Unit 4 Flashcards
How do you create a bank balance sheet
assets on left with required reserves, excess reserves, loans, and bonds
liabilities on right with demand deposits and owner’s equity
M1 (money supply)
CIC + checkings
M0 (monetary base)
bank reserves + CIC
M2
M1 + “near money” aka less liquid but easily converted to cash
M1 + savings + CDs + etc
money multiplier
1/req reserves %
Federal Funds Rate (FFR)
The interest rate at which banks lend reserves to each other overnight
Discount Rate
The interest rate the Federal Reserve charges commercial banks and other financial institutions for loans
max change in money supply
inital change * money multiplier
Commodity Money
Money that has intrinsic value, meaning it is valuable even without being used as money (e.g., gold, silver, or other goods).
Fiat Money
Money that has no intrinsic value but is valuable because the government declares it as legal tender (e.g., U.S. dollars).
how to make a money market graph
nominal interest rate on the y axis
quantity of money on the x axis
MD curve going down (money demand)
what happens when nom interest rates decrease?
when nominal interest rates decrease, the quantity of money increases so lowering return on savings and less expensive to borrow
Fractional Banking System
Banks keep only a fraction of deposits as reserves and lend out the rest. This system allows for the expansion of the money supply through loans.
What do banks want to do with excess reserves?
Banks typically lend out excess reserves to earn interest, as holding reserves does not generate significant profit.
How do banks create new money?
Banks create new money by making loans. When a bank lends out excess reserves, the loan amount is deposited into the borrower’s account, increasing the total money supply.
Why do open market operations not affect demand deposits or the required reserves?
Open Market Operations (OMOs) involve the buying or selling of government bonds by the central bank.
OMOs directly impact reserves and the monetary base, not demand deposits.
Required reserves only change when deposit levels change, which OMOs do not directly influence.
Monetary policy vs fiscal policy
Monetary Policy: Actions by the Federal Reserve to manage the money supply and interest rates to influence the economy. Goals include controlling inflation, promoting employment, and stabilizing the economy.
Fiscal Policy: Actions by the government involving changes to taxation and government spending to influence economic activity. Goals include stimulating growth during a recession or cooling down an overheating economy.
What are the FEDs three tools of monetary policy
Open Market Operations (OMO):
Buying and selling government bonds to adjust the money supply.
Discount Rate:
The interest rate the FED charges commercial banks for borrowing reserves.
Reserve Requirement:
The percentage of deposits banks must hold as reserves, not lending out.
Expansionary vs contractionary monetary policy
Expansionary Policy (used in a recession):
- Increases the money supply to stimulate economic growth.
- Lowers interest rates → increases borrowing and spending → boosts aggregate demand (AD).
FED tools: Buys bonds, lowers discount rate, reduces reserve requirement.
Contractionary Policy (used during inflation):
- Decreases the money supply to slow down economic growth.
- Raises interest rates → decreases borrowing and spending → reduces AD.
FED tools: Sells bonds, raises discount rate, increases reserve requirement.
Does the FED control interest rates? What do they control?
The FED does not directly control all interest rates but influences them through:
Federal Funds Rate (FFR): The rate at which banks lend reserves to each other overnight.
By buying/selling bonds or adjusting reserves, the FED influences the supply of money, indirectly affecting other interest rates like mortgage rates and car loans.
Explain how aggregate demand will shift if the FED Buys Bonds? If the FED sells bonds?
Buys Bonds: Injects money into the economy → increases the money supply → lowers interest rates → increases investment and consumer spending → shifts AD to the right (expansionary).
Sells Bonds: Withdraws money from the economy → decreases the money supply → raises interest rates → reduces investment and spending → shifts AD to the left (contractionary).
Fed Funds Rate
Fed Funds Rate (FFR): The interest rate at which banks lend reserves to each other overnight.
The FED sets a target for the FFR because the actual rate depends on the supply and demand for reserves in the banking system. The FED uses open market operations to influence this rate.
How would the FED change the target for the Fed Funds Rate in a recession? In an inflationary period?
Recession: FED lowers the target for the FFR, encouraging banks to lend more, reducing borrowing costs, and stimulating economic activity.
Inflationary Period: FED raises the target for the FFR, discouraging borrowing, increasing the cost of credit, and slowing down spending.
What shifts MD? What shifts MS?
MD
Changes income and wealth: as income increases MD increase and vice versa
Changes in inflation/price level: as inflation increase, MD increases (bc more money needed) and vice versa
Changes in tech: as tech improves → reduce the need for cash → MD decreases
MS:
- Controlled by the FED:
- Buys Bonds → MS increases (right shift).
- Sells Bonds → MS decreases (left shift).
How to calculate total change in the money supply if the FED buys or sells bonds
TotalChangeinMoneySupply = Initial Change in Reserves × Money Multiplier
How do changes in interest rates impact the price of previously issued bonds.
Inverse Relationship: Bond prices and interest rates move in opposite directions.
If interest rates increase, newly issued bonds pay a higher return (yield), making older bonds with lower interest rates less attractive → price of old bonds falls.
If interest rates decrease, older bonds with higher interest rates become more desirable → price of old bonds rises.
Example: If a bond pays a fixed interest rate of 5% and market rates rise to 6%, investors prefer new bonds with 6%, reducing demand for the old bond → its price drops.
InflationRate
(CPI (current) - CPI (base))
/(CPI base)
x 100
Real Interest Rate
Nominal Interest Rate − Inflation Rate
Market for Loanable Funds Graph
- Y-axis: Real interest rate.
- X-axis: Quantity of loanable funds.
- Demand is downward sloping (lower interest rates → more borrowing)
- Supply is upward sloping (higher interest rates → more saving)
Who demands loans?
Borrowers like businesses (for investment in capital, expansion), governments (to finance deficits), households (for mortgages, education)
Who supplies loans? What is the source of supply?
Lenders like Households (through savings in banks or financial markets), foreign entities (if the country has foreign savings inflows)
Shifters of demand for loanable funds and shifters of supply of loanable funds
Demand for loanable funds:
- Changes in Investment Opportunities: Increased business optimism → demand increases (right shift) and vice versa
- Changes in Government Borrowing: Higher government deficit → demand increases (right shift) and vice versa
Supply for loanable funds:
- Changes in Private Savings Behavior: More saving (e.g., due to higher income) → supply increases (right shift) and vice versa
- Capital Inflows: Foreign investment in domestic markets → supply increases (right shift) and vice versa
How does a government budget deficit impact the market for loanable funds?
A budget deficit increases the government’s borrowing needs. Demand for Loanable Funds increases (curve shifts right). Real interest rates rise.
max change in total demand deposits in banking system
new money (calculated from doing max change) + original money deposited
3 functions of money
- store of value
- medium of exchange
- unit of account
discretionary vs automatic fiscal policy
Discretionary fiscal policy is the government actively making a change to spending or taxes. Automatic fiscal policy happens as a result of taxes or government programs that are already in place.
