Unit 4- Monetary Policy

Types and Functions of Money

• 3 types of money: Commodity, Representative, and Fiat
• Commodity- a good that has other purposes serves as money; not usually divisible or durable
• Representative- currency being used represents a specific quantity of a precious metal; for example: the gold standard of the old U.S.
• Fiat- money is not backed by a precious metal; it is legal tender that must be accepted for transactions and is backed by the word of the government

• Functions of money- Medium of exchange, Store of Value, and Unit of Account
• Medium of Exchange- trade money for a desired good or service
• Store of Value- putting money in a bank and expecting it to retain value
• Unit of Account- equating price to worth(value and quality)

Money Market Graphs

• Vertical Axis- interest rate(i)
• Horizontal Axis- Quantity of Money
• The demand for money is sloping down because when the interest rate is high, the quantity of money demanded is low
• The supply of money is vertical because it does not vary based on the interest rate, instead it is set by the Fed
• When demand increases, there is upward pressure on interest rates
• The Fed can increase money supply to bring interest rates back down

Fed's Tools of Monetary Policy

• There are two types of monetary policies: Expansionary(easy money) and Contractionary(tight money)
• The Fed can control the Reserve Requirement(RR) which is the percentage of the bank's total deposits that they must hang on to
• If the Fed wants to increase money supply, then they can lower the RR because the money that has been in RR becomes excess reserves which is the money that can be loaned out
• The Fed can control the discount rate which is the interest rate at which banks can borrow money from the Fed
• If the Fed wants to increase money supply, then they can lower the discount rate which encourages banks to borrow more money
• Most common tool of the Fed is buying and selling government bonds/securities
• If the Fed wants to increase money supply, then it buys bonds/securities

Loanable Funds Market

• Loanable funds is the money that is in the banking system that is available for people to borrow
• Vertical Axis- Interest rate(i)
• Horizontal Axis- quantity of loanable funds (Qlf)
• The demand for loanable funds is downward sloping because when the interest rate is higher then people want to borrow less
• The supply of loanable funds is upward sloping - it comes from the amount of money people have in banks (dependent on savings); the more money people save then the more money the bank has available for loans
• If people have incentives to save less, then the supply of loanable funds shifts to the left
• If the government is running a deficit: demand for money shifts right, interest rates increase, and the demand for loanable funds increases

Money Creation and Multiple Deposit Expansion

• Banks create money by making loans
• The money multiplier (1/RR) is used to determine the total amount of money created on a loan; the formula is: amount deposited x money multiplier
• Multiple Deposit Expansion- all the potential loans that are possible if a person deposits a set amount of money
• Depositing a set amount of money doesn't mean it is guaranteed to make the maximum amount of money because it is assuming that the banks have no excess reserves
• If there are excess reserves, it decreases the total increase of money

Relating Money Mkt, Loanable Funds Mkt, and AD-AS

• Money Market- the vertical axis is interest rate and the horizontal axis is the quantity of money. The demand for money is downward sloping while the supply of money is vertical because it is controlled by the Fed.
• Loanable Funds Market- the vertical axis is interest rate and the horizontal axis the quantity of loanable funds. The demand for loanable funds is downward sloping while the supply of loanable funds is upward sloping.
• AD-AS- the vertical axis is price level and the horizontal axis is the GDP. AD is downward sloping while AS is upward sloping.
• In Deficit spending: In the money market the demand for money increases and interest rate increases, in the loanable funds market the demand for loanable funds also increases along with the interest rate or the supply of loanable funds decreases, in AD-AS the AD increases along with the price level and GDP
• MV = PQ ; an increase in interest rate also increases price level

Fiscal Policy

• Changes in the expenditures or tax revenues of the federal government

Tools of Fiscal Policy

• Taxes- Government can increase or decrease taxes
• Spending- Government can increase or decrease spending

Budgets

• Balanced budget- Revenues = Expenditures
• Budget deficit- Revenues < Expenditures
• Budget surplus- Revenues > Expenditures
• Government debt- Sum of all deficits - sum of all surpluses
• Government borrows from: individuals, corporations, financial institutions, and foreign governments whenever it is is in a deficit

Fiscal Policies

• Discretionary- requires government action
• Automatic- takes effect without action from the government
• Contractionary- response to inflation, decrease government spending and increase taxes
• Expansionary- response to recession, increase in government spending and decrease in taxes

Automatic Stabilizers

• policies and programs that are designed to offset shifts in the economy that do not require government action
• Examples: welfare checks and social security

Tax Systems

• Progressive Tax System- average tax rate (Tax Revenue/ GDP) rises with GDP
• Proportional Tax System- average tax rate remains constant as even as GDP changes
• Regressive Tax System- average tax rate falls with GDP

Consumption and Savings

Consumption

Disposable Income (DI)

• the net income or the income after taxes
• DI= Gross Income - taxes
• Households can either consume or save disposable income

Consumption

Household spending

The ability to consume is constrained by - the amount of disposable income and the propensity to save   

Savings

• Household are not spending
• The ability to save is constrained by the amount of disposable income and the propensity to consume

Average Propensity to Consume (APC) and Average Propensity to Save (APS)

• APC + APS = 1
• 1 - APC = APS
• 1 - APS = APC
• APC > 1 .: Dissaving
• APS .: Dissaving

Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS)

• Marginal propensity to consume - ΔC/ CD 
• % of every extra dollar earned that is spent

• Marginal Propensity to save - ΔS/ ΔDI
• % of every extra dollar earned that is saved

• MPC + MPS = 1
• 1 - MPC = MPS
• 1 - MPS = MPC

Spending Multiplier

• An initial change in spending (C, IG, G, XN) causes a larger change in Aggregate Spending, or Aggregate Demand
• Multiplier = Δ AD / Δ C,I,G,or X
• Multiplier = 1 / (1-MPC) or 1/MPS
• Multipliers are positive when there is an increase in spending and negative when there is a decrease

Tax Multiplier

• When the government taxes, the multiplier works inverse
• Tax Multiplier = -MPC / (1-MPC) or -MPC / MPS
• If there is a tax-cut, then the multiplier is positive

Schools of Economics

Classical

• Modern Followers: Adam Smith, John B. Say ,David Ricardo, and Alfred Marshal
• Say's Law: supply creates its own demand, production = income = spending, under spending us unlikely, whatever output produced will be demanded
• Savings (leakage) equals investment (injections)
• prices and wages are flexible downward
• supply curve is vertical
• Aggregate supply determines output and employment
• Unemployment rarely exists due to wage/price flexibility
• Aggregate demand determines price level and is usually stable
• Basic Equation: MV = PQ
• Role of Government: monetary rule, maintain money
• Laissez faire is best
• Economy is self regulating
• Inflation is caused by too much money
• The short run is actually short

Keynesian

• Modern followers: J.M. Keynes
• Say's Law: depressions refute Say's law, demand creates own supply, under spending persists
• Savings does not equal investments; different motivations
• Prices and wages are inflexible downward ; known as Ratchet Effect
• Supply curve is horizontal
• Aggregate demand determines output and employment
• Unemployment usually exists
• Aggregate demand changes due to determinants and is usually unstable
• Basic Equation: C + Ig + G + Xn = GDP
• Role of government: fiscal policy is tax and spend, believe in active government, economy is not self regulating
• Inflation caused by too much demand
• Short run is actually long

Investment Demand and Interest Rates

Investment Demand

• Investment- money spend or expenditures on: new plants, physical capital, new technology, new homes, and inventories (goods sold by producers)
• Shape of the ID curve is downward sloping because, when interest rates are high, fewer investments are profitable; when investment rates are low, more investments are profitable

Shifts in Investment Demand

• Costs of production

  -Lower costs shift ID right
 - Higher costs shift ID left

• Business taxes

-Lower business taxes shift ID right
-Higher business taxes shift ID left

• Technological change

-New technology shift ID right
-Lack technology change shifts ID left

• Stock of Capital

-economy is low on capital, then ID shifts right
-economy has plenty of capital, then ID shifts left

• Expectations

-Positive expectations shift ID right

-Negative expectations shift ID left

Interest Rates

Expected Rates of Return

•  businesses make investment decisions with cost/benefit analysis
•  businesses determine the benefits of investment with the expected rate of return
•  business count the cost with the interest cost
• business determine the amount of Investment they undertake?                                       - Compare expected rate of return to interest cost                                                         - If expected return > interest cost, then investment should be made                             - If expected return < interest cost, then don't invest

Real Interest Rate (r%) vs Nominal Interest Rate (i%)

• Nominal is the observable rate of interest
• Real subtracts out inflation (π%) and is only known ex post facto (after the fact)
• real interest rate (r%) formula: r% = i% - π%

Aggregate Demand and Aggregate Supply

Aggregate Demand

• demand by consumers, businesses, government, and foreign countries
• relationship between price level and real GDP output is indirect

Reasons Why AD is Downward Sloping

1. Real - Balance Effect- higher price levels reduce the purchasing power of money

• decreases the quantity of expenditures
• Lower price levels increase purchasing power and increase expenditures.

      2. Interest - Rate Effect- When the price level increases, lenders need to charge higher interest rates to get a return on their loans.

• Higher interest rates discourage business investment and consumption

     3. Foreign Trade Effect- When U.S price level rises, foreign buyers purchase fewer U.S goods and Americans buy more foreign goods.

• Exports fall and imports rise causing real GDP demanded to fall

Shifts of AD

• components of GDP (Consumption, Domestic Investment, Government Spending, and Net Exports) shift AD

Consumption

1. Consumer wealth

• More wealth = more spending (AD shifts right)
• Less wealth = less spending (AD shifts left)

2. Consumer expectations

• Positive expectations = more spending (AD shifts right)
• Negative Expectations = less spending (AD shifts left)

3.Household Indebtedness

• Less debt = more spending (AD shifts right)
• More debt = less spending (AD shifts left)

Domestic Investment

1. Real interest rate

• Lower real interest rate = more investment (AD shift right)
• Higher real interest rate = less investment (AD shifts left)

2. Expected Returns

• Higher expected returns = more investment (AD shift right)
• Lower expected returns = less investment (AD shift left)
• Expected returns are influenced by: Expectations of future profitability, Technology, Degree of excess capacity, Business taxes

Government Spending

• More government spending (AD shift right)
•  Less government spending (AD shift left)

Net Exports

1. Exchange Rates

• Strong USD = more imports and fewer exports (AD shifts to left)
• Weak USD = fewer imports and more exports (AD shifts to right)

2. Relative Income

• Strong foreign economy = more exports (AD shifts to right)
• Weak foreign economy = less exports (AD shifts to left)

Aggregate Supply

• level of real GDP that firms will produce at each price level

Long run AS

• Period of time where input prices are completely flexible and adjust to changes in the Price level
• In the long-run, the level of Real GDP supplied is independent of the price level
• Long-run Aggregate Supply or LRAS marks the level of full employment output
• LRAS is vertical at the economy's level of full employment.

Short run AS

• Period of time where input prices are sticky and do not adjust to changes in the price level.
• In the short run, the level of real GDP is directly related to the price level
• Because input prices are sticky in the short-run, SRAS is upward sloping

Shifts in SRAS

• An increase in SRAS is a shift to the right.
• A decrease in SRAS is a shift to the left
• Per unit cost of production = Total input cost / Total output

Input Prices

• Domestic Resource Prices

          - Wages (75% of all business costs)

          - Cost of Capital

          - Raw materials (commodity prices)

• Foreign Resource Prices

          - Strong USD = lower foreign resource prices

          - Weak USD = higher foreign resource prices

• Market Power

          - Monopolies and cartels that control resources control the price of those resources

          -Increase in Resource Prices = SRAS left

          -Decrease in Resource Prices = SRAS right

Productivity - Total output / Total inputs

• More productivity- lower unit production cost = SRAS right
• Lower productivity-higher unit production cost = SRAS left

Legal-Institutional Environment

• Taxes (money to government) on business increase per unit production cost = SRAS left
• Subsidies (money from government) to business reduce per unit production cost = SRAS right

Government Regulation

•          Government regulation creates a cost of compliance = SRAS left
•          Deregulation reduces compliance costs = SRAS right