Loanable funds

The market where savers and borrowers exchange funds (Qlf) at the real rate of interest (r%)

The demand for loanable funds, or borrowing comes from households, firms, gov and foreign sector. The demand for loanable funds is the supply of bonds

The supply of loanable funds, or savings comes from households, firms, govt, and foreign sectors. The supply of loanable funds changes in demand for loanable funds

Demand for loanable funds- borrowing ( ie. Supplying bonds)

The more borrowed the more demand there is for loanable funds (shifts à)

Less borrowing= less demand for loanable funds ( ß)

Ex. Gov deficit spending= more borrowing= more demand for loanable funds

.: DLF à .: r % increase

Less investment demand= less borrowing = less demand = less borrowing = less demand for loanable funds .:Dlf ß .: r% decrease

Changes in supply of loanable funds

Supply of loanable funds = savings (ie. Demand for bonds)

More savings = more supply of loanable funds ( à)

Less savings = less supply of loanable funds ( ß)

Ex. Gov budget surplus = more savings = more supply of loanable funds :         .:SlF à .:r% decrease

Decrease in consumers mps= less savings= more supply of loanable funds:       .: Slf ß .: r% increase

Loanable funds market determines real interest rate (r%)

Changes in saving and borrowing create changes in loanable funds and therefore the r% changes

When govt does fiscal policy it will affect the loanable funds market

Changes in real interest rate (r%) will affect gross private investments 

Key principles

A single bank can create money through loans by the amount of excess reserves

The banking system as a whole can create money by a multiple (deposit on money multiplier) of the initial excess reserves.

Initial deposit	New or existing  $	Bank reserves	Immediate change in MS (money supply)
Cash (money created in the banking system only)	Existing	Increase	No:  composition of money changes( cash to currency)
FED purchase of a bond from public	New	increase	Yes: money coming from the fed puts new $ in circulation
Bank purchase of bond from the public	New	increase	Yes: money is coming from actual reserve which puts new money in circulation

Initial deposit + money created in the banking system = total or change in money supply

Factors that weaken the effectiveness of the deposit multiplier:

1.       If banks fail to loan out all of their excess reserves

2.       If bank customers take their loans in cash rather than in new checking account deposits it creates a cash or currency drain.

The money market

The demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded

1.       What happens to the quanitity demanded of money when interest rates increase?

MD DM  increase à IR decreases

MD DM decreases à IR increases

Video Summaries

Money Market: basic concepts

The types of money include commodity money, representative money, and fiat money. Commodity money is commodities that function as money (goods that have monetary value such as animals used for trade.) Representative money represents a quantity of a precious metal (ex. gold standard.) Fiat money is money which is not backed, has no value but the value we give it. The three functions of money are: money serves as a medium of exchange, money is a store of value, and money is a unit of account/ quality.

Money market graphs: The price paid to borrow money is interest. label the y axis price, the x- axis quantity. Demand always slopes down because when price is high demand decreases which is the law of demand. The supply of money is vertical because it doesn't vary based on the interest rate. it is fixed by the fed. increasing demand puts upward pressure on interest rate. If the fed wants to bring the rate down they increase the money supply which will stabilize interest rates.

The fed: tools of $ policy

Expansionary money policy (also called easy money) lowers reserve requirement, increases money supply. Contractionary money policy:(also called tight money) lowers RR and decreases money supply. reserve requirements are a % of the banks total deposits the banks must hold on to either as vault cash or it must be on reserve with a fed branch. excess reserves are used to make loans. The discount rate is the rate banks borrow money from the fed. lowering the discount rate creates money, raising it lowers money supply. Buying/selling govt bonds and securities: fed buying increases money supply, selling decreases MS. Federal open market committee makes decision to buy/sell. Federal funds rate is rate at which banks borrow from each other. 

Loanable  funds:

money available in the banking system for people to borrow. First label interest rate, price and quantity. demand is downward sloping, supply slopes upward. Supply of loanable funds depends on savings. if the gov is running a deficit it is demanding money in order to spend it, shifts right and increases interest rates. govt demands money its decreasing supply and increasing interest rates

Money creation process:

Banks create money by making loans. 1 of the feds tools for monetary policy is being able to adjust RR. Money multiplier is 1/RR. multiple deposit expansion creates money through loans. if banks hold excess reserves they diminish the amount of money potentially created. 

Relating the money market, loanable funds market, and AD-AS

The money market has interest rate on vertical axis, quantity of money on horizontal, demand slopes down supply is verticle and equilibrium is markets. Loanable funds has interest rate on vertical axis, same equilibrium interest rate, tie it into AD- AS. MV=PQ change in money = change in price.

Tools of monetary policy

Fiscal policy is run by congress and the president, they tax or spend

Monetary policy is conducted by the FED. The only people that benefit from fed are banks FDIC insured. OMO open market operations, discount rate, federal fund rate, reserve requirement.

Reserve requirement= amount of money banks have to keep in reserves

Discount rate is the interest rate that the fed charges commercial banks for borrowing money

Federal fund rate is where FDIC member banks loan each other overnight funds in order to balance accounts each day (simply interest rates for banks to borrow from banks)

Prime rates the interest rate the banks charge their most credit worthy customers (usually below 4%)

	expansionary (Easy money, recession)	Contractionary “tight money” inflation
Open market operation (OMO) ( buy or sell securities (Bonds)	Buy bonds increase money supply	Sell bonds decrease money supply
Discount rate	Decrease	increase
Reserve requirement	decrease	increase

Key principles

A single bank can create money through loans by the amount of excess reserves

The banking system as a whole can create money by a multiple (deposit on money multiplier) of the initial excess reserves.

Initial deposit	New or existing  $	Bank reserves	Immediate change in MS (money supply)
Cash (money created in the banking system only)	Existing	Increase	No:  composition of money changes( cash to currency)
FED purchase of a bond from public	New	increase	Yes: money coming from the fed puts new $ in circulation
Bank purchase of bond from the public	New	increase	Yes: money is coming from actual reserve which puts new money in circulation

Initial deposit + money created in the banking system = total or change in money supply

Factors that weaken the effectiveness of the deposit multiplier:

1.       If banks fail to loan out all of their excess reserves

2.       If bank customers take their loans in cash rather than in new checking account deposits it creates a cash or currency drain.

The money market

The demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded

1.       What happens to the quanitity demanded of money when interest rates increase?

MD DM  increase à IR decreases

MD DM decreases à IR increases

Money

$MONEY$

Money is any asset that can be used to purchase goods and services

3 uses of money:

·         As a medium of exchange- using it to determine value

·         Unit of account- used to compare prices

·         Store of value: where they put it

3 types of money:

·         Commodity money: has value within itself

-3 ex. Salt, olive oil, gold

·         Representative money: represents something of value

-IOU

·         Fiat money: money gov says has value

-Consists of paper money and coins

è Currency is money but not all money is currencyß

6 characteristics of money:

1.       Durability: lasts through being washed, etc.

2.       Portability: can be taken anywhere

3.       Divisibility: can be broken down

4.       Uniformity: money is the same no matter where you go

5.       Limited supply

6.       Acceptability: people take it

Money Supply

Money supply is the total value of financial assets available in the U.S economy.

M1 money:

involves liquid assets : easily converted to cash

-          Liquid assets include: checkable deposits (demand deposits), coins, currency, travelers checks

M2 Money

Not as liquid as M1 money: includes M1 money+ savings account+ money market account

3 purposes of financial institutions

·         Store money

·         Save money

·         Loan money

2 reasons money is loaned

1.       For credit cards

2.       Mortgages

4 ways to save

1.       Through a savings account

2.       Through a checking account

3.       Through a money market account

4.       Through a certificate of deposit (CD)

(Last 2 have higher interest rates)

Loans

Banks operate on a fractional reserve system: they keep a fraction of the funds and loan out the rest

Interest: The money charged for borrowing money

Interest rates:

-          Principal: the amount of money borrowed

-          Interest: simple and compound

o   Simple: paid on the principal

o   Compound: paid on the principal plus accumulated interest

Simple interest: I=( PxRxT)/100

-          P= principal

-          R= interest rate

-          T=time

Time = (Ix100)/ PxR

Principal= (Ix100)/ RxT

Interest rate=( Ix100)/ PxT

Financial institutions

1.       Bank

2.       Savings and loans institution

3.       Mutual savings banks

4.       Credit unions

5.       Finance companies

Investments

Investment:  is redirecting resources, consume now for the future

Financial assets: claims on property and income of borrower

Financial intermediaries : institutions that channel funds from savers to borrowers

-          3 purposes of financial intermediaries

-          Share risk: through diversification: spreading out investments to reduce risks

-          Provide information:  get a financial advisor

-          Liquidity: returns. The money investor receives above/ beyond the sum of money initially invested. The higher the risk the higher the return

Stocks and loans:

Bonds you loan, stocks you own

Bonds: loans or IOUs that represent debt that the government or a corporation must repay to an investor

-          Generally low risk investments

-          3 components:

-          Coupon rate: interest rate that a bond issuer will pay to a bond holder

-          Maturity: time at which payment to a bond holder is due

-          Par Value:  the principal, the amount the investor pays to purchase a bond

Yield: the annual rate of return on a bond if the bond were held to maturity.

With disposable income, households can either

o   Consume (spend money on goods and services )

o   Save ( not spending money on goods and services )

·         Disposable Income ( DI )

o   Income after taxes or net income

o   DI = Gross Income – Taxes

·         Consumption

o   Household spending

o   Ability to consume constrained by

o   The propensity to save

§  Do households consume if DI = 0?

·         Autonomous

·         Saving

o   Household not spending

o   Amount of disposable income

o   Propensity to consume

§  So households save if DI = 0?

·         No

Ø  APS= S / DI = % DI that is not spent

Ø  APC and APS

o   APC + APS = 1

o   1 – APC = APS

o   1 – APS = APC

o   APC > 1 : Dissaving

o   –APS: Dissaving

Ø  MPC and MPS

o   Marginal Propensity to consume

§  changeC / changeDI

§  Percent of every extra money earned that is spent

o   Marginal Propensity to save

§   change S / changeDI

§  Percent every extra money earned is saved

o   1 – MPC = MPS  

o   1 – MPS = MPC

Spending Multiplier Effect

·         Initial change spending ( C, Ig, G, Xn)  causes a larger change in aggregate spending, or aggregate demand ( AD )

·         Multiplier =           Change in AD___

Change in spending

·         Multiplier = changeAD / change C, I , G, or Xn

·         Expenditures and income flow continuously sets off a spending increase in economy.

·         Spending Multiplier can be calculated from the MPC or MPS

·         Multiplier = 1/1-MPC or 1/MPS

·         Multiplier are positive when there is an increase in spending and negative when there is a decrease.

·         The government taxes the multiplier works in reverse.

o    Because money is leaving the circular flow

o   Tax Multiplier (negative)

§  -MPC/ 1-MPC or –MPC/MPS

If tax – cut, multiplier is positive because now money is in the circular flow

Three schools of economics

Classical:

 Adam smith

 john b say

David Riccardo

 Alfred Marshall

Keynesian:

John Maynard Keyne

Congress,

Monetary school:

Allen greenspan,

ben Bernake

Classical School:

Competition is good

 Invisible hand (market runs itself)

Liaises fare

 Say’s law: supply creates its own demand (whatever output is produced creates its own demand

Economy is always close to or at full employment

 Trickle-down effect: help rich then everyone else

Savings is a leakage

Investing is an injection

Savings increase with the interest rate

Prices and wages are flexible downwards

In the long run the economy will balance out at full employment

They focus on AS: it determines output

AS=AD at full equilibrium

Keynesian School

Competition is flawed.

AD is the key, not AS

Demand creates its own supply

AD determines output

Savings doesn’t = investment

Savings are inverse to interest rates

Leaks causes constant recessions

Savings cause recessions

Ratchet effects and sticky wages block Say’s Law

Since there is no guarantee for full employment, in the long run we are dead

The economy is not always close to or at full employment

Will use fiscal policy

Will add stabilizers

Will use expansionary and contractionary policies

Monetary School

Congress can’t time the policy options

Voters won’t allow contractionary options

Easy money, tight money

We can change the required reserves if needed

We can buy and sell bonds through open market operations

We can use the interest rate to change the discount rate and the federal fund rate

Consumption and Saving

-Disposable Income:

Income after taxes or net income
DI = Gross Income - Taxes
2 choices
* with disposable income, household
- consume (spend money on goods, and services )
- save (not spend money on goods & services)

- Consumption
Household spending
the ability to consume is constrained by the amount of disposable income
the propensity to save
* Do households consume if DI = O
- Autonomous consumption
-Dis-saving
APC = C/ DI = DI that is Spent saving
house hold NOT spending
the ability to save is constrained by the amount of disposable income
the propensity to consume
Do house holds save if DI + O- NO

APS = S/DI=%DI that is not spent
APC and APS
APC+APS=1
1-APC = APS
1-APS =APC
APC > 1.: dis-saving
-APS.: Dis-saving
MPS and MPC

*Marginal Propensity to consume 
- change in C/ change in DI
-% of every extra dollar earned that is spend
* Marginal Propensity to save
- change in S/ change in DI
-% of every extra dollar earned that is save
- MPC + MPS = 1
-1-MPC=MPS
-1-MPS=MPC

Full Employment – February 17, 2015

·         Full employment equilibrium exists where AD intersects SRAS and LRAS at the same point

Recessionary Gap

·         A recessionary Gap exists when equilibrium occurs below full employment output

·         Any time you are in a recession or in a recessionary gap, AD is shifting to the left which means it is decreasing

Inflationary Gap

·         An inflationary gap exists when equilibrium occurs beyond full employment output.

·         AD will shift to the right which shows an increase

Changes (Triangle) In AD

·         AD = Aggregate Demand

·         Pi symbol and Percentage = Inflation

·         u and Percent = unemployment

Investment

·         Investments are money spent or expenditures on:

o   New Plants (factories)

o   Capital equipment (machinery)

o   Technology (hardware & software)

o   New Homes

o   Inventories (goods sold by producers)

Expected Rates of Return

·         How does businesses make investment decisions?

o   Cost/Benefit Analysis

·         How does business determine the benefits?

o   Expected rate of return

·         How does business count the cost?

o   Interest costs

·         Hoe does business determine the amount of investment they undertake?

o   Compare expected rate of return to interest costs

§  If expected return > interest cost, then invest

§  If the expected return < interest cost, then do not invest

Real (r%) v. Nominal (i%)

·         What’s the difference?

o   Nominal is observable rate of interest. Real subtracts out inflation (pi%) and is only known ex post facto.

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

o   r% = i% - pi%

·         What then, determines the cost of an investment decision?

o   The real interest rate (r%)

Investment Demand Curve (ID)

·         What is the shape of the Investment demand curve?

o   Downward sloping

·         Why?

o   When interest rates are high, fewer investments are profitable; when interest rates are low, more investments are profitable