Unit 4

Money is any assets to purchase any good or service

3 uses:

• Medium of exchange
• Unit of account: how to compare prices
• Store value: how money can be stored

3 types of money:

• Commodity money
• Has money within itself
• Salt
• Olive oil
• Gold
• Representative money
• Represents something of value
• An IOU
• Fiat money
• It is money because the government said so
• Paper currency
• Coins

6 characteristics of money

• Durability
• Portability
• Divisibility
• Uniformity
• Limited supply
• Acceptability

Money supply is the total value of financial assests available in the US economy

M1	M2
Liquid assets = east to convert to cash Cash Paper currency Coins Checkable deposits or Demand Deposits Travelers checks	M1 money + savings acct or money market account

Purpose of financial institutions

• Store money
• Save money
• Loan money
• most loan for credit cards/mortgages

4 ways to save money

• Savings
• Checkable accounts
• Money market account
• Certificate of deposit (CD)

Loans

• Banks operate on a fractional reserve system
• Which is where they keep a fraction of funds and loan out the rest

Interest rates

• Principle amount of money borrowed
• Interest: price paid for use of borrowed money
• Simple interest: paid on the principle
• Compound: paid on the principle + accumulated interest

Types of financial institutions

• Commercial banks
• Savings and loans
• Mutual savings banks
• Credit unions
• Finance companies

Investments

• Redirecting resources you'd use now for the future
• financial assets: claims on property or income of borrowers
• financial intermediary: institution that channels funds from savers to borrowers
• Purpose of these
1. Sharing risk, by diversification: spread investment to reduce risk
2. Providing information
3. Liquidity returns: amount investors receive above and beyond the sum of money invested

Bonds you OWN -- Stocks you LOAN

Bonds: loans or IOUs that represent debt that govt. or corporations must repay to an investor; a relatively low risk investment

• Coupon rate: interest rate the issuer pays the bond holder
• Maturity: time which payment to bond holder is due
• Par value: amount an investor pays to purchase an bond and that would be paid to investor at maturity
• Yield: annual rate of returns on a bond if bond is held to maturity

Time value of money

1. Is a dollar today worth more than tomorrow?
• Yes, because inflation topp. cost
• This is the reason for charging and paying interest

• Let V = future value of money
• P = present value of $
• r = real interest rate (nominal - inflation rate)
• n = years
• k = # of times interest is credited per year
• Simple interest formula: V = (1 + r) ^n * p
• Compound interest rate: V = (1 + r/k)^nk * p

FUNCTIONS OF THE FED

• issue paper currency
• set reserve requirements and hold reserves of banks
• lend money to bank and charge interest
• they are a check clearing service for banks
• act as personal bank for government
• supervise member banks
• control money supply in the economy

• Types of multiple deposit expansion: 
• Type 1: calculate initial change in excess reserves: amount single bank can loan form initial deposit
• Type 2: calculate change in loans in banking system. 
• Type 3: calculate change in money supply.
• Type 4: calculate change in demand deposit

How banks work

Assets	Liabilities + equities
Reserves Required reserves (RR): % required by FED to keep on hand to meet demand Excess Reserves (ER): % reserves over & above amt needed to satisfy minimum reserve ratio set by the FED	Demand Deposits ($ put in banks)
Loans to firms, consumers and other banks (earns to interest)	Checkable Deposits (CD's)
Bank property- if bank fails, you can liquidate the building/property	Loans from Federal Reserve & other banks
Loans to government-- treasury securities	Shareholders equity - to set up a bank, you must invest your own money in it to have a stake in the bank success or failure

• Creating a bank:
• transaction #4
• depositing reserves in a FED. reserve banks
• required reserves
• reserve ratio

Reserve ratio = commercial bank required reserve / commercial bank checkable deposit

• Reserve requirements
• Excess reserves
• Actual reserves - required reserves
• Required reserves
• checkable deposits * reserve ratio

Key principle:

• A single bank can create money (through loans) by the amount of excess reserves
• Banking system as a while can create money by a multiple (deposit on money multiplier) of the initial excess reserves.

Factors that weaken effectiveness of deposit multiplier

1. If banks fail to loan out excess reserves
2. if banks customers take their loans in cash rather than i nnew checking acct deposit, creates a cash/ currency drain

Money market

• inverse between money demand and the interest rates
• money demanded is downward sloping
• money supply is vertical
• fed buy bonds then interest rate is low
• decrease money supply by selling bonds

Fiscal	FED
Congress & the President	The Fed (Fed revenue bank)
Tax and spend	OMO (open market operation)
	Discount rate
	Federal fund rate
	Reserve requirements

• Federal fund rate: the interest rate that commercial banks charge each other for overnight loans
• Will always be opposite of bank reserves & money supply
• Money & bank increase, this decreases
• Prime rate: interest rate banks charge to their most credit worthy customers
• if higher than 4%. not prime rate

Loanable funds market

• market where savers and borrowers exchange fund (Qlf) at the real rate of interest
• demand for loanable funds or borrowing comes from households, firms, government and the foreign sector
• the demand for loanable funds is infact the supply of bonds
• supply of loanable funds is also the demand for bonds

Changes in demand for loanable funds

• Demand for loanable funds = borrowing (i.e supply bond)
• more borrowing = more demand for loanable funds shifts to the right
• less borrowing = less demand for loanable funds shifts to the left
• Ex. Govt. deficit spending = more borrowing
• Less investment demand = less borrowing, ir decrease

Changes in supply

• Supply of loanable funds = saving
• more saving = mor supply of loanable funds, shift to the right
• less saving = less supply of loanable funds, shift to the left
• Ex. Govt. budget surplus = more saving = more supply of loanable funds
• Decrease in consumer MPS = less saving = less supply of loanable funds

March 29th Video Response

Video #1:
     This video sought to teach us the basics of the money market. Commodities are basically goods that serve a purpose and representative money represents the quantity of precious metal and fiat money does not represent anything but the promise from the government that the money does have value. The functions of money include becoming a medium of exchange, which basically means it is through money that exchanges happen, money as a store of value and being a unit of account. (p > worth (quality)).

Video #2:
     Though there is a difference in labels, money market graphs are very similar to supply and demand graphs in their concepts. When the price is high, the demanded is high, when the interest rate is low, people have an incentive to borrow more. The supply of money is fixed and set by the FED, and it doesn't move unless the FED does so. When you increase demand, more pressure is put on interest rates. Quantity stays the same because supply is vertical, nothing can impact it. If they'd like to bring interest rates down, they'd have to increase money supply.

Video #3:
     The FED has two types of Monetary policy: Expansionary policy (easy money) and Contractionary policy (tight money). Under easy money, required reserves decrease in an effort to increase spending to battle recession and under tight money, required reserves increase in an effort to decrease spending to battle inflation. Discount rate isn't used very often as even if they have the incentive, it isn't guaranteed banks will comply and accept what is given. To expand the money supply, the FED buys bonds (expansionary), by doing this, money supply increases. The contract the money supply, the FED sells bonds (contractionary) and in turn reduces money supply. The Federal Funds rate i the rate at which banks borrow from one another.  

Video #4:
    Loanable funds is basically money that is available in banks for people to borrow. The loanable funds graph follows the basics of the previous graphs, but in this case, quantity stands for quantity of loanable funds and supply is upward sloping. Supply is dependent on savings As you increase demand in both the money market graph and loanable funds graph, interest rates increase. During a deficit, the government demands money in order to spend it.

Video #5:
     A key point in the money creation process is that banks create money by making loans. In a banking system, you'd multiply your excess reserves by your money multiplier. To get the money multiplier, you'd write it as 1/RR, 1 over the reserve ratio. An assumption of no excess reserves would reduce your total amount. To get the initial increase, you'd multiply the loan by the money multiplier.

Video #6:
     The equation of exchange follows the formula of MV=PQ, where M is the amount of money in the economy and V is the velocity of the money, it is stable and relates to the GDP expenditures. P is the average price of goods and Q serves as the total quantity or volume, this ties in with GDP income. A change in money will cause a change in price, just as the supply and demand graphs. Ultimately they are all related and with the shift of one side, the other will shift in response.

Unit 3 notes

Aggregate demand (AD)

• Shows the amount of real GDP that the privat, public and foreign sector collectively desire to purchase at each possible price level.
• The relationship between price level and level of real GDP is inverse
• Price level increases, output increases

Real balances effect

• Based on purchasing power
• High price, households and businesses cut on output purchase
• Low, more affordable

Interest rate effect

• High price level increases interest rate which tends to discourage investment
• Low price level decreases interest rate which tends to encourage investment

Foreign purchases effect

• High price level increases demand for relatively cheap imports 
• Low price levels increase foreign demand for cheaper US exports

What causes shifts in AD?

• Two parts to a shift in AD
• Change in C, Ig, G, Xn
• multiplier effect that produces a greater change than the original change in the 4 components
• An increase in AD would shift to the right, and the opposite if it were to decrease.

Consumption:

• Household spending affected by:

1. Consumer wealth
• More wealth, more spending (AD shifts to the right)
• Less wealth, less spending (AD shift to the left)
2. Consumer expectations
• Positive expectations = more spending (AD shift to the right)
• Negative expectations = less spending (AD shift to the left)
3. Household indebtedness
• Less debt = more spending (AD shift to the right)
• More debt = less spending (AD shift to the left)
4. Taxes
• Less taxes = more spending (AD shift to the right)
• More taxes = less spending (AD shift to the left)

Gross Private Consumption

• Investment spending sensitive to:

1. The real interest rate
• Low real interest rte= more investment (AD shift to the right)
• High real interest rate = less investment (AD shift to the left)
2. Expected returns
• Higher expected returns = more investment (AD shifts to the right)
• Lower expected returns = less investment (AD shifts to the left)
• Expected returns are influenced by:
• expectations of future probability
• technology
• degree of excess capacity (existing stock of capital)
• business taxes

Government spending

• More government spending (AD shift to the right)
• Less government spending (AD shift to the left)

Net exports

1. Exchange rate
• Strong $ = more imports, fewer exports (AD shift to the left)
• Weak $ = less imports. more exports (AD shift to the right)
2. Relative income
• Strong foreign economies = more exports (AD shift to the right)
• Weak foreign economies = less exports (AD shifts to the left)

Aggregate Supply

The level of Real GDP (GDPR) that firms will produce at each price level (PL)

Long Run v. Short Run

• Long run: time where input prices are flexible and adjust to change in price level
• level GDP supplied is independent of the price level
• Short run: time where input prices are sticky and don't adjust to change in price level
• level of GDP supplied is directly related to price level

Long run AS

• LRAS marks level of full employment in the economy (analogous to PPC)
• because input is completely flexible in the long run, changes in price level do not change firms real profits and so don't change firms level of output
• Meaning LRAS is vertical at the economies level of full employment
• SRAS is upward sloping because input prices are sticky

Remember

1. No matter whether its a decrease in supply or demand, it will always shift left
2. If it increases it will shift right

Per-unit production cost

• To get per-unit production cost = total input cost/total output
• The per-unit production cost is the key in understanding shifts

Determinants of SRAS:

• Input price
• Productivity
• Legal institutional environment

1. Input prices
• Domestic Resource prices
• wages (75% of all business prices)
• cost of capital
• raw materials (commodity prices)
• Foreign resource power
• Strong money = low foreign resource prices
• Weak money = high foreign resource prices
• Market power
• monopolies and cartel that control resources and control prices of those resources
• an increase in resource price shifts SRAS to the left
• a decrease would shift it to the right
2. Productivity
• Productivity = total output/total inputs
• More productivity = low unit production cost (AS shift to the right)
• Less productivity = high unit production cost (AS shift to the left)
3. Legal institutional enviroment
• Taxes and subsidies
• Taxes ($ to the govt.) on business increase per-unit production cost (AS shift to the left)
• Subsidies ($ from the govt.) to business reduce per-unit production cost (AS shift to the right)
• Government regulation
• Government regulation creates a cost of compliance (AS shift to the left)
• Deregulation reduce compliance cost (AS shift to the right)

Interest

• Full employment equilibrium exist where AD intersects with SRAS and LRAS at the same point
• Recessionary gap: exist when equilibrium occurs below full employment output
• AD shift to left with recessionary gap
• Inflationary gap: when equilibrium occur beyond full employment output
• AD shift to right with inflationary gap
• Unemployment increase, deflation decreases

Interest rate and investment demand

Investment: your expidentures

• New plants
• Capital equipment (machinery)
• Technology (hardware and software)
• New homes
• Inventories

Expected rates of return

• How business makes investment decisions
• cost benefit analysis
• How businesses determine benefits
• Expected rate of return
• How businesses count cost
• interest cost
• How to determine the amount of interest
• compare expected rate of return to interest cost
• if expected cost > iterest then invest, if not, then don't invest

Real (r%) v. Nominal (i%)

• What is the difference?
• Nominal is the observable rate of interest
• Real subtracts out inflation only known to ex post facto
• How to compute real interest rate?
• r% = i% - π%
• What then determines cost of investment  decision?
• real interest rate (r%)

Investment demand curve (ID)

• is downward sloping because when interest rate is high people don't want to pay, few investments profitable

1. Cost of production
• Low cost shit ID to the right
• High cost shift ID to the left
2. Business taxes
• Low business taxes shift ID to the right
• High business taxes shift ID to the left 
3. Technological change
• New technology shift ID to the right
• Lack of technology shift ID to the left
4. Stock of capital
• Economy low on capital, ID shift to the right
• More capital, ID shifts to the left
5. Expectations
• Positive expectations shift ID to the right
• Negative expectations shift ID to the left
6. Long run
• Always vertical at full employment
• Represents point on an economy's production possibilities curve (PPC)
• Doesn't change as price level changes
• Only factors which would change it would be what  shifts the PPC outward
•  Δresources
•  Δtechnology
•  Δeconomic growth

Three Schools of Economics

Classical	Keynesian	Monetary
Savings(leakage) = investment injection	Savers ≠ investors	Allen Greenspon
Adam Smith	John Maynard	Ben Bernank
John B. Say
David Ricardo
Affard Marshall

• Classical
• Competition is good
• Adam Smith: invisible hand >> don't need government intervention, run without it
• Say's law
• supply creates own demand
• As determine output
• In the long run, economy will balance at FE
• The economy is always at or close to FE
• AS=AD at full employment equilibrium
• Trickle down effect
• Help rich first, everybody else later
• Savings increase with interest rate
• save more at high interest, low interest rate you spend
• Prices and wages flexible downward
• Foster Laissez faire >> don't need the government
• Keynesian
• Competition is flawed
• AD is key, not AS 
• AD determines own output, demand create own supply
• Leaks cause constant recessions
• savings cause recessions
• Savings and investors save and invest for different reasons
• savings inverse to interest rate
• Ratchet effect and sticky wages block Say's law
• Prices and wages inflexible downward
• Since there is no guarantee of FE, in the long run, we are all dead
• The economy is never close to or at FE
• Use fiscal policy, add stabilizers, use expansionary and contract policy
• Monetary
• Fine tuning needed
• Voters won't allow contract. actions
• Congress can't time policy actions
• Institute easy money and type money
• Change regulation reserves if needed
• Buy and sell bond via open market operations
• Use interest rate to change discount and federal fund rates

Consumption and Savings

• Two choices; with disposable income, households can either:
1. Consume (spend money on goods and services)
2. Save (not spend money on goods and services)
• Disposable income (DI)
• Income aft taxes or net income
• DI = gross income - taxes
• Consumption
• Household spending
• Ability to consume constrained by
• amt of disposable income
• propensity to save
• Do households consume if DI = 0?
• autonomous consumption
• Dissaving
• APC = C / DI = % DI that is spent
• Saving
• Household not spending
• Savings constrained by
• amt of  disposable income
• the propensity to save
• Do households save if DI = 0?
• No
• APS = S/DI = % that is not spent
• Calculations
• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 = Dissaving
• -APS = Dissaving

MPC and MPS

• Change in consumption/change in DI
• Marginal propensity to save and marginal propensity to consume
• ΔS/ΔDI
• % of every extra dollar earned that is saved
• MPC + MPS = 1
• 1 - MPC = MPS
• 1 - MPS = MPC
• Spending multiplier effect
• initial change in spending (C, Ig, G, Xn) causes larger change in Aggregate spending or Aggregate demand
• Multiplier = Δ in AD/C, Ig, G, Xn
• Why does this happen?
• Expenditures and incomes flow continuously which sets off a spending increase in the economy
• Spending multiplier can be calculated from MPC or MPS
• Multiplier = 1/1-MPC or 1/MPS
• Multipliers are positive (+) when there is an increase in spending and negative (-) with a decrease
• Tax multiplier (note it is negative)
• When government taxes, multipliers work in reverse because money is leaving the circular flow
• -MPC/1-MPC or -MPC/MPS
• If there is a tax cut, then mulltiplier (+), because more money is in the circular flow

Fiscal Policy

• Change in expenditures or tax revenues of federal government
• 2 tools
• Taxes (increase or decrease)
• Spending (increase or decrease)
• Deficits, surpluses, & Debt
• Balanced budget
• Revenue=Expenditures
• Budget deficit: spending more than what is being brought in
•  Revenue<Expenditures
• Budget surplus: bringing in more than what spent out 
• Revenue>Expenditures
• Government debt
• sum of all deficits – summation of all surplus
• Government must borrow money when in budget deficit
• Borrow from:
• Individuals
• Corporation
• Financial institutions
• Foreign entitled foreign government

Fiscal policy

• Two options:

1. Discretionary (action)
• expansionary fiscal policy (think deficit)
• contractionary (think surplus)
2. Non-discretionary (no action)

Discretionary v. Automatic

• Discretionary
• Increase or decrease government spending/taxes in order to return the economy to full employment
• Involves policy makers in response to economic problems
• Automatic
•  Unemployment compensation and marginal tax rates are examples of automatic policies that mitigate recession and inflation effects
• Takes place without policy makers having to respond to current economic problems

• Contractionary fiscal policy
• policy designed to decrease AD
• strategy for combating inflation
• decrease govt. spending and increase taxes
• Expansionary fiscal policy 
• policy designed to increase AD
• strategy for increasing GDP
•  strategy for combating recession and reducing unemployment
• increase govt. spending and decrease taxes.  
• Automatic or built-in stabilizers: (non-discretionary)
• anything that increases the governments budget deficit during a recession and increases its budget surplus during inflation without requiring action from policy makers
• Transfer payments:
• Welfare checks
• Unemployment checks
• Social security
• Food stamps
• Corporate dividends 
• Veteran's benefit
• Progressive tax system:
• avg. tax rate (tax revenue/GDP) rises w/ GDP 
• Proportional tax system
• avg. tax rate remains constant as GDP changes 
• Regressive tax system
• avg. tax rate falls w/ GDP