Macro Notes Exam 2 CH 13 16 17 18 19 20 Nov 7th Mock Nov 12 Exam Ch 13 Financial Institutions The financial system the group of institutions that helps match the savings of one person with the investment of another Financial markets institutions through which savers can directly provide funds to borrowers o Ex The Bond Market o Bond a certificate of indebtedness o Ex The Stock Market o Stock a claim to partial ownership in a firm Financial intermediaries institutions through which savers can indirectly provide funds to borrowers o Ex Banks o Mutual funds institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds Different Kinds of Saving Private saving the portion of households income that is not used for consumption or paying taxes Y T C Public saving tax revenue less govt spending T G National saving private saving public saving Note National income accounting identity o Y T C T G o Y C G Saving and Investment o Y C I G NX For closed economy case o Y C I G o Solve for I Y C G Budget Deficits and Surpluses o T G o public saving o G T o public saving The Meaning of Saving and Investment Budget surplus an excess of tax revenue over govt spending Budget deficit a shortfall of tax revenue from govt spending Private saving the income remaining after housholds pay their taxes and pay for consumption Note Only firms can invest households save in stocks and bonds Ex of what households do with savings o Buy corporate bonds or equities o Buy shares of a mutual fund o Let accumulate in saving or checking accounts Investment the purchase of new capital o House a company buying a new factory you buy computers for your business o Note Investment is NOT purchase of stocks and bonds Budget Deficits Crowding Out and Long Run Growth Our analysis increase in budget deficit causes fall in investment The govt borrows to finance its deficit leaving less funds available for investment This is called crowding out Investment is important for long run economics growth Hence budget deficits reduce the economy s growth rate and future standard of living Ch 16 The 3 Functions of Money Medium of exchange an item buyers give to sellers when they want to purchase g s Unit of account the yardstick people use to post prices and record debts Store of value an item people can use to transfer purchasing power from the present to the future 2 Kinds of Money 1 Commodity money takes the form of a commodity w intrinsic value a Ex gold coins cigarettes in POW camps 2 Fiat money money w o intrinsic value used as money bc of govt decree a Ex the U S dollar bill The Money Supply The money supply or money stock the quantity of money available in the economy What assets should be considered part of the money supply Here are 2 candidates o Currency the paper bills and coins in the hands of the non bank public o Demand deposits balances in bank accounts that depositors can access on demand by writing a check Central Banks Monetary Policy Central bank an institution that oversees the banking system and regulates the money supply Monetary policy the setting of the money supply by policymakers in the central bank Federal Reserve Fed the central bank of the U S Bank Reserves In a fractional reserve banking system banks keep a fraction of deposits as reserves and use the rest to make loans The Fed establishes reserve requirements regulations on the minimum amount of reserves that banks must hold against deposits Banks may hold more than this minimum amount if they choose The reserve ratio R o fraction of deposits that banks hold as reserves o total reserves as a percentage of total deposits Bank T account T account a simplified accounting statement that shows a bank s assets and liabilities Ex Reserves 10 Loans 90 Deposits 100 Banks liabilities include deposits assets include loans reserves In this ex R 10 100 10 Banks and Money Supply Examples REFER TO SLIDES The Money Multiplier Money multiplier the amount of money the banking system generates with each dollar of reserves The money multiplier equals 1 R In the ex R 10 so money multiplier 1 R 10 100 of reserves creates 1000 of money The Fed s 3 Tools of Monetary Control 1 Open Market Operations OMOs the purchase and sale of U S govt bonds by the Fed To increase money supply Fed buys govt bonds paying with new dollars o which are deposited in banks increasing reserves o which banks use to make loans causing the money supply to expand Fed sells govt bonds taking dollars out of circulation and the To reduce money supply process works in reverse 2 Reserve Requirements RR affect how much money banks can create by making loans Fed reduces RR Banks make more loans from each dollar of To increase money supply reserves which increases money multiplier and money supply To reduce money supply Fed rarely uses reserve requirements to control money supply frequent changes would disrupt banking Fed raises RR and the process works in reverse 3 The Discount Rate the interest rate on loans the Fed makes to banks When the banks are running low on reserves they may borrow reserves from the Fed Fed can lower discount rate which encourages banks to borrow To increase money supply more reserves from Fed Banks can make more loans which increases the money supply To reduce money supply Fed can raise discount rate The Federal Funds Rate On any given day banks with insufficient reserves can borrow from banks with excess reserves Many interest rates are highly correlated so changes in the fed funds rate cause changes in other The interest rate on these loans is the federal funds rate rates and have big impact in the economy The FOMC uses OMOs to target the fed funds rate So fed funds rate policy monetary policy are connected Problems Controlling the Money Supply If households hold more of their money as currency banks have fewer reserves make fewer loans money supply falls If banks hold more reserves than required they make fewer loans money supply falls Yet Fed can compensate for household bank behavior to retain fairly precise control over the money supply Ch 17 The Value of Money P the price level e g the CPI or GDP deflator o P is the price of a basket of goods measured in money 1 P is the value of 1 measured in goods o Example basket contains one candy bar If P 2 value of 1 is 1 2 candy bar If P 3 value of 1 is 1 3 candy bar Inflation drives up prices and drives down the value of money Money Supply MS In real world determined by Federal Reserve the banking
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