1. Money, Banking, The Fed, Fiscal and Monetary Policy
AP Macro
Chapters 12, 13, 14 and 15
Loanable Funds-Chapter 29

2. Mechanics of Fiscal Policy
AP Macro

3. Fiscal Policy
Government efforts to promote full employment and price stability by changing government spending (G) and/or taxes (T).
Recession is countered with expansionary policy.
Increase government spending (G )
Decrease taxes (T )
Inflation is countered with contractionary policy
Decrease government spending (G )
Increase Taxes (T )    

4. Expansionary Fiscal Policy
In order to combat recession, the government engages
in expansionary policy.   
If G or T ,then AD shifts causing PL and GDP ,which causes u%   
Notice that the PL increased: this means expansionary
fiscal policy creates some inflation.

5. Expansionary Fiscal Policy
SRAS
LRAS PL  P1  P
AD1 AD  Y YF
GDPR
IF RECESSION, THEN G↑.: AD  .: GDPR↑ & PL↑ .: u%↓ & π% ↑
OR T↓ .: DI↑ .: C↑.: AD  .: GDPR↑ & PL↑ .: u%↓ & π% ↑

6. In order to combat inflation, the government engages
Contractionary Fiscal Policy
In order to combat inflation, the government engages
in contractionary policy.  
If G or T ,then AD shifts causing PL and GDP , which causes u%    
Notice that the u% increased: this means contractionary
fiscal policy creates some unemployment.

7. Contractionary Fiscal Policy
LRAS PL
SRAS  P  P1 AD
AD1  YF Y
GDPR
IF INFLATION, THEN G↓ .: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓
OR T↑ .: DI↓ .: C↓ .: AD  .: GDPR↓ & PL↓ .: u%↑ & π%↓

8. Discretionary v. Automatic Fiscal Policies
Increasing or Decreasing Government Spending and/or Taxes in order to return the economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem
Automatic
Unemployment compensation & marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems.

9. Weaknesses of Fiscal Policy
Lags
Inside lag – it takes time to recognize economic problems and to promote solutions to those problems
Outside lag – it takes time to implement solutions to problems
Political Motivation
Politicians face re-election and are more likely to support expansionary rather than contractionary fiscal policy.
Increased government spending and decreased taxes are almost always more popular with voters than increased taxes and decreased spending.

10. Government Lags Recognition-Aware a recession is happening?
Administrative-democracy is slow to move.
Operational-time between actual and efforts occur with output, employment or price level.
Political business cycle-fiscal policy is political, election years, etc.

11. Expansionary Fiscal Policy Side-effect: ‘Crowding-out’ of Investment and Net Exports
A possible side-effect of increased government spending
and reduced taxes is a budget deficit which may lead to
the ‘crowding-out’ of Gross Private Investment (IG) and
Net Exports (XN) 
When G or T , then government must borrow in order to continue
spending. This leads to an increase in the demand for loanable funds
or a decrease in the supply of loanable funds, which results in r % .
This change in r % leads to IG . In addition, the increase in r% causes
D$ and/or S$ as investors seek higher returns in the U.S. This leads to
$ which leads to X and M , so XN . Because IG and XN are direct
components of AD, these decreases offset some of the increase in AD.         

12. Expansionary Fiscal Policy Side-effect: ‘Crowding-out’
SLF r% r% r1 r
DLF 1 ID
DLF IG q q1
QLF I1 I
G↑ and/or T↓ .: Government deficit spends .: DLF  .: r%↑ .: IG↓
(Crowding-Out Effect)

13. Contractionary Fiscal Policy Side-effect: ‘Crowding-in’ of Investment and Net Exports
A possible side-effect of decreased government spending
and increased taxes is a budget surplus which may lead to
the ‘crowding-in’ of Gross Private Investment (IG) and
Net Exports (XN)
When G or T ↑ , then government develops a budget surplus
This leads to a decrease in the demand for loanable funds
or an increase in the supply of loanable funds, which results in r % .
This change in r % leads to IG . In addition, the decrease in r% causes
D$ and/or S$ as investors seek higher returns abroad. This leads to
$ which leads to X and M , so XN . Because IG and XN are direct
components of AD, these increases offset some of the decrease in AD.         

14. Stabilizers
Built in stabilizers are anything that↑ government budget deficit or ↓ a budget surplus during a recession or ↑ a surplus or ↓deficit during inflation without requiring any action by policy makers (Congress).

15. Government Spending
Gov’t Taxes $ C A=deficit B=balanced T&G B G C=Surplus A GDP

16. Taxes Progressive Taxes ↑ as GDP↑ Proportional Taxes= as GDP↑
The more progressive the tax, the more built in stability
Regressive Taxes ↓ as GDP↑

17. Budget
The Full Employment or Standardized budget adjusts to actual deficits or surpluses to eliminate automatic changes in tax revenues.
Compare actual government expenditures to those that would have occurred if the economy reached full employment.
Cyclical deficit is a by product of the economy’s slide into a recession.

18. Money: Definitions, Measures, Time value + introduction to Quantity Theory
AP Macro

19. Money Defined Money is anything that can be used as:
A medium of exchange
A store of value
A unit of account/standard of value
Money works best when it meets these criteria:
Portable
Durable
Divisible
Acceptable
stable

20. Money Facts What backs the dollar and makes it valuable? Gold?
No!!!!!!!The dollar is legal tender because the government says it’s money and people willingly accepted it. The dollar is backed by the Full FAITH and credit of the US Gov’t.
This is referred to as an inconvertible fiat standard.

21. The Supply of Money
In the United States, the Federal Reserve System is the sole issuer of currency.
This means the Fed has monopoly control over the money supply.
There are two important measures of the money supply today: M1 M2

22. M1 M1 serves primarily as a medium of exchange. It includes:
Currency and Coin
Demand Deposits

23. Certificates of DepositM2
M2 serves as a store of value. It includes:
The M1
Time Deposits
Money Market Mutual Funds
Overnight Eurodollars
Certificates of Deposit
Savings Accounts

24. M1 and M2 The measure becomes smaller As we go from M1 to M2
The measure becomes larger
Money becomes less liquid
As we go from M2 to M1
The measure becomes smaller
Money becomes more liquid

25. Time Value of Money
Is a dollar today worth more than a dollar tomorrow?
Yes!!!!!
Why??
Opportunity Cost and inflation
This is the reason for charging and
paying interest

26. Time Value of Money Let v = future value of $ p = present value of $
r = real interest rate (nominal rate – inflation rate) expressed as a decimal
n = years
k = number of times interest is credited per year
The Simple Interest Formula
v = ( 1 + r )n * p
The Compound Interest Formula
v = ( 1 + r/k )nk * p

27. Time Value of Money Illustrated
Assume that inflation is expected to be 3% and that the nominal interest rate on simple interest savings is 1%. Calculate the future value of $1 after 1 year.
Step 1: Calculate the real interest rate
r% = i% - p%
r% = 1% - 3% = -2% or -.02
Step 2: Use the simple interest formula to calculate the future value of $1
v = ( 1 + r )n * p
v = ( 1 + (-.02))1 * $1
v = (.98) * $1
v = $0.98

28. Time Value of Money Illustrated
Assume that inflation is still expected to be 3% but that the nominal interest rate on simple interest savings is 4%. Calculate the future value of $1 after 1 year.
Step 1: Calculate the real interest rate
r% = i% - p%
r% = 4% - 3% = 1% or .01
Step 2: Use the simple interest formula to calculate the future value of $1
v = ( 1 + r )n * p
v = ( )1 * $1
v = $1.01

29. Time Value of Money FUN!!!
Assume that annual inflation is expected to be 2.5% and that the annual nominal interest rate on a 10 year certificate of deposit is 5% compounded monthly. Calculate the future value of $1,000 after 10 years.
Step 1: Calculate the real interest rate
r% = i% - p%
r% = 5% - 2.5% = 2.5% or .025
Step 2: Use the compound interest formula to calculate the future value of $1,000
v = ( 1 + r/k )nk * p
v = ( /12)10*12 * $1,000
v = ( )120 * $1,000
v = $1,283.69

30. Relating Money to GDP Economist Irving Fisher Postulated that:
Nominal GDP=The money supply * Money’s velocity

31. The Monetary Equation of Exchange
MV=PQ
M=money supply (M1 or M2)
V=money’s velocity (M1 or M2)
P=price level (PL on the AD/AS graph)
Q=real GDP (sometimes labeled as Y on the AD/AS diagram)
P*Q or PQ=Nominal GDP

32. The Monetary Equation of Exchange
MV=PQ
M1=$2 trillion
V of M1 = 7
PQ = $14 trillion
LRAS
SRAS PL P AD QF
GDPR

33. The Money Market
AP Macro

34. The Money Market
The market where the Fed and the users of money interact thus determining the nominal interest rate (i%).
Money Demand (MD) comes from households, firms, government and the foreign sector.
The Money Supply (MS) is determined only by the Federal Reserve.

35. Money Demand
Transaction Demand – demand for money as a medium of exchange (independent of the interest rate).
Asset Demand – demand for money as a store of value (dependent on the interest rate).
Total Money Demand – (MD) is downward sloping because at high interest rates people are less inclined to hold money and more inclined to hold stocks & bonds. At lower interest rates people sacrifice less when they hold money.

36. Money Supply
The money supply is determined by the Federal Reserve because the Fed has monopoly control over the supply of money.

37. The Money Market i% MS i MD Q QM
The equilibrium of MS & MD determines the nominal interest rate (i%). MD is downward sloping because the nominal interest rate is the opportunity cost of holding money. MS is vertical because it is independent of the interest rate.

38. Changes in Money Demand
Money Demand is dependent on both the Price Level and Real GDP which together comprise the Nominal GDP
Nominal GDP↑ .: MD .: i%↑
Nominal GDP↓ .: MD .: i%↓

39. ↑In MD i% MS  i1 
MD1  i MD Q QM
MD .: i%↑

40. ↓in MD i% MS  i  MD  i1
MD1 Q QM
MD .: i%↓

41. Changes in the Money Supply
Only the Fed determines the money supply
Expansionary Monetary Policy
MS .: i%↓
Contractionary Monetary Policy
MS .: i%↑

42. Changes in the Money Supply
Only the Fed determines the money supply
Expansionary Monetary Policy
MS .: i%↓
Contractionary Monetary Policy
MS .: i%↑

43. ↑in MS i% MS
MS1  i   i1 MD Q Q1 QM
MS .: i%↓

44. ↓in MS i%
MS1 MS  i1   i MD Q1 Q QM
MS .: i%↑

45. Multiple Deposit Expansion
AP Macro

46. Banking Banks are a business and therefore want to make a profit.
Profit=spread (difference between money earned in loans-money paid out in interest).
Banks loan money to make money
Where does the money come from?
People/businesses put money into banks
Time deposits-savings accounts
Demand deposits-checking accounts

47. Reserve Requirement
The Fed requires banks to always have money readily available to meet consumers’ demands for cash.
The amount, set by the Fed, is the Required Reserve Ratio.
The Required Reserve Ratio is the % of demand deposits (checking account balances) that must not be loaned out.
Typically the Required Reserve Ratio =10%

48. The Money Multiplier
Similar to the spending multiplier, the money multiplier shows us the impact of a change in demand deposits on loans and eventually the money supply.
To calculate the money multiplier, divide 1 by the required reserve ratio.
Money Multiplier=1/reserve ratio
Example: If the reserve ratio is 25%, then the multiplier is 4.
Why????????? 1/.25=4

49. The Three Types of Multiple Deposit Expansion Questions
Type 1: Calculate the initial change in excess reserves.
The amount a single bank can loan from the initial deposit.
Type 2: Calculate the change in loans in the banking system.
Type 3: Calculate the change in the money supply.
Sometimes type 2 and 3 will have the same result (no Fed involvement.
Read these types of questions carefully to avoid confusion!!!

50. Example 1
Given a required reserve ratio of 20%, assume the Federal Reserve purchases $100 million worth of US Treasury Securities on the open market from a primary security dealer. Determine that amount that a single bank can lend from this Federal Reserve purchase of bonds.
The amount of new demand deposits (dd)-required reserve (rr)=initial change in excess reserves(er)
$100 million- (20% * $100 million)
$100 million-$20 million=$80 million in ER

51. Example 2
Given a required reserve ratio of 20%, assume the Federal Reserve purchases $100 million worth of US Treasury Securities on the open market from a primary security dealer. Determine the maximum total changes in loans in the banking system from this Federal Reserve purchase of bonds.
The initial change in excess reserves * the money multiplier=maximum change in loans
$80 million * (1/20%)
$80 * 5=$400 million maximum in new loans

52. Example 3
Given a required reserve ratio of 20%, assume that the Federal Reserve purchases $100 million worth of US Treasury Securities on the open market from a primary security dealer. Determine the maximum total changes in the money supply from this Federal Reserve purchase of bonds.
The maximum change in loans + $ amount of Fed action
$100 * 20%=$ $100-$20=$80
$80* 1/ $80*5=$400
$400 million + $100 million=$500 million max change in the money supply

53. Monetary Policy
AP Macro 

54. Monetary Policy
Central Bank (The Fed, Bank of England, ECB, Bank of Japan…) efforts to promote full employment, maintain price stability, and encourage long run economic goals through control of the money supply and interest rates.

55. Monetary Policy Analogy
The Fed is to a Capitalist Economy as
a Driving Instructor is to a hormonal 15 year old student driver.

56. Types of Monetary Policy
Expansionary
Contractionary
Easy Money
Monetary policy designed to counteract the effects of recession and return the economy to full employment.
Tight Money
Monetary policy designed to counteract the effects of inflation and return the economy to full employment.

57. Tools of Monetary Policy
Required Reserve Ratio (+Contractual Clearing Balances)
The discount rate
Open Market Operations (OMO)
(New) Term Auction Facility (TAF)

58. The Required Reserve Ratio
The % of demand deposits that must be stored as vault cash or kept on reserve as Federal Funds in the bank’s account with the Federal Reserve.
The Required Reserve Ratio determines the money multiplier (1/rr).
↓ the rr ↑ the rate of money creation in the banking system and is expansionary.
↑ the rr ↓ the rate of money creation in the banking system and is contractionary.
Changing the required reserve ratio is the least used tool of monetary policy and is usually held constant at 10%.

59. Contractual Clearing Balance
Even though some deposits are not subject to the reserve requirement, banks may contract with the fed to maintain a clearing balance in order to have funds necessary to clear transactions at the end of the day.
Contractual Clearing Balances provide the Fed with information to better conduct monetary policy.

60. The Discount Rate
The interest % banks pay the Fed for overnight loans in order to meet the required reserve.
↓ the discount rate ↓the cost of borrowing for banks, thus creating an incentive for banks to loan more of their ER and borrow from the Fed in order to meet their RR or contractual clearing balance. This effect is to ↑ the money supply and is expansionary.
↑ the discount rate ↑ the cost of borrowing for banks, thus creating an incentive for banks to loan less of their excess reserves. The effect is to ↓ the money supply and is contractionary.
The discount rate is a secondary tool of monetary policy. It functions as a substitute to the Fed Funds Market, providing banks with necessary liquidity when they are unable to access Fed Funds from other private sector banks. However, banks are often reluctant to utilize the discount window.
The discount rate is usually higher than the fed funds rate.

61. Open Market Operations
The purchase and sale of government securities by the Fed in order to increase or decrease the banks’ excess reserves. OMO determines the Fed Funds rate which is the interest % banks pay each other for overnight loans of Federal Funds.
When the Fed buys bonds, excess reserves ↑, and is expansionary.
When the Fed sells bonds, excess reserves ↓ and is contractionary.
OMO is the primary tool of monetary policy.

62. Term Auction Facility (TAF)
Instituted in Dec in response to a crisis in the Fed Funds market and a reluctance of banks to utilize the Fed’s discount window. Under the TAF, banks can competitively bid against each other on collateralized 28 day loans from the Fed in incremental amounts of $10 M to $3B. The total amount of funds available for auction are determined prior to the auction by the Fed. The purpose of the TAF is to ensure bank liquidity without the perceived downsides of using the discount window.
The TAF is a tool of expansionary monetary policy.
The interest rate on a TAF loan (stop-out rate) is most likely between the Federal Funds rate and the discount rate.

63. Why do banks need overnight loans?
Banks are like any other business in that they seek to maximize profits. Banks make a profit by loaning out as much of their excess reserves as possible and charging interest to the borrower.
If in the course of business, they have loaned out all excess reserves and do not have enough money to satisfy the required reserve ratio or their contractual clearing balance, then they must either borrow from the Fed’s discount window, borrow from the Fed through the TAF, or most likely borrow from each other in the Fed. Funds market.

64. Expansionary Monetary Policy to Counteract a Recession w/ reinforcing effect on Net Exports
Res. Ratio
Disc. Rate
Buy Bonds
TAF 
ER ,therefore MS causing i% which leads to IG     = 
so AD ,resulting in PL and GDPR ,making u%    
And now! Because i% either D$ or S$ which causes $ making U.S. goods
relatively and foreign goods relatively causing X and
M which means XN thereby reinforcing the increase in AD already caused by
the increase in IG.    
cheaper
more expensive   
AD = Aggregate Demand
PL = Price Level
GDPR = Real Gross Domestic Product
u% = Unemployment Rate
S$ = Supply of Dollars in FOREX
M = Imports, XN = Net Exports
ER = Excess Reserves
MS = Money Supply
i% = Nominal Interest Rate
IG = Gross Private Investment
D$= Demand for dollars in FOREX
X = Exports

65. Graphing Expansionary Monetary PolicyMS
MS1 i% i%
Graphing Expansionary Monetary Policy  i i    i1 i1 ID MD  Q Q1 QM I I1 IG
Fed buys bonds, TAF loan,
Lower discount rate
.: ER↑ .: MS .: i%↓
.: IG↑
.: AD.: GDPR↑ & PL↑
.: u%↓ & π%↑
LRAS PL
SRAS  P1  P
AD1 AD  Y YF
GDPR

66. Contractionary Monetary Policy to Counteract Inflation w/ reinforcing effect on Net Exports
Res. Ratio
Disc. Rate
Sell Bonds 
ER ,therefore MS causing i% which leads to IG     = 
so AD ,resulting in PL and GDPR ,making u%    
And now! Because i% either D$ or S$ which causes $ making U.S. goods
relatively and foreign goods relatively causing X and
M which means XN thereby reinforcing the decrease in AD already caused by
the decrease in IG.    
more expensive
cheaper   
AD = Aggregate Demand
PL = Price Level
GDPR = Real Gross Domestic Product
u% = Unemployment Rate
S$ = Supply of Dollars in FOREX
M = Imports, XN = Net Exports
ER = Excess Reserves
MS = Money Supply
i% = Nominal Interest Rate
IG = Gross Private Investment
D$= Demand for dollars in FOREX
X = Exports

67. Loanable Funds
AP Macro

68. Loanable Funds Market
The market where savers and borrowers exchange funds (QLF) at the real rate of interest (r%).
The demand for loanable funds, or borrowing comes from households, firms, government and the foreign sector. The demand for loanable funds is in fact the supply of bonds.
The supply of loanable funds, or savings comes from households, firms, government and the foreign sector. The supply of loanable funds is also the demand for bonds.

69. Loanable Funds Market in Equilibrium
SLF & DBonds r
DLF & SBonds
QLF q

70. Changes in the Demand for Loanable Funds
Remember that demand for loanable funds = borrowing (i.e. supplying bonds)
More borrowing = more demand for loanable funds ()
Less borrowing = less demand for loanable funds ()
Examples
Government deficit spending = more borrowing
= more demand for loanable funds
.: DLF  .: r%↑
Less investment demand = less borrowing
= less demand for loanable funds
.: DLF .: r%↓

71. Increase in the Demand for Loanable Funds
SLF r1 r
DLF 1
DLF
QLF q q1
DLF  .: r% ↑ & QLF ↑

72. Decrease in the Demand for Loanable Funds
SLF r r1
DLF
DLF 1
QLF q1 q
DLF  .: r% ↓ & QLF ↓

73. Changes in the Supply of Loanable Funds
Remember that supply of loanable funds = saving (i.e. demand for bonds)
More saving = more supply of loanable funds()
Less saving = less supply of loanable funds ()
Examples
Government budget surplus = more saving
= more supply of loanable funds
.: SLF  .: r%↓
Decrease in consumers’ MPS = less saving
= less supply of loanable funds
.: SLF .: r%↑

74. Increase in the Supply of Loanable Funds
SLF
SLF 1 r r1
DLF
QLF q q1
SLF  .: r% ↓ & QLF ↑

75. Decrease in the Supply of
Loanable Funds
SLF 1 r%
SLF r1 r
DLF
QLF q1 q
SLF  .: r% ↑ & QLF ↓

76. Final thoughts on Loanable Funds
Loanable funds market determines the real interest rate (r%).
Loanable funds market relates saving and borrowing.
Changes in saving and borrowing create changes in loanable funds and therefore the r% changes.
When government does fiscal policy it will affect the loanable funds market.
Changes in the real interest rate (r%) will affect Gross Private Investment

77. Effect of Expansionary Fiscal Policy on Loanable Funds & Investment
SLF r% r% r1 r
DLF 1 ID
DLF IG q q1
QLF I1 I
G↑ and/or T↓ .: Government deficit spends .: DLF  .: r%↑ .: IG↓
(Crowding-Out Effect)