Unit IV

3 Uses of Money

• medium of exchange
• unit of account
• store of value

Types of Money

• Representative Money- paper money backed by a tangible product
• Commodity Money- gold and silver coins
• Fiat Money- it is money b/c the government says it is 

Characteristics of Money 

• Durability - how long is money good for 
• Portability - can carry it anywhere
• Divisibility - can be broken into smaller units
• Scarcity
• Acceptability

M1 Money

• consists of currency in circulation (paper and coins, travelers check)
• Checkable deposits- checking accounts, demand deposits 
• Account for 75% of $ in circulation

M2 Money 

• savings accounts
• money- market accounts
• accounts held by banks outside the U.S

Assets= Liabilities + Net Worth 
Reserve Ratio: commercial banks required reserves/ commercial banks check able deposit liabilities

3 Important Issues

• Excess Reserves = actual reserves - required reserves
• lending ability
• asset or liability to which bank
• M1 money as well
• money market account- accounts interests; large money account
• Banks create money by lending excess reserves and destroy it by loan repayment. Purchasing bonds from the public also creates money
• Monetary Multiplier = 1 / (required reserve ratio)
• Maximum check able deposit creation = excess reserves x monetary multiplier

Reserve Requirement

• The Fed. requires banks to always have some money readily available to meet consumers demand for cash
• The amount set by the Fed.  is the Required Reserve Ratio 
• The required reserve ratio is the % of demand deposits that must not be loaned out 
• Typical Reserve Ratio = 10%

Monetary policy

• Controlled by the federal reserve bank (fed)
• Influencing the economy through changes in reserves which influences the money supply and available credit

4 options

1.       Reserve requirement – percent that is set by the fed of the minimum reserve that the bank must keep

2.       Discount rate – rate of interest that the fed charges for overnight loans to banks  

3.       Federal fund rate – rate that FDIC members charge each other for loans

a.       Decrease = expansionary monetary policy

b.      Increase = contractionary monetary policy

4.       OMO(open market operation)- buy or sell securities (bonds)

a.       Fed buys bonds = expand money supply

b.      Fed sells bonds = decrease money supply

Prime rate – interest rate that banks charge their most credit worthy borrowers 

	Expansionary (easy money)	Contractionary (tight money)
OMO	Buy bonds	Sell bonds
Discount rate	Decrease	Increase
Federal fund	Decrease	Increase
Required reserve	Decrease	Increase

Easy money - dollar depreciates

Tight money - high interest rate 

Single bank- amount of money single bank can create (loan out) = ER

Ar - Rr = Er

Banking system - can create money by a multiple of its initial ER

Deposit multiplier = 1/rr

New money system - deposit multiplier X initial ER

If initial deposit is not new money, the total change in the MS is only the money created by the banking system

Money Market 

Loanable Funds 

Video Notes

Video 1: Types and Functions of Money 

3 types of money 

• Commodity – goods that act as money

• Representative – coins and dollars 

• Flat money – government’s word 

3 main functions 

• Medium of exchange 

• Storage of value 

• Unit of account 

Video 2: Money Market Graphs 

Money supply 

• Constant b/c it is controlled by the interest rates and gov’t. 

• Vertical b/c it’s not based off of interest rates 

• Increase demand = increase interest rates

The law of demand – if the price is high quantity demanded is low, if price is low quantity demanded is high

Video 3: The Fed’s tools of monetary policy 

The gov’t uses two options regarding changes in the money supply

• Contractionary (tight money)

• Expansionary (easy money) 

Contractionary fiscal policy 

• Reserve rate will ↑

• Discount rate will ↑

• Gov’t will sell bonds and securities 

Expansionary fiscal policy 

• Reserve rate will ↓

• Discount rate will ↓

• Gov’t will buy bonds and securities 

Video 4: The Loanable funds Market 

Loadable funds graph 

• Supply curve is completely dependent on saving

• If more people save, then more loans are available 

• If gov’t is in a deficit then demand for loans will increase, which leads to a decrease in supply of loans 

Video 5: Money creation and multiple deposit expansion 

Money is created when banks make loans 

To find how much money a loan creates you must:

• Find the multiplier – (1/RR)

• Multiply by the loan amount = multiple deposit expansion 

Example

• RR = 20% 

• (1/.2)=5

• 5(500) = 2500

Video 6: Relating Money market, Loanable funds Market, AD/AS model

Exchange : MV = PQ

• Increase in demand for money increases price level 

• Increase in demand for money increases interest rate, which causes the demand curve to increase resulting in the price levels to increase as well as GDPr  in AD/AS graphs 

Unit III

Aggregate Demand - shows the amount of RGDP that the private, public and foreign sector collectively desire to purchase at each positive price

• relationship between price and RGDP is inverse
• price of Y
• Quantity of X

Why AD is Downward Sloping

• Real Balancing Effect
•  price is high; businesses and households cannot afford to buy as much output 
• Interest-Rate Effect
• high price level increases interest rate, discourages investment
• Foreign Purchases Effect
•  higher price level increases the demand for relatively cheaper imports

Shifts in AD

• Change in C, Ig, G and Xn
•  a multiplier effect that produces a greater change than the original change in the 4 components
• Consumption
• Affected by:
• consumer wealth
• more wealth, AD increases
• Consumer Expectations
•  positive, AD increases
•  Household indebtedness
• less debt, AD increases
• Taxes
• Less Taxes, AD increases

• Gross Private Investment
• Affected by:
• · The real interest rate
•  low interest rate, AD increases
• Expected Returns
•  Higher Expected Returns, AD increases
•  Influenced by
•  expectations of future profitability
• technology
•  degree of excess capability
• business taxes
• Government Spending
• More, AD increases
• Net Exports
• Affected by:
•  Exchange Rate
•  strong money = more imports fewer exports, AD decreases
• weak money = fewer imports and more exports AD increases
• Relative Income
• Strong Foreign Economy = increase in exports, AD increases
• Weak Foreign Economy = decrease in exports, AD decreases

Aggregate Supply

• Long Run 
• · input prices are completely flexible and adjust to changes in the price level
•  level of RGDP supplied is independent of the Price Level 
• marks the level of full employment in the economy (analogous to PPC) 
• Vertical 
• Short Run
•  input prices are sticky and do not adjust to changes in the PL
•  level of RGDP supplied is directly related to the PL
• Changes in SRAS
• Increase in SRAS seen as shift to right: SRAS →
• Decreases in SRAS shift to left: SRAS ←
• Per unit of production:
• (Per Unit Production Cost = Total Input Cost / Total Output)
• Determinants of SRAS
• Input Prices
• Domestic Resource Prices
• Wages (75% of all business costs)
• Cost of capital
• Raw materials (commodity prices)
• Foreign Resource Prices
• Strong money = Lower Foreign Resource Prices
• Weak money= Higher Foreign Resource Prices
• Productivity
• (Productivity = Total Output / Total Input)
• More Productivity = Lower Unit Production Costs = SRAS shifts right
• Lower Productivity = Higher Unit Production Costs = SRAS shifts left
• Legal-Institutional Environment
• Taxes and Subsidies
• Taxes ($ to government) on businesses increase per unit production costs = SRAS shifts left
• Subsidies ($ from government) on businesses reduce per unit production cost = SRAS shifts right
• Government Regulation
• Government regulation creates a cost of compliance = SRAS shifts left
• Deregulation reduces compliance costs = SRAS shifts right

The AS/AD Model 

• the equilibrium of AS & AD determined where AD intersects SRAS & LRAS at the same point

Recessionary Gap

• exists when equilibrium occurs below Full Employment output

Inflationary Gap

• exists when equilibrium occurs beyond full employment output

3 Ranges

• Horizontal or Keynesian Range
• It includes only levels of real output that are less than the FE output.
• It implies that the economy is in recession.
• Vertical or Classical Range
• The economy reaches its full capacity real output.
• Increase in PL = constant production
• Intermediate
• Expansion of real output and price level

Consumption and Saving

• Disposable Income (▵DI)
• income after taxes, net income
• DI= gross income - taxes
• households cane either consume or save
• Consumption - household spending
• the ability to consume is constrained by:
• the amount of DI
• the propensity to save
• Do household consume if DI=0?
• Yes; autonomous consumption 
• Average Propensity to Consume (APC) = C/DI = % of DI that is spent
• Saving - household NOT spending
• the ability to save is constrained by:
• the amount of DI
• the propensity to consume
• Do household save if DI=0?
• No
• Average Propensity to Save (APS) = S/DI = % of DI that is saved
• Equations
• APC+APS=1
• 1-APC=APS
• 1-APS=APC
• APC>1, dissaving
• -APS, dissavings
• Marginal Propensity to Consume (MPC) = C/DI = % of every extra dollar earned that is spent
• Marginal Propensity to Save (MPS) = S/DI = % of every extra dollar earned that is saved
• MPC+MPS=1
• 1-MPC=MPS
• 1-MPS=MPC

Determinants of C & S

• wealth, expectations, household debt, taxes

Spending Multiplier Effect

• an initial change in spending (C, Ig, G, Xn) causes a larger change in AS or AD
• AD/( C, Ig, G, Xn)
• Why does this happen?
• expectations and income flow continuously which sets off a spending increase in the economy
• = 1/(1-MPC) or 1/MPS
• (+) when increase in spending
• (-) when decrease in spending

Tax Multiplier 

• when the government taxes, the multiplier works in reverse because money is leaving circular flow
• = -MPC/(1-MPC) or -MPC/MPS
• if tax is cut, then multiplier is positive because there is more money in the circular flow

Interest Rates and Investment Demands

Investment

• Money spent on expenditures on:
• New plants or factories
• Capital equipment 
• Technology 
• New homes
• Inventories 
• Expected Rates of Return
• investment decisions
• Cost/Benefit analysis
• determine the benefits
• Expected rate of return
• count the cost
• Interest cost
• determine the amount of investment they undertake
• Compared expected rate of return to interest cost
• If expected return > interest cost, then invest.
• If expected return > interest cost, then do not cost.

Real (r%) v. Nominal (i%)

• Nominal is the observable rate of interest. Real accounts for inflation (π%), only known ex post facto.
• Computing r%: (r% = i% - π%)
• determining the cost of an investment decision
• Real interest rate (r%)

Investment Demand (ID)

• Downward sloping
• When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable.

Shifts in ID

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

Fiscal Policy

• Fiscal policy is the changes in the expenditures or tax revenues of the federal government
• 2 tools of fiscal policy:
• Taxes: Government can increase or decrease taxes
• Spending: Government can increase or decrease spending
• enacted to promote our nation's economic goals: full employment, price stability, economic growth

Deficits, Surpluses, and Debt

• Balanced budget: Revenues = Budget
• Budget Deficit: Revenues < Budget
• Budget Surplus: Revenues > Budget
• Government Debt: sum of all deficits - sum of all surpluses
• Government must borrow money when it runs a budget deficit from:
• individuals, corporations, financial institutions, and foreign entities/governments

Fiscal Policy : Two Options

• Discretionary (actions)
• Expansionary - deficit
• to increase RGDP, combat recession, and reducing unemployment
• Government Spending increases, Taxes decrease
• creates inflation
• Contractionary  - surplus
• strategy for controlling inflation
• Government Spending decreases, Taxes increase
• Non-Discretionary (no action) - AUTOMATIC
• Discretionary increases or decreases taxes
• Automatic - takes in unemployment compensation, social security, etc, that help eases the effects of recession and inflation

Tax Systems

• Progressive Tax System
• Average tax rate that rises with GDP
• Proportional Tax System
• Average tax rate remains constant as GDP changes
• Regressive Tax System
• Average tax rate falls with GDP

Graphs: