Econ test 4

Overview

This lecture covers the fundamentals of money and banking, monetary policy, bank regulation, and government fiscal policy, focusing on key concepts, definitions, and exam-relevant mechanisms.

Money and the Banking System

• Barter is trading goods/services directly without money, requiring a double coincidence of wants.
• Money functions as a medium of exchange, store of value, unit of account, and standard of deferred payment.
• Commodity money has intrinsic value (e.g., gold), while fiat money has value because the government declares it legal tender (e.g., US dollar).
• An asset is something valuable owned (e.g., loans receivable); a liability is something owed (e.g., customer checking accounts).
• Asset-liability time mismatch occurs when liabilities are short-term but assets are long-term.
• A bank's balance sheet includes assets, liabilities, and equity.
• Reserves are bank funds not loaned out; required reserves are mandated, excess reserves can be lent out.
• M1 money supply includes currency, checking accounts, traveler’s checks; M2 includes M1 plus savings, money markets, CDs.
• Money multiplier = 1/reserve requirement; used to calculate the total money creation potential.

Monetary Policy and Bank Regulation

• A bank run is when many depositors withdraw funds out of fear.
• FDIC insures deposits up to $250,000 per individual.
• Federal funds rate is the rate for overnight bank-to-bank loans; the Fed sets a target, not the actual rate.
• Discount rate is what the central bank charges banks for reserve loans.
• Reserve requirement is the minimum % of deposits a bank must keep in reserve (currently 0% in the US).
• The Federal Reserve System is the US central bank; the FOMC sets monetary policy, especially open market operations.
• Open market operations involve buying/selling Treasury bonds to affect money supply and interest rates.
• Expansionary monetary policy (buy bonds, lower rates/requirements) increases money supply to combat recession.
• Contractionary monetary policy (sell bonds, raise rates/requirements) decreases money supply to fight inflation.
• Quantitative easing involves large-scale bond purchases to stimulate the economy during crises.
• Interest on Reserve Balances (IORB) is an active tool; raising IORB is contractionary, lowering is expansionary.

Government Budgets and Fiscal Policy

• Balanced budget: government spending equals tax revenue.
• Budget surplus: tax revenue exceeds spending; deficit: spending exceeds revenue.
• National debt: total of accumulated government borrowing not repaid.
• Discretionary fiscal policy involves explicit legislative changes to spending/taxes; automatic stabilizers adjust automatically (e.g., unemployment insurance).
• Fiscal policy effectiveness may be limited by crowding out (interest rates rise), and recognition, legislative, and implementation lags.
• Expansionary fiscal policy (increase spending/lower taxes) is used in recessions; contractionary (decrease spending/raise taxes) during inflation.
• Tax systems: progressive (higher earners pay higher %), regressive (lower earners pay higher %), proportional (flat %).
• Excise tax is applied to specific goods.
• Marginal tax rate applies only to the next dollar of income, not total income.

Key Terms & Definitions

• Barter — direct exchange of goods/services without money.
• Double Coincidence of Wants — both parties want what the other offers.
• Commodity Money — money with intrinsic value.
• Fiat Money — money by government decree, no intrinsic value.
• Asset — item of value owned.
• Liability — debt or obligation owed.
• Reserves — bank funds not lent or invested.
• M1/M2 Money Supply — categories of money in circulation.
• Money Multiplier — formula to estimate money creation.
• Bank Run — mass withdrawal due to fear.
• FDIC — federal deposit insurance agency.
• Federal Funds Rate — overnight bank-to-bank loan rate.
• Discount Rate — rate Fed charges banks for loans.
• Federal Reserve (Fed) — US central bank.
• FOMC — committee that sets US monetary policy.
• Open Market Operations — buying/selling bonds to manage money supply.
• Quantitative Easing — central bank money-creation by buying assets.
• IORB — interest paid by Fed on reserve balances.
• Balanced Budget — spending equals revenue.
• Crowding Out — government borrowing raises interest rates, reducing private spending.
• Progressive/Regressive/Proportional Tax — types of tax rate structures.
• Marginal Tax Rate — rate applied to each additional dollar earned.

Action Items / Next Steps

• Review and memorize the functions of money and types of monetary policy.
• Practice applying the money multiplier formula with different reserve ratios.
• Understand fiscal policy tools and when to use expansionary vs. contractionary approaches.