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AP MACROECONOMICS UNIT 4 PART 2 NOTES EDITED 2010 AND 2011

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AP MACROECONOMICS UNIT 4 PART 2 NOTES EDITED 2010 AND 2011 Powered By Docstoc
					PART TWO:

V. The Money Multiplier: When an increase or decrease initially occurs in the money
supply, the overall effect of that change will be greater than the immediate change in
the money supply.

****this multiplier only directly affects the money supply.

****Important to keep in mind that M1 (Coin, Currency, Checking (Demand) Deposits)

       A. Formula for calculating the Money Multiplier

***R = Reserve Requirement


               1. Formula:      _____1______
                              Reserve Requirement

               2. If the Reserve Requirement is .10 then the Money Multiplier is _______



         B. Application of the Money Multiplier to various Scenarios. (These are in order
of likelihood you will see them on the test.

Typical Questions you will be asked about anything that can change the Money Supply.

-How will the action described immediately affect the Money Supply?

-How much will the action change the immediate amount that banks could lend?
                                                 -
-How much will the action change the overall money supply (in the longer run)

-How will the action affect the Money Supply/Supply of Loanable Funds and interest
rates (nominal or real)

-What actions can be taken by individuals or lending institutions that could limit the
affect of the action.
                 1. Open Market Operations

                       a. Expansionary (FED Buys Treasury Bonds from a bank)

Assume 1 Billion Dollars
Reserve Ratio = .20

                              1. Initial Change in the Money Supply = 1 Billion Dollars
(Reason: was not counted in M1 when the FED had the Money-counts when it goes to
banks (will be part of Excess Reserves)

                              2. Amount that can be loaned by the Bank = 1 Billion
(Reason: all of it would be excess reserves-the bank does not have to hold onto all of it)
Reserves only have to be held on money deposited in a bank-this is not a deposit.
                              3. Overall Affect on the Money Supply:

1 Billion X 5 = 5 Billion Dollars Overall Change)

Amount the Money Supply Changes by the first time it changes X the Money Multiplier
                                                                     (1/R)
                         4. Graph the Change in the Money Supply and Nominal
                         Interest Rates



Nominal
Interest Rates




                       ______________________________________________________


                                                     Quantity of Money

                      5. Actions which could limit overall effect-Bank could lend less
than the maximum amount. (“Hold Excessive Reserves”)
              b. Contractionary (FED Sells Treasury Bonds to a Bank)
***The opposite will occur

                       1.   The Money Supply will shrink by 1 Billion
                       2.   The cannot lend immediately 1 Billion
                       3.   The Money Supply will shrink by 5 Billion
                       4.   Graph
Nominal
Interest Rates




                        ______________________________________________________


                                                     Quantity of Money


                               5. If the Bank usually kept Excessive Reserves (not a likely
                               question)


Second Scenario

                 1. Money is deposited or taken out from a Bank (This is usually done by
                    individuals when the deposit “Held Cash” or they withdraw money to
                    “Hold as Cash”) though it applies any time money is either deposited
                    in a bank account or withdrawn from an account)

Assume:

Mr. Smith Deposits 1,000 dollars he was holding as cash in his checking account.
Reserve Requirement is .10

                      a. Immediate Change in the Money Supply is 0
(Reason: the money was counted in M1 when it was held as cash, and it is still counted as
part of a checking account)

                       b. Maximum the bank can immediately loan = 900
(Reason: 1,000 dollar deposit X .10 ( R)
                       c. Maximum overall change in the Money Supply = 9,000
(Reason: 900-the first change in the Money Supply X 10 (Money Multiplier)
                      d. Graph change in Supply of Loanable Funds and Real Interest
                      Rates.



Real
Interest Rates




                      ___________________________________________________


                                            Supply of Loanable Funds

                       e. If Mr. Smith Held some of the cash or if the Bank held some
excess reserves than the overall effect would be limited.

If Mr. Smith withdraws 1,000 dollars from his checking account the opposite will
occur.

                      -The money supply will be unchanged in the immediate period

                      -The Bank will not be able to loan 900 dollars

                     -The Money Supply (and the Supply of Loanable Funds) will
shrink by 9,000 dollars.

                      -Graph



Real
Interest Rates




                      ______________________________________________________

                                                    Supply of Loanable Funds
THIRD SCENARIO

Third and Fourth Scenarios are very unlikely to be test on.

                 2. Found Money is Deposited in a Checking Account: Examples of
                    Found Money
Assume:

Mr. Jones finds 10,000 dollars buried in his backyard and deposits the money in his
checking account.

Reserve Ratio is .25

                       a. Immediate Change in the Money Supply = ____________

Reason:


                       b. Amount the Bank can immediately lend =_____________

Reason:


                       c. Overall Change in the Money Supply = ______________

Explanation:



                       d. Graph effect on the Money Supply and Nominal Interest Rates



Nominal
Interest Rates




                       __________________________________________________


                                             Quantity of Money

                       e. Actions that can limit the overall effect on the Money Supply
Fourth Scenario

                 3. Banks can decide to loan excess reserves it is holding, or it could
                    decide to hold an increased amount of excess reserves (reducing that
                    amount a bank would lend)

Assume:

Bank of America decides to shift 1 Million in Excess Reserves to Loanable Funds
Reserve Ratio is .50


                        a. Immediate Change in the Money Supply = ____________

Explanation


                        b. Amount the Bank will be able to Immediately Loan =_______

Explanation



                        c. Overall Effect on the Money Supply = ___________________

Explanation:


                        d. Graph the effect on the Supply of Loanable Funds and Real
                           Interest Rates.


Real
Interest Rates




                        ___________________________________________________


                                       Supply of Loanable Funds

*****If the bank shift money from its loanable funds to excess reserves the opposite
would happen.
   I.     Historical Evolution of Money and Monetary Standards

          A. Barter: define: TRADING OFF GOODS AND SERVICES FOR
          OTHER GOODS AND SERVICES

               1. Problem of Double Coincidence: IN ORDER FOR
TRANSACTIONS TO OCCUR EVERYTIME ONE PERSON WANTS A
PARTICULAR GOOD OR SERVICE THERE HAS TO BE SOMEONE WITH
THAT GOODD/SERVICE WHO WANTS WHAT THE ORIGINAL PERSON
HAS TO TRADE. (MIGHT WORK IN A SMALL ECONOMY-BUT NOT IN A
LARGE ECONOMY.)


        B. Commodity Money: MONEY THAT HAS OTHER USES OTHER
THAN ITS USE AS MONEY. (EXAMPLES:



          C. Fiat Money: MONEY THAT HAS NO OTHER USE OTHER THAN
             ITS USE AS MONEY.


          D. Monetary Standards: Basis of a Nation’s Money-determines the value of
             a Nation’s Money.

                   1. Gold Standard (begins after the fall of Napoleon in 1815-lasts
                      until the Great Depression)

                       a. MONEY’S VALUE IS STATED IN TERMS OF A
                       CERTAIN AMOUNT OF GOLD.

                       b. MONEY CAN BE EXCHANGED FOR GOLD.




***Nation’s abandoned the Gold Standard during the economic crisis of the 1920s and
1930s. A modified Gold Standard was reintroduced after World War II for International
Purposes only-then the Gold Standard was completely abandoned in the early 1970s
when the US decided to the maintain the system.
                     2. Inconvertible Fiat Standard: Define: MONEY CANNOT BE
                        EXCHANGED FOR GOLD/SILVER.

                       a. Value in this type of Monetary Standard is determined by
                          Exchange Rates.

                              1. Fixed Exchange Rates:


                              2. Floating Exchange Rates:



   II.     International Money Markets/INTERNATIONAL EXCHANGE MARKETS
           (WE DID THIS IN UNIT ONE AND INDIRECTLY IN UNIT 3-this will be
           the focus of Unit 6)

           A. Factors that affect Exchange Rates on International Money Markets

                     1. The key factors is the demand (from other countries-not always
                        governments) for a nation’s money. Investors, governments,
                        individuals need a country’s money in order to purchase things
                        from that nation. This includes goods/services and various forms
                        of investments. (SUCH AS TREASURY BONDS OR STOCKS)

***You may not see this exchange of money-but it ultimately has to happen. You want a
country’s stuff-you need to first buy that country’s money.

           B. More specific Factors

                     1. Demand for a country’s goods and services (same factors we
                        looked at in Unit III that effect Exports and Imports)

                       a. If a nation’s rate of inflation is higher than other countries-the
                          demand for its products goes down and the demand for its
                          money goes down. (because its products are relatively more
                          expensive

                              1. This causes the value of a nation’s money to go down.

***If a nation’s rate of inflation is lower than other nations-the opposite will happen-the
demand for its products will rise-so will the demand for its money-and the value of its
money will then rise.
                      b. If a nation’s National Income (GDP) is rising faster than other
                         nations-the demand for its products will go down-the demand
                         for its money will go down. (because its have relatively more
                         ability to buy products-other countries have relative less
                         income to buy products)

                             1. This will lower the value of that nation’s money.


****If a nation’s National Income rises slower than other nations the opposite will
happen. The demand for its products will go up-so will the demand for its money-(this is
because the other nations now have relatively more income to purchase products)

       This will cause the value of that nation’s money to drop.


                             2. The demand for a nation’s securities (paper
                                investments-such as stocks, corporate bonds, and
                                government bonds)-aka “Financial Assets”


Explain the difference between stocks and bonds.



                      a. If for any reason foreign investors demand more of a nation’s
securities-the demand for that nation’s money will go up-and so will the value of its
money.


                    b. Specifically, changing interest rates effect the demand for bonds.
Especially Government Bonds (Securities) such as Treasury Bonds.


                             1. If interest rates rise (relative to other countries) in a
                             nation-the demand for Bonds will rise (especially
                             government securities)-the demand for that nation’s money
                             will rise-and so will the value of that money.


                             2. If interest rates fall (relative to other countries)in a
                                nation-the demand for that nation’s Bonds will fall
                                (especially government securities)-the demand for that
                                nation’s money will also fall-and so will the value of
                                that money.
CLASSICAL VIEW OF MONETARY POLICY (MILTON FRIEDMAN)

   I.     Monetarism: Belief that the best way to gradually grow the economy in the
          Long-run-is through slow steady growth in the Money Supply. (Milton
          Friedman)

          A. Basic Concepts

                   1. Velocity: speed at which money circulates through the economy.
                      It measures the number of time each dollar is used in transactions
                      in a given year. (Monetarist believe that Velocity is constant in
                      the Long-run)


                   2. Quantity Theory of Money: the Monetarist belief that in the
                      Long-run Velocity of Money is constant.


                   3. Equation of Exchange:

M (Money Supply) X      V (Velocity) = Nominal GDP


****If V is constant than an easy way to grow Nominal GDP is to gradually grow the
Money Supply.

				
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