$9.2 T - The total amount of all bank deposits in the United States. The FDIC has just 25 billion dollars in the deposit insurance fund that is supposed to "guarantee" those deposits. $10 T - The total amount of mortgage debt in the United States. $10.4 T - The M2 money supply in the United States. $15 T - U.S. GDP. It is a measure of all economic activity in the United States for a single year. $16 T - The size of the U.S. national debt. $32 T - The total amount of money that the global elite have stashed in offshore banks. $50 T - The total amount of government debt in the world. $56 T - The total amount of debt (government, corporate, consumer, etc.) in the U.S. financial system. $61 T - The combined total assets of the 50 largest banks in the world. $70 T - The approximate size of total world GDP. $190 T - The approximate size of the total amount of debt in the entire world.

Unit 4 Notes Money, Banking and Monetary Policy

Money  Money is anything used to facilitate the exchange of goods between buyers and sellers.  Financial assets are purchases made by firms and households who expect to see a rate of return:  Stock – A claim of ownership of a firm.  Bonds – A certificate of indebtedness used by firms or government to raise money.

Functions of Money  Our money is fiat money in that it has no intrinsic value (gold) or value as a commodity.  Our money serves 3 functions: 1. Medium of exchange – Allows us to exchange our resources for goods. 2. Unit of Account – Measures the relative worth of goods and services. 3. Store of value – Allows us to receive value for our resources to be used at a later time.

Time Value of Money  Money loses value over time due to the natural occurrence of inflation.  If you gave out a $100 loan today, you would want to receive your payment back as soon as possible.  Time value of money is the reason we receive interest on savings and charge interest on borrowing.

Present Value and Future Value  Assume you have lent $100 at 10% interest for one year that has no inflation (for simplicity).  FV - Future Value, PV - Present Value  FV = PV×(1+r) or FV = $100×(1.10) = $110  PV = FV/(1+r) or PV = $110/(1.10) = $100

PV vs. FV  Money today is more valuable than the same amount of money in the future.  The present value of $1 received one year from now is $1/(1+ r)  The future value of $1 invested today is $1×(1 + r)

Classwork: Money  Read Pages 229 – 232  Answer Questions 1, 3, and 4 on pages 242 – 243

Money Market

Supply of Money  Monetary policy - The actions of the central bank, that determines the size and rate of growth of the money supply, which in turn affects interest rates.  Stabilizing MS guarantees the value of money which is measured by the US central bank as M1, M2 and M3.  The components of MS are defined by their liquidity (how easily they can be converted to cash:)

Components of MS  M1 = cash + coins + checkable deposits  M2 = M1 + savings deposits + small time deposits (CDs) + money market deposits + Money market mutual funds  M3 = M2 + large (over $100,000) time deposits + Institutional money market mutual funds  At any given point MS is constant so the current MS curve is vertical.

Demand for Money  Transaction Demand – As nominal GDP increases, consumers demand more $ to buy goods and services. As PL increases more $ is demanded to pay for more expensive goods.  Asset Demand – At higher i % for bonds, people will invest more, and the D for $ decreases. At lower i % for bonds, people invest less and asset Demand for money increases.  Total Demand: MD = Transaction Demand + Asset Demand

The Money Market  The money market compares the quantity of money supplied and demanded based on nominal interest rates.  If NIR is set below E, a shortage occurs and the NIR will rise. If NIR is set above E, a surplus occurs and the NIR will fall. MD Money NIR Q$ i % MS

Money Market vs. Loanable Funds Market  The S of loanable funds comes from national savings. The S of the money market includes currency and checking deposits.  The D for loanable funds comes from Investment. The D of the money market includes I, and also C, and asset demand.  The loanable funds market graphs the real i %, while the money market uses the nominal i %  Δ in the money market are short term, where expected inflation is negligible. Δ t o loanable funds focus on long-term decisions so the real i % is used.

Changes to MS

Increase in the MS  Original MS = $1000, Original Bond Price = $100, Original i % = 10%, Interest = $10  When the Fed increases MS to $1500, a surplus of money occurs.  With this money people buy assets, like bonds and the D for those assets , increasing the P of bonds.  New MS = $1500, New Bond Price = $125, New i % = 8%, Interest = $10  Increasing MS decreases i % MD Q$ NIR $ % MSMS 1 8 % $1500

Decreasing the MS  Fed decreases MS from $1000 to $500 leaving a shortage of money. Bondholders sell their bonds, causing a decrease in D and price for bonds.  The decrease in P to $90 with the same interest amount - $10, brings the i % up to 11.1%. Higher i % causes MD to fall until the i % rises to the point of Q$ = $500 MD Q$ NIR $ % MSMS % $500

Decreasing the MS  Fed decreases MS from $1000 to $500 leaving a shortage of money. Bondholders sell their bonds, causing a decrease in D and price for bonds.  The decrease in P to $90 with the same interest amount - $10, brings the i % up to 11.1%. Higher i % causes MD to fall until the i % rises to the point of Q$ = $500 MD Q$ NIR $ % MS 11.1 % $500

Fractional Reserve Banking & Money Creation

Fractional Reserve Banking  When people deposit money into a bank only a fraction is reserved by the banks for withdrawals.  Very little of the $7 Trillion in savings is ever withdrawn by savers.  Banks loan out most of that money and give some of the interest from those loans to savers.  The fraction of deposits kept on reserve is called the reserve ratio.

Money Creation  Assume the reserve ratio is 10%  Reserve ratio (rr) = required reserves/total deposits =.10  To see how loans turn into new money create a T- Account or balance sheet.  Total assets must always equal total liabilities  Asset – Anything owned by the bank or owed to the bank. Cash on reserve and loans to citizens are assets  Liability – Anything owned by depositors or lenders to the bank. Checking deposits of citizens or loans to the bank.

Jen deposits $1000 in Chase Bank. AssetsLiabilities Required Reserves $100 Checking Deposits $1000 Excess Reserves $900 Total Assets $1000Total Liabilities $1000

Chase Bank lends out the $900 in excess reserves to Bob the farmer. AssetsLiabilities Required Reserves $100Checking Deposits $1000 Excess Reserves $0 Loans $900 Total Assets $1000Total Liabilities $1000

Bob uses the $900 at Tractor Supply, which has an account at Chase. Chase must keep $90 and $810 become excess reserves. AssetsLiabilities Required Reserves $190Checking Deposits $1900 Excess Reserves $810 Loans $900 Total Assets $1900Total Liabilities $1900

Chase makes an $810 loan to Bill who buys a couch from Couch World, who also has an account with Chase. The $810 goes back to Chase who must keep $81. AssetsLiabilities Required Reserves $271Checking Deposits $2710 Excess Reserves $729 Loans $1710 Total Assets $2710Total Liabilities $2710

The Money Multiplier  An initial deposit of $1000 creates, after only two loans are made, $2710 of checking deposits.  This process continues until there are no more excess reserves, when $10,000 will have been created.  This process is known as the money multiplier which is identical to the spending multiplier from Unit 3  M = 1/(reserve ratio) = 1/rr (=1/.10 = 10 in our example)  This process works in reverse when withdrawals are made (money destruction) Danskin Rules!

Tools of Monetary Policy

Fed’s Actions  Expansionary Policy – When unemployment and declining GDP is a problem, the Fed buys bonds, ↓ the discount rate, or ↓ the reserve requirement which ↑ MS.  Contractionary policy – When inflation is a problem, the Fed sells bonds, ↑ the discount rate, or ↑ the reserve requirement which ↓ MS.

Open Market Operations  Through the FOMC, the Fed buys and sells US bonds on the open market. Of the three tools, OMO is used the most because it causes the least disruption to the markets.  Buying securities – Commercial banks hold Treasury bonds rather than excess cash reserves. If the Fed buys those securities, the banks would receive excess cash, which they would then loan out, creating money and causing interest rates to fall.

 Selling securities – If the Fed sells bonds to commercial banks, excess reserves would fall. Money destruction begins, MS declines and interest rates rise.  B uying B onds = B igger B ucks  S elling B onds = S maller B ucks

Discount Rate  The discount rate is the i % the Fed charges banks for short term loans.  Lowering the discount rate (or FFR) increases excess reserves in commercial banks and expands the MS.  Raising the discount rate (or FFR) decreases excess reserves in commercial banks and shrinks the MS.

Required Reserve Ratio  Lowering the rrr increases MS  Increasing the rrr decreases MS Problem: Unemployment Problem: High Inflation Monetary tool could be… Buy bonds in an OMOSell bonds in an OMO Or…↓ the discount rate↑ the discount rate Or…↓ the reserve requirement ↑ the reserve requirement Possible effect would be… ↑MS, ↓ i %, ↑ I, ↑AD, ↑ real GDP, ↓ unemployment ↓MS, ↑ i %, ↓ I, ↓AD, ↓ real GDP, ↓ price level

Federal Funds Rate  FFR – The interest rate that banks charge for short term loans.  The FFR is set as a target rate and the FOMC then proceeds to engage in OMOs to hit that target rate.  The analysis of monetary policy is the same whether talking about Δ to MS or the FFR

Monetary Policy  Read pages  Answer questions 4, 6, and 8 on page 281

Monetary Policy, Real GDP and Price Level

Expansionary Policy  When the Federal Reserve encourages banks to make loans, the MS will increase, lowering interest rates.  As interest rates decrease, businesses will be more likely to increase I. As I increases so too does AD.  As AD and Real GDP increases, unemployment decreases. MD Q$ NIR 5 % MS 1 MS 4 % Real GDP SRAS LRAS AD AD 1 PL

Contractionary Policy  When the Fed discourages banks from making loans, the MS will decrease, raising interest rates.  As interest rates increase, businesses will be more likely to decrease I. As I decreases so too does AD.  As AD and Price Level decreases, inflation decreases. MD Q$ NIR 5 % MS 1 MS 6 % Real GDP SRAS LRAS AD AD 1 PL

The Federal Reserve & Monetary Policy  Structure of The Federal Reserve (pg. 235)  Makeup of the FOMC (pg. 236)  Purpose of the FOMC (236)  7 Fed Functions and the Money Supply (237)  (Provide explanations when necessary)  Reasons the Fed is Independent of Govt. (238)  Reasons for Using Expansionary Monetary Policy and Its Effects (268)  Reasons for Using Restrictive/Contractionary Monetary Policy and Its Effects (268)

Quantity Theory of Money

Monetary Policy and Real GDP  The link between monetary policy and real GDP is the relationship between changes in MS, i %, and the level of private investment.  IF MS ↑, and there is no ↑ in I, expansionary monetary policy would have no effect on real GDP and unemployment.  Some economists, called monetarists, have become proponents of the quantity theory of money.

Quantity Theory of Money  This theory states that increasing MS has no effect on real GDP, but only serves to increase the price level  This theory uses the equation of exchange:  MV = PQ  V = PQ/M  GDP = (P × Q)  Quantity of money = M

 Velocity = V = the number of times each dollar is spent in a year.  If in a given year the money supply is $100 and nominal GDP is $1000, then each dollar must be spent 10 times; V = 10  If the money supply (M) increases, this must be reflected in the other 3 variables.  Velocity must fall  Price level must rise  Output must increase

 Historically velocity has remained stable and constant  Many economists believe that output is a function of technology and supply of resources  Therefore, the increase in M will only lead to an increase in price level (P) – inflation  The quantity theory of money ignores the effects of MS on AD, which is why it is controversial.