Unit 4: 3 Tools of Montary Policy

3 Tools of Monetary Policy

1) Reserve Requirements: 

• Only a small percent of you bank deposit is in the safe. The rest of your money has been loaned out. This is called Fractional Reserve Banking 
• FED sets the amount that bank must hold
• RR is % of deposits that banks must hold in reserve and NOT loan out.

- When FED increase the MS it increases the amount of money held in bank deposit.

a) if there's a recession, what should the FED do to the RR?

     1) Bank hold less money and have more ER

     2) Banks create more $ by loaning out express

     3) MS supply increases, interest rates fall, AD goes up

b) if there inflation, what should to FED do to the reserve requirements?

     1) Banks hold more money have less ER

     2) Banks create less $

     3) MS decreases, interest rates up, AD down

2) The Discount Rate

the interest rate that the FED charges commercial bank

• To increase the MS, the FED should decrease the discount rate ( easy money policy)
• To decrease the MS, FED should increase the discount rate ( tight money policy )

3) Open Market Policy 

• FED buy/sell government (securities) 
• This is the most important and widely used monetary policy
• to increase MS, FED should buy government securities
• to decrease MS, FED should sell government securities 

When a customer deposits cash or withdraws cash from their demand deposit account, it has no effect on money supply. It only changes:

1. The composition of the money
2. Excess Reserves
3. Required Reserves

How does it effect the three:

Effect ER & RR because the 

Single bank: loan money from ER

Banking System : ER x Multiplier (1/rr) 

                           *total money supply*

Unit 4: Loanable Funds, The Time Value of Money

Loanable Funds

Essential Question: What factor has the biggest impact on the money supply, lending and investment? 

      - Interest Rates (the price of borrowing & using money) 

Nominal v. Real Interest Rates

Nominal:

• Real interest rates + expected inflation
• % increase in money that the borrower pays including inflation

Real:

• Nominal interest rate - expected inflation
• % increase in purchasing power that the barrow pays (adjusted)

What are loanable funds?

-funds available for borrowing or lending

Demand for Loanable Funds

• the quantity of credit wanted and needed at every real interest rate by borrows in an economy
• Loanable Funds demand consists of any and all activities of borrowers who were credit, including: loan application and financial asses sales.

Demand for loanable funds? 

• the quantity of credit wanted and needed at every real interest rate by borrowers in an economy
• Loanable funds demand - consists of any and all activities of borrowers who desire credit, including: loan application and financial asset sales.

Time Value of Money

Is a dollar today worth more than a dollar tomorrow? YES 

Why? 

- inflation and opportunity cost

- this is the reason for charging and paying interest

Let V = future value of $.

       P = present value of $.

       r = real interest rate ( nominal rate - inflation expressed as a decimal)

       n = years 

       k = # of times interest is credited per year

Demand Money

- has an inverse relationship between nominal interest rates and the quantity of money demanded

What happens to quantity demanded money when interest rates increases? 

- quantity demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities

What happens to quantity demand when interest rate decreases? 

- quantity demanded increases.

- There is no incentive to convert cash into interest earning asset.

What happens if price level increase? 

- then money demand shift to the right

   3 Causes:

- change in price level

- change in income

- changes in taxation that affects investment

Increasing Money Supply

If the FED increases the money supply, a temporary surplus of money will occur at 5% interest.

- the surplus will cause interest rate to fall 2%

How does this affect AD?

Increase MS > Decrease interest rate > increase investment > Increase in AD

How do we decrease Money supply?

Decrease MS > Increase interest rate > decrease investment > decrease AD

Fiscal Sector

• Financial assets vs. Financial liability
   - Assets: stocks or bonds that provide expected future benefit.
                : benefits the owner only if the ensure of the asset need certain obligation
   - Liability: it is incurred by the ensure of a financial asset to stand by the issue asset
                   : what you owe
• Interest Rates: it is the price paid used for financial assets
• stock v. bonds
    - stocks: financial asset that convey ownership in cooperation
  
  - bonds: promise to pay a certain amount of money
  and interest in the future

What do Banks do?

A bank is financial intermediary 

• uses liquid assets (i.e bond deposits) to finance the investment of borrowers 
• Process is known as fractional reserve banking 
• system in which depository institution liquid assets less than the amount of deposit
• can take the form of:
  1. currency in bank vaults
  2. bank reserves - deposits held at the Federal Reserve 

Basic Accounting Review

• T-account (balance sheet)
  - statements of assets and liabilities
• Assets (amount owned)
  - items to legal to which a bank holds legal claim
  - the uses of funds by financial intermediates
• Liabilities (amount owned )
  - legal claim against a bank

Federal Reserve Bank 

Function of FED: 

- it issues paper money 

it sets reserve requirement and it hold reserve of the bank 

- lend money to bank and change their interest

-check clearing service for bank

-acts as a personal bank for government

- supervises member banks

- control money supply 

4/4/16 Monetary Policy Video

https://youtu.be/EntQgHxh-IA