ECON 202 Exam #2: Chapter 13 - 17
Capital Requirement
- Capital Requirement: -- A government regulation specifying a minimum amount of a bank capital -- Intended to ensure banks will be able to pay off depositors and debts - Financial Crisis of 2008-2009 -- Banks find themselves with too little capital to satisfy capital requirements -- Credit Crunch: The shortage of capital induced the banks to reduce lending
Important Identities- 2
- Closed Economy: NX=0 -- Y=C+I+G so, I=Y-C-G - National Saving (saving), S=Y-C-G -- Total income in the economy that remains after paying for consumption and government purchases --- By definition: S=Y-C-G - It follows: Saving (S) = Investment (I) for a closed economy
The Kinds of Money
- Commodity Money: Money that takes the form of a commodity with intrinsic value -- The item would have value even if it were not used as money. Ex. Gold coins, cigarettes in POW camps - Flat Money: Money without intrinsic value, used as money because of government decree. Ex. The US dollar
Compounding and the Rule of 70
- Compounding: The accumulation of a sum of money where the interest earned on the sum earns additional interest - Because of compounding: Small differences in interest rates lead to big differences over time - The Rule of 70: If an amount grows at a rate of x% per year, that amount will double in about 70/x years
The Fed's Organization
- Consist of: -- Board of Governors --- 7 members appointed by the president and confirmed by the Senate --- 14-year terms, located in Washington, DC -- 12 regional Federal Reserve Banks located around the US
Are Unions good or bad for the economy?
- Critics: Unions are cartels: they raise wages above equilibrium, which causes unemployment and depresses wages in non-union labor markets. Inefficient and inequitable - Advocates: -- Unions counter the market power of large firms -- Make firms more responsive to workers' concerns -- Keep a happy and productive workforce
Important Identities- 3
- Define T= taxes minus transfer payments -- S=Y-C-G can be rewritten as: S=(Y-T-C) + (T-G) - Private Saving = Y-T-C: Income that households have left after paying for taxes and consumption - Public Saving = T-G: Tax revenue that the government has left after paying for its spending - National Saving (S) = Private Saving + Public Saving
Efficient Markets Hypothesis
- Efficient Markets Hypothesis (EMH): -- The theory that asset prices reflect all publicly available information about the value of an asset -- Each company listed on a major stock exchange is followed closely by many money managers -- The equilibrium of supply and demand sets the market price - Stock market exhibits informational efficiency: Each stock price reflects all available information about the value of the company - Stock prices should follow a random walk: The path of a variable whose changes are impossible to predict - If prices reflect all available information: No stock is a better buy than any other. The best you can do is to buy a diversified portfolio
The Federal Open Market Committee, FOMC
- FOMC: -- All 7 members of the Board of Governor -- Plus 5 of the 12 regional bank presidents --- All 12 regional presidents attend each FOMC meeting, but only the 5 get to vote - Open-market operations, OMO: -- Buy US government bonds to increase the money supply -- Sell US government bonds to decrease the money supply
The Federal Reserve System
- Federal Reserve (Fed): The central bank of the US - Central Bank: An institution designed to oversee the banking system and regulate the quantity of money in the economy
Financial Institutions
- Financial Systems: Group of investors in the economy that help to match one person's saving with another person's investment - Financial Institutions: Institutions through which savers can directly provide funds to borrowers 1. Financial Markets 2. Financial Intermediaries
Financial Markets
- Financial institutions through which savers can directly provide funds to borrowers - The Bond Market - The Stock Market
Financial Intermediaries
- Financial institutions through which savers can indirectly provide funds to borrowers - Banks - Mutual Funds
Bank Reserves
- Fractional reserve banking system: Banks keep a fraction of deposits as reserves and use the rest to make loans - Reserves: Deposits that banks have received but have - The reserve ratio, R -- = Fraction of deposits that banks hold as reserves -- = Total reserves as a percentage of total deposits
Why are there always some people unemployed?
- Frictional unemployment: Results because it takes time for workers to search for the jobs that best suit their tastes and skills - Structural unemployment: Results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants on. Due to wages stuck above the equilibrium level. Usually, longer-term
Important Identities- 1
- GDP (Y) = C+I+G+NX -- C= Consumption -- I= Investment -- G= Government Purchases -- NX= Net Exports
Public Policy and Job Search
- Government- run employment agencies: Provide information about job vacancies - Public training programs: Aim to ease workers' transition from declining to growing industries and help disadvantage groups escape poverty - Advocates: Keeps the labor force more fully employed and reduce the inequities inherent in a constantly changing market economy - Critics: -- Is better to let the private market match workers and jobs -- The government is most likely worse: Disseminating the right info to the right workers and deciding what kinds of worker training would be most valuable
The Markets for Insurance
- How insurance works: -- A person facing a risk pays a fee to the insurance company, which in return agrees to accept all or part of the risk -- Insurance allows risks to be pooled and can make risk averse people better off
Reaching Equilibrium
- If interest rate < equilibrium: -- Qs < Qd, so shortage of loanable funds --- Encourage lenders to raise the interest rate --- Encourage saving (increase Qs) --- Discourage borrowing for investment (decreasing Qd) - If interest rate > equilibrium: -- Surplus of loanable funds -- Decrease interest rate
A brief look at the adjustment process
- Increasing money supply causes P to rise: -- At the initial P, an increase in MS causes an excess supply of money -- People get rid of their excess money: spend it on goods and services or by loan it to others, who spend it -- Result: Increased demand for goods and services -- But supply of goods does not increase, so prices must rise, so the quantity of money demanded increases because people are using more dollars for every transaction
Inflation, Deflation, and Hyperinflation
- Inflation: Increase in the overall level of prices - Deflation: Decrease in the overall level of prices - Hyperinflation: Extraordinary high rate of inflation
The Demand for Loanable Funds
- Investment is the source of the demand for loanable funds: -- Firms borrow the funds they need to pay for new equipment, factories, etc. -- Households borrow the funds they need to purchase new houses
Job Search
- Job Search: Process by which workers find appropriate jobs given their tastes and skills - Some frictional unemployment is inevitable: -- Because the economy is always changing. -- Sectorial Shifts: Changes in the composition of demand among industries or regions -- Changing patterns of international trade
The Money Stock
- M1 Includes: Currency, demand deposits at banks, some other liquid deposits (balances in savings accounts) - M2 Includes: Everything in M1 plus small time deposits and money market funds (except those held in restricted retirement accounts) -- Money Stock M2 = (Currency + Demand Deposits + Other liquid deposits like savings accounts) + small time deposits + money market funds - The money stock includes not only currency but also deposits in banks and other financial institutions that can be readily accessed and used to buy goods and services
Market Irrationally
- Many believe that stock price movements are partly psychological - Speculative Bubbles: The price of an asset rises above what appears to be its fundamental value - Possibility of speculative bubbles: Value of the stock to a stockholder depends on the stream of dividend payments and final sale price - Debate: frequency and importance of departures from rational pricing -- Market irrationality: Movement in stock market is hard to explain- news that either a rational valuation -- Efficient markets hypothesis: Impossible to know the correct/ rational valuation of a company
Minimum- Wage Laws
- Matter most for those with low levels of skill and experience, such as teenagers - Causes structural unemployment - Quantity of labor supplied exceeds the quantity of labor demanded - Workers are unemployed because they are waiting for jobs to open up
The Neutrality of Money
- Monetary Neutrality: The proposition that changes in the money supply do not affect real variables - Doubling Money Supply: Causes all nominal prices to double and relative prices don't change - Most economists believe: The classical dichotomy and neutrality of money describes the economy in the long run
Money Demand, MD
- Money Demand: -- How much wealth people want to hold in liquid form -- Depends on P: an increase in P reduces the value of money, so more money is required to buy goods and services - Quantity of money demanded: -- Is negatively related to the value of money -- And positively related to P, other things equal
The Money Multiplier
- Money Multiplier =1/R -- Amount of money that results from each dollar of reserves -- Is the reciprocal of the reserve ratio - The higher the reserve ratio -- The less of each deposit banks loan out -- And the smaller the money multiplier
Money in the US Economy
- Money Stock: The quantity of money circulating in the economy - Currency: Paper bills and coins in the hands of the (non-banking) public - Demand Deposits: Balances in bank accounts that depositors can access on demand by writing a check
Money Supply, MS
- Money supply in the real world: Influenced by the Fed, the banking system, and consumers - Money supply in this model: We assume the Fed precisely controls MS and sets it at some fixed amount
Risk Aversion
- Most people are risk averse: dislike uncertainty -- People dislike bad things happening to them - Utility: -- A person's subjective measure of well-being or satisfaction -- Diminishing marginal utility help explain why most people are risk adverse
How long are the unemployed without work?
- Most spells of unemployment are short: Typically 1/3 of the unemployed have been unemployed under 5 weeks, 2/3 have been unemployed under 14 weeks. Only 19.3% have been unemployed over 6 months - Most unemployment observed at any given time is long term: The small group of long-term unemployed persons has fairly little turnover, so it accounts for most of unemployment observed over time
Unemployment
- Natural rate of unemployment: The normal rate of unemployment around which the unemployment rate fluctuates - Cyclical unemployment: The deviation of unemployment from its natural rate
Does it offer inflation protection? (Characteristic of Bond)
- Nominal terms: specific number of dollars - Indexed to a measure of inflation: when prices rise, the payments rise proportionately (lower interest rates)
Open Market Operations
- Open- Market Operations (OMOs): The purchase and sale of US government bonds by the Fed - To increase the money supply: The Fed buys a government bond from the public, and pays for the bonds with newly created dollars -- Increase the number of dollars in economy -- Some of these new dollars are held as currency and some are deposited in banks
Level of Prices and Value of Money
- Price level, P: Number of dollars needed to buy a basket of goods and services. When price level rises, people have to pay more for the goods and services they buy - Value of Money, 1/P: The quantity of goods and services that can be bought with $1. A rise in the price level: lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services - Inflation drives up prices and drives down the value of money
Classical Theory of Inflation
- Prices rise when the government prints too much money -- Most economists rely on the quantity theory of money to explain long-run determinants of the price level and the inflation rate --- Asserts that the quantity of money determines the value of money --- This theory using two approaches: ---- 1. A supply- demand diagram ---- 2. An equation
Banks
- Primary role for banks: -- Take in deposits from savers (small interest rate) -- Use these deposits to make loans to borrowers (charge a higher interest rate) - Secondary role of banks: --Facilitate purchases of goods and services --- Checks and debit cards to access deposits ---Medium of exchange --- Store of value
Meaning of Saving
- Private Saving: -- Income remaining after households pay their taxes and pay for consumption -- Examples of what households do with saving: Buy corporate bonds or equities, purchase a certificate of deposit at the bank, buy shares of a mutual fund, and let accumulate in saving or checking accounts
Credit Risk (Characteristic of Bond)
- Probability of borrower default - High probability of default: higher interest - Junk bonds (issued by financially shaky corporations) pay very high interest rates
The Quantity Equation
- Quantity Equation: M*V = P*Y - Relates the quantity of money (M) to the nominal value of output (P*Y) - Shows that an increase in the quantity of money in an economy must be reflected in one of the other three variables: 1. The price level must rise 2. The quantity of output must rise 3. Or the velocity of money must fall
Inflation Tax
- Revenue the government raises by creating (printing) money - Like a tax on everyone who holds money -- When the government prints money, the price level rises and the dollars in the your wallet are less valuable - In the US the inflation tax today accounts for less than 3% of federal receipts
Trade- off Between Risk and Return
- Riskier assets pay a higher return, on average, to compensate for the extra risk of holding them - Over the past 200 years, average real return: -- On stocks, 8% (riskier asserts) -- On short-term government bonds, 3%
The Supply of Loanable Funds
- Saving is the source of the supply of loanable funds: -- Households with extra income can loan it out and earn interest -- Public saving --- If positive, adds to national saving and the supply of loanable funds --- If negative, it reduces national saving and the supply of loanable funds
Mutual Funds
- Sell shares to the public and use the proceeds to buy a portfolio of stocks and bonds - Advantages: 1. Allow people with small amounts of money to diversify their holdings (less risk) 2. Give ordinary people access to the skills of professional money managers -- Financial economists, skeptical: hard to "best the market"
Diversification of Firm- Specific Risk
- Standard Deviation: Measures the volatility of a variable - Diversification: -- The reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risks -- Can eliminate firm-specific risk (affecting a single company), but not market risk (affecting all companies in the stock market)
Explaining Structural Unemployment
- Structural unemployment occurs when there are not enough jobs to go around - Occurs when wage is kept above equilibrium - There are three reasons for this: 1. Minimum Wage Laws 2. Unions 3. Efficiency Wages
The T- Account
- T-Account: A simplified accounting statement that shows a bank's assets and liabilities - Banks' liabilities: Amount the bank owes (deposits, bank borrowing, etc.) - Assets: Amount the bank owns (reserves, loans, securities, etc.) - Reserve ratio R = 100*(Reserves/Deposits)
Fiscal Policy and Saving: Policy 1: Saving Incentives
- Tax incentives for saving increase the supply of loanable funds - Which reduces the equilibrium interest rate - And increase the equilibrium quantity of loanable funds - Greater S and I
How the Fed Influences the Reserve Ratio
- The Fed changes reserve requirements: -- Regulations on the minimum amount of reserves banks must hold against deposits - Reducing reserve requirements would lower the reserve ratio and increase the money multiplier - Interest on Reserves (2008) -- The interest ratio paid to banks on the reserves held in deposit at the Fed -- Raising it: Increase the reserve ratio, lower the money multiplier, and lower the money supply -- One of the most important tools
Problems in Controlling the Money Supply
- The Fed does not control: -- The amount of money that households choose to hold as deposits in banks -- The amount that bankers choose to lend - Yet, the fed can compensate for household and bank behavior to retain fairly precise control over the money supply
The Federal Funds Rate
- The Federal Funds rate -- Interest rate at which banks make overnight loans to other banks -- If a bank finds itself short of reserves, it can borrow reserves from another bank - Decisions by the FOMC: To change the target for the federal funds rate are also decisions to change the money supply - A decrease in the target for federal funds rate: Means an expansion in the money supply
The History of US Government Debt
- The government finances deficits by borrowing (selling government bonds) -- Persistent deficits lead to a rising government debt - The debt-to-GDP ratio -- Useful measure of the government's indebtedness relative to its ability to raise tax revenue -- Rises during wartime and falls during peacetime- until the early 1980s -- Rises during economic downturns
Equilibrium on the market for loanable funds
- The interest rate adjusts to equate supply and demand - The equilibrium quantity of loanable funds = equilibrium I = equilibrium S
Term (Characteristic of Bond)
- The length of time until the bond matures - Short term or long terms -- Long term bonds: riskier, higher interest - Never matures: perpetuity
The Market for Loanable Funds
- The market in which those who want to save supply funds and those who want to borrow to invest demand funds - A supply- demand model of the financial system - Helps us understand: How the financial system coordinates saving & investment and how government policies and other factors affect saving, investment, the interest rate - Assume: Only one financial market -- All savers deposit their saving in this market -- All borrowers take out loans from this market -- There is one interest rate, which is both the return to saving and the cost of borrowing
Meaning of Investment
- The purchase of new capital - Investment is NOT the purchase of stocks and bonds
The Velocity of Money
- The rate at which money changes hands - Velocity Formula: (P*Y)/M -- P*Y = Nominal GDP= Price level * Real GDP -- M= Money Supply
Real Wage
- The real wage is the price of labor relative to the price of output - Real wage = W/P -- W= Nominal Wage
Relative Price
- The relative price of a good is the price of one good in terms of another
The Classical Dichotomy
- The theoretical separation of nominal and real variables - Monetary developments affect nominal variables but not real variables: -- If central bank doubles the money supply: -- Then all nominal variables- including prices- will double But all real variables- including relative prices- will remain unchanged - Nominal Variables: Measured in monetary units. Nominal GDP, nominal interest rate (rate of return measured in $), nominal wage ($ per hour worked) - Real variables: Measured in physical units. Real GDP, real interest rate (measured in output), real wage (measured in output)
Efficiency Wages
- The theory of efficiency wages: Firms voluntarily pay above- equilibrium wages to boost worker productivity and increase firm profitability - Different types of efficiency wage theory: Suggest different reasons why firms pay high wages
Measuring the Unemployment Rate
- The u-rate: -- Not a perfect indicator of joblessness or the healthy of the labor market --- It excludes discouraged workers --- It does not distinguish between full-time and part-time work, or people working part time because full-time jobs not available --- Some people misreport their work status - Still a very useful barometer of the labor market and economy
Monetary Policy
- To raise Fed funds rate, Fed sells government bonds (OMO) -- This removes reserves from the banking system, reduces supply of federal funds -- Causes Federal Funds Rate (rf) to rise
Store of Value
- Transfer purchasing power from the present to the future: Hold money or nonmonetary assets - Wealth: The total of all stores of value, including both money and nonmonetary assets - Liquidity: The ease with which an asset can be converted into the economy's medium of exchange
Unemployment Insurance
- Unemployment Insurance, UI: -- A government program that partially protects workers' income when they become unemployed -- Reduces the hardship of unemployment -- Increases unemployment: UI benefits end when a worker takes a job, so workers have less incentive to search or take jobs while eligible to receive benefits - Benefits of UI: -- Reduces income uncertainty -- Unemployed have more time to search -- Unemployed can look for jobs that better suit their tastes and skills -- Improves the ability of the economy to match each worker with the most appropriate job
Unemployment Rate and LFPR
- Unemployment rate, u-rate -- Percentage of labor force that is unemployed -- U-rate = 100*(# of unemployed/ Labor Force) - Labor- force participation rate, LFPR -- Percentage of adult population that is in the labor force -- Labor-force population rate = 100 * (Labor force/Adult population)
Bureau of Labor Statistics, BLS
- Unemployment statistics - produced by Bureau of Labor Statistics (BLS), in the US Dept. of Labor -- Based on a monthly survey of 60,000 households: Current Population Survey -- Based on "adult population" (16 yrs or older)
The Economics of Unions
- Unions raise the wage above equilibrium: -- Quantity of labor demanded falls and unemployment results -- "Insiders"- workers who remain employed, are better off -- "Outsiders" - workers who lose their jobs, are worse off --- Some outsiders go to non-unionized labor markets, which increases labor supply and reduces wages in those markets
Tax Treatment (Characteristic of Bond)
- Way the tax laws treat the interest earned on the bond - Interest on most bonds is taxable income - Municipal bonds (issued by state and local governments): no tax, lower interest rates
Changes in Money Supply
- When banks make loans, they create money - A fractional reserve banking system creates money, but not wealth
Asset Valuation
- When deciding whether to buy a company's stock: You compare the price of the shares to the value of the company - Stocks are: -- Undervalued if Price < Value -- Overvalued if Price > Value -- Fairly valued if Price = Value - Value of a share: -- = PV of any dividends the stock will pay -- + PV of the price you get when you sell the share - Problem: When you buy the share, you don't know what future dividends or prices will be - Fundamental analysis (one way to value a stock): The study of a company's accounting statements and future prospects to determine its value
Unions
- Worker association that bargains with employers over wages, benefits, and working conditions - Exert their market power to negotiate higher wages for workers
Two Problems in Insurance Markets
1. Adverse selection: -- A high-risk person benefits more from insurance, so is more likely to purchase it -- People with chronic illnesses have more incentive to buy health insurance (provided it covers their treatment) than other people 2. Moral Hazard: -- People with insurance have less incentive to avoid risky behavior -- People with good fire insurance: less incentive to replace the batteries in their smoke detectors
The Functions of Money
1. Medium of exchange: item that buyers give to sellers when they want to purchase goods and services 2. Unit of account: Yardstick people use to post prices and record debts 3. Store of value: Item that people can use to transfer purchasing power from the present to the future
The Fed's Jobs
1. Regulate banks, ensure the health of the banking system -- Monitors each bank's financial condition -- Facilitates bank transactions (clearing checks) -- A bank's bank: makes loans to banks; lender of last resort 2. Control the money supply (quantity of money available in the economy) -- Connected to level of interest rates in short run -- Monetary policy: decisions concerning the money supply and interest rates
Four Characteristics of Bonds
1. Term 2. Credit Risk 3. Tax treatment 4. Inflation Protection
The Quantity Theory of Money
1. V is relatively stable over time 2. A change in M causes nominal GDP (P*Y) to change by the same percentage 3. A change in M does not affect Y: Money is neutral, Y is determined by technology and resources 4. So, P changes by the same percentage as P*Y and M 5. Rapid money supply growth causes rapid inflation
The Quantity Theory of Money
A theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate
Chapter 13: Saving, Investment, and the Financial System
Chapter 13: Saving, Investment, and the Financial System
Chapter 14
Chapter 14
Chapter 15: Unemployment
Chapter 15: Unemployment
Chapter 16: The Monetary System
Chapter 16: The Monetary System
Chapter 17: Money Growth and Inflation
Chapter 17: Money Growth and Inflation
Efficiency Wage Theory
- 1. Worker Healthy -- In less developed countries, poor nutrition is a common problem -- Better-paid workers eat a more nutritious diet, and workers who eat a better diet are healthier and more productive -- A firm may find it profitable to pay high wages to ensure its workers are healthy and productive 2. Worker turnover -- Hiring and training new workers is costly -- Paying higher wages gives workers more incentive to stay, reduces turnover 3. Worker quality: Offering higher wages attract better job applicants, increases quality of the firm's workforce 4. Worker Effort -- Workers have discretion over how hard to work, and some may choose to work as little as possible - Is being fired a good deterrent? Depends on how hard it is to find another job and if market wage is above equilibrium wage, there aren't enough jobs to go around, so workers have more incentive to work hard 5. Worker Morale -- High wages improve worker morale; content workers are more productive -- Workers are less productive if they think they are being treated unfairly
The Stock Market
- A (share of) stock -- Is a claim to partial ownership in a firm -- Is a claim to some of the profits the firm makes -- Carry greater risk but offer potentially higher returns - Equity finance: sale of stock to raise money - Stock Exchange: -- Trading stock shares stockholders -- The business (that issued the stock) receives no money - Prices of shares on stock exchanges: determined by the supply of and demand for the stock in these companies - The demand for a stock: reflects people's perception of the corporation's future profitability - A stock index: An average of a group of stock prices= Dow Jones Industrial Average and Standard & Poor's 500 Index
The Bond Market
- A bond is a certificate of indebtedness (an IOU) that specifies: -- Principal: The amount borrowed -- Date of Maturity: The time at which the loan will be repaid -- Rate of Interest: That the borrower will pay periodically until the loan matures -- Bond buyer is a lender: can hold the bond until maturity, or he can sell the bond at an earlier date to someone else - Debt Finance: Sale of bonds to raise money
Bank Runs and the Money Supply
- A run on banks: If people suspect their banks are in trouble, they "run" to the bank to withdraw their funds, holding more currency and less deposits - Under Fractional- Reserve Banking: -- Banks don't have enough reserves to pay off ALL depositors: banks may have to close -- Also, banks may make fewer loans and hold more reserves to satisfy depositors - These events increase R: Reverse the process of money creation, cause money supply yo fall
The slope of the Supply Curve and Demand Curve
- An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied - A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded
Fiscal Policy and Saving: Policy 2: Investment Incentives
- An investment tax credit increases the demand for loanable funds - Which raises the equilibrium interest rate - And increases the equilibrium quantity of loanable funds - Greater S and I
The Money Supply-Demand Diagram
- As the value of money rises, the price level falls - The Fed sets MS at some fixed value, regardless of P - A fall in value of money (or increase in P) increases the quantity of money demanded - P adjusts to equate quantity of money demanded with money supply - If the Fed increases the money supply, then the value of money falls and P rises
A more Realistic Balance Sheet
- Assets: Reserves, loans, securities (stocks and bonds) - Liabilities: Deposits, debt, and equity - Bank Capital (owner's equity): The resources a bank obtains by issuing equity to its owners. -- = Bank Assets - Bank Liabilities - Leverage: The use borrowed funds to supplement existing funds for investment purposes -- Leverage Ratio = Assets/ Capital
How is unemployment measured?
- BLS divides population into 3 groups: 1. Employed: Paid employees, self- employed, and unpaid workers in a family business, full-time and part-time 2. Unemployed: People not working, are available for work, and have looked for work during previous 4 weeks 3. Not in the labor force: Everyone else - Labor Force = Employed + Unemployed -- The total number of workers
Fed Lending to Banks
- Banks borrow from Fed's -- Paying an interest rate called the discount rate -- Increasing reserves in the banking system, and increasing the money supply -- If the Fed lowers the discount rate, it encourages banks to borrow more, increasing the quantity of reserves and the money supply - Term Auction Facility (2007-2010) -- Fed sets a quantity of reserves it will loan, than banks bid against each other for these loans - The Fed lends to help financial institutions
The Fed's Tools of Monetary Control
- Banks create money in a system of fractional- reserve banking: The Fed's control of the money supply is indirect - Two groups of tools: -- Those that influence the quantity of reserves (OMO< Fed Lending) -- Those that influence the reserve ratio and money multiplier (regulate reserve requirement, change interest on reserves)
The Meaning of Money
- Barter -- Exchange one good or service for another -- Requires a double coincidence of wants: unlikely occurrence that two people each have a good or service the other wants -- Waste of resources: people spend time searching for others to trade with - Using money: Solves those problems - Money: The set of assets in an economy that people regularly use to buy goods and services - Money has three functions: -- Medium of exchange, a unit of account, and a taste of value -- Distinguish money from other assets
Budget Surplus or Deficit
- Budget Surplus: T-G>0 -- Excess of tax revenue over government spending= public saving (T-G) - Budget deficit: T-G<0 -- Shortfall or tax revenue from government spending= -(public saving)= G-T
Fiscal Policy and Saving: Policy 3: Government Budget Deficits and Surpluses
- Budget deficit G > T: Excess of government spending over tax revenue - Government debt: Accumulation of past government borrowing - Budget Surplus, T > G: Excess of tax revenue over government spending and repay some of the government debt - Balanced Budget: G = T
Policy 3: Lessons
- Budget deficits: Reduce national saving, decrease the supply of loanable funds, interest rate rises and investment falls - Budget surplus: Increase national saving, increase the supply of loanable funds, and reduce the interest rate, and stimulates investment
