Unit 4

Unit 4

Uses of Money

1. Medium of exchange
1. Bartering or trading
2. Unit of account
1. Establishes economic worth
3. Store of value
1. Money holds value over a period of time

Types of Money

1. Commodity money/goods
1. It gets its value from the type of material from which it is made
2. Representative money
1. (I.O.U.) Paper money that is backed by something tangible
3. Fiat money
1. Money because the government says so

Characteristics

1. Durability- able to endure damage (water, rips)
2. Portability- bill or coin form
3. Divisibility- make change
4. Uniformity- same money in all states
5. Scarcity- 2 dollar bill, Suzanne B. Anthony coin
6. Acceptability- accepted all over the world

Money Supply

• M1 money
• currency (coins and paper money) in circulation + checkable deposits(demand deposits) + traveler's checks
• M2 money
• M1 money + savings accounts + money market accounts + deposits held by banks outside the U.S.

Fractional Reserve Banking

• process by banks of holding a small portion of their deposits in reserve and loaning out the excess

1. Banks keep cash on hand (required reserves) to meet depositor's needs
2. Banks must keep reserve deposits in their vaults or at the Federal Reserve Bank
3. Total reserves(total funds held by a bank) = required reserves + excess reserves
1. TR = RR + ER
2. excess reserves are reserves beyond those that are required
4. Banks can legally lend only to the extent of their ER
5. Reserves ratio= required reserve / total reserves

Significance of a Fractional Reserve System

1. Banks can make money by lending more money than their reserve.
2. Required reserves don't prevent bank panics because banks must keep their required reserves (FDIC)
3. Reserve requirement gives the Fed control over how much money banks can create

Functions of the Fed (Federal Reserve Bank)

1. Control money supply through monetary policy (circulation of currency and adjusting the interest rate)
2. Issue paper money
3. Serve as a clearing house for checks
4. Regulate banking activities
5. Serve as a bank for banks

Balance Sheet

• Statement of assets and claims summarizing the financial position of a firm or bank at some point in time
• Must balance at all times

Assets	Liabilities
·         own	·         Owe ·         Claims of non owners

Multiple Deposit Expansion

Assets

Liabilities + Equity

·         Reserves: o   Required Reserves(rr): percent required by Fed to keep on hand to meet demand o   Excess Reserves(er): percent over and above amount needed to satisfy minimum reserve ratio set by Fed ·         Loans to firm, consumers, and other banks (earns interest) ·         Loans to government = treasury securities ·         Bank property-(if bank fails, you could liquidate the building/property) ·         Required Reserve ratio is 10% and is set by the Fed

· Demand deposits($ put into bank) · Time deposits · Loans from Federal Reserve and other banks · Share holders equity- (to set up a bank, you must invest your own money in it to have a stake in the banks success or failure)

Required Reserve Ratio

• Percent of demand deposits that must be stored as vault cash or kept on reserve as Federal Funds in bank's account with Fed Reserve
• Required reserve ratio determines money multiplier(1/rr)
• decrease in reserve ratio, increase rate of money creation in banking system/ expansionary
• increase in reserve ratio, decrease rate of money creation/ contractionary
• Changing the required reserve ratio is the least used tool of monetary policy and held at 10%

Monetary Multiplier

• 1 / reserve ratio
• Shows the impact of a change in demand deposits in loans and eventually money supply
• Indicates total number of money created by each addition to the monetary base (bank reserves and currency in circulation)

Types of Multiple Deposits Questions

1. Calculate initial change in excess reserves:
• amount a bank can loan from initial deposit
• amount of new demand deposit - required reserve = initial change in excess reserve
2. Calculate change in loans in banking system
• initial change in excess reserve x money multiplier = max change in loans
3. Calculate change in money supply
• max change in loans + amount of Fed reserve action
4. Calculate change in demand deposits
• max change in loans + amount of initial deposits

Fiscal Policy	Monetary Policy
· Congress · Tax or spend	·    Fed 1.  Open market Operations: Feds can buy or sell bonds (securities) 2.  Required Reserves 3.  Discount rate: interest rate charged by Fed for overnight loans to commercial banks, doesn’t directly change money supply 4.  Fed Fund rate: interest rate charged by one commercial bank for overnight loans to another commercial bank

• The Fed has several tools to manage the money supply by manipulating the excess reserves held by banks, a practice known as monetary policy

Monetary Policy Option	Expansionary (easy money) Increase money supply	Contractionary (tight money) Decrease Money supply
Open Market Operations	Buy back bonds	Sell bonds
Reserve Ratio	Decrease reserve ratio	Increase reserve ratio
Discount Rate	Decrease Discount rate	Increase discount rate
Fed Fund Rate	Decrease Fed Fund rate	Increase Fed Fund Rate

Loanable Funds Market

• Market where savers and borrowers exchange funds (Qlf) at the real interest rate
• Demand comes form households, firms, government, and foreign sector, demand for loanable funds = supply of bonds
• supply of loanable funds, or savings comes from households, firms, government , foreign sector, supply of loanable fund = demand for bonds
• If supplying, some one's demanding (vice versa)

Change in Demand for Loanable Funds

• Dlf = borrowing (i.e. supplying bonds)
• increase borrow = increase Dlf (shifts right)
• decrease borrow = decrease Dlf (shifts left)
• government deficit = increase borrow = increase Dlf (shifts right), increase r% 
• decrease investment demand = decrease borrow = decrease Dlf (shifts left), decrease r%

Change in Supply for Loanable Funds

• Slf = saving (demand for bonds)
• increase saving = increase Slf (shifts right)
• decrease saving = decrease Slf (shifts left)
• government surplus = increase saving= increase Slf (shifts right), decrease r% 
• decrease consumer's MPS = decrease saving= decrease Slf (shifts left), increase r%

If you are still unclear on anything in the this unit, the Mr. Clifford's videos may be able to help you out, afterall a teacher can probably explain the concepts better than a student.

This particular video covers the Money Market graphs and the tools of the Federal Reserve as well as how they use them.

This video focuses on the connection between the Money Market, Investment, and AD & AS graphs.

This is a continuation on what was discussed in the last video. It is more practice on the Money Market, Investment, and AD & AS graphs.

The topic of this video is the Money Multiplier and the Reserve Requirement. Mr. Clifford does an excellent job of explaining this part of the unit.

If you still aren't sure what the heck to do with a "multiple thingy" or you actually understand what's going on with the money multiplier and the reserve requirement, this video helps to teach as well as reinforce those concepts, but also gives you something to practice on.

If you still need a little help with real and nominal interest rates or inflation rates, then this is the video to watch.

Mr. Clifford focuses on the Loanable funds graph as well as the concept of Crowding out.

Unit 3

Unit 3

Aggregate Demand(AD)

• shows amount of Real GDP that private, public, and foreign sectors collectively desire to purchase at each possible price level
• the relationship between the price level and the level of Real GDP is inverse

Three reason for Downward Slope

1. Real-Balance Effect:
• When price level is high, households and businesses can't afford to purchase as much output
• When price level is low, household and businesses can afford to purchase more output
2. Interest-rate effect:
• Higher price level increases interest- rate which tends to discourage investment
• Lover price level decreases interest rate which tends to encourage investment
3. Foreign purchases effect
• Higher price level increases demand for relatively cheaper imports
• Lower price level increases foreign demand for relatively cheaper U.S. Imports

Shifts in AD

• There are two parts to a shift in AD
• Change in C, Ig, G, and/or Xn
• Multiplier effect that produces a greater change than the original change in the four components
• increase in AD shift to right
• decrease in AD shift to left

Determinates of AD

• Consumption (C)
• Consumer wealth: more wealth = more spending (AD =>), less wealth = less spending (AD<=)
• Consumer expectations: positive expectations= more spending (AD =>), negative expectations = less spending (AD <=)
• Household in debt: less debt = more spending (AD =>), more debt = less spending (AD <=)
• Taxes: less taxes = more spending (AD <=), more taxes = less spending (AD <=)
• Gross Private Domestic Investment (Ig)
• real interest rate: lower real interest rate = more investment (AD =>), higher real interest rate = less investment (AD <=)
• expected returns: higher expected returns= more investment (=>), lover expected returns = less investments (<=)
• influenced by
• technology, business taxes, degree of excess capacity(existing stock) (lack of capital), expectations for future profitability
• Government Spending (G)
• More government spending (=>), less government spending (<=)
• Net Exports (Xn)
• exchange rates (International value of $)d: strong $ = more imports and fewer exports (<=), weak $ = fewer imports and more exports (=>)
• Relative income: strong foreign economies = more exports (=>), weak foreign economies = less exports (<=)

Aggregate Supply (AS)

This is the level of Real GDP that firms will produce at each price level

Long-run vs. Short-run
Long-Run	Short-Run
·   Period of time where input prices are completely flexible and adjust to changes in the price level	·   Period of time where input prices are inflexible (sticky) and do not adjust to changes in the price level.
·   The level of Real GDP supplied is independent of the price level	·   The level of Real GDP supplied is directly related to the price level

Long-Run Aggregate Supply (LRAS)

• The long-run aggregate supply or LRAS marks the level of full employment in the economy (analogous to PPC)        ***LRAS will always be vertical at full employment***

Changes in SRAS

• An increase in SRAS is seen as a shift to the right (=>)
• A decrease in SRAS is seen as a shift to the left (<=)
• The key to understanding shifts in SRAS is per unit cost of production
• per unit production cost= (Total input cost) / (total output)

Determinates of SRAS

• All of the following effect per unit production cost
• Input prices
• Increase in resource prices = SRAS (<=)
• Decrease in resource prices = SRAS (=>)
• Productivity
• Productivity = (Total output) / (total input)
• more productivity = lower unit production cost = SRAS (=>)
• Lower productivity = higher unit production cost = SRAS (<=)
• Legal-institutional environment

Ranges/ Shapes/ Views of AS

Keynesian Range (Horizontal)

• Followers of Keynesian view believe in a horizontal AS curve because when the economy is below full employment AD shifts outward (increase in Real GDP, unemployment drops by the price level is constant/ Demand creates its own supply)

Classical Range (Vertical)

• In the long-run, AD curve is vertical because the only effects of an increase in AD is when we are already at full employment thus you have an increase in price level and supply creates its own demand "Say's Law"

Intermediate Range

• AS is between the classical and Keynesian range, when this occurs as AS shifts outward, price level and Real GDP increase

AS/AD model

• equilibrium of AS and AD determines current output (Real GDP) and price level

Full Employment

• Full employment: equilibrium exists where AD intersects SRAS and LRAS at the same point

Recessionary Gap

• A recessionary gap exists when equilibrium occurs below full employment output

Inflationary Gap

• An inflationary gap exists when equilibrium occurs beyond full employment output

Changes in AD

• Change in Consumption C), Gross Private Domestic Investment(Ig), Government Spending(G), and Net Exports(Xn)
• Change(^)   AD(>)   Real GDP (^)   PL (^)   u%(v)   π%(^)
• Change(v)   AD(<)   Real GDP (v)   PL (v)   u%(^)   π%(v)
• u% = unemployment                    π% = inflation

Increase in C, Ig, G, and/or Xn

• AD (>)   Real GDP(^)   PL(^)   u%(v)   π%(^)

Decrease in C, Ig, G, and/or Xn

• AD(<)   Real GDP (v)   PL (v)   u%(^)   π%(v)

Changes in SRAS

• Input prices and Legal-institutional environment
• decrease/deregulation
• SRAS(>)   Real GDP(^)   PL(v)   u%(v)   π%(v)
• increase/regulation
• SRAS(<)   Real GDP(v)   PL(^)   u%(^)   π%(^)
• Productivity
• Increase
• SRAS(>)   Real GDP(^)   PL(v)   u%(v)   π%(v)
• Decrease

• SRAS(<)   Real GDP(v)   PL(^)   u%(^)   π%(^)

Increase in SRAS

• Input prices (v), Productivity (^), and/or deregulation
• SRAS(>)   Real GDP(^)   PL(v)   u%(v)   π%(v)

Decrease in SRAS

• Input prices (^), Productivity (v), and/or regulation
• SRAS(<)   Real GDP(v)   PL(^)   u%(^)   π%(^)

Long-run aggregate supply

• Measuring potential output, assessing if all resources are used efficiently
• efficient- no pressure to raise or lower factor prices
• inefficient(under-utilizing resources)- factor prices are pressured to fall
• over-utilizing resources- factor prices are pressured to rise

Shifts of long-run AS

• Technology
• Economic growth
• Capital
• Entrepreneurship
• More resources available

What is an investment?

• money spent(expenditures) on:
• new plants (factories)
• capital equipment (machinery)
• inventories (goods sold by producers)
• technology (hardware and software)
• new homes

Expected rates of return

• How does a business make investment decisions?
• Cost/benefit analysis
• How does a business determine benefits?
• Expected rate of return
• How does a business count cost?
• Interest costs
• How does a business determine the amount of investment they undertake?
• Expected return > interest cost, they invest
• Expected return < interest cost, they do not invest

Real (r%) vs Nominal (i%)

• Nominal is observable rate of interest. Real subtracts out inflation and is only known ex post facto
• r% = i% - π%
• What determines the cost of investment decisions?
• Real interest rate (r%)

Investment demand curve (ID)

• Shape of IDC?
• Downward sloping because:
• When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable
• Conversely, there are few investments that yield high rates of return, and many that yield low rates of return

Shifts in ID

• Cost of production
• Business taxes
• Technological change
• Stock of capital
• Expectations

Consumption and Saving

• Disposable income
• income after taxes or net income
• households can either:
• consume (spend money on goods and services)
• save (not spend money on good and services)
• Consumption
• household spending, the ability to consume is constrained by:
• amount of DI and propensity to save
• Do households consume if DI=0
• autonomous consumption and dissaving
• Saving
• household NOT spending
• ability to save is constrained by:
• amount of DI and propensity to consume
• Households don't save if DI=0

APS and APC

• Average propensity to save or consume
• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 = dissaving       -APS = dissaving

MPC and MPS

• Marginal propensity to consume or save
• MPC = Change in C / Change in DI 
• % of every extra dollar earned that is spent
• MPS = Change in S / Change in DI
• % of every extra dollar earned that is saved
• MPC + MPS = 1
• 1 - MPC = MPS
• 1 - MPS = MPC

Determinates of C and S

• Wealth
• Expectations
• Taxes
• Household debts

Spending Multiplier Effect

• initial change in spending (C, Ig, C, Xn) causes a larger change in AD
• Multiplier = Change in AD / Change in spending(C, Ig, C, Xn)
• Expenditures and income flow continuously which sets off a spending increase in the economy
• Multiplier = 1/(1-MPC) or 1/(MPS)
• Multipliers are (+) when there is an increase in spending and (-) when there is a decrease in spending

Calculating the Tax Multiplier

• When the government taxes, the multiplier works in reverse
• Why?
• Because now money is leaving the circular flow
• Tax Multiplier(its negative) = -MPC / (1-MPC) or -MPC/MPS
• If there is a tax cut, then the multiplier is (+), because there is now more money in the circular flow

Steps to solve a multiplier problem

1. Calculate MPC and MPS
2. Decide which multiplier and whether it is (+) or (-)
3. Calculate spending and/or tax multiplier
4. Calculate the change in AD

Other Multipliers

• Investment multiplier
• change in GDP = change in investment x investment multiplier
• Government spending multiplier
• change in GDP = change in government spending x government spending multiplier
• Tax multiplier
• change in GDP = change in taxes x tax multiplier

Fiscal Policy

• expansionary and contractionary policy, deficits and surpluses, built in stability,
• changes in the expenditures or tax revenues of the federal government
• tools:
• taxes- government can increase or decrease taxes
• spending- government can increase or decrease spending
• Fiscal policy is enacted to promote our nation's economic goals: full employment, price stability economic growth

Deficits, surpluses, and debt

• Balanced budget: revenues = expenditures
• Budget deficit: revenues < expenditures
• Budget surplus: revenues > expenditures
• Government debt: sum of all debts - sum of all surpluses
• borrows from
• individuals(taxes)
• corporations
• financial institutions
• foreign entities or foreign governments

Fiscal Policy Two Options

• Discretionary Fiscal Policy(action)
• expansionary fiscal policy: think deficit, recession easy money policy
• contractionary fiscal policy: think surplus, inflationary period
• Non-discretionary fiscal policy(no action)

Discretionary vs Automatic

Discretionary	Automatic
Increasing or decreasing government spending and/or taxes in order to return economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem.	Unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems.

Contractionary Fiscal Policy

• Policy designed to decrease aggregate demand
• strategy for controlling inflation
• inflation is countered with contractionary policy
• decrease government spending (G(v))
• increase taxes (T(^))

Expansionary Fiscal Policy

• policy designed to increase aggregate demand
• strategy for increasing GDP, combating a recession and reducing unemployment
• recession is countered with expansionary policy
• increase government spending (G(^))
• decrease taxes (T(v))

Tax System

• progressive: average tax rate (tax revenue / GDP rises with GDP
• proportional: average tax rate remains constant as GDP changes
• Regressive: average tax rate falls with GDP
• the more progressive the tax system, the greater the economy's built-in stability