Tools of Monetary Policy & 3 Shifters of MS (04/03/17

The FED adjusting the money supply by changing any one of the following:

1. Reserve Requirement
2. Open Market Operation 
3. Discount Rate

Reserve Requirement

In the Reserve Requirement the FED sells the amount that banks must hold. 

The reserve requirement (reserve ratio) is the percent of deposits that banks must hold in reserve (the  percent they can NOT loan out)

If there is a recession what should the FED do to reserve requirement?

Decrease the Reserve Ratio

1. Banks hold less money and have more excess reserves
2. Banks create more money by loaning out excess
3. Money supply increases, interest rates fall, AD goes up. RR↓ MS↑ i↓ I↑ AD↑

If there is inflation what should the FED do to the reserve requirement?

Increase the Reserve Ratio

1. Banks holds more money and have less excess reserves
2. Banks create less money
3. Money supply decreases, interest rates up, AD down. RR↑MS↓ i↑I ↓AD↓

Open Market Operation 

• Open money operation is when the FED buys or sells government bonds (securities)
• This is the most important and widely used monetary policy
• If the FED BUYS bonds it takes bonds out of the economy and replaces them with money. MS↑
• If the FED SELLS bonds it takes money and gives the securities to the investor. MS↓
• It also depends on whether or not the Purchase (or sale) is from a bank or from the nonbank pubilic

Discount Rate

The Discount Rate is the interest rate that the FED charges commercial banks for short term loans.

Federal Funds Rate 

The Federal Funds Rate is the interest rate that banks charge one another for overnight loans.

When they say the FED has "raised rates" they will charge us more to take out a loan.

The Prime Rate 

It is the interest rate that banks charge their most credited worthy customers.

Money Creation Process (03/29/17)

Money Creation Process

Required Reserves = 100 (.10 x $ 1000)

Single Bank: Amount of money they can loan out (ER).

$1000 - 100 = $900

Banking system: Can create money by a MULTIPLE of its initial excess reserves.

1/RRR = 1/.10 = 10    $900 x 10 = $9000

ER x mm 

Total Change in money supply as a result of the deposit:

Initial Deposit   +   Banking system created money  = Total Change in MS

     $1,000          +                         $9,000                   =       $10,000

Money creation (03/27/17)

Money Creation Formula

• A single bank can create $ by the amount of its excess reserves

• The banking system as a whole can create $ by a multiple of the excess reserves

• MM x ER = Expansion of money 

• Money Multiplier = 1/RR 

New vs Existing $

• If initial deposit in a bank from FED or bank purchase of a bond or other money out of the circulation ( buried treasure), the deposit is immediately increases the money supply.

• The deposit then leads to further expansion of the money supply through the money creation process.

• Total change in MS if initial deposit is new $ = Deposit + $ created by banking system.

• If a deposit in a bank is existing $ (already counted in M1; ex: currency of checks), depositing the amount does NOT change the MS because it is already counted.

• Existing currency deposited into a checking account changes only the composition of the money supply from coins/paper $ to checking accounts deposits

• Total change in the MS if deposit is existing $ = banking system created money only.

Practice:

http://schools.birdvilleschools.net/cms/lib2/TX01000797/Centricity/Domain/4466/Classroom%20practice%20on%20Banking%20and%20Money%20Creation.pdf

Money Market (03/23/17)

Money Market

(Supply and Demand for money)

 Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded.

Money Demand Shifter 

1. Changes in price level
2. Changed in income
3. Changes in taxation that affects investment 

Increasing the Money Supply 

Increase money supply > decrease interest rate > increase investment > increase AD

How do banks create/make money

Demand deposits are created through the Fractional reserve system.

• It is the process in which banks hold a small portion of their deposits in reserve, and they loan out the excess
• Banks keep cash on hand (required reserves) to meet depositors needs
• Banks must keep reserve deposits in their volts or at their district FED
• Total reserve (total funds held by a bank) =

Required reserves + excess reserves

• Banks can only lend out their excess reserves 

Bonds & Stocks(03/22/17)

Bonds & Stocks

Bonds are loans, or IOUs, that represent debt that the government or corporation must repay to an investor.

The bond holder has NO OWNERSHIP of the company.

• If a corporation issues and then sells a bond,

- it is a liability or an asset for the corporation? Liability!

- it is a liability or an asset for the buyer? Asset!

• If that corporation issues a 10K loan with a 10 yr term and a 5% interest 

- What is the nominal interest rate at the time of issue? 5%

- If the Nominal interest rate falls 3%, what happens to the value of the bond? Increase

- If the Nominal interest rate rises 8%, what happens to the value of the bond? Increase

Stockowners can earn a profit in two ways:

1. Dividends, which are portions of a corporations profits, are paid out to stockholders.

The higher the corporate profit, the higher the dividend.

2.  A capital gain is earned when a stockholder sells stock for more than he or she paid for it.

A stockholder that sells stock at a lower price than the purchase price suffers a capital loss.

Financial Institutions (03/21/17)

Purposes of Financial Institutions:

a. Store $

b. Save $

- savings account
- checking account
- CD
- money market

c. Loan $

Interest- price paid for the use of borrowed money

Principal- amount that you borrow

Types of Financial intermediaries:

Credit Union

1. Comercial Bank
2. Savings + Loans Institutions
3. Credit Union
4. Mutual Fund Companies
5. Finance Companies

The Financial System

Assets: Anything of monetary value owned by a peerson or business.

• Financial Asset- a paper claim that entitles the buyer to future income from the seller
• Physical Asset-  a claim on a tangible object (ex: house, car)

If you go to your bank and take out a loan ... the bank has created a Financial Asset 

You have created a Liability

Liability - a requirement to pay money in the future ( usually with interest)

• There are 5 major financial assets: Loans, Stocks, Bonds, Loan-backed securities and bank deposits.

The Time Value of Money - A dollar is worth more today than it is tomorrow, you are losing monry every secon you are not investing it.

Present Value Vs. Future Value

FV = Future value   PV = Present value   i = Nominal Interest rate   t = time

Future Value: If you invest( or lend ) money to someone according to the following equation:

 FV= PV(1 + i)^t

Present Value: Is the amount of money I need to invest now, in order to get some amount ( FV is Known) in the Future.

 PV = FV/( 1 + i  )^N

Time Value of Money

v = FV  p = PV  k = number of times interest is credited per year   n = year r = real interesst rate

• The Simple Interest Formula

v = (1 + i )ⁿ * p

• The Compound Interest Formula

v = (1 + r/k )^nk    * p

Money (03/20/17)

The Barter System: goods and services are traded directly. There is no money exchanged.

Money: is anything that is generally accepted in payment for goods and services. Money is not the same thing as wealth or income.

Wealth: is the total collection assets that store value.

Income: is a flow of earnings per unit of time.

Money can be usd as:

1) Medium of Exchange: it is used to determine value.

2) Unit of Account: comparing cost or price.

3) Store of value: how wel does the money hold.
-Where do you put it and when do you expect it to grow

Types of Money

Characteristics of money

1) Durability: money is durable
2) Portability: you can carry it anywhere
3) Uniformity: all the same
4) Divisibility: break it in many ways
5) Limited supply
6) Acceptability

Liquidity: ease with which an asset can be accessed and converted into cash (liquidized).

Types of Money Supply

M1 (High liquidity) - Coins, Currency, and Checksble deposits ( personal and corporate checking accounts which are the largest components of M1). AKA demand deposits.
In general, this is the money supply.

M2 (Mediun Liquidity) - M1 plus savings deposit ( money market accounts), time deposits ( CD = certificate of deposit), and Mutual Funds below $100K.

M3 ( Low Liquidity)- M2 plus time deposits above $100k.