1. Macro Review Day 3

2. The Multiplier Model 28 The Multiplier Equation Multiplier equation is an equation that tells us that income equals the multiplier times autonomous expenditures Y = Multiplier x Autonomous expenditures Expenditures multiplier is a number that tells us how much income will change in response to a change in autonomous expenditures Multiplier = ____1____ (1 – mpe) 28-2

3. The Financial Sector and the Economy 30 Why is the Financial Sector Important to Macro? For every real transaction, there is a financial transaction that mirrors it The financial sector channels savings back into spending For every financial asset, there is a corresponding financial liability Financial assets are assets such as stocks or bonds, whose benefit to the owner depends on the issuer of the asset meeting certain obligations Financial liabilities are obligations by the issuer of the financial asset 30-3

4. The Financial Sector and the Economy 30 The Financial Sector as a Conduit for Savings Financial institutions channel savings back into the spending stream as loans Saving is outflows from the spending stream from government, households, and corporations Savings deposits, bonds, stocks, life insurance Loans are made to government, households, and corporations Business loans, venture capital loans, construction loans, investment loans 30-4

5. The Financial Sector and the Economy 30 The Definition and Functions of Money Money is a highly liquid financial asset that serves as a: Medium of exchange Unit of account Store of wealth Liquid means to be easily changeable into another asset or good Money is a financial asset that makes the real economy function smoothly 30-5

6. The Financial Sector and the Economy 30 Alternative Measures of Money Economists have developed different measures of money Two are M 1 and M 2 M 1 is a measure of the money supply; it consists of currency in the hands of the public plus checking accounts and traveler’s checks M 2 is a measure of the money supply; it consists of M 1 plus other relatively liquid assets 30-6

7. The Financial Sector and the Economy 30 The U.S. Central Bank: The Fed The Federal Reserve Bank (the Fed) is the U.S. central bank Federal Reserve notes are liabilities of the Fed that serve as cash in the U.S. A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms Individuals’ deposits in savings and checking accounts serve the same function as does currency and are also considered to be money 30-7

8. The Financial Sector and the Economy 30 Distinguishing Between Money and Credit Credit cards are not money Credit card balances are assets of a bank in the form of a prearranged loan and liabilities of the credit card user Generally credit card holders carry less cash A debit card is part of the monetary system because it serves the same function as a checkbook 30-8

9. The Financial Sector and the Economy 30 Banks and the Creation of Money The first step in the creation of money The Fed creates money by simply printing currency Currency is a financial asset to the bearer and a liability to the Fed The bearer deposits the currency in a checking account at the bank The form of money has changed from currency to a bank deposit 30-9

10. The Financial Sector and the Economy 30 Banks and the Creation of Money The second step in the creation of money The bank lends a fraction of the deposit The amount of money has expanded: Initial deposit + new loan The amount of money is multiplied 30-10

11. The Financial Sector and the Economy 30 The Money Multiplier Reserves are currency and deposits a bank keeps on hand or at the Fed or central bank, to manage the normal cash inflows and outflows The reserve ratio is the ratio of reserves to deposits a bank keeps as a reserve against cash withdrawals Banks can keep more reserves: excess reserve ratio Reserve ratio = required reserve ratio + excess reserve ratio 30-11

12. The Financial Sector and the Economy 30 Calculating the Money Multiplier We will call the ratio 1/r the simple money multiplier The simple money multiplier is the measure of the amount of money ultimately created per dollar deposited in the banking system, when people hold no currency It tells us how much money will ultimately be created by the banking system from an initial inflow of money The higher the reserve ratio, the smaller the money multiplier, and the less money will be created 30-12

13. The Financial Sector and the Economy 30 Determining How Many Demand Deposits Will Be Created To find the total amount of deposits that will be created, multiply the original deposit by 1/r, where r is the reserve ratio If the original deposit is $100 and the reserve ratio is 10 percent (0.1), the amount of money ultimately created is: New money created = $1000 – $100 = $900 $100 x 1/0.1 = $1000 30-13

14. The Financial Sector and the Economy 30 Initial T-Account McGraw-Hill/Irwin Colander, Economics 14 AssetsLiabilities and Net Worth Currency$ 15,000 Checking deposits $150,000 Loans 315,000Net worth 350,000 Property 170,000 Total assets $500,000Total liabilities $500,000 and net worth

15. The Financial Sector and the Economy 30 T-Account With 10,000 Deposit: Reserve Ratio 10% McGraw-Hill/Irwin Colander, Economics 15 AssetsLiabilities and Net Worth Currency$ 15,000 Checking deposits $150,000+10,000 Total:25,000Total:160,000 R.R.16,000 Excess R.9,000 Loans 315,000Net worth 350,000 Property 170,000 Total assets $510,000Total liabilities $510,000 and net worth

16. The Financial Sector and the Economy 30 Initial Loan (bank holds no excess reserves) McGraw-Hill/Irwin Colander, Economics 16 AssetsLiabilities and Net Worth Currency25,000Checking deposits 160,000 -9,000 Total16,000 Loans 315,000Net worth 350,000 +9,000 Total:324,000 Property 170,000 Total assets $510,000Total liabilities $510,000 and net worth

17. The Financial Sector and the Economy 30 Change in Demand Deposits 10,000 * 1/.1= 100,000 New Money Created 100,000-10,000= 90,000 Same amount that there is for change in loans McGraw-Hill/Irwin Colander, Economics 17

18. The Financial Sector and the Economy 30 Final Balance McGraw-Hill/Irwin Colander, Economics 18 AssetsLiabilities and Net Worth Currency$ 25,000 Checking deposits $250,000 Loans 405,000Net worth 350,000 Property 170,000 Total assets $600,000Total liabilities $600,000 and net worth

19. The Financial Sector and the Economy 30 Calculating the Money Multiplier when People Hold Currency The simple money multiplier reflects the assumption that only banks hold currency When firms and individuals hold currency, the money multiplier in the economy is: Where r is the percentage of deposits banks hold in reserve and c is the ratio of money people hold in currency to the money they hold as deposits (1 + c) (r + c) 30-19

20. The Financial Sector and the Economy 30 Why People Hold Money The only reason people would be willing to hold money is if they get some benefit from doing so The transactions motive is the need to hold money for spending The precautionary motive is holding money for unexpected expenses and impulse buying The speculative motive is holding cash to avoid holding financial assets whose prices are falling 30-20

21. The Financial Sector and the Economy 30 Equilibrium in the Money Market The demand for money is downward-sloping: as the interest rate falls the cost of holding money falls When interest rates rise, bonds and other financial assets become more attractive, so you hold more financial assets and less money Interest Rate Q of Money S i0i0 D 30-21

22. Monetary Policy 31 Monetary Policy Monetary policy is a policy of influencing the economy through changes in the banking system’s reserves that influence the money supply and credit availability in the economy Fiscal policy is controlled by the government directly Monetary policy is controlled by the U.S. central bank, the Federal Reserve Bank (the Fed) Monetary policy works through its influence on credit conditions and the interest rate in the economy 31-22

23. Monetary Policy 31 Monetary Policy Price level Real output AD 0 P0P0 AD 1 P1P1 Y0Y0 Y1Y1 SAS Monetary policy affects both real output and the price level AD 2 Expansionary monetary policy shifts the AD curve to the right Contractionary monetary policy shifts the AD curve to the left Y2Y2 P2P2 31-23

24. Monetary Policy 31 Monetary Policy Price level Real output P0P0 P1P1 YPYP LAS SAS 1 SAS 0 If the economy is at or above potential, expansionary monetary policy will cause input costs to rise The only long-run effect of expansionary monetary policy when the economy is above potential is to increase the price level Rising input costs will eventually shift the SAS curve up so that real output remains unchanged AD 0 AD 1 31-24

25. Monetary Policy 31 Monetary Policy and the Money Market Interest Rate Q of Loanable Funds S1S1 D Money Market Loanable Funds Market Interest Rate Q of Money M1M1 i0i0 D i1i1 M0M0 S0S0 i0i0 i1i1 Expansionary monetary policy leads to… … an increase in loanable funds The decline in interest rates increases investment spending, which shifts the aggregate demand curve out to the right 31-25

26. Monetary Policy 31 Monetary Policy Expansionary monetary policy is a policy that increases the money supply and decreases the interest rate and it tends to increase both investment and output Contractionary monetary policy is a policy that decreases the money supply and increases the interest rate, and it tends to decrease both investment and output M i IYM i IY 31-26

27. Monetary Policy 31 Duties of the Fed Conducts monetary policy (influencing the supply of money and credit in the economy) Supervises and regulates financial institutions Lender of last resort to financial institutions Provides banking services to the U.S. government Issues coin and currency Provides financial services to commercial banks, savings and loan associations, savings banks, and credit unions 31-27

28. Monetary Policy 31 The Conduct of Monetary Policy The Fed influences the amount of money in the economy by controlling the monetary base Monetary base is vault cash, deposits of the Fed, and currency in circulation Monetary policy affects the amount of reserves in the banking system Reserves are vault cash or deposits at the Fed Reserves and interest rates are inversely related 31-28

29. Monetary Policy 31 Open Market Operations Open market operations are the primary way in which the Fed changes the amount of reserves in the system Open market operations are the Fed’s buying and selling of government securities To expand the money supply, the Fed buys bonds To decrease the money supply, the Fed sells bonds 31-29

30. Monetary Policy 31 Open Market Operations An open market purchase is expansionary monetary policy that tends to reduce interest rates and increase income When the Fed buys bonds, it deposits money in banks’ account with the Fed Bank reserves are increased, and when banks loan out the excess reserves, the money supply increases 31-30

31. Monetary Policy 31 Open Market Operations An open market sale is a contractionary monetary policy that tends to raise interest rates and lower income When the Fed sells bonds, it receives checks drawn against banks The bank’s reserves are reduced and the money supply decreases 31-31

32. Monetary Policy 31 The Reserve Requirement and the Money Supply The reserve requirement is the percentage the Fed sets as the minimum amount of reserves a bank must have The money multiplier is (1+c)/(r+c) The Fed can increase the money supply by decreasing the reserve requirement, which increases the money multiplier The Fed can decrease the money supply by increasing the reserve requirement, which decreases the money multiplier 31-32

33. Monetary Policy 31 Borrowing from the Fed and the Discount Rate In case of a shortage of reserves, a bank can borrow reserves directly from the Fed The discount rate is the interest rate the Fed charges for those loans it makes to banks An increase in the discount rate makes it more expensive to borrow from the Fed and may decrease the money supply A decrease in the discount rate makes it less expensive to borrow from the Fed and may increase the money supply 31-33

34. Monetary Policy 31 The Fed Funds Market Banks with surplus reserves loan these reserves to banks with a shortage in reserves Fed funds are loans of excess reserves banks make to each other Fed funds rate is the interest rate banks charge each other for Fed funds By selling bonds, the Fed decreases reserves, causing the Fed funds rate to increase By buying bonds, the Fed increases reserves, causing the Fed funds rate to decrease 31-34