Monetary policy video

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