Unit IV( Basic accounting review)

• T-account (balance sheet): 

-statements of assets and liabilities 

• Assets(amounts owned): 

-items to which a bank holds legal claim 

-uses of funds by financial intermediaries

• Liabilities(amounts owed): 

-legal claims against a bank

-sources of funds for financial intermediaries  

• Federal Reserve Bank :

-uses paper currency

-holds reserves of the banks

-lends money and charges interests

-check clearing service for the bank

-personal bank for the government  

-supervises members  of banks  

-control money supply in economy  

• Reserve Requirement: 

-federal requires bank to always have some money readily available to meet consumer's demand for cash 

-amount set by the federal is required reserve

-the required reserve ratio is the % of demand deposits (checking account balance) that must not be loaned out 

-typically its 10% 

• Three types of multiple deposit expansion question:

1. Calculate the initial change in excess reserves:  aka the amount a single bank can loan from the initial deposit 
2. Calculate the change in the money supply
3. Calculate the change in the money supply: sometime type 2 and type 3 will have the same result  (if no Fed involvement)

1) The Reserve Requirement:

-only a small % of your bank deposit is in the safe the rest of your money has been loaned out

-this is called "Fractional Reserve Banking"

- the FED sets the amount that banks must hold

-the reserve requirement (reserve ratio) is the % of deposits that banks must hold in reserve and not loan out

-when the FED increases the money supply it increases the amount of money held in bank deposits  

-if there is a recession, what should the FED do to the reserve requirement?  

•  decrease the RR 

1. Banks hold less money and have more ER
2. Banks create more money by loaning out excess 
3. Money increase, interest rates fall, AD goes up  

 -if there is inflation what should the FED do to the reserve requirement, what should the FED do to the reserve requirement?  

•  decrease the RR 

1.  Banks hold more  money and have less ER 
2. Banks create less money 
3. Money Supply decrease, interest rates rise, AD goes down   

 2) The Discount Rate:

-Discount Rate is  the interest rate that the FED charges commercial banks 

 -Ex: If the banks of America needs $10 million, they borrow it from the U.S Treasury (which the FED controls, but they must pay it back with interest)

 -To increase the Money Supply, FED should DECREASE the Discount Rate (Easy Money Policy)

-To Decrease the Money Supply, the FED should INCREASE the Discount Rate (Tight Money Policy) 

 3) Open Market Operations:

-FED buys/sell government bonds (securities)

-This is the most important and widely used monetary policy

-To increase the MS, the FED should BUY government securities

-To decrease the MS, the FED should SELL government securities  

• Monetary policy:

-Expansionary: buy bonds, decrease discount rate, decrease RR = increase in loan, AD increases, GDP increase, MS increases. interest rate decreases 

-Contractionary: sell bonds, increase discount rate, increase RR= loans decrease, AD decrease. GDP decrease, MS decrease, interest rate increases   

*Federal Fund Rate: where FDIC member bank loans each other overnight funds
* Prime Rate: interest rate that banks give to their most credit- worthy customers  

Unit IV (Money)

• Uses of Money: 

-Medium of exchange: trade or barter

-Unit of account: establishes economic worth in the exchange process 

-Store of value: money has its value over a period of time, where products may not  

• Types of Money: 

-Commodity money: gets it value from the type of material from which it is made

    ex: gold and silver coins 

-Representative money: paper money backed up by something tangible that it gives it value  

Fiat Money: money because government says it is money and that is used in the U,S 

• Characteristics of money: 

-portable 

-durable

-uniform

-scarce

-acceptable 

-divisible  

• Money Supply:

-M1 money: currency (cash, coins, checkable deposits/ checking account, traveler's checks, and demand deposits) 

-75% of money in circulation and it mostly liquid because it easy ti convert to cash  

-M2 money: consists of M1 money  + savings accounts and deposits held by banks held outside of the U.S

-M3 money: consists of M2 money + certificates of deposits, known as CD's 

 

• time value of money:

Is a dollar today worth more than a dollar tomorrow?

-YES 

-Why?

-opportunity cost and inflation

-let v= future value of money

-let p= present value of  money

-let r= real interest rate (nominal rate- inflation rate) expressed as a decimal  

-let n = years

-let k= # of times interest is credited per year

-simple interest forumla: v=  (1+r)^n * p 

-compound interest forumla: v= (1+r/k)^nk *p 

• demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded  
• what happened to the quantity demanded of money when interest rates increase?

-quantity demanded falls because individuals would prefer to have interest rate assets instead of borrowed liabilities

• what happens to the quantity demanded when interest rates decrease? 

-quantity demanded increase, there is no incentive to convert cash into interest earning assets      

• Demand for money 

-money demand shifters:

1. change in price level
2. change in income 
3. change in taxation of investments

-How money supply affects AD? 

-money supply increases= decrease in interest rates, increase in investments, and decrease in AD

-money supply decreases = increase in interest rate, decrease in investment, decrease in AD

-Financial Assets vs Financial Liabilities 

-FA: assets such as stocks and bonds provide expected future benefits 

            - it benefits the owner, based upon the issue of the asset meeting certain obligations

-FL: liabilities incurred by financial asset to stand behind the issued asset  

-Interest rate: price paid for a financial asset 

-Stocks vs Bonds: 

-Stocks: assets that convey ownership in a company

-Bonds: promise to pay a certain amount of money + interest in the future

-What banks do?

- it is a financial intermediary  

-uses liquid assets (i.e. bank deposits) to finance the investments of borrowers

-process known as Fractional Reserve Banking

  - a system in which depository institutions hold liquid assets > the amount of deposits  

     -can take form of:  

• currency in bank vaults 

• bank reserves: deposits helad at federal reserves  

Unit III (Automatic or Built-In Stabilizers)

• Anything that increases the government’s budget deficit during a recession and increases its budget  surplus during inflation WITHOUT REQUIRING EXPLICIT ACTION BY POLICY MAKERS
• Economic Importance:
  -Taxes reduce spending and aggregate demand 
  -Reductions in spending are desirable when the economy is moving toward inflation
  -Increases in spending are desirable when the economy is heading toward recession.

• Progressive Tax System:
  
  
  -Average tax rate (tax revenue/GDP) rises with GDP
• Proportional Tax System:
  
  
  -Average tax rate remains constant as GDP changes
• Regressive Tax System:
  
  
  -Average tax rate falls with GDP
• The more progressive the tax system, the greater the economy’s built-in stability.

Unit III (Discretionary vs. Automatic Fiscal Policies)

• Discretionary:
  
  
  -Increasing or Decreasing Government Spending and/or Taxes in order to return the economy to full employment. Discretionary policy involves policy makers doing fiscal policy in response to an economic problem.
  
  
  -Example: Recession and Inflation
  
  
• Automatic:

-Unemployment compensation and marginal tax rates are examples of automatic policies that help mitigate the effects of recession and inflation. Automatic fiscal policy takes place without policy makers having to respond to current economic problems.

-Example: Medicare and Medicaid

“Easy” Expansionary Fiscal Policy	“Tight” Contractionary Fiscal Policy
Combats Recession	Combats Inflation
Increases Government Spending Decreases Taxes	Decrease in Government Spending Increase in Taxes

• Automatic or Built-In Stabilizers:

-Anything that increases the government’s budget deficit during a recession and increases its budget  surplus during inflation WITHOUT REQUIRING EXPLICIT ACTION BY POLICY MAKERS

• Economic Importance: 

-Taxes reduce spending and aggregate demand  

-Reductions in spending are desirable when the economy is moving toward inflation 

-Increases in spending are desirable when the economy is heading toward recession

Unit III (Deficits, Surpluses, and Debt)

• Balanced Budget:
  -Revenues = Expenditures
• Budget Deficit:
  -Revenues < Expenditures
• Budget Surplus:
  -Revenues > Expenditures
• Government Debt:
  -Sum of all deficits - Sum of all Surpluses
• Government must borrow money when it runs a budget deficit. They borrow from:
  -Individuals
  -Corporations
  -Financial Institutions
  -Foreign Entities or Foreign Governments

• Fiscal Policy (Two Options):

• Discretionary Fiscal Policy (action)

-Expansionary fiscal policy - think deficit

• Contractionary fiscal policy - think surplus

-Non - Discretionary Fiscal Policy (no action)

Unit III (Fiscal Policy)

- Changes in the expenditures or tax revenues of the federal government.

• 2 tools of Fiscal Policy:
  -Taxes - government can increase order or decrease taxes
  -Spending - Government can increase or decrease spending

-Inverse relationship

Unit III (The Spending Multiplier Effect)

- An initial change in spending (C, IG, G, Xn) causes a larger change in any aggregate  Spending,or Aggregate Demand (AD).

-Multiplier = Change in AD / Change in Spending-Multiplier = Change in AD / Change in C, I, G, or Xn

• Calculating the Spending Multiplier:

-The Spending Multiplier can be calculated from the MPC or the MPS.

-Spending Multiplier = 1 / 1 - MPC or 1 / MPS-Spending Multipliers are (+) when there is an increase spending and (-) when there is a decrease in spending.

• Calculating the Tax Multiplier:

-When the government taxes, the multiplier works increase 

-Why?  

-Because now $ is leaving the circular flow.

-Tax Multiplier ( note: it’s negative)-Tax Multiplier = -MPC / 1 - MPC or -MPC / MPS-If there is a tax -CUT, then the multiplier is (+), because there is now more $ in the circular flow.