Macroeconomics Exam 4 Material

What does a balance sheet show?

A balance sheet shows assets, liabilities, and net worth.

What is a bank run?

A bank run is when a bank's depositors rush to withdraw their funds from the bank. As you know, most of a bank's deposits have been loaned out, and only a fraction of them are on reserve. So even if the bank is healthy, it will not be able to pay all of its depositors at once. This can lead to a banking panic, as fear causes bank runs on other banks. Reserves flow out of the banking system and the money supply collapses.

What are the assets of a bank? What are its liabilities?

A bank's assets consist of things of value that it owns such as its reserves, loans it has made, bonds it holds, and even the value of its building. A bank's liabilities consist of money it owes others. A bank's main liability is usually the money it owes its depositors. It may also owe money to others from whom it has borrowed money, such as the Federal Reserve

Imagine that you are in the position of buying loans in the secondary market (that is, buying the right to collect the payment on loans made by the banks) for a bank or other financial service company. Explain why you would be willing to pay more or less for a given loan considering: the borrower has been late on a number of loan payments

A borrower who has been late on a number of payments looks less likely to repay the loan, or to repay it on time, and so you would pay less for the loan.

what would be the effects of increasing the reserve requirements of banks on the money supply?

An increase in reserve requirements would reduce the supply of money, since more money would be held in banks rather than circulating in the economy.

why does expansionary monetary policy cause interest rates to drop?

An increase in the amount of available loanable funds means that there are more people who want to lend. There, therefore, bid the price of borrowing (the interest rate) down.

Someone finds a stash of currency worth $20 million and deposits it all into Humongous Bank. a. By how much has the money supply changed as a result of the initial deposit? b. Suppose Humongous Bank is required to hold 5% of its deposits as reserves, and to loan out the rest. By how much will the money supply increase after this first round of loans? c. The banking system in this economy has several banks. By how much could the money supply increase with the original loan from Humongous Bank?

Answer: a. The money supply would not change; it would just change forms from currency to deposits. b. The bank loans out 95% of the $20 million, or $19 million. When the check it issues is deposited, the money supply will rise by $19 million. c. The money supply can increase by the money multiplier times the new excess reserves. In this case the money multiplier is 1/0.05 = 20. The new excess reserves are $19 million. So the money supply could increase by 20 x $19 million = $380 million.

In casinos, people can use gambling chips to buy food, drinks, and even hotel rooms. Do gambling chips in a casino serve all 3 functions of money?

As long as you remain within the walls of the casino, chips fit the definition of money; they serve as a medium of exchange, unit of account, and a store of value. Chips do not work very well as money once you leave the casino, but many kinds of money do not work well other places.

In a program of deposit insurance as it is operated in the United States, what is being insured and who pays the insurance premiums?

As the name implies, deposit insurance insures deposits. The intent is to prevent bank runs. Even if a bank fails, its depositors will receive their money because of the insurance. Banks pay the insurance premiums.

Explain why you think the Federal Reserve Bank tracks M1 and M2.

As we will discuss in the next chapter, one main task of the Federal Reserve is to control the size of the money supply. As you already know, a too-rapid increase in the money supply will cause inflation. As you will learn in the next chapter, changes in the money supply will also affect aggregate demand. The Fed must measure the money supply to see if it is too big or too small.

Review: To increase the money supply

BUY/SELL bonds, Lower R, and lower discount rate

Review: To decrease the money supply

BUY/SELL bonds, Raise R, and Raise discount rate

Who are intermediaries

Banks

Why is a bank called a financial intermediary?

Banks are an intermediary between savers and borrowers. Savers earn interest without having to find people to borrow their money

How do banks create money?

Banks create money by accepting deposits and then loaning out their excess reserves. When the excess reserves loaned out are deposited in another bank, new deposits are created. New deposits imply a bigger money supply.

Given the danger of bank runs, why do banks not keep the majority of deposits on hand to meet the demand of depositors?

Banks make their money from issuing loans and charging interest. The more money that is stored in the bank's vault, the less is available for lending and the less money the bank stands to make.

In government programs of bank supervision, what is being supervised?

Banks' balance sheets are being supervised. The supervisors want to make sure that the banks' loans are not too risky and that they each have a positive net worth.

3 types of Money

Commodity money, representative money, and fiat money

Explain how contractionary monetary policy works. What effect should it have on equilibrium real GDP and the price level?

Contractionary monetary policy decreases the money supply. All else equal, that will increase interest rates. All else equal, higher interest rates should decrease investment and consumption. That, in turn, will decrease aggregate demand. Lower aggregate demand will decrease both equilibrium real GDP and the price level

why does contractionary monetary policy cause interest rates to rise?

Contractionary policy reduces the amount of loan-able funds in the economy. As with all goods, greater scarcity leads to a greater price, so the interest rate, or the price of borrowing money, rises.

The term "moral hazard" describes increases in risky behavior resulting from efforts to make that behavior safer. How does the concept of moral hazard apply to deposit insurance and other bank regulations?

Deposit insurance is intended to make the banking system safer by preventing bank runs. But if a bank knows that deposit insurance will cover its deposits if it goes broke, it may be tempted to take excessive risks in the hope of making large profits. If the risks pay off, it makes a lot of money; if the risks cause it to fail, somebody else pays to clean up the mess. Thus, the deposit insurance might cause banks to take more risks, which makes the banking system less safe.

D3.) Equilibrium in the Money Market

Equilibrium: where the lines cross, we don't need to know how it gets there

How do expansionary and contractionary monetary policies affect the quantity of money?

Expansionary monetary policy increases the money supply. Contractionary monetary policy reduces the money supply.

Explain how expansionary monetary policy works. What effect should it have on equilibrium real GDP and the price level?

Expansionary monetary policy increases the money supply. All else equal, that will reduce interest rates. All else equal, lower interest rates should increase investment and consumption. That, in turn, will increase aggregate demand. Higher aggregate demand will increase both equilibrium real GDP and the price level.

FDIC

Federal Deposit Insurance Company this is insurance on bank deposits so if a bank fails, the deposits will be covered by the FDIC. Deposit insurance was put into place after the bank runs of the 1930s. some banks failed and people panicked and tried to withdraw deposits from healthy banks. The bank panic spread so excess reserves suddenly disappeared. The amount of currency people held relative to deposits increased dramatically, money supply shrunk which was very bad for the economy. Insurance is intended to stop bank runs

D. 2.) Money Supply

For the most part, the size of the money supply is determined by the Fed. The Fed control is not 100% because: people can choose to hold more money or less currency relative to bank deposits, and banks may or may not choose to loan all excess reserves. Graph - positive slope is very steep. Shifts right due to expansionary monetary policy (buys bonds, reduces discount rate, and reduces the reserve requirement) Shifts left if it does the opposite

What would the money multiplier be if banks were not required to keep reserves?

If banks were not required to keep reserves, the reserve requirement would be zero. That means the money multiplier would be 1/0, which is undefined. As the reserve requirement approaches zero, the money multiplier approaches infinity.

Imagine that you are in the position of buying loans in the secondary market (that is, buying the right to collect the payment on loans made by the banks) for a bank or other financial service company. Explain why you would be willing to pay more or less for a given loan considering: interest rates in the economy as a whole have risen since the loan was made

If interest rates generally have risen, then this loan made at a time of relatively lower interest rates looks less attractive, and you would pay less for it

Imagine that you are in the position of buying loans in the secondary market (that is, buying the right to collect the payment on loans made by the banks) for a bank or other financial service company. Explain why you would be willing to pay more or less for a given loan considering: interest rates in the economy as a whole have fallen since the loan was made

If interest rates in the economy have fallen, the loan is worth more

What is the risk if a bank does not diversify its loans?

If the bank has made mostly one type of loan, say loans to homebuilders, then its assets will be wiped out if that industry collapses. That is one aspect of the most recent financial crisis. Homebuilders suffered large losses and were unable to repay their bank loans. Banks that "specialized" in loans to homebuilders were devastated.

Imagine that you are in the position of buying loans in the secondary market (that is, buying the right to collect the payment on loans made by the banks) for a bank or other financial service company. Explain why you would be willing to pay more or less for a given loan considering: the borrower is a firm that has declared high levels of profit

If the borrower is a firm with a record of high profits, then it is likely to be able to repay the loan, and you would be willing to pay more for the loan.

Explain what will happen to the money multiplier process if there is an increase in the reserve requirement.

If the reserve requirement increases, then the money multiplier will be smaller. That means that any given increase in excess reserves will have a smaller effect on the money supply. In the previous question, the money supply increased by $10 billion. If the reserve requirement had been larger, say 10%, then the money multiplier would have been 1/0.1 = 10. The money supply would have only increased by 10 x $500 million = $5 billion.

If the reserve requirement is 5% and the banking system acquires $500 million in new excess reserves, by how much can the money supply increase?

If the reserve requirement is 5%, then the money multiplier is 1/0.05 = 20. The money supply can increase by 20 x $500 million = $10 billion.

What is the lender of last resort?

In the U.S., the Federal Reserve is the lender of last resort. In a bank run, even a healthy bank will lack the funds to pay all of its depositors at once. The Federal Reserve will step in and loan the bank all the funds it needs to pay its depositors.

The Bring it Home Feature discusses the use of cowrie shells as money. Although cowrie shells are no longer used as money, do you think other forms of commodity monies are possible? What role might technology play in our definition of money?

In the past, many different commodities have served as money. For example, salt, tobacco, cattle, and large stones have been used as money. New technologies have already affected what we consider to be money; think about Bitcoin and other "crypto-currencies."

Intermediaries do what?

Investigate how credit worthy the borrowers are

Which Federal Reserve district includes Iowa?

Iowa is in district seven; its Federal Reserve Bank is in Chicago.

Why is it important for the members of the Board of Governors of the Federal Reserve to have longer terms than elected officials, like the president?

Longer terms insulate the Board from political forces. Since the presidency can potentially change every four years, the Federal Reserve's independence prevents drastic swings in monetary policy with every new administration and allows policy decisions to be made only on economic grounds

How the money supply is defined in the US

M1 and M2

Is this in M1, M2, or neither? $1200 in your checking account

M1 and M2

Is this in M1, M2, or neither? $50 worth of travelers checks you have not used yet

M1 and M2

Is this in M1, M2, or neither? 4 quarters in your pocket

M1 and M2

What components of money are counted as part of M1?

M1 consists of currency, traveler's checks, and all checkable accounts owned by the non-bank public.

Is this in M1, M2, or neither? $2000 you have in a money market account

M2

What components of money are counted in M2?

M2 consists of M1 plus savings accounts, money market funds, certificates of deposit, and other time deposits.

Can you name some item that is a store of value, but does not serve the other functions of money?

Many physical items that a person buys at one time but may sell at another time can serve as an answer. Examples include a house, land, art, rare coins, stamps, and so on.

3 Functions of Money

Medium of exchange, unit of account, and store of value

How is bank regulation linked to the conduct of monetary policy?

Monetary policy involves control over the money supply. Banks play a key role in the money creation process. If the banking system fails, monetary policy is not possible.

D.) 1. Money Demand

Money demand rises (shifts right) when income and/or prices rise and it falls (shifts left) when interest rates rise When income rises people spend more so they hold more money. When prices rise it takes more money to purchase things. When interest rates rise people don't want to invest as much because it costs more

How does the existence of money simplify the process of buying and selling?

Money eliminates the need for barter. Money eliminates the requirement for a double-coincidence of wants that must exist in a barter system. Barter makes a sophisticated economy almost impossible.

What are the three functions of money?

Money serves as a medium of exchange, a unit of account, and as a store of value

What is the asset-liability time mismatch that most banks face?

Most of a bank's liabilities are deposits, and these can usually be withdrawn quickly. Most of a bank's assets are in the form of loans and bonds that may take years to be repaid. This creates a problem: If interest rates rise, it will have to pay higher interest rates to its depositors, but it will only receive the old, lower interest rate on its existing loans; the bank may therefore lose money.

The total amount of U.S. currency in circulation divided by the U.S. population comes out to about $3,500 per person. That is more than most of us carry. Where is all the cash?

Most of the cash is in one of three places: 1. Cash is used in the underground economy (such as the drug trade) because it does not leave a trail. 2. In countries with high inflation rates, many people hold dollars as a store of value rather than their domestic currency. 3. There are a few countries around the world (such as Ecuador) that use the U.S. dollar as their currency.

Is this in M1, M2, or neither? You $5,000 line of credit on your Bank America Card

Neither

If you take $100 out of your piggy bank and deposit it in your checking account, how did M1 change? Did M2 change?

Neither M1 nor M2 changed. All that happened was that the form of M1 changed; you have less currency but a larger checking account.

A bank has deposits of $400. It holds reserves of $50. It has purchased government bonds worth $70. It has made loans of $500. Set up a account balance sheet for the bank, with assets and liabilities, and calculate the bank's net worth.

Net worth: $220

Are credit cards money?

No, they provide access to a line of money that somebody else is paying and you owe them a debt which you pay back when the bill comes

Explain what would happen if banks were notified they had to increase their required reserves by one percentage point from, say, 9% to 10% of deposits. What would their options be to come up with the cash?

One option is that when loans the banks have made are repaid, the banks keep the funds as reserves rather than loaning them out again. Another option is for the banks to sell bonds that they own and use the proceeds to increase reserves.

Which kind of monetary policy would you expect in response to high inflation: expansionary or contractionary? Why?

One would expect contractionary monetary policy. High inflation means that the money supply is growing too fast and that aggregate demand is too high. Contractionary monetary policy reduces the money supply. All else equal that will raise interest rates, reduce investment and consumption, and thereby reduce aggregate demand.

Monetary policy (how the fed controls the money supply) 3 major tools with which to change the size of the money supply

Open market operations, change the reserve ratio, change the discount rate

Why do presidents typically reappoint Chairs of the Federal Reserve Board even when they were originally appointed by a president of a different political party?

The Chairs of the Federal Reserve are not political appointees; they are chosen for their macroeconomic expertise. In addition, reappointing a Chair allows for a continuity of policy

Name and briefly describe the responsibilities of each of the following agencies: FDIC, NCUA, and OCC.

The FDIC is the Federal Deposit Insurance Corporation. It collects insurance premiums from banks and pays depositors up to $250,000 if a bank fails and is unable to pay its depositors. The NCUA is the National Credit Union Administration. It supervises credit unions. The OCC is the Office of the Comptroller of the Currency. It supervises banks and savings & loans.

Change the Reserve Ratio

The Fed sets the required reserve ratio and can change it whenever. To increase the money supply, the Fed will LOWER R, and to decrease the money supply, the Fed with RAISE R because of equation - the higher reserve ratio reduces the stock of excess reserves AND it reduces the money multiplier

The Federal Reserve System - AKA ?

The Fed, the central bank of the US

Describe the structure of the Federal Reserve.

The Federal Reserve's decision-making body is called the Board of Governors. The Board consists of seven people appointed by the President of the U.S. with the advice and consent of the senate. The appointment is for 14-years; terms are staggered so that one expires every two years. One of the seven is appointed to a four-year term as the Chair. Below the board are 12 Federal Reserve banks, one for each Federal Reserve district. These banks serve as "bankers' banks," i.e. they make loans to, and accept deposits from, commercial banks.

Structure of the Fed - The Federal Reserve Banks

The US is divided into 12 regions (for Fed purposes) and each region has its own Federal Reserve Bank. Iowa is in the 7th region and our Federal Reserve Bank is in Chicago The presidents of the federal reserve banks are chosen by the commercial banks (and board of directors)

If the central bank sells $200 in bonds to a bank that has issued $10,000 in loans and is exactly meeting the reserve requirement of 10%, what will happen to the amount of loans and to the money supply in general?

The bank has to hold $1,000 in reserves, so when it buys the $500 in bonds, it will have to reduce its loans by $500 to make up the difference. A reduction in loans means that deposits in other banks will fall. The money multiplier operates to reduce the money supply by a multiple of the $500 reduction in loans.

If you are out shopping for clothes and books, what is the easiest and most convenient for you to spend; MI or M2? Why?

The currency and check in M1 are easiest to spend. It is harder to spend M2 directly, although there is an automatic teller machine in the shopping mall, you can turn M2 from your savings account into an M1 or currency quite quickly. If your answer is about "credit cards" then you are really talking about spending M1 - although it is M1 from the account of the credit card company, which you will repay later when your credit card bill comes due.

What is the double-coincidence of wants?

The double-coincidence of wants is required for barter. Each person must find someone who wants what they have AND has what they want before they can trade. That means that trade can consume most of one's time.

Bank runs are often called "self fulfilling prophecies" why is this appropriate?

The fear and uncertainty created by the suggestion that a bank might fail can lead depositors to withdraw their money. If many depositors do this at the same time, the bank may not be able to meet their demands and will, indeed, fail.

Why does fiat money have value?

The government says so, and people accept it

What are the main tasks of a central bank like the Federal Reserve?

The main tasks of a the Federal Reserve are: 1. To conduct monetary policy (i.e. control the size of the money supply), 2. To make the financial system stable, and 3. To provide banking services to commercial banks and to the federal government.

What is the formula for the money multiplier?

The money multiplier equals 1 divided by the reserve requirement. If, for example, the reserve requirement is 20%, then the money multiplier equals 1/0.2 = 5.

How do you calculate the net worth of a bank?

The net worth of a bank is equal to the value of its assets minus the value of its liabilities. If a bank has $10 billion in assets and $9 billion in liabilities, its net worth is $1 billion.

How can a bank end up with negative net worth?

The typical way a bank ends up with negative net worth is when the loans or bonds its own go bad. This happens when people "default," that is, do not pay what they owe the bank. Think of a bank with $20 million in reserves, $75 million in loans, and deposits of $90 million. Its assets would be $20 million + $75 million = $95 million. Its net worth could be positive, equal to $95 million - $90 million = $5 million. Now suppose a customer who had borrowed $7 million defaults. The bank's loans fall in value to $68 million and therefore its assets fall to $88 million. Its net worth is then negative, equal to $88 million - $90 million = -$2 million.

Why was quantitative easing used in late 2008 and 2009 instead of the usual tools of monetary policy such as open market operations?

The usual tools of expansionary monetary policy work by reducing interest rates. But the rate of interest was already close to zero; it could not be reduced any further. Consequently the Fed had to find another way to boost aggregate demand.

How do tight and loose monetary policy affect interest rates?

Tight monetary policy increases interest rates. Loose monetary policy reduces interest rates.

Explain how to use an open market operation to expand the money supply

To expand the money supply, the Fed will buy bonds. That will increase excess reserves. That, in turn, will increase the money supply by the increase in excess reserves times the money multiplier

Explain how to use the discount rate to expand the money supply.

To expand the money supply, the Fed would reduce the discount rate. The discount rate is the interest rate the Fed charges banks that borrow from it. A lower discount rate makes it more attractive for banks to borrow from it; all the money banks borrow from the Fed are excess reserves. The money supply will rise by the increase in excess reserves times the money multiplier.

Explain how to use the reserve requirement to expand the money supply.

To expand the money supply, the Fed would reduce the reserve requirement. A lower reserve requirement increases the money multiplier AND immediately creates more excess reserves. Both of those will increase the money supply

Explain the difference between how you would characterize bank deposits and loans as assets and liabilities on your own personal balance sheet and how a bank would characterize deposits and loans as assets and liabilities on its balance sheet.

To me, my bank deposits are assets and my bank loans are liabilities. To the bank, my deposits are liabilities and my loans are assets.

D4) The money supply and the rate of interest

To reduce interest rates (shift right): the Fed will INCREASE money supply and to increase interest rates(shift left), the Fed will DECREASE money supply due to monetary policy

Imagine that you are a barber in a world without money. Explain why it would be tricky to obtain groceries, clothing, and a place to live.

You would have to find people who have these things who also want a haircut. Plus, it is unlikely that the person who has the place to live would need enough haircuts for you to pay the rent. This is an illustration of why the double-coincidence of wants required for barter can be a major problem.

Store of Value

accumulating money = accumulating value. Other stores of value (gold, silver, land, etc.) which do not lose value with inflation but money does. Money is the most liquid store of value. It is easily converted into purchasing power

Net Worth =

assets - liabilites

How do banks make money?

by charging higher interest rates on loans than on the interest rate they pay savers

Bank reserves

cash in the bank + funds deposited with Federal Reserve Bank

D.) How Monetary Policy affect the macro-economy how changes in the money supply affect business cycles

changes in the money supply --> changes in interest rates --> changes in I & C (& X-M) --> changes in real GDP and the price level

M2

includes a few things that are not as liquid. Consists of M1, savings account, money market funds, and certificates of deposit and other small tiny deposits All very limited (have to promise to leave money in for a while so you can't spend it as easily

Explain why the money listed under assets on a bank balance sheet may not actually be in the bank?

includes cash held in their vaults, but assets also include monies that the bank holds at the Federal Reserve Bank (reserves), loans that are made to customers, and bonds

The size of the money supply affects what?

inflation rates and the business cycles

Structure of The Fed - Board of Governors

main decision making body of the Fed. There are 7 members and each is appointed to a staggered 14 year term by the president with the advice and consent of the senate. They have long terms to shield them from political pressures and the board is supposed to make the best decision without concern for current politics.

M1

narrow definition of money. Highly liquid money, it is clearly money and has functions of money. Consists of: coins and currency in the hands of the non bank public, check-able deposits (checking account), travelers checks

Fiat Money

not convertible into gold, silver, etc. by people who issue it. Used by almost every modern economy. It is not backed up by anything.

Commodity money

oldest form. Commodities of intrinsic value function like money Ex. tobacco, gold, silver, cattle

Chair of the Fed

one of the 7 is appointed to this 4 years term. The current chair is Janet Yellen

Representative money

paper that represents ownership of a commodity money

Unit of account

prices are expressed in a unit of money - easy to compare value

Financial Markets

savers and borrowers interact directly. When large businesses and governments want to borrow money they issue things called bonds. Bonds are promises to repay a loan at a future date + interest. They are IOUs.

Purpose of the Fed

supposed to regulate the banking system so as to make the financial system more stable. determines the size of the money supply because somebody has to decide how much fiat money we have The Fed acts as a bank to commercial banks and the Federal Government (makes loans to and holds deposits from commercial banks and holds checking account of the US treasury.)

Open market operations

the Fed can buy and sell US Treasury bonds on the open bond market. When the Fed BUYS bonds, there are excess reserves so the money supply rises and when the Fed SELLS bonds the excess reserves are eliminated which prevents the money supply from growing.

Change the discount rate

the interest rate that banks pay when they borrow money from the Fed. All else equal, the lower the discount rate, the more banks will want to borrow from the Fed. To increase the money supply the Fed will lower the discount rate which is telling banks to borrow more, and to decrease the money supply the Fed will raise the discount rate which is telling banks to borrow less

Bank Regulations: banks are required to do what? (5 things)

they have to hold a minimum amount of their deposits in the form of reserves. The Fed sets this reserve ratio They must have a minimum positive net worth. Banks must purchase deposit insurance Banks must act as "the lender of last resort" which means in the case of a bank run, the Fed will loan money to healthy banks to cover withdraws ad calm the bank runs Bank Supervision - banks are "supervised" to make sure they do not make "excessively risky" loans. The Fed supervises Bank holding companies and the Office of the Comptroller of the Currency supervises individual banks

Medium of Exchange

use it to buy things, eliminates bartering