Econ 317 Final

Goals of Monetary Policy

In addition to price stability:
1. high employment and output stability
2. economic growth
3. stability of financial markets
4. interest-rate stability
5. stability in foreign exchange markets

Sources and Uses of Bank Funds

Uses of Bank Funds:
Sources of Bank Funds:
Liabilities: ownership claims on assets by someone outside the bank
Stockholder's Equity: ownership claims on assets by owners of the bank
Banks profit when there is a positive spread between the average r

Money Supply Measures

C: Currency
D: Deposits
M: Money Supply
M1: C + demand deposits, travelers' checks, other checkable deposits
M2: M1 + small time deposits, savings deposits, money market mutual funds, money market deposit accounts

Banks' Role in the Monetary System

M = C + D
money supply includes demand deposits

Total Reserves

Reserves: assets that financial intermediaries can use to meet their reserve requirements
Reserves Consist of:
Cash in vaults of financial intermediaries
Deposits at Central Bank

Monetary Base (high powered money) includes:

Currency in Circulation

Typical Balance Sheet

Deposits at other banks
Other assets
Liabilities + Stockholders' Equity
Borrowing from the central bank
Borrowing from other banks
Stockholders' equity

Bank Capital

the resources a bank's owners have put into the bank


the use of borrowed money to supplement existing funds for purposes of investment
leverage ratio: assets/capital
being highly leveraged makes banks vulnerable to economic downturns

Capital Requirement

minimum amount of bank capital mandated by regulators
intended to ensure banks will be able to pay off depositors
higher for banks that hold more risky assets

2008-2009 Financial Crisis

losses on mortgages shrank bank capital, slowed lending, exacerbated the recession
govt injected capital into banks to ease the crisis and encouraged more lending

No Banks

No deposits
M = C

100% Reserve Banking

a situation in which banks' reserves equal 100% of their deposits
Before deposit:
C=1000, D=0 -- M=1000
After deposit:
C=0, D=1000 -- M=1000
No impact on size of money supply

Fractional-Reserve Banking

a banking system that keeps only a fraction of funds on hand and lends out the remainder
Banks create money

Money Creation in the Banking System

A fractional-reserve banking system creates
money, but it doesn't create wealth:
Bank loans give borrowers some new money
and an equal amount of new debt.

A Model of the Money Supply (exogenous variables)

Monetary Base: B=C+R, controlled by the central bank
Reserve-Deposit Ration: rr=R/D, depends on regulations & bank policies

Solving for Money Supply

M = m x B
where: m = cr+1/cr+rr

The Money Multiplier

the increase in the money supply resulting from a 1-dollar increase in the monetary base
if the monetary base changes by deltaB; deltaM = m x delta B

Why the Fed can't precisely control M

- Households can change (cr) causing m and M to change
- Banks often hold excess reserves (reserves above the reserve requirement).
- if banks change their excess reserves, then rr, m, and M change.

What Causes Changes in the Monetary Base

Rule of Thumb: A nation's monetary base changes only when funds cross our imaginary horizontal line
Domestic and Foreign: Individuals, businesses, banks and other financial institutions, govt

What Causes the Monetary Base to Increase

- when the central bank INCREASES ITS ASSETS (i.e. when it buys something or lends)

What Causes the Monetary Base to Decrease

- when the central bank DECREASES ITS ASSETS (i.e. when it sells an asset or outstanding bank loans are repaid)

Assets Purchased by Central Banks

- govt securities
- foreign exchange
- discount loans to financial intermediaries

The Instruments of Monetary Policy

- open market operations
- the discount rate
- reserve requirements
- interest on reserves

Open Market Operations

- Fed's preferred method of monetary control)
- to increase the base, the Fed could buy govt bonds, paying with new dollars

Discount Rate

- the interest rate on the loans that the Fed makes to banks
- to increase the base, the Fed could lower the discount rate, encouraging banks to borrow more reserves

Reserve Requirements

- Fed regulations that impost a minimum reserve-deposit ratio
- to reduce the reserve-deposit ratio, the Fed could reduce reserve requirements
- Depository Institutions Deregulation and Monetary Control Act of 1980 sets the reserve requirement the same fo

Interest on Reserves

- the Fed pays interest on bank reserves deposited with the Fed
- to reduce the reserve-deposit ratio, the Fed could pay a lower interest rate on reserves

Advantages of Open Market Operations

- the Fed has complete control over the volume
- flexible and precise
- easily reversed
- quickly implemented

Advantages and Disadvantages of Discount Policy

- used to perform role of lender of last resort
- important during the subprime financial crisis of 2007-2008.
- cannot be controlled by the Fed; decision maker is the bank
- discount facility is used as a backup facility to prevent the federal funds rate

Disadvantages of Reserve Requirements

- no longer binding for most banks
- can cause liquidity problems
- increases uncertainty for banks

The 2007-2009 Financial Crisis: QE but no Inflation

- quantitative easing: the Fed bought long-term govt bonds instead of T-bills to reduce long-term rates
- Fed also bought mortgage-backed securities to help the housing market; monetary base tripled

The 2007-2009 Financial Crisis and the Money Supply

- currency ratio fell somewhat that would raise the money multiplier and the money supply because it would increase the overall level of deposit expansion
- effects of the decline in c were entirely offset by the extraordinary rise in the excess reserves

Russian Flu" (1997-1998)

- Asian Crisis causes speculative attack on ruble
- CBR defends the ruble, loosing $6 million1997 ends with a 0.8 % growth
- prices of oil and non ferrous metals begin to drop
- new tax code submitted to the Duma, IMF funds requested (FEB. 1998)
- politic

Capital Flight

a large and sudden reduction in the demand for assets located in a country

Real-World Examples of Capital Flight

- Russia, 1998
- Mexico, 1994
- Southeast Asia, 1997
- Argentina, 2002

Private Saving

- the portion of households' income that is not used for consumption or paying taxes

Public Saving

- tax revenue less govt spending

National Saving

- private saving + public
- the portion of national income that is not used for consumption or govt purchases

Saving and Investment

- saving = investment in a closed economy

National Income Accounting Identity

Y = C + I + G + NX


- the equilibrium quantity of loanable funds = the equilibrium of investment and equilibrium of saving
- interest rate adjusts to equate supply and demand

Saving Incentives

- tax incentives for saving increase the supply of loanable funds
- which reduces the equilibrium interest rate and increases the equilibrium quantity of loanable funds
- S1 shifts right

Increase in Budget Deficit

- reduces national saving and the supply of loanable funds
- which increases the equilibrium rate and decreases the equilibrium quantity of loanable funds and investment
- S1 shifts to the left

Crowding Out

- increase in budget deficit causes fall in investment
- the govt borrows to finance its deficit, leaving less funds available for investment

International Capital Flows

- net capital outflow
- when S > I, country is a net lender
- when S < I, country is a net borrower

Net Capital Outflow

S - I
- net outflow of "loanable funds"
- net purchases of foreign assets-the country's purchases of foreign assets minus foreign purchases of domestic assets.

The Market for Loanable Funds

S: saving
I: domestic investment
NCO: net capital outflow
- supply of loanable funds = saving
- demand for loanable funds = I+NCO

The Loanable Funds Market Diagram

- r adjusts to balance supply and demand in the LF market
- Both I and NCO depend negatively on r, so the D curve is downward-sloping

Budget Deficit and Capital Flows

- LF market determines r
- then this value of r determines NCO

The Link Between Trade & Capital Flows

NX = Y-(C+I+G)
thus: NX=S-I
trade balance = net capital outflow
- a country with a trade deficit (NX<0) is a net borrower (S<I)

The Market for Foreign-Currency Exchange

- in the market for foreign-currency exchange
- NX: the demand for dollars, because foreigners need dollars to buy U.S. net exports
- NCO: the supply of dollars, because U.S. residents sell dollars to obtain the foreign currency they need to buy fo

The Market for Foreign-Currency Exchange Graph

an increase in E has no effect on saving or investment, so it does not affect NCO or the supply of dollars

Budget Deficit and Exchange Rate

- the budget deficit reduces NCO and the supply of dollars
- the real exchange rate appreciates, reducing nx
- since NX=0 initially, the budget deficit causes a trade deficit (NX<0)
- S shifts left, E shifts up

The Effects of a Budget Deficit: Summary

- national savings falls
- the real interest rate rises
- domestic investment and net capital outflow both fall
- the real exchange rate appreciates
- net exports fall (or, the trade deficit increases)

Russia: Political Instability and Capital Flight

- 1998: political instability in Russia made world financial markets nervous
- people worried about the safety of Russia assets they owned
- people sold many of these assets, pulled their capital out of Russia

Capital Flight from Russia

LF diagram:
- D shifts right
- r shifts up
NCO diagram:
- NCO shifts right
- r shifts up

Capital Flight from Russia pt.2

- the increase in NCO causes an increase in the supply of rubles in the foreign exchange market
- the real exchange rate value of the rubles falls
- E shifts down
- S shifts right

The Model of Aggregate Demand and Aggregate Supply

- the model determines the equilibrium price level and real GDP

The Aggregate-Demand (AD) Curve

shows the quantity of all goods and services demanded in the economy at any given price level

Why the AD Curve Slopes Downward

- Y=C+I+G+NX
- assume G is fixed by govt policy
- to understand the slope of AD, we must determine how a change in P affects C, I, and NX

The Slope of the AD Curve: Summary

An increase in P reduces the quantity of g&s demanded because:
- the wealth effect (C falls)
- the interest-rate effect (I falls)
- the exchange-rate effect (NX falls)

Why the AD Curve Might Shift

Any event that changes C, I, G, or NX (except a change in P) will shift the AD curve
- example: a stock market boom makes households feel wealthier
- C rises
- AD curve shifts right

Why the AD Curve Might Shift: Summary

- Changes in C
- stock market boom/crash
- preferences: consumption/saving tradeoff
- tax hikes/cuts
- Changes in I
- firms buy new computers, equipment, factories
- expectations: optimism/ pessimsim
- interest rates, monetary policy
- investment tax cred

Classical Economics

- Classical Dichotomy (the separation of variables into 2 groups)
- real: quantities, relative prices
- nominal: measured in terms of money
- Neutrality of Money
- changes in the money supply affect nominal but not real variables

Why LRAS is Vertical

- YN determined by the economy's stocks of labor, capital, and natural resources, and on the level of technology.
- An increase in P does not affect any of these, so it does not affect YN. (classical dichotomy)
- P increases

Why the LRAS Curve Might Shift

- Any event that changes any of the determinants of YN will shift LRAS
- example: immigration increases L, causing YN to rise

Using AD & As to Depict LR Growth and Inflation

- over the long run, technical progress shifts LRAS to the right
- growth in the money supply shifts AD to the right
- result: ongoing inflation and growth in output

Why the Slope of SRAS Matters

- if AS is vertical, fluctuations in AD do not cause fluctuations in output or employment.
- if AS slopes up, then shifts in AD do affect output and employment.

The Sticky-Wage Theory

- Imperfection: - Nominal wages are sticky in the short run, they adjust sluggishly.
- Due to labor contracts, social norms
- Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail.
- if P > PE, revenue is hi

The Sticky-Price Theory Pt.2

- imperfection:
- many prices are sticky in the short run
- menu costs
- firms set sticky prices in advance based on PE

Menu Costs

- the costs of adjusting prices
- examples: cost of printing new menus, the time required to change price tags
- higher P is associated with higher Y, so SRAS curve slopes upward


Y=YN + a(P-PE)
- in the long run, PE=P and Y=YN

The Long-Run Equilibrium

- in the long-run equilibrium, PE=P, Y=YN
- unemployment is at its natural rate

The Effects of a Shift in AD

- Event: Stock Market Crash
1. Affects C, AD Curve
2. C falls, so AD shifts left
3. SR equilibrium at B. P and Y lower, unemployment higher
4. Over time, PE falls, SRAS shifts right, until LR equilibrium at C. Y and unemployment back at initial levels

The Effects of a Shift in SRAS

- Event: Oil Prices Rise
1. Increases costs, shifts SRAS (assume LRAS constant)
2. SRAS shifts left
3. SR equilibrium at point B. P higher, Y lower, unemployment higher from A to B
- stagflation


A period of falling output and rising prices

Accommodating an Adverse Shift in SRAS

- If policymakers do nothing
- low employment causes wages to fall, SRAS shifts right, until LR equilibrium at A
- or, policymakers could use fiscal or monetary policy to increase AD and accommodate the AS shift:
- Y back to YN, but P permanently higher

The Theory of Liquidity Preference

- money demand reflects how much wealth people want to hold in liquid form
variables that influence money demand: Y, r, and P
example: a household's "money demand" reflects its preference for liquidity

Money Demand

- an increase in Y causes an increase in money demand, other things equal
Y: real income

Changes in r

r: the opportunity cost of holding money
- an increase in r reduces money demand
- households attempt to buy bonds to take advantage of the higher interest rate
- an increase in r causes a decrease in money demand, other things equal

Changes in P

an increase in P causes an increase in money demand, other things equal

How r is Determined

- MS curve is vertical: Changes in r do not affect MS, which is fixed by the Fed.
- MD curve is downward sloping: A fall in r increases money demand.

How the Interest-Rate Effect Works

- A fall in P reduces money demand, which lowers r
- A fall in r increases I and the quantity of g&s demanded

The Effects of Reducing the Money Supply

- The Fed can raise r by reducing the money supply.
- An increase in r reduces the quantity of g&s demanded.

Fiscal Policy

- Fiscal Policy: the setting of the level of govt spending and taxation by govt policymakers
- Expansionary Fiscal Policy:
- an increase in G and/or decrease in T
- AD shifts right
- Contractionary Fiscal Policy:
- a decrease in G and/or increase in T
- A

The Marginal Propensity to Consume

- change in consumption/change in income
MPC = change in consumption/change in disposable income

Marginal Propensity to Save

- the fraction of each additional (marginal) dollar of disposable income not spent on consumption

Money Multiplier

deltaY = (1/1-MPC) * deltaG
- a bigger MPC means changes in Y cause bigger changes in C, which in turn cause more changes in Y

The Multiplier Effect

- the increase in Y causes C to rise, which shifts AD further to the right

The Crowding-Out Effect

- A fiscal expansion raises r
- which reduces investment
- which reduces the net increase in agg demand.
- So, the size of the AD shift may be smaller than the initial fiscal expansion.

How the Crowding-Out Effect Works

� A $20b increase in G initially shifts AD right by $20b
� But higher Y increases MD and r, which reduces AD.

Changes in Taxes

- A tax cut increases households' take-home pay.
- Households respond by spending a portion of this extra income, shifting AD to the right.
- The size of the shift is affected by the multiplier and crowding-out effects.
- Another factor: whether household

India's Currency Practices

- in an April 2018 report, U.S. Treasury reports an increase in the "scale and persistence" of the country's net foreign exchange purchases
- India has been buying the U.S. dollar in exchange for the rupee to keep its domestic currency from surging to eco

RBI Has Been on a Buying Spree

- India's net currency purchases rose to around $56B, or 2.2% of its GDP, over 2017
- compared to the $10B, or 0.4% of GDP, net purchases in calendar year 2016
- the increase in intervention came in the context of strong capital inflows, with FDI of $34B

India's Currency Practices Pt.2

- at end of 2017 foreign currency reserves were valued at $385B
- equal to 3.5x gross short term external debt
- 9 months of import cover and 15% of GDP

Three Criteria That Define an "Unfair Practice

1. a country has at least a $20B trade surplus with the U.S.
- meaning the value of goods it exports to the U.S. exceeds the value of its American imports by that much
2. a country has net foreign currency purchases of at least 2% of GDP over a 12-month p

Currency Manipulator

- economics that fulfill 2 out of 3 criteria are put on a monitoring list
- increases the risks of race sanctions from the U.S.
- 6 countries being watched: china, Japan, South Korea, germany, Switzerland, and India

India at Risk of "Currency Manipulator" Label from U.S. Treasury

- used to meet only one of those criteria
- its trade surplus with the U.S. came in at $23B in the 12 months to June
- higher than the $20B threshold
- the country's current account deficit and net foreign exchange purchases of 1.8% of GDP were helping it

New Report (October 17, 2018)

- RBI net sales of foreign exchange over the first six months of 2018 led net purchases through June 2018 to fall to $4B, or 0.2% GDP
- India has a significant bilateral goods trade surplus with the United States, totaling $23B over the four quarters thro

Calculating Exchange Rate

E=(e x P)/P*
e: nominal exchange rate
P: price in USA (or other country)
P*: price in foreign country