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Unit 4- Financial Sector
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Barter Inefficient Prevents economic growth
Double coincidence of wants
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Time Value of Money Money and Interest Rates
PV=FV/(1+r)n FV = PV (1+r)n 13% interest rate I give you $100 today I give you $100 on March 17, 2017 *No calculators on the AP exam, so…
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Types of Money Commodity money- money itself serves a purpose (i.e. tulip bulbs, salt, tobacco) Commodity-Backed money- money’s value is backed by a commodity (gold, silver) *Fiat money- value based solely on acceptance of value and government backing
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Functions of Money Medium of Exchange
Unit of Account (Standard of Value) Store of Value
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Fed Tools Open Market Operations- buy/sell bonds
Discount Rate- rate Fed charges banks Reserve Requirement/Required Reserve Ratio
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What should the Fed do? During a recessionary period? List 3
During an inflationary period? List 3
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What should the Fed do? During a recessionary period?
Expansionary Monetary Policy During an expansionary period? Contractionary Monetary Policy
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Money Market
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Open Market Operations
Buy Bonds Sell Bonds
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Money Multiplier Simple Deposit Multiplier = 1 /Required Reserve Ratio
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Money Multiplier New Deposits Open Market Operations (buying bonds)
Apply multiplier after subtracting required reserves Example: Bob finds $100 under his mattress and deposits it 10% RR Bank can loan $90 $90 x 10 = $900 increase in money supply Open Market Operations (buying bonds) Apply multiplier to full amount Example: Fed buys $100 in bonds from the open market $100 x 10 = $1000 increase in money supply *What if the RR is 20%?????
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Money Supply Measures based on Liquidity
Monetary Base = M0 = M1= M2=
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Money Supply Expansion
Expansion = Multiplier X Excess Reserves
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Money Multiplier New Deposits Open Market Operations (buying bonds)
Apply multiplier after subtracting required reserves Example: Bob finds $100 under his mattress and deposits it 10% RR Bank can loan $90 $90 x 10 = $900 increase in money supply Open Market Operations (buying bonds) Apply multiplier to full amount Example: Fed buys $100 in bonds from the open market $100 x 10 = $1000 increase in money supply *What if the RR is 20%?????
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How Bankers Keep Books Banks keep balance sheets Assets = liabilities + net worth (Equity) Assets include: Reserves Loans Liabilities include: Deposits owed to customers.
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Money Market
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Money Market Q of money is fixed at any given point in time MS = M1
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Money Market i = nominal interest rate
Money Market graphs short term interest rates
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Money Market Nominal Interest rate is the Federal Funds Rate
FFR = rate banks charge each other for overnight loans
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Money Market MD= Q of money demanded at various interest rates
Q of money demanded = amount of wealth held as money over other assets
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Money Market What is the opportunity cost of holding money?
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Money Market Change in “i“ causes movement along the curve
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Money Market Increase Price Level will shift MD to the right
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Fed Tools Open Market Operations- buy/sell bonds
Discount Rate- rate Fed charges banks Reserve Requirement/Required Reserve Ratio
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What should the Fed do? During a recessionary period? List 3
During an inflationary period? List 3
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What should the Fed do? During a recessionary period?
Expansionary Monetary Policy During an expansionary period? Contractionary Monetary Policy
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FIGURE 28-1 Bank Failures in the United States, 1915-2000
2,200 FDIC established 2,000 1,800 200 1,600 160 1,400 Number of Bank Failures 120 Number of Bank Failures 1,200 80 1,000 40 800 1935 1945 1955 1965 1975 1985 '95 '00 600 Great Depression begins 400 200 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 '95 '00 Year Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
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The Banking System Bank Regulation Deposit Insurance Bank Supervision
The Federal Deposit Insurance Corporation insures people’s deposits at banks. Bank Supervision Ensures banks take only sensible, defensible risks Controls the money supply Reserve Requirements Helps control the money supply
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Just what is a bond? Issued by a government or business to raise $
Bond purchaser is the lender Purchaser receives regular interest payments Interest rate is called coupon rate Purchaser is paid the principle at maturity Longer the term, higher the interest Bonds can be traded before maturity Privately issued bonds have higher coupon rates- more risk US government bonds have “zero” risk
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Stock v. Bonds Stock = owner Bond = lender
Riskier company = higher coupon rate
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Trading Existing Bonds
If interest rates go up? If interest rates go down? Premium Discount
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How Bankers Keep Books Banks keep balance sheets Assets = liabilities + net worth (Equity) Assets include: Reserves Loans Securities (bonds) Other holdings Liabilities include: Deposits owed to customers.
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Balance Sheets- Important Points
1. Deposits and withdraws do not INITIALLY change M1 2. Required Reserves only apply to demand (checkable) deposits
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Balance Sheets- Important Points
If a bank falls below reserve requirement: -call in loans -borrow from another bank (federal funds rate) -borrow from the Fed (discount rate)
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Balance Sheets- Important Points
-Reserve Requirement = 10% -Required Reserve Ratio = .1
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Fed Policy Recessionary Gap Inflationary Gap Expansionary policy
Buy bonds Increase Money Supply “easy money” Interest rates down Quantity of Investment Increase AD Increase (speed up) Price Level Increase Inflationary Gap Contractionary policy Sell bonds Decrease Money Supply “tight money” Interest rates up Quantity of Investment Decrease AD decrease (slows) Price Level Decrease
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Crowding Out Government deficit spending causes real interest rates to rise (loanable funds) Quantity of Investment Spending Decreases May partially or fully restrict AD increase from increase in “G” with decrease in “I”
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Demand for Money Transaction Demand- function? Asset Demand- function?
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Demand for Money Transaction Demand- money for spending
Increase in PL will cause rightward shift
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Demand for Money Financial Assets- stocks, bonds, loans, deposits
Asset Demand- inverse relationship to interest rates
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Monetarism Money Supply is chief determinant of economic growth
MV = PQ
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MV = PQ Equation of exchange M= money supply V= velocity of money
P= price level Q= quantity of goods and services produced PQ =
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Quantity Theory of Money
MV=PQ Change in M will cause proportional change in P Classical View
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MV = PQ
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Investment Demand
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Investment Demand Investment leads to capital formation
This changes future capital stock This influences growth rate In LR, increased investment spending will increase LRAS
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