MIDTERM TOPICS

•Modeling Money
•Aggregate Deman & Supply
•Modern Macroeconomics Model
•Economic Interdependence
•The Federal Reserve System
•Monetary Control
 Why Do We Need a Model?
• To show how the functions of money affect
the demand for money
• To learn how money interacts with other
variables in the economy, such as income,
prices, and interest rates
The ATM Model of Demand for Cash

 How do we decide how often to go to the ATM?

– The costs (both in time and money) of using the ATM

– The amount we want to spend
– The risk of loss or theft
– Opportunity of holding cash in lieu of earning money in
the bank (dependent upon nominal interest rates)
Exogenous & Endogenous Variables

• Exogenous variables occur outside a model.

– In the ATM model, four variables are exogenous.
• Nominal interest rate
• Tracy’s daily spending
• Costs of a visit to the ATM
• Possibility of loss or theft
• Endogenous variables are determined within the
model itself.
– In the ATM model, three variable are endogenous.
• Number of days between visits to the ATM
• Amount withdrawn at each visit
• Average cash balances
 The Liquidity Preference Model
 Illustrates how money demand and supply determine
the nominal interest rate.
 The model assumes that people choose between
either holding cash (a preference for liquidity) or
investing it at the nominal interest rate.
 In general, people will prefer to invest more money
when the nominal interest rate (the price of money)
is higher.
 The Liquidity Effect
• This model demonstrates the liquidity effect, the
inverse relationship between the money supply
and the nominal interest rate.
• This is widely believed to be the primary short-
run effect of expansionary monetary policy.
• This also correlates to business cycles—when
people’s incomes rise and/or as the prices of
goods and services increase, they increase their
demand for money, and vice versa.
 The Dynamic Model of Money
 The liquidity-preference model is a static model, or
one which does not allow for changes in variables
over time.
 A dynamic model does allow for such changes.
 Time is important to include in a model of money
because, like financial investments, money can also
serve as a store of value.
 Further, both the inflation rate and the nominal
interest rate are both dependent on time.
 Can the Federal
Reserve Accurately
Forecast the Demand
for Money?
 Aggregate Demand & Aggregate Supply

 A model of the overall economy that we can use to understand

long-term output growth, business cycles, etc.

 Aggregate demand tells us the total amount of goods and

services being purchased.

 Aggregate supply tells us the total amount of goods and

services produced.

 Equilibrium is where aggregate demand = aggregate supply.

 Aggregate Demand
• Aggregate demand is the total demand for goods and
services by everyone in the economy.
– Consumption: demand by people for consumer goods
– Investment: demand by business firms for equipment and
buildings and demand by people for housing
– Net exports: demand by foreigners for our goods and
services
– Government spending: demand by the government for
goods and services, as well as government investment
spending
 Consumption
• Largest component of aggregate demand
(about 2/3 of total)
• Durable goods: autos, furniture, and major
appliances
• Nondurable goods: do not last as long as
durables (clothing)
• Services: consumed immediately
• Housing is not considered a durable good, but
rather an investment good
What affects consumption?

• Current income: consumers buy more goods and

services when they have more income.
• Future income: if you expect a future income
increase, you may spend more now.
• Wealth: people with greater accumulated assets
generally spend more.
• Taxes: the more taxes consumer have to pay, the
less disposable income they have to spend.
• The real interest rate: higher real interest rates
encourage consumers to save rather than spend.
 Investment
 Investments in physical capital are about one-sixth
of aggregate demand.
 Physical capital is the equipment such as
computers, or build structures such as office
buildings use in production and houses that people
live in.
 The total amount of physical capital in an economy
is its capital stock.
 Financial investment is NOT included; only
investment in physical capital.
What affects business investment?
• Size of existing capital stock compared to desired capital
stock
• Future consumption spending on the part of consumers
(businesses want to anticipate consumer demand)
• Firms’ ability to pay for the new capital
– May use retained earnings in times of profit
– Lower real interest rates stimulate investment as the opportunity
cost of investing or holding cash goes down
 Net Exports
• International trade must be included when calculating
aggregate demand.

• Net exports = exports − imports

– This is the only component of aggregate demand which may
be negative.

• The level of net exports depends on:

– Current domestic income (−)
• Domestic citizens import more from abroad if their incomes are
higher.
– Current foreign income (+)
• Domestic companies export more to foreigners if foreigners have
higher income.
 Government Spending
• Government spending accounts for about one-sixth
of aggregate demand.
• Includes payments to government workers,
government purchases of goods and services, and
gross government investment in physical capital.
 Aggregate Supply
Aggregate supply is the economy’s total
production of goods and services.
Economists distinguish between short- and
long-run aggregate supply.
LRAS is fixed at full employment.
In the short-run, output increases with the
price level, as producers are incentivized to
offer more for sale.
 Long-Run Aggregate Supply
Does the price level affect the amount
produced in the long run?
– Full employment: when capital and labor are fully
utilized; the unemployment rate = the natural rate
of unemployment (reflecting normal job
turnover).
– Full-employment output: the output produced
when the economy is at full employment
 Short-Run Aggregate Supply
Does the price level affect the amount
produced in the short run?
– The amount of capital in the economy is fixed
in the short run, so SRAS cannot be adjusted.
– Producers are reluctant to increase prices
when demand increases, so higher demand
leads to increased output.
– If prices throughout the economy rise (because
of inflation), a firm might think increased
demand for its product means demand for its
product has increased, instead of realizing that
it should raise its prices.
 Monetary Policy &
the AD-AS Model
 Monetary policy refers to the Fed’s decisions about
the size of the money supply.
 If the economy is in a recession, the Fed can increase
the money supply, restoring full-employment
equilibrium with a higher price level.
 Fiscal Policy & the AD-AS Model
Fiscal policy refers to the government’s
decisions regarding levels of taxation and
government spending.
The government can increase aggregate
demand by reducing taxes or increasing
government spending, and vice-versa.
If in recession, the government might cut taxes
or increase government spending to attempt
to restore full employment.
 Rational Expectations Theory
 Rational expectations theory means that people use
all available information in making economic
decisions.
 Large macro models assume people do not have
rational expectations; treat expected inflation as
exogenous, based on past data.
 Under rational expectations, expected inflation
becomes an endogenous variable to which people
can respond in a future-oriented manner.

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 Dynamic Models
• A dynamic model is one in which actions that occur
at one time affect what happens at other times.
• A static model focuses on just one point in time.
• Advantages of dynamic models
– Allow modeling of expectations, thus avoiding the Lucas
critique.
– Examine how people are affected by government policy
actions by including microeconomic foundations of the
macroeconomy.

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Dynamic models are ones with
microeconomic foundations, or are based on
decisions of economic agents.
– Economic agents include households, firms,
governments, and foreigners who make exchange
decisions.
The main disadvantage of dynamic models is
that they are more complicated than static
models.
 Changes in Income
 Consumers with different incomes have different
budget constraints.
 A change in income shifts the entire budget
constraint.
 The budget constraint shifts by the exact amount
as the change in income.
 Changes in Interest Rates
• A change in the interest rate will cause the
slope of the budget constraint to change.
• The point where households neither borrow
nor save in unaffected; at such a point they
neither pay nor receive interest.
 The impact of interest rate
1. Higher benchmark rates imposed by the
Central Bank force banks to increase the
interest rates in loans they charge to
customers. A form of interest in housing, car,
or credit card loan
2.Bank may also choose to raise the interest on
deposit accounts.
 Precautionary Savings
 When households are uncertain about income, they
often decide to save more as a precaution.
 This “extra” amount of saving is known as
precautionary saving.
 Greater uncertainty generally results in more
precautionary savings.
 A household must therefore decide how much to
spend without knowing exactly where their budget
constraint will lie.
 Expectations
 Expectations are people’s beliefs about future
economic variables.
– People have rational expectations when they form
expectations using all available information.
– Expectations are best modeled as endogenous
variables; decisions depend on future variables.
– For example, households might care about future
inflation and form rational expectations of inflation.
– Since inflation depends on monetary policy, it follows
that households will monitor what monetary
policymakers say and do.
 The Impact of Changes in
Government Policy
Consider a change in fiscal policy
– Suppose the government gives everyone in the two-
period model a tax rebate of $1,000 in period 1
(household income rises by $1,000).
– Do the households think the present value of their
incomes has risen by $1,000?
– Not if they realize that the government will increase
taxes in period 2 to pay for the rebate in period 1
– Realizing that the government will tax them $1,800 in
period 2 (= $1,000 × 1.8), people will save the entire
tax rebate, as the present value of their lifetime after-
tax income is unchanged.
 The International Business Cycle
• Countries are not independent of one another;
downturns in one country may coincide with others.
• The relationship between these countries is the
international business cycle.
1. What causes the business cycles of different countries to
be related?
2. Is the whole world in the same phase of the business
cycle simultaneously?
3. How are shocks in one country transmitted to other
countries?
 Why Is There an International
Business Cycle?
 Shocks may affect several countries.
– A shock is an unexpected change in an exogenous variable.
When large enough, shocks can lead to macroeconomic
fluctuations.
– Example: uncertainty about the price of oil demanded by OPEC
(negative shock) or a change in technology (positive shock).
 Shocks may spread because of economic
interdependence.
– When a shock hits one country, others are affected because of
international trade.
– Example: a tax cut in one country to reduce aggregate demand
also decreases demand for imports, affecting the
output/income of another country.
 The International
Transmission of Shocks
Three mechanisms whereby shocks are transmitted:
 Trade effects
– Exports are a component of aggregate demand, so demand
from other countries bears influence.
 Interest-rate effects
– Investment flows across borders, so increased foreign
investment raises output domestically.
 Exchange-rate effects
– Exchange rates help determine the prices of exports and
imports, thereby affecting aggregate demand.
 Exchange Rates
 The exchange rate is the amount of one currency needed to
purchase one unit of another currency.
 Consumers desire foreign currency so that they can purchase
goods from other countries.
 Because currency is traded via the market, the price of
currencies change.
– Appreciation: when the value of one currency increases relative to
another
– Depreciation: when the value of one currency decreases relative to
another
– Example: Exchange rate: Y/Z
 if Y/Z falls, Z depreciates & Y appreciates
 if Y/Z rises, Z appreciates & Y depreciates
 How International Trade
Affects Exchange Rates
• The law of one price: if only one good exists,
it should sell for the same price everywhere.
• The equilibrium exchange rate will hold if the
law of one price is true.
• But in reality, many goods are traded between
countries.
 Purchasing-Power Parity
• Exchange rates depend on price indexes in different
countries.
• Absolute Purchasing-Power Parity
– The exchange rate should equal the ratio of price indexes
of different countries.
– Idea: generalize the law of one price to all goods
– Problem: does not hold in practice because goods differ
across countries and not all goods are traded
• Relative purchasing-power parity is the idea that a
currency in one country should depreciate relative to
the currency in a second country by the amount by
which inflation is higher in the first country.
– Idea: levels of prices may not be reflected in exchange
rate, so absolute purchasing-power parity doesn’t hold;
but changes in inflation do affect exchange rates
– Evidence: works reasonably well, though other factors
matter more and it takes a long time to adjust
 Real Exchange Rates
 Real exchange rates are exchange rates adjusted for
inflation in both countries.

P
xX F
P
– real exchange rate: x = number of units of foreign good
per unit of domestic good
– nominal exchange rate: X = amount of foreign currency
per unit of domestic currency
How Financial Investment Affects the
Exchange Rate

How has the Dollar’s Value Changed Over

Time?
 The Federal Reserve System
• What is the Federal Reserve?
– The “Fed” is the central bank of the United States.
It oversees many financial institutions and ensures
the continued efficient functioning of the
payments system.
– Comprised of three main parts:
• The Federal Reserve banks
• The Board of Governors
• The Federal Open Market Committee (FOMC)
 System is headed by the
Board of Governors.
Figure 15.1 The Structure of the Federal
 The twelve Federal Reserve System
Reserve banks are
located throughout the
nation.
 U.S. monetary policy is
determined by the
FOMC.
 Open-Market Operations
• Open-market operations are the buying and selling of
government securities in the secondary market; a tool to
adjust the money supply.

• Carried out at Open Market Desk (the Desk) of Federal

Reserve Bank of New York

• The interest rate for overnight loans on bank reserves

between banks is called federal funds rate.
• Fed buys securities  more reserves  M ↑  fed funds
rate ↓
• Fed sells securities  less reserves  M ↓  fed funds
rate↑
• The Desk buys or sells from primary government securities
dealers, which are large investment banks and brokers that
meet certain capital requirements and agree to actively
transact.

• The Desk uses repurchase agreements (repos)—an

agreement where the dealer agrees to sell securities to the
Fed and promises to buy it back at a later date—to increase
bank reserves.
 Monetary Control
The Fed does not control the money supply
directly, but indirectly through adjustments to
its monetary base.

This base supports a larger money supply

through the money-multiplier process.

The money supply is a measure of the amount

of money held in the economy, such as M1 or
M2.
 The Money Supply
• Money supply = Money multiplier ×
Monetary base
• Money supply: M1 or M2
• Monetary base: determined by Federal
Reserve; equal to reserves + currency held by
nonbank public
• Money multiplier: depends on decisions by
people, banks, and the Fed
 Money Creation and Destruction
• Fed influences money supply by affecting banks’
reserves, mainly through open-market operations.
• The Fed’s main asset is its portfolio of securities.
• Banks create and destroy money by changing
amount of outstanding loans.
– Money is “created” when more loans are made available
through banks and destroyed when fewer loans are given.
 How Banks Create Money
1. Fed buys securities in open market.
2. First Bank gets reserves and now has excess
reserves.
3. First Bank makes additional loans.
4. Funds go to Second Bank, which now has excess
reserves.
5. Second Bank makes additional loans.
6. Third Bank has excess reserves and so on.
 Realistic Money Multipliers
• Simple examples thus far: money created by banks
and deposited in banks stays in banks
• For a more realistic example, examine:
– how the monetary base is split into reserves and currency
held.
– how different measures of money are split into their
components.
– how banks split between required & excess reserves and
required clearing balances.
– how people split holdings into different assets.
 Bank Reserves
• Banks hold reserves both because of reserve
requirements and because they may desire to
hold some excess reserve.
• Reserves = Required reserves + Excess
reserves
R = RR + ER
 How People & Banks Affect
the Money Supply

• Changes in the multiplier affect the money supply

simultaneously.
• Who determines multipliers?
– People: C/D (ratio of currency to deposits), N/D
(nontransaction deposits to transaction deposits), MMF/D
(money market mutual funds to transaction deposits)
– Banks: ER/D (excess reserves to deposits)
How Decisions by People and Banks Affect the
Multiplier and the Money Supply
 The Tools of Monetary Policy
1. Open-market operations
2. Changes in the discount rate
3. Changes in the interest rate on banks’
reserve balances
4. Changes in reserve requirements
• Bank’s reserves can be broken down into
those borrowed from the Fed:
Monetary base = reserves + currency
 Open-Market Operations
 The most commonly used tool.
 Example: People demand more money during the
holidays, so the Fed increases the monetary base
to prevent the decline in the multiplier from
affecting M1.
 Defensive open-market operations are
undertaken because of seasonal effects or
temporary changes in market demand.
 Dynamic open-market operations are undertaken
when the Fed wants to actively change monetary
policy.
 Discount Lending
 The discount rate is the interest rate banks
pay when they borrow from the Fed at the
discount window.
 When the discount rate is higher, fewer
loans are made.
 The Fed takes a haircut on loan’s collateral
(requires collateral valued at more than the
amount of the loan).
• Primary credit discount loan
– requires CAMELS rating of 1, 2, or 3
– no questions asked
• Secondary credit discount loan
– CAMELS rating of 4 or 5
– questions asked
– secondary credit discount rate currently set at ½
percentage point above primary credit discount rate
• Seasonal credit discount loan
– program to lend at the discount window for
small banks
– for small banks with seasonal demands for credit
(e.g., farm banks)
– rate equals ½ average fed funds rate over the
previous two-week maintenance period + ½
average rate on negotiable CDs over the same
period