Tools of Monetary Policy and Countercyclical Fiscal Policies in the Domestic US Market

Expansionary Policy (AKA "Easy Money Policy")

• Used to fight a recession
• Open market operation consists of buying bonds, which increases money supply
• Discount rate decreases
• Reserve requirement decreases
• Taxes decrease
• Government spending increases
• There will be a budget deficit
• Consumption and Government Spending increases
• Aggregate Demand increases
• Demand for money increases
• Interest rate increases
• Gross Domestic Private Investment decreases
• Supply of loanable funds decreases
• Demand for loanable funds increases

Contractionary Policy (AKA "Tight Money Policy")

• Used to fight inflation
• Open market operation consists of selling bonds, which decreases money supply
• Discount rate increases
• Reserve requirement increases
• Taxes increase
• Government spending decreases
• There will be a budget surplus
• Consumption and Government Spending decreases
• Aggregate Demand decreases
• Demand for money decreases
• Interest rate decreases
• Gross Domestic Private Investment increases
• Supply of loanable funds increases
• Demand for loanable funds decreases

• Fiscal Policy is carried out by Congress and the President, and it usually has to do with taxing and spending

• Monetary Policy is carried out by the Federal Reserve Bank (the Fed), and it deals with open market operations, the discount rate, the federal fund rate and the reserve requirement

• Discount Rate - The interest rate that the Fed charges commercial banks for borrowing money 
• The lower it is, the more banks borrow
• Federal Fund Rate - The interest rate that commercial banks charge one another for an overnight loan

• Bank reserves and money supply have a direct relationship with each other
• The Federal Fund Rate has an inverse relationship with the two in the previous bullet
• Prime Rate - The interest rate that banks charge their most credit-worthy customers

Loanable funds market

Changes in the Demand for Loanable Funds

It is the market where savers and borrows exchange funds (Qlf) at the real rate of interest (r%)

• The demand for loanable funds, if borrowing, comes from households, firms, government and the foreign sector. The demand for loanable funds is in fact the supply of bonds.
• The supply of loanable funds, or savings comes from households, firms, govt and foreign sector. Supply of loanable funds is also demand for bonds.

• Remember that demand for loanable funds = borrowing (i.e supplying bonds)
• More borrowing = more demand for loanable funds (--->)
• Vice-versa for less borrowing

Examples:

• Govt deficit spending = more borrowing = more demand = real interest rate would increase
• Vice versa for less spending

Change in the Supply of Loanable Funds:

• Supply of loanable funds = saving (I.e. Demand for bonds)
• More saving = more supply (-->)
• Vice versa for less saving

Examples:

• Govt budget surplus = more saving = more supply of loanable funds = real interest rate decrease
• Vice-versa for budget deficit

Final Thoughts on Loanable Funds:

• When government does fiscal policy it will affect the loanable funds market
• Changes in real interest rate will affect Ig

Crowding out

What is it? - A critique and flaw of Keynesian policies that are applied to fight a recession (an expansionary period).

Why does it happen? - The policy of cutting taxes and raising spending will create a budget deficit

• So, the budget deficit must be funded and to do this, Congress orders the sale of US bonds

• This money mostly comes from US citizens, companies and investment firms

• Therefore, money that could be spent on consumption or used for private savings is now being used to buy bonds

• On the Money Market, this will cause the money demand curve to shift outward. Remember, this is a fiscal event.

• On the Loanable Funds Market, this will cause the supply curve to shift inward because we are not saving money privately anymore. Also, this can cause the demand curve to shift outward because the private and public demand for money increases.

• On both graphs, the nominal and real interest rate will increase.

• Therefore, on the investment demand graph, the increase in nominal and real interest rates will cause Ig to decrease

• It's counterproductive, but it is done because Fiscal Policy supporters insist that gains in consumption and government spending will outweigh any loss in future Ig

Why? - Consumption and government spending are greater than Ig and they are Short Run improvements. Ig is longer run and Keynesian don't worry about that, because in the long run, we are all dead.

Creating A Bank

Transaction #4: Depositing reserves in a federal reserve bank

• Required reserves
• Reserve Ratio = commercial bank's required reserves / commercial bank's check-able deposit liabilities

Reserve Requirements-

Excess Reserves = Actual Reserves - Required Reserves

Required Reserves = Checkable Deposits x Reserve Ratio

Assets

• Reserves
• Required reserves (rr) - % required by fed to keep on hand to meet demand
• Excess Reserves (er) - % reserves over and above amount needed to satisfy minimum reserve ratio set by fed
• Loans to firms, consumers and other banks (earns interest)
• Loans to govt = treasury securities
• Bank property - if bank fails. ( you could liquidate the building/property)

Liabilities + Equity

• Demand Deposits ($ put into bank)
• Times Deposits (CDs)
• Loans from: Federal Reserve and other banks
• Shareholders Equity - (to set up bank, you must invest your own money in it to have a stake in the bank's success or failure)

Banks and creation of money

How do Banks Create Money?
 By lending out deposits that are used multiple times

Where do the Loans Come From?

 From depositors who take cash and place it in their banks

How are the Amounts of Potential Loans Calculated? 

Using their bank balance sheet, or T-accounts that consist of assets and liabilities for banks

Bank Liabilities (right side of the T-account sheet)

1 - Demand Deposits (DD) or checkable deposits

• Cash deposits from the public
• They are liabilities because they belong to depositors

2 - Owners Equity (stock shares)

• There are values of stock held by public ownership of bank shares

Key Concepts for AP concerning Liabilities:

• If demand deposits comes from someone's cash holdings, then the DD is already part of money supply
• If DD comes in from purchase of bonds (by the FED), this creates new cash and therefore creates M1 (new money supply)

Bank Assets (left side of the T-account sheet)

1 - Required Reserves (RR)

• These are the percentages of DD that must be held in the vault so that some depositors have access to their money.

2 - Excess Reserves (ER) 

• Sources of new loans. These amounts are applied to the Monetary Multiplier/Reserve Multiplier (DD = ER + RR)

3 - Bank Property Holdings (buildings and fixtures)

4 - Securities (Federal Bonds)

• Bonds purchased by bank, or new bonds sold to the bank by the Federal Reserve. These bonds can be purchased from the bank, turned into cash that immediately become available as ER. 

5 - Customer Loans

Amounts held by banks from previous transactions, owed to the bank by prior customers.

Money Creation (Using Excess Reserves)

Banks want to create profit, they generate it by lending the excess reserves and collecting interest. Since each loan will go out into customer's and business accounts, more loans are created in decreasing amounts (because of reserve requirement). Rough estimate of number of loan amounts created by any first loan is the money multiplier. 

The Monetary Multiplier (AKA)

• Checkable Deposits Multiplier
• Reserve Multiplier
• Loan Multiplier 
• Multiplier = 1/RR
• Excess Reserves are multiplied by the monetary multiplier to create new loans for the entire banking system and this creates new money supply 

Types of Deposits and how they affect the money supply

If the initial deposit is just cash from a person: 

• It consists of existing money
• It increases bank reserves
• It doesn't have an immediate impact on the money supply because it is already composed of M1 money

If the initial deposit is a result of the FED purchasing a bond from the public:

• It consists of new money (new money is being created)
• It increases bank reserves
• It has an immediate impact on money supply because money from the Fed puts new money in circulation

If the initial deposit is a result of the bank purchasing a bond from the public:

• It consists of new money (new money is being created)
• It increases bank reserves
• It has an immediate impact on the money supply because money coming from actual reserves puts new money in circulation

Key Principles

• A single bank can create money (through loans) by the amount of excess reserves
• The banking system as a whole can create money by a multiple of the initial excess reserves
• 

Factors That Weaken the Effectiveness of the Deposit Multiplier

• If banks fail to loan out all of their excess reserves
• If bank customers take their loans in cash rather than in new checking account deposits, it creates a cash or currency drain

Four types of Multiple Deposit Expansion Questions

1: Calculate initial change in excess reserves
- The amount a single bank can loan from initial deposit

2: Calculate change in loans in the banking system

Given a required reserve ratio of 20%, assume the Federal Reserve purchases $100 million worth of US Treasury Securities on the open market from a primary security dealer. Determine the maximum change in loans in the banking system from this Federal Reserve purchase of bonds. 

Initial Change in ER x Money Multiplier = Max Change in Loans

$80 million x (1/.20)
$80 million x 5 = $400 million max in new loans

 3: Calculate change in money supply

1. Given a required reserve ratio of 20%, assume the Federal Reserve purchases $100 million worth of US Treasury Securities on the open market from a primary security dealer. Determine the maximum change in the money supply from this Federal Reserve purchase of bonds.
2. Maximum Change in Loans + $ Amount of Federal Reserve action
3. $400 million + $100 million = $500 million max change in the money supply

[Sometimes Type 2 and Type 3 will have same result (i.e. No fed involvement)]

4: Calculate change in demand deposits

1. Given a required reserve ratio of 20%, assume the Federal Reserve purchases $100 million worth of US Treasury Securities on the open market from a primary security dealer. Determine the maximum change in demand deposits from this Federal Reserve purchase of bonds.
2. Maximum Change in Loans + $ Amount of Initial Deposit
3. $400 million + $100 million = $500 million max change in demand deposits

Interests, Money, Loans, and Bonds

Money is any asset that can be used to purchase goods or services

It has three uses: 

• Medium of exchange (determining value)
• Unit of account (comparing cost)
• Store of value (how money can be kept, such as in the bank, personal savings, etc.)

Three Types of Money

• Commodity Money - Money that has value in itself (salt, olive oil, gold)
• Representative Money - Represents something of value (IOU, 
• Fiat Money - Money because the gov't says so, (ex. paper currency, coins)

Six Characteristics of Money

1. Durability
2. Portability 
3. Divisibility 
4. Uniformity
5. Limited supply
6. Susceptibility 

Money Supply - All the money available in the US economy

M1 Money

• Liquid Assets (Liquidity) - Easy to convert to cash 
1. Cash
2. Currency
3. Checkable or demand deposits (checking accounts)
4. Traveler's Checks 

M2 Money 

• M1 Money + Savings Acct. and Money Market Accts. 

Purposes of Financial Institutions

• Store money
• Save money
• Loan money

They Loan Money for Two Reasons:

•  Credit cards
• mortgages

Four Ways to Save Money:

1. Savings account (low interest)
2. Checking account (no interest)
3. Money market account
4. Certificate of Deposit (CD) (fixed rate of interest)

(The last two pays higher interest, but with stricter rules)


Loans

• Banks operate on a fractional reserve system (keep a fraction of funds in the bank and lend out the rest) 

Interest Rates

• Principal - Amount of money borrowed

• Interest - Price paid for the use of borrowed money
1. Simple interest - Paid on the principal
2. Compound interest - Paid on the principal + accumulated interest

How to Calculate Simple Interest

I = P x R x T / 100

1. P stands for Principal
2. R stands for interest rate
3. T stands for time

Rearrange equation as needed to find different variables: 

1. P = I x 100 / R x T
2. R = I x 100 / P x T
3. T = I x 100 / P x R

Five Types of Financial Institutions

1. Commercial Banks
2. Savings and loans institutions
3. Mutual savings bank
4. Credit unions
5. Finance companies 

Investments 

1. Redirecting resources that we would consume now for future purposes 
2. Financial Assets - Claims on property and income of the borrower
3. Financial Intermediaries - Institution that channels funds from savers to borrowers 

Savers ---> Financial Institutions --> Investors

Three Purposes of Financial Intermediaries 

1. Share risk (diversification, spreading out investments to reduce risks)
2. Provide Information 
3. Liquidity - Returns (money an investor receives above and beyond the sum of money that was initially invested) 

Bonds

1. Loans or IOU's that represent debt that the govt or a corporation must repay to an investor
2. Bonds are generally low-risk investments

3 Components of a Bond

1. Coupon Rate - The interest rate that a bond issuer will pay to a bond holder 
2. Maturity - Time at which payment to a bond holder is due 
3. Par Value - Amount that an investor pays to purchase a bond and that will be repaid to the investor at maturity 

Example:

Coupon Rate: 5%
Maturity: 10 years
Par Value: 1,000

Bond = $500

Time Value of Money

• Is a dollar today worth more than a dollar tomorrow? 

1. Yes, because of inflation and opportunity cost 
2. This is the reason for charging and paying interest

The Simple Interest Formula

v = (1 + r)^n x p

Compound Interest Formula

v = (1 + r/k)^nk x p

v = future value of $
p = present value of $
r = real interest rate (nominal rate - inflation rate) expressed as a decimal
n = years
k = number of times interest is credited per year

7 Functions of the FED

1. It issues paper currency
2. Sets reserve requirements and holds reserves of banks 
3. It lends money to banks and charges then interest
4. They are a check clearing service for banks
5. Acts as a personal bank for the govt
6. Supervises member banks
7. Controls money supply in the economy

Unit 4 Money Banking and Monetary policy video notes

1. The three types of money is commodity money, representative money, and fiat money. Commodity money is the oldest and most basic form of money, and it is composed of goods that act as currency, such as cattle. Representative money is money backed by a precious metal, such as gold or silver. Fiat money,is money that we use today, and is legal tender backed by the word of the government. Money functions as a medium of exchange, store of value, and unit of account.

3. On the Money Market graph; the y-axis is labeled with 'i' which stands for interest rate and the x-axis is labeled as 'QM' which stands for quantity of money. Demand for money slopes downward because, when the price is high, the quantity demanded is low, and vice-versa. The supply of money,which is unlike the demand for money, is vertical and is fixed by the Fed, which means that it is not affected by the interest rate and only the Fed actions can shift it left or right. An increase for the demand of money is shown by a shift to the right; a decrease, is a shift to the left. If the Fed increases the money supply, they will bring the interest rate down, which then stabilizes it. 

4. The tools of monetary policy can be divided into two categories: expansionary [easy money]  and contractionary [tight money]. In a expansionary policy, the Fed lowers the reserve requirement and discount rate and buys bonds. In a contractionary policy, the Fed raises the reserve requirement for the discount rate and then sells bonds. The discount rate is the rate at which banks can be borrow money from the Fed. Buying bonds results in an increase in the money supply; selling bonds results in a decrease. The Federal Funds Rate is the rate at which banks borrow money from each other.

7. When creating a Loanable Funds graph, the y-axis is labeled as interest rate, and the x-axis is labeled as quantity of loanable funds. Both demand and supply is depicted in this graph. The supply of loanable funds comes from the amount of money that people have in banks. An increase in demand for money can also increases the demand for loanable funds, because both changes increase the interest rate. More demand for money means reducing the supply of money, since the government is demanding more of it; which they are buying more of; which also leaves less in terms of supply.

8. Banks create money by making loans. The reserve requirement is the amount of money that banks must keep in reserves, determined by the reserve ratio. The money multiplier can be calculated by dividing 1 by the reserve ratio. You take this multiplier and multiply it by the amount of the initial deposit in order to figure out how much money the bank can loan out. This is possible due to multiple deposit expansion; however, it is not guaranteed that this exact amount of money will be created, because that would mean that none of the banks hold excess reserves.


9. The relationship between the money market, the loanable funds market, and the AD-AS model is integral to macroeconomics. Using government deficit spending as an example, there is an increase in the demand for money, which also causes the demand for loanable funds to increase and the supply of loanable funds to decrease, and then an increase in aggregate demand. An increase in the interest rate also means an increase in the price level; this is known as the 'Fisher Effect'. It is better to show either an increase in demand or an increase in supply across all three graphs, because it shows consistency and it is easier to understand the concept.

Economic schools

Classical

1. Key Players: Adam Smith, John B. Say, David Ricardo, Alfred Marshall
2. Supply creates its own demand (whatever output is produced will be demanded
3. Savings are leakages
4. Investments are injections
5. Aggregate Supply determines output
6. "Invisible Hand" - Where market functions by itself, no government intervention (laissez-faire)
7. Savings increase with the interest rate
8. Aggregate Supply = Aggregate Demand at full employment equilibrium
9. In the long-run, the economy will balance at full employment
10. The economy is always close to or at full employment
11. "Trickle-Down Effect" - Help the rich first, and the poor will benefit later. Much later.
12. Prices and wages are flexible downward

Keynesian

• Savers do not equal investors
• Key Player: John Maynard Keynes 
• Competition is flawed, Aggregate Demand is key, not Aggregate Supply
• Aggregate Demand determines output, demand creates its own supply
• Savers and investors save and invest for different reasons
• Savings are inverse to interest rates
• Leaks cause constant recessions
• Savings cause recessions
• Ratchet effects and stick wages block Say's Law
• Prices and wages are inflexible downward
• There is no mechanism capable of guaranteeing full employment
• In the long run, we're dead
• Economy is not close to or at full employment
• Some government intervention is needed
• Stabilizers
• Use expansionary/contractionary policy
• Fiscal policy

Monetary

1. Key Players: Alan Greenspan, Ben Bernanke
2. Fine-tuning is needed
3. Congress can't time the policy options
4. Voters won't allow contractionary options
5. Uses tight money and easy money
6. Change required reserves if needed
7. Buy and sell bonds on the open market
8. Change interest rates for discount rate and federal fund rate