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Unit 4 Review Guide

Three Basic Purposes of Money:

  1. Medium of Exchange
  2. Unit of Account/Yardstick for Value
  3. Short-Run Store of Value

Fiat Money:

  • Definition: Money whose value is based on government decree only; it has no intrinsic value or commodity (like gold) backing its value.

Monetary Base (M0):

  • Definition: Currency in circulation and in bank vaults plus bank reserves at the Fed.

M1:

  • Includes: M0 + Checking accounts and some other bank savings and money market accounts.

M2:

  • Includes: M1 + Non-Bank money market accounts, savings accounts, CD’s, etc.

The Roles of the Financial System:

  • Main Functions:
  • Bringing together savers and borrowers.
  • Financial intermediation: The process of connecting savers and borrowers, often for a fee.
  • Providing a means for the investment of personal wealth.
  • Three tasks:
  • Reduce transaction costs.
  • Reduce risk.
  • Provide/increase liquidity.

Functions of the Federal Reserve Bank:

  • Key Roles:
  • Providing financial services for the country, including acting as a banker for the government.
  • Overseeing the nation’s payments system.
  • Supervising the banking system.
  • Stabilizing U.S. financial markets during crises.
  • Conducting monetary policy.

Protections against Bank Failures/Runs:

  • Federal Reserve oversight of banks.
  • Reserve requirements.
  • On-site inspections.
  • “Lender of Last Resort.”
  • Glass-Steagall Act (1933): Separated banking (commercial banks) from securities activities (investment banks).
  • FDIC (Federal Deposit Insurance Corp): Protects individual deposits up to $250,000.

Structure of the Fed:

  • 3 Main Decision-Making Components:
  • Board of Governors (including the Chairperson).
  • 12 Regional Federal Reserve Banks.
  • Federal Open Market Committee (FOMC) which decides on monetary policy in its meetings every 6 weeks.

The Fed’s Dual Mandate:

  • Keep inflation low (~2%).
  • Attempt to achieve full employment.

Interest Rates:

  • Definition: The ‘cost’ of money, representing the opportunity cost of holding cash.
  • Formula: Nominal Interest Rate (i) = Real Interest Rate (r) + Inflation Rate.
  • Zero-Bound: Nominal interest rates cannot be < 0, as banks are better off holding cash than making loans at negative rates.
  • Real Interest Rates: Can be < 0.

Fractional Reserve Banking:

  • Concept: Banks are required to hold a certain percentage of customer deposits as required reserves, with excess reserves able to be lent out or invested.
  • Historical Reserve Ratio: Was 10% (reduced to 0% in 2019).
  • Money Multiplier: = 1/RR. At 10%, MM = 10x.

The Market for Money:

  • Y-axis: Nominal Interest Rate (i).
  • X-axis: Quantity of Reserves.
  • Demand: Standard downward sloping.
  • Supply: Vertical (set by the Fed).

Shifts in Demand for Money:

  • Impacted by changes in the aggregate price level, real GDP, technology, and regulations.

Shifts in Supply for Money:

  • Due to changes in Fed monetary policy in response to changing economic conditions—increases/decreases in the supply of money to fill recessionary/inflation gaps.

The Goals and Tools of Fiscal Policy:

  • Goals: Shifting AD (Aggregate Demand) inward or outward as needed, using expansionary policy to correct recessionary gaps, and contractionary policy to correct inflationary gaps.
  • Tools: Government spending, government transfer payments, taxes.

The Goals and Tools of Monetary Policy:

  • Goals: Manipulating AD through the effects of monetary policy on consumption and investment.
  • Tools: Depend on whether under a limited reserves regime (pre-2019) or an ample reserves regime (current).

Important Interest Rates:

  • Discount Rate: Set by the Fed, it sets an upper bound on short-term interest rates.
  • Fed Funds Rate: A market interest rate that reflects the cost of borrowing between banks.

The Money Market Curve under Limited vs. Ample Reserves:

  • Under limited reserves, the discount rate becomes an upward bound to short-term interest rates.
  • Under ample reserves, the supply of money is set by the Fed, with administered rates such as IOR (Interest on Reserves) influencing banking behaviors.

Fed Policy Tools under Ample Reserves:

  • Quantitative Easing: Buying longer maturity Treasury and mortgage bonds to influence long-term interest rates lower while adding liquidity to the banking system.
  • Paying Interest on (Bank) Reserve Balances: Encourages banks to hold reserves by offering a return on these funds, acting as a carrot rather than a stick.
  • Administered Rates: Including Interest on Reserves (IOR) and the Reverse Repo Rate (RRR), set by the Fed to influence banking behaviors and the broader financial market.

Comparing Limited and Ample Reserves Curves

Understanding the distinction between operating under limited versus ample reserves is crucial for grasping how the Federal Reserve's policies and tools adapt to changing economic conditions. In a limited reserves environment, the focus is on managing the quantity of reserves to influence short-term interest rates directly. Conversely, with ample reserves, the emphasis shifts towards managing interest rates directly through administered rates, providing ample liquidity to ensure the banking system operates smoothly.

The Loanable Funds Market

  • Overview: Models the activities of all financial markets with simplifying assumptions such as a single market for funds and a single interest rate.
  • Differences from the Money Market: The supply curve is upward sloping (not vertical) and not controlled by the Fed. The y-axis represents real interest rates (r), not nominal interest rates (i).

At Equilibrium

Projects with an Internal Rate of Return (IRR) greater than the equilibrium interest rate (re) get funded, optimizing the efficient use of savings. If a disequilibrium exists, market forces work to move the real interest rate back to equilibrium.

Demand Shifters

  • Changes in perceived business opportunities.
  • Investment tax credits.
  • Changes in government borrowing, which can lead to "crowding out."

Supply Shifters

  • Changes in private spending behavior, where increased consumption can reduce the supply of loanable funds.
  • Changes in international capital inflows, where international turmoil can lead to a "flight to safety," increasing the supply of loanable funds in the U.S.

National Savings and Investment

For a comprehensive economic analysis, it's important to account for government spending/savings and international capital inflows:

  • National Savings: Private savings + government budget balance.
  • Investment: National savings + international capital inflows.

The Loanable Funds Market encapsulates the interaction between savings and investment, highlighting the critical role of interest rates in allocating resources efficiently across the economy.