Section 5 Lecture December 2016 Mr. Gammie

Section 5 Lecture December 2016 Mr. Gammie
AP Macroeconomics Section 5 Lecture December 2016 Mr. Gammie

Module 22: Saving, Investment, and the Financial System

When a firm invests money in machinery, equipment, factories, they usually do so by borrowing money. Where does that money come from?

Simple Economy No gov’t No trade
--- all money spent by consumers and firms ends up in another persons pocket as profit

Total Income = Total Spending Total Spending =
GDP = C+I+G+Xn

You have $500 of disposable income for the month of December
You have $500 of disposable income for the month of December. What can you do with it? MPC + MPS = 1 Spend or Save

Some Math… Total Income = Total Spending Total Income = C + S Total Spending = C + I C + S = C + I Therefore….. S = I

Savings = Investment

+ Government Budget Balance = tax revenue – gov’t spending – transfer payments Budget surplus (+) Budget deficit (-) National Saving = S + BB S = I S = National Saving = Private Saving + BB Surplus – investment increases Deficit – investment decreases

+ Other Countries Capital Inflow = the total inflow of foreign funds minus the total outflow of domestic funds to other countries I = S S = National Saving + Capital Inflow Capital inflow = investment increases Capital outflow = investment decreases

Financial market – where households invest their current savings, accumulated savings, wealth

Three Tasks of a Financial System
Reduce Transaction Costs vs. Pork, apples, and bread Supermarket = bank

Reducing Risk Owners can spread risk by selling shares in their company.

Diversification: investing in several assets with unrelated, or independent risks. It allows a business owner to lower his/her total risk of loss. Key Takeaway: The desire of individuals to reduce their total risk by engaging in diversification is why we have stocks and the stock market.

Providing Liquidity

Financial Assets Financial Asset: A paper claim that entitles the buyer to future income from the seller. Four Types: Loans Bonds Loan Backed Securities Stocks

Financial Intermediaries
Financial Intermediary: an institution that transforms funds gathered from many individuals in financial assets. Three Key Types: Mutual Funds Pension Funds and Life Insurance Companies Banks

Review Question Economists view investment spending as which of the following: Stocks Bonds Spending on physical capital Mutual investment spending Spending on human capital c

Review Question Given: Closed Economy S=I
In a closed economy suppose that GDP is $12 trillion. Consumption is $8 trillion, government spending is $2 trillion, and taxes are $0.5 billion. How much is national saving? $2 trillion $3 trillion $3.5 trillion $4 trillion None of the above a

Review Questions Financial markets: Increase transaction costs
Reduce diversification Provide liquidity Determine tax rates Are the same as resource markets c

Module 22 Summary The saving investment identity tells us that, in a simple economy without gov’t or foreign trade, that private dollars saved must equal private dollars invested. When the gov’t is included we discover that they can also contribute to the national savings if there is a budget surplus, and can detract from national savings if there is a budget deficit. Money can also flow into Canada from foreign citizens and money can flow out of Canada into foreign economies. This inflow or outflow affects domestic saving and investment. If more money flows into Canada than leaves Canada to other nations, there is a capital inflow. This increases domestic investment. (Vice versa applies). The financial system facilitates transactions between savers and investors and provides three key roles in this process: reducing transaction costs, reducing risk, and increasing liquidity.

Module 23: The Definition and Measurement of Money

Define: money

Average price of a home?

How much is this car?

Money and wealth are often confused, we need to separate money from assets that have value
What makes this $20 different from you’re your laptop, cell phone, car, or even tooth brush for that matter? Which one could you bring to the subway across the street to exchange for a sub? --- only the $ that is the key difference.

Defined: money is any asset that can easily be used to purchase goods and services.
Of course you could take your laptop, or cell phone and sell it for money then bring that money to subway. Or you could give your cell phone to subway in exchange for a sub. But how many subs will you get? This is barter. Barter is one of the things money reduces the need for.

Roles of Money Medium of Exchange
Imagine you have just worked al week in your summer job. Your employer has decided to pay you in apples. They give you 1 bushel of apples, obviously more than you can eat on your own. What would you do with those apples? You could try to sell them, or bring them to another place and try to trade them.

Roles of Money Store of Value
As long as there is not rapid inflation, money is a good way to store value. You can put money in your bank account and it will still be useful – essentially be of the same value- -- a week or month later. Cheese maker, store all your value in cheese, cheese will go bad

Roles of Money Unit of Account
How much is this house, car, toothbrush? in money? In terms of the other … Value is measured on a consistent scale.

Types of Money Commodity Money ex. Commodity-backed Money ex.
Fiat Money ex.

Measuring the Money Supply
M1: currency and coin in circulation + checking deposits + travelers checks M2: M1 + savings accounts + short term CDs + money market accounts *Review this section in your textbook. CD = certificate of deposit

Review Question Suppose you transfer $500 from your checking account to your savings account. With this transaction M1 _____ and M2 _____. Increased; stayed the same Stayed the same; increased Decreased; stayed the same Decreased; increased Increased; decreased c

Review Question The narrowest definition of money excludes:
Currency in the vault at a bank Traveler’s checks Currency in circulation Checkable bank deposits Coins in circulation a

Review Question The medium of exchange function means that money is used: As the common denominator of prices As the common denominator of future payments. To save and earn interest income. To accumulate purchasing power. To pay for goods and services. e

Module 23 Summary Money is not the same as wealth. Money is essentially anything that is easily exchangeable for goods and services. Many things have been used as money by different human civilizations. All successful forms of money must serve as a medium of exchange, a store of value, and unit of account. Two aggregate measures of the money supply are M1 and M2. M1 is the narrowest definition. You will most often work with this definition. M2 adds several other assets, known as near-moneys, that can easily be converted into cash. HW: M22 CYU 1, 2 MC 1-5, FR 2 HW: M23 CYU 1, 3 MC 1-5, FR 2

Module 24: The Time Value of Money

What if you could invest $10,000 now and receive a guaranteed $20,000 later.
Is this a good deal?

$1000 If you could have $1000 today or $1000 next year, which would you choose? Today! Why? --- allows me to buy or save today, rather than wait a year to do so If you put $1000 in a bank today, you could have more than $1000 in a year from now

$1 today > $1 tomorrow

Lending Why should you receive interest if you lend money?
What would be repayment of $100 after 1 year? What about after 2 years? Loan $100 at 10% interest

In Context Your friend, a borrower, must pay you $21 to compensate you for the fact he has your $100 for 2 years. You, as a saver, could put $100 in the bank today, and two years from now, you would have $121 to spend on goods and services. Therefore, we can say you would be completely indifferent to having $100 today, or $121 2 years from now.

Key Takeaway These are equivalent measures of purchasing power, just measured at two different points in time.

$1.5 billion parsed out in slowly increasing annual intervals, beginning at $22 million and ending at $92 million paid 30 years down the line. The other, more popular possibility, is a fat, one-time lump sum of $930 million.

Defining Present Value
To see the difference between dollars today (present value or PV) and dollars 1 year from now (future value or FV) we apply an equation. FV = PV*(1+r) r = interest rate FV = 100*1.10 = 110 Our example … (100*1.1)= 110

Defining Present Value
Rearranging the formula we can solve for present value when we know the FV. PV = FV/(1+r) PV = 110/(1+0.1) = 100

1 Year 2 Years 3 Years 20 Years How long are most loans? 1 = 110
2 = 121 3 = 133 20 = 259

PV = FV/(1+r)t FV = PV (1+r)t
PV and FV Formulas PV = FV/(1+r)t FV = PV (1+r)t

Applications of PV What if you could invest $10,000 now and receive a guaranteed $20,000 later. Is this a good deal? Maybe! Depends on time and interest rate

Applications of PV $10,000 today or $20,000 10 years from now
Interest rate of 8% could be earned if you invest the money. Should you take the 10,000 today, or the $20,000 in 10 years? FV of $10,000 is $21,589.25 PV of $20,000 is $ Take 19,000 today

Applications of PV Interest rate of 3%

Applications of PV PV example

Applications of PV

M24 Summary Money today is more valuable than the same amount of money in the future. The present value of $1 one year from now is $1/(1+r) The future value of $1 invested today is $1*(1+r) Interest paid on savings and interest charged on borrowing are designed to equate the values of dollars today with the value of future dollars.

Module 25: Banking and Money Creation

The Monetary Role of Banks
M1 = currency + coin + traveler’s checks + checking deposits

What Banks Do Banks are financial intermediaries in business to earn a profit. In the process, banks actually do make more money. Banks are a safe place for deposits. Banks offer lending services. Interest is paid or earned.

Banks take liquid assets (cash) and turn them into illiquid assets (homes and capital equipment).

Banks hold a fraction of deposits in reserve, the rest is lent out

T accounts

T Accounts Assets Liabilities Assets and Liabilities

Jim’s Jerseys Assets Liabilities Equipment $50,000 Cloth $10,000
Loan $25,000 Assets and Liabilities

Main Street Bank Assets Liabilities Loans $2,000,000
Cash Reserves $200,000 Deposits $2,000,000 In this example Main street is holding 10% of its deposits in reserve

Bank Regulation Deposit Insurance Capital Requirements
Reserve Requirements Discount Window

Determining the Money Supply

How Banks Make Money Eli has $5000 in cash and decides that he needs to open a checking account at Main Street Bank. The t-account shows assets and liabilities of the bank. Has money been created? No, Eli has just moved money from his home to the bank.

How Banks Make Money Main Street keeps 10% of Eli’s deposit in reserve, and makes a $4500 loan to Max so he can buy some furniture at Melanie’s Mega Mart. The loan has the following effect:

How Banks Make Money Melanie Banks at the First Bank of Sherman, so when Melanie receives $4500 from Max for the furniture, she deposits the money at the FBS. The effect on the t-account for FBS is:

How Banks Make Money The FBS must also keep 10% of Melanie’s deposit in reserve, and then can make a $4050 loan to Fekru. How much did the initial deposit of $5000 result in? 5000 increase in M1 vs = increase in M1 Difference = $8550, so the intial deposit of $5000 resulted in an increase in the money supply (M1) of $8550.

Summary Eli deposits $5000. Max borrows $4500 to buy furniture.
Melanie receives the payment for her furniture, and then deposits $4500. Fekru borrows $4050.

Money Multiplier Excess reserves = total reserves – required reserves Money Multiplier (MM) = 1/rr rr = reserve ratio What was the money multiplier from our last example? Excess reserves can be lent out 1/0.1 = 10 Therefore the total increase would be $4500 *10 = $45,000

Money Market in Reality
In theory 10 In reality 1.9

M25 Summary Banks create money by taking a deposit from one customer (a saver) and lending a fraction of that deposit to another customer (a borrower). Through the process of lending, when money is deposited into a bank, that initial deposit multiplies into an amount much greater than the initial deposit. This is known as the money multiplier.

Module 26: The Federal Reserve System: History and Structure

Federal Reserve The central bank, not quite government, not quite a private institution, that overseas and regulates the banking system, and controls the monetary base.

Monetary Base vs. Money Supply
Monetary Base = Bank Reserves + Currency in Circulation Money Supply = Currency in Circulation + Checkable Bank Deposits

Structure of the Fed

M26 Summary The federal reserve is a central bank – an institution that overseas and regulates the banking system and controls the monetary base. The creation of the federal reserve system in 1913 was largely a response to lessons learned in the Panic of The Fed also played a major role in the banking crises of 1980 and 2008.

Module 27: The Federal Reserve System: Monetary Policy

What does the “Fed” actually do?
Financial Services Supervise and Regulate Banking Institutions Maintain Stability of the Financial System Conduct Monetary Policy Overnight rate, bankers bank, bank for the govt Safety and soundness of banks and financial institutions Provide liquidity to banks In order to prevent or address extreme economic conditions

Monetary Policy Three tools: Reserve Requirement Discount Rate
Open-market Operations 1

Reserve Requirement Banks that fail to meet the reserve requirement face penalties If a bank has insufficient reserve it can borrow from other banks via the federal funds market The federal fund rate is the rate at which funds are borrowed on this market This rate plays a key role in in modern monetary economic policy

Reserve Requirement How would a change in reserve requirements effect the money supply? Higher rr = lower money multiplier Lower rr = higher money multiplier

Discount Rate How would a change in the discount rate effect the money supply? Higher rate = higher cost Lower rate = lower cost

Money and Interest Rates
In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate from 1/2 to 3/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2 percent inflation. – December 14, 2016

Open Market Operations
In an open market operation, the Fed buys or sells US Treasury Bills, normally through a transaction with commercial banks. Example: If the Fed buys $100 million in T Bills from commercial banks, this increases the monetary base by that amount because it increases bank reserves by $100 million.

Open Market Operations
Opposite Example: If the Fed sells $100 million in T Bills to commercial banks, this decreases the monetary base by that amount because it decreases bank reserves by $100 million.

Monetary Policy

Practice Question Suppose that the reserve ratio is 10% when the Fed buys $150,000 of U.S. Treasury Bills from the banking system. If the banking system does NOT want to hold any excess reserves, calculate the change in the money supply. MM = 1/rr Change in Money Supply = 1/0.1 = $150,000 *10 = 10 = $1,500,000 (increase) Formula: Change in money supply = fed purchases (sale) * MM

Key Takeaway When the Fed directly injects money into a bank when buying T-Bills, the bank is not required to hold a fraction of those dollars as required reserves. The money multiplier takes over on the entire amount.

Practice Question Suppose RGDP is $2.5 trillion and potential GDP is $1 trillion. What open market operation could the central bank use to close the gap? How much would the open market operation need to be if the reserve requirement was 20%? RGDP > Yp therefore inflationary gap. Inflationary gap requires a leftward shift of the AD curve.

Decreasing the money supply with shift the AD curve left
Decreasing the money supply with shift the AD curve left. Selling T-Bills decreases the money supply, How much should the central banks sell? MM = 1/0.2 = = x*5 1.5/5 = 0.3 trillion or $300 Billion Therefore to close an inflationary gap of $1.5 trillion the central bank should sell $300 billion in T-Bills.

Remember…. From M17 When the central bank increases the money supply …. AD increases (shifts to the right). When the central bank decreases the money supply… AD decreases (shifts to the left).

M27 Summary The Fed does many things to regulate the banking industry and stabilize the business cycle. The monetary policy function is the most important element that we will focus on. The Fed can increase the money supply in three ways: lowering the reserve requirement lowering the discount rate, or buying T Bills from commercial banks. The Fed can decrease the money supply in three ways: raising reserve requirements, raising the discount rate, or selling T Bills to commercial banks.

Module 28: The Money Market

MONEY Who has cash on them today? Why do you have cash?
Why would you have more money in your pocket today than you had yesterday? What else could you do with your money? Save it What would convince you to save that money?

Opportunity Cost of Holding Money
What is the price of the convenience to make purchases? Suppose you could put $100 in a 12 month CD that would earn 5%. What is the cost of holding $100 in your pocket instead of in the CD? 50%? 0.5%? That is what is the price of holding money in your pocket? 5% - $5 What if the interest rate was 50%? Would you still hold the cash? 0.5%?

Key Takeaway The higher the short-term interest rate, the higher the opportunity cost of holding money. The lower the short-term interest rate, the lower the opportunity cost of holding money. Long-term rates? We don’t consider long term because we hold money to make purchases in the short term

The Money Demand Curve Nominal --- not real interest rate – short term – no inflation You need to be able to recreate this graph As interest rate rise, the opportunity cost of holding money does as well, so the qd of money falls

Shifts of the MD

Shifts of the MD Curve Changes in the Aggregate Price Level
Changes in Real GDP Changes in Technology Changes in Institutions Any external change that makes holding money in your pocket more desirable at any interest rate will cause the demand curve for money to shift to the right.

Shifts of the MD Curve Aggregate Price Level
Higher prices increases demand for money. Demand for money is proportional to the price level. If the aggregate price level rises by 20%, it takes 20% more money buy the same goods.

Shifts of the MD Curve 2. Changes in Real GDP The larger the quantity of goods and services we buy, the larger the quantity of money we will want to hold at any given interest rate.

Shifts of the MD Curve 3. Changes in Technology Advances in technology tend to reduce the demand for money by making it easier for the public to make purchases without holding significant sums of money (think ATM).

Shifts of the MD Curve 4. Changes in Institutions If the banking system becomes (or appears to be) unstable, the demand for money will increase.

Equilibrium Interest Rate
Money supply is determined by the Fed at any given point in time and is fixed. Think of it as if you can only put your money in two places – Cds, or your pocket. If interest rate is above i* … Qms > Qmd --- high interest rates mean CD’s are attractive savings options, banks lower i until equilibirum If interest rate is below i* … Q md > Qms --- CDs are not very attractive saving options because of low interest rates --- banks raise I until equilibrium Above and below i*

Liquidity Preference Model

M28 Summary People hold (demand) money (think M1) primarily to make transactions. The other alternative is to save money in interest-bearing assets. When money is held as M1, earned interest is forgone, thus the short-term (or nominal) interest rate is the opportunity cost of holding money. As the nominal interest rate rises, the opportunity cost of money rises, so the quantity of money held (demanded) falls. Thus the money demand curve is sloping downward with the nominal interest rate plotted on the vertical axis.

M28 Summary Money demand will shift to the right if: the aggregate price level rises, real GDP rises, technology is slow to improve, and if banking systems become less reliable. Vice versa applies. The liquidity preference model of the interest rate says that the nominal interest rate is determined by the intersection of the supply and demand for money in the market for money. The model assumes that the supply of money is vertical, and chosen by the Fed, and that the demand for money is downward sloping Bank runs, work sheets,

Monetary Policy Review
Recessionary Gaps require Expansionary Monetary Policy to… >Increase Money Supply, decrease interest rates, increase Investment, increase Aggregate Demand Inflationary Gaps require Contractionary Monetary Policy to… >Decrease Money Supply, increase interest rates, decrease Investment, decrease Aggregate Demand

Monetary Policy Review
Three tools the Fed uses to conduct Monetary Policy: Reserve Requirement Discount Rate Open-market Operations* 1

Review Question Suppose RGDP is $2 trillion and potential GDP is $1.5 trillion. What open market operation could the central bank use to close the gap? How much would the open market operation need to be if the reserve requirement was 10%?

RGDP > Yp therefore inflationary gap
RGDP > Yp therefore inflationary gap. Inflationary gap requires a leftward shift of the AD curve. Decreasing the money supply with shift the AD curve left. Selling T-Bills decreases the money supply, How much should the central banks sell? MM = 1/0.1 = billion = x*10 500/10 = $ 50 billion Therefore to close an inflationary gap of $0.5 trillion ($500 billion) the central bank should sell $50 billion in T-Bills.

Liquidity Preference Model of the Interest Rate
Money supply is determined by the Fed at any given point in time and is fixed. Think of it as if you can only put your money in two places – Cds, or your pocket. If interest rate is above i* … Qms > Qmd --- high interest rates mean CD’s are attractive savings options, banks lower i until equilibirum If interest rate is below i* … Q md > Qms --- CDs are not very attractive saving options because of low interest rates --- banks raise I until equilibrium Above and below i*

Module 29: The Loanable Funds Market

Savings-Investment Identity
In a closed economy: S=I Add the public sector: National Savings = I (Private Savings + Public Savings) = I Add the foreign sector: National Savings + Capital Inflow = I

It is through financial markets that the funds of the savers are borrowed by investors.
Economists use the market for loanable funds to explain these interactions and determine the equilibrium real interest rate.

The Equilibrium Interest Rate
If you have money to save, where can you put it? Simplified Model > one market that brings together those who want to lend money and those who want to borrow. This is the Market for Loanable Funds

Market for Loanable Funds
Real interest rate on y axis

Liquidity Preference Model of the Interest Rate
Nominal interest rate on y axis

Remember.. Real Interest rate = Nominal interest rate - inflation

Real and Nominal Interest Rates
If inflation = 0 … then the Real interest rate = If expected inflation is constant … then any change in the nominal rate will be reflected in an identical change in the real rate. This is why in your text you will see the y axis labelled as “nominal interest rate for a given rate of future expected inflation rate”

Breaking Down the Graph

Demand for Loanable Funds
Demand comes from firms looking to borrow money to pay for capital investment projects. If the project has an expected rate of return that is higher than the real interest rate, the investment will be profitable and the funds will be demanded. This is why the demand for loanable funds is downward sloping.

Demand for Loanable Funds

Rate of Return Rate of Return (%)
= (Revenue from project – cost of project) *100 (cost of project) As the real rate falls, so does the cost of the project, and more projects will become profitable.

The Supply of Loanable Funds
Savers can lend their money to borrowers, but in doing so must forego consumption. Savers receive interest income to compensate for foregone consumption. As the real interest rate rises, the opportunity cost of spending today rises, and more money will be saved. As the real interest rate rises, the quantity of funds supplied will increase.

Supply of Loanable Funds

Equilibrium in the Loanable Funds Market

Shifts in the Market Both Demand and Supply can shift. Demand
Changes in Perceived Business Opportunities Changes in Government Borrowing Supply Changes in Private Saving Behaviour Changes in Capital Inflows

Crowding Out Effect When the gov’t runs a budget deficit, the treasury must borrow funds. This increases the demand for loanable funds, and in effect, increases the equilibirum interest rate. When this occurs, fewer investment projects will be profitable, so I will decrease. Why does a gov’t run a budget deficit? To counteract a recessionary gap, but if G increases, and I decreases, what will be the result?

Changes in Supply

Inflation and Interest Rates
Fisher Effect: the expected real interest rate is unaffected by the change in expected future inflation. An increase in expected future inflation drives up nominal interest rates, where each additional percentage point of expected future inflation drives up the nominal interest rate by 1 percentage point.

Key Takeaway: Both lenders and borrowers base their decisions on the expected real interest rate. As long as the level of inflation is expected, it does not affect the equilibrium quantity of loanable funds or the expected real interest rate, all it affects is the nominal interest rate.

Expected Inflation is 0% Real interest rate = 5% Loanable funds = F1 Dollars What happens if the expected future inflation rate changes to 5%? Both curves shift upwards = new equilibrium interest rate is 10% at F1 dollars

Reconciling the Two Models
According to the liquidity preference model, a fall in the interest rate results in an increase in I spending, and following that an increase in RGDP and Consumption The increase in RGDP results in an increase in consumption AND savings (through the multiplier) How much do savings rise? Because of the savings-investment identity we know that savings = investment So a fall in the interest rate leads to higher investment spending, and the resulting increase in RGDP generates exactly enough additional savings to match the rise in investment spending. After a fall in the interest rate, the quantity of savings supplied rises exactly enough to match the quantity of savings demanded

The Interest Rate in the Long Run
In the long run, changes in the money supply DO NOT affect the interest rate. In the long run, aggregate price level will rise by the same proportion as the increase in the MS (due to the neutrality of money concept) As the aggregate price level rises, so does the demand for money, result in a shift to the right, and a return to the original interest rate of R1 In the loanable funds market, the supply of loanable funds eventually shifts back as price and nominal wages rise.

The Interest Rate in the Long Run
In the long run the equilibrium interest rate matches the supply and demand for loanable funds that arise at potential output.

Why do we care???

Expecting a recession

Monetary Policy Power Recessionary Gaps require Expansionary Monetary Policy to… >Increase Money Supply, decrease interest rates, increase Investment, increase Aggregate Demand Inflationary Gaps require Contractionary Monetary Policy to… >Decrease Money Supply, increase interest rates, decrease Investment, decrease Aggregate Demand HW 29.1 29.2 Exit Slip TB CYU #1, 3 MC #1-5 FR #1, 2

increase, have no impact on
Practice Question: Expansionary monetary policies will ______ interest rates and _______ savings in the short run. increase, increase increase, decrease decrease, increase increase, have no impact on c

Section 5 Lecture December 2016 Mr. Gammie

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