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MACRO STUDY GUIDETEST 4: Final ExamCHAPTERS 14,15,16Functions of Money:1. Medium of Exchange: used to buy and sell goods and services2. Unit of Account: monetary units to measure relative worth of goods, services, and resourcesa. Easily compare prices of various goodsb. Define debt obligationsc. Determine taxes owedd. Calculate GDP3. Store of Value: transfer of purchasing power from the present to the future, retains value over timeM1- Currency (coins, paper money)- Checkable depositso 50% - checking account balancesM2 – includes M1 and “near-monies”- Near-monies = highly liquid finances that don’t function directly as a medium of exchange but can be converted into M1- Savings deposits- Small-denominated (<$100,000) time deposits- Money market mutual fundsFaith in the government backs our money supply.Federal Reserve System = U.S. central bank- Board of Governors of the Federal Reserve- 12 Federal Reserve Bankso Control the lending activity (money supply)- Privately owned, publically operated- Doesn’t want high inflation because lenders (banks) lose- Doesn’t interest rates until FE reaches 6.5% (full = 6%)Functions of the Fed:1. Issuing currency : create Federal Reserve Notes (paper currency)2. Setting reserve requirements and holding reserves : set the fractions of checking account balances that banks must maintain as currency reserves- Central banks accept as deposits any portion of the mandated reserves not held as vault cash from the banks3. Lending to financial institutions and serving as an emergency lender of last resort: routine short-term loans to banks, charging them an interest rate (discount rate), occasionally auctions off loans to banks4. Providing for check collection : adjusts the reserves of the two banks involved in check depositsCHAPTER 14 – MONEY, BANKING, FINANCIAL INSTITUTIONSMACRO STUDY GUIDETEST 4: Final ExamCHAPTERS 14,15,165. Acting as fiscal agent : provides financial services for the Federal government - Gov’t collects huge sums through taxes, spends large amounts, sells and redeems bonds- Uses Fed’s facilities to carry out activities6. Supervising banks : periodic exams to assess banks profitability and make sure they perform in accordance to regulations7. Controlling the money supply : makes amount of money available consistent withhigh and rising levels of output, employment, and a relatively stable price level- Influence interest rates- Make unique policy decisions---------------------------------------------------------------------------------------------------------------------Banks creates money thanks to the:1. Fractional Reserve Systema. Lend out depositsb. Only a portion (10-15%) of checkable deposits are backed up by reservesin bank vaultsi. Excess money converted to loans, increasing available cashc. Goldsmiths – “IOU” system, paper money backed by gold2. Checking account balancesa. Included in definition of money – part of the money supplyb. Convert “IOUs” into checkable-depositsc. Money destroyed when lenders repay bank loansd. Use excess reserves to buy public bonds  create checkable-deposit $i. Money vanishes when banks sell bonds to the public- Money creation is limitedo Bank can only lend amount = to excess reserves (actual-required)o Checks drawn by borrowers are likely deposited in other banks  Loss of reserves and deposits to lending bank = amount of $ lentMoney Multiplier = increase in the amount of cash in circulation generated by thebanks’ ability to lend money out of their depositors’ funds- Loan creates money  loan becomes new deposit from which the borrow canwithdraw cash to spend- = 1 RSpending Multiplier vs. Money Multiplier:Fed can wipeout anyCHAPTER 15 – MONEY CREATIONR = required reserve ratioSimilar Concepts:$ Saved not spent/lent 1 vs. 1MPS RMACRO STUDY GUIDETEST 4: Final ExamCHAPTERS 14,15,16changes made to the money supply by the banks simply by shifting MS (money supply)curve.- 1 day to change MSCost of banks creating money:- Fed doesn’t have total control over MS- Can do it when they want  profit drivenLarge MS = recession, MS is actually lowBanks act opposite to what Fed wantsFederal Funds Rate = interest rate banks and other depository institutions charge one another on overnight loans made out of their excess reserves---------------------------------------------------------------------------------------------------------------------Monetary Policy = change in MS that changes the FFR (federal funds rate), causing otherinterest rates to change as well as changes in interest sensitive spending, which leads to a shift in the AD curve, bringing an economy back to full employment- Investment spending- Consumer durable goods spending∆ MS  ∆ FFR  ∆ interest rates  ∆ interest sensitive spending  AD shift  FE** Interest rates affect spending, therefore affecting RGDP- Connects power of Fed and money market to spending, AD curve, and RGDPImportant Interest Rates:- FFR - interbank, overnight lending rate of > $ 1 million = 0 – ¼ %- Discount Rate - rate at which the Fed lends to banks = .75 %- Prime Rate – rate that banks charge their most preferred customers = 3.25 %- T-Bill Rate – rate that the treasury pays to lenders (national debt) = 1 year .13 &- Mortgage Rate – rate on houses = 30 years 4.45 %Too much money in circulation = inflationToo little money in circulation = stagnationFed and MS:- Economy heading downward  lower FFR- Economy headed upward  raise FFR- Taylor Rule = tells the Fed what the optimal FFR should be given the currentstate of the economy Monetary Policy in Action:Interest Sensitive SpendingCHAPTER 16 – INTEREST RATES & MONETARY POLICYMACRO STUDY GUIDETEST 4: Final ExamCHAPTERS 14,15,161. Begin with AS/AD model 2. Use Taylor Rule to find targetFFR*FFR* = ∆Pc + FFRave + ½ (∆Pc - ∆P*) + ½ ((Yt – YFE)/ YFE) x100)3. Adjust MS  increase to lower FFR- Bring equilibrium rate to target rate- Monet Market = supply and demand of money (M2 = $11 trillion)o Determines equilibrium rate of interest- MS = vertical because Fed has control - MD = money in pockets not bondso Reasons for keeping money out of bonds: Transactions Speculation Emergencieso Downward sloping – hold less money at higher interest rates- MS = MD shift right, interest rates fallEconomy in Recession- Lower FFRFEADASRGDPPL∆Pc = current inflation


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