Section 5: The Financial Sector
REVIEW
Saving-Investment Identity
(Remember: One persons spending is another person’s income)
Closed Economy = no government & no interaction with other
countries.
• Total income = Total spending
People have two chooses: Spend or Save
• Total income = Consumer spending + Savings
Spending consists of either: consumer spending or investment
spending
• Total spending = Consumer spending + Investment spending
Putting these together:
• Consumer spending + Savings = Consumer spending + Investment
spending
Subtract consumer spending from both sides:
• Savings = Investment spending
(*Taxes is a component of spending)
Functions of Money
Medium of Exchange: a asset that individuals acquire for the purpose
of trading for goods and services rather than for their own
consumption
• Your employer exchanges dollars for an hour of your labor.
• You exchange those dollars for a grocer’s pound of apples.
Unit of Account: a measure used to set prices and make economic
calculations Units of currency (dollars, euro, yen, etc.) measure the
relative worth of goods and services
• The value of a pound of cheese in a barter economy is measured
in dozen eggs, or a half pound of sausage, etc.
Store of Value – an asset that is a means of holding purchasing power
• So long as prices are not rapidly increasing, money is a decent
way to store value.
T-Accounts Review
• Asset – Anything owned by the bank or owed to the
bank (Cash on reserve and loans made to citizens)
• Liability – Anything owned by depositors and lenders
to the bank. (Checking deposits of citizens or loans
made to the bank)
• Reserve Ratio (rr) = cash reserves/total deposits
• Money Multiplier = 1/rr
Chart all the following examples:
• Situation 1: Katie takes $1,000 from under
her mattress, deposits it at ECB, and opens a
checking account. ECB must put 10% in
required reserves, but the remaining amount
are excess reserves and can be either kept on
reserve or lent.
Balance Sheet EGB (Situation 1)
ASSETS
Required
Reserves
Excess Reserves
Total Assets
LIABILITIES
$
100
$
900
$ 1,000
Checking Deposits
$ 1,000
Total Liabilities
$ 1,000
Situation 2: ECB lends out all of the above “Excess Reserves” to
Bob, a local farmer.
Balance Sheet EGB (Situation 2)
ASSETS
Required
Reserves
$
100
Excess Reserves
$
0
Loans
$
900
Total Assets
$ 1,000
LIABILITIES
Checking
$ 1,000
Deposits
Total Liabilities
$ 1,000
Situation 3: Bob uses his money at the Tractor Supply store,
which has a checking account with ECB. The Tractor Supply
Store deposits all the money into ECB where they bank
Balance Sheet EGB (Situation 3)
ASSETS
LIABILITIES
Required
Reserves
$
190
Excess Reserves
$
810
Loans
$
900
Total Assets
$ 1,900
Checking
Deposits
$ 1,900
Total Liabilities
$ 1,900
Situation 4: ECB takes the entire excess reserves from Situation 3 and
makes a loan to Brent, who is looking to buy some furniture. Brent
spends the entire amount at Furniture Factory, which also banks with
ECB, increasing checking deposits by the entire amount.
Balance Sheet EGB (Situation 4)
ASSETS
LIABILITIES
Required
Reserves
$
271
Excess Reserves
$
729
Loans
$ 1,710
Total Assets
$ 2,710
Checking
Deposits
$ 2,710
Total Liabilities
$ 2,710
Supply of Money
• M1 = cash + coins + checking deposits + traveler’s
checks
• M2 = M1 + savings deposits + small time deposits
(CD ‘s --under $100,000) + money market
deposits + money market mutual funds
• M3 = M2 + large time deposits (CD’s -- over
$100,000)
Practice
• Example 1: What happens when a waitress
deposits her cash tips into her savings
account?
M1 decreases (Cash is already a category of
M2 & M3. So, only M1 is affected, the
money was taken from M1 and shifted into
M2.)
Practice
• Example 2: Suppose you find a $50 bill you
put in a coat pocket last winter. What effect
will it have on the M’s, if you deposit it in your
checking account?
There is no change to any of the M’s.
(Cash was already calculated into M1, so it
was just transferred from one category of
M1 to another category of M1.)
Defining Present Value
• Let:
FV = future value of $
PV = present value of $
r = real interest rate
n = # of years
• The Simple Interest Formula
FV = PV( 1 + r )n
PV = FV / (1 + r)n
Practice
1Example: You are going to lend your friend $100 at
10 percent interest.
Calculate what the repayment would be for one
year: $100 + $100*.10 = $100*(1+.10)
• What if you were going to lend your friend the
money for two years?
$100(1.10)*(1.10) = $121
• If I put my $10,000 in an alternative investment
earning 8%:
FV = 10,000*(1.08)10 = $21,589.25
• What is the $20,000 in 10 years worth today?
PV = 20,000/(1.08)10 = $9263.87
What would you have to invest in order to make $20,000 at the
listed year at each rate of interest?
PV = FV/(1+r)ᶰ (round to the nearest penny)
Interest
(r)
Years
10
20
30
40
5
$ 12,278.27
$ 7,537.79
$ 8,643.85
$ 2,840.91
8
$ 9,263.87
$ 4,290.96
$ 1,987.55
$ 920.62
10
$ 7,710.87
$ 2,972.87
$ 1,146.17
$ 441.90
If I invested $20,000 at each rate of interest, what would it be
worth in each year?
FV = PV*(1+r)ᶰ (round to the nearest penny)
Interest
(r)
Years
1
2
3
4
5
$ 21,000
$ 22,050
$ 23,152.50 $ 24,310.13
10
$ 22,000
$ 24,200
$ 26,620
15
$ 23,000
$ 26,450
$ 30,417.50 $ 34,980.13
$ 29,282
Expansionary Monetary Policy
• Designed to fix a recession and increase AD,
lower the unemployment rate and increase
real GDP.
– By increasing the money supply, the interest rate
is ↓ (Money Market model)
– A lower rate of interest ↑both private C & I
– Shifts AD (R) (AD-AS model)
Expansionary Monetary Policy
Interest
Rate
LRAS
MS
MS1
SRAS
r
p1
p
r1
AD1
MD
M
M1
Money
AD
Y*
Y1
Real
GDP
Contractionary Monetary Policy
• Opposite effect of expansionary
• Designed to avoid inflation by decreasing AD,
which lowers the PL and decreases GDP back
to full employment level
– By decreasing the money supply, the interest rate
↑(Money Market model)
– A higher rate of interest ↓ private C & I
– Shifts AD (L) (AD-AS model)
Expansionary Monetary Policy
Interest
Rate
LRAS
MS1
MS
SRAS
r1
p1
p
r
AD
MD
M1
M
Money
AD1
Y*
Y1
Real
GDP
Problem:
High Unemployment
Monetary tool could Buy bonds in an OMO
be…
Lower the discount
Or…
rate
Or…Effect would
be…
Effect would be….
Problem:
High Inflation
Sell bonds in an OMO
Raise the discount rate
Lower the reserve ratio Raise the reserve ratio
↑MS, ↓r%, ↑I,
↑AD(R), ↑GDPr,
↓unemp
↓MS, ↑r%, ↓I, ↓AD (L),
↓GDPr, ↓PL
Deep recessionary gap → expansionary monetary
policy could be used to assist expansionary fiscal
policy to quickly move to full employment.
RISK = a burst of inflation
Mild recessionary gap → contractionary monetary
policy could be used to offset expansionary fiscal
policy to gradually move to full employment.
RISK = rising interest rates
Inflationary gap → contractionary monetary policy
could be used to assist contractionary fiscal
policy to put downward pressure on the PL.
RISK = rising unemployment rate
The Problem
Deep
recessionary
gap and high
unemployment
Mild
recessionary
gap and
moderate
unemployment
Fiscal Policy
Solution
Budget
Impact
Potential
Consequence
Tax cuts and
increased
spending to
rapidly increase Large Deficit
AD and real GDP
Higher interest
rates, crowding
out private
investment, lower
net exports and
even weaker AD
Tax cuts or
increased
spending to
gradually
increase AD and
real GDP
Rising prices.
Mild crowding out
and lower net
exports,
weakening AD
Tax hikes and/or
decreased
spending to
Inflationary gap rapidly decrease
AD and real GDP
Moderate
Deficit
Surplus
Lower interest
rates "crowding
in"{ private
investment,
higher net exports
and even stronger
AD
Monetary
Keep An Eye
Policy
On…
Complement
expand MS to
Higher
keep interest
Inflation
rates from
rising,
Increases AD
to assist fiscal
policy.
Contract MS
Rising
to keep
Interest
inflation from
Rates
rising.
Decreases AD,
offsetting
fiscal policy.
contract MS
Higher
to keep
Uneminterest rates
ployment
from falling.
Decreases AD
to assist fiscal
policy.
Practice Graphing:
1. The following figure illustrates the
relationship between the nominal quantity of
money, M, and the interest rate, r.
Interest
Rate
MD
Money
For each of the following situations, use the previous graph
for reference.
a. Holding everything else constant, the interest rate
increases from r1 to r2. Graph this in the following
figure.
Interest
Rate
r1
r
MD
M1
M
Money
b. Holding everything else constant, the level of aggregate real
income decreases. Graph this in the following figure.
Interest
Rate
MD1
MD
Money
As the level of aggregate real income decreases, this
causes the money demand to curve to shift (L) as
individuals demand less money at every interest rate.
c. Holding everything else constant, there is an increase in the
aggregate price level. Graph this in the following figure.
Interest
Rate
MD
MD1
Money
An increase in the aggregate price level causes the money
demand curve to shift (R), as individuals demand more
money at every interest rate to facilitate making their
transactions at the new higher price levels.
d. Holding everything else constant, individuals in a
community are now able to use Internet banking for their
money and financial assets accounts. Graph this
in
the following figure.
Interest
Rate
MD1
MD
Money
With new technology for managing money and financial
assets, people will decrease their demand for money at
every interest rate. This will cause money demand to shift
(L).
2. Use the following figure of the nominal money
demand and money supply curves to answer this
question. Assume this market is initially in
equilibrium with the nominal quantity of money
equal to “M” and the interest rate equal to “r”.
Interest
Rate
MS
r
MD
M
Money
a. Suppose the FOMC engages in an open-market purchase of
Treasury bills. Holding everything else constant, what happens
to the equilibrium quantity of money and the equilibrium
interest rate? Sketch a graph illustrating these changes.
Interest
Rate
MS
MS1
r
r1
MD
M
M1
Money
When the Fed increases the MS through an OMO
purchase of T-bills, this shifts the MS (R) to MS1
Resulting in… ↓r to r1 ↑M to M1
b. Suppose the FOMC engages in an open-market sale of Treasury
bills. Holding everything else constant, what happens to the
equilibrium quantity of money and the equilibrium interest rate?
Sketch a graph illustrating these changes.
Interest
Rate
MS1
MS
r1
r
MD
M1
M
Money
When the FOMC decreases the money supply through an
OMO sale of T-bills, the MS shifts (L) from M to M1
Resulting in…. ↑r to r1
↓ M to M1
c. Suppose the aggregate price level increases. Holding everything
else constant, what happens to the equilibrium quantity of money
and the equilibrium interest rate? Sketch a graph illustrating these
changes.
Interest
Rate
MS
r1
r
MD
M
MD1
Money
An increase in the aggregate PL shifts the MD (R) from
MD to MD1.
Results = ↑r to r1 MS (-) unchanged
Use the AS-AD model to answer the following questions.
Scenario 1: The economy of Macroland is initially in long-run
equilibrium. Then the FOMC of Macroland decides to reduce interest
rates through an open-market operation. (Expansionary Policy)
a. Draw a graph
representing the initial
situation in Macroland.
In your graph, be sure to
include the short-run
aggregate supply curve
(SRAS), the long-run
aggregate supply curve
(LRAS), and the
aggregate demand curve
(AD), on your graph
mark the equilibrium
aggregate price level and
the aggregate output
level as well as potential
output.
LRAS
SRAS
p
AD
Y*
Real
GDP
b. Draw a graph of the money market showing its initial situation
before the FOMC of Macroland engages in monetary policy
and showing as well as the effect of the FOMC’s monetary
policy actions. Be sure to indicate the initial equilibrium as
well as the equilibrium after the monetary policy.
Interest
Rate
MS
MS1
r
r1
MD
M
M1
Money
c. How well does this monetary policy action affect the
aggregate economy in the short run? Explain your
answer verbally while also including a graph of the ASAD model to illustrate your answer
LRAS
SRAS
p1
p
AD1
AD
Y* Y1
Real
GDP
When the FOMC
reduces interest
rates through an
OMO by
purchasing T-bills
it results in….
↑in AD (R) shift to
AD1 In the ShortRun = Output ↑
from Y to Y1 PL
to ↑ from p to p1
(unemployment to
↓)
d. Illustrate and explain how this monetary policy action
affect the aggregate economy in the long run?
LRAS
SRAS1
SRAS
p2
p1
p
AD1
AD
Y* Y1
Real
GDP
• Long Run: Economy
must return to LRAS –
adjusting the economy
• SRAS shifts (L) to SRAS1
as nominal wages rise -- eliminates the
inflationary gap &
restores the economy
to its potential output
level
• Result = ↑PL (p to p2)
Scenario 2: Econoland is currently operating with a
recessionary gap.
e. Draw a graph
representing
Econoland’s economic
situation using AS-AD
model. Be sure to
indicate in your graph:
SRAS, LRAS, AD, the
short-run equilibrium
aggregate PL (p1) the
short-run equilibrium
aggregate output level
(Y1), and the potential
output level (YE).
LRAS
SRAS
p1
AD
Y1
YE
Real
GDP
f. Illustrate and explain what monetary policy you would
suggest the FOMC of Econoland pursue if its only goal is
to restore production in Econoland to the potential output
level.
LRAS
SRAS
p2
p1
AD1
AD
Y1 YE
Real
GDP
• If the FOMC expands the money supply through
OMO purchases ↓r and stimulates spending:
AD shifts (R) to AD1 Real GDP ↑ to Y
PL ↑
from p1 to p2
g. Is there a potential drawback to the implementation of
this particular monetary policy? Explain.
• If the FOMC engages
in activist monetary
policy, this will cause
the aggregate PL to
↑. Alternatively,
policymakers could
do nothing and wait
for the SRAS to shift
(R) as nominal wages
fall. In the Long-run,
aggregate output
would return to Y,
and the PL would fall
below the initial
level of p2 to p3.
LRAS
SRAS
SRAS1
p2
p1
p3
AD1
AD
Y1 Y* Y2
Real
GDP
Scenario 3: Upland is currently operating with an inflationary
gap.
a. Draw a graph representing Upland’s economic situation using
an AS-AD model. Be sure to indicate in your graph SRAS, LRAS,
AD, the short-run equilibrium aggregate price level (P1), the
short-run equilibrium aggregate output level (Y1), and the
potential output level (Y*).
LRAS
SRAS
p1
AD
Y*
Y1
Real
GDP
i. What monetary policy would you suggest the FOMC
of Upland pursue if its only goal is to restore
production in Upland to the potential output level?
Explain how this monetary policy would achieve this
goal.
The FOMC should ↓ money supply = ↑r through
OMO sales of T-bills. Causing AD shift (L) ;
restoring the economy to potential output level at
a ↓PL than p1 to p2
j. Is there a potential drawback to the implementation
of this particular monetary policy? Explain your
answer.
No, this policy restores the economy to its
long-run position without raising the PL
4. Suppose that when the FOMC reduces the
interest rate by 1 percentage point it increases
the level of investment spending by $500 million
in Macroland. If the marginal propensity to save
equals .25, what will be the total rise in real GDP,
assuming the aggregate price level is held
constant? Explain your answer.
Causes real GDP to increase due to the
multiplier process 1/(1-MPC) or 1/MPS
1/.25 = 4
4 x $500 million = $2 billion