AP Macroeconomics: Unit 3 Federal Reserve System and Monetary Policy.
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Transcript of AP Macroeconomics: Unit 3 Federal Reserve System and Monetary Policy.
AP Macroeconomics: Unit 3 Federal Reserve System and
Monetary Policy
Topic 1: Money
What makes money effective?
Generally Accepted - Buyers and sellers have confidence that it IS legal tender.
Scarce - Money must not be easily reproduced.
Portable and Divisable - Money must be easily transported and divided.
Functions of Money
1. Medium of Exchange
It is accepted as a form of payment
2. Unit of accounting
• helps to determine the value of an item and allows comparison
3. Store of value
• Money can be saved for use in future
Money Systems: 1. Barter system
• People trade one object for another
2. Commodity money system
• An item with intrinsic value is used as money
Examples:
Cigarettes used in prison
Animal furs used in colonial times
3. Representative Money System
Money “backed” by somethingExample: The Gold standard; people didn’t
carry around the gold, they had a gold certificate that represented the gold
*4. Fiat money system
• Money that is declared so by the government
• It is not “backed” by anything
Money in the U.S. economy
• Money stock = quantity of $ circulating in the U.S. economy
M1= coins, currency & checkable deposits (checking accounts)
M2 = M1 + savings
• Liquidity: ease with which an asset can be accessed and converted into cash
Topic 2: The Federal Reserve and the Banking System
The Federal Reserve System (the Fed)
- The Fed is the central bank of the U.S.
- Created in 1913
Jobs of the Fed
• Print money
• Clear checks
• Supervise banks
• Act as a bank to banks
• Manage money supply
Organization of the Fed
Member banks
Organization of the Fed
• Board of Governors: Head of the Fed
Janet Yellen = current chairman
• Federal Reserve Banks – 12 districts – see map
Federal Reserve Banks: 12 Districts
Member Banks
FDIC insured (Federal Deposit Insurance
Corporation)
Insures money in banks up to $250,000
60 minutes video: FDIC
Topic 3: Banks and the Money supply
Fractional Reserve Banking
If you have a bank account, where is your money?
Only a small percent of your money is in the safe. The rest of your money has been loaned
out.
This is called “Fractional Reserve Banking”
The Fed sets the amount that banks must hold
Demand Deposits
• Money placed in banks by customers
Required Reserve vs. Excess Reserve
Reserve requirement (reserve ratio)
• the percent of deposits that banks must hold in reserve (the percent they can NOT loan out)
Excess Reserve• Money that is not part of the required reserve
* Banks can loan out all of this money if they wish to do so; when they do, they “create” money
The process of how banks “create” money
Banks only influence the amount of $ in the economy if they make loans.
When a loan is taken out, it is spent and ends back up in the bankingSystem
Example: complete the chart assuming the reserve requirement is 10% Bank Deposit Reserve
requirement Loan
A $1000 $100 $900
B
C
The process of how banks “create” money – banks
“create” money by LOANS
Bank Deposit Reserve requirement
Loan
A $1000 $100 $900.00
B $900 $90 $810.00
C $810 $81.10 $728.90
MoneyMultiplier Reserve Requirement (ratio)
1=
The Money Multiplier
28
• Used to determine how much a loan can impact the overall economy
What is the Money multiplier on the following reserves?
• 10%
• 20%
• 5%
Maximum total change in Demand deposits
= Money multiplier X Deposit
Example: Billy deposits $400 in his bank and the reserverequirement is 10%.
What is the money multiplier? 1/.10 = 10
What is the multiple expansion of demand deposits? 10 X $400 = $4000
Maximum change in the money supply =
Money multiplier X Deposit = total - deposit
Example: Billy deposits $400 in his bank and the
reserve requirement is 10%.
What is the money multiplier?
1/.10 = 10
What is the maximum change in the money
supply?
10 X 400 = 4000
4000-400 = $3600
Maximum change in Loans =
Money multiplier X deposit = total - deposit
Example: Billy deposits $400 in his bank and the
reserve requirement is 10%.
What is the money multiplier?
1/.10 = 10
What is the maximum change in LOANS?
10 X $400 = $4000
4000-400 = $3600
THE MULTIPLE EXPANSION of money will be less if:
• 1. Banks DO NOT loan out all of their excess • 2. People DO NOT spend all the money that they
borrow • 3. When money is spent, it is NOT placed back
into a bank
Bank Balance Sheet central to the accounting practices of a
bank (also called a T account) • Assets = required reserves, excess
reserves, loans, securities
(anything of value to the bank)
• Liabilities = Deposits, borrowed reserves, stockholder’s (owner) equity
(anything the bank owes to someone else)
Balance Sheet – 2 sides must = each other
• Assets Liabilities
required reserves 10 deposits 100 excess reserves 10
Loans 80
________ __________
100 100
* Based on this chart, what is the banks required reserve ratio?
Balance Sheet
• Assets Liabilities
required reserves 6 deposits 100 excess reserves 40
Loans 54
________ __________
100 100
• Based on this chart, what is the banks required reserve ratio? • What happens on this balance sheet if a new deposit of $100 is made?
Balance Sheet
• Assets Liabilities
required reserves 12 deposits 200 excess reserves 134
Loans 54
________ __________
200 200
• Based on this chart, what is the banks required reserve ratio? • What happens on this balance sheet if a new deposit of $100 is made?
Topic 4: The Money Market
(Supply and Demand for Money)
The Demand for MoneyAt any given time, people demand a certain amount of liquid assets (money) for everyday purchases
Transaction demand for money = The demand for money as a medium of exchange
Asset demand for money = The demand for money to use it for savings
Transaction demand + asset demand = total money demand
Nominal Interest Rate
(ir)
Quantity of Money(billions of dollars)
20%
5%
2%
0
Md
Inverse relationship between interest rates and the quantity of money demanded
The Demand for Money
Increase in Money demand
• Curve shifts to the right
Nominal Interest rate
Decrease in Money demand
• Curve shifts to the left
Nominal Interest rate
The Demand for Money
Money Demand Shifters
1. Changes in price level
2. Changes in GDP
200
Ms
The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System
(FED)
The Supply for Money
20%
5%
2%
Quantity of Money(billions of dollars)
Interest Rate (ir)
Increasing the Money Supply
200
Ms
10%
5%
2%
Quantity of Money(billions of dollars)
Interest Rate (ir)
250
Ms1
Decreasing the Money Supply
200
Ms
10%
5%
2%
Quantity of Money(billions of dollars)
Interest Rate (ir)
150
Ms1
Money supply shifted by:
Fed action
200
Md
Ms
Money market graph
20%
5%
2%
Quantity of Money(billions of dollars)
Interest Rate (ir)
Draw a graph that shows: The Fed increases the money
supply ….
What will happen to nominal interest rates?
Draw a graph that shows: an increase in the price level…
What will happen to nominal interest rates?
Topic 5: Monetary Policy
• What the Fed does to regulate the money supply
• The Fed controls the money supply by adjusting Nominal interest rates
Video:
Monetary policy: Part Art, Part Science
The Fed Today
The nominal interest rate impacts other interest rates:
Prime Interest rate: interest rate banksgive to their least risky borrowers
Federal Funds Rate
54
The Federal funds rate = interest rate that banks charge one another for short term
(overnight) borrowing
The Fed can’t simply tell banks what interest rate to use. Banks decide on their own.
The Fed sets a target for the Federal funds rate and then implements policies to influence banks
Expansionary monetary policy
Implemented during Recession
Goal is to speed up the economy; they want people to get out and spend $ in economy
Contractionary Monetary Policy
• Implemented during INFLATION
• Goal = slow down the economy; want less spending to occur in the economy
Tools of monetary policyThe Fed adjusts the money supply by
changing any one of the following:
1.Setting Reserve Requirements (Ratios)
2. Changing the Discount rate of interest •Discount Rate- Interest rate the Fed charges banks to borrow money
**3. Open Market Operations•Buying and selling Bonds (securities)
1. Changing the Reserve Requirement
Expansionary monetary policy
Contractionary Monetary Policy
The Fed Decreases the Reserve RatioBanks required to hold less money - have more money available to loan
The Fed Increases the Reserve Ratio Banks required to hold more money – have less money available to loan
2. Changing The Discount Rate
The Discount Rate is the interest rate that the Fed charges banks to borrow $
Example:
• If a bank needs $10 million, they borrow it from the U.S. Treasury (which the FED controls) but they must pay it bank with 3% interest.
Changing the The Discount RateExpansionary Monetary Policy
The Fed will decrease the Discount rate; Banks will be encouraged to borrow more = more $
to loan
Contractionary Monetary Policy
The Fed will increase the Discount rate; banks will be discouraged from borrowing = less $ to loan
60
Open market operations
3. Open Market OperationsThe Fed buys or sells government bonds (securities).
• This is the most important and widely used monetary policy
(THIS IS THE TOOL USED TO INFLUENCE THE FEDERAL FUNDS RATE)
Expansionary monetary policyThe Fed will BUY (back) bonds = more
money in banks (buy = big)
Contractionary monetary policy The Fed will SELL bonds = less money in
banks (sell = small) 62
Graph of expansionary monetary policy
Graph of contractionary monetary policy
Review of multiple expansion
1. Tim deposits $300 into his bank. If the reserve requirement is 20%, the maximum amount the money supply can expand by is……
2. $400 is deposited into a bank. If the reserve requirement is 25%, what is the maximum potential of loans the banking system can give out?
ASSETS LIABILTIES
Required reserves $80 deposits $400
Excess reserves $ 20
Loans $ 300
______________________________________
$400 $400
What happens on this balance sheet when a new $200 deposit comes into the bank?
ASSETS LIABILTIES
Required reserves $120 deposits $600
Excess reserves $ 180
Loans $ 300
______________________________________
$600 $600
Open market operations: accounting for money
multiplier • The Fed has to account for the Money
Multiplier any time they take an action!!!
Examples: 1. The Fed sells $20 million of bonds. What is
the total change in the money supply if the reserve requirement is 10%. 1/.10 = 10 10 X 20 = $200 million
**$200 million DECREASE in money supply
Accounting for the Money multiplier
*Less money is always created when the Fed buys bonds from the public vs banks –
Buying from the public is subject to the reserve
requriement (the bank must hold part of the
money)
If the Fed buys bonds from banks, the bank
doesn’t have to hold any of the money in
reserve because it is THEIR money
Monetary policy: Fed buying from banks vs. the public
2. The Fed buys $10 million in bonds back from banks. If the reserve requirement is 20%, what is the total change in the money supply?
1/.20 = 5 5 X 10 = 50 million INCREASE
3. The Fed buys $10 million in bonds back from the public which is then deposited into bank accounts. If the reserve requirement is 20%, what is the total change in money supply?
1/.20 = 5 5 X 10 = 50 50 -10 = 40 million INCREASE
Topic 6: The Effects of Monetary Policy
The Fed influences:1. Interest rates (of saving and borrowing)
2. Bond Prices
inversely related to interest rates
if IR go up, price of bonds go down
if IR go down, bond prices go up
Monetarist view
• View based on the QUANTITY THEORY OF $
and
EQUATION OF EXCHANGE
MV=PQ
MV=PQ
Suppose the money supply in an economy is $200, velocity is 2 and price level is 2. What is Q? __________
Suppose money supply in an economy is $400, price level is 3 and Q is $400. What is the velocity of money? ________
Monetarist view
*The money supply of a nation has a DIRECT proportional relationship to output because spending is VERY sensitive to the interest rate
* Economic output will grow steadily as long as the money supply grows steadily
Expansionary monetary policy
• The Fed can:
____________ the reserve requirement
____________ the discount rate
____________ government bonds
If the Fed increases the money supply nominal
Interest rates fall
When NIR fall; price of bonds go UP
Expansionary monetary policy
77
200
Md
Ms
10%
5%
2%
Quantity of Money(billions of dollars)
Interest Rate (ir)
250
Ms1
Impact of expansionary monetary policy
INTEREST RATES GO DOWN!!!
As a result: 1. people are encouraged to borrow money instead of save it (which is what the Fed wants people to do!)
2. People also less likely to purchase bonds because the price of these go up
S&D of Money
79
200
DM
Ms10%
5%
2%
QuantityM
Interest Rate
(i)
250
Ms1
AD/AS
Qe
AD
AS
GDPR
PL
AD1
Q1
PLe
PL1
Expansionary Monetary policy
Money supply increase
Interest rates go down
Borrowing increases
Spending increases
AD shifts to the right
Contractionary monetary policy
• The Fed can:
____________ the reserve requirement
____________ the discount rate
____________ government bonds
If the Fed decreases the money supply, Interest
rates will go up
The price of bonds go down
Contractionary monetary policy
200
Md
Ms
10%
5%
Quantity of Money(billions of dollars)
Interest Rate (ir)
150
Ms1
Impact of Contractionary Policy
INTEREST RATES GO UP!!!!!
As a result: 1. people are encouraged to save money instead of borrow it (which is what the Fed wants people to do!)
2. people are more likely to buy bonds because their prices are low
S&D of Money
83
200
Md
Ms10%
5%
2%
QuantityM
Interest Rate
(i)
175
Ms1
AD/AS
Qe
AD
AS
GDPR
PL
AD1
Q1
PLe
PL1
Contractionary monetary policy
Money supply decreases
Interest rates decrease
Borrowing decreases
Spending decreases
AD shifts to the LEFT
Topic 7: Economic Theories
Keynesian View
Money supply has INDIRECT link to output because spending is NOT very sensitive to IR
• Favor FISCAL POLICY
Fiscal policy Monetary policy
Responsibility
Of
The government The Fed
Theory associated with
Keynesian theory
Monetarist theory
Theory based on C + I +G +XN Q theory of money
MV=PQ
Fiscal policy Monetary policy
View on investment demand
Not very sensitive to IR (impacted more by taxes)
Very sensitive to IR (strongly influenced by interest rates)
Tools Used Income taxes
G spending
Reserve requirement
Discount rate
Open market operations
Lag time Long Short
Graph used to illustrate
Fiscal policy
AD/AS
Monetary policy
Money market
Directly impacts Price level and Q of real GDP
Interest rates and money supply
Fiscal policy
The government can influence economic activity by
1. Changing government spending
2. Changing income taxes
• Use AD/AS graph to show FISCAL POLICY
Fiscal Policy shifts AD curve ONLY!!
Expansionary fiscal policy
• Implemented in times of recession
• Government can: 1. Increase G
spending
2. Decrease income taxes
Impact of:
price level ___
output ____
employment ___
Leads to DEFICIT budget
Contractionary Fiscal Policy Implemented during
times of INFLATION
To slow down economy, Government can: 1. Decrease government spending 2. Increase income taxes
• Impact of: Price level _____
Output _______
Employment ______Leads to SURPLUS budget
Monetary Policy
What the Fed does to regulate the money supply. The Fed directly impacts nominal interest rates.
The Fed can influence money supply in 3 ways: 1. open market operations 2. changing the reserve requirement 3. changing the discount rate of interest
Use Money market graph to show Monetary PolicyMonetary policy shifts MS curve ONLY!! – leads to a
change in AD
Expansionary Monetary Policy
To speed up economy, Fed can:
1. Buy (back) bonds (AKA securities)
2. Lower the discount rate
3. Lower the reserve requirement
Impact of:
interest rates ____
bond prices _____
Contractionary Monetary Policy
To slow down economy, Fed can: 1. Sell bonds (AKA securities)2. Raise the discount rate 3. Raise the reserve requirement Impact of:
interest rates __
bond prices ___