Economics 311 Handout 1 Professor Tom K. Lee
Section I: Review of basic economic concepts and relations
Part 1: Basic economic concepts of prices and money
CH 2
Barter economy is an economy where goods & services are exchanged
for goods & service.
Monetary economy is an economy where goods & services are exchanged
for money.
Relative price is the exchange rate of goods & services with goods
and services.
Absolute price is the exchange rate of goods & services with money.
Advantages of monetary economy -remove double coincidence of wants
-allows specialization
-economize on price information
Functions of money -medium of exchange
-unit of account
-store of value
-standard for deferred payments
Characteristics of money -general acceptance
-portable
-divisible
-identifiable
-durable
-liquidity: marketability & reversibility
-optimal scarcity
-relative stability of supply
Types of money -Commodity money is money with intrinsic value.
-Fiat money is money with no intrinsic value.
Gresham Law states that bad money drives out good money.
Measures of money supply: M1 andM2
Part 2: Economic relations of money supply growth rate and
inflation rate, nominal interest rate, business cycle
and federal government budget deficit
CH 1
Inflation rate is the rate of change of general price level.
Money growth rate and inflation rate
Money growth rate and nominal interest rate
Fisherian Theory of Interest Rate: 1 + nominal interest rate =
(1 + real interest rate) x (1 + expected inflation rate)
Money growth rate and business cycle
Federal government budget constraint
Money supply and the federal gov't budget deficit
Part 3: Circular flow of a monetary economy
Circular flow of a 3-sector 3-market economy
Three sectors: gov't, households & firms
Three markets: product, asset(money) & resource(labor) mkt.
Two national income identities
-flow of product (expenditures) approach to measure real GDP
-disposal of income approach to measure real GDP
Economics 311 Handout 2 Professor Tom K. Lee
Part 4: The importance of financial intermediation
CH 3 pp 60-61, CH 11
Financial intermediation is the process whereby small amounts of
savings funds are collected from the households and transformed
into the hands of firms and gov't for investment
Flows of funds: from savings-surplus units to savings-deficit units
Investment opportunity frontier is the income today and tomorrow
that can be achieved when one invests efficiently.
Indifference curve is the combinations of consumption today and
tomorrow that give a consumer the same level of satisfaction .
Capital market & discounting: present value vs future value
Optimal investment point is the maximum present value income point
on the investment opportunity frontier.
Intertemporal budget constraint & present value income maximization
Consumption opportunity curve is the combinations of consumption
today and tomorrow that a consumer can afford when she uses up
all her maximum present value income.
Utility maximization and optimal consumption point
Functions of financial intermediaries
-facilitate intertemporal consumption choice & equalize marginal
investment returns,
-reduce transaction costs,
-produce information,
-pool resources to provide divisibility & flexibility,
-diversification of risk,
-participate in money supply creation process,
-provide expertise & convenience.
Diversification is the holding of assets with less than positively
perfectly correlated returns.
A portfolio is a collection of assets.
The Insurance Principle states that diversification provides risk
reduction, and if sufficient number of assets with uncorrelated
returns are included in a diversified portfolio, then the risk
of the portfolio can be practically reduced to zero.
Section II: Institutional facts of financial institutions and
financial markets
Part 5: Facts of financial institutions
CH 3 pp 61-64, CH 13 pp 323-338
Different types of financial institutions
-Depository institutions: Commercial banks
Savings & loans associations
Mutual savings banks
Credit unions
-Contractual savings institutions: Life insurance
Pension funds
Fire & casualty insurance
-Investment intermediaries: Mutual funds
Money market mutual funds
Finance company
Economics 311 Handout 3 Professor Tom K. Lee
Primary liabilities(sources of funds) & primary assets(uses of
funds) of different financial institutions
Part 6: Four major financial markets and four major forms of
a financial market
CH 3 pp 50-60, CH 9
Money mkt, bond mkt, stock mkt and foreign exchange mkt.
Spot mkt, forward mkt, futures mkt and options mkt.
Organized exchange as broker-specialist system
Over-the-counter exchange as dealership system
Mark-to-market arrangement
Part 7: Money market instruments and capital market instruments
CH 3 pp 43-50
Money market instruments -U.S. Treasury bills
-Negotiable bank CD
-Commercial papers
-Bankers' acceptance
-Repurchase agreements
-Federal funds
-Eurodollars
Capital market instruments -Stocks
-Corporate bonds and notes
-Mortgages
-U.S. Treasury bonds & notes
-State and local gov't bonds
-U.S. gov't agency securities
-Consumer loans & Commercial loans
Foreign bonds, Eurobonds & Euroequities
Section III: Theories of interest rate
Part 8: Types of loan and concepts of investment returns
CH 6 pp126-133
Types of loans: Simple & fixed payment loans, coupon bonds,
discount bonds & consols
Yield to maturity is the discount rate that equates the present
value of future stream of cash inflows to current cash outflows.
Bonds prices are inversely related to market interest rate.
Current yieldyield on a discount basis
Holding yield = current yield + rate of capital gains
Bid vs asked bond prices
Bond ratings , junk bonds and risk premium
Part 9: Mirror image of bond market and loanable funds market
CH 6 pp 133-142
Supply of bonds, demand of bonds & the bond market equilibrium
Determinants of the demand for bonds -wealth
-expected returns
-expected inflation
-risk
-liquidity
Economics 311 Handout 4 Professor Tom K. Lee
Determinants of the supply of bonds -profitability of investment
-expected inflation
-gov't budget deficits
Loanable funds market: supply, demand & equilibrium interest rate
Part 10: Why are there so many market interest rates?
CH 6 pp 123-130
Why do interest rates differ -differences in time to maturity
-differences in risk
-differences in tax treatment
-difference in administrative cost
-differences in bond features
A callable bond is a bond that the issuer can prepay the principal
before the time to maturity of the bond.
A convertible bond a bond that the holder of the bond can
exchange the bond for some specify number of corporate shares
some time within the time to maturity.
Part 11: The term structure of interest rate
CH 7
The term structure of interest rate is the relation between
yield to maturity & time to maturity.
The yield curve is the graph for term structure of interest rate.
Theories of the term structure of interest rates
-Liquidity Preference Hypothesis & liquidity premium
-Unbiased Expectations Hypothesis & forward interest rate
-Segmented Market Hypothesis
-Preferred Habitat Hypothesis
Section IV: Management of depository institutions
Part 12: Balance sheet of depository institutions
CH 12 pp 284-296
The balance sheet identity: Total assets=total liabilities
ASSETS LIABILITIES
Reserves Checkable deposits 22%
Cash items in process of collection Nontransaction deposits 48%
Deposits with other banks Borrowings 23%
Securities Bank capital 7%
Loans
Other assets
Off balance sheet activities -foreign exchange transactions
e.g. Franklin National Bank in 1974
-loan guarantees/bankers acceptance
-lines of credit
Economics 311 Handout 5 Professor Tom K. Lee
Part 13: Four problems of depository institution management
CH 12 pp 296-308
Four primary problems of depository institution management
- Liquidity management is to provide sufficient funds to meet
depository withdrawals,
-Asset management is to maximize returns of bank assets
subject to a level of risk tolerance,
-Liability management is to raise funds for a bank in a timelymanner,
-Interest rate risk management is to minimize risk exposure of
bank assets & liabilities due to interest ratefluctuations.
To solve liquidity problems, banks can engage in
-asset approach: call back loans
sell secondary reserves
sell loans
repurchase agreements
-liability approach: borrow from other banks
issue CD/commercial papers
borrow from the FED
attract more deposits
Part 14: Asset management and portfolio theory
CH 5
Expected value, variance, standard deviation & covariance
Minimum variance opportunity set is the combinations of expected
returns & risk that minimize risk subject to a required
expectedreturn among the set of risky assets.
Efficient set is the combinations of expected returns and risk
that maximizes expected returns subject to risk among the set
ofrisky assets.
Risk-free assetmarket portfolio
Capital market line is the combinations of expected returns and
risk that maximizes expected returns subject to risk among the
set of risky assets and the risk-free asset.
Indifference curve is the combinations of expected returns and
risk that yield the same level of satisfaction to an investor.
Optimal portfolio point is the point of tangency of anindifference
curve with the capital market line.
Price of risk is the marginal rate of substitution of expected
returns per unit of risk(= slope of the capital market line).
Risk premium = Price of risk x quantity of risk
Part 15: Interest rate risk management
Fixed rate vs interest-rate sensitive assets(liabilities)
Measure of interest rate risk
-gap analysis
-maturity bucket approach
-standardized gap analysis
-duration analysis(Macaulay's duration)
Economics 311 Handout 6 Professor Tom K. Lee
Strategies of interest rate risk management (interestimmunization)
-matching maturity & amount of assets & liabilities
-matching duration & present values of assets & liabilities
-interest-rate swap
-hedge with futures & options on debt instruments
Section V: Financial regulatory agencies and money supply
Part 16: Financial regulatory agencies
CH 14
Financial regulatory agencies
-Securities & Exchange Commission(SEC)
-Commodities Futures Trading Commission(CFTC)
-Office of the Comptroller of Currency(OCC)
-Federal Reserve Bank(FED)
-Federal Depository Insurance Corporation(FDIC)
-State Banking Commissions
-Office of Thrift Supervision(OTS)
Two primary methods for FDIC to handle failed banks
-payoff method
-purchase and assumption method
Part 17: Fractional reserve banking and money supply
CH 13 pp320-333, CH 14 pp347-367
Fractional reserve banking system is a banking system that legally
allow banks to hold less than 100% of their deposits as bank
reserves.
Bank reserve is the sum of the cash in the vault of the bank
and the bank's deposits at the FED.
Required reserve ratio is the percentage of bank deposits that has
to be held as required reserves.
Money creation & destruction processes
Potential money supply multiplier is the change in money supplydue
to a dollar increase in reserve under the assumptions thatthere is no excess reserves and coins & currency remains constant.
High-powered money(Monetary base) is the sum of coins & currency
in the public hand and bank reserves.
Excess reserve is bank reserves minus required reserves.
Currency demand-deposit ratio
Actual money supply multiplier is the change in money supply dueto
a dollar increase in high-powered money under the assumptions
that there may be excess reserve, and currency demand-deposit
ratio is constant.
Part 18: Financing of Federal government spending
Financing of gov't spending: tax financing
debt financing
inflation financing
Menetizing the debt is when the FED buys gov't securities from
the general public converting gov't debt into money in the
geberal public's hand.
Economics 311 Handout 7 Professor Tom K. Lee
Part 19: The Federal Reserve Bank
CH 15, CH 17 pp 422-427
The Federal Reserve Bank and the Federal Reserve Act of 1913
Consolidated balance sheet of the FED(in billions of US dollars)
ASSETS LIABILITIES
S1US gov't securities 779.6 U1 Federal Reserve notes 778.2
S2 Discount loans 10.6 U2 Bank deposits 20.7
S3 Gold & SDR certificates 13.2 S5 US Treasury deposits 4.3
U3 Coin 1.3 S6 Foreign & other deposits 0.9
S8 Cash items in process of S9 Deferred availability cash
collection 2.2 items 3.0
S4 Other Federal Reserve assets S7 Other Federal Reserve
42.2 liabilities& capital
accounts 41.8
Uses of monetary base = U1+U2-U3+Treasury currency outstanding
-Cash held by the Treasury
Sources of monetary base = S1+S2+S3+S4-S5-S6-S7+(S8-S9)
+Treasury currency outstanding
-Cash held by the Treasury
Float = S8 - S9
Goals of the FED -Price stability
-economic growth
-full employment
-interest rate stability/affordability
-financial market stability
-foreign exchange mkt stability
Part 20: Tools of the Federal Reserve Bank in controlling money
supply
CH 17 pp 428-446, CH18
Open market operation(OMO) is the buying and selling of gov't
securities by the FED to control money supply.
The Banking Act of 1933
Two types of OMO -dynamic OMO
-defensive OMO
Two means of OMO -purchase or sale of gov't securities
-repo & reverse repo
Advantages of OMO -complete control
-flexible
-reversible
-no administrative delay
Discount policy and the Federal Reserve Act of 1913
Three types of discount loans -adjustment credit loans
-seasonal loans
-extended credit loans
Four costs of discount loans -interest cost at the discount rate
-raise chances/frequency of audit
-reduces chances of future loans
-may not do reverse repo
Advantages of discount policy -lender of last resort
-signal FED intention
Economics 311 Handout 8 Professor Tom K. Lee
Disadvantages of discount policy -announcement effect
-spread of i vs d & money supply
-incomplete control
-not easily reversible
Reserve requirement and the Banking Act of 1935
The Depository Institutions Deregulation & Monetary Control Act
of 1980
Disadvantages of required reserve regulation -sensitivity
-liquidity of banks
Contemporaneous reserve requirements is the implementation of the required reserve regulation through a seven-week cycle with transaction deposit daily averages calculated over a reserve computation period and reserve daily average calculated over a reserve maintenance period.
Section VI: Macroeconomic theories of the effect of changes in
money supply on the economy
Part 21: Classical model and the neutrality of money
CH 20 pp 515-526
Velocity of money is the number of times money changes hand in
an economy in one year.
The equation of exchange: MV = Py
The Simple Quantity Theory of Money assumes that velocity of money
is constant.
Assumptions of -flexible interest rates
the Classical -flexible product prices
Model -flexible wages
-certainty
-competitive labor market
-production function is the mapping of inputs to
output when inputs are used efficiently.
-Say's Law: supply creates its own demand.
-Simple Quantity Theory of Money
-Classical savings function: real saving is
positively related to real interest rate.
-investment function: real investment is inversely
related to real interest rate.
-competitive loanable funds market
-7 endogenous variables: W/P, N, y, P, i, S & I
Neutrality is that changes in money supply have no effect on
equilibrium real income(GDP).
Dichotomy is that the determination of the equilibrium levels of
real variables is separated from the determination of the
equilibrium levels of nominal variables.
Crowding-out effect is that an increase in gov't expenditures
drives up interest rate & reduces investment.
Ricardian Equivalence Theorem states that government budget deficit
due to a tax cut financed by borrowings has no effect on real
interest rate and investment but increases savings.
Economics 311 Handout 9 Professor Tom K. Lee
Part 22: Second generation Keynesian model
CH 20 pp526-539
Assumptions of -flexible interest rates
the 2nd generation -fixed product prices and fixed wages
Keynesian Model -certainty
-product market and money market equilibria
-production function
-investment function
-Keynesian savings function: real saving is
positively related to real income.
-5 endogenous variables: i, y, N, I & S
IS curve is the combinations of real interest rate and real income
that yield an equilibrium in the product market.
Why is the IS curve downward sloping?
Motives for money demand -transactional and precautionary
-speculative
LM curve is the combinations of real interest rate and real income
that yield an equilibrium in the money market.
Why is the LM curve upward sloping?
Simultaneous equilibrium in the product and the money market
determines the equilibrium real interest rate and real income.
Part 23: Monetary transmission mechanisms
CH 23pp 607-617
Monetary Transmission Mechanism is the process through which
changes in money supply affect equilibrium real income in an
economy.
8 Monetary transmission mechanisms -Classical
-Keynesian
-Availability Hypothesis
-Tobin's q
-Consumer durable expenditures
-Wealth effect
-Liquidity effect
-Exchange rate effect
Part 24: Fourth generation Keynesian model
CH 21
Assumptions of -flexible interest rates
the 4th generation -flexible product prices
Keynesian Model -flexible wages
-uncertainty
-adaptive expectations
-product market equilibrium
-money market equilibrium
-investment function
-Keynesian savings function
-labor market equilibrium
-production function
-7 endogenous variables: P, y, i, I, S, N & W
Economics 311 Handout 10 Professor Tom K. Lee
Aggregate demand is the combinations of general price level &
real income that yield simultaneous equilibria in the product
and money market.
Why is the aggregate demand curve downward sloping?
Determinants of aggregate demand
-investment
-gov't expenditures
-savings
-taxes
-money supply
-transactional demand for money
-speculative demand for money
Aggregate demand management policies are gov't policies that try
to shift the AD curve to affect equilibrium real income,
e.g. fiscal & monetary policies
Aggregate supply is the combinations of general price level &
real income that yield an equilibrium in the labor market.
Why is the aggregate supply curve upward sloping?
Determinants of aggregate supply -labor demand
-labor supply
-price expectations
-production function
Aggregate supply management policies are gov't policies that
try to shift the AS curve to affect equilibrium real income.
e.g. labor market policy and research & development policy.
Supply side shocks, stagflation vs deflationary growth
Demand side shocks, recession vs inflationary growth
Short-run vs long-run aggregate supply curve
Section VII: Determinants of foreign exchange rates