Macro Economics Chapter 10-13

cash equivalents

Cash equivalents are riskless, liquid assets that a bank can immediately access

How do we solve for inflation?

Change: Growth Rate of Money Supply = Growth rate of Nominal GDP To: Growth Rate of Money Supply= Growth rate of real GDP + inflation To Solve for inflation by subtracting Growth rate of real GDP from Both Sides: Growth Rate of Money Supply- Growth Rate of Real GDP= Inflation NOTE: if the growth rate in the money supply (M2) is greater than the growth rate in Real GDP, the U.S. will have inflation NOTE 2: And if the growth rate in the money supply (M2) is significantly greater than the growth rate in Real GDP, the U.S. will have excessive inflation

What does it mean if there is a SHIFT of the Credit Supply Curve?

Changes in motives of households and firms.

If the demand for new loans decreases, what impact does that have on the creation of new Demand Deposits at Private Banks ?

If the demand for new loans decreases, the creation of new demand deposits at private banks will also decrease

The Federal Reserve

Or the 'FED' is the USA's Central Bank. It is not part of the Government Instead, its an independent regulatory agency/bank that operates almost completely autonomously from the rest of the federal government

What makes the demand curve for reserves SHIFT?

if some factor other than the federal funds rate changes, the entire demand curve shifts

Banks transform short-term liabilities, into long-term investments by...

...maturity transformation EX: Banks take short-term Demand Deposits (i.e. money on deposit in your savings and checking accounts) and lends that money to borrowers for things like long-term car loans and mortgages

supply curve for reserves

**LINE RS** Fed policy controls the supply of reserves. Thus we represent the supply curve for reserves as a vertical line The point where the supply and demand curves cross in the federal funds market is the federal funds market equilibrium This Equilibrium informs us of what is the Equilibrium Federal Funds Rate Note: The Fed can increase or decrease the quantity of reserves supplied on a daily basis. And by shifting the the quantity of reserves supplied, the Fed can set the Fed Funds Rate to whatever target it chooses And if the Demand Curve for reserves were to shift, the Fed can simply supply more or less reserves to keep the federal funds rate at the rate it desires to have). Shifting Reserves to keep the Federal Funds Rate Fixed even as demand for reserves shifts

Credit Demand Curve & its Role in Real Interest Rate

**LOOK ONLY AT CD1 CURVE ON PICTURE** Because REAL INTEREST RATE is what matters for business and individual decisions, the demand of credit will also be a function of this real interest rate

Credit Supply Curve

**LOOK ONLY AT CS1** The Credit Supply Curve is upward sloping suggesting that as the Real Interest Rate increases, the Quantity of Credit Supplied will also increase.

5 categories of money

- Currency (i.e. cash) - Transaction Deposits (checking account) - Traveler's checks - Bank savings deposits - Money market accounts

what are the 3 readily available categories of money?

- Currency(i.e. cash) - Transaction Deposits (checking account) - Traveler's checks

3 functions that money serves

- It is a medium of exchange. - It is a store of value. - It is a unit of account (measure of worth).

If the real interest rate were to increase, would you save more or less?

- More, a higher real interest rate implies a higher return to savings - At a higher real interest rate, the tradeoff between consuming or saving will swing in favor of saving i.e. the opportunity cost of consuming would increase at higher real interest rates i.e. with consumption you are giving up the opportunity to earn higher interest rates on your savings

So what happens when a banks' assets lose value ?

- This first translates into a reduction in stockholders' equity - When shareholders' equity falls to zero, the bank's creditors may also face losses - On the other hand, the bank's depositors will always be repaid if their deposits are in FDIC-insured accounts. - This means that the FDIC is ultimately on the hook to cover the depositors.

What are the 2 not as liquid categories of money?

-Bank savings deposits - Money market accounts

As long as the bank's assets are greater than its liabilities....

....every change in the value of the assets is absorbed one-for-one by stockholders (investors)

Banks identify profitable lending opportunities through...

...Rigorous credit analysis

Banks manage risk through diversification...

1. Diversification means lending not just to households for mortgages, but also investing in a diverse set of assets, including business loans, loans to other financial institutions, and government debt 2. A diversified portfolio is useful in that different assets are unlikely to underperform all at the same time

Banks perform three interrelated functions as financial intermediaries... what are they?

1. Identify profitable lending opportunities. 2. Transform short-term liabilities into long-term investments (maturity transformation). 3. Manage risk through diversification.

What are the Fed's 2 key goals?

1. Low and predictable levels of inflation (target is 2%) 2. Maximum (sustainable) levels of employment These two goals are referred to as the Fed's "dual mandate"

What conditions could cause the credit demand curve to SHIFT?

1. Perceived business opportunities for firms 2. Household preferences or expectations 3. Government policy

What 3 activities does the Fed engage in to achieve dual mandate?

1. Regulation 2. Interbank Transfers 3. Management of the Quantity of Bank Reserves

What do people save for?

1. Retirement 2. Their kids (bequests) 3. Large Expenses: House, car, computer, or other large purchase 4. To start a business 5. A "rainy day" (insurance)

Banks provide credit to businesses and households that wish to borrow. But where do banks obtain the money that they lend out ?

1. Savers -- Households and firms with excess cash deposit their money in a bank 2. Banks use that cash to fund lending Thus, banks play the role of middleman, matching savers and borrowers

If the rate of Borrowing slows down, this will impact the Money Suppy... But why?

1. The bank lends you money 2. You spend it to buy something e.g. a new car 3. The money you spend to buy this new car ends up in the dealership's bank account as a deposit Thus: new loans give rise to new deposits Note: Each time a bank lends money to a household or a firm, that money gets spent and ends up deposited in some other bank Remember we defined the Money Supply (M2) as the the sum of 1) currency in circulation (cash) and 2) bank deposits. So, Money Supply increases each time a bank makes a new loan because that increases deposits ***Thus, if there is a decrease in new loans (due to a reduction in borrowing), the rate of growth in the money supply will also decrease (i.e. fewer new deposits)***

How many Federal Reserve District Banks are there?

12... San Francisco Philadelphia Minneapolis Kansas City Dallas Chicago St. Louis Cleveland Atlanta Richmond Washington D.C. New York Boston

If the bank lends you money at a Nominal Interest rate of 5%, and inflation is at 3%, what is the real interest that the bank earns back on the loan?

2% because... Nominal Interest Rate- Inflation Rate = Real Interest Rate so... 5%- 3%= 2%

What does it mean if there is a movement ALONG the Credit Supply Curve?

A change in Real Interest Rate.

What would cause movement ALONG the Credit Demand Curve?

A change in real interest rate---the price to be a borrower

Liabilities

A liability is something that is owed to another institution or person....Demands Deposits, Short-term borrowings, Long-term Debt, Stockholders Equity.

According to the Inflation Equation, if there is reduction in the growth rate of the Money Supply, what impact does that have on Inflation?

According to the Inflation Equation, a reduction in the growth rate of the Money Supply will decrease the rate of Inflation

Interest Rate

Also known as THE NOMINAL INTEREST RATE- is the additional payment above and beyond the PRINCIPAL value that must be payed back

Assets

An asset is something owned by a bank... Reserves, cash equivalents, and long term investments.

So what is the impact of higher Long-Term interest rates ?

At higher interest rates, households and firms will not wish to borrow, or will slow down the rate of borrowing. At higher interest rates households and firms will reduce borrowing which will decrease creation of new bank loans and deposits If the rate of Borrowing slows down, this will impact the Money Suppy

Reserves

Bank reserves are vault cash (money held at the bank in their safe) and money held on deposit at the Federal Reserve Bank

The Process of Financial Intermediation

Banks and financial intermediaries are the organizations that connect savers and borrowers.

Why is defining money and measuring the the Money Supply important ?

Because changes in the Money Supply affect important economic variables, such as --- Inflation --- Interest rates --- Employment --- Level of real GDP

Demand Deposits

Demand deposits are funds that depositors can access on demand e.g. your savings or checking account

Why is diversification by itself insufficient?

Diversification by itself is insufficient to manage risk because a large fraction of a diverse set of assets can still underperform

what are the 3 key reasons the demand curve for reserves would shift?

Economic expansion or contraction --E.g. The economy expands; firms need financing to buy more machinery & equipment to meet the increased demand of a growing economy. Thus banks need additional reserves to obtain the funds they need to lend to meet firms' expansion needs Changing liquidity needs (liquidity shocks) --E.g. An anticipated increase of deposit withdrawals will require additional liquidity, thus the demand for reserves will increase Changing deposit base --E.g. an increase in deposits will increase the demand for reserves

Types of economic agent that would need to borrow from time to time.

Entrepreneurs- to open new companies. Businesses- to invest in plant, machinery, and equipment. Households- for mortgages, car loans, student loans etc.

Interbank Transfers

Example: You bank at Bank of America (BoA) You write a check to someone who banks at PNC When that check is deposited at PNCBank, PNC doesn't call up BoA and ask for the money Instead, the transfer of money takes place within the Federal Reserve Bank using bank reserves ----------------------------------------------- Remember when you deposit money at a bank, the bank only keeps a small fraction (10%) of your deposit in reserve, and the remainder they lend out or invest in Gov't bonds - that's how they make their money

If a household becomes nervous about their job which way would the credit demand curve shift?

If Households become nervous about their jobs, they will cut back on their spending. Thus the credit demand curve would shift to the left-- Meaning demand and interest rate are going down

If firms buy more capital equipment which way would the credit demand curve shift?

If firms buy more capital equipment, they will need to borrow funds to finance the purchase. Thus the credit demand curve would shift to the right-- Meaning demand and interest rate are going UP

If the U.S. federal government decreases its budget deficit which way would the credit demand curve shift?

If the U.S. federal government decreases its budget deficit, then it doesn't have to borrow as much to cover the deficit. Thus the credit demand curve would shift to the left-- Meaning demand and interest rate are going down

What is the Inflation equation?

Inflation = Growth Rate of Money Supply- Growth Rate of Real GDP

What is this an example of? Principal $1,000 Interest $ 50 ______________________ Total $1,050

Interest Rate

Money as a medium of exchange

It can be exchanged in return for goods and services, thereby facilitating trade

money as a unit of account

It serves as a yardstick for describing the price of different goods and services.

What impact does an increase in Long-Term Interest Rates have on the demand for loans i.e. will it increase or decrease the demand for new loans ?

It will decrease the demand for new loans

What impact does the raising of the Fed Funds Rate have on Long-Term Interest Rates?

It will increase Long-Term Interest Rates

How exactly would the Fed decrease the quantity of reserves i.e. would it sell Gov't Bonds to private banks or buy Gov't Bonds from private banks ?

It would sell Gov't bonds to banks and thus reduces bank reserves held at the Fed

Which way does the Credit Supply Curve SHIFT if households become nervous about their jobs?

It would shift to the right, If Households become nervous about their jobs they will increase their savings

Money as a store of value

It's value can be transferred into the future i.e. that a $10 bill received today will be accepted as a form of payment of $10 on into the future

Long-term Debt

Long-term Debt is the debt to be repaid in a year or more to an institution that loaned the bank the money

Long-term investments

Long-term investments are loans to households (mortgages, car loans etc.) and firms

Money

Money is an asset that people use to make and receive payments when buying and selling goods and services.

The total value of all 5 categories of money is called what?

Money supply

Does Nominal GDP account for inflation?

No, so we have to add it. growth rate of Nominal GDP= growth rate of Real GDP + INFLATION.

"Fiat" money

Or paper money...Has no intrinsic value like silver and gold. It only has value because other people accept it as money. We trust that money issued by the Government can be used as a medium of exchange, a store of value and a unit of account.

What happens in the Credit Market if businesses become more optimistic about the future of the economy, and decide to distribute more of their earnings as dividends to their shareholders ? There are two parts to this question. 1) Businesses become more optimistic (and thus will invest) and 2) they decide to distribute more of their earnings as dividends to shareholders

Part 1: -If businesses become more optimistic about the future of the economy -Businesses will increase their borrowing to fund investment and expansion -Thus the Demand for Credit will increase -Thus the Demand Curve will shift to the right Part 2: -If businesses decide to distribute more of their earnings as dividends -They're not saving as much (i.e. they're distributing their savings to shareholders who will most likely spend it) -Thus the Supply of Credit will decrease -Thus the Supply Curve will shift to the left So...Part 1) the demand for credit will increase shifting the credit demand curve to the right and Part 2) the supply for credit will decrease shifting the credit supply curve to the left Depending upon the degree of the horizontal change in the credit supply curve vs. the credit demand curve, the quantity of credit will either increase or decrease. Thus there's no standard answer, its indeterminate Thus, the impact to the Credit Market of 1) an increase in business optimism and investment and 2) an increase in dividends to shareholders is: -The Equilibrium real interest rate increases and -The Equilibrium quantity is "indeterminate"

What happens in the Credit Market if households begin to fear that the recovery from the 2007-2009 recession will not last, and become more pessimistic about the economy ? Note: if households become more pessimistic about the economy, they will cut consumption and save. Thus households will take two actions in response to this pessimism...

Part 1: -The increase in household pessimism would result in a decline in borrowing as households reduce consumption -Thus the demand for credit would decrease and the Credit Demand Curve would shift to the left Part 2: - The increase in household pessimism would result in an increase in savings i.e. if households are not consuming, they are saving - Thus the supply of credit would increase and the Credit Supply Curve would shift to the right SO....Putting this altogether, according to Part 1) the demand for credit will decrease and shift to the left and Part 2) the supply for credit will increase and shift to the right Depending upon the degree of the horizontal change in the credit supply curve vs. the credit demand curve, the quantity of credit will either increase or decrease. Thus there's no standard answer, its indeterminate 1. The Equilibrium real interest rate decreases and 2. The Equilibrium quantity is "indeterminate"

Management of the Quantity of Bank Reserves

Reserves are broken down into two categories, (1) Vault Cash and (2) Reserves held at the Fed Note: Each bank is required to keep a large portion of their reserves at the Federal Reserve Bank Remember on a daily basis thousand of checks are written by households and firms to other households and firms. Thus money has to be moved from one bank to the other But rather than having the banks make payments and seek collections from each other for all of these checks, the sum total of what each bank owes the other is settled by the Fed **the movement of funds between banks is handled by the Fed by adjusting the banks reserves** Note: In any given day, a private bank may not have enough reserves to conduct its business.In such a case, a private bank (BOA) can borrow reserves from another bank who has excess reserves at the Fed

Reserves held at the Fed

Reserves held at the Federal Reserve Bank are needed to cover checks written by their depositors (i.e. interbank transactions)

Vault Cash

Reserves held at the private bank are needed to cover cash withdrawals

Short-term Borrowings

Short-term borrowing consists of loans from other financial institutions that are short in duration

Stockholders equity

Stockholders' equity is the difference between a bank's total assets and total liabilities.

Demand Curve for Reserves

The Demand Curve is downward sloping and shows the Quantity of Reserves demanded at different Fed Funds Rates (which is the price to borrow reserves). Banks desire reserves (even beyond the required 10%) since having more reserves provides a safety net for the bank i.e. it provides protection and liquidity in the event of large withdrawals, or if additional reserves are needed for new lending opportunities. Thus, at a high Fed Funds Rate, the cost of this protection is very high and thus the demand for additional reserves is low. On the other hand, if the Fed Funds Rate is low, banks will demand more reserves since the cost of the protection is more affordable Note: reserves are a safety net for banks, and they prefer to have a bigger safety net if the cost of the safety net falls

Equilibrium in the Credit Market

The Equilibrium in the credit market is the point at which the credit supply curve and the credit demand curve intersect This intersection determines both the total quantity of credit in the market (Q*) and the equilibrium real interest rate (r*)

So what determines the Fed Funds Rate?

The Fed Funds Rate is determined by the laws of Demand and Supply for Bank Reserves

How would the Fed go about increasing the Fed Funds Rate, would it increase or decrease the quantity of reserves supplied ?

The Fed would decrease the quantity of reserves supplied

If the Fed is concerned about the rate of growth in inflation, would the Fed increase or decrease the Fed Funds Rate ?

The Fed would increase the Fed Funds Rate

What caused the German hyperinflation of 1922-23 ?

The German government could not make reparation payments to the Allies after World War I As the German economy struggled, the government started to print more and more currency to pay its bills - thus significantly increasing the Money Supply without a corresponding increase in Real GDP.

What is the Quantity Theory of Money?

The Quantity Theory of Money predicts a simple relationship between the Money Supply and Nominal GDP. It predicts that over the long run: "Growth rate" of Money Supply = "Growth rate" of Nominal GDP Note: It's the "growth rate" that's the same, not the dollar value of the Money Supply or Nominal GDP Growth Rate of Money Supply = Growth rate of Nominal GDP

Why does the credit demand curve slope downward?

The Real Interest Rate is the "price" of credit. Thus an increase in the real interest rate will raise the cost of borrowing and decrease the number of potential borrowers

Credit Market

The borrowing of money that results in an economic agent becoming a debtor to receive a credit.

Regulation

The central bank is the key regulator of banks, particularly large banks It audits the financial statements of large banks. It monitors the amount of shareholders' equity of these large private banks It requires them to perform a "stress test" periodically

Credit

The funds that a debtor borrows.

If there is a reduction in the demand for new loans and as a consequence a reduction in the creation of new Demand Deposits at Private Banks, what impact does that have the growth rate of Money Supply ?

The growth rate of the Money Supply will decrease

What is the Federal Funds Rate

The interest rate charged on Fed Funds and is set by the Federal Reserve Bank.

Real Interest Rate

The interest rate corrected for the effects of inflation. To find Real Interest Rate you take the Nominal Interest Rate minus the inflation rate. ***WE USE REAL INTEREST RATE WHEN CONSIDERING THE COST OF A LOAN***

What is the fed funds market?

The market where banks borrow and lend reserves amongst one another.

If the U.S. federal government has to borrow more to cover its deficits, the credit demand curve will shift to the right, WHAT DOES THAT MEAN FOR THE EQUILIBRIUM?

The new equilibrium point has a higher real interest rate (r**) and a greater quantity of credit supplied and demanded (Q**).

Principal

The original amount of borrowed money.

What are transactions that that shift the quality of reserves supplied called?

These transactions are known as OPEN MARKET OPERATIONS and they are the Fed's most important monetary policy tool !!

An economic expansion leads firms to borrow more to fund their expansion plans, thus banks need to obtain more reserves to fund the increase in loan activity. What does this do to the demand curve for reserves???

This drives the demand curve for Reserves to the right.

Which way would the Credit Supply Curve SHIFT if as a result of improved economic conditions, firms pay more dividends and retain less earnings ?

To the left, if as a result of improved economic conditions, firms pay more dividends and retain less earnings, then firms are saving less, thus the Credit Supply Curve would shift to the left

Total Liabilities + Stockholders Equity = ?

Total Assets

So why does a decrease in the Money Supply reduce inflation ?

Well remember the "Inflation Equation" which stated that if the Growth Rate of the Money Supply was greater than the Growth Rate of Real GDP, you'd have inflation...Well, if inflation starts to rise above the Fed's inflation target of 2%, the Fed will slow down the growth rate of the Money Supply which will slow down the rate of inflation Thus, by slowing down the growth rate in the Money Supply, the Fed can decrease the rate of inflation Note: The Fed cannot control the Money Supply, but it can influence it by raising interest rates --> which decreases new loans --> which decreases new deposits --> which decreases the Money Supply and lowers inflation The Fed can influence the rate of inflation principally by manipulating the supply of Bank Reserves through Open Market Operations The management of the quantity of bank reserves is one of the most important roles of the Fed !! By increasing or decreasing the quantity of bank reserves, the Fed can influence: Interest rates (short-term and long-term rates) Money Supply By INCREASING the total quantity of bank reserves held at the Fed, the Fed Increases money supply Lowers interest rates Lowers unemployment by stimulating the economy By DECREASING the total quantity of bank reserves held at the Fed Decreases money supply Raises interest rates Lowers inflation by cooling down the economy

Debtor

an economic agent that borrows money.

What are 'Fed Funds'?

borrowings of bank reserves held at the Federal Reserve Bank

So how does the Fed control the Supply of Reserves ?

by shifting the the quantity of reserves supplied, the Fed can set the Fed Funds Rate to whatever target it chooses. If the Fed wishes to DECREASE the quantity of reserves that private banks hold, it will "SELL" Gov't Bonds to banks who pay for these bonds with their reserves at the Fed If the Fed wishes to INCREASE the quantity of reserves that private banks hold, it will "BUY" Gov't Bonds from banks and pay for them by increasing bank reserves held at the Fed

What happens to the demand curve for reserves if there is a change in the Fed Funds Rate?

changes in the Fed Funds Rate generate movements "along" the demand curve for reserves

What happens in the Credit Market as the real estate market recovers from the 2007-2009 financial crisis, households begin to buy more houses and condominiums, and apply for more mortgages to enable those purchases ?

the Demand for credit would increase. Thus the equilibrium real interest rate would increase and the equilibrium quantity of credit would increase

What happens in the Credit Market If firms receive good news about the general economic environment, leading them to become more optimistic about the future of their businesses ?

the demand for credit increases. Thus the equilibrium real interest rate and quantity of credit increase

What happens in the Credit Market if Congress agrees to a reduction in the federal deficit, which involves a significant decrease in the amount of government borrowing?

the demand for credit would decrease. Thus the equilibrium real interest rate and quantity of credit decrease

What happens in the Credit Market if bad economic news lead households to become nervous about the future of their jobs, so they start borrowing less ?

the demand for credit would decrease. Thus the equilibrium real interest rate and quantity of credit increase

Is the management of the quantity of bank reserves is one of the most important roles of the Fed?

the management of the quantity of bank reserves is one of the most important roles of the Fed

What happens in the Credit Market if bad economic news lead households to save more in anticipation of a possible interruption to their incomes ?

the supply of credit would increase. Thus the equilibrium real interest rate would decrease but the equilibrium quantity of credit would increase