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

Unit 4 – Money & Banking / Monetary Policy Videos

Unit 4: Part 1 - Types and Functions of Money

There are three types of money: commodity money, fiat money, and representative money. Representative money is money that we do not use today, but some argues that we should. These types of money have three kinds of function. Medium of exchange means that through money things exchanges, for example buying an item, you give them the money you get the item. The second one is  store of value, this means that you are putting your money away and you expect it to still have its value. This leads to rapid of inflation, which then your money is decreasing its value. Lastly, money is a unit of account. Unit account establishes economic worth in the exchange process. We believe the price implies worth. For example, the higher the price of an item means the greater the quality it is.

Part 3 - Money Market Graph

In the money market graph, the demand money slopes downward because when the price is high, the quantity demand is low, and when price is low quantity demand is high. The supply money is vertical because it does not varies from the interest rate. Supply money only moves by Fed. When you increase demand, you put pressure on the interest rate.  To bring the interest rate back down or its normal position, you increase the money supply or increase it by shifting it to the right.


The Fed's tools of Monetary Supply

If the Fed wants to increase the money supply, they can lower the reserve requirements. This means that money becomes excess reserves. If they want to contract the money supply, then they would do the opposite which is increasing the reserver requirements. Fed also uses the discount rate. Discount rate is the rate at which banks can borrow money from the Fed. If they want the bank to borrow more money than they lower the discount rate and if they want to discourage the banks from borrowing money they do the opposite. The discount rate is barely used because it is not a guarantee. Lastly, a way to expand the money supply, the Fed buy bonds. If the Fed wants to reduce the money available, they would sell bonds.

Part 7 - The Loanable Funds Market

In loanable funds graph, the slope of demand loanable funds is still downward sloping and supply loanable funds (SLF) is upward sloping. SLF comes from the amount of money people have in their bank. SLF is dependent on savings. The more people save, the more banks can make loans. If people want to save more we increase the SLF. In money market when the government runs a deficit, it increase demand in money, in loanable funds market an increase demand means interest rate also goes up.

Part 8: Money creation & Multiple Deposit Expansion

Banks create money by making loans. The formula for the money multiplies is one over reserve requirements. To find the total money created loan you multiply your reserve requirements by your loan. Loan increases through the process of multiple deposit expansion. This is by adding all potential loans. 

Unit 4 Part 9

Unit 4: Money

Money

3 uses of $$

1) Medium of Exchange

    - to trade

2) Unit of Account

    - establishes economic worth in the exchange process

3) Store of Value

    - money holds value over a period of time where as product do not

3 Types of $$

1) Commodity Money

     - it gets its value from the type of material from which it is made 

   ex: gold and silver coins

 2) Representative Money

      - Paper money backed up by something tangible that glues it value

3) Fiat Money 

    - It's money because the government say so

  [money we use in U.S]

Characteristics of Money

• Portable Money - you can take your money anywhere ..folded, washed, wrinkled
• Durable
• Scarce - credit card
• Divisible - how many ways to break
• Acceptable
• Uniform - save no matter where you go

Money Supply

a) m1 money

• Currency - composed of cash and coins
• checkable deposit or demand deposit
• travel check
• 75% of correlation
• most liquid (easy to connect to cash )

b) m2 Money

• Consist m1 money along with saving account, market account and deposit held by banks outside U.S
• not as liquid money to convert

c) m3 money

• consist m2 money + certificate of deposit (CD) held by private institution

Unit 3: Consumption & Saving; MPC & MPS; Fiscal Policy

Consumption & Saving

Disposable Income:

• Income after taxes or net income

• DI= Gross income - taxes

2 choices

With disposable income, households can either:

- consume (spend monet on goods and services)

- save (not spend money on goods and service)

Consumption: 

• Household spending

• The ability to consume is contained by:

   - the amount of disposable income

   - the propensity to save

•Do households consume if DI=0?

  - autonomous consumption

  - dissaving

Saving

• Household NOT spending

• the ability to save is constrained by 

  - the amount of disposable income

  - the propensity to consume

APC + APS

APC: the average propensity to consume

APS: the average propensity to save

APC + APS = 1

1 - APC = APS

1- APs = APC

* if negative, or >1 then enter world of dissaving*

MPC & MPS

MPC

Marginal Propensity to Consume 

• the fraction of any change in disposable income that is consumed

• MPC= change in consumption / change in disposable income

MPS 

Marginal Propensity to Save

• fraction of any change in disposable income that is saved

• MPS = Change in savings / change in disposable income

Marginal Propensities 

MPC + MPS = 1

MPC = 1 - MPS

MPS = 1- MPC

* remember, people do two things with their disposable income, they either consume or save it *

Spending Multiplies Effect:

• initial change in spending ( C, Ig, G, Xn) causes a lawyer change in aggregate spending or demand

• Multiplier = change in AD/ change in Spending 

Calculating Spending Multiplier

• can be calculated from MPS or MPC

• Multipiers = 1/ 1- MPC or 1/MPS

• multipliers are (+) when there is an increase in spending and (-) when there's a decrease

Calculating Tax Multiplier

• when government taxes, the multiplier works in reverse

Why?

     because new money is leaving circular flow

•Tax multiplier (note: it's negative)

  -MPC/ 1 - MPC or -MPC/MPS

• if there's a tax cut, then the multiplier is positive, because there is now more money in circular flow

Fiscal Policy

What is Fiscal Policy?

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

• 2 tools of fiscal policy:

  - taxes: government can increase or decrease taxes

  - spending: government can increase or decrease spending

Deficit, Surpluses, Debt

• Balance budget 

   revenues = expenditure

• Budget deficit

   revenues < expenditures

• Budget surplus

    revenues > expenditure

• Government Debt

  sum of all deficit - sum of all surpluses

•government must borrow money when it runs a budget deficit

  - government borrows from

     Individuals                             Corporation

     Financial Institution               Foreign government

Fiscal Policy two options:

1) Discretionary Fiscal Policy (action)

     • expenditures fiscal policy - think deficit

     • contractionary fiscal policy - think surplus

2) Non-Discretionary Fiscal Policy (no action)

Discretionary v. Automatic Policies

Discretionary : 

  - increasing or decreasing government spending without taxes in order to return the economy to full employment 

  - involves policy makers doing fiscal policy in response to an economic problem

Automatic :

 - Unemployment compensation and marginal tax rates are examples of automatic polls that help mitigate the effects of recession and inflation

 - takes place without policy makers having to respond to current economic problem

Expansionary v. Contractionary

Expansionary:

  - combat a recession

  - Gov. spending increases, taxes decreases

Contractionary:

  - Combat inflation

  - Gov. spending decreases, taxes increases

Automatic/Built-in Stabilizers

• anything that increases the government's budget deficit during a reckon and increases its budget surplus during inflation without requiring explicit action by poly maker

• economic importance:

   - Taxes reduce spending and aggregate demand

   - reductions in spending are desirable when the economy is moving toward inflation

   - increases in spending are desirable when the economy is heading toward recession

Tax:

• Progressive Tax System

  - average tax rate (tax revenues/GDP) rises with GDP

•Proportional Tax System

  - average tax rate remains control as GDP changes

•Regressive Tax System

  - Average tax rate falls with GDP

Unit 3: Investment Demand; Real v. Nominal

Investment Demand:

What is an Investment Demand?

• The lower loans demanded the higher the interest rate

• The higher loans demanded the lower the interest rate

• In the U.S. interest rates are a cost of borrowing money

• Reasons to barrow:

  - business 

  - mortgage

  - education

What is Investment?

Money spend or expenditures on:

  • New plants (factories)

  • capital equipment

  • technology (hardware and software)

  •  new homes

  • inventories (goods sold by producers)

Expected Rates and Return

How does business make investment decision?

cost / benefit analysis

How does business determine benefits?
expected rate of return

How does business count the cost?

interest cost

How does business determine the amount of investment they under take?

• compare expected rate of return interest cost

  - if expected return > interest cost, then invest.

  - if expected return < interest cost, then do not invest.

Investment Demand Curve

What is the shape of the investment demand curve? 

Downward sloping

Why?

when interest rates are high, fewer investment are profitable; when interest rates are low, more investment are profitable. 

Shifts in Investment Demand:

1) Cost production

    • lower costs shifts ID -->

    • higher costs shifts ID <--

2) Business Taxes

    • lower business taxes shift ID -->

    • higher business taxes shift ID <--

3) Technological Change

    • New technological change shift ID -->

    • lack of technological change shift ID <--

4) Stock Capitals

    • If an economy is low on capital, then ID -->

    • if economy has much capital, then ID <--

Real v. Nominal

What is the difference?

- Nominal is the observable rate of interest

- real subtracts out inflation 

How do you compute real interest rate (r%) ? 

r% = i% - π%

What then, determine the cost of an investment decision? 

- the real interest rate (r%)

Unit 3: Aggregate Demand Curve, Aggregate Supply Curve

Aggregate Demand Curve:

AD = Consumption Expenditures + Gross Private Domestic Investment + Government spending + Net Export 

      = (C+Ig+G+Xn)

Aggregate Demand is the demand by consumers, business, government & foreign. 

What definitely doesn't shift the curve? 

changes in price level cause a move along the curve.

Why is AD downward sloping? 

1. Real-Balance Effect 

    - higher price levels reduce the purchasing power of money, which decreases the quantity of expenditures

    - lower price levels increase purchasing purchasing power and increases expenditures.

ex: If the balance in your bank was $50,000, but inflation erodes your purchasing power, you will likely reduce your spending.

2. Interest-Rate Effect

    - when the price level increases, leaders need to change higher interest rates to get a REAL return to their loans. 

    - Higher interest rates discourage consumer spending and the business investment. 

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 rises causing real GDP demand to fall (Xn decreases )

ex: If the price triple in the U.S., Canada will no longer buy U.S. goods causing quantity demanded of U.S. products to fall. 

What are the shifters of aggregate demand?  

1) A change in C, Ig, G, Xn

2) a multiple effect that produces a greater change than the original change in the four components

Increase in AD = AD --> 

Decrease in AD = AD <--

Determinants of Aggregate Demand:

1) Consumption 

      Household spending is affected by :

       • Consumer wealth 

          - More wealth = more spending (AD shift --> )

          - Less wealth = less spending (AD shift <-- )

       • Consumer expectation

          - positive expectations = more spending (AD shift --> )

          - negative expectations = less spending (AD shift <-- )

       • Household indebtedness

          - less debt = more spending (AD shift -->)

          - more debt = less spending (AD shift <--)

2) Gross Private Investment

      Investment spending is sensitive to : 

      • Real Interest Rate 

        - lower real interest rate = more investment (AD shift -->)

        - higher real interest rate = less investment (AD shift <--)

      • Expected Returns

        - higher expected returns = more investment 

        - lower expected returns = less investment (AD shift <--)

        - expected returns is influenced by : 

           ○ expectations in the future profitability 

           ○  technology
           ○  degree of excess capacity ( existing stocks of capital )
           ○  business
3) Gov. spending 
      • more gov. spending (AD shift -->)
      •less gov. spending (AD shift <--)
4) Net Exports 
     sensitive to:
      • Exchange rates (international value of $)
        - strong $ = more imports & fewer exports (AD shift -->)
        - weak $ = fewer imports & more exports (AD shift <--)
      • Relative income
        - strong foreign economies = more export (AD shift -->)
        - weak foreign economies = less export (AD shift <--)

Aggregate Supply:

What are the difference between Long Run and Short Run?

Long Run:   

   • period of time where input prices are completely flexible and adjust to changes in the price level

   • level of Real GDP supplied is independent of the price level

Short Run:

   • period of time where input prices are sticky and do no adjust to change in the price level

   • the level of Real GDP supplied directly related to the price level

Long-Run Aggregate Supply (LRAS) 

- marks the level of full employment in the economy (analogous to PPC)

- because input prices are completely flexible in long run, change in price level do not change firms real profits and therefore do not change firms level of output. (This means LRAS is vertical at the economy's level of full employment)

Change in SRAS

• An increase in the SRAS is seen as a shift to the right (SRAS -->)
• A decrease is seen as shift to the left (SRAS <--)

Key to understanding the shifts is per unit cost of production. 

Total Input Cost

___________________

Total Output

Determinant of SRAS (all affect unit production cost) 

1) Input Prices

    • Domestic Resource Prices:

       - Wage (75% of all business cost)

       - Cost of capital

       - Raw material (commodity prices)

    • Foreign Resource Prices

       - strong $ = lower foreign resource

       - weak $ = higher foreign resource

    • Market Power 

Increase in Resource Prices = SRAS <--

Decrease in Resource Prices = SRAS -->

2) Productivity

     • Productivity = Total Output / Total Input

More productivity = lower unit production cost = SRAS -->

Lower Productivity = higher unit production cost = SRAS <--

3) Legal-Institution Environment 

     • Taxes & Subsides:

       - Taxes ($ to government) on business increase per unit production cost = SRAS <--

       - Subsides ($ from government) to business reduce per unit production cost = SRAS -->

Full employment, Recessionary Gap, Inflationary Gap

Full Employment :

    - full employment equilibrium exists where AD intersect SRAS and LRAS at some point

Recessionary Gap:

- exists when equilibrium occurs bellow full employment output

Inflationary Gap: 

   - exists when equilibrium occurs beyond full employment output

SRAS (Short Run Aggregate Supply) 

Nominal wages - the amount of money receive by worker per unit of time

Real Wages - The amount of goods and services a worker can purchase with their nominal wages.

Sticky wages - Where nominal wage level is set according to an initial price level and it does not vary due to labor contracts or other restriction