nominal v. real interest rates definition, measurement...

Topics from the CED:

Financial Assets

Nominal v. Real Interest Rates

Definition, Measurement, and Functions of Money

Banking and the Expansion of the Money Supply

The Money Market

Monetary Policy

The Loanable Funds Market

Financial sector: The network of institutions that link borrowers and lenders

Includes banks, mutual funds, pension funds, and other financial intermediaries

The most liquid forms of money are cash and demand deposits (money deposited into a checking account)

The opportunity cost of money is the interest that could have been earned from holding other assets such as bonds

Other financial assets that people can hold in place of the most liquid forms of money include bonds (interest-bearing assets) and stocks (equity)

Stock represents ownership of a corporation

The stockholder is often entitled to a portion of the profit paid out as dividends

Bonds (securities) are loans, or IOUs, that represent debt that the government, business, or individual must repay to the lender

The bond holder has no ownership of the company and is paid interest

The price of previously issued bonds and interest rates on bonds are inversely related

Friendly reminder: although you can invest money into stocks and bonds, the word “investment” in economics ALWAYS refers to business spending on tools and machinery

DO NOT confuse the two

• A nominal interest rate is rate of interest paid for a loan, unadjusted for inflation

• The rate you “see” and pay for a loan

• Lenders and borrowers establish nominal interest rates as the sum of their expected real interest rate and expected inflation

• A real interest rate it is the nominal interest rate adjusted for inflation

• It can be calculated by subtracting the actual information rate from the nominal interest rate

• Real interest rate= Nominal interest rate – inflation

• Money is anything that is generally accepted as a means of payment for goods or services

• Money is a highly liquid financial asset —it is easily changeable into another asset or good

Commodity money: something that performs the function of money and has alternative uses

• Examples: Gold, silver, cigarettes, etc.

Fiat money: Something that serves as money but has no other important uses

• Examples: Paper money and coins

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Medium of exchange

Money can easily be used to buy goods and services without bartering

Unit of account (measure of value)

Money measures the value of all goods and services

Store of wealth

Money allows you to store purchasing power for the future

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• The money supply is measured using monetary aggregates designated as M1 and M2

• M1 consists of coins and currency plus checking accounts (checkable deposits) and traveler’s checks

–It is highly liquid

• M2 consists of M1 plus savings deposits (money market accounts), time deposits (CDs = certificates of deposit), and mutual funds

–Considered near money; less liquid than M1 (have to covenrt to cash to use it)

The monetary base (MO or MB) includes currency in circulation and bank reserves

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• Credit cards are not money

• They are a short-term loan (usually with a higher than normal interest rate)

• A debit card is part of the monetary system because it serves the same function as a check since it allows you to spend money from your bank account

The transactions motive is the need to hold money for spending

The precautionary motive is holding money for unexpected expenses and impulse buying

The speculative motive is holding cash to avoid holding financial assets whose prices are falling

Colander, Economics

• The Federal Reserve Bank (the Fed) is the U.S. central bank

• Federal Reserve notes are liabilities of the Fed that serve as cash

• A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms

Board of Governors

7 members appointed by the president and confirmed by the

senate

FINANCIAL SECTOR GOVERNMENT

Regional Reserve Banks and Branches

12 regional Federal Reserve banks and 25 branches

Oversees

Federal Open Market Committee (FOMC)

Board of Governors plus 5 Federal Reserve bank presidents

Provides ServicesOpen Market Operations

1. Conducts monetary policy (influencing the supply of money and credit in the economy)

2. Supervises and regulates financial institutions

3. Lender of last resort to financial institutions

4. Provides banking services to the U.S. government

5. Issues coin and currency

6. Provides financial services to commercial banks, savings and loan associations, savings banks, and credit unions

Monetary policy: influencing the economy through changes in the banking system’s reserves, which in turn, influences the money supply and credit availability in the economy

If commercial banks need to borrow money, they can do so from the Fed

If there’s a financial panic and a run on banks, the central bank is there to make loans

Can we go to the Fed to get a loan?

No

Expansionary monetary policy is designed to counteract the effects of recession and return the economy to full employment

It increases the money supply

It decreases interest rates and it tends to increase both investment and output

Also called the easy money policy

M i I Y

M=money supply i=interest rate I=investment Y=output

Price level

Real GDP

AD1

P1 AD2

P2

Y1 Y2

SRAS

LRAS

Contractionary monetary policy is designed to counteract the effects of inflation and return the economy to full employment

It decreases the money supply

It increases the interest rate, and it tends to decrease both investment and output

Also called the tight money policy

M i I Y

M=money supply i=interest rate I=investment Y=output

Price level

Real GDP

AD1

P1

Y1

SRAS

AD2

Y2

P2

LRAS

1. Reserve requirement

2. Discount rate

3. Open market operations

These are the 3 shifters of the money supply

These tools are used by the Fed to regulate the amount of money in circulation

The reserve requirement is the percent of deposits that banks must hold in reserve (the percent they can NOT loan out)

• Banks keep some of the money in reserve and loan out their excess reserves

• Reserves and interest rates are inversely related

By changing the reserve requirement the Fed can increase or decrease the money supply

If the Fed increases the reserve requirement it contracts the money supply—banks have to keep more reserves and lend out less money (decreases the money multiplier)

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• If the Fed decreases the reserve requirement it expandsthe money supply—banks have more money to lend out (increases the money multiplier)

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If there is a recession, what should the Fed do to the reserve requirement?

It should decrease the reserve ratio

This means banks hold less money and have more excess reserves

Banks create more money by loaning out excess reserves

The money supply increases, interest rates fall, and AD increases

McGraw-Hill/IrwinColander, Economics37

If there is inflation, what should the Fed do to the reserve requirement?

• Increase the reserve ratio

• This means banks hold more money and have less excess reserves

• Banks create less money

• The money supply decreases, interest rates increase, and AD decreases

McGraw-Hill/Irwin38

Discount rate: the interest rate the Fed charges for the loans it makes to commercial banks

• To increase the money supply, the Fed should decreasethe discount rate

• To decrease the money supply, the Fed should increasethe discount rate

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The primary way in which the Fed changes the amount of reserves in the system

• Open market operations occur when the Fed buys or sells government securities (bonds)

• To expand the money supply, the Fed buys bonds

• To decrease the money supply, the Fed sells bonds

How are you going to remember this?

Buy-BIG: Buying bonds increases the money supply

Sell-SMALL: Selling bonds decreases the money supply

There is an inverse relationship between bond prices and interest rates

When the Fed buys bonds, the price of bonds rises and interest rates fall

When the Fed sells bonds, the price of bonds falls and interest rates rise

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An open market purchase is an expansionary monetary policy that tends to reduce interest rates and increase income

When the Fed buys bonds, it deposits money in banks’ account with the Fed

Bank reserves are then increased

When banks loan out the excess reserves, the money supply increases (it also increases the monetary base)

An open market sale is a contractionary monetary policythat tends to raise interest rates and lower income

When the Fed sells bonds, it receives checks drawn against banks

The bank’s reserves are reduced and the money supply decreases (it also decreases the monetary base)

The federal funds rate is the interest rate that banks charge one another for one-day loans of reserves

• Federal funds are loans of excess reserves that banks make to one another

• (Often asked about on the AP exam)

The Fed can increase or reduce reserves by buying or selling bonds

By selling bonds, the Fed decreases reserves

This causes the fed funds rate to increase (banks have less reserves to loan out)

By buying bonds, the Fed increases reserves

This causes the fed funds rate to decrease (banks have more reserves to loan out)

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If the federal funds rate is above the Fed’s target range, it buys bonds to increase reserves and lower the Fed funds rate

If the federal funds rate is below the Fed’s target range, it sells bonds to decrease reserves and raise the Fed funds rate

The current federal funds rate is 1.5%

It can take as long as 12-18 months for a change in this rate to affect the entire economy

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Quantitative easing is a monetary policy used by the Fed to buy government bonds to stimulate the economy

The Fed might decide to purchase assets from commercial banks in order to increase the price of those assets, which increases the money supply and lowersinterest rates

May be used when inflation is low and open market operations are not working

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• Demand deposits: Money deposited in a commercial bank in a checking account

• Required reserves (or reserve ratio): The percent of a deposit that banks must hold

• Excess reserves: Reserves that a bank can loan out beyond required reserves

• Bank balance sheet: A record of a bank’s assets, liabilities, and net worth

• Owner’s equity: Money put into a business or bank; not held in reserves

• Our banking system is a fractional reserve system

• Banks must hold a portion of deposits (known as the reserve requirement, which is set by the Fed) and can loan out the rest of the money

• 1/r is the simple money multiplier

• The simple money multiplier is the measure of the amount of money ultimately created per dollar deposited in the banking system, when people hold no currency

• It tells us how much money will ultimately be created by the banking system from an initial inflow of money

• The higher the reserve ratio, the smaller the money multiplier, and the less money that will be created

A customer deposits $100 into a bank. What is the immediate impact on the money supply?

No impact—the money was already in the money supply (M1) so there is no change

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• Remember, customer demand deposits can be withdrawn at any time

• To find the total amount of deposits that will be created, multiply the original deposit by 1/r, where r is the reserve ratio

A customer deposits $100 into the bank. The reserve ratio is 10 percent (0.1). The amount of money ultimately created from this deposit is:

$100 x 1/0.1 = $1,000

New money created = $1,000 – $100 = $900

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Why is the amount of new money created only $900 and not $1,000?

Because the $100 deposit was already in the money supply (part of M1)

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The Fed buys bonds equal to $10 million and the required reserve ratio is 0.2. What is the maximum change in the money supply throughout the banking system?

1/r =1/0.2=5

5 *(10 million)=50 million

Buying bonds creates money so the money supply increases by $50 million

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The Fed buys bonds equal to $10 million and the required reserve ratio is 0.2. What is the maximum change in loans throughout the banking system?

1/r =1/0.2=5

5 *(10 million)=50 million

To loan this money out, a bank has to hold 20%

50 million*(0.2)=10 million

Total available for loans: 50 million -10 million= 40 million

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Assets Liabilities

Loans $8,000Reserves $500Treasury bonds $1,500

Demand deposits $5,000Owner’s equity $5,000

Total: $10,000 Total: $10,000

• First, both sides of the balance sheet must equal one another• Demand deposits are always on the liability side (the bank “owes” this money to its

customers) • Loans are always on the asset side (money owed to the bank)• If the reserve requirement is not listed, you can figure it out by dividing reserves by demand

deposits (500/5,000=0.1 or 10%); **Be careful as the balance sheet can include terms such as total reserves as well as excess reserves; be sure to use the right numbers**

Assets Liabilities

Loans $15,000Total reserves $ 5,000Treasury bonds $10,000


Total: $30,000 Total: $30,000

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The reserve requirement is 10%. How much is the bank’s required reserves?To answer, we will look at the demand deposits.$20,000 x .1 = $2,000

Is the bank holding excess reserves? If so, how much?Yes: $3,000 (Total reserves – required reserves)

Assets Liabilities

Loans $15,000Total reserves $ 5,000Treasury bonds $10,000


Total: $30,000 Total: $30,000

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How much could the bank increase the money supply if it loaned out its excess reserves?$3,000 x 1/.1 = $30,000

Assume John deposits $1,000 into the bank. What is the initial change in the money supply?None—the $1,000 was already in the money supply

Assets Liabilities

Loans $15,000Required reserves $2,000Excess reserves $3,000Treasury bonds $5,000


Total: $25,000 Total: $25,000

If a customer deposits $1,000 into this bank:1. What is the required reserve ratio (before the deposit is made)? 2. Will the money supply (M1) initially increase, decrease, or stay same?3. How much is the required reserves?4. How much is the excess reserves?5. What is the maximum change in money supply from the deposit?

Assets Liabilities

Loans $15,000Required reserves $2,100Excess reserves $3,900Treasury bonds $5,000


Total: $26,000 Total: $26,000

If a customer deposits $1,000 into this bank:1. What is the required reserve ratio (before the deposit is made)? 10% ($2,000/$20,000)2. Will the money supply (M1) initially increase, decrease, or stay same? Stay the same3. How much is the required reserves? $2,1004. How much is the excess reserves? $3,9005. What is the maximum change in money supply from the deposit? $9,000 ($1,000 x 1/0.1= $10,000 - $1,000 (amount of initial deposit); OR $900 x 1/0.1)

The market where the Fed and the users of money interact thus determining the nominal interest rate (i%)

In the money market, equilibrium is achieved when the nominal interest rate is such that the quantity demanded and quantity supplied of money are equal

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Money Demand (MD) comes from households, firms, government, and the foreign sector

It is downward sloping

There is an inverse relationship between nominal interest rate and the quantity of money demanded (the quantity of money people want to hold)

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The Money Supply (MS) is determined by the Federal Reserve

The money supply curve is vertical because it is determined by the Fed’s (or central bank’s) particular monetary policy

It is also vertical because it is independent from the interest rate

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NOTE:•i=nominal interest rate

•I= Investment

Be careful!

QM1

MD or DM

MS

i1

Quantity of Money or QM

Nominal Interest Rate

(ir)

What happens to the quantity demanded of money when interest rates increase?

Quantity demanded falls because individuals would prefer to have interest-earning assets instead

What happens to the quantity demanded when interest rates decrease?

Quantity demanded increases

There is no incentive to convert cash into interest-earning assets

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1. Changes in price level

An increase in the price level leads to an increase in the demand for money

A decrease in the price level leads to an decrease in the demand for money

2. Changes in national income (GDP)

When real GDP increases there will be an increase in the demand for money (when real GDP decreases there will be a decrease in the demand for money)

3. Changes in money technology

We may decide to hold less cash as we use debit cards and credit cards more often (decreasing the demand for money)

QM1

MD1

MS

i1

QM

(billions of dollars)

Nominal Interest Rate (ir)

MD2

i2

Scenario: The price level increases.

QM1

MD2

MS

i2

QM



(ir)

MD1

i1

Scenario: The price level decreases

1. Reserve requirement

2. Discount rate

3. Open market operations

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QM1

MD1

MS1

i1

QM



(ir)

i2

MS2

QM2

Scenario: The Fed buys bonds on the open market

QM2

MD1

MS2

i2

QM



(ir)

i1

MS1

QM1

Scenario: The Fed sells bonds on the open market

How does this affect AD?

An increase in the money supply leads to a decrease in interest rates, an increase in investment and therefore an increase in AD

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IM I ADi

How does this affect AD?

Decreasing the money supply leads to an increase in interest rates, which decreases investment and AD

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M i I AD

The economy is in a recession. Using the AS/AD model and the money market, demonstrate an expansionary monetary policy to move the economy out of a recession.

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The economy is in a recession. Using the AS/AD model and the money market, demonstrate an expansionary monetary policy to move the economy out of a recession.

QM1

MD1

MS1

5%

QM(billions of dollars)


2%

MS2

QM2

The economy has rising inflation. Using the AS/AD model and the money market, demonstrate a contractionary monetary policy to move the economy out of an inflationary gap.

X81

The economy has rising inflation. Using the AS/AD model and the money market, demonstrate a contractionary monetary policy to move the economy out of an inflationary gap.

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QM2

MD1

MS2

7%

QM



5%

MS1

QM1

The loanable funds describes the behavior of savers and borrowers

This market shows the effect on the real interest rate (r)

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Demand for loanable funds: there is an inverserelationship between the real interest rate and the quantity of loans demanded

At higher interest rates, households prefer to delay their spending and put their money in savings

Simply put, the demand for loanable funds represents borrowers and investors

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Borrowing is the demand for loanable funds

Private investment is borrowing by businesses and consumers

Government borrowing is deficit spending when government spending is greater than tax revenue

A change that effects borrowing will shift the demand of loanable funds

For example: investment tax credits

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Supply of loanable funds: there is a direct relationship between the real interest rate and the quantity of loans supplied

An increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out)

Simply put, the supply of loanable funds represents savers and lenders

Saving is what makes lending possible so, the supply of loanable funds is the amount of money that is saved

Private saving is the amount that households save instead of consume

Public saving is the amount that the government saves instead of spends

National savings = Public saving+ private saving

A change in public or private saving will shift the supply of loanable funds

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Foreigners also lend money so the supply of loanable funds also depends the amount of money that enters or leaves the country

Capital inflow: the amount of money entering the country

Capital outflow: the amount of money leaving the country

Net capital inflow = Inflow - outflowA change in net capital inflow will shift the supply of loanable

funds

In a closed economy, national savings is the sum of private saving and the public saving

In an open economy, national saving is the sum of private savings, public savings, and net capital inflows

Demand Shifters

Changes in borrowing by consumers

Changes in borrowing by businesses

Changes in borrowing by the government (such as deficit spending)

Supply Shifters

Changes in private savings behavior

Changes in public savings

Changes in foreign investment (such as inflow of foreign financial capital)

Real Interest Rate

Q of Loanable FundsQ1

S1 or SLF1

r1

D1 or DLF1

S2 or SLF2

r2

Q2

Real Interest Rate


S1 or SLF1

r2

D1 or DLF1

S2 or SLF2

r1

Q1

Real Interest Rate


S1 or SLF1

r2

D1 or DLF1

r1

Q2

D2 or DLF2

Real Interest Rate


S1 or SLF1

r1

D1 or DLF1

r2

Q1

D2 or DLF2

The government increases deficit spending

Draw the graph that illustrates this concept

Real Interest Rate


S1 or SLF1

r2

D1 or DLF1

r1

Q2

D2 or DLF2

Real interest rates increase

causingcrowding out

(of investment)

Government borrows from the private sector, increasing the demand for loans

Real interest rates increase

causingcrowding out

(of investment)

Government borrows from the private sector, increasing the demand for loans

Real Interest Rate


S1 or SLF1

r2

D1 or DLF1

S2 or SLF2

r1

Q1

**A correct answer for this could also be a decrease in the supply of loanable funds**

If there is an expansionary monetary policy, what are the results?

AD increases

MS increases

The supply of loanable funds increases

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If there is a contractionary monetary policy, what are the results?

AD decreases

MS decreases

The supply of loanable funds decreases

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Money Market

Interest Rate

Q of Money

MS2

i1

DM

i2

MS1

Expansionary monetary policy leads to…

QM1 QM2

Interest Rate

Q of Loanable Funds

SLF2

DLF

Loanable Funds Market

SLF1

r1

r2

… an increase in loanable funds

Q1 Q2

Expansionary Monetary Policy: Increases AD

Interest Rate

Q of Loanable Funds

SLF1

DLF

Loanable Funds Market

SLF2

r2

r1

… an decrease in loanable funds

Q2 Q1

Contractionary Monetary Policy: Decreases ADMoney Market

Interest Rate

Q of Money

MS1

i2

DM

i1

MS2

Contractionary monetary policy leads to…

QM2 QM1

nominal v. real interest rates definition, measurement...

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