THE TWO ARGUMENTS, BOTH PASSIVELY AND ACTIVELY FOR BANKS -Congress in charge of regulating money and credit...Aldridge Commission (came out in 1907)...suggested government should regulate banks, Legal Reserve Requirements (LRRs), etc...prior to that no LRRs...because of Wicksell writings, Congress created Fed in 1913 and delegated to it the control of money and credit (SO CONTROL BANKS TO PREVENT INFLATION...CONTROL THEIR EXCESS RESERVES? IN BOTH CASES OR JUST THE 2ND ONE? WOULD IT WORK IN THE FIRST ONE BY NOT LETTING THEM LOAN AT THE SAME MARKET RATE? FIGURE THIS OUT VERY IMPORTANT LOGIC AND CONCLUSION) -People helped by MEI increase go borrow from banks, which leads to delta M, creates money -Natural rate remains above the market rate after supply up from delta M, so still diff? (just diff in ST, figure this out, probably irrelevant, but it was your question in class) GRAPH So not (mkt?) rate up when MEI up -In Wicksell case, natural rate goes to r1, and if banks create money by making loan, they can keep the same market rate, but not rate r1, market rate less than natural rate because banks create money by making loans VERY IMPORTANT SO MAKES SENSE WHY REGULATING THEM WITH LRRs WOULD HELP -And if not equal, and start from optimal employment, get inflation -And this is why LRRs...Fed decided to regulate -Of course does not completely eliminate inflation, money supply still changes, IMPORTANT Expect these questions on the final exam WICKSELL IS IMPORTANT, THE REASON WE CREATED THE FEDERAL RESERVE

1) Classical/neoclassical Interest Rate Theory:

Background: Begins with 1776 Adam Smith Wealth of Nations book...also in this year Declaration of Independence, and beginning of Industrial Revolution -In Wealth of Nations, argued that man, when left alone does what is good for themselves, but this is also good for the country -So introduces economic freedom? -Political freedom with Declaration of Independence -And Industrial Revolution -Classical/neoclassical ends with John Marshall in 1924? maybe?...so fairly long period of time... -Based on Hedonistic Philosophy: -Hedon argued that man in making economic decisions looks at the sacrifice and the return, and tries to maximize pleasure and minimize pain -And saving is painful, want to spend today, but have to postpone consumption, and that is why you have to be paid an interest rate Arguments/Key Points: -Classical economists argue that interest rates are determined by the supply and demand of savings -It is a real interest rate determined by the supply and demand of savings -And money (supply? my note) doesn't have anything to do with it GRAPH -How much we save is a function of the interest rate, and the interest rate is a payment for postponing (purchase or investment?) consumption...payment for postponing consumption -Hedonistic Philosophy (above) -Investment (business makes (LIKE GDP I? MY NOTE)) depends on the MARGINAL EFFICIENCY OF INVESTMENT, which is the expected rate of return on new investment -Lower interest rate means more investment, the interest rate is the cost of making the investment (because borrow money, etc? logic? my note) -Return - Cost? My note think about this makes sense, what was I saying here? -In equilibrium condition, saving and investment must be equal...S and I must be equal at all times? (in equilibrium?) -If people decide to increase savings...or if MEI increases due to better equipment, technology, etc... GRAPH -So savings and investment are always equal, and both depend on the interest rate -Changes in one change the interest rate, which changes the other one? IMPORTANT, THINK ABOUT THIS -S = S(r), I = I(r), S = I -WHAT MAINTAINS S AND I EQUAL IS THE CHANGE IN INTEREST RATE, IMPORTANT, THINK ABOUT THIS -Quantity of S, I always the same on x axis, makes sense -Classical economists argue that a man/person acting rationally will not hold any cash balances except for what is needed for transaction purposes, IMPORTANT -Transaction purposes means amounts of money to pay rent, tuition, buy groceries, etc...money you need to spend soon -And those are the only reason people hold cash balances, otherwise put in savings or invest it? to get a return/interest? -DOES SAVINGS MEAN STOCKS, BONDS, ACCOUNTS, ETC? WHAT DOES IT MEAN HERE, IMPORTANT -So for this theory, demand for money is only related to transaction purposes -Demand for savings depends on MEI?...Demand for savings? THINK ABOUT THIS...HOW? HOW DOES THIS MAKE SENSE?, FIGURE THIS OUT, IMPORTANT MEI GRAPH Why downward sloping? Means int rates down, the amount of investment increases Because in any one period of time there are hundreds of investment opportunities, some pay 10%, 5%, 2%, etc... If high interest rates, few opportunities for investment? MAKES SENSE...(few give that high return? my note) -Invest at a point where int = return (at least, my note), after that stop investing, because interest rate is cost -Classical economists say interest rates will always be positive, so will always have investment opportunities and good to invest, rationally should invest as long as interest rate does not equal 0 (DOES THIS CONTRAST WHAT'S GOING ON NOW? OR IS IT NOT ACTUALLY 0% INT NOW FOR PEOPLE, IMPORTANT CONCEPTUALLY FIGURE THIS OUT) -If you assume always investment opportunities that give positive rate of return -Classical economists argue inequality in the distribution of income is good...why? (argued for income inequality, IMPORTANT0 -They argued the more savings you have, the greater is the investment, and the faster is the rate of economic growth -And in order to get a high level of savings, know rich people save more than poor, which leads to more investment and economic growth -So to have fast economic growth, need inequality, IMPORTANT (that's what they argue, and we find out maybe not a good argument) IMPORTANT, REVIEW AND UNDERSTAND THIS

3) Keynes Interest Rate Theory

Background: -John Maynard Keynes -1931 Keynes Treatise on Money...expanded on his liquidity preference model -1938 Keynes General Theory of Money, Income, and Employment -1919 Keynes Economic Consequences of Peace Treaty (after WW1)...predicted German inflation in that book, reparations...Germany paid off all debts, extreme inflation...some historians argue this inflation gave rise to the Nazi Party -Different theory -Suggested interest rate payment was made to get people to give up liquidity (cash most liquid, and if invest, less liquidity) -For classical economist, it was to postpone consumption -Keynes divided demand for money into two parts: 1) Demand for Transaction Purposes (same as classical and Wicksell) 2) Demand for Speculating Purposes -Argued that a rational person/man could hold cash balances for other reasons than just transaction purposes (as in classical)...speculating purposes Arguments/Key Points: -Distinguishing factors: For Keynes, interest is the payment for departing with liquidity (and cash balances are the most liquid, WHAT ARE CASH BALANCES, DEFINE) -For Keynes, interest rate is determined by the supply and demand of money, IMPORTANT (for classical it was the supply and demand of savings...and for Wicksell what was it?) -Divided demand for money into two parts: 1) Demand for money for transaction purposes (Mt) 2) Demand for money for speculating purposes (Ms) -For Keynes, man acting rationally can hold cash balances for purposes other than transaction purposes (vs classical, only for transaction purposes) -May be better to keep cash than a gov bond...if market int rate goes up, bond value down, so would have been better off not buying, keeping cash (if bond value drops more than the int payment you get on bond, lose more in principal than gain in int, if was a perpetual bond, bond value diff, but still has a value so compare gain?) THIS IS SPECULATION RIGHT? -So Keynes argued that it is possible to be rational and hold cash other than for transaction purposes (was above an example of speculating? FIGURE THIS OUT) Gov Securities...bidding, government takes best bid, and that becomes the market rate of interest (for that period, the term on the bond/sec? MY NOTE)...IMPORTANT...so supply/demand? but that's just primary market then supply and demand after that changes market interest rate right? IMPORTANT, FIGURE THIS OUT LIQUIDITY PREFERENCE CURVE Demand for Money = M = Mt + Ms -When interest rate are high, the demand for money for speculative purposes becomes inelastic, don't want to hold cash balances for speculative purposes, for two reasons: 1) Interest rates high, high returns 2) If interest rates are high, expectation is for them to get lower, which would increase the value of bonds, so principal value up -So want to buy bonds...(is it just bonds? does it work for other investments too? IMPORTANT, stocks? if expect int rates go down, buy stocks too right? Inverse relationship, REVIEW THOSE FORMULAS for assets) -So don't want to hold money for speculating purposes...(but still need for transaction purposes, that doesn't change, RIGHT? MY NOTE) -When interest rates very low, demand for money for speculative purposes decreases, for two reasons: 1) Returns low, so making very little money (int rates) 2) Expectation is for interest rates to go up, and as interest rates go up, bond value goes down (WHY EXPECT IT TO CHANGE WHEN ITS LOW OR HIGH? ECON ACTIVITY RELATED? THINK ABOUT THIS AND FIGURE IT OUT) ON FINAL EXAM: THE DEMAND FOR MONEY IS DETERMINED BY 3 FACTORS (UP TO NOW IT WAS 2): 1) Inflation (Inflation up, demand for transaction purposes increases, need more) 2) Economic Activity (If up, more things to sell(/buy, right, my note) need more money 3) Changes in Interest Rate (AT LEAST FOR SPECULATIVE PURPOSES, CHANGES AS ABOVE IN THE LIQUIDITY PREFERENCE CURVE AND EXPLANATIONS) VERY IMPORTANT, KNOW THIS IF ASKED FOR THE THREE THINGS -Different people in the economy have different liquidity preference functions (each individual)...Liquidity preference function is more or less the average of all the individual ones...IMPORTANT GRAPH GRAPH (TWO GRAPHS HERE, IMPORTANT) -Demand for money for transaction purposes is interest inelastic, IMPORTANT, need for transaction purposes regardless (of interest rates, right?) (FIGURE OUT WHAT ELASTIC AND INELASTIC MEAN AND USE THEM IN TEST ANSWERS) -But people may try to postpone or spend less if interest rates high? opp cost of holing money increases, but for all practical purposes it is inelastic in relation to interest rate -M0 money supply for Keynes, same as for classical, MONEY SUPPLY IS GIVEN (DECIDED BY FED), VERY IMPORTANT, ADD THIS TO CLASSICAL...so interest rate is determined by supply and demand of money -For Wicksell money supply was not important? Maybe he said? REVIEW, COMPARE THE METHODS, IMPORTANT -Keynes books Another difference between Classical and Keynes: -Classical said savings was a function of interest rate, but Keynes said that was wrong, and said tat saving was a function of THE LEVEL OF INCOME -But for Keynes too savings had to = investment...for Classical, changes in interest rate kept this true, but for Keynes, it was kept true(/equal? my note) due to changes in THE LEVEL OF INCOME...SO CHANGES IN LEVEL OF INCOME KEEP I=S FOR KEYNES...REVIEW/MEMORIZE THESE DIFFERENCES, VERY IMPORTANT Who was right? -In the past 3 or 4 years interest rates went down to 0, or just about 0, and savings accounts at banks went up, total savings and CDs went up quite a lot...Much of savings basically due to income, and some changes due to interest rate (so both, mostly income), VERY IMPORTANT CONCEPT So: Classical: S = S(r), I = I(r), S = I because of fluctuations in interest rate (THINK ABOUT THIS LOGICALLY, FIGURE IT OUT) Keynes: S = S(Income), I = I (INCOME?) (I THINK INCOME, BUT MAKE SURE...COULD BE R TOO, HE MIGHT HAVE WRITTEN R, VERY IMPORTANT S = I because of fluctuations in income (IF ONE FUNCTION OF INCOME, AREN'T BOTH? FIGURE THIS OUT AND LOOK IT UP, COULD GO EITHER WAY)

Houses/Businesses Money Supply Charts

DRAW OUT Average money supplies for periods, IMPORTANT CONCEPTS, for m = 100 (= M2, my note)

T-Accounts #4: Commercial Bank Borrowing from the Federal Reserve Bank (2nd Source of Short Term Funds For Banks)

FED: Loans and Discounts (Assets) increases by $1,000,000, Member Bank Deposits (Liabilities) increases by $1,000,000 Commercial Bank: Deposits with FED (Assets) increases by $1,000,000, Borrowings from FED (Liabilities) increases $1,000,000 Commercial Bank: Total Reserves: + $1,000,000 Excess Reserves: +$1,000,000 (1,000,000 - .10 x 0) Required Reserves: Unchanged, because Demand Deposits are unchanged Legal Reserve Requirements are only on Demand Deposits, only based on Demand Deposits So, Total/Excess Reserves for the entire system increase by $1,000,000

How The Fed and Treasury Can Modify The Yield Curve

Fed Uses Operation Twist: Sell LT and buy ST, not spending any more than before, buy same amount you sell, that modifies the yield curve, not a whole lot...sell one side of the curve and buy the other side of the curve How Does/Can The US Treasury Modify The Yield Curve? -US Treasury takes longer than Fed, but can concentrate on one side of the curve in selling bonds (its always selling so many billions, etc, he said, MY NOTE)...eg sell all ST, and increase the ST interest rate (HOW? LOGIC HERE, IMPORTANT TO REVIEW AND FIGURE OUT), or concentrate on LT, so can modify the structure of the debt/bonds that represent the debt, can shorten or lengthen the maturity of the debt, which modifies the yield curve (IMPORTANT FIGURE THIS OUT WITH OTHER YIELD CURVE STUFF) Not Going To Discuss The Taylor Rule

Venture Capital

Finances startups/young companies First Round (startup has to have 5 year (maybe 10 year) business plan....corporation....$1,000,000 at $1/share Second Round (VCs know you need more money, but as long as you show you have followed the plan, the VCs will give you more money...if plan going well...$5,000,000 at $5/share...value has gone up Third Round (Things going well, need to hire management)...$5,000,000 at $6/share IPO (now need a lot more money, to get that want to go public, hire I Bank...$50,000,000 at $15 share...sell shares to general public (through I Bank) VC knows its equity money, know (most?) going to fail, not get $ back...company doesn't pay interest on that capital...it is EQUITY CAPITAL Apple, Microsoft IPOs...stock jumped up a lot first day...there was no way to find out what price was going to be, there were no similar companies on the market (unique products)...so company got less money

Futures Market (Better define the three agents, and how to use for FX and Int Rate futures) (IMPORTANT)

Future Markets, Markets for Future Contracts (for int rates, foreign exchange/currency, agricultural commodities, metals, etc) -First in agricultural industry 3 Agents Work in Future Markets: 1) Hedger 2) Speculator 3) Broker/Dealer 1) Hedger: Producer or buyer of a particular commodity...not interested in price fluctuations? wants to protect itself against future price changes (IMPORTANT) 2) Speculator: Takes advantage of price changes (in future? my note) 3) Broker: Makes the transaction/sale for 3rd party or himself (DEFINE ALL 3 OF THESE BETTER) -In Santa Clara County, most corporations that use futures try to protect themselves against price/currency changes, so they buy or sell futures Say Petroleum prices are rising each month: -Say you're an airline, know how much fuel you need per month, and know fuel is your 2nd largest expenditure behind personnel, see that prices are going to go up, and have good prices now...So say for June, you buy a contract today for delivery in June, or say December (AIRLINE HEDGER HERE) -Airlines don't make price of ticket lower, just make more rev when oil is low price -Producer of oil can do same thing too, and agree to sell at $34.10 (the higher projected June price?) for June, so protects against price fluctuations -So companies could do the same thing for Euro, if selling there, futures etc to protect against fluctuations in value of $ -Could use futures to see what economy going to do, what people think economy going to do -If Euro future goes up, means for Europe that the economy doing better (people think European economy going to do better, (more foreign demand/investment? my note)) -Eg Venezuela Bolivar, a year ago, 200 to $1, today on black markets 2,760 to $1...so protect yourself, if selling to them and getting paid later, buy futures Better define the three agents, and how to use for FX and Int Rate futures (IMPORTANT) -So that's all we are discussing for financial markets

4) Hicks and Hansen Integration of Classical and Keynes Theories, Coordination of Fiscal and Monetary Policy

GENERALLY THIS IS ON THE FINAL EXAM: Background: -Didn't collaborate, came to same conclusion separately -JR Hicks and AH Hansen Arguments/Key Points: -Argue that if we accept savings as a function of income (from Keynes), then the Classical Theory of Interest cannot give us the interest rate, and Keynes' Interest Rate Theory does not give us the interest rate either -Argued that in order to write savings function, you have to know the level of income, but in order to know the level of income, you have to know the level of investment, which requires you know the interest rate, but to know the interest rate you have to know the level of savings, for which you have to know the level of income...so the interest rates in both models are undeterminable if we accept Keynes conclusion that savings is a function of income GRAPH -In order to know the savings function, have to know the level of income, so they provided a function for each level of income...so you have to know y, which equals level of income -At each of these points, S=I at a different level of income and a different interest rate -As the level of income increases, savings is increasing -So that was with the classical model -And they did the same thing with Keynes model -They argued that Keynes interest rate was undetermined, because in order to know Mt, you have to know the level of income, then go through same thing, to know income you have to know investment, and to know investment you have to know the interest rate, for which you need to know savings, for which you have to know income...loop? (DOES THIS WORK LIKE A LOOP? HOW DO YOU COME BACK AROUND TO Mt?) GRAPH -So for different levels of income, there are different Mt and therefore M, and different interest rates Two parts of the economy: 1) Monetary 2) Real (produce products) -These have to be in equilibrium, and what keeps them in equilibrium is interest rates Equilibrium in the Real Sector: Requires Savings and Investment To Be Equal For Equilibrium GRAPH (FOUR GRAPHS) -This series of graphs gets you the IS Curve...connecting the various equilibriums...every point on the IS curve gives us an equilibrium where S = I at a particular r and y -This solves the classical condition where you have to know the level of (? what) to know...(have to know level of income, then loop...etc...REVIEW, FIGURE THIS OUT) -So this was Hicks and Hansen's solution for the real sector Equilibrium in the Monetary Sector: Requires Demand and Supply of Funds To Be Equal For Equilibrium GRAPH (FOUR GRAPHS) -This series of graphs gets you the LM Curve...each point on the LM Curve is an equilibrium where Demand for Money and Supply of Money are equal at a particular r and y -So equilibrium in real sector solves some problems of classical, and equilibrium in monetary solves some problems of Keynes (IMPORTANT) General Equilibrium In The Economy: Must be one left of income, one interest rate (one level of money supply? FIGURE THIS OUT), LM = IS GRAPH (LM AND IS CURVES TOGETHER) -Previously, (past two graphs, or series of four graphs) had a lot of interest rates and levels of income, but for general equilibrium -Because of this integration between Classical and Keynes by Hicks and Hansen, we found that interest rates and the level of income are co-determined by four variables: (IMPORTANT TO MEMORIZE) 1) MEI (expected rate of return on new investments, represented by I) 2) Marginal Propensity to Consume (which tells us given a certain y, how much consume and how much save, represented by S?) (determines level of S) 3) Ms (demand for money for speculative purposes, gives us that L (From liquidity preference? MY NOTE, FIGURE OUT/REVIEW) 4) M (Money Supply) (Represented by M) -So that's four variables, LM and IS -So interesting things...savings is important in determination of level of income and r, from Classical, but money supply (and demand for money, is this my note or not? seems right, Ms...demand for money for speculative purposes) is also important, which is part of what Keynes argued (IMPORTANT POINT) -IS Curve generally shows us what happens with all changes in FISCAL POLICY, look for changes in economic, activity, r, and y...IMPORTANT CONCEPT -LM Curve gives changes in r and y from MONETARY POLICY (and can probably get changes in economic activity from that, my note) -Later we show that Fiscal Policy and Monetary Policy need to work together to achieve best results -Monetary Policy: Use of monetary system to influence levels of economic activity (IMPORTANT) -Fiscal Policy: Use of taxes, government money, government budget to influence the level of economic activity (IMPORTANT, MIGHT WANT BETTER DEFINITIONS FOR THESE TWO AND HOW THEY WORK) All of you should be able to answer: -Assume we have an EXPANSIONARY FISCAL POLICY -IS shifts right -Eg technological change increases MEI, or Congress cuts taxes, increasing consumer spending, eg....or building roads...(FIGURE OUT THESE EXAMPLES AND MORE) GRAPH Why does this increase interest rates? (IMPORTANT) -Why does the interest rate have to go up with change in Fiscal Policy alone? -As income (y) goes up (due to fiscal policy change), Mt goes up (demand for money for transaction purposes) -Money supply remains constant, so where get more money for the increase in Mt? Ms has to go down, the demand for money for speculative purposes has to go down, given that money supply is constant (IMPORTANT LOGIC HERE) -Diagrams show this (SERIES OF FOUR GRAPHS) -Ms decreases, and Mt increases, when money supply is constant, so that's why interest rate has to go up -But if Fed increases money supply, r does not have to go up, which lets us increase income without interest rates increasing, SO THIS IS WHY ITS BEST TO WORK TOGETHER -Inflation depends on what employment level, wages, etc (FIGURE THIS OUT IN THIS CONTEXT...IMPORTANT) Labor Department statistics discussion GRAPH -So best result is a coordination of fiscal and monetary policy -1981 example, cut taxes during recession, which is an expansionary fiscal policy so IS Curve shifts right -At the same time, the Fed chairman went to Congress and said inflation is Public Enemy #1, so the Fed is going to cut the growth of money supply to reduce inflation (sacrificing growth in employment, sacrifice they had to make, the American people, to control inflation) -Fed drastically cut the money supply, so the LM curve shifts in, money supply reduced -Prime interest rate (rate banks charge their best customers), went from 7.0% to 21.5% quickly -SO THIS WAS EXPANSIONARY FISCAL POLICY AND RESTRICTIVE MONETARY POLICY (I THINK THAT'S WHAT I WROTE) -So interests rate got really high, people postponed buying/borrowing, investment, construction, and economic activity went down a lot, so that is why there was a big recession (less economic activity (DEFINE RECESSION BETTER, I THINK THIS IS WHAT IT IS THOUGH)) -Very few investments where expected return can give you something more than 21.5% back (IMPORTANT, REVIEW/REMEMBER THAT INVESTMENT CURVE, THIS MAKES SENSE IN THAT CONTEXT) -Then Fed put more money out, money supply, to help fix recession -Fed did decrease inflation, but also recession -If they want to, Fed can reduce inflation, has the tools, but causes recession -The problem is they cannot really increase economic activity the way the want to? IMPORTANT, QUESTIONS ON THIS STUFF ON FINAL EXAM SO TWO THINGS TO TAKE AWAY: 1) Both Fiscal Policy and Monetary Policy should be used, but need to be coordinated (these changes had higher int rate, but not really higher income (REVIEW GRAPH, FIGURE THIS OUT)) 2) GRAPH -At very low levels of income, it is better to use fiscal policy than monetary policy...LIQUIDITY TRAP...not going to change much with money supply? but change with fiscal policy, increase income with very little interest rate change (IMPORTANT)...(at low income, Mt perfectly inelastic? or elastic? FIGURE OUT ELASTIC VS INELASTIC) -When LM Curve becomes inelastic, use just monetary policy...change in fiscal policy does not change very much -In between, use both, increase y with little change in interest rate? -THIS STUFF MAKE SENSE LOOKING AT THE GRAPH, DRAW IT CLEARLY AND FIGURE IT OUT -There a point that if that is optimum employment, fiscal/monetary policy after that gives us inflation (THINK ABOUT IT LOGICALLY, SHOULD MAKE SENSE, FIGURE IT OUT) -So this is the end of Hicks and Hansen's integration of Keynes and Classical Interest Rate Theories

Balance of Payments

Getting into exchange rates, international capital flows, currency movements, etc... Balance of Payments: A system of social accounting (like GDP, social accounting) where all the transactions between one country and the rest of the world are listed/included -It balances, 0, except for statistical discrepancies (Mostly due to difficulty of counting) Divided Into Three Parts (FIGURE THESE OUT/DEFINE BETTER): 1) Current Account: Includes the BALANCE OF TRADE of goods and services, BALANCE IN THE INCOME ACCOUNT (difference between...? FIGURE OUT)...income earned abroad (people working here send money home to other countries and Americans abroad too, so they are included in the Current Account), also included UNILATERAL TRANSFERS...(eg, government gives economic aid, not buying goods or services, giving money) -In the US today, we have about -$500 billion balance in the Current Account, so we have purchased from abroad or sent abroad larger amount of goods or serves larger than what foreigners haver purchased from us (or what we send back from abroad? MY NOTE, IMPORTANT, FIGURE THIS OUT) -So about $500 billion trade deficit? (IS IT ALL JUST TRADE DEFICIT, FIGURE THIS OUT AND DEFINE IT, TRADE DEFICIT VS CURRENT ACCOUNT DEFICIT?) -But BALANCE OF PAYMENT? is 0, so ti comes back to the US in the CAPITAL ACCOUNT? (FIGURE THESE THINGS OUT) -Most $s we pay people abroad tend to come back to us in the form of 1) PORTFOLIO INVESTMENT (foreigners purchase stock, bonds, MBS, etc, HAVE NO CONTROL OVER THIS KIND OF INVESTMENT (FOREIGNERS DON'T)) (China and Japan have trillions of our Government bonds) and 2) DIRECT INVESTMENT (FOREIGNERS DO HAVE CONTROL OVER IT, eg company, land, hotel, bought by foreigner) (Department of Commerce considers 20% (or more, my note) of stock of a company DIRECT INVESTMENT...(enough control? I think he said, my note) -So if we add these things up, very close to 0? but statistical discrepancy -REMEMBER HOW WE SAID WE HAD DEFICIT BUT NOT CROWDING OUT EFFECT BECAUSE FOREIGNERS PUTTING MONEY IN, REVIEW IN THE CONTEXT OF DEFICIT FINANCING METHODS, MAKES SENSE... (NEED TO BETTER FIGURE OUT AND DEFINE THE THREE THINGS/ACCOUNTS AND HOW THEY ARE AFFECTED)

Graph #2: Interest Rate vs Investment

Higher interest rates lead to less investment, downward sloping line...the slope of the line is the Marginal Efficiency of Investment? The expected rate of return in making a new investment? (this seems constant though, REVIEW THIS)

The Federal Reserve System (History/Creation, Organization)

History/Creation: -The Federal Reserve System is the US Central Bank (every country has a central bank) -Created by Congress in 1913 -Established as an independent bank/agency (Does not have to go to Congress each year for a budget, does not depend on Congress or the President, does not take orders from them either -Article 1 of the US Constitution says Congress has the power to control money and credit, but in 1913 Congress created the Federal Reserve System and gave the Fed this power -Federal Reserve System decides (monetary policy, I think) so the Chairman of the Fed has more economic power than the President and Congress Organization: -Board of Governors: -The Board of Governors consists of 7 governors, in Washington DC -Appointments made by the President and confirmed by the Senate -Each member of the Board of Governors is appointed for 14 years on a staggering 2 year basis (new person appointed every 2 years) (so in 4 or 8 year term, a single President can only appoints 2 or 4 members, respectively) -Of the 7 members, 1 is the Chair, 1 is the Vice-Chair, and both the Chair and Vice Chair are appointed as Chair/Vice Chair when they are originally appointed, but the Chair/Vice Chair appointments are only for 4 years (but overall 14...chair chosen from sitting board members, probably not too important..., just not all as Chair? current chair is Janet Yellen, and current Vice Chair is Mr. Fischer) -12 Federal Reserve Banks: -The country is divided into 12 districts, (each district bank has less power) -Do not have monetary policy power -Each of these 12 banks has a 9 member Board of Governors, 3 are appointed by the Board of Governors (overall one I assume), 3 are appointed by bankers, and 3 are appointed by industry -Open Market Committee (MOST IMPORTANT PART): -Decides on monetary policy, interest rate, etc -Called the Open Market Committee because the committee (decides to) purchase(s) government securities, etc., and they must do this on the open market. They (The Federal Reserve System, my note) cannot purchase government securities directly from the Treasury/government, have to buy from you and I, other banks, etc... (the public) -12 people, 7 from the Board of Governors (overall one I assume), 1 is the President of the Federal Reserve Bank of New York, and the other 4 are Presidents of other Federal reserve (district, my note) Banks on a rotating basis (new 4 each year? I think I wrote that) -Each member votes on the monetary policy for the US -So that is how the Federal Reserve System is organized

What Interest Rates Consist Of/Are Made Up Of

How are interest rates formed? What is the market rate of interest made up of? Market Rate of Interest (Determined by supply and demand (of funds, money? WHAT, IMPORTANT, INVESTIGATE/STUDY) Is Composed Of: 1) Real Interest Rate (Corrected for inflation): -Basically what is determined by the SUPPLY AND DEMAND OF SAVINGS -Somewhere around 2.5%-3% in the US (3% probably for 30 years, 2.5% for 20 years, etc...varies based on maturity) -This is very close to what the country's REAL RETURN is? WHAT? 2) Expected Inflation: (If it is 2.5%-3.0%, then market rate of int would be 5.0% to 6.0%, so you add them together, they make up the Market Rate of Return) -This means if no inflation is expected, int rate would be much lower -Rate depends on maturity, of course -And this is how to look at changes in interest rates -Real int rate doesn't change that much unless demand for funds up a lot or investment up a lot, but uncommon -Inflation expectations cause changes, if you expect more inflation, market rate increases, and vice versa How do we know what expected inflation is? -CPI gives you actual, not expected Look to 2 places to find out what expected inflation is: 1) Comparison between the regular government (Treasury) bond and the TIP bond (Treasury Inflation Protected, protected against inflation), comparison of the yield/int rate (same thing, my note), so if regular bond is 5% int/yield, and TIP is 2.5% int yield, subtract TIP from regular and know that expected inflation is 2.5%, so in this case the market is telling us that the expected inflation for those 10 years (maturity) on the average would be 2.5% per year (I think per year, my note) 2) The Consumer Sentiment Index (University of Michigan publishes this twice a month, tells us expected inflation, from interviews) -Inflationary Expectation may not be right, but it is what the market is telling you is expected

Quantity Theory of Money, How the Federal Reserve System Decides How Much Money Should Be In the Economy At Any One Period of Time, LOTS OF IMPORTANT DETAILS

How does the Fed Reserve System decide how much money should be in the economy at any one period of time? -Under normal conditions, uses a very simple framework, called the Quantity Theory of Money Quantity Theory of Money: (Applies in the Medium/Long Term, not in the Short Term) Mv = Py M = M2 (as opposed to M1), the average money supply that exists in the economy (over/at? my note) a given period of time v = Average turnover (velocity) of M in the same period of time P = Average price level of all G and S produced in the economy in the same period of time...(Stands for GDP inflation?) y = Average level of output of G and S in the economy in the same period of time (Actual GDP?) So...: Py = Nominal GDP (at CURRENT PRICES, everything measured twice (on a real and nominal basis) P = Inflation (use it to pass between nominal and real (constant prices) GDP...GDP deflator? y = Real GDP When Department of Commerce gives us .7%, that is the real GDP, but they also tell us inflation IMPORTANT: Py represents the DEMAND FOR MONEY in any period of time 1) So if prices increase (P) (inflation), demand for money increases, takes more money to buy the same goods?) 2) If economic activity (REAL GDP) (y) goes up, Demand for money increases (more Goods and Services to buy) -Generally, both of these increase 3) Int rate affects this as well, when constant no change, when int rate increases, the demand for money decreases and vice versa, not a big change? When interest rates increase, the OPPORTUNITY COST OF HOLDING MONEY increases, rather have bonds, etc...and f you expect interest rates to go down, then bond value will increase, in addition to the fact that you're getting a good interest rate/high return...and conversely, when interest rates are low, opportunity cost of holding money is low, so hold more cash (more savings accounts? my note, less bonds/securities, etc...MY NOTE, IMPORTANT LOGIC) IMPORTANT: M represents the SUPPLY OF MONEY (Fed Reserve decides this, demand is more up to the economy) -And v is given, turnover is given, tends to be fairly fixed. v is institutionally determined (how fast/slow we make payments or how often we get paid, if get paid just once a year, need an amount of money equal to all of the income (total pmt), int, cap gain, etc, equals total payments -But if paid twice, need half and velocity equals 2 -If paid 4 times, need a quarter of the money supply (at any one time, my note), and v = 4 -Turnover means you get paid then spend, the faster the velocity/higher the velocity, the less total money supply we need (IMPORTANT CONCEPT) -Again, v is relatively constant, we do not make many changes, may be .1% per year, but for our purposes can be considered relatively fixed/constant for all practical purposes v = Py / m, and again, relatively constant And m = Py / v...the constant...(my note, but may be useful) -v is practically constant, given -Py represents very large part of demand for money -Int rate also matters, but if it does not change, Py is what matters -Low int rate, demand for money up, higher int rate, demand for money down, IMPORTANT CONCEPT, AND REMEMBER DEFINITION OF MONEY SUPPLY (M2 I THINK) HERE -Fed reserve system's goal is to obtain an inflation rate of around 2% per year, so DELTA P = 2.0% per year (change in P, change in prices) -So as long as this is near 2%, they do not interfere -This is true for most central banks -Why not below 2% inflation as a target/goal? Because they are basically concerned about deflation, and want to avoid that, so do not want to get close to 0% -Deflation is a decrease in prices, which leads wages to decrease, economic activity to decrease, so recession? -y represents the Medium/LR Potential rate of growth of the economy, the yearly growth in the American economy on average for the last 60 years (before Great Recession) is about 3.2% -So the Fed Reserve wants to achieve the potential rate of growth (REMEMBER, WITH INFLATION AND THIS ARE OBJECTIVES/GOALS OF THE FEDERAL RESERVE SYSTEM, IMPORTANT CONNECTION, so if we consider this 3.2%, then DELTA y = 3.2%....so assuming a constant v...Delta P of 2.0% + Delta y of 3.2% = DELTA M of 5.2% (INCREASE IN MONEY SUPPLY (M2) of 5.2%)...Increasing the money supply to maintain/achieve the potential rate of growth and the inflation goal -So this would say that M2 should be growing on average 5.2% per year in the Medium/Long Term -(how this has differed after Great Recession, potential lower, some argue that potential growth is now around 2.5% The Potential Rate of Growth, Potential Delta y (Potential Rate of Growth of REAL GDP) is made up of 2 things: 1) Delta Labor Force (Growth of labor force, generally 1.0-1.2% per year, from growing population and immigration) 2) Delta Labor Productivity (2.2%, Growing around 2.2% per year, except for last few years) Labor Productivity is the output per man hour (increasing at 2.2% in Long Run, but not last few years...New tech, processes, etc increase productivity, but last few years Investment, business spending on investment, machinery, IP, software, etc has been declining, and this is what gives us changes/increases in productivity, as there is technological change and businesses adopt these things) -This is why wages haven't gone up, productivity hasn't been going up, (Productivity up, more money top ay higher wages) So...1) 1.0-1.2% + 2) 2.2% = Delta y, 3.2-3.4% Why Increases in Productivity Are Important to the Economy: 1) Increases in Productivity are very important because it gives us an increase in the standard of living 2) Given the wages, an increases in productivity helps us/the Fed System/everyone to keep inflation down (HOW?) 3) Increases in our productivity relative to other countries makes our goods more competitive (for exporting, my note) -Again, velocity, v, changes very little, but does increase as our financial institutions create faster ways to make payments -So how much money should Fed Reserve allow economy to have at any one time? Delta P + Delta Y = Delta M of 5.2%...increase in supply of money per year (or per period, my note)...So Fed should increase money supply by 5.2% each year? IMPORTANT: Do not be confused here: Do not answer by saying the Fed Reserve should allow the money supply to grow according to demand (Py), because you have to DEFINE Py, WANT TO MEET TARGET RATE FOR INFLATION OF 2.0%, AND DELTA y OF 3.2% SO IF INFLATION IS ACTUALLY 8-10%, DO NOT WANT TO INCREASE MONEY SUPPLY, CREATE MORE INFLATION...SO DO IT ACCORDING TO GOALS AND COMPARE TO WHERE YOU ACTUALLY ARE, VERY IMPORTANT, -WANT TO SAY THE FED RESERVE WANTS TO INCREASE MONEY SUPPLY ACCORDING TO TARGET RATES FOR DELTA P AND DELTA Y (SUM OF THESE), NOT BASED ON ACTUAL DEMAND FOR MONEY, WHICH COULD BE VERY DIFFERENT, IF DEMAND IS 17%, INFLATION HIGH AS PART OF DEMAND, WANT TO SUPPLY ACCORDING TO LOWER TARGETS TO GET LOWER INFLATION DELTA M = EXCESS RESERVE / LEGAL RESERVE REQUIREMENT = POTENTIAL INCREASE/CHANGE IN MONEY SUPPLY, VERY IMPORTANT CONCEPT

State vs National Banks

In the United States the term "state chartered bank" or "state chartered savings bank" is used in contradistinction to "national bank" or "federal savings bank", which are technically chartered across all US states. All national banks and savings institutions are chartered and regulated by the Office of the Comptroller of the Currency. State banks are chartered and regulated by a state agency (often called the Department of Financial Institutions) in the state in which its headquarters are located. In addition, state banks that are members of the Federal Reserve are regulated by the Federal Reserve; state banks that are not members of the Federal Reserve are regulated by the Federal Deposit Insurance Corporation (FDIC). Therefore, virtually every state chartered bank has both a state and federal regulator. There are a very small number of state banks that do not have FDIC insurance.

Interest Rates and the Value of Real and Financial Assets

Learn for exams, for all purposes: Changes in interest rates, besides affecting economic activity, also affects the value of real and financial assets -Bond Example -The price of a bond depends on the market rate of interest when the bond is sold, INVERSE RELATIONSHIP between change in interest rates and value of bonds, when interest rates increase, bond value decreases, (if market rate above the stated rate, discount, etc...) -Economic value/true value of an asset (FINANCIAL OR REAL) is equal to the PV of the stream of payments that you are going to receive as long as you have that asset -FORMULA IN NOTEBOOK -Basically the returns/cash flows get divided by 1 + the interest rate, so an increase in interest rate increases the denominator and decreases the value of the REAL OR FINANCIAL ASSET -For stocks too, INVERSE RELATIONSHIP: Numerator is earnings or dividends, which is not fixed like bonds, so stock price increases when earnings or dividends increase if interest rates are constant, but same effects of interest rate changes as bonds/real assets -Real assets work the same way, eg building, say you know 100k CF per year, what you pay for it (VALUE/PRICE) decreases as interest rates increase (desired rate of return/market rate, IMPORTANT)...INVERSE RELATIONSHIP HOLDS HERE TOO

The Yield Curve (VERY IMPORTANT)...A Leading Economic Indicator

Market Rate of Return = Real Rate of Return (After inflation? what?) (2.0%-2.5%?)...equal or very close to LR increases in productivity for the US? FIGURE HOW HOW THIS RELATES? WHAT IT MEANS? Yield Curve: is the relationship between ST and LT interest rates...also a LEADING ECONOMIC INDICATOR (1 of 10 of these? IMPORTANT) Leading Economic Indicators: move before the economy, which is why they're called leading -Before economy reaches bottom, leading indicator says economy going to get better?, eg, or could be high and leading indicator is low, etc (SEE GRAPH, WHAT DOES IT MEAN?) -Yield Curve is one leading indicator (money supply, stock market, etc, are others, durable goods orders too, IMPORTANT) -So leading indicators...yield curve is 1, IMPORTANT Yield curve changes all the time (every day?), but usually small changes... There are three kinds of yield curves

The Tools Available to the Federal Reserve System to Accomplish Its Goals (The Goals Above), Effects of Interest Rate Changes, Monetary Policy Definition

Monetary Policy Tools of the Fed Reserve (Are these all monetary policy? seems like they all affect money supply, so would make sense, my note): Monetary Policy: Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and rate of growth of the money supply, which in turn affects interest rates QUANTITATIVE Tools (Change the QUANTITY of credit, but not necessarily who gets the credit or the quality of credit): 1) Changes in the Legal Reserve Requirement: -Has not touches this since 1981 (currently 10% of Demand Deposits for financial institutions) -If want more liquidity in the system, reduce it, so banks can make more loans (more liquidity = more money supply?, my note) -Can increase if they want to restrict lending -Powerful tool, small changes in the Legal Reserve Requirement have big effects in the amounts of loans made by banks -Limits: The Federal Reserve can only change it to between 7% and 25%, 7% minimum and 25% maximum, these limits are according to/imposed by Congress 2) Changes in Interest Rates (Changes in the Federal Funds Rate): -The Federal Reserve controls the Federal Funds Rate (via the Open Market Committee) -Decides when to increase/lower the Federal Funds Rate -Right now the rate is .25%-.5% -IMPORTANT: When the Federal Reserve System changes the Federal Funds Rate, all interest rates in the economy change in the same direction (and most by the same amount) -When the change comes out, not even an hour later, all rates of banks change accordingly -Prime Interest Rate: The rate that banks charge their best customers, this is the first rate to change in the same direction as the Fed Funds rate, it is equal to the Fed Funds rate + 3%, and that's what the bank charges their best customers, and this changes in the same direction and by the same amount as changes in the Fed Funds rate -Fed Reserve changes interest rates many times (or has changed many times? my note) -IMPORTANT: If interest rates decrease, economic activity increases (NOT AN INVERSE RELATIONSHIP BETWEEN INTEREST RATES AND ECONOMIC ACTIVITY) GDP = Consumer Spending (C) + Investment Spending (I) + Government Spending (G) + (Exports (X) - Imports (M)) GDP = C + I + G + (X - M) So a decrease in interest rates has the following effects: -Consumer spending (C) increases (cheaper to use credit card, buy car, borrow money to buy things, etc...) -Increase in Investment (I) (businesses borrow money to invest in equipment, etc...even if they use their own money, its cheaper?) (Interest rate is the COST OF MAKING AN INVESTMENT, IMPORTANT)...New housing, construction, residential investment also part of this -Government spending (G) is pretty much the same, constant, budget for G and S set in place (the Government pays less on the financing of Government Debt, but this is not a part of GDP, Gov Spending for GDP is just government spending on Goods and Services? Review/better define) -Value of the dollar decreases, because the lower interest rates that can be earned tends to attract less foreign investment, which leads to lower demand for the currency, which decreases the price of the dollar, which leads to higher exports and lower imports (imports become more expensive and exports become cheaper), so (X-M) increases -Also, when interest rates decrease, the value of real and financial assets increases (INVERSE RELATIONSHIP) (we will come back to this) -So this is how GDP (and economic activity) increases with decreasing interest rates If interest rates increase, the opposite happens: -Consumer spending (C) decreases -Investment (I) decreases -Government spending (G) constant -Value of dollar increases because the higher interest rates that can be earned tends to attract more foreign investment, which leads to higher demand for the currency, which increases the price of the dollar, (INVERSE RELATIONSHIP BETWEEN INT RATES AND VALUE OF DOLLAR), so exports decrease and imports increase, (X-M) decreases -And this is how GDP (and economic activity) decreases with increasing interest rates -IMPORTANT: So changes in interest rates affect level of economic activity and value of assets 3) Quantitative Easing (QE): -Used beginning in 2009 and ended in October of 2015 -Started using when interest rates were down to 0% (had slowly changed Fed Funds Rate from 5% to 0%), once down to 0%, they could not/cannot change more in that direction, so they changed to QE -QE is the purchase of government securities on the open market to keep interest rates from going up (puts more reserves into the system, I think he said) -From 2009-2015, Fed Reserve System bought over $3 trillion of government securities -When it buys government securities, it increases the amount of reserves in the system by the same amount (as we'll see later) -Where did the money come from to purchase these government securities? -They did not print the money, they just paid by using credit, by crediting the banks that sold them the securities -The Fed cannot buy from the government, had to buy from the public, which includes banks -(So QE was not to change interest rates/fed fund rate, but to keep it low once it was already changed to 0...so HOW DID THEY CHANGE THE RATE DOWN TO 0% IN THE FIRST PLACE? IMPORTANT) -There is no money involved in the purchase -What changes in the system is the MONETARY BASE: Monetary Base = TOTAL Bank Reserves (Total, mostly this) + Currency in Circulation, this increases by the amount of the purchase Qualitative Tools: 1) The Federal Reserve System regulates Margin Requirements for the purchase of stock (how much credit goes to the purchase of stock, so where the credit is going, qualitative? quality of credit instead of quantity of credit in the total system): -The person who purchases stock has to put down 50% of the price of the stock, the other 50% can be borrowed from banks, by brokers? -Purchasing stocks on the margin: if you buy $10k of a stock, you have to pay $5k, and that is the equity you have, and the broker borrows the other 5k, so 50% equity, 50% credit (DO YOU OWN ALL THE STOCK OR DOES THE BROKER OWN HALF?) -Why do this? you can purchase twice as much if you expect the stock to go up (WHICH IMPLIES THAT YOU OWN ALL OF THE STOCK, BUT ARE JUST BORROWING HALF OF THE AMOUNT SO IT'S HALF CREDIT?) -If value of the stock goes up to 12k, can purchase 4k more of stock without putting any more money, or can take the extra 2k out, as long as you maintain an equity of at least 25-30% (for most brokerage firms 30%) -He usually buys on the margin, easy to take money out, and generally pay low rate borrowing on the margin -So the Fed Reserve dictates which stocks can be margined (investopedia), and how much equity you have to have in there? (my note, REVIEW/STUDY/UNDERSTAND THIS) 2) Moral Suasion or Moral Persuasion: -Fed Reserve sends letters to banks saying do not do something -Does not have the force of law, but banks obey -Other: -Sometimes when there's an emergency, like WW2, Congress gives additional power/responsibility to the Fed, then takes it away after, IMPORTANT: All of Fed Reserve operations have to be open market, eg purchasing government securities on the open market...so are all of these open market operations? REVIEW THIS, DEFINE/DISTINGUISH OPEN MARKET OPERATIONS

Money: Definition. 4 Major Functions In The Economy. TIP Bonds. Measures of Money Supply. Legal Tender.

Money: Anything that a society uses in exchange of Goods and Services. Anything used as a medium of exchange. Money Performs 4 Major Functions In The Economy: 1) Medium of Exchange 2) Standard of Value 3) Store of Value 4) Standard for Deferred Payments (payments made in the future, need stable money for this) To perform these functions well, the value of money must be relatively stable (other countries use the dollar because it is stable) US Gov issues bonds protected against inflation, TIP bonds, Treasury Inflation Protected Bonds: Government gives you back face value plus whatever inflation occurred. Have lower interest rates because protected against inflation. (other ways to protect against inflation, gold, other bank notes, etc.) Brief history of money in the US How We Measure Money Supply in the US: M1 = Currency in Circulation + Demand Deposits Currency in Circulation: Currency in the hands of the public, does not include currency in banks. Consists of two items: Coins: Mint by the US Treasury (and generally put into circulation by Federal Reserve Banks) Federal Reserve Notes: Issued by Federal Reserve Banks (Coins and Federal Reserve Notes Created By Gov...No restrictions on Fed Reserve by Congress in issuing notes/coins, issue whatever we demand/want...because this is relatively small portion of money supply just used for convenience in place of credit card, checks, etc...in other countries, currency in circulation could be higher percentage of m1, because people are paid in cash....currency in circulation has stopped declining in relation to total money supplies, because of black market, cash for drugs, etc...illegal activity) Legal Tender: Government money, Coins and Federal Reserve notes. You cannot refuse to take a legal tender in payment of debt (could refuse check or credit card) Demand Deposits: Checking accounts in all of the banks, etc...? M2 = M1 + Savings Accounts + Time Accounts (CDs) + Money Market Accounts (Individual or Retail) + Traveler Checks Time Accounts (Certificates of Deposits): With savings accounts, can withdraw money whenever you want, but CDs will be for 3 months, 6 months, 1 year, cannot withdraw before these dates without paying a fairly big penalty Money Market Accounts: Like savings accounts, but given by money market funds, which are invested in New York. Usually pay you a little more than savings account (higher interest rate), can withdraw whenever, but not insured by the Federal Deposit Insurance Corporation (FDIC, Government) FDIC: Insures all Savings Accounts, Time Accounts, Checking Accounts, for up to 250k (even if the bank goes bankrupt, you can get this amount back) Traveler Checks: You buy these when you go on a foreign trip, can change them wherever (exchange), then spend the money. Sometimes people keep them, or do not spend them all, so generally there is a lot of these outstanding (from commercial banks? my notes) M1 vs M2: M1 is more liquid than M2. For demand deposits, can get money back whenever, cannot really do that with Savings, Time, or Money Market Accounts (can write checks, but usually have to transfer to checking (for savings/MMF)...CDs are not very liquid

Normal Yield Curve

Normal Economic Conditions SEE GRAPH Upward sloping Under Normal Yield Curve: -Economy going well, but not operating at capacity, some slacks in economy but not a whole lot -Optimum capacity utilization around 82% for industrial? and it would be around 77%? -Stock prices going up, but only according to the earnings of corporations -Bond prices are stable because under Normal Yield Curve interest rates are stable? -If normal yield curve, FED RESERVE SYSTEM WILL LEAVE THINGS ALONE, IMPORTANT...Fed relies on yield curve for decisions -Employment doing well, not optimum but close -INFLATIONARY EXPECTATIONS NOT MOVING UP, STABLE, IMPORTANT...so market rate of int = real rate of return + expected inflation, so market rate of int is stable (MAKES SENSE BUT REVIEW TO BE SURE) -So these are conditions of a normal yield curve

T-Accounts #6: Government Buying/Selling Government Securities (OPEN MARKET OPERATIONS), HOW BANKS CONTROL RESERVES IN THE SYSTEM

OPEN MARKET OPERATIONS: Take place at the NY Fed, at 10/11 AM know the reserve position for the entire banking system, (and adjust accordingly, my note) Buying (ACCOUNTING IS SAME FOR QE, BUT THIS IS MORE WITH NORMAL CIRCUMSTANCE): Fed: Gov Sec: + $1,000,000 Member Bank Deposits: + $1,000,000 Banks: Deposits with Fed: + $1,000,000 Securities: - $1,000,000 So bank Total Reserves increase by $1,000,000, and Excess Reserves increase by $1,000,000 Selling: Fed: Gov Sec: - $1,000,000 Member Bank Deposits: - $1,000,000 Banks: Deposits with Fed: - $1,000,000 Securities: + $1,000,000 So bank Total Reserves decrease by $1,000,000, and Excess Reserves decrease $1,000,000

Capital Market Instruments (HE DID NOT REALLY GO OVER THIS? IMPORTANT...what is he talking about here? FIGURE THIS OUT IMPORTANT...should be LT debt...and also other things are equity backed securities for capital markets...so LT debt and equity backed securities should be? (not LT debt backed securities, don't read it that way)

Purchase Stocks on the Margin (can do for bonds too, with a margin requirement of 10%...want to do when interest rates on bonds are higher than the interest rate the broker will charge you on the margin) -Margin requirement is 50% of the value of the stocks (FIGURE OUT HOW THIS WHOLE THE WORKS) -Do this when you expect stock to go up (IMPORTANT) Can also Short Stock, Shorting of Stock: -Borrow money from broker? -50% of the value of stocks? (for what? requirement? equity/cash in broker account? FIGURE THIS OUT) -To sell a stock you do not have (stock must be available) -Broker will borrow stock and sell it, if short at $40, and it goes down to $30, then you buy it and you made $10 -So do it when you think the stock will go down (IMPORTANT) -Broker borrows from you? WHAT? IMPORTANT: Fro both of these, need a broker and need money in broker account, for both need 50% of the stock value in the account (in equity/money? WHAT?), to cover in case it goes the opposite of how you want it to, stock goes in different direction -And both you have to tell the broker a price to buy/sell at...for shorting, give price to sell at (if higher and lose) or buy at (if lower, gain difference in price), IMPORTANT, think about this FIGURE OUT HOW THESE TWO ABOVE WORK, IMPORTANT Buy/Sell, Call and Put Options (handout): Calls: (Right to the?) Purchase of a stock at a given price for given period of time -Buy when you expect the stock to go up (IMPORTANT) -Right to purchase that stock at a given price and period Puts: Right to sell that stock at a given price and period -Buy when you expect the stock to go down (IMPORTANT) For each of these memorize whether you buy when you expect the stock to go down or up and how they work So example...from handout maybe? Microsoft: Calls April 15, 2016...Closing Price $52.50...Strike Price $52.50....Final Price $2.16...Each call is 100 shares....so $216 -So if things go against you, your option is worth nothing, so you only lose $216, so not a big loss, but if goes up a lot, get the gain -So that's the call option, if bought the stock itself, costs $52.50 per share -Some commissions to get in and out -If stock goes up, the option goes up by the same amount (in price), and you can sell the option whenever, or wait until it expires and the broker sells it for you? (OR USES IT MY NOTE HOW DOES THIS WORK?) -There are options on everything -NOT MAKING SENSE TO ME WHY YOU WOULD EVER BUY ACTUAL STOCK THEN (FIGURE THIS OUT, LOOK UP HOW ALL THESE THINGS WORK, MAYBE INVESTOPEDIA) -Use these to see if you can get an idea of the market So: Purchase Stocks on Margin: 50% of Value Shorting a Stock: 50% of Value Calls Puts Now one more: ETF Exchange Traded Funds (ETF): Say you want to buy Chinese stocks, but you don't know a lot about it, buy ETF for Chinese stocks -Somebody (from US?) who is an expert in those stocks sets up/puts together a group of what they think are the best Chinese companies, set up a fund, the ETF, and list the ETF on the nYSE, trades like a stock, the price is the average price of the companies in that fund (IMPORTANT) -EG BRIC, Brazil Russia India and China ETF, deals with securities in those four countries -OR COULD BE BY INDUSTRY

T-Accounts #5: Quantitative Easing, Monetary Base

Quantitative Easing: The Federal Reserve bought government securities from the public (banks): Say the Fed buys $1,000,000 of Gov Sec from a bank: The effects are as follows: FED: Government Securities (Asset) account increases by $1,000,000 and Member Bank Deposits (Liab) increases by $1,000,000 Banks: Deposits With FED (Asset, I THINK, REVIEW) Account increases by $1,000,000 and Securities (Asset) account decreases by $1,000,000 (MY LOGIC: So, Required Reserves are unchanged for the Bank, but the Banks Total Reserves increase by $1,000,000, it's Excess Reserves increase by $1,000,000, and the potential money creation increases by 1mil / .1 = $10,000,000. So the bank can make more loans/create more money, supply of funds increases, and int rate stays low? REVIEW THIS LOGIC VERY IMPORTANT) -So there is no money involved -IMPORTANT: What changes in the system is the MONETARY BASE: MONETARY BASE = Bank Reserves (Total?) + Currency in Circulation, this increases by the amount of the purchase, $1,000,000 in this case

Repossession Agreements

Repossession Agreement (From later): -Becoming more useful -Fed Reserve System sells gov sec two different ways: 1) Buys or Sells gov sec on a permanent basis -Say to increase money supply permanently, needs to put reserves into the system, so they buy in market (or sell in market, normal way) 2) Repossession Agreement: -Used when the Fed feels Total Reserves are too low or too high, but they feel it is a temporary situation, so tells the bank we are going to buy government securities for, eg, 15 days, and bank agrees to buy it back in 15 days...or vice versa with Fed selling and 15 days later you sell it back to us, which would decrease reserves (my note) -For when the too large/small reserve amount is known by the Fed to be due to some temporary factor -ALSO USED BY COMMERCIAL BANKS TO IMPROVE THEIR BLANCE SHEETS OR EARNINGS, SELLING BAD LOANS -Important thing is the Fed Reserve's use of RA -So source of ST funds for the bank if the Fed buys gov sec temporarily (my note)

Securitization (KNOW/UNDERSTAND ALL THIS BETTER, ARE THESE MONEY MARKET OR CAPITAL MARKET, AND IS THIS WHAT HE MEANS BY THE INNOVATIONS?)...RECENT ADDITIONS OF INSTITUTIONS?

Securitization: To create marketable securities by bundling together certain kinds of credits or debits -Eg Bank of America makes a lot of mortgage loans, for people to buy homes, generally keeps about 25% of those loans and sells 75% to other banks or investment banks -Say Bank of America has $100 million of mortgage loans, and say from this it creates 100,000 mortgage bonds at 5.0% and sells these 100,000 mortgage bonds to the public...done by housing government agency? -Sells these 100,000 mortgage bonds at $1,000 each at 5.0%, called Mortgage Bonds Securities, MBS...(ISN'T IT MORTGAGE BACKED SECURITIES? LOOKED IT UP AND I THINK SO) -These loans are guaranteed by the mortgages underlying those bonds -Fed Reserve buys a lot of these, which are issued by gov housing agencies, guaranteed by gov? (BANK OF AMERICA INVOLVED IN THIS OR IS THIS DIFFERENT FROM THE ONES COMMERCIAL BANKS LIKE THAT DO?, FIGURE THIS OUT) -Int rate generally higher than government bonds and secured/guaranteed by house/mortgage behind those bonds? -In Europe, some of these bonds are double guaranteed, first by mortgage, but if default banks pay, double guaranteed -Here, if default, bondholder (you?) pay -So created a security out of a certain amount of debt...mortgage eg...MBS Also CDOs, COLLATERALIZED DEBT OBLIGATION: -Bonds are created, eg, by using student loans, guaranteed by loans behind those bonds, collateralized means guaranteed by something...eg student, car, credit card loans, etc...any kind of debt put together and sold as security -These things are part of the financial crisis, these bonds defaulted, the loans (behind them) defaulted So we were discussing financial instruments created through securitization: -MBS (Mortgage Backed Securities, right name here) -Most banks do not keep all of the mortgages/loans they give out through mortgages, sell to I Bank or Financial Institution that creates MBS? Say they make MBS...and they are rated by S&P, Moody's, Fitch...rates securities If AAA, best rating, the mortgages guaranteed by those securities were the best...so lower int rate, and as ratings get worse int rates get worse...higher the int rate, more risk...B-...junk mortgages...figure that if something goes bankrupt it would just be these...and people felt good about the higher ones -Pension funds cannot purchase stock or Bonds with a rating less than B (no C rating) (JUST B OR B WITH A SIGN? WHAT ABOUT B-?, PROBABLY NOT IMPORTANT)...does he mean all B's or single B rating, etc..? -Now one more thing CREDIT DEFAULT SWAP (CDS): Financial instruments used to insure bonds or debt of some corporation/bank, or a government? -Each CDS insures $10,000,000 worth of bond (eg), and say it costs $168,000 every year for 5 years...Eg say Goldman Sachs bonds, insured for $10,000,000 of these bonds -So has a maturity of 5 years? you pay 168,000 for 5 years? -Say you have $100,000,000 of bonds that pay you 6%...to protect yourself, buy CDS to insure, and you pay, so you're giving up some of that interest in order to insure, say you're giving up 1.7% (because 168,000? my note)...then you essentially earn 4.3% and the bonds are insured...6.0%-1.7%=4.3% -Cannot collect on the CDS unless company goes bankrupt, liquidates, otherwise cannot collect (IMPORTANT) -In 2007-2008, AIG was largest insurance company in world? had sold lots of CDS, didn't have money to pay the, Fed bailed them out by buying stock/making loans? bought 80% of their stock and gave them money to survive, and AIG has now paid that back? -In 2007, like $57 trillion of CDS outstanding, in June of last year, only $17 trillion, so used less now, after the issues with them...total market I'm assuming, not just AIG, but numbers aren't probably important, just trends, this part my note -In Europe, people who bought government debt used CDS to protect themselves -If issuer of bonds starts doing poorly, value of the CDS goes up (IMPORTANT), these things are traded, they are securities, IMPORTANT -Eg government and economy doing poorly, people get concerned, value of CDS go up, people even buy CDS if they don't have the bond, just to speculate on the CDS -European gov made it illegal to purchase naked CDS, (CDS without bonds for speculation, IMPORTANT) -CDS is an insurance on debt (debt issued by corporation, gov, bank, insurance company, etc)...generally $10 million for $5 years, pay $168,000 every year for 5 years -CDS on US Gov Debt, to insure $10mil of US gov debt for 5 years, a few years ago it was $70k/year during crisis now around $35k/year, does not cost that much (makes sense, unlikely to default, my note) -Keep in mind what CDS are and how they'r used, IMPORTANT KNOW/UNDERSTAND ALL THIS BETTER

Money Markets and Capital Markets, Primary Markets and Secondary Markets

The Financial System Is Divided Into Two Parts, Each With a Primary and Secondary Market: 1) Money Market a) Primary Market b) Secondary Market 2) Capital Market a) Primary Market b) Secondary Market 1) Money Market: Deals with financial instruments with maturities of 1 year or less 2) Capital Market: Deals with financial instruments with maturities greater than 1 year In Each Market, Two Divisions: 1) Primary Market: The market for first issues (like IPO, US Treasury issuing/auctioning Treasury Bills, etc (banks that bid/buy for them initially represent the primary market FOR THE TREASURY STUFF AND IPOs IT SEEMS) (REMEMBER HOW HE SAID IPO WORKS, IS THAT FINANCIAL FIRM/I BANK THE PRIMARY MARKET? LOOK IT UP/FIGURE IT OUT, ANSWERED BELOW, IMPORTANT)) 2) Secondary Market: People/organizations that initially bought sell to someone else (NYSE, NASDAQ stock markets are secondary, IPO companies hire investment banking house to help them go public, I Bank House decides with company how many stock to sell and price per share, I Bank buys the whole thing (THAT IS THE PRIMARY MARKET), that's how the IPO takes place, then next morning on NYSE or NASDAQ, has to go on stock exchange exactly at the price they agreed to, I Bank sells, and I Bank charges a commission per share (that's how they make money on this), then fluctuates based on demand, etc...once on NYSE/NASDAQ, SECONDARY MARKET, market decides price after that (ARE STOCKS PART OF MONEY MARKET OR CAPITAL MARKET? MATURITIES? THINK OF OTHER INSTRUMENTS AND WHICH ONE THEY WOULD BE IN Works same way with SCU, SCU is considered same way as city/state, issues bonds, int rate generally quite low, because for SCU/state/city bond, tax deductible (don't pay tax on int), you do pay int on Federal Bonds, (don't pay fed or state tax? my note)...SCU uses I Bank, I Bank buys all bonds, then I Bank sells to the secondary market....This is true for all kinds of bonds, securities, etc...(This is what happening with the gov debt, 40 banks? MY NOTE, IMPORTANT TO FIGURE THIS OUT, IS IT 40 BANKS? REVIEW THIS PROCESS FOR HOW TREASURY INITIALLY SELLS THESE THINGS)

T-Accounts #1: Structure of Bank Balance Sheet (Commercial Bank, Bank of America...but similar to other banks? I think, my note, seems that way)

The Government creates very little money. Commercial banks create a lot. Demand Deposits are created by banks, and every time a bank makes a loan, it creates money equal to the size of the loan (the principal) Accounts for Bank of America, Balance Sheet, Commercial Bank Assets (Uses of Funds, What Bank Does With Money): Cash In Vault (Currency for people to deposit/withdraw) Deposits with the FED (Federal Reserve Bank of their district) Loans Securities (Gov Securities Not Allowed to have corporate securities/stocks, usually about 10% of assets...portfolio and other securities) Other Assets (Building, Furniture, Equip, etc...) Total Assets Liabilities (Sources of Funds): Demand Deposits (Checking Accounts, anything else? define better) Other Deposits (Savings, Money Market, Time, etc...?) Other Liabilities (Wages Payable, Taxes Payable, etc...) Net Worth (Capital) (Sources of Funds (Both L and NW Sources of Funds?)): Common Stock Paid in Surplus (APIC, my note) (Stock Sales Price - Par Value) Retained Earnings Assets = Liabilities + Net Worth (Capital)

Regulations on (Commercial) Banks Imposed by the Federal Reserve Banks/Gov (Monetary Authority?) Legal Reserve Requirement, Capital Asset Ratio

The Government has no currency issuance restrictions (Coins and Fed Reserve Notes), but banks have restrictions on creating money. Bank Regulations (Imposed by Fed Reserve Banks/Gov...): 1) Banks are subject to a Legal Reserve Requirement (Today, this is 10% of Demand Deposits for all banks) 2) Banks have Capital Requirements. They must maintain a minimum Capital Asset Ratio. (Today, the minimum Capital Asset Ratio is 6%. (FIRST QUESTION ON MIDTERM EXAM) CAPITAL ASSET RATIO = Capital / Assets -When the CA Ratio goes below this, a bank gets a letter, a Cease and Desist Order, from the FDIC, saying the bank cannot issue anymore loans without raising more capital -If a bank's CA ratio goes below 3%, the FDIC closes the bank down -These first two change all the time, not the required percentages, but with changes in reserves/activity, etc, a bank's Required Reserves and CA Ratio changes 3) Bank Lending Limits (13-15% of capital of the bank lending) -To avoid (mostly for small banks) loans going to a small amount of people? -To one person/organization, or what? -Lending limits protect the safety and soundness of national banks, promote diversification of loans, and help ensure equitable access to banking services. These limits prevent excessive loans to one person, or loans to related persons who are financially dependent. The lending limits regulation applies to all loans and extensions of credit made by national banks and their domestic operating subsidiaries. 4) Officer Lending Limits (people who work for banks are limited in the size of loans they can make) -The higher up the chain, the higher limits -Determined by the bank itself, but have to supply this information/tell this to the FDIC (this info is used in audits, to make sure there is proper authorization for loans) 5) Conditional Lending (bank cannot make a loan to an officer of the bank unless it (the loan) follows the same rules and conditions as loans to everybody else, to avoid favoritism) 6) Quality of Loans (Reserves for Loan Losses) (Auditors look at the quality of loans on banks' books) -"Reserves for Loan Losses" Account -The following categories: -Loss: 100% of the loan written off from the reserve account if it is determined the loan is a loss (if/when a borrower did not pay principal or interest for 90 days) -Doubtful: 50% of the loan (kept in the reserve account or written off?) (if/when the regulator thinks the loan has problems, but not a complete loss) -Substandard: 20% of the loan (in the/written off from the reserve account?) (if/when lack of statements, documents, paperwork (IS, Tax Return, etc...) -Regular/All Loans: 1% has to be kept in the Reserves for Loan Losses account for all/regular loans (generally?, would this not vary by bank?, my note obviously) -Regulator sends note to bank telling them which of these their loans are, and they have 30 days to write off? (or to put the proper amount in reserves?) -If written off then paid, reinstate, put back in reserves, then record payment, etc...accounting -What if the bank does not have enough in the Reserves for Loan Losses account? (Writeoffs > Reserves) -Have to transfer money from Net Worth (Retained Earnings) to the account, so the bank's capital goes down (out of NI? direct expense? expense increases the reserve account, seems to make sense, IMPORTANT) -And if capital gets too low, FDIC closes you down -Loans - Reserves for Loan Losses = Net Loans 7) Nondiscriminatory Lending: -Banks must appoint an officer to ensure nondiscriminatory lending practices -Cannot do any red-lining, which is not lending to a certain area -No geographical/racial, etc discrimination allowed as long as the borrower is qualified in all the other ways, has the same qualifications 8) Stress Test: -Remember, the goal of the Federal Reserve is to have stability/avoid crisis -A new important regulation/rule that started a few years ago (after the 2007/2008 situation) -The 50 largest US banks (with $50 billion or more in capital) are required every year to do a stress test, which is conducted by the Federal Reserve System -The Fed gives banks a set of numbers or economic circumstances and says assume these (bad?) things happen, then what happens to your CA Ratio, etc? -So these banks have to run a simulation and see what would happen/happens to their assets, loans, etc...and this is why banks need economists -This is why the ask so many questions before lending, because they need information for this/these stress test(s) -At the end of the Stress Test, the simulation, the banks have to come out with a minimum Capital Asset Ratio of (at least) 5% -If after (as a result of) the Stress Test/simulation a bank's CA Ratio is less than 5%, the bank has to raise more capital Other: -Also, as of just a few months ago, the Federal Reserve is requiring big banks to issues bonds (liabilities), because it wants bondholders to pay if the banks go bankrupt and not just stockholders, so part of the loss would be taken by bondholders and not just stockholders -Says bondholders themselves will have to pay some if (a bank) defaults, rather than getting priority and stockholders taking all of the losses (creditor/stockholder preference? INVESTIGATE IMPORTANT) -Makes these banks' bonds more risky, so the interest rates they offer have to be higher, have to compensate bondholders for the additional risk -And SEC corporate regulations for banks

Relationship Between the US Treasury and the Federal Reserve System and the Banking System (Banks)

The US Treasury at all times is involved in two types of operations: 1) Refinancing the existing government debt (selling bonds (my note, kind of) 2) Financing the current deficit (the government deficit) 1) Refinancing the existing government debt: -Any year we have a government deficit, a government deficit increases the gov debt by the same amount, so gov deficit (not enough revenues to cover expenses, borrows money for the rest) increases government debt -How do we reduce the government debt? (the treasury?), the government has to have a budget surplus (government revenue > government expenses), this is THE ONLY WAY TO REDUCE GOVERNMENT DEBT -Surpluses are very rare -What is important as far as government debt is the total amount of the government debt held by the public (institutions, individuals, corporations, Fed Reserve, foreign governments, foreigners, etc... are all part of the public, IMPORTANT CONCEPT) -And the other part is held by the US government? -So HOW TO REFINANCE: When it comes due, the US Treasury refinances it by selling new debt to pay off the old debt (so every Monday the Treasury selling that new debt, much of it to pay off the old debt that comes due that Monday) -Some countries use consolidated/permanent debt for this -Studies show that countries start getting into a lot of trouble when their government debt is above 90% of their GDP (people stop trusting/buying Gov bonds/debt, out of fear gov won't pay, Greece) -In the US debt held by the public is about 72-74% of GDP, so not a lot of problems for us yet -The refinancing of government debt generally does not really create problems/affect the interest rates, IMPORTANT CONCEPT, the government pays the market rate of interest at the date it sells/refinances debt, if interest rates increase, the government pays more int, and vice versa, all according to the market rate -When refinancing, SUPPLY AND DEMAND OF SECURITIES/FUNDS REMAINS THE SAME, SO INT RATE NOT REALLY AFFECTED BY THIS REFINANCING ITSELF (SAME SUPPLY/DEMAND, RETIRING SOME THAT ARE MATURING, AND SELLING NEW, NETS OUT) 2) Financing of the current deficit DOES affect interest rates: -Two major methods/ways the government(s) (Treasury) uses to finance the current deficit: 1) Sell bonds/gov securities to the public (the LEAST INFLATIONARY WAY of financing the government (CURRENT) deficit, to sell securities directly to public) 2) Sell gov securities directly to the central banks (MOST INFLATIONARY WAY of financing the government (CURRENT) deficit) -Some countries use a mix of both -When Treasury account at Fed Reserve bank increases, Total Reserves decrease in the banking system, and vice versa, FED RESERVE IS THE FISCAL AGENT (BANK OF) THE US TREASURY, IMPORTANT -To become a member of the Euro, all the countries had to agree to keep deficit at a max of 3% of GDP and their debt at a max of 60% of GDP -Why that 3%? Our average deficit last 60 years with exception of previous few years, our deficit was on average 1.9% of GDP, and this is SUSTAINABLE in the US -Deficit increases our government debt, but sustainable means we can pay it off -What is important for any country is to be able to pay the interest on the debt -1.9% is sustainable because our GDP can grow at least 2%, so as long as our GDP grows faster than the debt (which is increased by the deficit)/deficit, can pay off interest, because government gets the revenue to pay off the interest from GDP (money, income tax, to pay off int, etc...), and this is what makes it sustainable -In Greece, Debt grew too fast, people didn't think they could pay off, so people stopped buying the debt -Gov also has assets if needed to sell off to pay debt, gov has gold, land, etc... -If debt grew faster (like has been lately), not sustainable -So first way to finance government debt, is to sell bonds to the public, and this is the LEAST inflationary way DELTA M = EXCESS RESERVE / LEGAL RESERVE REQUIREMENT = POTENTIAL INCREASE/CHANGE IN MONEY SUPPLY, VERY IMPORTANT CONCEPT -In the US, selling gov sec to public (banks/financial institution, method 1) (FED CAN'T BUY FROM US TREASURY DIRECTLY, HAS TO USE/BUY/SELL ON OPEN MARKET, MY NOTE) -In other countries, especially developing countries, often sold to CB (which might then sell some to public, or keep it)

Total Reserves, Required Reserves, and Excess Reserves, How Much Money a Bank or the Entire System Can Create

Total Reserves = Cash in Vault + Deposits with FED Required Reserves = Rate (10%) x Demand Deposits Excess Reserves: Total Reserves - Required Reserves Add these for all banks in the US, and you get the Total, Required, and Excess Reserves for the US (US Banking System? My note) Banks cannot make any new loans (and therefore create any money) unless it has excess reserves (reserves in excess of the Legal Reserve Requirement) Money Banks Can Create = Amount of Outstanding Excess Reserves / Legal Reserve Requirement Percentage (10%) IMPORTANT: The Federal Reserve System controls at all times the amount of Excess Reserves available to banks. The Fed provides reserves to banks so banks can create money

Money Market Instruments

What Are The Major Financial Instruments Used In The Money Markets? 1) Call Money -Used when someone purchases stock on the margin (if you put up 50% and broker puts up other 50%), most of the time broker borrows money?...used to finance margin requirement? -Bank can call the loan at any time...generally don't, but could -No maturity (LOOK THIS UP AND BETTER UNDERSTAND IT) 2) Federal Funds (large amount) -24 hour maturity -Basically excess reserves bank has that they can't use a particular day, so they sell to another bank that needs for a day -Every day controller of bank sell or buys federal funds -Generally small banks that have excess reserves sell to bigger banks that want to increase excess reserves 3) US Treasury Bills: -Fed Reserve buys/sells T Bills (3, 6 months or 1 year) (but can't do directly with the Treasury right? REVIEW) -Different interest rates on different maturities -US Treasury Bills are about 40% of the government debt in the hands of the public, so very liquid, a lot of these things (biggest? he said, but what does it mean? most common security/instrument that makes up the debt? FIGURE THIS OUT IMPORTANT) -Yesterday WSJ said Treasury increasing the amount of the issue of these ST issues -Partly because today there is a shortage? Demand is high because of uncertainty about interest rates (how does this work, maybe think yield curve?) -Also because int rate on ST, T Bills is very low compared to LT w/ higher rates? (so gov pays lower int rates?) 4) Government Agencies Bills (Short Term Paper) -Our agencies in the US sell financial paper on their own (directly to the public? but would have to be through a primary market right? figure this out) -Carry somewhat higher int rate even though rate guaranteed by the Treasury (agency paper guaranteed by the Treasury, so basically like buying Gov bonds/bills/paper?) -Why higher? (same maturities as T Bills) LACK OF LIQUIDITY, NOT AS LIQUID AS T BILLS (not as many outstanding, could be more difficult to sell, might have to wait a day or two to sell? unlike T Bills/Gov Sec...if you have a big chunk/large amount to sell, this is lack of liquidity) 5) Commercial Paper (different from corporate bond? think so, bonds LT?, my note, IMPORTANT FIGURE THIS OUT) -Generally 3 months (90 days) maturity -Generally sold by big corporations (GE, GM, Ford, etc) to satisfy needs of their working capital, working purposes, if they need money for these things -Why not borrow from bank? Pay lower int rate to issue commercial paper, costs less, much cheaper 6) Financial Paper: (FIGURE THIS OUT AND DISTINGUISH FROM COMMERCIAL PAPER) -Same as commercial paper, but used by finance company, eg American Express, GM/Ford finance companies? sell on credit? -3 months, 6 months maturity (mostly 3 months) -So borrow the money to sell car to individual? on credit? (or GM/FORD borrow from finance institution?) -Buy car, couldn't pay cash, because if you take their credit, get extra $1,000 discount, so then paid the whole thing off after 1 month -Where they get the money to finance this, where does Amex get the money to finance people who use the Amex card? They borrow it, use financial paper -When int rate goes up, all these financial company profits decline (not as much profit when interest rates go up)...because they borrow ST money, and when the interest rate goes up, they have to pay more on this ST money, and they don't increase the int they charge on the credit cards accordingly, but int payments up for the, so profits down -Visa/Amex charge you about same amount regardless of cost of money to the, so int rate up, value of these financial stocks down? (SAYING CAR COMPANIES LIKE CREDIT CARD COMPANIES BECAUSE THEY BORROW FUNDS/MAKE LOANS? SELL ON CREDIT? EXTEND CREDIT TO CUSTOMERS? IMPORTANT TO FIGURE THIS OUT) 7) Bankers' Acceptances: -Occur because of international trade -If you're an exporter, and export $1million worth of goods, but you don't know much about the buyer, but know payments of invoice in international trade are about 90 days (3 months) -Before you send the goods, you ask the other company to send you a BANKER ACCEPTANCE for that amount, and their bank signs that paper -Their bank accepts the responsibility to pay the invoice if the importer does not pay (IMPORTANT) -Why is it a ST financial instrument? (collect from bank or importer in 90 day), but might need money before 90 days, so exporter COULD SELL THAT $1 million paper (banker acceptance?) to someone at the appropriate discount, (pay int to the person who buys it, TVM, think about it) 8) Eurodollars (mostly?) (or Asian dollars, or LA dollars?) -Come about because of international change -30, 60, 90 days maturity -Buy Eurodollars, pay int on it -Can get money back in any kind of convertible currency (pounds, Euro, etc..) -In Europe, you can deposit your money in any currency that is convertible -Sold at the LIBOR RATE, mainly dealt in the London Money Market (2nd largest after NY), London Inter Bank Rate, what you pay when you get Eurodollar, can borrow, sell, buy Eurodollar -LIBOR Rate is important rate because some loans made are made at the LIBOR rate (in Europe, some in US, eg Europe housing loans, etc...) -IMPORTANT TO FIGURE OUT WHAT THIS ACTUALLY IS, UNDERSTAND IT BETTER -THESE 8 THINGS HAVE INTEREST RATES, CAN FIND THEM IN THE WSJ (IMPORTANT)

4 Major Sources of Short Term Funds That Banks Can Go To (There are actually 5) (actually 6)

When banks run out of excess reserves, they cannot issue new loans or create any more money (demand deposits), but if you go to a bank for a loan, the bank will not turn you down... Banks have 4 major sources of short term funds that they will go to before they say no (remember, they have some time, TWO WEEKS? to meet the requirement): 1) Borrowing from the Federal Funds market: -Federal Funds are 24 hour funds that a bank lends to another bank (from one bank that has excess reserves to another bank that needs the funds (for their reserves, to loan out?)) -If banks (often small banks) have excess reserves they do not need, they may sell them to a bank that needs them. Banks generally do not keep a penny they do not need -Bank knows its position from Fed Reserve Bank of District by 9AM, (then can decide to sell funds on the market, loan out excess reserves they do not need, my note) -Called Federal Funds because the Federal Reserve System sets the Federal Funds rate (interest rate, each day he said?) -This is the interest rate the Fed is increasing, it was 0, and is now .25% going to .5%? -Huge Fed Funds market in New York -This does not change any Total Reserves or Money Supply for the system, (One bank gets the reserves, another bank loses it for a day? my note, one bank up the other down, so it offsets, and no net change, my note) 2) Borrowing from the Federal Reserve Bank (Of Their District): -Banks have to furnish some guarantees for these borrowings (generally Government Securities, from the securities account) -The Federal Reserve Bank charges a discount rate (Eg .5% higher than Fed Funds Rate) -Max term for a loan is 3 months -So, more expensive to borrow this way, so banks do not want to do this if they can get Fed Funds -Also could get audited (by Federal Reserve auditor) if keep borrowing -When a bank borrows from the Fed Reserve System, Total and Excess Reserves increase by the amount borrowed, so Money Supply (M1 and therefore M2) increases (see T-Accounts #4) 3) Banks can sell government or portfolio securities: -Does not change reserves in the system -Can consider securities as being part of their reserves? -One banks Total and Excess Reserves increase, but opposite for the bank that bought the securities (or if a person bought using a check/money they had in another bank? my note, based on later note) 4) Banks can sell negotiable certificates of deposit (CDs): -Someone can buy it today and sell it tomorrow (that's what makes it negotiable?) -Essentially borrowing money by using/selling CDs -CD is an IOU from the bank, sold on markets -CDs are generally short term, (months, (not years?, my note)) -Institutions/companies/people buy these to get returns on extra funds they do not need/are not using for a short period of time -The interest rate on the negotiable CDs that the bank sells represents the Marginal Cost (MC) of money to the bank -Does not change the reserves in the system. Again, banks that sell CD gain but banks that buy CDs lose (reserves) (or people buy by writing checks from other bank) (Or, if bought by someone who uses same bank, still no reserve change, my note, but would make sense I think, because reserves go up and down again, no net change, again my note) 5) Banks can borrow money from the Euro-Dollar (or Eurodollar?) Market (mainly from London) -The bank pays the Libor rate (London Interbank Rate) -30, 60, or 90 days generally, borrow for these times So these are the sources of ST funds for the commercial banks, and only #2, Borrowing from the Fed Reserve System/Bank, changes the reserves in the entire system...IMPORTANT POINT 6) Repossession Agreement (From later): -Becoming more useful -Fed Reserve System sells gov sec two different ways: 1) Buys or Sells gov sec on a permanent basis -Say to increase money supply permanently, needs to put reserves into the system, so they buy in market (or sell in market, normal way) 2) Repossession Agreement: -Used when the Fed feels Total Reserves are too low or too high, but they feel it is a temporary situation, so tells the bank we are going to buy government securities for, eg, 15 days, and bank agrees to buy it back in 15 days...or vice versa with Fed selling and 15 days later you sell it back to us, which would decrease reserves (my note) -For when the too large/small reserve amount is known by the Fed to be due to some temporary factor -ALSO USED BY COMMERCIAL BANKS TO IMPROVE THEIR BLANCE SHEETS OR EARNINGS, SELLING BAD LOANS -Important thing is the Fed Reserve's use of RA -So source of ST funds for the bank if the Fed buys gov sec temporarily (my note)

T-Accounts #7: Withdrawal of Cash from a Bank

When someone goes to a bank and (uses a check?, CHECKING ACCOUNT? DEMAND DEPOSIT?) to withdraw cash?), Say $1,000 Bank: Cash in Vault: - $1,000 Demand Deposits: - $1,000 MONEY SUPPLY IS UNCHANGED BY THIS, currency in circulation increases, demand deposits decreases (by the same amount both of these), just changing composition of money supply -But what does change is: Total Reserves of Banking System decrease by $1,000, and Legal Reserve Requirement decreases by $100, so Excess Reserves decreases by 900, so reduces potential money supply by 900? (OR BY 9,000? REVIEW, IMPORTANT DISTINCTION/CONCEPT)