Macroe conomics unit 4 PDF

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detailed summary of chapters 13-14 for macroeconomics...

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Unit 4 Chapter 13 The Financial Sector and Economy Why is the financial sector important to macro?  For every real transaction, there is a financial transaction that mirrors it.  Financial sector is central to almost all macroeconomic debates b/c behind every real transaction, there is a financial transaction that mirrors it.  Financial sector (financial markets and institutions) has two roles: o Facilitates trade, making it possible for normal business to happen o Transfer saving back into savings  If the financial sector expands too much, you get inflationary pressures.  If it contracts the spending flow too much, you get recession  Financial assets- assets such as stock or bonds, whose benefit to the owner depends on the issuer of the asset meeting certain obligations. o Financial liabilities- obligations by issuer of financial asset The Role of Interest Rates in the Financial Sector 

Interest rates- prices that are charged/paid for the use of a financial asset o Key variable in financial sector. o Long term: price paid for use of financial asset with long repayment period  Ex: mortgages and gov’t bonds  Market called loanable funds market o Short term: price paid for use of financial assets with shorter repayment periods  Ex: savings deposit and checking accounts  Called money market

Definition and Functions of Money 

Money- highly liquid financial asset that’s generally accepted in exchange for other goods, is used as reference in valuing other goods, and can be stored as wealth. o To be liquid means to be easily changeable into another asset or good. o The reason you are willing to hold money is that you know someone else will accept it in trade for something else.

The US Central Bank: The Fed  Federal Reserve Bank (the Fed)- US central bank whose liabilities (federal reserve notes) serve as cash in the united states. o Individuals are willing to accept Fed’s IOUs in return for real goods/services, which means that Fed notes are money.

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Bank- financial institution whose primary function is accepting deposits for, and lending money to, individuals and firms.

Functions of money:  Serve as medium of exchange o Barter- direct exchange of goods and/or services o Makes it possible to trade real goods/service without bartering  Serve as unit of account o Measure of value o Having a single unit of account makes life much easier; saves our limited memories and helps us make reasonable decision based on relative prices. o Money is useful unit of account only as long as its value relative to other prices doesn’t change too quickly. o In hyperinflation, all prices rise so much that our frame of reference is lost.  Serve as store of wealth o as long as money is serving as medium of exchange, it automatically also serves as store of wealth. o Because money is highly liquid, it is more easily translated into other goods than are other financial assets. Alternative Measures of Money 

What believe is money and what people will accept as money are determining factors in deciding whether a financial asset is money.

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Consists of currency in hands of the public checking accounts balances, and traveler’s checks Measure of money supply

M1

 M2   

Made up of M1, plus savings deposits, small-denomination time deposits, and money market mutual fund shares. Measure of money often most closely correlated with price level and economic activity Include more financial assets than M1

Distinguishing Money and Credit  Credit cards are not money  Credit cards created liability for their users and banks have a financial asset as a result Money Multiplier  Reserves- currency and deposits a bank keeps on hand or at the Fed or entral bank, to manage the normal cash inflows and outflows.

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Reserve ratio- ratio of reserves to total deposits o Ratio of currency to deposits a bank keeps as reserve against currency withdrawals. Required reserve ratio- Banks are required by Fed to hold percentage of deposits Excess reserve ratio- additional percentage banks can choose to hold Reserve ratio is sum of required reserve ratio and excess reserve ratio

Calculating the money multiplier  Simple money multiplier- measure of amount of money ultimately created per dollar deposited in banking system, when people hold no currency  When people hold no currency, it equals 1/r  The higher the reserve ratio, the smaller the money multiplier An example of creation of money  Excess reserves- reserves held by banks in excess of what banks are required to hold o Decrease money multiplier as much as required reserves do Calculating the money multiplier  Money multiplier (1+c)/(r+c)  Where r is percentage of deposits banks hold in reserve  c is ratio of money people hold in currency to the money they held as deposits Endogenous money and credit  Caused by factors inside the system  Pedagogical- relating to a teacher or education The Demand for Money and Role of the Interest Rate Why people hold money  Money allows you to buy things o Can spend money, can’t spend bonds o Can change financial asset into spendable money, but that takes time and effort o Transactions motive- need to hold money for spending  Hold money for emergencies o Precautionary motive- holding money for unexpected expenses and impulse buying  Speculative motive- holding cash to avoid holding financial assets whose prices are falling o Comes about b/c price of financial assets such as bonds varies in value as interest rate fluctuates o Hold money rather than longer-term financial assets so you don’t lose if prices fall.

Equilibrium in money market  Demand for money is downward-sloping o b/c as interest rates fall, cost of holding money falls, so it makes sense to hold more money. o When interest rates rise, bonds and other financial assets that pay high interest rates become more attractive, so you hold more financial assets and less money.

Chapter 14 Monetary Policy 

Monetary policy- policy of influencing economy through changes in banking system’s reserves that influence the money supply and credit availability in the economy. o Controlled by US central bank, the Federal Reserve Bank, unlike fiscal policy which is controlled by government directly.

How Monetary Policy Works in the Models       

Works through its influence on credit conditions and interest rate in economy. If economy is significantly above potential output, once long-run equilibrium is reached, monetary policy affects only nominal income and price level. Expansionary monetary policy does not affect real output General rule is: expansionary monetary policy increases nominal income Demand for money comes from people’s desire to hold money, which is affected by short-term interest rate. Expansionary monetary policy- increases money supply and decreases interest rate o Tense to increase both investment and output Contractionary monetary policy- decreases money supply and increases the interest rate o Decrease both investment and output

How Monetary Policy Works in Practice Monetary Policy and the Fed  Central bank- type of banker’s bank whose financial obligations underlie and economy’s money supply o It is central bank’s ability to create money that gives it the power to control monetary policy.  If commercial banks (banks normal people use) need to borrow money, they go to central bank  If financial panic and run on banks, central bank is there to make loans until panic goes away  Fed can create money simply by issuing an IOU Structure of the Fed  The Fed is not just one bank, it is composed of 12 regional banks along with the main Federal Reserve Bank in WA DC  Federal open market committee (FOMC)- Fed’s chief body that decides monetary policy o All 12 regional bank presidents attend and speak at FOMC meetings o Pres of Us appoints each governor for a term of 14 yrs.

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Can also designate one of the governors to be chairperson for a four-year term

Duties of Fed  Conduct monetary policy (influencing supply of money and credit in the economy)  Supervising and regulating financial institutions  Serving as lender of last resort to financial institutions  Providing banking services to US gov’t  Issuing coin and currency  Providing financial services (like check clearing) to commercial banks, savings and loan associations, savings banks, and credit unions. Conduct of Monetary Policy  Monetary base- vault cash, deposits at the Fed, plus currency in circulation o Serves as legal reserves of banking system o By controlling monetary base, Fed can influence the amount of money in economy and activities of banks.  Money supply is determined directly by monetary base, and indirectly by amount of credit that banks extend  Allowable reserves are either banks’ vault cash or deposits of the Fed Open marketing operations  Open market operations- Fed’s buying and selling of gov’t securities o Primary way that Fed changes amount of reserves in system o When Fed buys Treasury bills, treasury bonds or any other assets, it pays for them with IOUs that serve as reserves for banks. o When Fed sells treasury bonds, it collects back some of its IOUs, reducing banking system reserves and decreasing money supply. Thus:  To expand the money supply, the Fed buys bonds  Reduces interest rates and raises income  To contract the money supply, the Fed sells bonds  Raises interest rates and lowers income  Open market operations involve purchase/sale of federal gov’t securities (bonds)  Open market purchase is example of expansionary monetary policy since it raises the money supply  Open market sale is contractionary monetary policy. Reserve requirement and money supply  Reserve requirement- percentage the federal reserve bank sets as min. amount of reserves a bank must have.  For checking accounts (also called demand deposits), the amount banks keep in reserces depends partly on federal reserve requirements and partly on how much banks feel they need for safety.

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Banks typically hold as little in reserves as possible b/c reserves earn little interest for a bank. Total money supply, which includes checking account deposits in banks, depends upon reserve requirement. By changing reserve requirements, the Fed can increase/decrease money supply o If Fed increases, contracts money supply; banks have to keep more reserves so they have less money to lend out; decreased money multiplier contracts money supply. o If Fed decreases, expands money supply; banks have more money to lend out; increased money multiplier further expands the money supply. The money multiplier is (1+c)/(1+r) o R holds % of each dollar that banks hold o C is ratio of people’s cash to deposits. Ways banks can do if it comes up short of reserves: o Can borrow from another bank that has excess reserves called Federal funds market  Fed funds rate- rate of interest at which these reserves can be borrowed o Stop making new loans and to keep as reserves the proceeds of loans that are paid off. o Sell treasury bonds to get needed reserves  Treasury bonds sometimes called secondary reserves, do not count as bank reserves  Can easily be sold and transferred into cash, which does count as reserve Discount rate- rate of interest the Fed charges for loans bit makes to banks. Increase in discount rate makes it more expensive for banks for borrow from the Fed. o Discourages banks from borrowing and contracts the money supply A discount rate decrease makes it less expensive for banks to borrow. o Encourages banks to borrow and increases the money supply.

Fed Funds Market  Fed Funds- loans of excess reserves banks to make to one another.  Federal funds rate- interest rate banks charge one another for Fed funds.  Federal funds market- market in which banks lend and borrow reserves o Highly efficient o Fed can reduce reserves, and thereby increase Fed funds rate, by selling bonds  Defensive actions- designed to maintain current monetary policy o Fed can, and does, offset such changes by buying and selling bonds.  Offensive actions- actions meant to make monetary policy have expansionary or contractionary efforts on the economy.  Fed determines whether monetary policy is tight/loose depending on what is happening to the Federal funds rate.

Complex Nature of Monetary Policy 

Fed focuses on its ultimate target: stable prices, acceptable employment, sustainable growth, and moderate long-term interest rates o Indirectly affected by changes in Fed funds rate o Fed watched intermediate targets: consumer confidence, stock prices, interest rate spreads, housing starts, and a host of others

Taylor Rule  Taylor rule- set the Fed funds rate at 2% plus current inflation if the economy is at desired output and desired inflation. If inflation rate is higher than desired, increase Fed funds rate by 0.5 times the difference between desired and actual inflation. Similarly, if output is higher than desired, increase the Fed funds rate by 0.5 times the percent deviation. o Focuses on discussion of monetary policy on interest rate, not money supply.    

Fed does control amount of money in economy, but uses that control to target an interest rate, not to control money supply. As demand for money shifts, Fed adjusts the money supply so that the market equilibrates at the targeted interest rate. Fed is choosing monetary rule that creates effective supply curve of money that is perfectly flat at the interest rate. Fed targets interest rate by adjusting the money supply so that its targeted interest rate will equalize the supply and demand for money

Limits to fed’s control of interest rate  Long-term interest rate in the economy is determined in the loanable funds market, not money market  As long as short-term interest rate and long-term interest rate move in tandem, then Fed can also control long-term interest rate.  Yield curve- curve that shows the relationship between interest rates and bonds’ time to maturity.  Inverted yield curve- yield curve in which short-term rate is higher than long-term rate,  Shape of yield curve is important because standard discussion of monetary policy is based on the assumption that when Fed pushes the short-term rate, the long-term rate moves up as well.  If long-term rate doesn’t move with the short-term rate, then investment won’t respond and monetary policy won’t have any significant effect. Quantitative easing  Fed can’t lower interest rate below zero, which places limit on how much expansionary pressure the Fed can create using normal monetary policy.  Quantitative easing tools- tolls that increase money supply but that don’t affect the Fed funds rate.

Maintaining policy credibility  Needed to prevent inflationary expectations from becoming built into the system.  Long-term rates have 2 components: o Rate interest rate component o Inflationary expectations component  Nominal interest rate- rates you actually see and pay  Real interest rates- nominal interests rates adjusted for expected inflation. Monetary policy regimes  Monetary regimes- predetermined statement of the policy that will be followed in various situations.  Distinction b/t nominal and real interest rates and possible effect of monetary policy on expectations of inflation has led most economists to conclude that monetary regime, not monetary policy, is best approach to policy. Problems with monetary regimes ...