Macroeconomics Unit 4: Financial Markets Summary

Hi everybody, Jacob Reed here from ReviewEcon.com. Today we're going to be looking at Macroeconomics Unit 4. This one is all about financial markets. These videos go alongside the total review booklet from ReviewEcon.com, so if you're interested, head down to the links below. Also, don't forget to like and subscribe. Let's get into the content. Since this unit is all about financial markets, we're going to start off by talking about some financial assets. The first asset we'll discuss is stocks. Stocks are certificates of ownership for a corporation. Bonds, on the other hand, are a certificate that gives the owner the right to be paid back for a loan to a business or the government. There is an inverse relationship between the price of bonds and the interest rate. Money is another financial asset that is the most liquid or most easily spent of all assets. It's that money asset that this unit focuses on. Now, money is not what economics is all about, but we discuss it a lot in this unit. Let's talk about the three functions of money now. Money, first of all, must be able to be a medium of exchange. That means it can be used to buy goods and services. The second thing money must be able to do is serve as a unit of account or standard of value. That means it can be used as a yardstick or measuring tool to measure relative values. The third thing money must be able to do is store value. If I work really hard today, the value of my work will be stored in the dollars, and they will keep their value for the foreseeable future, assuming we have low inflation. When it comes to measures of the money supply, we have three ways of measuring it. The first one and most narrow definition of money is the M0 or monetary base measure of the money supply. That includes bank reserves and that's money that the bank has in their possession, but they haven't yet loaned out. And officially, bank reserves are not money because they are not a medium of exchange. But in the monetary base, we also include currency, which is cash and coins. And that currency is money. M1 is another measure of the money supply and that includes money that is usable as a medium of exchange. This includes currency, the cash and the coins, as well as checkable deposits and savings deposits. M2 is the most broad definition of money. It includes all of M1 plus small time deposits, that's certificates of deposit for less than $100,000, as well as money market mutual funds. Next, we're going to talk about the Fischer formula. The Fischer formula tells us the relationship between nominal and real. rates of change. The difference between the two is the inflation rate. We have a formula. It's little i approximately equals little r plus pi. What do those variables stand for? Well, the little i is the nominal rate of interest. The little r is the real interest rate. And pi is not 3.14. It's the rate of inflation. Here's an example to put that formula into use. Let's say the bank wants. a real interest rate of 5%. That's the expected rate of return they hope to achieve. At the same time, the expected rate of inflation is 2%. Add those together and that tells us the nominal rate of inflation this bank will charge is 7%. We can also flip this formula around and work backwards. Let's say the actual rate of inflation ends up being 3% instead of 2%. We can take the nominal rate of interest that the bank charges, subtract the 3% actual inflation rate, And that will give us an actual real interest rate of only 4%. Since the actual rate of inflation is sometimes different than the expected rate of inflation, that tells us that unexpected inflation can help some people and hurt other people. Here are the two main categories that you need to know. Borrowers are primarily the group of people that are helped by higher than expected rates of inflation. That's because they pay lower real interest rates and they pay back their loans with less valuable money or fewer real dollars. Lenders, on the other hand, are hurt by higher than expected rates of inflation. That's because the real interest rate they earn decreases when inflation increases. They are also paid back fewer real dollars or less valuable money. The next thing we're going to do is look at what is often considered one of the most difficult concepts in AP economics. I don't think it's that bad if you take it one step at a time and make sure you understand each little part. These are called bank balance sheets. First of all, on our bank balance sheet, we have an asset side. and a liability side. On the asset side, those are the things of value that the bank owns. On the liability side, those are the things of value that the bank owes to somebody else. Let's talk about the components of that liability side. We have demand deposits. Those are also called checkable deposits. Those are checking account deposits that are owed to the bank's customers. Savings deposits are also there. Those are the savings accounts deposits and they are also a liability because they're owed to other people. Finally, we have other liabilities. Those could be loans that the bank owes to other banks, to the Federal Reserve, or it could even be profit, sometimes even a loan. called owner equity that is owed to the owners of the corporation. On the asset side, we have total reserves. Total reserves are the funds that the bank has available to them. This is broken up into two categories, required reserves and excess reserves. Let's talk about required reserves first. Required reserves are a percentage of checkable deposits. That percentage is set by the Federal Reserve for monetary policy. We'll get to that in a little while. The second component of total reserves is excess reserves. Excess reserves are the funds that the bank has available that they can loan out. To find the excess reserves, you take the total reserves, subtract the required reserves, and what's left is excess reserved. That's the money the bank can loan out. Next thing you'll find on the asset side are loans. Now, these aren't loans that the bank has borrowed from other people. These are loans the bank has made to their customers. These are IOUs. They have value, and it's the value of whatever money was loaned to the customers. Finally, we have other assets. The bank has all kinds of things of value. The building itself, the desks, etc. That stuff is assets and the value of it goes on the asset side. The last thing you need to be aware of is that assets and liabilities will always be equal on the bank balance sheet. If they aren't equal, you've gone wrong somewhere and you need to double check your math. Now, manipulating the values within a bank balance sheet is something you should be able to do. We're going to go over an example right now, but if you still need some help. make sure you head over to ReviewEcon.com and check out the bank balance sheet game that I have there. Let's say a customer of this bank puts $100 cash in their checking account. Let's see how that will impact this bank balance sheet. First of all, demand deposits is going to increase by $100. Now that's also going to have to balance out on the other side. Here we're going to have total reserves increase by $100 because the customer gave them $100 and now the bank has that $100. They owe it on the liability side. They also have it on the assets side. That total reserves is $100, but it will be broken into two different values. If there's a 10% reserve requirement set by the Federal Reserve, $10 of it will be required reserves and the rest of it, $90, will be excess reserves that can be loaned out. The next thing we're going to talk about is the money multiplier. The money multiplier tells us how many dollars worth of new loans, deposits, and money can be created from excess reserves. Here's how that works. Just a reminder, we have a $100 deposit with a 10% reserve requirement. When the first customer deposits that $100, $90 of it can be loaned out. That money will eventually be redeposited and then 90% of that... $81 will be loaned out again. That is $81 of new money. Then that $81 will be eventually redeposited. And 90% of that $72 and 90 cents here will also be loaned out and then redeposited. This will happen over and over and over again. And the new loans are new money because every new amount that is redeposited in a checking account is money because checkable deposits are part of the M1 money supply. In order to find out how much money can be created from the excess reserves, you take one and divide it by the reserve requirement. Here are some examples. With a 10% reserve requirement, we will have a multiplier of 10. With 20%, we will have a multiplier of 5, 25%, 4. 33 and a third percent, three, and 50%, two. Those are the most common numbers you're gonna see on your exams. For this example, we're going to look at a multiplier of 10 because the reserve requirement right now is 10%, and one divided by 10% is 10. So we're gonna take the money multiplier and multiply that by the excess reserves. That tells us how much new money, loans, and deposits will be created from those excess reserves. You may also need to include the original amount depending on the question you're being asked on your exams. Getting back to the example we just looked at, we've got $90 worth of excess reserves. We're going to take that and multiply it by the multiplier of 10, and that gives us $900 worth of new loans that can be created. Since the original amount of $100 wasn't a loan, we're just going to leave it at that $900. If we're looking at new amounts of money, we take the $90 and... times that by the multiplier of 10, that's $900 worth of new money that's created. And we again don't add in the original amount because remember it was a cash deposit into the checking account and as a result it was already part of the M1 money supply. So we're going to leave this number at $900 as well. If we were asked how many deposits were created on the other hand, it would be a little bit different. First we take the excess reserves of $90 and times it by 10, which gives us $900 worth of new deposits. But then we also need to add in that original $100 again, because that was a new deposit from the start. As a result, the total amount of new deposits that would be created as a result of this first new deposit of $100 is $1,000 worth of deposits. The money multiplier tells us the maximum ...ounce of new loans, deposits, and money that can be created from excess reserves. In reality, the numbers will be much lower. And that's because we have some leakages within this model. First of all, many banks hold excess reserves, and they don't loan out as much as they could. The second leakage comes from consumers holding onto cash, rather than depositing their money into their banks. The next thing we're going to do is look at the money market graph. Just like other markets we've learned, we've got a supply curve and a demand curve. We're going to look at the demand curve first. Money demand is based on the fact that the opportunity cost of holding money is the nominal interest rate. When nominal interest rates are high, people demand fewer dollars because the opportunity cost of holding your money as cash increases. Likewise, when the interest rate is low, the opportunity cost for holding your assets as cash decreases and people will demand more dollars. When we graph it out, we've got the nominal interest rate there on the y-axis, we've got the quantity of money down here on the x-axis, and we have a downward sloping demand curve. because there's an inverse relationship between the quantity of money that people will demand and that nominal interest rate. So when interest rates fall, the quantity of money demanded will increase. Just like other demand curves, this demand curve can shift. The demand for money is comprised of two things. First we have the asset demand for money. That's the desire to hold your wealth as money because money itself is an asset and it's a liquid asset. The second part of the demand for money is the transaction demand for money. That's because money is needed in order to buy goods and services. What determines the transaction demand for money is the formula for GDP. C plus I plus G plus XN. The other part we need to look at is the price level. If either of those things change, it's going to increase or decrease that demand for money. And just like we've seen with other demand curves, a rightward shift is going to be an increase. and a leftward shift is going to be a decrease. Now let's talk about the money supply curve. The money supply is determined by the actions of the central bank in an economy with scarce reserves. As a result, there is no relationship between the nominal interest rate and the quantity of money that is going to be supplied, and that gives us a vertical money supply curve that is perfectly inelastic. So at high nominal interest rates, we will have one quantity of money, and at low nominal interest rates, we will have the same quantity of money. The actions of the central bank can increase or decrease the supply of money. And that will cause a rightward shift for an increase and a leftward shift for a decrease, just like we've had on previous supply curves. When you graph these two curves together, it gives us our equilibrium nominal interest rate and our equilibrium quantity of money. If either of these curves shifts, just like any other market you've learned, it will change the equilibrium price and quantity. It's just here that the equilibrium price is called the nominal interest rate. Next we're going to go over monetary policy and how central banks can target interest rates to move the economy around to fight inflation and unemployment. And there are two systems for targeting these interest rates. One is the ample reserve system and the scarce reserve system. The scarce reserve system uses the money market to target those interest rates, while the ample reserve system uses the reserves market to target those interest rates. In the United States, the Federal Reserve has a ample reserve system. And so the Federal Reserve targets the policy rate, the federal funds rate, in the reserves market. The next thing we're going to do is look at how the central bank of an economy with scarce reserves can change the money supply. They have three tools at their disposal. The first one is called open market operations. Open market operations is the buying or selling of government bonds or securities. The second one is called the discount rate. The discount rate is the interest rate that the central bank charges banks for overnight loans. The third one is the reserve requirement. The reserve requirement, as we've already mentioned, is the percentage of money that the banks cannot loan out. That money stays as required reserves when new deposits are made. All three of these tools are used to target the policy rate. In the United States, the federal funds rate is the policy rate. That's the interest rate that banks charge each other for overnight loans. Central banks with scarce reserves target that policy rate through changes in the money supply. Just like we saw with new bank deposits, actions of the central bank can multiply through the economy as well. Let's say, for example, the central bank makes an open market purchase of $10 million worth of government securities. With a 10% reserve requirement, that will give us a money multiplier of 10. We take that $9 million of excess reserves. That's because a bond dealer will receive $10 million and they will deposit it into their checking account, leaving $1 million as required reserves. and $9 million is excess reserves. You take that $9 million of excess reserves, times it by the 10 multiplier, and that gives us $90 million of new loans that will be created. We don't add in the original amount because it was not a loan. New deposits, on the other hand, are going to be $100 million, and that's because that original amount, the $10 million purchased, will be immediately deposited by the bond dealer into their checking account. So then, Number of deposits created here is $100 million worth. New money also is $100 million because that new $10 million purchase is new money that was created. When the Federal Reserve holds those funds, it isn't money. But when it is deposited into the bond dealer's checking account, it is money. So if we have an ample reserve system within an economy, the central bank is going to use the reserves market graph. The reserves market graph has the policy rate there on that y-axis and the quantity of reserves on the x-axis. The demand for reserves has an upward portion that is flat followed by a downward sloping portion and last we have a flat portion at the bottom there. The upper flat portion is at the discount rate and the lower portion there moves up or down with changes in interest on reserves. Then we also have the supply of reserves, and that is determined by actions of the central bank in an ample reserve system. When the supply of reserves intersects that demand curve in the downward sloping portion, then we have scarce reserves. And there, changes in reserves will actually increase or decrease the policy rate. But when the supply of reserves intersects the demand curve on the lower flat portion, then we have ample reserves. And changes in the supply of reserves will not impact the policy rate. As a result, central banks with ample reserves must use different policy tools. Thank you. now one of those policy tools for an ample reserve system is open market operations open market operations are only used to buy and sell bonds to increase or decrease the supply of reserves buying reserves is going to shift that supply of reserves to the right and it can be used to maintain an ample reserve system the demand curve on the other hand moves with changes in administered rates the upper flat portion changes with the discount rate and the lower flat portion changes with interest on reserves And it is that interest on reserves rate that is the key policy tool that is used by central banks with ample reserves. The Federal Reserve is one of those central banks. So if we have an economy with a recessionary gap as we have here, the economy is going to have high unemployment. And the central bank can use expansionary monetary policy to fight that unemployment. If the central bank is working in a scarce reserve system, it is going to buy bonds, lower the discount rate, or lower the reserve requirement to increase the money supply. That will decrease the nominal interest rate. leading to greater gross investment. If there are ample reserves, decreasing the interest rate on reserves will also decrease the policy rate. They could also decrease the discount rate, which lowers the upper portion of that demand curve, or they could decrease both of them, which is decreasing administered rates. Either way, we have a lower policy rate. Those lower interest rates increase gross investment, shifting that aggregate demand curve to the right, increasing real output. decreasing unemployment. And if it's done just right, we're back to long-run equilibrium. If, on the other hand, we have an inflationary gap, then central banks will use contractionary monetary policy to fight inflation. If there are scarce reserves, they can sell bonds, raise the discount rate, and raise the reserve requirement to decrease the money supply. That will mean higher interest rates and less gross investment. In the ample reserve system, they will increase interest on reserves. That increases the federal funds rate or the policy rate. They could also increase the discount rate, which moves the upper portion as well, or both of them together, which is increasing administered rates. Either way, we see higher interest rates, which means less gross investment, shifting that aggregate demand curve to the left, restoring long run equilibrium and resulting in a lower price level, which means we have successfully fought inflation. The last graph you need to know for this unit is called the loanable funds market. The loanable funds market is the demand and supply for long term loans. Here, we're going to have the real interest rate. on that Y axis abbreviated with little r. We're going to have the quantity of loanable funds there on the X axis. And our demand curve is a downward sloping investment demand labeled ID. That is the demand by businesses for gross investment. The downward sloping investment demand curve tells us there's an inverse relationship between the real interest rate and the quantity of loanable funds demanded to purchase physical capital. At high interest rates, we will have low quantities of investment demanded. And at low interest rates, we will have higher quantities of investment demanded in the loanable funds market. What shifts that investment demand curve? Well, it's anything that can impact the potential profit for new investments, changes in economic outlook, investment tax credits, and countless other things. If there's an increase in expected rate of returns for new investments, you're going to see that investment demand curve shift to the right. Or if they decrease, we will see it shift to the left. The supply curve in the loanable funds market is often called the saving supply. It is the money that is saved by households and it's available for loans. We see an upward sloping saving supply curve in the loanable funds market, and that's because there is a direct relationship between the real interest rate and the quantity of loanable funds that will be supplied by households. So when real interest rates rise, the quantity of loanable funds available will also rise. Here are some things that can shift that saving supply curve. Changes in disposable income for households, increases in the household income will increase supply, decreases in household income will decrease supply, the economic outlook, if people expect a recession, they'll save more, for example, and foreign investment. When foreign investors put money in our loanable funds market by saving in the United States, that will increase the supply of loanable funds, for example. If we see any of those things increase, it will of course shift our supply to the right, and if they decrease, it will shift it to the left. If we put both of these curves on the same graph, we can find our equilibrium real interest rate and the equilibrium quantity of loanable funds. And if either of those curves shift, it will change the real interest rate and the equilibrium quantity. There is one more concept you need to know about when it comes to understanding the loanable funds market. You'll learn more about it in the next unit. It's called crowding out. Crowding out is the idea that an increase in the government deficit will increase interest rates and reduce gross investment. You can graph an increase in the deficit caused by an increase in government spending or a decrease in government taxes as an increase in investment demand because the government is having to borrow more so they demand more loans alongside businesses. Or another way of looking at it is they reduce the supply available for businesses. Either of these methods is acceptable on the AP Macroeconomics exam. I suggest you use the one that your teacher uses, but either way, that interest rate increases as a result of the increase in the deficit, and that higher interest rate will mean less gross investment, leading to lower growth in the overall economy. If, on the other hand, the government has a budget surplus or a decrease in the deficit, that will do the opposite. It means the government won't have to borrow quite as much money, and you can graph that as a decrease in the demand for loanable funds or an increase in the supply of loanable funds. Either way, the real interest rate falls and gross investment within the economy. will increase. We got through it. That was a lot of information there. And if you knew it all, you are on your way to acing your next exam. If you need a little more help, head down to the links below where there are lots of games and activities from reviewecon.com to help you study and practice the skills you need for that next exam. If you want to support this channel, make sure you like and subscribe and then head over to reviewecon.com and pick up the total review booklet with everything you need to know to pass your final exam. or ap economics exam thank you very much i'll see you guys next time

Let's get into the content. Since this unit is all about financial markets, we're going to start off by talking about some financial assets. The first asset we'll discuss is stocks. Stocks are certificates of ownership for a corporation. Bonds, on the other hand, are a certificate that gives the owner the right to be paid back for a loan to a business or the government.

There is an inverse relationship between the price of bonds and the interest rate. Money is another financial asset that is the most liquid or most easily spent of all assets. It's that money asset that this unit focuses on. Now, money is not what economics is all about, but we discuss it a lot in this unit.

Let's talk about the three functions of money now. Money, first of all, must be able to be a medium of exchange. That means it can be used to buy goods and services. The second thing money must be able to do is serve as a unit of account or standard of value.

That means it can be used as a yardstick or measuring tool to measure relative values. The third thing money must be able to do is store value. If I work really hard today, the value of my work will be stored in the dollars, and they will keep their value for the foreseeable future, assuming we have low inflation. When it comes to measures of the money supply, we have three ways of measuring it. The first one and most narrow definition of money is the M0 or monetary base measure of the money supply.

That includes bank reserves and that's money that the bank has in their possession, but they haven't yet loaned out. And officially, bank reserves are not money because they are not a medium of exchange. But in the monetary base, we also include currency, which is cash and coins.

And that currency is money. M1 is another measure of the money supply and that includes money that is usable as a medium of exchange. This includes currency, the cash and the coins, as well as checkable deposits and savings deposits.

M2 is the most broad definition of money. It includes all of M1 plus small time deposits, that's certificates of deposit for less than $100,000, as well as money market mutual funds. Next, we're going to talk about the Fischer formula. The Fischer formula tells us the relationship between nominal and real.

rates of change. The difference between the two is the inflation rate. We have a formula.

It's little i approximately equals little r plus pi. What do those variables stand for? Well, the little i is the nominal rate of interest.

The little r is the real interest rate. And pi is not 3.14. It's the rate of inflation. Here's an example to put that formula into use.

Let's say the bank wants. a real interest rate of 5%. That's the expected rate of return they hope to achieve. At the same time, the expected rate of inflation is 2%.

Add those together and that tells us the nominal rate of inflation this bank will charge is 7%. We can also flip this formula around and work backwards. Let's say the actual rate of inflation ends up being 3% instead of 2%. We can take the nominal rate of interest that the bank charges, subtract the 3% actual inflation rate, And that will give us an actual real interest rate of only 4%.

Since the actual rate of inflation is sometimes different than the expected rate of inflation, that tells us that unexpected inflation can help some people and hurt other people. Here are the two main categories that you need to know. Borrowers are primarily the group of people that are helped by higher than expected rates of inflation.

That's because they pay lower real interest rates and they pay back their loans with less valuable money or fewer real dollars. Lenders, on the other hand, are hurt by higher than expected rates of inflation. That's because the real interest rate they earn decreases when inflation increases.

They are also paid back fewer real dollars or less valuable money. The next thing we're going to do is look at what is often considered one of the most difficult concepts in AP economics. I don't think it's that bad if you take it one step at a time and make sure you understand each little part. These are called bank balance sheets. First of all, on our bank balance sheet, we have an asset side.

and a liability side. On the asset side, those are the things of value that the bank owns. On the liability side, those are the things of value that the bank owes to somebody else. Let's talk about the components of that liability side.

We have demand deposits. Those are also called checkable deposits. Those are checking account deposits that are owed to the bank's customers.

Savings deposits are also there. Those are the savings accounts deposits and they are also a liability because they're owed to other people. Finally, we have other liabilities.

Those could be loans that the bank owes to other banks, to the Federal Reserve, or it could even be profit, sometimes even a loan. called owner equity that is owed to the owners of the corporation. On the asset side, we have total reserves.

Total reserves are the funds that the bank has available to them. This is broken up into two categories, required reserves and excess reserves. Let's talk about required reserves first. Required reserves are a percentage of checkable deposits. That percentage is set by the Federal Reserve for monetary policy.

We'll get to that in a little while. The second component of total reserves is excess reserves. Excess reserves are the funds that the bank has available that they can loan out. To find the excess reserves, you take the total reserves, subtract the required reserves, and what's left is excess reserved. That's the money the bank can loan out.

Next thing you'll find on the asset side are loans. Now, these aren't loans that the bank has borrowed from other people. These are loans the bank has made to their customers. These are IOUs.

They have value, and it's the value of whatever money was loaned to the customers. Finally, we have other assets. The bank has all kinds of things of value.

The building itself, the desks, etc. That stuff is assets and the value of it goes on the asset side. The last thing you need to be aware of is that assets and liabilities will always be equal on the bank balance sheet. If they aren't equal, you've gone wrong somewhere and you need to double check your math.

Now, manipulating the values within a bank balance sheet is something you should be able to do. We're going to go over an example right now, but if you still need some help. make sure you head over to ReviewEcon.com and check out the bank balance sheet game that I have there.

Let's say a customer of this bank puts $100 cash in their checking account. Let's see how that will impact this bank balance sheet. First of all, demand deposits is going to increase by $100.

Now that's also going to have to balance out on the other side. Here we're going to have total reserves increase by $100 because the customer gave them $100 and now the bank has that $100. They owe it on the liability side. They also have it on the assets side. That total reserves is $100, but it will be broken into two different values.

If there's a 10% reserve requirement set by the Federal Reserve, $10 of it will be required reserves and the rest of it, $90, will be excess reserves that can be loaned out. The next thing we're going to talk about is the money multiplier. The money multiplier tells us how many dollars worth of new loans, deposits, and money can be created from excess reserves.

Here's how that works. Just a reminder, we have a $100 deposit with a 10% reserve requirement. When the first customer deposits that $100, $90 of it can be loaned out.

That money will eventually be redeposited and then 90% of that... $81 will be loaned out again. That is $81 of new money.

Then that $81 will be eventually redeposited. And 90% of that $72 and 90 cents here will also be loaned out and then redeposited. This will happen over and over and over again.

And the new loans are new money because every new amount that is redeposited in a checking account is money because checkable deposits are part of the M1 money supply. In order to find out how much money can be created from the excess reserves, you take one and divide it by the reserve requirement. Here are some examples. With a 10% reserve requirement, we will have a multiplier of 10. With 20%, we will have a multiplier of 5, 25%, 4. 33 and a third percent, three, and 50%, two.

Those are the most common numbers you're gonna see on your exams. For this example, we're going to look at a multiplier of 10 because the reserve requirement right now is 10%, and one divided by 10% is 10. So we're gonna take the money multiplier and multiply that by the excess reserves. That tells us how much new money, loans, and deposits will be created from those excess reserves. You may also need to include the original amount depending on the question you're being asked on your exams. Getting back to the example we just looked at, we've got $90 worth of excess reserves.

We're going to take that and multiply it by the multiplier of 10, and that gives us $900 worth of new loans that can be created. Since the original amount of $100 wasn't a loan, we're just going to leave it at that $900. If we're looking at new amounts of money, we take the $90 and...

times that by the multiplier of 10, that's $900 worth of new money that's created. And we again don't add in the original amount because remember it was a cash deposit into the checking account and as a result it was already part of the M1 money supply. So we're going to leave this number at $900 as well.

If we were asked how many deposits were created on the other hand, it would be a little bit different. First we take the excess reserves of $90 and times it by 10, which gives us $900 worth of new deposits. But then we also need to add in that original $100 again, because that was a new deposit from the start. As a result, the total amount of new deposits that would be created as a result of this first new deposit of $100 is $1,000 worth of deposits. The money multiplier tells us the maximum ...ounce of new loans, deposits, and money that can be created from excess reserves.

In reality, the numbers will be much lower. And that's because we have some leakages within this model. First of all, many banks hold excess reserves, and they don't loan out as much as they could.

The second leakage comes from consumers holding onto cash, rather than depositing their money into their banks. The next thing we're going to do is look at the money market graph. Just like other markets we've learned, we've got a supply curve and a demand curve. We're going to look at the demand curve first. Money demand is based on the fact that the opportunity cost of holding money is the nominal interest rate.

When nominal interest rates are high, people demand fewer dollars because the opportunity cost of holding your money as cash increases. Likewise, when the interest rate is low, the opportunity cost for holding your assets as cash decreases and people will demand more dollars. When we graph it out, we've got the nominal interest rate there on the y-axis, we've got the quantity of money down here on the x-axis, and we have a downward sloping demand curve.

because there's an inverse relationship between the quantity of money that people will demand and that nominal interest rate. So when interest rates fall, the quantity of money demanded will increase. Just like other demand curves, this demand curve can shift.

The demand for money is comprised of two things. First we have the asset demand for money. That's the desire to hold your wealth as money because money itself is an asset and it's a liquid asset. The second part of the demand for money is the transaction demand for money. That's because money is needed in order to buy goods and services.

What determines the transaction demand for money is the formula for GDP. C plus I plus G plus XN. The other part we need to look at is the price level.

If either of those things change, it's going to increase or decrease that demand for money. And just like we've seen with other demand curves, a rightward shift is going to be an increase. and a leftward shift is going to be a decrease.

Now let's talk about the money supply curve. The money supply is determined by the actions of the central bank in an economy with scarce reserves. As a result, there is no relationship between the nominal interest rate and the quantity of money that is going to be supplied, and that gives us a vertical money supply curve that is perfectly inelastic. So at high nominal interest rates, we will have one quantity of money, and at low nominal interest rates, we will have the same quantity of money.

The actions of the central bank can increase or decrease the supply of money. And that will cause a rightward shift for an increase and a leftward shift for a decrease, just like we've had on previous supply curves. When you graph these two curves together, it gives us our equilibrium nominal interest rate and our equilibrium quantity of money.

If either of these curves shifts, just like any other market you've learned, it will change the equilibrium price and quantity. It's just here that the equilibrium price is called the nominal interest rate. Next we're going to go over monetary policy and how central banks can target interest rates to move the economy around to fight inflation and unemployment.

And there are two systems for targeting these interest rates. One is the ample reserve system and the scarce reserve system. The scarce reserve system uses the money market to target those interest rates, while the ample reserve system uses the reserves market to target those interest rates.

In the United States, the Federal Reserve has a ample reserve system. And so the Federal Reserve targets the policy rate, the federal funds rate, in the reserves market. The next thing we're going to do is look at how the central bank of an economy with scarce reserves can change the money supply.

They have three tools at their disposal. The first one is called open market operations. Open market operations is the buying or selling of government bonds or securities.

The second one is called the discount rate. The discount rate is the interest rate that the central bank charges banks for overnight loans. The third one is the reserve requirement.

The reserve requirement, as we've already mentioned, is the percentage of money that the banks cannot loan out. That money stays as required reserves when new deposits are made. All three of these tools are used to target the policy rate.

In the United States, the federal funds rate is the policy rate. That's the interest rate that banks charge each other for overnight loans. Central banks with scarce reserves target that policy rate through changes in the money supply.

Just like we saw with new bank deposits, actions of the central bank can multiply through the economy as well. Let's say, for example, the central bank makes an open market purchase of $10 million worth of government securities. With a 10% reserve requirement, that will give us a money multiplier of 10. We take that $9 million of excess reserves.

That's because a bond dealer will receive $10 million and they will deposit it into their checking account, leaving $1 million as required reserves. and $9 million is excess reserves. You take that $9 million of excess reserves, times it by the 10 multiplier, and that gives us $90 million of new loans that will be created.

We don't add in the original amount because it was not a loan. New deposits, on the other hand, are going to be $100 million, and that's because that original amount, the $10 million purchased, will be immediately deposited by the bond dealer into their checking account. So then, Number of deposits created here is $100 million worth.

New money also is $100 million because that new $10 million purchase is new money that was created. When the Federal Reserve holds those funds, it isn't money. But when it is deposited into the bond dealer's checking account, it is money. So if we have an ample reserve system within an economy, the central bank is going to use the reserves market graph.

The reserves market graph has the policy rate there on that y-axis and the quantity of reserves on the x-axis. The demand for reserves has an upward portion that is flat followed by a downward sloping portion and last we have a flat portion at the bottom there. The upper flat portion is at the discount rate and the lower portion there moves up or down with changes in interest on reserves. Then we also have the supply of reserves, and that is determined by actions of the central bank in an ample reserve system.

When the supply of reserves intersects that demand curve in the downward sloping portion, then we have scarce reserves. And there, changes in reserves will actually increase or decrease the policy rate. But when the supply of reserves intersects the demand curve on the lower flat portion, then we have ample reserves.

And changes in the supply of reserves will not impact the policy rate. As a result, central banks with ample reserves must use different policy tools. Thank you. now one of those policy tools for an ample reserve system is open market operations open market operations are only used to buy and sell bonds to increase or decrease the supply of reserves buying reserves is going to shift that supply of reserves to the right and it can be used to maintain an ample reserve system the demand curve on the other hand moves with changes in administered rates the upper flat portion changes with the discount rate and the lower flat portion changes with interest on reserves And it is that interest on reserves rate that is the key policy tool that is used by central banks with ample reserves. The Federal Reserve is one of those central banks.

So if we have an economy with a recessionary gap as we have here, the economy is going to have high unemployment. And the central bank can use expansionary monetary policy to fight that unemployment. If the central bank is working in a scarce reserve system, it is going to buy bonds, lower the discount rate, or lower the reserve requirement to increase the money supply.

That will decrease the nominal interest rate. leading to greater gross investment. If there are ample reserves, decreasing the interest rate on reserves will also decrease the policy rate.

They could also decrease the discount rate, which lowers the upper portion of that demand curve, or they could decrease both of them, which is decreasing administered rates. Either way, we have a lower policy rate. Those lower interest rates increase gross investment, shifting that aggregate demand curve to the right, increasing real output.

decreasing unemployment. And if it's done just right, we're back to long-run equilibrium. If, on the other hand, we have an inflationary gap, then central banks will use contractionary monetary policy to fight inflation. If there are scarce reserves, they can sell bonds, raise the discount rate, and raise the reserve requirement to decrease the money supply.

That will mean higher interest rates and less gross investment. In the ample reserve system, they will increase interest on reserves. That increases the federal funds rate or the policy rate. They could also increase the discount rate, which moves the upper portion as well, or both of them together, which is increasing administered rates. Either way, we see higher interest rates, which means less gross investment, shifting that aggregate demand curve to the left, restoring long run equilibrium and resulting in a lower price level, which means we have successfully fought inflation.

The last graph you need to know for this unit is called the loanable funds market. The loanable funds market is the demand and supply for long term loans. Here, we're going to have the real interest rate.

on that Y axis abbreviated with little r. We're going to have the quantity of loanable funds there on the X axis. And our demand curve is a downward sloping investment demand labeled ID. That is the demand by businesses for gross investment.

The downward sloping investment demand curve tells us there's an inverse relationship between the real interest rate and the quantity of loanable funds demanded to purchase physical capital. At high interest rates, we will have low quantities of investment demanded. And at low interest rates, we will have higher quantities of investment demanded in the loanable funds market.

What shifts that investment demand curve? Well, it's anything that can impact the potential profit for new investments, changes in economic outlook, investment tax credits, and countless other things. If there's an increase in expected rate of returns for new investments, you're going to see that investment demand curve shift to the right. Or if they decrease, we will see it shift to the left.

The supply curve in the loanable funds market is often called the saving supply. It is the money that is saved by households and it's available for loans. We see an upward sloping saving supply curve in the loanable funds market, and that's because there is a direct relationship between the real interest rate and the quantity of loanable funds that will be supplied by households.

So when real interest rates rise, the quantity of loanable funds available will also rise. Here are some things that can shift that saving supply curve. Changes in disposable income for households, increases in the household income will increase supply, decreases in household income will decrease supply, the economic outlook, if people expect a recession, they'll save more, for example, and foreign investment.

When foreign investors put money in our loanable funds market by saving in the United States, that will increase the supply of loanable funds, for example. If we see any of those things increase, it will of course shift our supply to the right, and if they decrease, it will shift it to the left. If we put both of these curves on the same graph, we can find our equilibrium real interest rate and the equilibrium quantity of loanable funds. And if either of those curves shift, it will change the real interest rate and the equilibrium quantity.

There is one more concept you need to know about when it comes to understanding the loanable funds market. You'll learn more about it in the next unit. It's called crowding out. Crowding out is the idea that an increase in the government deficit will increase interest rates and reduce gross investment.

You can graph an increase in the deficit caused by an increase in government spending or a decrease in government taxes as an increase in investment demand because the government is having to borrow more so they demand more loans alongside businesses. Or another way of looking at it is they reduce the supply available for businesses. Either of these methods is acceptable on the AP Macroeconomics exam. I suggest you use the one that your teacher uses, but either way, that interest rate increases as a result of the increase in the deficit, and that higher interest rate will mean less gross investment, leading to lower growth in the overall economy. If, on the other hand, the government has a budget surplus or a decrease in the deficit, that will do the opposite.

It means the government won't have to borrow quite as much money, and you can graph that as a decrease in the demand for loanable funds or an increase in the supply of loanable funds. Either way, the real interest rate falls and gross investment within the economy. will increase.

We got through it. That was a lot of information there. And if you knew it all, you are on your way to acing your next exam. If you need a little more help, head down to the links below where there are lots of games and activities from reviewecon.com to help you study and practice the skills you need for that next exam. If you want to support this channel, make sure you like and subscribe and then head over to reviewecon.com and pick up the total review booklet with everything you need to know to pass your final exam.

or ap economics exam thank you very much i'll see you guys next time

Transcript for:Macroeconomics Unit 4: Financial Markets Summary

Transcript for:
Macroeconomics Unit 4: Financial Markets Summary