Financial+Sector

Laura, Emma, Ivy Zack Berman, Dan Trauner

-M1: the most narrowly defined money supply, equal to currency in the hands of the public and the checkable deposits of commercial banks and thrift institutions -M2: a more broadly defined money supply, equal to M1 plus non-checkable savings accounts (including money market deposit accounts), small time deposits, and individual money market mutual fund balances
 * I. Money - Definitions M1 and M2**

Functions of Money -Medium of Exchange: bartering requires a coincidence of wants -Unit of Account: gives buyers and sellers something to measure the value of something -Store of Value: allows transfer of value from present to future -Liquidity: how easily it can be accessed without losing value


 * II. The FED - structure and function**

(Zack) There are 12 Federal Reserve Banks together make up the nation’s central bank. “Bankers’ banks.” They are quasi-public banks, meaning that private banks are required to own shares in their district’s Federal Reserve Bank, but the actual Federal Reserve is monitored by government appointed officials. The Federal Reserve Banks accept deposits and make loans to private banks throughout the United States.

The President of the United States appoints seven members to the Board of Governors, who all serve staggered 14-year terms. The FOMC is made up of 12 individuals and aids the Board of Governors. The 12 individuals include the Board of Governors itself, the president of the New York Federal Reserve Bank, and four remaining presidents of the Federal Reserve Banks on a 1-year rotating basis. This awesome group of guys and girls meets regularly to direct open-market-operations to control the nation’s money supply and influence interest rates.

The Fed does lots of cool stuff. Let’s go over that stuff: - Issues currency - Sets reserve requirements - Lends money to banks at the **discount rate** - Provides for check collection (transfers reserves within the Federal Reserve Bank) - Acts as a fiscal agent - Supervises banks - **CONTROLS THE MONEY SUPPLY**


 * III. Money Creation -transactions, balance sheets**

Key ideas: Assets = liabilities + net worth. When solving balance sheet problems, the goal is to make both sides of this equation equal. When deposits are made, an equal amount of cash is placed under reserves and checkable deposits. A bank can lend from its excess reserves (excess reserves = actual reserves - requires reserves). When loans are made, the quantity of money lent is added as "Loans" under the assets section and "Checkable Deposits" under the liabilities section. Once a check is drawn on the loan, money is removed from "Reserves" and "Checkable Deposits." Once the money is paid back (from an existing account at the bank), money is removed from "Loans" and "Checkable Deposits." Money is created through lending, because people can spend money that they don't have. The bank creates checkable deposits that did not exist before and therefore could not have been spent by consumers or investors.

Reserve Ratio is 20%
 * ** Assets ** ||  ||||||||   ||
 * ||  || a || b || c || d ||
 * ** Reserves ** || $60,000 ||  ||   ||   ||   ||
 * ** Loans ** || $90,000 ||  ||   ||   ||   ||
 * ** Property ** || $110,000 ||  ||   ||   ||   ||


 * ** Liabilities ** ||  ||||||||   ||
 * ||  || a || b || c || d ||
 * ** Checkable Deposits ** || $90,000 ||  ||   ||   ||   ||
 * ** Capital Stock ** || $160,000 ||  ||   ||   ||   ||

A) A $30,000 deposit is made by Ms. Nero. In column ‘a’ write the changes to the balance sheet B) The bank loans out all of its excess reserves after the deposit has been made. Write the changes in column ‘b’. C) A check is drawn against the bank for the amount taken out in the loan in part B. Write the changes in column ‘c’. D) The loan is paid back. Write changes in column ‘d’.

Reserve Ratio 20%
 * Assets ||  ||   ||
 * ||  || a || b ||
 * Reserves || $35,000 ||  ||   ||
 * Loans || $70,000 ||  ||   ||
 * Securities || $30,000 ||  ||   ||
 * Property || $95,000 ||  ||   ||

A) The bank purchases $11,000 in government securities. Show the changes in column ‘a’. B) The security dealer clears the check against the bank after the securities have been purchased. Show what happens in part ‘b’. C) What is the maximum amount of money that the entire banking system can create if this bank were to loan out all of its excess reserves?
 * Liabilities & Net Worth ||  ||   ||
 * ||  || a || b ||
 * Checkable Deposits || $45,000 ||  ||   ||
 * Capital Stock || $180,000 ||  ||   ||

__Dan:__
 * IV. Monetary Policy - demand and supply of money; tools; causes and effects of monetary policy**

__Dan:__
 * V. Present Value of Money**

Shows what hyperinflation (as a result of printing money) can do:

__Dan:__
 * VI. Stocks, Bonds, Mutual Funds**

Real World Applications: (Ivy: The Fed's monetary policy depends heavily on its regulation of banks. Financial institutions that are "too big too fail" force the Fed to take overly stabilizing monetary policy measures. Even if the dangerous size of these financial institutions is handled, the Fed still needs to better integrate monetary policy and regulation of banks.) http://www.reuters.com/article/idUSTRE63K3XI20100421 (Ivy: Indian news report about inflation in India rising to almost double-digit numbers. Input prices rising, high demand, and prices of manufactured goods rising are leading to dangerously high rates of inflation. The RBI (Reserve Bank of India) intends to partake in tight monetary policy, including raising interest rates, in order to combat the inflation.) http://www.youtube.com/watch?v=RYHyKWh0RB8 (Ivy: The Federal Reserve returns a record amount of income to US Treasury last year from holdings of Treasury securities, loans, and holdings of housing debt. Interest earnings soared so high because of the mortgage lending crisis, which allowed the Fed to purchase housing debt to support mortgage lending. Critics point to this rise in income as a signal of how big the Fed's role was in causing the financial crisis. The Fed ultimately aims to remove the housing debt from its balance sheet to make room for lower-yielding, less risky securities.) http://www.businessweek.com/news/2010-04-21/fed-returns-47-4-billion-of-earnings-to-treasury-update1-.html

Real World Video! (Zack) [] There are a group of economists who believe hyperinflation is bound to kill the value of a dollar, and those who invest in gold and silver today will continue to enjoy their current wealth, and those who keep their money in dollars will see their entire saving diminish. Economists who believe this have stated that the Fed's inexcusable printing policies are the cause. With the government's budget deficit increasing, the government will have no way to pay it's debt and will print the money it needs.

__Dan:__ Free Response Question: **
 * Free Response:

i. Full-employment output ii. Current output iii. Current price level Answers:
 * 1) Assume that the United States economy is operating at an unemployment rate of 3% and at an inflation rate of 10%.
 * 2) Using a correctly labeled AD-AS graph, show the following:
 * 1) Identify an open-market operation that the Federal Reserve could do to restore full employment in the short run.
 * 2) Using a correctly labeled graph of the money market, show how the open-market operation you identified in part b affects the interest rate in the short run.
 * 3) Explain how the change in the interest rate you identified in part c will affect AD.
 * 4) Show on the graph in part a how the change in the interest rate you identified in part c will affect output and price level.
 * 5) Explain how the interest rate you identified in part c will affect capital inflows and the value of the dollar in the foreign exchange market.
 * 6) Explain how the results from f will affect net exports.
 * 7) Explain how the government could fix this problem if the Federal Reserve decided not to intervene.

a. http://www.mhhe.com/economics/java/5/display.cgi?-1992245118 b. The Federal Reserve can sell securities to soak up the money causing inflation. c. Interest rate will increase: http://www.mhhe.com/economics/java/5/display.cgi?264296234 d. Aggregate demand will shift left because an increased interest rate means less investment spending, decreasing real GDP and AD. e. See part a. f. Capital inflows would increase because there would be more desire to buy bonds due to the higher interest rates. Therefore, the dollar will appreciate because there will be more demand for it from foreigner investors. g. Net exports will decrease because with an appreciated dollar, foreigners will be less able to buy more from the US, further decreasing net exports. h. If the Federal Reserve decided not to intervene in the inflation situation, the government could raise taxes and decrease government spending in order to soak up some of the excess money in the money supply (contractionary fiscal policy).


 * 1) Suppose the money supply is increased. What would happen to the equilibrium price level, the equilibrium quantity of output, and the unemployment rate according to
 * 2) Classical economic theory?
 * 3) Monetarist theory?
 * 4) Keynesian theory?

Answer:

a. According to Classical economic theory, the equilibrium price level would increase and the equilibrium quantity of output would remain unchanged. Since the quantity of output is unchanged, the unemployment rate is unchanged. b. According to Monetarist theory, the equilibrium price level would increase and the equilibrium quantity of output would increase as well. Since the quantity of output increase, the unemployment rate would fall. c. According to Keynesian theory, the equilibrium quantity of output would increase slightly and the equilibrium quantity of output would increase slightly as well. Since the quantity of output increased slightly, the unemployment rate would decrease slightly.

Overview on the 3 economic schools of thought: All three schools of thought agree that an increase in the money supply will raise the equilibrium price level. However, the Keynesians believe that the price level will only rise slightly. This is because they believe than an increase in the money supply will stimulate only a small amount of extra spending. In other words, the Keynesians fell that an increase in the money supply will shift the AD curve to the right, but only by a small amount. Similarly, the Keynesians fell that the equilibrium level of output will increase only slightly because total spending is not that sensitive to changes in the money supply. Therefore, unemployment falls modestly. The Monetarists, on the other hand, believe that an increase in the money supply has a significant impact on the economy. The equilibrium quantity of output rises substantially because spending is boosted by the increase in the money supply. Therefore, unemployment falls significantly. Only the Classical thinkers believe that the equilibrium level of output and the unemployment rate will be completely unaffected by the increase in the money supply. This is because of the Classical emphasis on the long run effects of any change in the economy. The amount of output that an economy can generate depends on the amount of resources available and the state of technology. An increase in the money supply affects neither of these and so the Classical conclusion is that output is not affected by an increase in the supply of money. It only serves to raise prices.

Site: Barron’s AP Micro/Macro Economics (2007/2008)

__Dan:__ Questions 1-5:
 * Multiple Choice:**

1) If a bank has $500 in checking deposits and the bank is required to reserve $50, what is the reserve ratio? How much does the bank have in excess reserves? a) 10%, $450 in excess reserves b) 90%, $50 in excess reserves c) 90%, $450 in excess reserves d) 10%, $50 in excess reserves e) 10%, $500 in excess reserves

2) Which is NOT a way that the Fed can affect the money supply? a) A change in discount rate b) An open market operation c) A change in reserve ratio d) A change in tax rates e) Buying treasury securities from commercial banks

3) If money supply increases, what happens in the money market? (Assuming money demand is downward sloping) a) The nominal interest rate rises b) The nominal interest rate falls c) The nominal interest rate does not change d) Transaction demand for money falls e) Transaction demand for money rises

4) Which of the following is a predictable advantage of expansionary monetary policy in a recession? a) Decreases aggregate demand so that the price level falls b) Increases agreagate demand, which increases real GDP and increases employment c) Increases unemployment, but low prices negate this effect d) It keeps interest rates high, which attracts foreign investment e) It boosts the value of the dollar in foreign currency markets

5) In what ways is contractionary fiscal policy in the US likely to affect domestic interest rates and the international value of the dollar a) Interest rates increase and the dollar depreciates b) Interest rates decrease and the dollar appreciates c) Interest rates increase and the dollar appreciates d) Interest rates decrease and the dollare is not affected e) Interest rates decrease and the dollar depreciates

6) If in the money market, the amount of money supplied is less than the amount of money businesses and households want to hold, the interest rate will: a) go up, causing businesses and households to hold less money. b) go up, causing businesses and households to hold more money. c) remain unchanged. d) go down, causing businesses and households to hold less money. e) go down, causing businesses and households to hold more money.

7) If the Federal Reserve increased the legal reserve ratio, one would see: (a) no change in interest rates. (b) lower interest rates, an expanded GDP, and a lower rate of inflation. (c) lower interest rates, a contracted GDP, and a higher rate of inflation. (d) higher interest rates, an expanded GDP, and a lower rate of inflation. (e) higher interest rates, a contracted GDP, and a lower rate of inflation.

8) How does the Federal Reserve regulate the money supply? (a) By making more or less money at the US mint. (b) By regulating who a bank can make loans to. (c) By selling and purchasing government bonds to regulate the reserves of banks. (d) The Fed has no control over the money supply. (e) By shredding money.

9) If the government wants to change the level of aggregate demand (increase or decrease), which would NOT succeed in doing that? (a) a tax decrease and an increase in the money supply. (b) a tax increase and an increase in the interest rate. (c) a tax increase and an decrease in government spending. (d) a tax increase and an increase in the money supply. (e) a decrease in government spending and a decrease in the money supply.

10) Which combination will help get the United States out of this recession? (a) Purchasing bonds and increasing government spending. (b) Purchasing bonds and decreasing government spending. (c) Selling bonds and increasing government spending. (d) Selling bonds and decreasing government spending. (e) No changes. The economy will work itself out.

11) The Federal Reserve decides to double the required reserve ratio. The new monetary multiplier: (a) Increases by a factor of two. (b) Increases by a factor of four. (c) Is divided by two. (d) Is divided by four. (e) Remains unchanged.

12) Banks are required to hold 20% of their reserves. Ransom Everglades Bank has $50,000 in actual reserves and lends out all of its excess reserves. What is the maximum amount of money that can be created? (a) $40,000. (b) $50,000. (c) $100,000. (d) $200,000. (e) $20,000.

13) Banks make overnight loans to each other in order to meet required reserves. At what interest rate are these loans made? (a) Discount rate. (b) Federal funds rate. (c) Reserve rate. (d) Risk-free rate. (e) Prime interest rate.

14) The Federal Reserve faces which of the following three lags: I. Recognition lags. II. Administrative lags. III. Operational lags.

(a) I. (b) I and II. (c) I and III (d) I, II, and III. (e) None of the above.

Answers: 1)a 2)d 3)b 4)b 5)e 6)a 7)E 8) C 9) D 10) A 11) C 12) D 13) E 14) C

Market for Money: http://www.mhhe.com/economics/java/5/display.cgi?1956011336