Macro 4.07 Podcast Notes PDF

Notes Unit 4 Macro More Than Just Cash or Credit Chapter 01 Consider the following scenarios and questions:  Two people both have a net worth of $5 million. However, one of them has no cash and the other is flush with cash. How could that be?  Three people all invest their di...

Notes Unit 4 Macro More Than Just Cash or Credit Chapter 01 Consider the following scenarios and questions:  Two people both have a net worth of $5 million. However, one of them has no cash and the other is flush with cash. How could that be?  Three people all invest their disposable income of the exact same dollar amount. At the end of one year, one person has modestly more wealth, another a great deal more wealth, and the third has lost half of their wealth. How?  Sometimes people really want to loan money to the government. Why would that be? By the end of this Lesson, you should know matter-of-factly the answer to all three of those questions. Some people always have money on their mind. Cash money. Financial Assets Consumers have two essential options with their income: they can spend it or they can save it. The focus of this Lesson is the different ways that they can save their disposable income, under the umbrella term financial assets. A financial asset is a claim that entitles the holder of the claim to future income from the issuer of the claim. There is an absolute kaleidoscope of financial assets, but there are three prominent types that you need to know:  1. A demand deposit, in which a bank holds your money and you can demand it at any time. This is what most people refer to as a "checking account." 2. A time deposit, in which a bank holds your money for a set period or requires notice for a withdrawal of funds. Certificates of deposit are a type of time deposit. 3. A bond, which is a loan to an institution, most prominently in this course the government, which cannot be demanded at any time. The bond has a "life" of an agreed upon number of years along with an interest rate. 4. A stock share, which is a fraction of ownership of or equity in a company. As the value of the company changes, so does the value of the equity. The flip side of the coin—pun intended—of financial assets are liabilities. When you deposit money in a checking account, it is a financial asset for you and a liability for the bank. The deposit, bond, or stock share is an asset to the financial investor and a liability to the bank, bond issuer, or company. Stretch Your Skills The details of bonds can get complicated fast, so keep it simple: for AP Macroeconomics, you just need to worry about if the issuer is the government, which directly impacts the G component of aggregate demand, or businesses, which corresponds to the I component of aggregate demand. A Treasury bond (T-bond) is a 10–30-year bond issued by the federal government's Department of Treasury; it's a government bond. Real Assets vs. Financial Assets If a person buys a bunch of gold because they think the price of gold only goes up, or purchases land near where they speculate property values will go way up, they are saving their money by investing in real assets—the gold can be held, the land can be walked and built on. Real assets are tangible, physical form. In contrast, financial assets are essentially an intangible, abstract set of rights and duties defined by contracts. For example, if a business funds the construction of a new plant by issuing bonds, the holders of those bonds have agreed to loan the company money in return for the company paying them back the bond's principal plus interest. On that note, this raises a major issue: financial investment and business investment are closely related but completely separate things. Business investment is a component of GDP because it represents new production; in the example above, the new production is a factory. Financial investment, on the other hand, does not directly produce a new good or service. A financial invesment such as a bond can be used to produce something new, but it also could be used to refinance existing debt. And as numerous stock market crashes have shown, the value of a stock is very loosely related to the production of any real good or service. You will explore the relationship between financial investment and business investment in more detail, but for now remember those essential differences. Are credit cards a real or financial asset to consumers? Neither A credit card is an instrument of liability to the person who uses it, as thousands of 18– 21-year-olds unpleasantly discover every year. It might feel like an asset when new physical assets are being purchased with it, but then the credit card statement with the interest payments arrives and reveals how quickly the liabilities add up. It's worth noting here that perspective matters; there's a reason this question included "to consumers." To the issuing credit card company, that individual card is an instrument of asset acquisition. When consumers make purchases on credit, they must pay back the creditor with interest. That interest is revenue for the credit card company, which it uses to obtain more financial or even real assets. What kind of asset is a house? A real asset This is the significant difference between renting and buying housing. A 12-month lease is a liability to pay a monthly rent, of which the renter gets zero percent back. However, a 30-year mortgage is the purchase of an asset that could make or lose money if the person sells the house, depending on if the house's market value goes up or down between buying and selling. Asset Analysis There are three key aspects of financial assets that you need to know: liquidity, rate of return, and risk. When people are considering which way(s) to save their money, they should consider these three things. Liquidity is how quickly a financial asset can be converted to cash. Say a family's car completely fails and they need to buy a new one. If they hold $15,000 in a checking account, they could be back on the road within a day; a demand deposit is practically as liquid as cash itself. However, if they hold that $15,000 in stocks instead, it's probably going to be a few days at least before they could buy another car with cash. Stocks are much less liquid. If they hold $15,000 in ten-year government bonds, they might have to sacrifice a good bit of the value of the bonds in order to sell them, and they might be riding the bus for a while. Bonds are much less liquid. The market might value this Van Gogh painting as much as this car, but if you stroll into the dealership with the artwork under your arm you're unlikely to drive away. A demand deposit at a bank is a much more liquid asset. The rate of return is how well a financial asset's value holds over time, ranging from 0 to several hundred percent. A person who bought several shares of stock in Apple Inc. in 2000, the year before the iPod transformed the music industry, would have seen an extremely nice rate of return. In addition, successful companies can make further investment in their stock more enticing by offering dividends to stockholders. The major banks' savings account interest rates have been much less than the inflation rate for quite some time, but a checking account has a rate of return of zero. Government bonds are better, but of course they are also less liquid. Then there are the stocks of major companies, which can rise by several percent in a year—or fall. This made a lot of people smile, especially those whose financial assets included Apple stock. Risk is simply the potential for gain or loss. Financial assets vary in their level of risk. The more an asset could potentially earn, the farther it could also fall in value. Since the Great Depression, the United States government has guaranteed demand deposits up to a certain amount. (This is to prevent bank runs, when crowds of people all wanted to withdraw their money from the bank at the same time, actually breaking the banks.) The amount is $250,000 per depositor, per bank as of this writing. There is a complex relationship between risk, rate of return, and liquidity. A so-called "junk bond" gets its name from the fact that credit agencies warn there is a high risk the company will go out of business. If that happens the bond is worthless junk, because there is no longer a company to pay the money back. However, junk bonds offer much higher rates of return (often because the companies are desperate for cash). This dog must have had a lot of shares of Pets.com, which lost more than 98% of its value in 2000 before the company went belly up (like a fish, not like a cute dog). The interest rate that could have been earned by investing it This is the second of two essential identities of the interest rate you should know: it is the price of borrowing money and the opportunity cost of holding onto cash rather than loaning it to someone. Selling Assets The key difference between saving and investing money is the latter is generally intended for the long term. Savings are funds put aside for purchases in the near future. This distinction is important when considering "liquidating" assets—savings are easily transferred into cash without financial penalty, although there may be a time delay. Note that some assets are nontransferable in the first place; a common example would be a manufacturer's warranty or an insurance policy on a real asset like a new roof on a building. Not only are assets like stocks, bonds, and real estate less easily converted, since they have to be sold to a willing buyer generally with professional assistance, but there are additional financial considerations. Selling an investment may lead to the investor having to pay certain fees to transfer the asset to its new owner. If the seller earned a significant profit from the sale, they may owe capital gains tax to the U.S. government. Stretch Your Skills All this stuff sounds like personal finance, so why is it in AP Macroeconomics? As has been hinted at, you will learn how these basics of financial assets shape all of the components of aggregate demand. New Bond Interest/Old Bond Price The relationship between previously issued bonds (existing bonds) and the interest rates on new bonds is a concept that is tested in different ways on almost every AP Exam. The relationship is inverse, and therefore not that difficult to remember: If the interest rate on new bonds goes up, the price of previously issued bonds will go down; if the interest rate on new bonds goes down, the price of previously issued bonds will go up. For a variety of reasons, it is also important to understand why this relationship exists. A simple scenario will suffice to explain it— Let's say that a government offers a 10-year bond for $1,000 with an interest rate of 2%. This means that a bond-holder will give the government $1,000 and each year will earn 2% in interest, which is $20 per year. At the end of 10 years, the person will have received $200 in interest payments (ignoring inflation) and will receive their $1,000 back. The $1,000 is called the bond's face value*, the amount of money guaranteed to the bond purchaser when it matures (in this case, 10 years). *Note that the face value and the purchase price of a bond are not necessarily the same, which is kind of the point of this lesson section. The initial purchase price and face value are the same in this example for the sake of simplicity. Now suppose that the next year the government increases the 10-year bond interest rate to 10% for the $1,000 bond. After this change, giving the government $1,000 will earn $100 per year. At the end of 10 years, the new bond purchaser will have earned $1,000 in interest, and then they get their $1,000 back. Once again, ignoring inflation, that means the new higher-interest bond offers five times the return. The person who has the previously issued bond is annoyed, and wants to sell it to buy the new bond. There's just one problem: everyone the old bond purchaser would sell the bond to knows the new bond interest rate. If they want to sell their previously issued $1,000 bonds, they can't charge the same $1,000 price or no one will buy it. Why loan $1,000 to get $20 per year when you can loan $1,000 to get $100 per year? The owner of the previously issued bond will have to lower the price until the return to the buyer is equivalent to the new bond. So now you should see the essential relationship: if the interest rate for new bonds goes up, the price of previously issued bonds will go down, and vice versa. Though already mentioned once in the Lesson, this is such an important distinction this whole page is dedicated to it. This is business investment—capital machinery and/or additional inventory of their products. This is the I in: Y = C + I + G + XN This is household financial investment—what you've been learning about in this lesson. It is NOT the I in: Y = C + I + G + XN The two are very closely related to each other, as you will soon learn, but it is critical that you remember the difference. Depending on the context, people will assume that if they don't clarify, they obviously mean one or the other. In AP Macroeconomics, if you read that an economy sees a $50 billion increase in investment, that is private business investment, not the household financial investment that you have been learning about in this Lesson. Individual or household financial investment does not count in aggregate demand nor in GDP because nothing new is being made. Again, it has a huge indirect impact on aggregate demand, which you will learn later. Chapter 02 Interest Rates: Inflation Strikes Back Imagine that a bank provides a $250,000 loan for the purchase of a house and charges an interest rate of 3 percent. That is the nominal interest rate—the advertised price of the loan, unadjusted for inflation. For simplicity, let's say that the borrower wins the lottery and pays back the full loan one year later. They will pay the bank $257,500 because $7,500 is 3 percent of the loan. If in that year the price level in the economy inflated by 3%, you can count on two things:   While the bank charged a nominal interest rate of 3 percent, its real interest rate was zero.  The bank expected the inflation rate to be lower, and its managers are not happy. Recall that the interest rate is the price of borrowed money. The bank managers in the scenario above are unhappy, because the real interest rate (the real price) for the $250,000 they loaned out was zero. The borrower had the bank's money for a year; in return, the bank collected the same amount of purchasing power back from that borrower, which means the bank, as the creditor, earned no real profit for the loan. The nominal interest rate had been set by the bank with inaccurate inflationary expectations. In a free market, many creditors compete for business, so they have a tough job— setting interest rates high enough to earn a real profit, but low enough to entice you to borrow from them. The Fisher Equation: (Nearly) All About Expectations The economist Irving Fisher made a major contribution to macroeconomics when he systematized this principle: borrowers and lenders agree upon a nominal interest rate based on their expectations of what inflation will be. It boils down to this mathematical equation: Nominal Interest Rate = Expected Real Interest Rate + Expected Inflation This is why it is always risky for lenders to offer fixed-rate loans: the money they receive back could be worth less than the money they loaned. Remember, a dollar is not forever a dollar: one dollar in 1950 could buy a movie ticket, popcorn, and soda; now the same exact dollar could not get even buy one of those three. The real purchasing power of a dollar generally decreases over time due to the impact of inflation. Review Real v. Nominal  Nominal interest rate: like any nominal value, the nominal interest rate is the advertised, stated rate of interest. It is independent of any price level changes.  Real interest rate: like any real value, the real interest rate is not an observed rate in the present. Rather, it is the observed, nominal rate adjusted for the expected change in price level. Note: the "after-the-fact" or historical real interest rate is the nominal interest rate minus the actual inflation rate (over the relevant time period). Mandy takes out a fixed-rate loan from a local bank with a stated annual interest rate of 5.2%. Inflation is expected to be 2% per year. What is the nominal rate of interest? What real rate of interest she will pay? Nominal rate is 5.2%; real rate of interest is 3.2%. The stated rate of 5.2% is the nominal interest rate. If inflation is expected to be 2% per year, then the real rate of interest that Mandy will pay on the loan is 3.2%. [nominal 5.2% – expected inflation 2% = real 3.2%] Stretch Your Skills The language of expectations is not super technical, so don't be thrown off if you see the phrase "anticipated inflation" rather than "expectated inflation" or the bank's "desired real interest rate" rather than "expected real interest rate." All of this underscores how important the inflation rate is, as tons of loans and bonds are issued based on expectations about it. If the actual inflation rate ends up being lower than borrowers and lenders expect, who is happy and why? The lenders are happy. Whatever the nominal interest rate was, it was based on a higher expected rate of inflation, which means that the real interest rate ends up being higher; banks are earning more than they expected. Thus, lenders benefit when inflation is lower than expected. Calculating with Fisher The great news is that the math here is basic algebra just applied to economic concepts. Of course, on your course exams and the AP Exams you must show your calculation work, no matter how simple the question seems. But first, take the time to appreciate the moral of this Lesson's story: nominal interest rates are all about inflationary expectations, and real interest rates are all about what inflation actually ends up being and doing to the price level. Each of these relationships represents a link on cause-and-effect chains that you will need to be able to trace at greater depth later in the course. Now get out your notes and pens to get calculating with Fisher. Example 1 Say that you would like to purchase an electric car, but you're not willing to pay a real interest rate higher than 5 percent. If the expected inflation rate is 4 percent, what is the maximum nominal interest rate you would be willing to pay?  Step 1  Step 2  Step 3 As always, start by writing out the formula: Nominal Interest Rate (Nom) = Real Interest Rate (Real) + Expected Inflation (Inf) Example 2 A bank offers a variable rate loan (meaning they can change the interest rate annually) with a nominal interest rate of 8 percent and an expected inflation rate of 3 percent. What is their target real interest rate?  Step 1  Step 2  Step 3 Write out the formula. (Shorthand is okay.) Nom = Real + Inf Based on Example 2, if after a year the actual inflation rate proved to be 5%, what would be the new target real interest rate and new nominal interest rate? AP Pro Tip It is not rare for the AP Exam to ask you for the new nominal and real interest rate after a change in inflation. If it is a fixed-rate loan, the nominal interest rate will not change; if it is a flexible-rate loan, the real interest rate will not change. Chapter 03 The Mysteries of Money What do eggs, gold, silver, sea shells, cigarettes, cows, paper, salt, grain, and fish all have in common? As the Lesson title probably gave away, they all have been used as money somewhere at some point in history. It facilitates transaction of goods and services. Barter has been and still is common, but it depends on the double coincidence of wants; money enables buyers and sellers to get around this issue. Money is so fundamental to economics that it is easy to overlook it, but its nature and uses are important to understand to preserve the health of economies that use them; whole empires have collapsed when their money system broke! Remarkably, all of these things have been used to make purchases. The Three Functions of Money—MUS Since anything could potentially be money, economists clearly define it through its three essential functions. You MUSt remember these functions because money has MUScle (it does a lot of heavy lifting in the economy). Money is a Medium of exchange, a standard Unit of account, and a Store of value.  Medium of Exchange  Unit of Account  Store of Value Money is a medium of exchange. This is the essential function of money. The word "medium" comes from the Latin word for middle, and in this context think of it as the bridge (thing in the middle) between a person who wants a good or service and the person who has it to provide. The classic alternative to a system with money is a barter system. If you're a painter in a barter system, you can only buy things from people who want a painting. Money allows for highly indirect exchange: a famous artist today can use the money earned from one painting to pay the rent, buy the groceries, and get more art supplies. The landlord, grocer, and art supplier don't need to like the painting or even see it! It's easier to exchange cash than sea shells for groceries. Money is a standard unit of account. This is one of the more amazing functions of money. The expression "that's like comparing apples to oranges" means that two things are too different to meaningfully compare to each other. However, the expression definitely doesn't work with money, because it enables people to compare anything exchanged in the market. With money, we can say that in some mysterious sense a movie, a burrito, an hour of manual labor, and two espresso drinks are about equally valuable—the same amount of money is exchanged for all of them. Money is a store of value. A thousand years ago a fishermen in a barter economy could not save up a bunch of catches to buy a house, because fish quickly rot. This is what makes government treasury notes—what you picture when you hear the word "cash"—so effective as money. As long as inflation isn't going crazy (the rough equivalent of a sudden fish rot), thousands of dollars can be saved to purchase something big or as security for if hard times hit. Think of it this way. Cash, or currency, serves as a financial asset just like bonds or stock shares. While holding cash pays no interest or return, the risk of it losing value is low (other than from major inflation). Proxy for Value and Fiat Currency The other historic items used as money started circulating because they had some kind of intrinsic value—fish can be eaten, precious metals like gold or silver can be used to make jewelry, grain can be ground and turned into bread, etc… However, over time people noticed something: the intrinsic value was not near as, well, valuable as the item's use as a proxy for value. Proxy means "substitute" or "stand- in." Money stands in for value itself when used as a medium of exchange. This wasn't always the case. The "gold standard" meant that the value of a country's currency was directly linked to gold; the government sets a price for gold, buying and selling it at that price, which sets the value of the coin and paper cash. In a multi-decade process (with some who still worry about this today), governments around the world stopped saying, "We'll give you this amount of gold or silver if you ask for it for every dollar/currency you have" and started saying, "This currency is valuable because it is what you can use to pay your taxes." This is referred to as "going off the gold standard." Ever since then, these currencies' value comes from fiat—the command of the government that accepts it as tax payment, and people's confidence in that government (and its central bank if it has one). Are U.S. dollars commodity or fiat money? What backs up their value today? Fiat money—technically, nothing backs up their value. In the 20th century U.S. economists determined that it was best for the economy to have the central bank (Federal Reserve) control the money supply and not anchor the value of currency to gold or other precious metals. Last Bit of Financial Lit For much of the history of banks, people thought that their money was just getting guarded in the big steel vault. The reality is that banks use the money people deposit with them to give loans to other people, and they only have a small fraction of deposits on reserve for when their customers need withdrawals. That said, the bank has an interest in you giving them a heads up on when you'll want to withdraw your money, so they give you more interest the more time you give them. You're sacrificing liquidity, some medium of exchange power, to strengthen your money's store of value. Here they are in descending order of liquidity:  Demand deposits/Checking accounts—You can withdraw 100% of your funds on demand; the bank gives you no interest for that (so with inflation your checking account steadily loses value year-to-year).  Savings accounts—You accept various kinds of withdrawal limitations; the bank offers you some interest.  Time deposits—You agree not to withdraw the value of the deposit for a contractual period of time or you pay a penalty; the bank gives you more interest (certificates of deposit, CDs, are the most famous example of a time deposit). Stretch Your Skills "Money is a matter with functions four: a medium, a measure, a standard, a store." — common rhyme If you come across this mnemonic in another economics resource, don't think less of this course as having missed one of money's functions. Money as a unit of account combines the functions of measure of value and standard of value; the essential connection between the two concepts should be clear. Money Supply Measures How much money is there in the whole world? This is one of those questions that is fun to think about…until you seriously try to answer it. For one, you've just learned that many different commodities have and still do function as money; there is not a single currency used all over the world in exclusion of all others. Additionally, the financial system multiplies money in diverse ways, something you will learn a great deal more about in the rest of this course. For AP Macroeconomics, you need to know the three broadest measures of money. The Federal Reserve Bank, the central bank of the United States, defines these measures as follows, organized by relative liquidity: Measure of Relative Money Description Liquidity M0 (you Coin and currency in circulation and in bank reserves. Completely might see it Essentially all the physical money that can circulate at any liquid as MB) given time, also called the monetary base M1 Coin and currency in circulation + demand deposits + Less liquid most near monies (savings accounts and money market Measure of Relative Money Description Liquidity mutual funds*); usually referred to as simply the money supply (Bank reserves are not counted in M1, so the only shared component between the monetary base and the money supply is the coin and currency in circulation.) M2 M1 + most time deposit accounts (such as certificates of Least liquid deposit, or CDs) *Don't worry about the details of money market mutual funds; just remember that they are near monies and counted as part of the money supply. The Federal Reserve Bank not only defines the measures of money, but it also tracks their values on a regular basis. The following graphic contains an example in real U.S. dollars, illustrating the relative sizes of the categories of money. Important! Note that unless otherwise indicated, the phrase "money supply" refers to M1. The monetary base is not the money supply, but forms part of the supply's base. The monetary base is not included in this graphic because it includes bank reserves, which are excluded from M1 and M2. If a person is paid for a gig job in cash and they deposit it directly into savings, how do M0, M1, and M2 each change? M0 decreases, M1 and M2 do not change If you missed this, look back at the information above. The cash in M0 was already being counted in M1 and M2, so when it is deposited into savings it leaves the monetary base but has no impact on the money supply or M2. If instead the gig worker placed those funds in a time deposit account, like a CD, then M0 would decrease, M1 would decrease, and M2 would increase. This is because cash would be moving out of both the M0 and M1 calculations and into M2. Beyond M2 There are other aggregate measures of money, but they become so much less liquid that they lose the essential function of being a medium of exchange. For example, a house or a government bond can be a great store of value, but you can't go to the grocery store with a bond and expect to leave with any food. Bottom line: the value of a bond purchase leaves the money supply for the life of the bond. What About Plastic "Money"? Debit cards and credit cards are simply tools for moving money, but they are not money themselves. Recall the functions of money; debit and credit cards do not serve the three functions MUS. Rather, a debit card is a means by which a person can move their demand deposits to make a purchase; the "money" exchanged is the withdrawal of funds from their bank account. For a credit card, it's the creditor that puts up the funds to complete the purchase, which the card user must pay back with their own demand deposit funds. They are tools, not money. A person can have one debit card or twelve, one credit card or no credit cards—those numbers have no impact on the money supply. Chapter 4 Think Outside the Vault Banks have two main purposes for consumers: providing a safe place for savings and providing loans to borrowers. This makes them "financial intermedaries" since banks take in deposits and loan out those deposits to others. Remarkably, many bank customers do not consider the connection between those functions. On March 12, 1933, Americans sat next to their radios and listened to President Franklin Roosevelt give a banking Lesson in his first fireside chat: "First of all let me state the simple fact that when you deposit money in a bank the bank does not put the money into a safe deposit vault. It invests your money in many different forms of credit—bonds, commercial paper, mortgages and many other kinds of loans […] A comparatively small part of the money you put into the bank is kept in currency— an amount which in normal times is wholly sufficient to cover the cash needs of the average citizen." Library of Congress, LC-DIG-hec-47251 In other words, one person's savings is another person's loan. In fractional reserve banking, only a small fraction of deposits are kept as reserves. The remaining deposits are loaned out to help people buy homes, start businesses, and engage in all sorts of other valuable economic activities—and to earn interest for the bank. As President Roosevelt said, normally this is no problem. Yet the Great Depression was not "normal times." Many people in a panic had run to the bank to withdraw much or all of their savings. The federal government did not insure bank deposits then as it does now. Unable to fulfill the sudden demand for cash, thousands of banks simply closed, many of their customers losing everything. Why does the federal government insure bank deposits rather than requiring banks to keep nearly all of customer deposits in reserve? Reserving most or all deposited funds would be like wrapping someone completely with bubble wrap, securing it with duct tape, and leaving only an air hole for breathing; the economy might be safer, but it could hardly move, and its growth would be unacceptably slowed. Understanding that metaphor is what the rest of this lesson is about, and it starts with looking at bank balance sheets. Meet the Bank Balance Sheet Pay careful attention to this presentation. You are expected to know bank balance sheets very well on the AP Exam. Assets Liabilities and Equity Required Reserves: $100 Demand deposits: $1,000 Excess Reserves: $0 Owner's Equity: $0 Loans: $700 Bonds: $200 Total: $1,000 Total: $1,000 This is a simplified bank balance sheet, and if you look at the bottom row you can see immediately where it gets its name—the total assets will equal the total liabilities and equity of the bank owner(s). Now it's time to get to know the individual components. Assets Liabilities and Equity Required Reserves: $100 Demand deposits: $1,000 Excess Reserves: $0 Owner's Equity: $0 Loans: $700 Bonds: $200 Total: $1,000 Total: $1,000 Start with demand deposits. The bank is liable to provide its customers with this money at any time. When you have a job in which your employer direct-deposits your pay directly into your bank checking account, that is a demand deposit. You can immediately demand that money. Of course, they only keep a fraction of the deposit, assuming that you will only withdraw a fraction at a time. Assets Liabilities and Equity Required Reserves: $100 Demand deposits: $1,000 Excess Reserves: $0 Owner's Equity: $0 Loans: $700 Bonds: $200 Total: $1,000 Total: $1,000 In this example, the bank is required to keep 10 percent of their demand deposits. You can see that clearly because the $100 of required reserves is = 0.1 = 10%. It is quite common to be given two of the three figures: required reserves, demand deposits, and the reserve ratio, and to have to solve for the missing number. Assets Liabilities and Equity Required Reserves: $100 Demand deposits: $1,000 Excess Reserves: $0 Owner's Equity: $0 Loans: $700 Bonds: $200 Total: $1,000 Total: $1,000 Banks might keep excess reserves if they are concerned about a significant amount of withdrawals, such as in the case of an impending natural disaster. That said, banks generally will minimize their reserves for the simple reason that they're sacrificing interest payments on loans and bonds. Remember, interest is the opportunity cost of holding onto money. It's worth noting that if you were missing just one of any of the items on either column you could figure out its value because you know the totals must be equal. So if you didn't know this bank had $200 in bonds, you could calculate that $1,000 = $100 + $700 + bonds, and therefore bonds = $200. Assets Liabilities and Equity Required Reserves: $100 Demand deposits: $1,000 Excess Reserves: $0 Owner's Equity: $0 Loans: $700 Assets Liabilities and Equity Bonds: $200 Total: $1,000 Total: $1,000 You're not a banker, so you can simply think of "owner's equity" as the value of the ownership of the bank. The critical thing for you to remember is that if this is not zero, then it adds to the total of this column and the assets must balance. For example, if the owner's equity above was $100 instead of $0 then one or more of the assets would have to increase by an aggregate of $100 and the totals at the bottom would be $1,100 and $1,100. What if someone deposited $100? See if you can guess how the balance sheet above would change. Assume the bank decides to hold it all in reserve. Assets Liabilities and Equity Required Reserves: $110 Demand deposits: $1,100 Excess Reserves: $90 Owner's Equity: $0 Loans: $700 Bonds: $200 Total: $1,100 Total: $1,100 The bank is now liable for that $100, so it is added to demand deposits and total liabilities. But the bank can also do with that $100 what it chooses as an asset. It must keep 10 percent, the required reserve ratio shown by the initial $100 required of $1,000. So of that $100, ten dollars is added to required reserves and the rest becomes excess reserves since the bank decided to reserve it all. If they had decided to loan out half of what they could and reserve the rest, excess reserves would have been $45 and loans would have increased to $745. Just take it one step at a time and remember the two columns must balance and you've got it. PreviousNext 1. 2. 3. 4.  5. 6. Note this down. Whether you are analyzing a bank balance sheet or your own personal budget, this simple equation is always true: Assets – Liabilities = Equity (or Net Worth) Practice 1 If the reserve requirement is 5% and the bank holds $25 of a $200 checking deposit, what is the value of its excess reserves? $15 The bank was only required to hold 5% of $200, which is $200 x 0.05 = $10. However, the bank reserved $25. Total reserves of $25 – $10 required reserves = $15 excess reserves. Practice 2 Assets Liabilities and Equity Required Reserves: $50 Demand deposits: $250 Excess Reserves: $0 Owner's Equity: $0 Loans: $200 Bonds: $0 Total: $250 Total: $250 On a new balance sheet, illustrate the impact of a $250 cash deposit on the bank above. Assume the bank lends out the maximum funds possible. Assets Liabilities and Equity Required reserves: $100 Demand deposits: $500 Excess reserves: $0 Owner's equity: $0 Loans: $400 Bonds: $0 Total: $500 Total: $500 The new $250 cash deposit is added to the demand deposits on the liabilities side ($250 + $250 = $500). Then, you can tell that the required reserve ratio is 20%, since in the given chart $50 required reserves is one-fifth of the $250 in demand deposits. Thus, of the new $250 deposit, an additional $50 (20%) must be held as required reserves. This leaves $200 ($250 – $50 = $200) in additional funds to keep as excess reserves or to lend as loans. Since the prompt said the maximum is lended, there are no excess reserves. The $200 is added to loans ($200 + $200 = $400) in the assets column of the bank balance sheet. AP Pro Tip Much like sketching out a quick AD–AS model makes changes in the price level and real GDP clear, making a quick balance sheet on any question that involves bank transaction is a wise move. Remember, it's about balance—if something changes demand deposits, it impacts the required reserves. Money Multiplier Here's why it would be tragic if the required reserve ratio was super high and banks had to keep almost all deposits in the vault. For the purposes of this example, assume that the required reserve ratio is 10 percent. 1. A sunglasses designer discovers $100 he had left in his jeans pocket and deposits it in Bank A. 2. Bank A keeps $10 in reserves and loans out $90 to someone else to buy something—the seller deposits that $90 into Bank B. 3. Bank B is required to keep $9 in reserves and loans out $81 to someone else for a purchase… 4. […tons more transactions because you get the idea…] 5. Roughly 100 transactions later, there have been $900 in new loans, $100 in new reserves, and $1,000 in new deposits. Finding the vault empty, disappointed would-be robbers discovered how low the required reserve ratio had fallen. Where did those total numbers come from? $900 in New Loans $100 in New Reserves $1,000 in New Deposits $90 of Bank A's first $10 in reserves from first $100 deposit from designer + loan + deposit + $90 from the seller of the first loan $81 of Bank B's loan $9 from second deposit + purchase, etc… + $8.10 from third + etc… $72.90 of Bank C's + etc… The sunglass designer depositing the $100 resulted in $900 worth of new loans, each of which represented income for the people selling whatever the loans were used to buy. If the sunglass buyer had not found the $100 and deposited it, or if the banks were required to reserve all of their deposits, then none of that additional money would have been supplied for these economic activities. This combining the functions of money as a store of value and a medium of exchange is the tremendous power of fractional reserve banking. It multiplies the amount of money being used as a medium of exchange in the economy. The money multiplier, also called the demand deposit multiplier, explains the relationship between excess bank reserves and the maximum change in the money supply based on loans created from those excess reserves (which came from demand deposits, hence the alternate name). It's not magic; this relationship can be calculated. The Formula Moneymultiplier=1RequiredReserveRatio In the example above, the required reserve ratio was 10 percent, so the money multiplier was: Moneymultiplier=10.1=10 Now this is the tricky part: avoiding double-counting the initial deposit. The maximum increase to the money supply as a result of the sunglass dealer's deposit of $100 is $900, not $1,000. Why? Because that $100 had already been in the money supply as the cash component of the monetary base. It has gone from the cash M0 component of M1 to the checking account, which is exclusively M1—but it had been counted in M1 already. The expansion of the money supply comes from new excess reserves and the new loans that come from them. So, the maximum change to the money supply is the immediate change in excess reserves that can be converted to new loans—in the example above $90—multiplied by the money multiplier (in this example 10). Don't sweat it if this is giving you a dull headache. Just remember to multiply the money multiplier by the amount of new loanable funds available. Quick practice: if the required reserve ratio is 20 percent, what is the money multiplier? 5 Moneymultiplier=10.2=5 If the required reserve ratio increases, will that increase or decrease the potential money supply? Decrease Think about it—if required reserves doubled say from 5% to 10%, that's less money in excess reserves that banks have to lend out. The money supply will still increase from new deposits, but it won't increase as much as it could with a lower required reserve ratio. Remember, it's a maximum! Much like the spending multiplier, which only represents a maximum possible change if everyone follows their marginal propensities to consume and save all the way to the last fraction of a penny after an autonomous expenditure, the money multiplier has three broad factors that could make the real-world increase less: 1. Banks might hold onto excess reserves for any number of reasons. 2. Customers might hold onto some cash for any number of reasons. 3. The chain reaction takes an unpredictable amount of time to play out. In part this is due to dependence on the demand for loans, which you'll examine later in the unit. Just remember excess reserves, retained cash, and time, and you're good! Stretch Your Skills If you're feeling a sense of déjà vu, it's completely normal. The expenditure multiplier may appear similar to the money multiplier. It is similar in the sense that an initial change in spending/bank deposits, through respending/reloaning, leads to a greater change in the real GDP/money supply. Remember, though, that they are operating within and affecting different elements of the economy. The money, or demand deposit, multiplier is specific to banking and the money supply. As you continue through the lessons, the connections and distinctions between the multipliers should become more clear. Chapter 05 Follow the Money Here's a strange way of thinking about commerce: if you purchase a donut for a dollar, you could say that you sold your dollar for a donut. It's obvious why you'd want the donut (it's delicious), but why did the seller give it to you for a dollar? That might seem obvious as well, but the point is that money can be analyzed as a marketable good. There is a quantity supplied and a quantity demanded, a price for the transaction, and supply and demand can each shift. Why does this matter? Because if you understand how the market for money works, you'll be able to anticipate when it will look good to buy a car or a house, or to take out a loan for school, and when you need to avoid debt if possible. There's a time for donuts and a time to refrain from donuts. The same goes for using money to make purchases. What Is the Price of Money? While it is certainly valid to think of it in terms of any commodity, including donuts, the money market that economists find the most valuable looks at the most universal price for money: nominal interest rates. How much interest will a person, business, or government have to pay to borrow money? How much interest will a person or business earn if they supply money by saving it in the various ways you've learned instead of spending it? That's the key price of money. Why can't the real interest rate rather than the nominal interest rate be the price of money? Because at the time of borrowing, the inflation rate and therefore the real interest rate cannot be known. Remember that the nominal rate is the actual, stated rate charged by the financial institution. The real interest rate, however, is the nominal rate after it has been adjusted for inflation; the adjustment can only happen in hindsight, once inflation has been observed and measured. Borrowers demand money based on what they know, which is the nominal, advertised interest rate. What Drives the Demand for Money? No, not greed or evil—this isn't philosophy class. There are two broad reasons that people demand money. Think of these as the money demand curve shifters. Transactions demand—This essentially means that anything that changes people's desire to consume goods and services—think aggregate demand and its components— will change the demand for the primary medium of exchange for those goods and services. Changes in household spending, business investment, government spending, and net exports will shift money demand. People, businesses, and government need money to buy goods and services; that's transactions demand for money. Transactions demand is highly sensitive to changes in nominal income. Asset demand—Think of this primarily as the store of value function of money motivating demand. It can be subdivided into precautionary demand—saving for a rainy day—and speculative demand, the belief that holding onto liquid assets will yield a better return than less liquid assets like bonds or CDs. People, businesses, and government will hold onto money as currency or in liquid accounts for emergencies or because investments are considered a poor alternative; that's asset demand for money. Asset demand is highly sensitive to changes in nominal interest rates. This transaction led to the exchange of money for coffee. This may be liquid money, but it likely won't flow out of the jar when needed. Money, like any other good, has a downward-sloping demand curve. People will demand a higher quantity of it the lower its price (the lower the nominal interest rate), and will demand a lower quantity as nominal interest rates rise. Put another way, there is an inverse relationship between nominal interest rates and the quantity demanded of money. What Drives the Supply of Money? This is the greatest difference between money and other goods: its supply is determined by a central bank's policies, which shape nominal interest rates rather than being shaped by them. This means that the supply of money is perfectly inelastic; the supply does not respond to changes in nominal interest rates at all. The money supply is independent of the nominal interest rate; thus, the supply curve for money is a vertical line. Stretch Your Skills In economics, the angle of the curve reveals how much the quantity supplied or demanded responds to changes in price. So a good with perfectly horizontal demand will see a quantity demanded of zero if it raises its price a penny above the market; this is common for goods like fruits and vegetables where most people don't care about brand name. A good with perfectly vertical supply means that the same quantity is demanded regardless of any price change—think Picasso paintings (no matter how high the price goes, he stubbornly just won't paint another one… because he died in 1973). The supply of money is perfectly vertical because the money supply is determined by the central bank. Graphing the Money Market The money market can be visualized in a graph. Follow the video carefully, taking notes. Viewing in fullscreen mode is recommended. Text Version On the AP Exam, you will analyze and likely draw a money market graph. Start with the axes. Quantity of money is on the horizontal axis, and nominal interest rate is on the vertical axis. Now, recall that money demand is downward sloping because asset demand is inversely related to interest rates. [Superimposed screen text reads "MD slopes downward"] At higher interest rates, the opportunity cost of holding cash, which is foregone interest, increases and less money is held. The money demand curve is downward sloping. Label this line MD1. [Hand adds MD1 line and label.] Money supply is a vertical line. This is key. [Superimposed screen text reads "MS is vertical"] It is vertical because the Federal Reserve determines the money supply through monetary policy. It is set by the Fed. Label it MS 1. [Hand adds dotted line and axes' labels.] Where MS and MD intersect is the money market equilibrium, label the equilibrium quantity and equilibrium interest rate. Either curve can shift. A prompt might state that nominal GDP increases or the price level increases. [Superimposed screen text reads "The government increases spending, and both nominal GDP and price level have increased. Illustrate the impact of this change in the money market."] Either way, that will cause an increase, or shift to the right, in money demand. This is because as output and/or prices increase, people need more money to pay for goods and services. The transactions demand for money increases, shifting outward the money demand curve. Draw a new MD to the right of the first and label it MD 2. What is the outcome of this change? Show it on the graph. [Hand adds new line and label and arrow.] Label a new equilibrium rate and use an arrow to indicate that the interest rate has increased. [Hand adds line for MD2, then arrow between MD1 and MD2, then dotted line, then label r2, then up arrow from r e to r2] However, the quantity will stay the same because money supply has not moved. It is vertical, set by the Fed, and not directly affected by changes in output or price level. [Superimposed screen text reads "↑MD → ↑nir, same QM"] The opposite outcome, meaning a decrease in the interest rate, would occur from a decrease in money demand, such as to MD3. [Hand adds line for MD3, then arrow between MD1 and MD3, then dotted line, then label r3, then down arrow from r e to r3.] Explanations for this shift would be a decrease in nominal GDP or a decrease in the price level due to contractionary fiscal policy or other factors. [Superimposed screen text reads "↓MD → ↓nir, same QM"] So what moves the money supply? Expansionary or contractionary monetary policy, which is determined by the central bank or the Federal Reserve. Start with a clean graph and label everything. Say the Fed wants to help close a recessionary gap. This calls for expansionary monetary policy. The Fed could increase the money supply to decrease interest rates by lowering the reserve requirement or buying government bonds on the open market. Any of these actions will increase the money supply, shifting it to the right. [Hand adds MS2 line and arrow.] Label it MS2. Use arrows to show the direction of changes. What's the outcome? Expansionary monetary policy leads to an increase in the equilibrium quantity of money and to a decrease in the equilibrium interest rate. [Superimposed screen text reads "The Fed ↑MS → ↓nir, ↑QM"] [Hand adds right arrow from Q e to Q2, then dotted line, then r2 label, then down arrow from r e to r2.] If the Fed instead uses contractionary policy to correct high inflation, the goal is to decrease the money supply. This decrease would lead to a lower quantity of money and a higher equilibrium interest rate. [Hand adds line and label for MS3, then dotted line, then label r 3, then up arrow from re to r3, then label Q3, then left arrow from Q e to Q3.] Contractionary policies are increasing the discount rate, increasing the reserve requirement, and/or selling government bonds. [Superimposed screen text reads "The Fed ↓MS → ↑nir, ↓QM"] Keep sketching these scenarios to master the money market model. Print Show Video The graph of the money market doesn't look much different from other supply and demand models, and that will be true for additional models you will learn. Therefore, it is critical to memorize the key elements of the money market model, such as the axes labels (nominal interest rate and quantity of money). Be sure you have noted the impact of changes in the money market:  A change in the nominal interest rate will simply cause movement along the money demand curve; the money supply curve is unaffected.  There can be disequilibrium in the money market. A too-high nominal interest rate will cause an excess of funds supplied in the market; interest rates will fall until equilibrium is restored. A too-low nominal interest rate will cause excess demand in the money market; interest rates will rise until equilibrium is restored.  Money demand can shift in response to changes in real output (real GDP) or in the price level (inflation). Changes in these indicators mean people will need more or less money to fulfill their purchases of goods and services, and so the MD curve will shift.  Money supply will not shift unless there is a change in central bank policy targeted at the money supply. You will examine this in more detail later. For now, recognize simply that if the central bank increases the money supply,  that's a shift to the right; a decrease in the money supply would mean a shift to the left. Practice Makes Permanent Illustrate the impact of an increase of the money supply on nominal interest rates and the quantity demanded of money. Check that you labeled your graph correctly. Sometimes you may see simply "interest rate" along the vertical axis; that's why it's up to you to remember that in the money market, it's nominal interest rate that is meant. An increase in the money supply means a shift in MS to the right, leading to a lower interest rate and, of course, higher quantity of money. Include arrows in your graph to show you understand what is changing and how. Assuming no change in price level, what would happen to the real interest rate based on the change above? Explain. It would decrease, because the equilibrium nominal interest rate would fall. The price level being constant means no adjustment for inflation needs to be made. It is very important to note that if you did not mention the price level in your explanation, then you would only earn half credit on this question on the AP Exam. Remember, in economics, "real" means "adjusted for inflation," so you must consider the price level. Bonds Return: (No) Time to Buy Remember that there is an inverse relationship between the interest rate and the price of previously issued bonds. So with that in mind, think about these next questions. What will happen to the price of previously issued bonds if the money supply decreases? The price of previously issued bonds will decrease. If you sketch out a quick money market graph you see immediately that a leftward shift of the money market causes the equilibrium interest rate to increase. If the interest rate is increasing, the price of previously issued bonds will have to decrease. What will happen to the price of previously issued bonds if real GDP increases? The price of previously issued bonds will decrease. Same answer, different reasons. If real GDP increases, that means that money demand will increase, or shift to the right. This raises nominal interest rates; again, if interest rates are rising, the price of previously issued bonds is falling. Check the graph. Stretch Your Skills Why would anyone want to sell their previously issued bond? Simple—they need cash. This connects all three of the aspects of financial assets that you've learned: the bond was purchased because it offered a higher rate of return than holding onto cash, but the buyer takes the risk that 1) they will not need cash quickly, and if they do that 2) the interest rate will not have risen so much that they must accept a painful financial loss to get the liquidity that they need. The more deeply you understand these relationships, the more able to assess financial risk you'll be personally and the more able to predict big trends you'll be macroeconomically. Knowledge is power. Chapter 06 Making Money Work "In the long run we are all dead," once wrote cheery fellow John Maynard Keynes. He was making an argument for government intervention when an economy is out of equilibrium, rather than waiting for the self-adjustment in the economic long run. (Recall the concept of long-run self-adjustment in the AD–AS model.) It is probably the most famous quote of a person known for his famous quotes. Keynes continued, "Economists set themselves too easy, too useless a task, if in tempestuous seasons they can only tell us, that when the storm is long past, the ocean is flat again." Keynes was an advocate of fiscal policy. However, there is another means by which a country can influence the short-run economy—monetary policy. This is fine. So what can a central bank do to intervene in a metaphorical storm, when an economy is in a bad recession or overheating badly with skyrocketing inflation? Really, it can do just one thing: it can influence nominal interest rates. Traditionally this has been done by changing the money supply, which indirectly influences interest rates. The central bank has three ways to change the money supply; these three tools of monetary policy are described below, and easily remembered with the catchy acronym DR. RRROMO (it helps if you really rev the Rs). Three Tools of Monetary Policy  ∆DR  ∆RRR  OMO The discount rate is the interest rate that banks must pay to borrow money from the central bank. If banks must pay a higher interest rate to borrow money, they will charge a higher interest rate, and they will be more cautious with the amount of excess reserves they hold, so the supply of money will decrease. Increasing the discount rate decreases the money supply, and decreasing the discount rate increases the money supply. From 1950 to 2020, the Federal Reserve Bank of the United States changed the discount rate 243 times, an average of about once every three-and-a-half months. As you've already seen, the required reserve ratio is the percentage of demand deposits that banks must keep on reserve. Obviously, if money cannot be lent out, it is not circulating in the economy, so an increase in the RRR decreases the money supply, and a decrease in the RRR increases the money supply. The U.S. central bank, or Federal Reserve, changed the RRR only 34 times from 1950 to 2020, of which only four times were between 1990 and 2020. It is used quite sparingly. Open market operations are the central bank's buying and selling of government bonds and other types of securities. When the central bank buys bonds from banks, the banks receive cash and the money supply increases. When the central bank sells bonds, the banks swap cash for bonds and the supply of money decreases. The executive leadership of the Federal Reserve meets eight times every year to give direction to what is known as its Trading Desk regarding what open market operations might be needed. That said, the central bank does in fact engage in open market operations much more often than that. Monetary Base v. Money Supply Say an economy's central bank purchases $1 billion worth of bonds in a single week. Throughout that week, one billion dollars in cash is being converted on bank asset columns from bonds to excess reserves. If they don't loan those new reserves out, their value is added to the owner's equity item of the liabilities column of their balance sheets. But of course the banks will loan much of those reserves out, because collecting interest that accrues on loans is the primary way that banks make money. Thus, from this transaction the monetary base will increase by $1 billion, but the total money supply will increase by much more. Remember that the monetary base includes all cash in circulation and held by banks as reserves; this means it includes all cash outside of the Federal Reserve. The monetary base does not include demand deposits, while the M1 money supply does include demand deposits. The M1 money supply excludes bank reserves; otherwise the same funds would be double counted. In the scenario above, how would you calculate the potential increase in the money supply? The money supply M1 will increase by up to: 1billionx1RRR This is the power of the money multiplier on display. It also raises an important consideration… What would be the effect on the money supply if a central bank bought bonds and increased the RRR simultaneously? Indeterminate It would depend on the relative magnitude of the increase in money from the bond purchase and the decrease in money from the increase in the RRR. To answer with a precise number, you would need to know the quantity of reserves that banks would have to raise. AP Pro Tip You have studied fiscal policy, a way for lawmakers to moderate the business cycle; this lesson is about another way to achieve and maintain a steadier economy through monetary policy. To remember the distinction between fiscal policy and monetary policy, just look for the word "money." The money supply is the realm of central banks through monetary policy and its associated tools, while fiscal policy is government legislation changes in taxes and spending. It's important to memorize these; an AP Exam question could depend on it. For example, you may be asked to identify an appropriate monetary policy action to address high inflation—and some of the (wrong) answer options are about taxes or spending. The Fed Up to this point, most of the time the generic term "central bank" has been used to refer to the chief monetary authority in an economy. For the most part, that will continue for the rest of the course. However, there are specifics to the American monetary system that you need to know, starting with the fact that the central bank in the United States is not a single bank like the Bank of England for the United Kingdom, the Bank of Japan, or the European Central Bank. It is an elaborate network of banks known as the Federal Reserve Bank of the United States, the Federal Reserve System, the Federal Reserve for short, or just "the Fed" for shortest. The Fed has been affectionately referred to as a decentralized central bank, and this is because of the deep suspicion Americans have had of centralized authority going back to the protests of the tyranny of King George III in 1776. Thomas Jefferson led the successful push to close the First Bank of the United States (1791–1811) and Andrew Jackson declared the Second Bank of the United States unconstitutional so it expired (1816–1836). The United States then went 77 years without anything like a central bank. During that time there was explosive economic growth and occasionally, staggering economic downturns. These economic "panics" drove the U.S. Congress to establish the Fed in 1913 in the hope of preventing such wild business cycle downswings. History has not judged its job performance during the Great Depression favorably, but since then the business cycle has been significantly smoothed compared to its peaks and troughs in the century before the end of World War II. The Moral of the Story You've learned that monetary policy, not nominal interest rates or profit, drives the supply for money. But what drives monetary policy? In brief, the central banks of each major economy have developed their own specific set of goals, but the Fed states very plainly its three goals: 1. Maximum employment (NRU) 2. Stable prices 3. Moderate long-term interest rates The long-term interest rates goal was a later addition to the first two, which were together known as the dual mandate. You will see them illustrated in various publications like the above image. Note that it's a metaphorical dartboard with a theoretical bullseye. The Fed's monetary policy is going to be rather modest if the economy is just off center. However, if the unemployment rate and/or inflation rate has a short-run equilibrium "off the board," you're likely to see news stories of open market operations and/or adjusting the discount window. (Discount window is a figure of speech for changing the discount rate.) As a result of the Great Recession (2007–2009), the Fed changed its approach to monetary policy. In 2020, it permanently lowered the reserve requirement to zero. This meant the United States changed from a banking system with limited reserves to one with ample reserves. With no required reserves, all of a bank’s reserves are excess. This change meant that the traditional monetary policy tools aimed at the money supply would be ineffective. And so the Fed identified a new primary tool of monetary policy: the target range for the federal funds rate, or what banks charge each other for loaned reserve funds. Banks lend each other money from their excess reserves. In fact, this is preferred to borrowing from the Fed itself, which is considered "the lender of last resort." The Fed sets a target range for the interest rate that banks charge each other and bases its open market operations off of that goal. It is a potentially confusing quirk of history that the Fed's interest rate for loans to banks became known as the discount rate while the interest rate that banks charge each other is known as the federal funds rate. This "target practice" is not unique to the United States though, and the generic expression for the federal funds rate is the overnight interbank lending rate. Brain Check and Review What open market operation can a central bank use to increase the money supply in a limited reserves system? Buy government bonds Think this through. When the central bank buys bonds, that means they are putting more cash in circulation in exchange for that bond note. The bank that sold bonds to the central bank now has more excess reserves to lend out; the money supply is increased. Conversely, when the central bank sells bonds, it is taking currency out of circulation from the buyers of the bonds (banks); the banks have less to lend out. The central bank buying bonds increases/expands the money supply; selling bonds decreases/contracts the money supply. Also note: If you thought "decrease the reserve requirement/discount rate," or if your answer contained all three monetary policy actions, you would be in good company. AP Exam Readers note that students often make this mistake on FRQs. Rather than focusing on answering exactly what the prompt asks for, they list everything that comes to mind as related to the prompt. This is not what you want to do. Take the time to carefully read and analyze each question. How would the central bank change the discount rate to contract the money supply? Raise the discount rate Increasing the discount rate means that banks will pay more in interest to borrow funds. This would discourage banks from borrowing funds and thus discourage banks from increasing their own lending. This slows down the economy and thus raising the discount rate is contractionary monetary policy. In contrast, decreasing or lowering the discount rate is expansionary monetary policy. An expansionary monetary policy would be to ______ the reserve requirement. Decrease Decreasing or lowering required reserves is expansionary monetary policy. Remember, this is because if the reserve requirement is lower, say 2% instead of 10%, then banks can lend out more funds; more of their deposits end up as excess funds. Thus, lowering required reserves increases the money supply. On the other hand, raising required reserves is contractionary monetary policy for all the opposite reasons as above. Why would the central bank want to use contractionary monetary policy? To slow down inflation Monetary policy is another way to moderate an economy. Runaway inflation is a sign of an overheating economy. In addition, expectations of inflation can become a vicious cycle; individuals demand higher wages to pay for goods, so businesses raise prices to address higher input costs … Since the United States now has an ample reserves system, the Fed would increase its target range for the federal funds rate. In a limited reserves system, increasing the discount rate or reserve requirement and selling government securities are ways of applying the brakes; in all cases, the central bank is discouraging lending. Interest rates rise and thus spending by government, consumers, and businesses will slow down and help control inflation. Stretch Your Skills Note that the Fed is an independent agency or central bank. What this means is that though it was created by Congress, it has both private as well as public elements to it. The U.S. government determines its board members' salaries and outlined its "dual mandate" among its specific functions. However, the Fed does not depend on the U.S. government for funding as it provides services to member banks and conducts its own open market operations. Why does this matter to you? Note that in this course whenever you see a reference to government spending (G), the focus is fiscal policy. The Fed is not considered "government," and monetary policy is separate from fiscal policy, although the Fed does consider what's happening with fiscal policy before making its own changes. (You'll examine that last idea in more detail later.) The Reserve Market Note that the traditional tools of monetary policy (DR, RRR, OMO) are specific to and effective in a banking system operating with limited reserves. Essentially, this is any banking system with a nonzero reserve requirement. However, the Great Recession led the Fed and some other central banks to rethink their approach to monetary policy. When reserves are ample due to having no required reserves, expansion of the money supply is potentially infinite. The other traditional tools would have little to no impact on the economy. And so, the Fed identified a different market to influence in order to meet its dual mandate—the market for reserves. That may sound nonsensical when there’s no reserve requirement. Yet banks will still hold some funds in reserve to ensure they can meet their obligations to their depositors and to other banks. If they lent out every dollar in the vault, there would be no cash at the ATM when you show up to make a withdrawal; that would be bad for business. Thus there is a reserve market, a market where banks are borrowing funds from each other and from the central bank. The graph for this market illustrates the buying and selling of reserve funds. It looks a little different from other markets; carefully watch this video and draw the graph in your notes. Text Version AP exam questions on monetary policy will specify a system with limited or ample banking reserves. When it says ample, think of the reserve market and its graph. You must be able to draw this graph and shift it. Start with drawing the axes, label the x-axis Quantity of Reserves and the y-axis Policy Rate. [Hand draws a horizontal axis labeled Q of Reserves and a vertical axis labeled Policy Rate] This could also be administered interest rate or just interest rate, but with the ample reserves, we focus on the central bank’s target policy rate. More on that in a moment. Now, draw the demand for reserves. Its shape differs from other demand curves. It begins generally horizontal from the y-axis, [Hand draws line from high on the vertical axis partially rightward] reflecting the discount rate when reserves are extremely limited and commercial banks must borrow funds to meet reserve requirements. [Portion of horizontal axis highlighted from where it meets the vertical axis and extending rightward under the drawn line] At some point, the quantity of reserves is sufficient for banking needs, but is still limited. The demand then becomes downward sloping. [Hand continues the demand line at a downward angle] Demand for reserves is sensitive to the overnight interbank lending rate, or the interest rates that banks charge each other to borrow cash. With limited reserves, changes in the supply of reserves through the other monetary policy tools will influence this interest rate. [A point is highlighted on the downward-sloping portion of the demand curve, which moves along the curve showing that the quantity of reserves has an inverse relationship with the policy rate] However, when the required reserve ratio is zero, there will be ample reserves. Demand bottoms out at a lower bound. Label your demand curve D sub R1. The central bank’s target policy rate determines this lower bound. [Hand extends demand horizontally to the right from the bottom point of where the curve was downward-sloping and labels the end of the line D sub R 1] Next, draw a dashed line from the lower bound to the y-axis. Label it P R1. The policy rate is the overnight interbank lending rate. [Hand draws a dashed line from the start of the lower bound of demand to the vertical axis and labels it P R 1 along the axis] The central bank does not set this rate, but it sets a target range for it based on macroeconomic goals. The central bank targets this rate through other administered interest rates it controls, such as interest on reserves. [A bracket over a section of the vertical axis around P R 1 indicates that the policy rate is not a single interest rate but rather a target range] This is what the central bank pays to commercial banks for cash deposits held with the central bank, changing its own rates leads banks to change what they charge each other, as well as nominal interest rates. In an ample reserves system, traditional monetary policy tools have little effect. This is because the supply of reserves is near vertical. Draw this line and label it S sub R. [Hand draws a vertical line that intersects demand in its lower bound and meets the horizontal axis, then labels it S sub R] Supply moving left or right will not affect interest rates. In fact, the central bank will use open market operations just to maintain ample reserves. [The vertical supply line moves to the left and right within the lower bound of demand, showing that as the quantity changes there is no change in the policy rate] In an ample reserves system, interest rates are the primary monetary policy tool. Say there’s an inflationary gap and prices are rising fast. The central bank could adjust its target policy rate and influence it by changing its own interest rates. Likely it will change all its rates together in the same direction. Raising interest rates slows inflation. [The points where the upper and lower bounds of demand meet the vertical axis are highlighted and paired with upward-psointings arrows] Show this by adjusting the upper and lower bounds of the demand curve upward. The downward-sloping portion does not change. Be sure to label the new curve D R2, label the new target policy rate P R2, and add upward arrows. [Hand draws a new, higher upper and lower bounds for demand, labeling the end of the lower bound D sub R 2, drawing a new dashed line from the lower bound to the vertical axis and labeling it P R 2, and adding upward arrows between the upper and lower bounds of demand and the two policy rate labels] By increasing its interest rates, the central bank causes nominal interest rates to increase. In turn, this reduces consumption, decreasing aggregate demand, real output, and the price level. On the other hand, say there’s a recession in a system with ample reserves. To encourage consumption, the central bank could lower its administered interest rates. [Original graph of reserve market reappears] Show this by drawing a decrease in both the upper and lower bounds of your demand curve, label the new curve, the new lower policy rate, and include the downward arrows. [Hand draws a new, lower upper and lower bounds for demand, labeling the end of the lower bound D sub R 2, drawing a new dashed line from the lower bound to the vertical axis and labeling it P R 2, and adding downward arrows between the upper and lower bounds of demand and the two policy rate labels] The decreased rates influence nominal interest rates downward, thus the increasing consumption, aggregate demand, real output, and the price level. So there you have it. Keep practicing to master graphing the effects of monetary policy on the reserve market. Print Show Video In an ample reserves system, what is the primary monetary policy tool? Administered interest rates With ample reserves, the central bank will adjust its own policy rate(s) to influence what banks charge each other to borrow funds. These rates are what it pays on reserves held with the central bank and what it charges to borrow funds. These form the target range for the policy rate. What will the Fed do when inflation is out of control? In the prior question, you may have been tempted to mention increasing the reserve requirement or selling bonds. Both are contractionary, for sure, but remember that they are only effective in a limited reserves system. Since the Fed's zero reserve requirement is permanent, the plan to maintain ample reserves is expected to be permanent. Thus, anytime the Federal Reserve is directly mentioned on the AP Exam, assume you are working with ample reserves and the reserve market graph. Monetary Policy in Action Just like with fiscal policy, monetary policy actions can be classified as either expansionary or contractionary. The direct effects of monetary policy in a limited reserves system can also be illustrated on a money market graph. Expansionary Monetary Policy with Limited Reserves Expansionary actions increase the money supply, shifting it to the right, and thus lowering interest rates. Tool of the Fed Expansionary Action Discount Rate Decrease/lower Reserve Requirement Decrease/lower Open Market Operations Buy securities Contractionary Monetary Policy with Limited Reserves Contractionary actions decrease the money supply, shifting it to the left, and thus raising interest rates. Tool of the Fed Contractionary Action Discount Rate Increase/raise Reserve Requirement Increase/raise Open Market Operations Sell securities Remember that the effect of open market operations on the money supply is greater than the effect on the monetary base because of the money multiplier. (Again, this is specific to a banking system that has a reserve requirement, or limited reserves.) Monetary Policy with Ample Reserves—Target Policy Rate in the Reserve Market  Expansionary—decrease/lower policy rate  Contractionary—increase/raise policy rate Ultimately, a central bank is trying to help achieve economic stability just as the government seeks the same through fiscal policy. Whereas the government changes its taxing and spending and has a direct impact on AD, however, a central bank's direct impact is on the money supply or on the reserve market, which will indirectly affect AD. Of course, you can argue that adjusting the policy rate in a system with ample reserves is perhaps a bit more direct than use of the traditional tools. This is because it affects nominal interest rates sooner. Hang in there—keep sketching and taking notes. Real News At the end of 2020, the Fed released a public statement, reading in part: “Effective December 17, 2020, the Federal Open Market Committee directs the [Open Market] Desk to:   Undertake open market operations as necessary to maintain the federal funds rate in a target range of 0 to 1/4 percent.  Increase the System Open Market Account holdings of Treasury securities by $80 billion per month and of agency mortgage-backed securities (MBS) by $40 billion per month. …" What does the quote reveal about the state of the economy and monetary policy at the time? The economy was likely in a recession, as the Fed wanted to stimulate the economy. A federal funds rate target between 0 and a mere quarter of a percent is extremely low. Likely before this announcement, the target policy rate had been higher. "Increase … holdings of Treasury securities" means that the Fed would be purchasing bonds, which also sounds expansionary. And it is, in a system with limited reserves. However, recall that now the Fed only uses open market operations to maintain ample reserves. The first bullet is a clearer indication of expansionary policy. Calculating the Effects in a Limited Reserves System You can calculate the potential impact of a monetary policy action with real data and should expect to do so on exams. Try these in your notes, step by step. Bountiful Bank's Balance Sheet Assets Liabilities Reserves $400,000 Demand deposits $900,000 Loans $150,000 Owner's equity $200,000 Securities $200,000 Facilities $150,000 Equipment $200,000 Assume that the reserve requirement is maintained at 10%, and that the central bank purchases $40,000 in securities from Bountiful Bank. What changes in this bank's balance sheet? What is the potential change in the money supply from this transaction? Start by determining the parts of the bank balance sheet affected. Bountiful Bank's Balance Sheet Assets Liabilities Reserves $400,000 + $40,000 = $440,000 Demand deposits $900,000 Loans $150,000 Owner's equity $200,000 Securities $200,000 – $40,000 = $160,000 Facilities $150,000 Equipment $200,000 The bank sells $40,000 in securities to the central bank. So, its securities are lower, but from that same transaction the bank adds that amount in cash from the central bank to its reserves. Asset and liability balance is maintained, because open market transactions have no effect on demand deposits. Thus, the bank's reserves increase by $40,000. Now use the 10% reserve requirement to determine the potential change in the money supply from this transaction. Bountiful Bank's Balance Sheet Assets Liabilities Reserves $400,000 + $40,000 = $440,000 Demand deposits $900,000 Loans $150,000 Owner's equity $200,000 Securities $200,000 – $40,000 = $160,000 Facilities $150,000 Equipment $200,000 Because demand deposits and the reserve requirement have not changed, the required reserves amount will not change. That $40,000 will be part of excess reserves. Thus, you can multiply it by the reciprocal of the reserve requirement to determine the potential change in the money supply in the overall economy: $40,000 x (1/RRR or 1/0.10 or 10) = $400,000 potential increase After this open market transaction, assume the central bank reduces the reserve requirement to 5%. How will this action change the money supply? Assets Liabilities Reserves (Total after OMO) $440,000 Demand deposits $900,000 At 10% RRR, excess reserves = $350,000 RRR 10% = $90,000 At 5% RRR, excess reserves = $395,000 RRR 5% = $45,000 Excess reserves increased by $45,000. Loans $150,000 Owner's equity $200,000 Securities $200,000 – $40,000 = $160,000 Facilities $150,000 Equipment $200,000 Now the demand deposits matter. The reserve requirement has been cut in half, from 10% to 5%. Thus, Bountiful Bank can lend out more money, potentially increasing the money supply in the economy. Do the math just based on the change in excess reserves: $45,000 x (1/RRR or 1/0.05 or 20) = $900,000 potential increase No math required—just think: what would have been different had the central bank sold securities to Bountiful Bank or if it had raised the reserve requirement? No math required—just think: what would have been different had the central bank sold securities to Bountiful Bank or if it had raised the reserve requirement? Selling securities or raising the reserve requirement would have reduced Bountiful Bank's excess reserves. In either case, the impact would have been to slow the expansion of the money supply or even decrease the money supply in the overall economy, depending on the specific values. in the overall economy, depending on the specific values. PreviousNext 1. 2. 3. 4.  5. Is calculating the impact of monetary policy any different than calculating the change in a bank's deposits? Explain. Yes, it is different. Remember that if a bank's demand deposit funds value changes, you first have to reduce (or add) to the bank's reserves the change in required reserves. In the Bountiful Bank example, the sold securities' value went straight to excess reserves, because initially there was no change in reserve requirement. Had that $40,000 been an increase in demand deposits instead, first it would be reduced by the reserve requirement (10% = $4,000). So only the new excess reserves would be used to determine the potential change in money supply ($36,000 x 10 = $360,000 versus the $400,000 from the OMO). Does the central bank selling securities change a bank's level of required reserves? No, not in the short run anyway. "A bank's level of required reserves" is referring to the literal funds in the bank after the transaction. This is not the same as the required reserve ratio, a central bank tool separate from open market operations. Now, had the question asked about "excess reserves," then yes, excess reserves would decrease in the short run from the bank buying securities from the central bank (taking cash out of its reserves). Monetary Policy and AD Recall that when the economy is in recession, the expected policy action would be expansionary to stimulate the economy. When the economy is overheating in an inflationary gap, policies will likely be contractionary. The key difference in fiscal and monetary policy, however, is how exactly this plays out. Fiscal policy, or changes in government spending and taxing, directly targets aggregate demand. Remember that G is a component of AD. Whether via the money supply or reserve market, monetary policy affects interest rates and thus will indirectly affect AD. Remember the big picture goal of macroeconomics: stated positively, to maintain steady economic growth; or negatively, to avoid repeating the Great Depression. So the analysis returns to aggregate demand. Y = C + I + G + XN Whereas fiscal policy targets "G," monetary policy targets "C" and "I" as follows:   If the economy is in a recession, the central bank will pursue an expansionary monetary policy. In a limited reserves system, they will expand the money supply. In an ample reserves system, they will lower the policy rate. This will lead to lower nominal interest rates, with the goal of stimulating (increasing) household consumption and business investment.  If the economy is overheating, the central bank will pursue a contractionary monetary policy. With a limited reserves system, they will decrease the money supply. In an ample reserves system, they will raise the policy rate. This will lead to higher nominal interest rates, with the goal of tapping the brakes on (slowing down) household consumption and business investment. Monetary Policy Basic Causal Chain Δ Tool → Δ MS/Policy rate → Δ Nom. ir → Δ C + I → Δ AD → Δ rGDP/PL The causal chain of a monetary policy action is critical for you to recognize and be able to reproduce on the AP Exam, both graphically and logically in writing. Copy and complete this chart in your module note guide. Using arrows, or decrease/increase, or rises/falls, are all fine as long as you have the correct direction of change. Expansionary monetary Contractionary monetary policy policy If the Central Bank Example: Central Bank buys Example: Central Bank sells uses… bonds bonds then 1. Excess reserves _____ Excess reserves ↓ 2. Federal funds rate ↓ Federal funds rate _____ 3. Money supply ____ Money supply _____ 4. Interest rate ____ Interest rate ↑ 5. Investment spending _____ Investment spending _____ 6. Aggregate demand ↑ Aggregate demand _____ 7. Real GDP _____ Real GDP _____ Check your chart  Expansionary monetary Contractionary monetary policy policy If the Central Bank Example: Central Bank buys Example: Central Bank sells uses… bonds bonds then 1. Excess reserves ↑ Excess reserves ↓ 2. Federal funds rate ↓ Federal funds rate↑ 3. Money supply ↑ Money supply ↓ 4. Interest rate↓ Interest rate ↑ 5. Investment spending ↑ Investment spending↓ 6. Aggregate demand ↑ Aggregate demand↓ 7. Real GDP ↑ Real GDP↓ The Limitations of Monetary Policy The recognition and administrative time lag is not as bad for monetary policy as it is for fiscal policy because of fewer distractions; the government has to worry about many more things and is by definition more political. However, the lags are still there for monetary policy as well. By the time what to do about a problem is being discussed, it might have been monitored with concern for a full quarter of a year or more. Then, there is the actual time it takes to implement whatever policy is decided. Monetary policy actions like open market operations and adjusting interest rates are still faster to conduct than waiting for a bill to pass Congress. Whether fiscal or monetary, intervention in the economy has timing issues. The unique limitation of monetary policy, however, is its inability to stimulate aggregate demand directly. When the government increases discretionary spending, real output immediately results and the multiplier effect can further encourage household consumption and/or business investment. But with an increase in the money supply or lowered interest rates, banks might just hold onto much of those excess reserves if they do not identify credit-worthy borrowers. This would mean little movement of the AD curve, and the recessionary gap would persist despite the money injection and lower interest rates. Thus, the initial lag (caused recognition and administrative lags) for fiscal policy is longer than it is for monetary policy, while the effect lag (operational lag) for fiscal policy is shorter than it is for monetary policy. Chapter 7 Borrowers, Savers, and Lenders You have learned about how banks and other financial institutions work. They earn profit, and increase the monetary base, by taking deposited and invested funds and lending those funds out to others. Now you'll take a closer look at this market. Loanable funds are a major driver of the household consumption and business investment components of aggregate demand, and therefore understanding the market for them is very important to analyzing the macroeconomy. There are several things about the loanable funds market that you must keep in mind:  Loanable funds are in fact banks' excess reserves, so also think "bank reserves market."  Banks' reserves come from customer deposits, so the savings of households, businesses, any government surplus, and savings from international sources together create the supply of loanable funds.  Savings and loans are long-term transactions. Thus, their pricing involves the real interest rate rather than the nominal; the inflation rate is a major factor. The construction of this business is likely made possible with a loan from a bank, which obtained those funds to loan from people's savings. What would be the impact on the loanable funds market if the central bank pursues an expansionary monetary policy? The supply of loanable funds would increase. Think of the asset column of a bank balance sheet. In a limited reserves system, either bonds are being converted to excess reserves as the central bank buys them or required reserves are becoming excess reserves. In an ample reserves system, interest rates are lower making it less expensive for banks to borrow funds and profit by lending them out. Either way, the banks have more funds they can loan out, and the S LF will shift right. Now it's time to look at the other loanable funds market shifters. Stretch Your Skills "With interest rates this low, let's go for that electric car." That is a classic expression of interest-sensitive consumption, the simple idea that some consumers will "go for it" on borrowing money for bigger purchases in response to lower interest rates. This can be the Fed's big hope for helping the economy get out of a recession, or a major drawback to government deficit spending—a concept you'll touch on in this lesson but learn much more about later. For now, just recognize that "deficit spending" means the government is borrowing funds to increase its spending in the economy. What Shifts the LF Curves? One of the most critical first principles to learn in all the markets you've learned so far has been the determinants of supply and demand—what moves the whole curves. The loanable funds market is no different. Hopefully, this MS. FADE mnemonic will help. Consider as well that there are correlations to TRIBE and ROTTEN you learned as basic shifters of any market; looking for those connections and noting them will help you remember. Beware though, if your study is not combined with practice and review, it'll be about as helpful as a new phone case that the phone is never put in; when the drop happens, so will the cracks. LF Supply Shifters o Monetary policy. If the money supply increases, so will the supply of loanable funds. The relationship is direct. o Saving in the economy. No need to overthink this: anything that increases national savings, such as the marginal propensity to save, will increase the supply of loanable funds. This is also a direct relationship. Dissavings result in a leftward shift in loanable funds. o Foreign exchange changes. A whole unit will be dedicated to this; for now just think of changes in international financial investments, known as net capital inflows (whether more funds are coming into or going out of the economy from or to others). An increase in net capital inflows increases national investment and will shift the supply of loanable funds to the right. LF Demand Shifters o All borrowing, lending, credit. This is something of a catch-all. This is any change in consumer or business confidence—anything that makes people more or less willing and able to borrow at every real interest rate level. o Deficit spending by the government is only possible through loans, so an increase in deficit spending shifts LF demand right and a decrease in defiict spending shifts LF demand leftward. o Expectations of future economic conditions. If borrowers expect the future to be better or worse for borrowing funds, that can shift market demand. For example, If the government offers an investment tax credit reducing businesses'  taxes if they invest in capital, that would increase demand for loanable funds when the credit takes effect. Practice For each of the following scenarios, sketch a loanable funds market. Illustrate what shift(s) will occur and identify what will happen to the equilibrium real interest rate and the equilibrium quantity of loanable funds exchanged. People begin to save more for retirement. The supply of loanable funds will shift right. The real interest rate will decrease and the equilibrium quantity of loanable funds will increase. It would not be wrong to say that the demand for loanable funds would shift left a bit as some loans are not taken out due to the shift toward savings. However, if you missed that the supply of loanable funds would shift right you would definitely get this wrong on the AP Exam. More savings directly represent a greater supply of loanable funds. Simultaneously, the government decreases deficit spending while the central bank lowers the reserve requirement.  The decrease in deficit spending decreases the demand for loanable funds.  The lower reserve requirement increases the supply of loanable funds.  The equilibrium real interest rate (IRR) will decrease, and the equilibrium quantity of loanable funds change will be indeterminate—it could decrease, stay the same, or increase. Remember that when you see the lopsided hashtag, either the x-axis or y-axis value will be #indeterminate. The best way to determine outcomes is to treat each shift's impact separately.  The decrease in deficit spending decreases the IR R and decreases the quantity of loanable funds transacted.  The lower reserve requirement decreases the IR R and increases the quantity of loanable funds transacted.  They both decrease the IRR but work in opposing directions on the quantity of loanable funds exchanged—without knowing the relative impact of each, the change in quantity is indeterminate. The economy is booming, and high-dollar tech product innovations are popular with consumers. The