Chapter 11 Flashcards
How do banks increase the money supply?
They make loans with money in excess of the reserve requirements. Those loans will be deposited in other banks, who will make loans in excess of reserve requirements and so on.
Say that Steven is back at the Bank of Anytown to make a deposit. This time he puts $100,000 into his account. The bank’s required reserve ratio is 10%, which means that the bank must hold onto $10,000 of the deposit. This now leaves $90,000 to lend out to the next person who needs it. In walks Serena, who needs a $90,000 construction loan for various home improvements which the Bank of Anytown approves and issues. Serena now takes that to her bank and deposits the funds. Her bank’s required reserve ratio is also 10% so now they have $81,000 to lend to someone else after keeping $9,000 on reserve.
How do banks earn money?
Interest on loans, Fees on accounts, Deposits from customers,
Investments in stocks, bonds, loans etc..
Money multiplier. Problems?
Used to calculate increase in money supply as a result of banks making deposits and lending the excess of those deposits above the reserve requirements.
Ex: RR: 10%. Deposit of $500
$500*(1-10%)=$450 (Able to be lent)
$4501/10%=$45010=$4,500 increase in money supply
Motives for having money
- Being for transactions
- For potential purchases (like when sales occur) or emergencies
- To invest
- To have some money as protection in case investments don’t do well
Why is the money demand curve downward sloping?
When interest rates are higher, investments are more attractive, so people will exchange having money in checking accounts or in plain cash for investments like bonds.
https://study.com/cimages/multimages/16/demand-curve-for-money.jpg
Shifters of money demand curve
Increases and decreases in real GDP
Higher price levels means more money demand
If a recession is expected, higher demand. If a boom, less.
Transfer Costs (Cost of converting investments into cash and checking accounts) (Less money demand if these costs are high)
Greater preference for risk means less money demand because they want to invest in more risky assets. Less means more.
What shifts Money Supply?
Central Bank
Federal Reserve structure
12 Central Bank offices around country with Presidents
Board of Governors
Open Market Operations Committee, which administer open market operations to influence federal funds rate and oversees balance sheet, discount rate and reserve requirements.
Federal Reserve Functions
Monetary Policy
Set rules and regulations for banking system
Ensuring stability of financial system
Serves as a bank for other banks
Why was the Fed created?
1907 Financial Crisis
How did the Fed change over time?
1935: FOMC would be responsible for monetary policy
1977: Established price stability as a Fed goal.
1978: Congress made full employment a goal of the Fed.
Open Market Operations
Fed buying and selling bonds to influence money supply.
Buying bonds will decrease federal funds rate. Selling will increase. The FFR is the rate charged by banks for borrowing with each other. It goes up, interest rates on loans go up and vice versa.
Why do banks lend to each other?
Banks lend to each other to satisfy regulations like reserve requirements
Discount rate
Rate at which Fed lends to other banks
Permanent vs Temporary OMO
- Permanent: Fed conducting usual business of selling and buying securities. Purchases are not temporary
- Temporary: Fed buys and sell securities with understanding that those transactions will be reversed. Ex: A Fed bond purchase will be reversed by reselling it back to seller.
Who sits on FOMC?
Board of Governors
NY Fed President
4 of 11 other Fed Presidents on rotating basis
How do reserve requirements determine the impact of the FOMC?
The lower the reserve ratio, the greater the impact of a purchase of bonds
Let’s say Fed gives $1m from purchasing bonds to economy
10%: 1/0.11m=$10m
20%: 1/0.21m=$5m
Why does the Fed lend to banks?
They lend to banks in case they are unable to obtain loans from other banks to meet reserve requirements.
Types of discount rates
Primary: Interest rate received by banks in sound financial condition
Secondary: Interest rate received by banks in non-sound financial condition. Usually 0.5% above primary rate.
Seasonal: the Fed’s rate for non-emergency lending to banks that provide services to agricultural and other communities where credit demand is highly seasonal.
Fourth tool of monetary policy
Fed paying interest on excess reserves held by banks.
Too high of interest earned can discourage banks from lending if federal funds rate is lower. Banks will see they can earn more by keeping money in the bank than lending to each other.
Fisher effect problems
Nominal interest rate=inflation+real interest rate
Real interest rate
Interest rate after accounting for inflation.
Used to assess if an interest-incurring investment is worth it.
If rate is negative, that means the interest being earned has not kept up with inflation and that you are losing your purchasing power. It’s like getting a raise, but your real income decreased.
Ex: If you are lending $100 at 3% interest, but inflation is 5% the next year. You need $105 to maintain that purchasing power, but you got $103 back. So, the purchasing power of that initial $100 is eroded.
If positive, that means the purchasing power of that interest is exceeding inflation, and that your ability to make purchases has increased. It’s like getting a raise and your real income increased.
Ex: If you are lending $100 at 8% interest, but inflation is 5% the next year. You need $105 to maintain that purchasing power, but you got $108 back. So, the purchasing power of that initial $100 actually increased beyond what was necessary to keep up with inflation.
Hyperinflation
More than 50% inflation
Policy lag
the lag between the time an economic problem arises, such as recession or inflation, and the effect of a policy (fiscal or monetary) intended to counteract it
Recognition Lag
Time taken to recognize problem with macroeconomy
Action Lag
Time taken to implement policy after decision lag
Decision Lag
Time taken to pass a policy in response to economic problem after recognition lag
Effectiveness Lag
the amount of time it takes for a fiscal or monetary policy’s effects to produce the desired result after action lag
Determinants of loanable funds demand
Expectations of state of economy
Determinants of loanable funds supply
- Disposable income of people
- Wealth of people
How does government borrowing cause crowding out?
Increases demand in loanable funds market, leading to higher interest rates for business owners, making borrowing for investments unattractive and thus, hindering economic growth
Supply-side economics
Focused on boosting aggregate supply through lower taxes, reduced regulation and privatization.
Contractionary gap. Problems?
Potential output at full employment - actual output when economy is in recession.
Expansionary gap. Problems?
actual output when economy is in boom and producing above potential output -Potential output at full employment
