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61 Cards in this Set
- Front
- Back
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Three Functions of Money
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1. Medium of Exchange 2. A unit of account 3. A store of wealth |
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M1 vs. M2
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M1- currency in the hands of the public plus checking account balances M2- M1 plus savings and money market accounts, small denomination deposits and retail money funds |
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What is the difference between money and credit? |
Money is the government's liability and your asset. Credit is your liability and an asset to the banks you owe. |
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Three demands for money
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1. Transactions Motive- we can buy things 2. Precautionary Motive- for unexpected expenses and impulse buying 3. Speculative Motive- avoid holding assets whose prices are falling |
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Money Multiplier
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the measure of the amount of money ultimately created per dollar deposited in the banking system when people hold no currency Amount of money created = multiplier X New deposit |
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Reserve Requirements
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Currency and deposits a bank keeps on hand to manage normal cash flows. Reserve Ratio- ratio of reserves to total deposits (1/r)(amount deposited)-(amount deposited)= money created |
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Faith as the backing of our money systems
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Gold Standard to Fiat Money Our money is the government's liability Backed by trust in the federal government |
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What role do Interest Rates have in the economy? |
When IR goes up, price of existing bonds goes down The longer the length of the bond to maturity, the more the price varies with the change in the interest rate |
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Short-term vs. Long-term Interest Rates
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Short- savings deposits/ Checking accounts. ie. Money. Market= money market Long- Market= loanable funds market |
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Role of the Financial Sector
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1. Facilitate Trade- lubricant to the economy 2. Transfer savings back into spending For every real transaction, there is a financial transaction that mirrors it. |
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What is the Fed? |
The US Central Bank, whose liabilities (Federal Reserve Notes) serve as cash in the US
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What is the Structure of the Fed? |
1. 12 Regional banks + 1 main one in DC 2. 7 members on the Board of Governors 3. FOMC (Federal Open Market Committee)- Board of Governors + President of NY branch + 5 other rotating presidents- chief body that decides monetary policy. |
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What are the 6 duties of the Fed?
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1. Conduct monetary policy 2. Supervising and regulating financial institutions 3. Serving as a lender of last resort 4. Providing banking services to the US government 5. Issuing coin and currency (with Treasury Dept) 6. Providing financial services to commercial banks, savings and loan associations, savings banks, and credit unions 7. Maintain stability to financial system 8. foster payment and settlement system safety and efficiency 9. Promoting consumer protection and community development |
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Expansionary vs. Contractionary Monetary Policy
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Expansionary: Money supply up, IR down, Investment up, Output up Contractionary: Money supply down, IR up, Investment down, Output down |
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Tools of the Fed
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1. Monetary Base 2. Open Market Operations 3. Reserve Requirement and Money Supply 4. Discount Rate 5. Fed Funds Market |
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Monetary Base
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Legal reserves of banking system. Money supply is controlled directly by monetary base and indirectly by amount of credit that banks extend |
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Open Market Operations
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The Fed's buying and selling of Treasury bills (>1 year), treasury notes (1-10 years), and treasury bonds (10-30 years) Fed buys bonds, money supply goes up Fed sells bonds, money supply goes down |
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Reserve Requirements
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The percentage the Fed sets as a minimum amount of reserves a bank must have. RR up, money supply down RR down, money supply up Fed pays interest on reserves. To encourage more reserves, it will pay a higher interest rate. |
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Discount Rate (Overnight Rate)
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The rate of interest the Fed charges for loans it makes to banks (set by Fed) DR up, money supply down DR down, money supply up |
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The Fed Funds Market
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Fed Funds: loans of excess reserves banks make to one another Fed Funds Rate: IR banks charge each other for Fed Funds (determined by market but fluctuates with discount rate) Operating target of the Fed If FFR is higher than target, Fed buys bonds If FFR is lower than target, Fed sells bonds |
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The Fed's Main Objectives
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1. Low inflation 2. Low unemployment 3. Economic growth 4. Moderate long-term interest rate (long-term economic health) |
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Policy Credibility
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Credibility decreases/prevents inflationary expectations Want to keep long-term IR low. If it goes up, you need strong contractionary policy. Real IR = Nominal IR - Expected Inflation Rate |
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Three Stages of an Asset Bubble
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1. Blowing Up (rapid price increase of some asset, extrapolative expectations, herding, leverage, Demand and Price go up) 2. Pop! (at an undeterminable point, increase in price is unsustainable, rapid sell-off, Demand down supply up and price down) 3. Clean up (people who used leverage owe a lot with little means to pay it back) |
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Extrapolative Expectations
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Expectations that a trend will accelerate
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Leverage
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The practice of buying an asset with borrowed money
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Herding
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All of society starts buying the same asset because it is expected to continue gaining value |
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The Fed as lender of last resort
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They decide how much to lend to the failing banks. Creates a Moral hazard- will bailout insurance encourage greater risk? |
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Efficient Market Hypothesis
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All financial decisions are made by rational people and are based on all relevant information that accurately reflects the value of assets today and in the future. Prevailing theory before 2008-09 |
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Financial Instability Hypothesis
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3 Stages of how people finance their debt 1. Hedge - people have cash to pay interest and principle (low risk) 2. Speculative- people have cash to pay interest, not principle (riskier) 3. Ponzi- People have to borrow to pay their interest (riskiest)- Collateralized Debt (have asset as collateral) |
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Deposit Insurance
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A system under which the federal government promises to reimburse an individual for any losses due to bank failure FDIC (Federal Deposit Insurance Corporation) Meant to prevent bank runs but people got riskier |
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Moral Hazard
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By having insurance, banks are more likely to take bigger risks knowing that the federal government will bail them out. |
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Glass-Steagall Act
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Established deposit insurance and implemented a number of banking regulations including prohibiting commercial banks from investing in the securities market Worked well through the 1970s |
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Law of Diminishing Control
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Any regulation will become less effective over time as individuals or firms being regulated will figure out ways to circumvent those regulations through innovation, technological change, and political pressure
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Dodd-Frank Act
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A new financial regulatory structure to limit risk taking and require banks to report their holdings so that regulators could assess risk-taking behavior puts responsibility on regulators (FDIC, SEC, Fed) |
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General Principles of Regulation
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1. Set as few bad precedents as possible 2. Deal with Moral Hazard 3. Deal with the Law of Diminishing Control |
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Too-Big-to-Fail Problem
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large financial institutions are essential to the workings of the economy, requiring government to step in to prevent their failure
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Unconventional Monetary Policy
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Quantitative Easing Credit/Qualitative Easing Operation Twist Precommitment Policy Negative Interest Rates |
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Quantitative Easing
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A policy of targeting a particular quantity of money by buying financial assets from banks and other financial institutions with newly created money Increase base money supply by buying assets |
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Credit/ Qualitative Easing
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Attempts to change the portfolio of the Fed's holdings. Fed buys risk from consumers because it can handle the blow.
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Operation Twist
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Selling short-term assets and buying long-term assets Increase trust in investment |
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Pre-commitment policy
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Fed tells public what to expect. Promise to keep IR low for 5 years |
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Negative Interest Rates
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Didn't happen in US Banks borrow from Fed and only have to pay back a percentage of it. |
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5 Criticisms of Unconventional Monetary Policy
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1. Fed is taking on too much risk 2. Federal debt is increasing 3. Investors and lenders lose money 4. Fed has no exit strategy- can't increase the money supply any more |
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Deficit vs. Debt
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Deficit- when you spend more than you take in (Flow Concept) Debt- Accumulated debt minus accumulated surplus (stock measure) |
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Debt to GDP Ratio
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GDP grows when ratio goes down Inflation and real growth reduce the problem of debt |
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3 Differences between individual and government debt |
1. Government lives forever, people don't 2. Government can print money, people can't 3. Government owes much of its debt to itself, to its citizens |
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Internal vs. External Debt
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Internal: debt owed to other government agencies or to its own citizens External: debt owed to individuals in foreign countries |
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Structural vs. Cyclical Deficits
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Structural- the part of a budget deficit that would exist even if the economy were at its potential income level Cyclical- the part of the deficit that exists because the economy is operating below its potential output (related to fiscal policy- smooth business cycle) |
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Actual Deficits
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Actual Deficit = Structural + Cyclical Cyclical = Tax Rate X (Potential - Actual Output) Structural = Actual - Cyclical |
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Nominal vs. Real Deficits
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Nominal- deficit determined by looking at the difference between expenditures and receipts Real- the nominal deficit adjusted for inflation (inflation wipes out debt) Real = Nominal - (Inflation X Total Debt) |
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Debts vs. Assets
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Debt is only 1/2 of the ledger and assets is the other Assets= real improvements in people's lives. Stock of wealth |
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Classical Economics and Sound Finance
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A view of fiscal policy that the government should always be balanced except in wartime
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Ricardian Equivalence Theory
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Deficits do not affect the level of output in the economy because individuals increase their savings to account for expected future tax payments to repay the deficit Deficits do not matter |
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Keynesian Economics and Functional Finance
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Government's should make spending and taxing decisions on the basis of their effect on the economy, not on the basis of some moralistic principle that budgets should be balanced |
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Assumptions of the AS/AD Model in regard to functional finance
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1. Financing the deficit doesn't have any offsetting effects 2. The government knows what the situation is 3. Government knows economy's potential income level 4. Government has flexibility to change spending and taxing 5. Size of government debt doesn't matter 6. Fiscal policy doesn't negatively affect other government goals |
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Crowding Out
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The offsetting of a change in government expenditures in the opposite direction Private investment decreases when government spending increases |
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Automatic Stabilizers
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A government program or policy that will counteract the business cycle without any new government action ex. Income Tax, Welfare Payments, and Unemployment Insurance |
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State Government Fiscal Policy
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Automatic Destabilizers- Constitutional requirements for a balanced budget Avoiding this... but politics get in the way 1. Rainy-day fund 2. 5 year rolling average |
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Procyclical Fiscal Policy
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changes in government spending and taxes that increase the cyclical fluctuations in the economy instead of reducing them
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Deficit Hawks, Doves, and Owls
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Hawks- attack deficit and control it Doves- It matters but not as much as spending Owl- Functional Finance |
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Modern Macro Policy Precepts
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Blend functional and sound finance
"Do Nothing" Approach- use automatic stabilizersIf it's severe enough, use expansionary fiscal policy |
