Unit 4 Macro: Monetary Policy

M1 and M2 Money Supply

M1: physical money, checkable deposits, and traveler's checks M2: M1 + Savings Accounts, Certificates of deposits, and money market funds

What is the difference between the money supply and the monetary base?

MS: money for economy to sue MB: sum of total currency in circulation and reserves banks

Monetary Policy during an Inflationary Gap

Money supply decreases, interest rates increase, investment and consumption decrease, AD decreases

Monetary Policy during a Recessionary Gap

Money supply increases, interest rates decrease, investment and consumption increase, AD increases

What shifts the demand for loanable funds?

New business opportunities, more government borrowing, more consumer borrowing

Real Interest Rate Equation

Nominal Interest Rate - Inflation rate

Does OMO initially change the money supply, the monetary base, or both?

Open market operations change the monetary base, but the impact on the money supply is larger due to the money multiplier.

What is monetary policy?

Policy that a central bank can use to affect the economy in some way

What shifts the supply for loanable funds?

Saving rates increases, changes in capital inflows, changes in public savings

Demand ad supply for the LF Market

Supply = saver Demand = borrower

Why is the supply for money vertical?

The nominal interest rate doesn't affect it.

Fractional reserve banking

The practice of keeping % of deposits on hand but loaning out the rest

Why does the loanable funds market involve real interest rates rather than nominal interest rates?

We want to factor inflation since it makes it easier to measure the costs of borrowing and the benefits to lending.

Graph for the Loanable funds market

X-axis = Quantity of loanable funds Y-axis = Real interset rate Supply for LF = Upward sloping Demand for LF = Downward sloping

Required reserves

a legal obligation to keep a minimum amount of reserves using the reserve requirement percentage

Bond

an IOU issued by a borrower with a promise to pay by a certain date

Liquidity

how easy it is to convert an asset into cash without losing a lot of time and money

Transaction demand for money

people hold money for everyday transactions

Asset demand for money

people prefer having money over assets since there's more liquidity

Financial Sector

section of the economy made up of firms and institutions that provide financial services to commercial and retail customers

Loanable Funds Market facts

-If the government increases borrowing, the real interest rate increases. -A decrease in business investment would decrease real interest rates and the quantity of loans. -An increase in private savings would increase real interest rates and increase the amount of physical capital.

Why is the demand for money downward sloping?

-Speculative motive: waiting to buy/sell is based on price -Transaction motive -Precautionary motive = keeping cash in case there's an emergency -Higher the interest rate, people want to hold less money!

The Three Functions of Money

1. Medium of Exchange 2. Store of Value 3. Unit of Value

Shifters of Money Supply

1. Reserve Requirement (ratio): % of RR goes up = less money, these are the deposits banks must hold in reserve 2. Discount Rate: the interest rate the Fed charges banks, the lower the Discount Rate, the greater the money supply 3. Open Market Operations: The Fed buys/sells bonds (securities) to private banks, buying it increases the money supply and vice versa.

Equation for the money multiplier

Initial * 1/reserve ratio

Some Monetary Policy Facts

An increase in the reserve requirement causes the money supply to decrease and interest rates to increase. If the central bank sells bonds, the money supply with decrease, interest rates increase, and investment decreases. If the central bank decreases the discount rate, the money supply will increase and interest rates decrease.

What is the difference between assets and liabilities?

Assets are what a bank owns and liabilities are what a bank owes.

Shifters of Money Demand

Changes in national income, changes in price level, changes in money technology (inverse relationship)

What is the difference between the discount rate and the federal funds rate?

Discount: Federal Reserve sets loans Federal: Bank sets loans

Demand deposits

Funds from a bank that can be withdrawn anytime

Loanbale Funds

Funds that people lend to other people and funds that want to be borrowed

Why are interest rates and bond prices inversely related?

If interest rates are high, bond prices would have to be low in order to be presented as a good opportunity cost (work like substitutes).

Relationship between investment and the National Savings

In a closed economy, (National Income - Consumption - Government Spending)/National Savings = Investment; this shows how the saved money is ultimately used for investment