No Bull Economics Lessons

Macroeconomics & Microeconomics Concepts You Must Know

Unit 4: Top 10 Banking & Monetary Policy Concepts to Know (Macro)

Unit 4: Top 10 things you need to know about money, banking, monetary policy, money markets, and the deposit expansion multiplier. This is geared toward college-level principles of macro courses and students enrolled in AP Economics. Top 10 concepts discussed in this video: #1. Functions of Money, #2. Defining Money Supply, #3. Bank’s Balance Sheet, #4. Interest Rates and Spending, #5. Monetary Policy, #6. “Easy” Monetary Policy in Short Run, #7. “Tight” Monetary Policy in Short Run, #8. Interest Rates and Bond Prices, #9. Money Multiplier, and #10. Present and Future Value of Money.

4.1 Bank Balance Sheet (Macro)

Learning objectives:
1. Students will be able interpret a commercial bank's balance sheet (or T-account).
2. Students will be able to differentiate between a bank's assets and liabilities. 
3. Students will be able to calculate the reserve requirement from a balance sheet.
4. Students will be able to adjust a bank's balance sheet after a financial transaction.
5. Students will be able to determine how a bank meets its reserve requirement when reserves are low.

4.2 Monetary Policy Graphs (Macro)

Learning objectives:
1. Students will be able to identify the appropriate open market operation for recessionary gaps and inflationary gaps.
2. Students will be able to demonstrate effects of the open market operation using the AD/AS model. 
3. Students will be able to illustrate open market operations using a money market graph. 
4. Students will be able to explain the Keynesian transmission mechanisms (cause-effect chains) of "easy" and "tight" monetary policies.

Money & Monetary Policy Review Sheet

  • Money should have portability, acceptability, durability, divisibility, and stability in value.
  • Four basic types of money throughout history are: commodity money, representative money, fiat money (it's money because the government says it is and we believe in it - no intrinsic value), and checkbook money.
  • Money's three functions: medium of exchange, standard of value, and store of value
  • M1 consists of checkable deposits, traveler's checks, and currency.  Checkable deposits make up about 75% of M1 and are also called demand deposits.
  • M2 and M3 are broader definitions of money and include savings accounts and other time deposits.
  • Velocity is the number of times per year the money supply is used to make payments for final goods and services.
  • The equation of exchange is MV=PQ or money x velocity = price x quantity.  PQ is the nominal GDP.
  • Banks create money when they make loans.  One bank's loan becomes another bank's demand deposit.  Money is destroyed when the loan is repaid.
  • Banks must keep a percentage of their deposits as reserves.  Reserves can be currency in the bank vault or deposits at the Federal Reserve Banks.  The reserve requirement limits the amount of money the bank can create.
  • Money Multiplier = 1/Reserve requirement
  • The higher the reserve requirement the less money that can be created and vice versa.
  • Federal Reserve has 3 tools to control the money supply: open market operations (buying and selling government bonds), changing the discount rate, and changing the reserve requirement.
  • Expansionary/"Easy" monetary policy could consist of decreasing the reserve requirement, decreasing the discount rate, and/or buying bonds on the open market.  Often this is used to battle unemployment.
  • Contractionary/"Tight" monetary policy could consist of increasing the reserve requirement, increasing the discount rate, and/or selling bonds on the open market.  The Fed follows a tight monetary policy during times of inflation.
  • Open market transactions are the most frequently used tool.  The reserve requirement is the most powerful and rarely used.
  • Monetarists believe that money directly affects the economy through the equation of exchange and the money supply should increase by the same amount as the GDP (3-5% per year).
  • Keynesians believe that money affects interest rates which in turn affect investment and GDP.  Easy money decreases interest rates and increases GDP during recessions.  Tight money increases interest rates, which decreases AD and helps fight inflation.
  • The Fed cannot target both the mony supply and interest rate simultaneously so it must choose which goal to strive for wisely.

Unit 4 Student Wiki

Functions of Money: Money has three key functions. It serves as a medium of exchange, a standard of value (unit of account), and a store of value. (Bianca L.) 

M1: Medium of exchange. M1 includes currency and coin, checkable deposits, and travelers checks. (Bianca L.) 

M2: Store value. M1 plus noncheckable savings accounts and money market savings accounts, money market mutual fund accounts, and small time deposits (<$100,000). (Bianca L.) 

M3: M2 plus large savings instruments (>100,000). Not as liquid as M1 or M2. (Bianca L.) 

Balance Sheet: A financial statement that summarizes a banks assets (cash, reserves, loans) and liabilities (demand deposits) at a specific point in time. It's called a balance sheet because both sides must balance out. Also known as a t-account. (T. Kim)

Demand Deposit: Also known as a checkable deposit. A transactional account in which any checks or drafts may be written. It is a liability on a bank's balance sheet and is part of M1 (Erin C.) 

Money Multiplier: (1/Reserve Ratio) (Jen S.)

Federal Reserve Bank: The central bank of the United States that determines the size of the money supply. It sets monetary policy in order to maintain price stability and promote economic growth. (Bianca L.) 

Open Market Operations: When the Federal Reserve buys or sells treasury securities (bills, notes, bonds). (Bianca L.) 

Interest-Bearing Asset: Bonds are a great example of an interest bearing asset. It is an asset that becomes more valuable as the interest rate rises (Ray I.)

Federal Funds Rate: Interest rate at which banks charge each other for short term loans. Currently 0-0.25%. (Bianca L.) 

Discount Rate: Short term Fed. loans to banks. (Bianca L.) 

Money Market: A graph which demonstrates the relationship between nominal interest rates and quantity of money. The Demand for money is down sloping and concave up to the origin. The supply of money, which is fixed by the Fed and can be shifted through open market operations, is a vertical line which intersects with the downward sloping demand curve. (Erin C.)

Easy Monetary Policy: The Fed buys bonds, increasing money supply. The nominal interest rates decrease, thus increasing investment spending. Aggregate demand increases along with the price level, real gross domestic product, and employment. (Bianca L.) 

Tight Monetary Policy: The Fed sells bonds, lowering the money supply, increasing interest rates, and decreasing investment spending. Aggregate demand decreases along with price level and employment. (Bianca L.) 

Monetary Equation of Exchange: Money stock multiplied by velocity is equal to price level multiplied by output. (Bianca L.)

This is part of a wiki project completed by Mr. Medico's students / Not responsible for typographical errors

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