CROWDING OUT

What is it? 

-A critique and flaw of Keynesian policies that are applied to fight a recession (expansionary policy).

Why does it happen?

-The policy of cutting taxes and raising spending will create a budget deficit.

So?

-The budget deficit must be funded and to do this congress orders the sale of US bonds.

This money comes from?

-Money comes from US citizens and companies and investment firms.

Therefore?

-Money that could be spent on consumption or used for private savings is now being used to buy bonds.

On the money market?

-This will cause the  money demand curve to shift outward.

On the loan-able funds?

-This will cause the supply curve to shift inward because the are not saving money privately anymore.

On both graphs?

-The nominal and real interest rate will increase.

Therefore, on the investment D graph?

-The increase in nominal and real interest rates will cause Ig to decrease.

Isn't this counterproductive?

-Yes.

Why do it?

-Fiscal policy supporters insist that gains in C and G will outweigh any loss in future Ig.

Why?

-C and G are greater than Ig and they are short run improvements. Ig is longer run and Keynesian don't worry about that. In the long run we are all dead.

Anymore?

-Yes, this is summarized on the aggregate model. The AD will move outward due to the increases in C and G and then "maybe" move inward due to the loss of Ig, but not as much as the increase. Therefore the economy improves.

COUNTER-CYCLICAL POLICIES: KEYNESIAN FISCAL POLICY VS. MONETARY POLICY

MONETARY TOOLS

1) Reserve requirement

    -Only a small percent of your bank deposit is in the safe. The rest of the money has been loaned out. This      is called "Fractional Reserve Banking". The FED sets the amount that the banks must hold. The                   RR(reserve ratio) is the % of deposits that banks must hold and not loan out.
  -When the FED increases money supply(MS), it increases the amount of money held in bank deposits.

If there is a recession, the FED should decrease the RR:

1) Banks hold less money and have more excess reserves.
2) Banks create more money by loaning out excess reserves.
3) MS increases, interest rates fall, AD goes up.

If there is inflation, FED should increase the RR:

1) Banks should hold more money and have less ER.
2) Banks create less money.
3) MS decreases, interest rates up, D down.

2) Discount rate

    -This is the interest rates that FED charges commercial banks.
    -To increase the MS, the FED should decrease the discount rate (easy money policy).
    -To decrease MS, the FED should increase the discount rate (tight money supply).
    -Only member banks are entitled to the discount rate.

3) Open market operations

    -The FED buys/sells government bonds(securities),
    -This is the most important and widely used monetary policy.
    -To increase the MS, the FED buy government securities.
    -To decrease the MS, the FED sell government securities.
    -Buying bonds = bigger MS, selling bonds = smaller MS.

Federal funds rate

-This is where FDIC member banks loan each other overnight funds.

Prime rate

-This is the interest rate that banks charge their most credit worthy customer.

When a customer deposits or withdraws cash from their demand deposit account, it has no effect on money supply. It only changes:

1) The composition of money
2) Excess reserves.
3) Required reserves.

Single bank

-Loan from your excess reserves (ER).

Banking system

-ER * multiplier (total money supply).

Anytime the FED buys or sells bonds, ER is created. 

BANKS AND THE CREATION OF MONEY

How do banks create money?

*By lending out deposits(money).

Where do loans come from?

*Loans come from depositors who take cash and place it in accounts at the banks.

How are the amounts of potential loans calculated?

*They are calculated by using a T-Account that consists of assets and liabilities.

Banks liabilities(the right side of the T-Account sheet):

*Demand deposits: these are cash deposits from the public, they are a liability because they belong to             depositors and can be withdrawn by depositors.
*Owner's Equity: values of stocks held by the public ownership of bank shares.

Key Concept for AP concerning liabilities:

1) If the DD comes in from someone's cash holdings then that DD is already part of the money supply.
2) If the DD comes in from the purchase of bonds(by the FED) then it creates new cash and therefore               creates new money supply.

Bank assets(the left side of the T-Account sheet):

1) Required reserves(RR): These are the percentages of DD that must be held in the vault so that some            depositors have access to their money. it is usually 5%, 10%, 20% but in reality is 10% or below.
2) Excess reserves(ER): They are source for new loans.
3) Property.
4) Securities(bonds): Securities are bonds purchased by the bank. These could be bonds purchased by the       FED.
5) Loans: These can be amounts held by banks from previous transactions owed to the bank by prior               customers.

Money creation (using excess reserves)

*Banks want to create profits.

The money multiplier (also known as):

*The loan multiplier.
*Reserve multiplier.
*Check-able deposit multiplier.

The formula is:

*1 divided by the reserve requirement ratio (1/RR).
Excess reserves are multiplied by the multiplier to create new loans for the entire banking system and this creates new money supply.

TIME VALUE OF MONEY

-Is a dollar today worth more than a dollar tomorrow?
 *Yes.
-Why?
 *Opportunity cost and inflation.
 *This is the reason for charging and paying interest.
-Let V= future value of $.
       P= present value of $.
       r= real interest rate (nominal rate - inflation rate).
       n= years.
       k= number of times interest credited per year.

-The simple interest formula:

 *V= (1+r)^n *P

-The compound interest formula:

 *V= (1+ r/k)^nk *P
Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded.
1) What happens to the quantity demanded of money when interest rates increase?
    *Quantity demanded falls because individuals would prefer to have interest earning assets instead of                 borrowing liabilities.
2) What happens to the quantity demanded when interest rates decrease?
     *Quantity demanded increases. There is incentive to convert cash into interest earning assets.
3) What happens if price level increase?
     Money demand shifters
     *Changes in price level.
     *Changes in income.
     *Changes in taxation that affects investment.
   If the FED increases the money supply, a temporary surplus of money will occur at 5% interest. The              surplus will cause the interest rate to fall to 2%.
4) How does this affect AD?
    a)Increase in money supply > decreases interest rates > increases investment > increases AD.
   If the FED decreases the money supply, a temporary shortage of money will occur at 5% interest. The          shortage will cause the interest rate to rise to 10%.
5) How does this affect AD?
    Decrease money supply > increase interest rate > decrease investment > decrease AD.

FINANCIAL SECTORS

Financial assets

-It is stocks and bonds whose benefit to the owner depends upon the issuer of the asset meeting certain          obligation.

Financial liabilities

-It is liabilities incurred by the issuer of a financial assets to stand behind the issued assets.

Interest rates

-Price payed for the use of a financial asset.

Stocks

-Financial asset that convey ownership in a corporation.

Bonds

-A promise to pay a certain amount of money plus interest in the future.

WHAT BANKS DO

A bank is a financial intermediary
-Uses liquid assets (i.e bank deposits) to finance the investments of borrowers.
-Process is known as fractional reserve banking.
 *A system in which depository institutions hold liquid assets less than the amount of deposits can take the        form of :
   1) Currency in banks vaults.
   2) Bank reserves: deposits held at the federal reserve.

BASIC ACCOUNTING REVIEW

T-Account (balance sheet)

-statements of assets and liabilities.

Assets (amounts owned)

-Items to which a bank holds a legal claim.
-The uses of funds by financial intermediaries.

Liabilities (amounts owed)

-The legal claim against a bank.
-The sources of funds for financial intermediaries.

FUNCTIONS OF THE FEDERAL RESERVE (FED)

1) It issues paper currency.
2) It sets reserve requirements and holds reserves of the bank.
3) It lends money to the banks and charges them interest.
4) They are a check clearing service for banks.
5) They act as a personal bank for the government.
6) They supervise member banks.
7) They control the money supply in the economy.

UNIT 4:MONEY

USES OF MONEY

-As a medium of exchange.

 *To barter (trade).

-Unit of account

 *This establishes worth in the exchange process.

-Storage values

 *Money holds value over a period of time.

TYPES OF MONEY

-Commodity money

 *It gets value from the type of material from which it is made.

-Representative money

 *Paper money backed by something tangible that gives it value.

-Fiat money

 *This is the type of money used in the U.S. It is money because the government says so.

CHARACTERISTICS OF MONEY

-Portable
-Durable
-Divisible
-Limited supply
-Acceptable
-Uniform

MONEY SUPPLY

-M1 Money (75%)

 *It consists of currency in circulation.
 *Check-able deposits(checking account).
 *Traveler's check.
 *It is held as a medium of exchange.
 *It is the most liquid.

-M2 Money

 *It consists of M1 money along with savings account, money market accountand deposits held by banks        outside the U.S.

-M3 Money

 *It encompasses M2 money and certificates of deposits (CD's).