Macro Unit 5

Interest Rates and Bond Prices

-Inversely related -Bond pays fixed annual interest payment -Lower bond price will raise the interest rate

Liabilities

Reserves of Commercial Banks: The Fed requires that commercial banks hold reserves against their checkable deposits. The Fed pays interest on these required reserves and also on the excess reserves that banks choose to hold at the Fed. Treasury Deposits: The US Treasury keeps deposits in the Federal Reserve Banks and draws checks on them to pay its obligations. Federal Reserve Notes Outstanding: The supply of paper money in the US consists of Federal Reserve Notes issued by the Federal Reserve Banks. When this money is circulating outside the Federal Reserve Banks, it constitutes claims against the assets of the Federal Reserve Banks. The Fed thus treats these notes as a liability.

Reserve Ratio

reserve ratio = commercial bank's required reserves / commercial bank's checkable-deposit liabilities

Federal Reserve System

The country's central banking system, which is responsible for the nation's monetary policy by regulating the supply of money and interest rates aka "the Fed"

Assets

The two main assets of the Federal Reserve Banks are securities and loans to commercial banks. Securities: Bonds that have been purchased by the Federal Reserve Banks. These securities are part of the public debt--the money borrowed by the federal government Loans to Commercial Banks: Commercial banks occasionally borrow from Federal Reserve Banks

The Demand for Money

Transactions demand for money: The demand for money as a medium of exchange Assets demand for money: The desire to hold money as an asset Total demand for money: We find the total demand for money by horizontally adding the asset for demand to the transactions demand, resulting in a downsloping line

Checkable Deposits

any deposit in a commercial bank or thrift institution against which a check may be written

Federal Reserve Banks

the 12 banks chartered by the U.S. government to control the money supply and perform other functions The bankers' banks

Factors that can cause the demand curve for loanable funds to shift

Changes in perceived business opportunities: Positive perceptions of business opportunities ⇒ Demand for LF will increase ⇒ Demand curve shifts to the right ⇒ equilibrium real interest rate and quantity of LF will both increase. And vice versa Changes in government's borrowing (government borrows when it has a budget deficit, i.e. when government spending is greater than its tax revenue): Budget deficit ⇒ Government will have to borrow more ⇒ Demand curve shifts right ⇒ real interest rate will increase (Crowding-out effect) Budget surplus ⇒ Government will borrow less ⇒ Demand curve shifts left ⇒ real interest rate will decrease

When does demand for money decrease

If interest rates increase

Effects of Increase in general price level

Demand for money will increase Interest rates will increase Investment spending will decrease

Shifts of the money supply curve

1. Expansionary policy (Increase money supply): Equilibrium interest rate decreases as MS curve shifts right. Both consumer and investment spending will increase ⇒ AD shifts to right Real GDP will increase. 2. Contractionary policy (Decrease money supply): Equilibrium interest rate will increase. Both consumer and investment spending will decrease ⇒ AD shifts to the left ⇒ Real GDP will decrease and price level will decrease.

Effects of an Expansionary Monetary Policy

1. Federal Reserve either buys bonds, lowers, reserve ratio, lowers the discount rate, reduces the interest rate on excess reserves, or initiates repos 2. Excess reserves increase 3. Federal funds rate falls 4. Money supply rises 5. Interest rate falls 6. Investment spending increases 7. Aggregate demand increases 8. Real GDP rises

Money Definition M2

A second and broader definition of money includes M1 plus several near-monies, certain highly liquid financial assets that do not function directly or full as a medium of exchange but can be readily converted into currency or checkable deposits. Savings deposits, including money market deposit accounts - A depositor can easily withdraw funds from a savings account at a bank or thrift or simply request that the funds be transferred from a savings account to a checkable account. Small-denominated (less than $100,000) time deposits - Funds from time deposits become available at their maturity Money market mutual funds held by individuals - A depositor can redeem shares in a money market mutual fund offered by a mutual fund company Money, M2 = M1 + savings deposits, including MMDAs + small-denominated (less than $100,000) time deposits + MMMFs held by individuals

Interest

A sum paid or charged for the use of money or for borrowing money

Liquidity

An asset's liquidity is the ease with which it can be converted into the most widely accepted and easily spent form of money, cash, with little or no loss of purchasing power.

Explain how the increase in money supply will affect aggregate demand, real GDP, and price level.

An increase in money supply would decrease the interest rate because there is more money available driving the price of money down. A decrease in interest rate would increase consumer and investment spending due to increased borrowing. This results in an increase in AD, as more people are spending money. An increase in AD results in an increase in real GDP. Because AD increases, price level also increases.

What will happen to the banks if the public desire to hold money increases?

Banks are less able to expand credit

If the public's desire to hold money as currency increases, what will the impact be on the banking system?

Banks will be less able to expand credit

What will happen if the Fed lowers reserve requirements?

Businesses will spend more money on factories and equipment

Maximum amount of money the entire banking system can create formula (Money supply)

Change in MS = (Money multiplier X Initial deposit) - initial deposit)

Factors that can shift the supply of loanable funds

Changes in private savings behavior: Increase in private savings ⇒ Supply of LF will increase ⇒ Supply shifting to the right ⇒ real interest rate will decrease And vice versa Changes in capital inflows Increase in capital inflows ⇒ supply of LF will increase ⇒ real interest rate will decrease And vice versa Special Factor: Expectations of future inflation: Changes in expectations about the future inflation can shift both demand and supply of loanable funds. Expectation of higher inflation in the future: Demand for LF will increase because borrowers expect their real interest rate to go down with higher inflation. Supply of LF will decrease because lenders expect the real interest rate to go down with higher inflation.

Factors that can shift the money demand curve

Changes in the aggregate price level: Increase in price level (inflation) ⇒ Increase the M1 money demand ⇒ MD curve will shift to the right ⇒ equilibrium interest rate will increase And vice versa Changes in Real GDP: Increase in real GDP ⇒ Increase the M1 money demand ⇒ MD curve shifts right ⇒ equilibrium interest rate will increase And vice versa Changes in Technology: Technology like ATM's, credit cards, online banking lowers the money demand ⇒ MD curve shifts left ⇒ equilibrium interest rate will decrease

Commercial banks

Commercial banks are the primary depository institutions. They accept the deposits of households and businesses, keep the money safe until it is demanded via checks, and in the meantime use it to make available a wide variety of loans. Can create money by lending excess reserves to customers

Currency of the United States

Consists of metal coins and paper money. The coins are issued by the US Treasury while the paper money consists of Federal Reserve Notes issued by the Federal Reserve System.

Excess reserves

Excess reserves = actual reserves - required reserves

monetary policy

Government policy that attempts to manage the economy by controlling the money supply and thus interest rates.

Board of Governors

In the Federal Reserve System, a seven-member board that makes most economic decisions regarding interest rates and the supply of money. Appointed by US president with confirmation of the Senate Terms are 14 years

How will consumer and investment spending be affected by an increase in interest rate?

Increase in interest rate means less borrowing, which leads to a decrease in consumer and investment spending.

Fed Functions

Issuing currency: The Federal Reserve Banks issue Federal Reserve Notes, the paper currency used in the US monetary system Setting reserve requirements and holding reserves: The Fed sets reserve requirements, which are the fractions of checking account balances that banks must maintain as currency reserves. Lending to financial institutions and serving as an emergency lender of last resort: The Fed makes routine short-term loans to banks and thrifts and charges them an interest rate called the discount rate Providing for check collection: The Fed provides the banking system with a means for collecting on checks. Acting as fiscal agent: The Fed acts as the fiscal agent for the federal government. The government collects huge sums through taxation, spends equally large amounts, and sells and redeems bonds. To carry out these activities, the government uses the Fed's facilities. Supervising banks: The Fed supervises the operations of banks. It makes periodic examinations to assess bank profitability, to ascertain that banks perform in accordance with the many regulations to which they are subject, and to uncover questionable practices or fraud. Controlling the money supply: The Fed has ultimate responsibility for regulating the supply of money, and this enables it to influence interest rates.

Maximum checkable-deposit creation formula

Maximum checkable-deposit creation = excess reserves x monetary multiplier +Initial deposit for total increase

The Functions of Money

Medium of exchange: Money is a medium of exchange that is usable for buying and selling goods and services. Unit of account: Money is also a unit of account. Society uses monetary units--dollars--as a yardstick for measuring the relative worth of a wide variety of goods, services, and resources. We gauge the value of goods in dollars. Store of value: Money also serves as a store of value that enables people to transfer purchasing power from the present to the future. The money you place in a safe or a checking account will be available to you a few weeks or months from now.

Monetary multiplier

Monetary Multiplier = 1/ required reserves ratio

Token money

Money whose face value is unrelated to its intrinsic value--the value of the physical material out of which that piece of currency is constructed

Money Definition M1

Money, M1 = Currency in the hands of the public + All checkable deposits.

Why might the banking system be unable to increase the money supply by the maximum possible amount?

People may not deposit all their money into the bank. Banks may not be able to loan out their entire excess reserves of deposits.

Thrift institutions

Savings and loan associations and mutual savings banks accept the deposits of households and businesses and then use the funds to finance housing mortgages and to provide other loans.

Federal Open Market Committee (FOMC)

The FOMC aids the Board of Governors in conducting monetary policy. The FOMC is made up of 12 individuals: The seven members of the Board of Governors, The president of the New York Federal Reserve Bank, and Four of the remaining presidents of the Federal Reserve Banks on a 1 year rotating basis

Tools of Monetary Policy

The Fed has four main tools of monetary control it can use to alter the reserves of commercial banks: 1. Open Market Operations: (Most important) The Fed either buys or sells government bonds (US securities) outright, or uses them as collateral on loans of money. Assets--in this case, government bonds--serve as collateral when they are pledged by a borrower to a lender with the understanding that the lender will get to keep the assets if the borrower fails to repay the loan. When Federal Reserve Banks buy government bonds from commercial banks, money supply increases and commercial banks' reserves increase, and aggregate demand increases, price level increases, and nominal interest rates decrease. (also decreases unemployment) When the Federal Reserve Banks sell securities in the open market to commercial banks, money supply decreases and commercial bank reserves decrease, and aggregate demand decreases, price level decreases, and nominal interest rates increase. (also increases unemployment) 2. Reserve Ratio: The Fed also can manipulate the reserve ratio in order to influence the ability of commercial banks to lend. If the Fed raised the reserve ratio, either banks lose excess reserves, diminishing their ability to create money by lending, or they find their reserves deficient and are forced to contract checkable deposits and therefore the money supply. Excess reserves decrease. Checkable-deposit multiplier is reduced. Money supply decreases If the Fed lowered the reserve ratio, The bank's lending ability would increase, and the banking system's money creating potential would expand. Excess reserves increase. Checkable-deposit multiplier increases. Money supply increases. 3. The Discount Rate: The Federal Reserve Banks charge interest on loans they grant to commercial banks. The interest they charge is called discount rate. Borrowing from the Federal Reserve Banks by commercial banks increases the reserves of the commercial banks and enhances their ability to extend credit. The Fed has the power to set the discount rate at which commercial banks borrow from Federal Reserve Banks. A lowering of the discount rate encourages commercial banks to obtain additional reserves by borrowing from Federal Reserve Banks. When the commercial banks lend new reserves, the money supply increases and aggregate demand increases. An increase in the discount rate discourages commercial banks from obtaining additional reserves through borrowing from the Federal Reserve Banks. So the Fed may raise the discount rate when it wants to restrict the money supply and decrease aggregate demand. Interest on Reserves: The Fed's ability to pay interest on excess reserves provided the Fed with a fourth policy tool by which it can implement monetary policy. If the Fed wants to reduce the amount of bank lending and the amount of money in the economy, it can increase the rate of interest that it pays on excess reserves held at the Fed. If the Fed wishes to increase the amount of money that banks lend and the money supply, the Fed can lower the interest rate that it pays on excess reserves. The lower rate will make it less attractive for banks to keep reserves, and banks will be incentivized to increase consumer and commercial lending and thereby stimulate the economy.

Expansionary Monetary Policy

The Fed will use expansionary monetary policy if the economy faces a recession and rising unemployment to increase the supply of credit in the economy, aggregate demand, and real output The Fed's approach involved lowering the federal funds rate to boost borrowing and spending and thereby increasing aggregate demand and real output. The Fed had three options for reducing the interest rate: they could lower the reserve requirement, lower the discount rate, or buy government bonds This increase in reserves had two important effects : It increased the supply of excess reserves offered in the federal funds market, thereby lowering the federal funds rate. It initiated a multiple expansion of the nation's money supply. Given the demand for money, the larger supply of money would stimulate aggregate demand and real output by putting downward pressure on other interest rates.

Restrictive Monetary Policy

The Fed will use restrictive monetary policy designed to reduce aggregate demand and lower the rate of inflation if the economy is overheating and inflation is rising too much. A higher interest on excess reserves (IOER) coupled with more reverse repo borrowing would reduce the supply of money, reduce aggregate demand, and lower inflation

Federal funds rate

The Federal Reserve focuses monetary policy on the federal funds rate, which is the short-term interest rate that the Fed can most directly influence. Most common way for the gov to decrease federal funds rate is to buy government bonds