#ECONOMIC 2130 - Principles of Macroeconomics
##Chapter 10
###Money
Anything accepted as a medium of exchange.
- Means of payment or Means of Exchange – accepted as payment for goods and services.
- Store of Value – transports purchasing power from one time period to another.
- Unit of Account – standard unit that provides a consistent way of quoting prices.
####Barter
- direct exchange of goods/services for other goods/services
- ineffective in large economy
####Liquidity Property of Money
Property of money that makes it a good medium of exchange as well as a store of value
- Portable
- Readily accepted
- Easily exchanged for goods.
####Commodity Monies
Items used as money that also have intrinsic value in some other use
- Ex. Gold or cigarettes
####Fiat or Token Money Items designated as money that are intrinsically worthless.
- Legal Tender – Money that a government has required to be accepted in settlement of debts.
- Promise no “Currency Debasement” – The decrease in the value of money that occurs when its supply in increase rapidly.
####M1 or Transactions Money
Money that can be directly used for transactions.
- Currency held outside banks + demand deposits + traveler’s checks + other checkable deposits
####M2 or Broad Money
M1 plus
- Near Monies – Close substitutes for money – savings accounts and money market accounts
- Savings accounts, money market accounts, and other near monies.
- M1 + savings accounts + money market accounts + other near monies
###How Banks Create Money
Financial Intermediaries – Banks and other institutions that act as a link between those who have money to lend and those who want to borrow money.
Run on a Bank – Occurs when many of those who have claims on a bank (deposits) present them at the same time.
Federal Reserve Bank (the Fed) – Central bank of the United States.
Reserves – Deposits that a bank has at the Federal Reserve bank plus its cash on hand.
Required Reserve Ratio (RRR) – Percentage of its total deposits that a bank must keep as reserves at the Federal Reserve.
Assets ≡ Liabilities + Net Worth
When some item on a bank’s balance sheet changes, there must be at least one other change somewhere else to maintain balance.
Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction.
Excess Reserves – The difference between a bank’s actual reserves and its required reserves.
Excess reserves ≡ actual reserves – required reserves
####Money Multiplier
The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio.
An increase in bank reserves leads to a greater than one-for-one increase in the money supply. Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multiplier. Stated somewhat differently, the money multiplier is the multiple by which deposits can increase for every dollar increase in reserves.
Money Multiplier ≡ 1 / Required Reserve Ratio
###The Federal Reserve System
####Federal Open Market Commiteee (FOMC)
- Group composed of the 7 members of the Fed’s Board of Governors, the president of the New York Federal Reserve Bank, and 4 of the other 11 district bank presidents on a rotating basis
- Sets goals concerning the money supply and interest rates and directs the operation of the Open Market Desk in New York.
- Controls money supply
- Clears interbank payments
- Regulates banking practices
- Lender of Last Resort –Provides funds to troubled banks that cannot find any sources of funds.
####Open Market Desk
Office in New York Federal Reserve Bank from which government securities are bought and sold by the Fed.
###How the Fed Controls Money Supply
If the Fed wants to increase the supply of money, it creates more reserves, freeing banks to create additional deposits by making more loans. If it wants to decrease the money supply, it reduces reserves.
####Tools to control Money Supply
- Changes in RRR
- Decreases in the required reserve ratio allow banks to have more deposits with the existing volume of reserves. As banks create more deposits by making loans, the supply of money ( currency + demand) increases. The reverse is also true; If the Fed wants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce their deposits by “calling in” some of their loans. The result is a decrease in the money supply.
- Changes in Discount Rate – Interest rate the banks pay to the Fed to borrow from it.
- The higher the discount rate, the higher the cost of borrowing and the less borrowing banks will want to do, therefore lowering money supply.
- Engaging in Open Market Operations – Purchase and sale of government securities in the open market
- Expands or contract the amount of reserves in the system and thus the money supply.
- Open market purchase of securities by the Fed results increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves.
####Methods to Increase Money Supply
- create reserves
- lower discount rate
- buy securities
- lower RRR
Moral suasion – the pressure that in the past the Fed exerted on member banks to discourage them from borrowing heavily from the Fed.
The Treasury cannot print money to finance the deficit.
##Chapter 11
###Interest
Monetary Policy – The behavior of the Federal Reserve concerning the money supply.
Interest – The fee that borrowers pay to lenders for the use of their funds.
Interest Rate – The annual interest payment on a loan expressed as a percentage of the loan. Equal to the amount of interest received per year divided by the amount of the loan. We assume universal.
###Demand for Money
Transaction Motive – The main reason that people hold money – to buy things.
Nonsynchronization of income and spending – The mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses.
When interest rates are high, people want to take advantage of the high return on bonds, so they choose to hold very little money.
Higher interest = higher opportunity cost = less people hold = reduced demand for money
Volume of transaction affects money demand, depends on number of transactions and average amount
When market interest rates fall, bond values rise; when market interest rates rise, bond values fall.
Speculative Motive – One reason for holding bonds instead of money: Because the market value of interest-bearing bonds is inversely related to the interest rate, investors may wish to hold bonds when interest rates are high with the hope of selling them when interest rates fall.
At any given moment, there is a demand for money-for cash and checking account balances. Although households and firms need to hold balances for everyday transactions, their demand has a limit. For both households and firms, the quantity of money demanded at any moment depends on the opportunity cost of holding money, a cost determined by the interest rate.
For a given interest rate, a higher level of output means an increase in the number of transactions and more demand for money. The money demand curve shifts to the right when Y rises. Similarily, a decrease in Y means a decrease in the number of transactions and a lower demand for money. The money demand curve shifts to the left when Y falls.
Increases in the prices level shift the money demand curve to the right, and decreases in the price level shift the money demand curve to the left. Even though the number of transactions may not have changed, the quantity of money needed to engage in them has.
###Equilibrium Interest Rate
When quantity demanded (Md) equals the quantity supplied (Ms) determines the equilibrium interest rate
To high of interest = excess supply of money = more people buy bonds = the interest rate will fall
To low of interest = excess demand for money = less buy bonds = the interest rate rise
An increase in Y shifts the money demand curve to the right (up).
An increase in the price level is like an increase in Y in that both events increase the demand for money. The result is an increase in the equilibrium interest rate.
A decrease in the price level leads to a decrease in the equilibrium interest rate.
Tight monetary policy – Fed policies that contract the money supply in an effort to restrain the economy.
Easy Monetary Policy – Fed policies that expand the money supply in an effort to stimulate the economy.
##Chapter 12
###Link Between Markets
Goods Market – The market in which goods and services are exchanged and in which the equilibrium level of aggregate output is determined.
Money Market – The market in which financial instruments are exchanged and in which the equilibrium level of the interest rate is determined.
Income is determined in goods market which determines volume of transactions which affects the demand for money in the money market.
Interest rate is determined in money market and affects planned investment spending in goods market.
- When the interest rate falls, planned investment rises.
Effects of a change in the interest rate
- A high interest rate (r) discourages planned investment (I).
- Planned investment is a part of planned aggregate expenditure (AE)
- Thus, when the interest rate rises, planned aggregate expenditure (AE) at every level of income fall
- A decrease in planned aggregate expenditure lowers equilibrium output (income) (Y) by a multiple of the initial decrease in planned investment.
r↑ → I↓ → AE↓ → Y↓
If money supply is constant
Y↑ → Md↑ → r↑
###Combining Markets
####Expansionary Fiscal Policy
An increase in government spending or a reduction in net taxes aimed at increasing aggregate output (income) (Y).
G↑ → Y↑ → Md↑ → r↑ → I↓ → Y increases less than if r did not increase
####Expansionary Monetary Policy
An increase in the money supply aimed at increasing aggregate output (income) (Y).
Ms↑ → r↓ → I↑ → Y↑ → Md↑ → r decreases less than if Md did not increase
####Crowding-out Effect The tendency for increases in government spending to cause reductions in private investment spending. Size depends on:
- Assumption that the Fed does not change the quantity of money supplied
- Interest sensitivity or insensitivity of planned investment
- The responsiveness of planned investment spending to changes in the interest rate.
- Sensitivity means planned investment spending changes a lot in response to changes in the interest rate
####Contractionary Fiscal Policy
A decrease in government spending or an increase in net taxes aimed at decreasing aggregate output (income) (Y).
G↓ OR T↑ → Y↓ → Md↓ → r↓ → I↑ → Y decreases less than if r did not decrease- Lift economy out of recession
####Contractionary Monetary Policy
A decrease in the money supply aimed at decreasing aggregate output (income) (Y).
Ms↓ → r↑→ I↓ → Y↓ → Md↓ → r increases less than if Md did not decrease- Fights inflation
####Policy Mix
The combination of monetary and fiscal policies in use at a given time.
####Determinates of Planned Investment
- The interest rate
- Expectations of future sales
- Capital utilization rates
- Relative capital and labor costs
##Chapter 18
###Monetarism
Velocity of money – the number of times a dollar bill changes hands, on average, during a year; the ratio of nominal GDP to the stock of money.
V ≡ GDP / M
Income Velocity of Money ≡ Nominal GDP / Stock of Money
GDP ≡ P x Y
Nominal GDP ≡ Overall Price Level x Real Output
Quantity theory of money – The theory based on the assumption that the velocity of money is constant
M x Ṽ = P x Y
Stock of Money x Constant Velocity of Money = Overall Price Level x Real Output
Inflation cannot continue indefinitely without increases in the money supply.
###Exchange Rates
When trade is free – unimpeded by government-instituted barriers – patterns of trade and trade flows result from the independent decisions of thousands of importers and exporters and millions of private households and firms.
Exchange rates determine the terms of trade.
- Exchange rates lead countries to realize gains of specialization and comparative advantage.
- Exchange rates determine which country gains the most from trade.
The free market will drive countries to shift resources into sectors that have a comparative advantage. Only these sectors will be competitive in world markets.
###Open Economy
Exchange rates – the price of one country’s currency in terms of another country’s currency; the ratio at which two currencies are traded for each other.
Foreign exchange – All currencies other than the domestic currency of a given country.
Balance of Payments – The record of a country’s transactions in goods, services, and assets with the rest of the world; also the record of a country’s sources (supply) and uses (demand) or foreign exchange.
Balance of Trade – A country’s exports of goods and services minus its imports of goods and services.
Trade Deficit – Occurs when a country’s exports of goods and services are less than its imports of goods and services in a given period.
Balance on Current Account – Net exports of goods, plus net exports of services, plus net investment incomes, plus net transfer payments.
Balance on Capital Account – in the United States, the sum in a given period of the following :
- Change in private U.S. assets abroad
- Change in foreign private assets in the United States
- Change in private U.S. government assets abroad
- Change in foreign government assets in the United States
###Flexible Exchange Rates
Price Feedback Effect – The process by which a domestic price increase in one country can “feed back” on itself through export and import prices. An increase in the price level in one country can drive up prices in other countries. This in turn further increases the price level in the first country.
Floating or Market-Determined Exchange rates – Exchange rates that are determined by the unregulated forces of supply and demand.
Equilibrium Exchange Rate - Occurs at the point at which the quantity demanded of foreign currency equals the quantity of that currency supplied.
Appreciation of a currency – The rise in value of one currency relative to another.
Depreciation of a currency – The fall in value of one currency relative to another.
Law of one price – If the costs of transportation are small, the price of the same good in different countries should be roughly the same.
Purchasing-Power-Parity Theory – A theory of international exchange holding that exchange rates are set so that the price of similar goods in different countries is the same.
A high rate of inflation in one country relative to another puts pressure on the exchange rate between the two countries, and there is a general tendency for the currencies of relatively high-inflation countries to depreciate.
A depreciation of a country’s currency is likely to increase its GDP
J-curve Effect – Following currency depreciation, a country’s balance of trade may get worse before it gets better. The graph showing this effect is shaped like the letter J, hence the name J-curve effect.