Money, Banking, and Macroeconomic Policy: Study Notes

Banking and Credit Markets

Bank Functions and Tradeoffs

Banks play a central role in the economy by accepting deposits and making loans. They must balance liquidity needs with profitability, holding reserves to meet withdrawals while lending out the rest to earn interest.

• Liquidity Needs: Banks keep a fraction of deposits in reserve to meet expected withdrawals. This fraction is called the reserve ratio, defined as $\text{Reserve Ratio} = \frac{\text{Reserves}}{\text{Deposits}}$.

• Profitability: Banks earn interest ("r") from loans, which must cover costs such as loan appraisals, monitoring, risk of default, labor, capital, and interest paid on deposits.

• Fractional Reserve Banking: Only a portion of deposits is held in reserve; the rest is lent out, increasing the money supply.

• Maturity Transformation: Banks pool short-term deposits to make long-term loans, earning returns based on the marginal product of capital (mpk).

• Law of Large Numbers: Large banks can diversify risk, making them more stable.

Example: If a bank receives a $1000 deposit and holds a 10% reserve ratio, it keeps $100 in reserve and lends out $900.

Bank Balance Sheets and Insolvency

Banks' balance sheets show assets (reserves, loans) and liabilities (deposits, owners' equity). Losses from defaults reduce owners' equity first; if losses exceed equity, the bank becomes insolvent.

• Assets: Reserves, loans, long-term investments, cash-equivalents

• Liabilities: Demand deposits, long-term debt, short-term borrowing

• Owners' Equity: The residual value after liabilities are subtracted from assets

Example: If a bank loses $100 from bad loans, owners' equity falls by $100.

Bank Regulation and Policy

To prevent insolvency and protect depositors, banks are regulated and insured.

• Diversification: Banks must diversify loans to reduce risk.

• FDIC: Federal Deposit Insurance Corporation insures deposits, reducing risk for depositors.

• Systemically Important Financial Institutions (SIFI): Large banks face stricter regulations, higher equity requirements, stress testing, and must have a "living will" for bankruptcy scenarios.

• Moral Hazard: Insurance can encourage riskier behavior, so regulations are stricter for big banks.

Credit Markets and Interest Rates

Risk and Return in Credit Markets

Credit markets depend on expectations about the future. Borrowing and lending involve risks such as default and inflation, which affect interest rates.

• Default Risk: The risk that borrowers will not repay.

• Inflation Risk: The risk that inflation will erode the value of repayments.

• Risk Premium: Extra interest charged to cover risks.

• Fisher Equation: Nominal interest rates adjust to cover risk premium and inflation.

Equation: $\text{mpk} = r = \text{nominal interest rate} - \text{risk premium} - \text{inflation}$

Example: If inflation rises, nominal interest rates must rise to compensate lenders.

Types of Financial Assets

• Loans: Least risky, protected by FDIC.

• Bonds: IOUs with fixed repayment terms, traded in secondary markets, mid-risk.

• Stocks: Ownership in firms, most risky but highest nominal return.

Bond Yield: The rate of return depends on the price paid and the bond's terms. If bond prices fall, yields rise.

Stock Return: $\text{Return} = \text{Price sold in future} - \text{Price paid} + \text{Dividends}$

Arbitrage: Competition between stocks and bonds; as bond yields rise, stock prices fall.

The Monetary System and Money Creation

Quantity Theory of Money

The quantity theory of money links the money supply to nominal GDP and inflation.

• Equation: $M \times V = P \times GDP$

• Money Growth: If velocity (V) is constant, then $\text{money growth} = \text{inflation rate} + \text{real GDP growth}$

• Implication: If money growth exceeds real GDP growth, inflation occurs.

Types and Functions of Money

• Medium of Exchange: Used to buy goods and services.

• Store of Value: Retains value for future purchases.

• Unit of Account: Standard measure for pricing goods.

Types of Money:

• Commodity Money: Has intrinsic value (e.g., gold).

• Convertible Money: Can be exchanged for a commodity (e.g., gold standard).

• Fiat Money: Value by government decree and public trust.

Money Supply Definitions

• Savings Accounts: 62.3%

• Checking Accounts: 10.5%

• Currency in Circulation: 10.5%

• Money Market Accounts: 6.5%

• Time Deposits: 2.8%

M1: Savings + Checking accounts

Money Creation and the Deposit Multiplier

Banks create money by lending out deposits, which are redeposited and lent again, multiplying the money supply.

• Deposit Multiplier: $\text{Total Change in Deposits} = \text{Initial Deposit} \times \frac{1}{\text{Reserve Ratio}}$

• Example: A $1000 deposit with a 10% reserve ratio leads to $10,000 in total deposits.

Inflation, Deflation, and Hyperinflation

Inflation

Inflation is the general rise in prices, often caused by excessive money growth.

• Causes: Wage contract rigidities, cyclical employment, logistical costs, voter responses, seignorage.

• Effects: Hurts savers, erodes purchasing power, can lead to price controls and structural unemployment.

Deflation

Deflation is a general fall in prices, often leading to delayed spending and higher unemployment.

• Causes: Wage rigidities, cyclical unemployment, delayed expenditures.

• Effects: Increases unemployment, reduces aggregate demand.

Hyperinflation

Hyperinflation is extremely high inflation (over 50% per year), leading to loss of monetary independence and inefficiency of barter.

The Federal Reserve System and Monetary Policy

Structure of the Federal Reserve

The Federal Reserve (Fed) is the central bank of the US, responsible for monetary policy and banking regulation.

• 12 Regional Banks: Liaison between Fed and local banks.

• Board of Governors: Seven members, appointed for 14-year terms, reflect political interests.

• FOMC: Federal Open Market Committee, includes Board and five regional presidents (NY always included), decides monetary policy.

Roles of the Fed

• Supervision and Regulation: Examines bank balance sheets, enforces reserve requirements, Dodd-Frank, Volker rule, stress tests.

• Banker's Bank: Provides liquidity, lender of last resort (discount rate), clears checks, holds reserves, pays interest on reserves.

• Monetary Policy: Dual mandate to maximize employment and maintain price stability. Targets the federal funds rate via open market operations (OMO), repurchase agreements, quantitative easing, and changes to reserve requirements and interest on reserves.

Monetary Policy Mechanisms

Expansionary monetary policy involves buying government bonds to increase reserves, lower interest rates, and stimulate spending.

1. Start from equilibrium.

2. FOMC orders reduction in federal funds rate via OMO.

3. Buy government bonds, bond prices rise, yields fall.

4. Former bond owners deposit payments, M2 increases via deposit multiplier.

5. Lending and borrowing increase, aggregate demand rises, prices and employment increase.

6. Long run: Prices rise, labor supply shifts, inflation increases.

7. Fed may need to buy more bonds to maintain targets, leading to more inflation.

Short Run: Unemployment decreases, labor increases. Long Run: Inflation increases, real effects dissipate.

Policy Independence and Expectations

• Board of Governors: Long-term interests (14-year terms).

• Regional Bankers: Short-term interests, sensitive to inflation.

• Government Policymakers: Short election cycles, may favor expansionary policy for re-election.

• Banker Expectations: If banks expect inflation, they charge higher nominal rates.

• Quantitative Easing (QE): FOMC purchases long-term bonds to lower long-term rates, controversial.

• Interest on Reserves (IOR): Sets a minimum rate for loans, prevents lending below IOR.

Business Cycles and Recessions

Characteristics of Recessions

• Co-movement: Macro aggregates (C, I, GDP, labor) move together.

• Limited Predictability: Turning points are hard to forecast.

• Persistence: Recessions last for extended periods.

Shapes of Recessions: L-shaped (Great Depression), W-shaped (1980s), U-shaped (Great Recession), V-shaped (Pandemic).

Business Cycle Theories

• Real Business Cycle Theory: Supply-side shocks (tech, energy, droughts) cause booms and recessions.

• Keynesian Theory: Demand-side shocks (animal spirits, expectations, sticky wages) drive cycles.

• Monetary/Financial Theory: Disruptions in credit markets, need for regulation and policy.

Recovery from Recession

• Induced Innovation: New products or methods.

• Wage Adjustments: Labor supply shifts to restore equilibrium.

• Policy Interventions: Monetary, financial, or fiscal stimulus.

Correlation of Economic Indicators with Real GDP

• Average Weekly Hours (Manufacturing): Positively correlated with real GDP.

• Initial Unemployment Insurance Applications: Negatively correlated with real GDP.

• New Orders for Capital Goods: Positively correlated with real GDP.

• New Building Permits: Positively correlated with real GDP.

• S&P 500 Index: Positively correlated with real GDP.

• Consumer Sentiment: Positively correlated with real GDP.

Labor Market Shocks

Positive Productivity Shock (e.g., Internet Boom)

• Labor demand curve shifts right (twice, due to multipliers).

• Businesses need more workers with technological skills.

• Increase in productivity raises marginal product of labor, increasing labor demand.

Negative Shock with Rigid Wages

• Labor demand curve shifts left (twice).

• With rigid wages, employment falls more than if wages were flexible.

Bank Reserves and Liquidity

Components of Bank Reserves

Included in Bank Reserves	Not Included
Deposits at the central bank	Gold or silver
Vault cash	Loans to commercial firms
	Loans to other private banks

Liquidity

• Definition: Funds available for immediate payment; assets that can be quickly sold.

• Excess Reserves: If excess reserves increase, liquidity increases.

• Reserve Requirement: If reserve requirement increases, excess reserves decrease.

Summary Table: Types of Banks

Type	Liquidity	Return
Investment Bank	Illiquid	Higher
Commercial Bank	Liquid	Lower

Summary Table: Types of Money

Type	Description
Commodity Money	Has intrinsic value (e.g., gold)
Convertible Money	Can be exchanged for commodity (e.g., gold standard)
Fiat Money	Value by decree and trust

Sample Questions and Answers

• The Stock Market crash of 1929: Reflected revised expectations about profitability of firms.

• Contributors to the Great Depression: Inadequate diversification, self-fulfilling expectations of bank failures, lack of Federal Reserve intervention.

• Smoot-Hawley Tariff: Trade war legislation contributed to the Great Depression.

• Fed Response to Supply Shocks: Raising discount rate leads to lower stock prices and higher bond yields.

• Keynesian vs Real Business Cycle Shocks: Demand-side shocks cause ambiguous price changes; supply-side shocks cause price increases.

• Fed's Dual Mandate: After energy shocks, Fed prioritized inflation and set higher federal funds rate.

Additional info: Academic context was added to clarify the mechanisms of money creation, the role of the Federal Reserve, and the effects of monetary policy on inflation and employment. Tables were reconstructed for clarity and completeness.