Economics 311 Handout 1 Professor Tom K



Part I: Review of basic economic concepts and relations

Chapter 1: Basic economic concepts of prices and money

Section 1.1: Two types of economy

Historically, there are two types of economy:

1) Barter economy is an economy where goods and services are

exchanged for goods and service.

2) Monetary economy is an economy where goods and services are

exchanged for money.

All modern day economies are organized as monetary economies.

Typically the government of a monetary economy controls its money

supply.

Section 1.2: Two kinds of price

Theoretically there are two kinds of price in economies:

1) Relative price is the exchange rate of goods and services for

goods and services.

2) Absolute price is the exchange rate of goods and services for

money.

All the prices we see on the price tags of products in the

stores are absolute prices. By taking the ratio of a pair of

absolute prices we can recover a relative price. For example, the

absolute price of orange is thirty cents an orange, and the

absolute price of apple is fifty cents an apple. By taking

the ratio of this pair of absolute prices, we get the relative

price of oranges for apples of the amount of five oranges for

three apples.

In microeconomics the interest is to determine the level of

relative prices. In macroeconomics the interest is to determine the

level of a value weighted average of the absolute prices of some

defined basket of goods.

Section 1.3: Advantages of monetary economy over barter economy

The three advantages of monetary economies over barter economies

are:

1) Money removes double coincidence of wants, which is a

situation in a barter economy where one person exchanges a

product with another person only if each person likes what the

other person has. In a barter economy, transaction cost is so

high that a lot of multilateral trades are foregone. In a

monetary economy, all multilateral trades of goods and

services for goods and services are broken down to bilateral

trades of goods and services for money so that more trades

take place. Since voluntary trades are mutually beneficial,

more trades are preferred to less trades.

2) Money allows specialization. In a barter economy, a lot of

mutually beneficial multilateral trades are forgone due to

high transaction cost. Since one cannot trade for the many

goods and services that one wants, one has to be able to

produce many different goods and services. One becomes a Jack-

of-all-trade. Specialization will not be feasible. In a

monetary economy, each member of an economy can do what one is

best at. One can exchange one’s good or service that one

produced for money from one person and with the money one can

exchange for goods and services one wants from another person.

Since everyone in a monetary economy produces what everyone is

best at producing, a lot more goods and services are produced

for consumption. This makes a monetary economy superior to a

barter economy. In fact one can conceive money as the greatest

invention of the human race.

3) Money helps to economize on information. In a barter economy

with n products, we need to establish n(n-1)/2 relative

prices. In a monetary economy of n products, we need only to

establish n absolute prices. When n is a large number,

n(n-1)/2 is so much larger than n. Yet one can always

recover relative prices by taking the ratio of a pair of

absolute prices. Hence there is no loss of information in

using absolute prices in a monetary economy and yet there

are fewer prices that need to be established. Consider a

barter economy. How many relative price tags of a product do

we need to attach to the product? In a monetary economy, each

product has one absolute price tag attached to it.

Section 1.4: Functions of money

There are four functions of money:

1) Medium of exchange facilitates transactions. People

exchange goods and services for money.

2) Unit of account sets absolute prices to account for the

value of the last unit of a product or service to

consumers.

3) Store of value is to defer current consumption to future

consumption to prepare for retirement.

4) Standard of deferred payments facilitates lending and

borrowing. One borrows a lump sum of money now in exchange

for repaying small amount of money by installments over a

period of time.

Hence money is commonly defined as anything that can perform the

four functions of money. It is a matter of degree how well a

financial asset satisfies the four functions of money and whether

it should be added to a measure of money supply. This means that it

is very hard to measure money supply accurately. Any measure of

money is only an approximation of what economists call money.

Sections 1.5: Characteristics of money

For one to recognize something as money, there are eight

characteristics of money:

1) General acceptance: people are willing to accept money in

exchange for goods and services. For example, tourism is a

major industry in Singapore. Singapore businessmen are

eager to accept major foreign currencies in exchange for

their merchandises. Singapore dollars and major foreign

currencies become money supply in Singapore.

2) Portable: money must be easy to carry around. This explains

why elephants are never used as money.

3) Divisible: US currency is divided into small denominations,

practically speaking, down to the pennies. A pair of Levi

jeans carries the price tag of thirty five dollars and

ninety nine cents. When it gets down to the penny, little

kids don’t even pick it up from the floor. They know a

penny practically cannot be used to buy anything this days.

However, they would pick up a quarter, because that would

yield a piece of bubble gum from a bubble gum machine.

4) Identifiable: money must be easy to identify as genuine and

not counterfeit. This is why governments have to be ahead

of counterfeiters in printing technology. The distinguish

features of the U.S. currency are the inserted magnetic

strip to the left that reads USA, the water mark to the

right, the never dry ink, and the red and blue threads on

the service.

5) Durable: money must not be easily destroyed in the process

of transaction or in storage otherwise it cannot perform

the functions of medium of exchange and store of value.

This explains why water is never used as money.

6) Liquidity: there are two properties of liquidity.

(a) Marketability means that there are always buyers and

sellers of the asset ready to do transactions with you

in case you want to sell or buy the asset for cash.

Cash is the most liquid of all assets. Marketability of

an asset can vary over time. An example is houses. In

the 1980s, a house could be sold within days of

listing. Normally it takes four to six months to sell a

house.

(b) Reversibility means that the price of the asset does

not change rapidly over time. A new car is not

reversible in value. Once you buy a car and drive it

out of the dealer’s parking lot, its resale value

normally drops ten percent.

(7a) Optimal scarcity: if we use a natural resource as money it

must be hard to find in the real world. This explains why

sand is never used as money. It is easy to scoop up tons

of sand from a beach.

(7b) Relative stability of supply: if we use a man-made resource

as money the producer of money must have self discipline

in controlling a steady growth of money supply. Under the

U.S Constitution, only Congress has the power to create and

destroy money, and that power is relegated to the Federal

Reserve Bank.

Section 1.6: Types of money

There are two types of money:

1) Commodity money is money with high intrinsic value. For

example, the gold contents of gold coins are more valuable

than their face value. Hence gold coins are commodity

money.

2) Fiat money is money with low intrinsic value. For example,

the paper money we use everyday is fiat money because the

material of paper money is worth less than its face value.

Since the main function of money is medium of exchange, we

should always use the least valuable resource as money for

circulation. Hence we should use fiat money. In the modern day

world most of our money is not currency but bank deposits. We have

electrons stored in the memory disc of our bank computers to

register the balance in our checkable deposit accounts and hence as

money. We have practically unlimited supply of electrons in the

universe. If one day every deposit transaction is done

electronically, we will have the cheapest resource as money, namely

electrons stored in bank computers to register the balance of bank

deposits.

Section 1.7: Gresham Law

Gresham Law states that bad money drives good money out of

circulation. An example of Gresham Law is as follows. The silver

quarter minted prior to the sixties are good money because the

silver content of those quarters are worth more than the face

value of twenty five cents. The modern day cheap copper-nickel

alloy quarters are bad money because the metal alloy is worth

less than the face value of twenty five cents. We rarely see

silver quarters in circulation. If you see one, you will pull it

out of circulation for the reason that the silver content of the

silver quarter is worth more than the face value of a quarter.

You will put it in your safety box. The cheap copper-nickel alloy

quarters remain in circulation.

Section 1.8: Measures of money supply

There are three official measures of money supply, namely, M1,

M2, and M3:

1) M1 is the sum of currency in the general public’s hand,

demand deposit, checkable deposits and travelers' check.

2) M2 is the sum of M1 and saving deposit, small denomination

time deposits, retail MMMF and MMDA.

3) M3 is the sum of M2 and Eurodollars, RP, large

denomination time deposits and institutional MMMF.

M1 serves the functions of medium of exchange, unit of account,

and standard of deferred payments. M2 and M3 include other assets

that serve the additional function of store of value. As we move

from M1 to M3 as a measure of money supply, we add less and less

liquid assets to the measure of money supply.

Section 1.9: Components of M1

Currency consists of coins minted by the U.S. Treasury and

federal reserve notes printed by the Federal Reserve Bank, the

central bank of the United States of America. A central bank of a

country is a bank for the government of that country. It creates

and destroys money, and regulates the value of money.

Demand deposits are deposits which earns no interest on the

Balance. This is due to Regulation Q of the Federal Reserve Bank,

which prohibits payment of interest on demand deposits. Depositors

can write checks to draw on the balance of the deposit of the

account. One reason for the existence of demand deposits is that

they are created when banks make loans to the general public. When

a bank makes a loan to a borrower, it does not give cash to the

borrower. Instead, it gives a demand deposit check book to the

borrower with the amount of loan the borrower applied for as the

balance in that checking account. There is no reason for a bank

to charge interest on a loan to a borrower and then pays the

borrower interest on the balance of the demand deposit created by

the loan.

Checkable deposits are deposits which earn interest on the

Balances. Depositors can write checks to draw on the balance of

the deposit of the account.

Travelers' checks are purchased from banks. Buyers are required

to sign the checks at the time of purchase. They have to sign

the checks again in front of the merchant selling the goods to the

buyers of the travelers' check when they use them. If you have

cash in a lost wallet, it is gone. If you have travelers' checks in

a lost wallet, you can call the bank that issued the travelers'

checks to stop payment and reissue the travelers' checks to you.

This is why people carry travelers’ check instead of cash when they

travel overseas.

Section 1.10: Components of M2

Savings deposits are deposits that you earn daily interest and

can withdraw any time you want but you have no checking facility.

Time deposits are deposits that you agree with a bank to leave

the sum of money for a specified period of time with interest

penalty for early withdrawal. Nowadays there are both fixed and

variable rate time deposits. Time deposits are more popular in

the form of certificate of deposit (CD).

Small denomination time deposits have balance in an amount less

than a hundred thousand dollars. They are typically non-negotiable

meaning that the CD has a bearer's name on it and only the bearer

can collect the principal and interest when the CD matures.

MMMF stands for money market mutual funds. A mutual fund is an

investment cooperative whereby small investors pool their

investment dollars together to allow a mutual fund manager to

diversify their investment dollars to a variety of assets.

MMMF is a mutual fund that the mutual fund manager is required to

invest only in money market instruments which means short-term

(maturity within a year), highly liquid (marketable and reversible

in value) financial assets.

Typically investors with MMMF accounts can write checks to use

the balance in their MMMF accounts. MMMF are offered by financial

brokerage firms and mutual fund companies. The federal government

does not insure balances in MMMF.

Retail MMMF refers to MMMF whose account holders are individual

investors. Typical retail MMMF account balances go up on pay day

and then go down over the month due to mortgage payment, car

payment and other payments. Since the balances are not stable, it

means they are liquid. That is why we classify retail MMMF under

M2.

Merrill Lynch was the first financial brokerage firm that

offered MMMF starting in 1970. Due to its tremendous popularity

over time, other forms of mutual funds flourish. Today we have

bond, equity, balanced (with fixed proportions in money market,

bond market and stock market), asset allocation (with variable

proportions in money market, bond market, and stock market),

precious metal, industry-specific, country-specific, foreign (with

funds invested only in foreign countries) and global (with funds

invested in domestic and foreign countries) mutual funds. Listings

in the Wall Street Journal covers three pages of mutual fund

listing and the number of pages are growing.

MMDA stands for money market deposit accounts. They are similar

to MMMF but are offered by banks and are insured by the Federal

Deposit Insurance Corporation (FDIC). They yield a lower return

than MMMF according to the principle of high risk high return.

Banks introduce MMDA in the eighties to lure depositors to take

some of their cash from MMMF back to banks.

Section 1.11: Components of M3

Eurodollars in general mean U.S. dollars deposited in banks

outside of the United States of America. After the end of the

Second World War, Russia and the United States of America entered

the Cold War. The Russian government did not want to deposit its

U.S. dollars in the United States of American to avoid having

its financial assets frozen by the United State government. It

turned out that a bank in London was willing to depart from

traditional bank practice of accepting only that country's currency

in that country's banks. The London bank found it profitable to

accept U.S. dollar deposits and to pay principal and interest in US

dollars because, after the Second World War, there was an immense

demand for U.S. dollars loans by European governments and

corporations to buy U.S. products and capital goods to rebuild the

European economies. The United States of America was the only large

industrialized country whose industrial base remained intact after

the Second World War. Since then, other European countries also

offer Eurodollar accounts. They are willing to accept other foreign

currency as well such as Japanese yen. Hence we speak of Euroyens.

The markets are then generically known as Eurocurrency markets.

Eurodollars in M3 stands for that amount of the Eurodollars as

defined above that are loaned back to the United States of

American through banks overseas.

RP or repo stands for repurchase agreement in which one sells

Treasury bills to another with the promise to buy them back

later in time at a higher price. It is similar to a secured loan

with the Treasury bills as collateral.

Large denomination time deposits refer to time deposits with

balances in excess of one hundred thousand dollars. They are

negotiable if the amount is at least one million dollars.

Negotiable means that whoever presents the bank CD on the date of

maturity will be entitled to the principal and interest. This

makes negotiable bank CD marketable.

Citibank is the first bank to introduce negotiable bank CD. It

is very popular among large corporations. If a large corporation

needs cash, it can easily sell its negotiable bank CD to any

corporation for cash.

For large denomination time deposits with amount less than one

million, they are not negotiable. This means the owner of such bank

CD stands to lose a large sum of money for early withdrawal. This

makes them less liquid, because the owner would hesitate on early

withdrawal.

Chapter 2: Economic relations of money supply growth rate and

inflation rate, nominal interest rate, business cycle,

and federal government budget deficit

Section 2.1: Inflation and its measures

Inflation rate is the rate of change of general price level.

There are many different measures of general price level. The most

common ones are consumer price index (CPI), producer

price index (PPI), and GDP deflator. They differ by the

composition of the baskets of goods and services from which

they are constructed. Consumer price index is based on the

basket of consumer goods and services that a typical middle age

American living in a large metropolitan area would buy. Producer

price index is based on the basket of raw material, labor

and intermediate goods that a typical business firm would buy.

GDP Deflator is based on the most comprehensive basket of

all final goods and services that the households, the firms, and

the government would buy.

Consumer price index and producer price index are

available on a monthly basis. In contrast, GDP deflator is

available on a quarterly basis, because it is very costly to

collect data on the basket of all final goods and services.

Consumer price index and producer price index are calculated

by the Laspeyres price index formula, which looks at a base year

basket of goods at today’s prices relative to the base year basket

of goods at the base year prices. In contrast, GDP deflator is

calculated by the Paasche price index formula, which looks at the

current year basket of goods at the current year prices relative to

the current year basket of goods at previous year prices.

Section 2.2: Money supply growth rate and inflations rate

Inflation rate is positively related to money supply growth

rate. The empirical fact to support this conjecture is that, in the

1960s and since 1985, we have single digit money supply growth

rate as well as single digit inflation rate. In the 1970s and

the first half of 1980s, we have occasions of double digit money

supply growth rate as well as occasions of double digit

inflation rate. However, this only shows correlation and not

causality. The following theory will give us causality.

Friedman’s Theory of Inflation: too much money chases after too

few goods will lead to inflation.

A buyer who has money and cannot get hold of a product will

offer a higher price to a seller to secure the sale of that product

to him from other buyers. If everyone in an economy suddenly has a

lot more money, everyone will offer a higher price for the product

that person wants and cannot get hold of. If everyone in the

economy does that, product prices will go up, leading to inflation.

Section 2.3: Money supply growth rate and nominal interest rate

Nominal interest rate is positively related to money supply

growth rate. The empirical fact to support this observation is that

we have single digit money supply growth rate as well as single

digit nominal interest rate in the 1960s and since 1985. In the

1970s and the first half of the 1980s, we have occasions of

double digit money supply growth rate as well as occasions of

double digit nominal interest rate. Again this only shows

correlation and not causality. The following theory will give us

causality.

Fisherian Theory of Interest Rate: 1 + nominal interest rate =

(1 + real interest rate) x (1 + expected inflation rate)

Fisherian theory of interest rate tells us that money lenders

need to be compensated for three reasons. First, lenders need to

be compensated for the erosion of the real purchasing power of

the dollars due to inflation over the loan period. This is

represented by the expected inflation rate in the Fisherian

theory of interest rate. Secondly, even in a world with no

inflation, lenders need to be compensated for foregoing their

current consumption. Thirdly, lenders need to be compensated for

taking the risk of default. The last two reasons is represented

by the real interest rate in the Fisherian theory of interest

rate. Combining real interest rate and the expected inflation

rate over the loan period helps lenders to determine the nominal

interest rate for a loan over that period.

As money supply growth rate increases without comparable rise in

real output, Friedman's theory predicts a higher inflation rate.

Then lenders will revise their expected inflation rate up and

through the Fisherian theory of interest rate the nominal

interest will go up.

Section 2.4: Money supply growth rate and business cycle

A business cycle is usually tracked by real GDP. It consists of

the peak of the real GDP, followed by a recession of an economy,

that is a downturn of real GDP. The trough of a business cycle is

when real GDP bottoms off, and is followed by a recovery of the

economy, that is an upturn of real GDP until another peak occurs.

The official definition of a recession is two quarters of real GDP

downturn.

There are two empirical facts about the relation of money supply

growth rate and business cycles, First, for the last eight

recessions in the USA since the Second World War, months before the

downturn of the business cycle money supply growth rate dropped.

Secondly, there were occasions when there were no downturn of the

business cycle after money supply growth rate dropped. The first

fact supports the argument that money supply is an important

determinant of business cycle; and the second fact supports the

argument that money supply is only one of many important

determinants of business cycle. Other determinants of business

cycle includes energy price hikes and drastic and unexpected

government fiscal or monetary policy changes.

Section 2.5: Federal government budget constraint

Federal government budget constraint says that every dollar of

the federal government expenditures has to be financed by one of

three ways: tax financing, debt financing and inflation

financing. Under the U.S. Constitution only the federal

government has the option of inflation financing, namely printing

money to pay its bills which causes inflation. State and local

government are not allowed to print money to finance their

expenditures. If we subtract taxes from government expenditures

and if the difference is positive, we have budget deficit. If

the difference is zero, we have balanced budget. If the

difference is negative, we have budget surplus.

Section 2.6: Money supply and federal government budget deficit

If a country borrows so much to the extent it cannot borrow

any more, then every dollar of budget deficit has to be financed

by a dollar change in high power money leading to inflation.

This is stereotypical of developing countries. Developing

countries, by definition, do not have a fully developed tax

system and they tend to rely on heavy military spending to gain

and maintain military support for their government. This

explains why developing countries have budget deficit and why on

the average they have higher inflation rate than developed

countries. This also limits the independence of fiscal and monetary

policies. Fiscal policies are government policies that try to

change government expenditure and/or taxes to affect real GDP of an

economy. Monetary policies are government policies that try to

change money supply to affect real GDP of an economy. In fact in

the absence of debt financing, every dollar of budget deficit leads

to a dollar change in high powered money, which is the sum of

currency in the general public’s hand and bank reserves.

Chapter 3: Circular flow of a monetary economy

Section 3.1: Closed versus open economy

Circular flow of a three-sector three-market economy helps us to

conceptualize any closed economy, namely an economy with no

international trade. Once we understand a closed economy we can

easily add net export, namely export minus import, to make it a

four sector open economy.

Section 3.2: The three sectors of a monetary economy

The three decision making sectors are government, households and

firms.

We include federal, state, county, city, township, and quasi-

government under the government sector. Quasi-government agencies

are government agencies that do not belong to neither the

executive, legislative nor judiciary branches of the government.

Federal Reserve Bank is an example of quasi-government agency.

We include over a hundred million households in the United

States of America under the household sector.

We include the tens of thousands of firms in diverse number of

industries under the firm sector.

Section 3.3: The three markets of a monetary economy

The three markets of a monetary economy are product, asset &

resource market. We include under product market all final goods

and services sold to the consumers, all military goods and services

sold to the government and all newly produced capital goods sold to

firms.

We include all financial markets under asset market, such as

stock market, bond market, money market and foreign exchange

market, and all financial intermediaries such as commercial bank,

savings and loans associations, mutual savings banks, and credit

unions under asset market. Foreign exchange market is the largest

financial market in terms of daily volume of transaction.

We include labor market and raw material market, such as

crude oil market, under resource market.

We study the three markets in the circular flow diagram to

understand how the three decision making sectors interact with

one another through the supply side and the demand side of each

market.

Section 3.4: Two national income identities

We also make use of the circular flow diagram to help us to

identify two national income identities to measure gross

domestic product(GDP) of an economy.

Gross domestic product is defined as the market value of all

final goods and services produced by residents of an economy within

one year.

With respect to the demand side of the product market, we can

measure GDP by asking who is buying up the final goods and

services through the product market. Households buy part of them

up as consumption expenditures, C. Firms buy part of them up as

investment expenditures, I. Note that investment here refers to

capital investment, that is the purchase of newly produced capital

goods. Government buys part of them up as government expenditures,

G. Hence real GDP, y = C + I + G. This is the flow of product

(expenditures) approach to measure real GDP.

With respect to the supply side of the product market, we can

measure real GDP by noting that every dollar of real GDP generates

a dollar of sale revenue to the firms. Through different channels

the sale revenue becomes real income to the households. We then

ask how the households would spend their real income. They spend it

as consumption expenditures, C, as private savings, S, or as tax

payments, T. Hence real income, y = C + S + T. This is the disposal

of income approach to measure real GDP.

Section 3.5: Use of the circular flow of a monetary economy

A circular flow diagram is a simple way to conceptualize an

economy. Economies differ from each other only in terms of which

decision making sector commands how much of the resources of the

economy. For example, in socialist countries the government sector

commands most of the resources of an economy but in a capitalist

economy the household sector commands most of the resources. In

addition some countries, such as Singapore, rely heavily on the

product market because they have practically no natural resources

while other countries such as Saudi Arabia rely heavily on the

resource market because they lack manufacturing industries but

are rich in natural resources.

Chapter 4: The importance of financial intermediation

Financial intermediation is the process whereby small amounts

Of savings funds are collected from the households and transformed

into the hands of firms and government for investment

Funds flow from savings-surplus units, namely households to

savings-deficit units, namely firms and government.

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 versus future value

Optimal investment point is the maximum present value income point

on the investment opportunity frontier.

Intertemporal budget constraint states that the present value

of one’s lifetime consumption spending has to be equal to one’s

present value lifetime income.

Intertemporal consumer budget line is the combinations of

consumption today and consumption a year from today that a

consumer can afford when she uses up all her maximum present value

income. It is the graph of the intertemporal budget constraint.

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 such as ATM counters.

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.

Part II: Institutional facts of financial institutions and

financial markets

Chapter 5: Facts of financial institutions

There are three different types of financial institution:

1) Depository institutions are financial institutions that

accept deposits from customers. There are four kinds of

depository institution.

a) Commercial banks are depository institutions that

serve both households and business in making a variety

of consumer and business loans.

b) Savings and loans associations in the good old days

provide only mortgage loans, but since the 1980s they

act like commercial banks and make a variety of

consumer and business loans. Commercial banks and

savings and loans associations have a separate class

of shareholders.

c) Mutual savings banks are similar to commercial banks

but there is no separate class of shareholders. The

depositors are de facto the shareholders.

d) Credit unions are similar to mutual savings banks

except that they are nonprofit organizations. Members

of a credit union have to have some common linkage,

such as the members of some organization.

2) Contractual savings institutions are financial institutions

through which participants agreed by contract to set aside

a certain amount of savings on a periodic basis. There are

three kinds of contractual savings institution.

a) Life insurance companies provide a lump sum of money

to the beneficiaries of a policyholder in the event

that the policyholder dies. While subscribing to a

life insurance, the policyholder pays an annual

premium to the life insurance company.

b) Pension funds are retirement funds set up by

employers for their employees to reward employees for

devoting so many years of their lives for the

employers. Each month an employer contributes to the

pension funds on behalf of an employee. After working

for five years for an employee, the contributions of

the employer is vested in the employee’s name. Before

the five years vesting period, an employee loses the

retirement if he/she resigns from the employer. Once

the pension is vested, even the employee changes job,

he/she at the retirement age will be able to withdraw

a pension from his/her pension account. Hence the

longer an employee works for an employer, the larger

is the amount of pension check he/she receives. Upon

retirement an employee will be entitled to the monthly

pension payment until the employee dies. A surviving

spouse will not be entitled to the pension payment

unless while the employee was working for the employer

decides to set up an employee contribution which will

then allows a surviving spouse to half of the pension

payment upon the death of the employee. During the

1990s it was discovered that even though on the book

money is transferred from an employer to an employee’s

pension account, in reality only partial contributions

have been transferred. For example, General Motors

pension funds are only sixty percent funded. During

the Clinton administration the federal government put

a lot of pressure for corporations to raise their

pension funding. The corporations excuse is that the

money transferred to a pension fund might be invested

in securities of the rival corporations. The more

convincing reason is that in the Department of Labor

there is an agency called Pension Benefit Guarantee

Corporation, which will pick up the tab of pension

payments to current retired employees in the event

their former employer declares bankruptcy. This

generates what economists call moral hazard, meaning

that if it is costly to avoid mishap, once there is

insurance, people will shirk the cost to avoid mishap

so that mishap happens more often. From the manager of

a pension fund, the source of funding is from the

employer and employee monthly contributions. The

pension fund manager in turn invests the money in

stocks, bonds and money market instruments.

c) Fire and casualty insurance companies are companies

that sells auto insurance, disability insurance, and

home owners policies etc. Their source of funds is

from insurance premium. The use of funds is to

diversify in a wide spectrum of markets as the pension

funds do.

Investment intermediaries:

a) Mutual funds are investment cooperatives in which

small sums of money are collected from many investors

into a large pot of money for a fund manager to

diversify into many different financial assets. If a

fund manager is restricted to invest in corporate

stocks, the fund is equity mutual fund. If he is

restricted to invest in long term government or

corporate debt instruments, the fund is a bond mutual

fund. If he is restricted to invest in a fixed

proportion of short-term debt, long-term debt, and

corporate stock, the fund is balanced fund. If he is

allowed to invest in whatever proportion of short-term

debt, long-term debt, and corporate stock, the fund is

an asset allocation fund.

b) Money market mutual funds are mutual funds where the

fund manager is restricted to invest in short-term,

highly liquid assets. Short-term assets mean assets

with maturity of one year or less. Highly liquid

assets mean assets where there are many buyers and

sellers of the assets and the values of the assets do

not change drastically over time.

c) Finance companies provide consumer loans to

individuals who have bad credit risk to the extent

that banks and savings and loans associations would

not provide them credit. These companies sell bonds

and stocks to raise funds for the financing of their

consumer loans.

Chapter 6: Four major financial markets and four major forms of

a financial market

Section 6.1: Major types of financial market

There are four major types of financial market in the financial

world:

1) Money market is the market for short term (with maturity

within a year), highly liquid (marketable and reversible

in value) asset.

2) Bond market is the market for long term debt instruments

of corporations.

3) Stock market is the market for ownership rights of

corporations.

(4) Foreign exchange market is the market for national

currencies.

Of the four major markets, the foreign exchange market is the

largest in terms of daily volume transactions.

Section 6.2: Sub-markets of a financial market

Within each financial market, we can further divide it into

four sub-markets:

1) Spot market is a market where transactions are completed

with forty eight hours.

2) Forward market is a market for forward contracts. A

forward contract is an agreement today on the price of

an asset to be used sometime in the future for a

specified quantity of the asset. That sometime in the

future is in excess of forty eight hours.

3) Futures market is a market for futures contracts. A

Futures contract is also an agreement today on the price

of an asset to be used sometime in the future for a

specified quantity of the asset. The differences of

futures and forward contracts will be explored shortly.

4) Options market is a market for option contracts. An

option gives the owner of the option the right to

exercise another contract within a limited time period.

Section 6.3: Differences between forward versus futures contract markets

Forward contracts and futures contracts differ in four respects:

1) Forward contracts are traded through over-the-counter

markets. Over-the-counter markets are done through a

dealership system, where each dealer holds an inventory of

the asset for investors to buy from or to sell to. The

dealers are to maximize profits. They buy low from and sell

high to investors. The profits made by a dealer are limited

by competition among dealers, the market interest rate and

the volatility of the asset prices.

Futures contracts are traded through organized exchanges.

Organized exchanges are done through a broker-specialist

system, where brokers take buy and sell orders from

investors around the world, and pass on to a specialist at

the organized exchange. The specialist then matches as

quickly as possible the buy and sell orders so that trades

are continuous. A specialist holds a small inventory of the

asset to facilitate trade by selling out of the specialist

inventory when there are too many buy orders, or by buying

to accumulate inventory when there are too many sell

orders. The organized exchange allows a specialist to earn

to fair rate of return on the inventory holding. The

specialist is not supposed to maximize profit.

2) Forward contracts are negotiable in size and maturity date.

A forward contract is a tailor made contract.

Futures contracts are standardized in size and maturity

date. Typical maturity dates are on the third Friday of the

month at the end of a quarter of a year. An organized

exchange sets the size and maturity of a futures contract.

You can buy one or multiple of a contract but not fractions

of the contract.

3) Forward contracts are nontransferable once the contracts

are agreed and hence not liquid. Once you sign a forward

contract, it remains legally binding until the contract is

fulfilled at maturity.

Futures contracts are marketable and hence liquid. If you

buy a futures contract at one moment of time, you can sell

it back to the market at the next moment of time.

4) Forward contracts involve no exchange of cash until the

contracts mature and hence create no interim cash flow

problem.

Futures contract has mark-to-market arrangement causing

possible interim cash flow problem. Mark-to-market

arrangement works as follows. Buyers and sellers of futures

contracts have to set up a cash account with a broker with

a specified minimum balance. At the end of each trading

day, the broker will calculate the net change in market

value of the futures contracts from the previous trading

day. If the futures contract values have gone up, cash will

be deducted from the sellers’ cash account and transferred

to the cash account of the buyers. When the cash balance of

an investor’s account drops to the minimum amount, the

broker will call the investor. Within twenty four hours,

the investors will need to add more cash to the account. If

an investor fails to do so, the broker will nullify the

position of the investor, namely if an investor has bought

a futures contract, the broker will sell the contract back

to the market, and if an investor has sold a futures

contract, the broker to buy the contract back from the

market. An investor will not be able to recover the losses

if the market later moves in favor of the investor. All

losses will be capitalized.

Section 6.4: Basic types of option contract

Options market is a market for rights to exercise another

contract within a limited time period. There are two major forms of

options:

1) A call option allows a buyer of the option to buy an asset

at an exercise price within a limited time period. One buys

a call option in anticipation of rising future price of the

underlying asset.

2) A put option allows a buyer of the option to sell an asset

at an exercise price within a limited time period. One buys

a put option in anticipation of falling future price of the

underlying asset.

Section 6.5: Derivative markets

Futures and options are examples of derivatives because they

derive their value from some underlying asset values. Derivatives

are high risk. For example, it costs you a small sum of money to

buy a call option. If within the specified time period, the

underlying asset price does not go up, then you suffer a hundred

per cent loss of your investment. Any investment that can yield a

hundred per cent loss is high risk. A notorious example is the

Orange County fiasco, where the county investor lost billions of

dollars in investing in derivatives.

Chapter 7: Money market instruments and capital market instruments

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 government bonds

-U.S. government agency securities

-Consumer loans & Commercial loans

Foreign bonds are bonds sold in a country and the principal and

interest are denominated in that country's currency but the

issuers of the bonds are from another country.

Eurobonds are bonds sold in a country but the principal and

interest are denominated in another country's currency.

Euroequities are shares of a corporation registered in a country

which are traded in another country.

Part III: Theories of interest rate

Chapter 8: Types of loan and concepts of investment returns

Types of loans:

A simple loan is a loan where the lender lends out a lump sum of money today, called the principal, in return for a larger lump sum of money in the future, called the principal and interest.

A fixed payment loan is a loan where the lender lends out a lump sum of money today in exchange for a fixed lump sum of money over several months or years in the future. A good example is a fixed rate mortgage loan.

A coupon bond is an IOU issued by government or corporation for a price with the name of the issuer, a face value, a coupon rate and a maturity date. The investor in return is entitled to annual coupon payments, calculated by taking the product of the coupon rate and the face value, until the bond matures, and on the date of maturity, the investor is entitled to the payment of the amount of the face value.

A discount bond is an IOU issued by government or corporation for a price with the name of the issuer, a face value and a maturity date. The investor is entitled to the payment of the amount of the face value on the date of maturity. There is no interim payment between the date of issuance and the date of maturity.

A consol is an IOU issued by the British government for a price with no maturity date. The investor is entitled a fixed consol payment per year indefinitely.

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 yield is coupon payment per the price of the coupon bond.

Yield on a discount basis is the product of two terms. The first term is the ratio of the difference of the face value and the price of a discount bond to the face value of the discount bond. The second term is the ratio of three hundred and sixty days and the number of days to maturity of the discount bond. This formula for estimating the yield of a discount bond understates the true yield of a discount bond. The formula was developed before the availability of slide rule. It simplified the multiplication and division in the hand calculation.

One-year holding yield = current yield + rate of capital gains

The bid price of a bond is the price investors can sell a bond through a bond dealer.

The asked price of a bond is the price investors have to pay to buy a bond through a bond dealer.

The Moody’s bond rating is as follows:

The highest “blue chip” bonds are rated as AAA bonds. From there it drops to AA, A and Baa. Any rating below Baa, such as Ba, B , C and D, are considered as junk bonds, because the risk of default is so high that those bonds can become practically junk. In fact a bond that has a D rating is a bond that since its issuance has defaulted for at least one coupon payment.

Risk premium is the difference between the yield to maturity of a

risk assets and the yield to maturity of a riskless asset with

the same time to maturity.

Chapter 9: Mirror image of bond market and loanable funds market

Supply of bonds, demand of bonds & the bond market equilibrium

Determinants of the demand for bonds -wealth

-expected returns

-expected inflation

-risk

-liquidity of investors

-liquidity of the bond

Determinants of the supply of bonds -profitability of investment

-expected inflation

-government budget deficits

Loanable funds market: supply, demand & equilibrium interest rate

Chapter 10: Why are there so many market interest rates?

Why do interest rates differ -differences in time to maturity

-differences in risk

-differences in tax treatment

-differences in administration costs

-difference in bond features

A municipal bond is issued by state and local government and the

interest earnings are federal and that state income tax free.

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.

Chapter 11: The term structure of interest rate

Section 11.1: Characteristics of a yield curve

The term structure of interest rate is the relation between

yield to maturity & time to maturity. The yield curve is the graph

for the term structure of interest rate. The typical shape of a

yield curve is upward sloping. Occasionally it can be downward

sloping, U-shaped, and hump-shaped. In any case the yield curve is

a smooth curve.

The are four theories of the term structure of interest rates

that help to explain the above empirical observation of yield

curves.

Section 11.2: Liquidity Preference Hypothesis

Liquidity Preference Hypothesis assumes that investors

prefer more liquid assets than less liquid assets. Cash is

the most liquid of all assets. The longer a lender makes a loan,

the longer the lender foregoes the use of the cash for the loan.

Hence the lender requires a higher yield to maturity to compensate

for the longer period of foregone cash use by the lender. The

difference between the higher yield to maturity on a long term loan

and the lower yield to maturity on a short term loan is known as

the liquidity premium. The liquidity premium should always be

positive. This means the Liquidity Preference Hypothesis can only

explain the typical case of an upward sloping yield curve, and

cannot explain the exceptional cases of a yield curve. The next

three hypotheses can explain the exceptional cases of a yield

curve.

Section 11.3: Unbiased Expectations Hypothesis

Unbiased Expectations Hypothesis assumes investors form

rational expectations and are risk neutral. Rational

expectations assumes investors form expectations in two steps.

First, investors gather information before they form

expectations. They gather information until marginal benefit of

information equals marginal cost of information. The amount of

information gathered is then known as the optimal information.

Secondly, investors form expectation based on the optimal

information collected such that the expectation is unbiased, that

is, on average the expectation is correct but sometimes they may be

over or under estimates. It is only on the average they are

correct. An example of rational expectation is that an investor

cannot be forever jinxed. If you ever find an investor that is

always wrong in investing, you have found a best friend. You invest

the opposite of your new found best friend and you will be rich.

Unbiased Expectation Hypothesis relies on the knowledge of a

concept called forward interest rate. First a forward loan is a

loan with an interest rate agreed today but to be taken out some

time in the future for a specified period of time. The interest on

the forward loan is called the forward interest rate.

A corporation can create a forward loan using the financial markets

by selling a long term security with maturity date being the

maturity date of the forward loan, and at the same time investing

the proceed from the sale of the long term security in a short term

security with maturity date being the date the corporation needing

the forward loan.

Unbiased Expectations Hypothesis implies that short-term and long-

term securities of perfect substitute of one another.

Section 11.4: Segmented Market Hypothesis

Segmented Market Hypothesis assumes the buyers and sellers of

short-term securities are separate groups of people to the buyers

and sellers of long-term securities. For example, younger investors

like long-term securities, but older investors like short-term

securities. It implies that short-term and long term securities are

not substitute of one another.

Section 11.5: Preferred Habitat Hypothesis

Part IV: Management of depository institutions

Chapter 12: Balance sheet of depository institutions

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

-loan guarantees/bankers acceptance

-lines of credit

Chapter 13: Four problems of depository institution management

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 timely

manner,

-Interest rate risk management is to minimize risk exposure of

bank assets & liabilities due to interest rate fluctuations.

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

Chapter 14: Asset management and portfolio theory

Expected value of a random variable measures the central tendency

of the random variable.

Variance or standard deviation of a random variable measures the

dispersion of the random variable.

Covariance of two random variable measures whether the two random

variables tend to move in the same directions or tend to move in

opposite directions.

Minimum variance opportunity set is the combinations of expected

returns & risk that minimize risk subject to a required expected

return 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 of

risky assets.

Risk-free asset & market 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 an indifference

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

Chapter 15: Interest rate risk management

Fixed rate versus interest-rate sensitive assets(liabilities)

Measure of interest rate risk

-gap analysis assumes horizontal yield curve and that short term

and long term interest rates have the same fluctuations.

-maturity bucket approach allows non horizontal yield curve and

different fluctuations of short term and long term interest

rates.

-standardized gap analysis recognizes different interest rate

elasticities of assets and liabilities.

-duration analysis(Macaulay's duration measures the weighted

average of the timing of cash flows)

Strategies of interest rate risk management

-matching maturity & amount of assets & liabilities using

discount bonds

-matching duration & present values of assets & liabilities

using discount bonds

-interest-rate swap

-hedge with futures & options on debt instruments

Interest immunization is that state when interest rate risk is

completely removed.

Interest immunization is not necessarily desirable because for a

high enough price of risk it may pay to take some interest rate

risk, a lesson from asset management and portfolio theory.

Part V: Financial regulatory agencies and money supply

Chapter 16: Financial regulatory agencies

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)

-National Credit Union Administration(NCUA)

-National Credit Union Share Insurance Fund(NCUSIF)

Two primary methods for FDIC to handle failed banks

-payoff method is for FDIC to liquidate the failed bank and

payoff all depositors up to a hundred thousand dollars for

their deposit.

-purchase and assumption method is when FDIC buys all the bad

loans of the failed bank at face value thereby injects cash to

the failed bank and then invites a well managed bank to buy the

failed bank.

Chapter 17: Fractional reserve banking and money supply

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) process is when a bank has

more(less) bank reserves it can make more(less) loans and hence

creates more(less) demand deposit and hence more(less) money.

In the modern day world money is created or destroyed through

electronic signal transfer to a bank computer by debiting or

crediting deposit account balances.

Potential money supply multiplier is the change in money supply

due to a dollar increase in reserve under the assumptions that

there 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 due

to a dollar increase in high-powered money under the assumptions

that there may be excess reserve, and currency demand-deposit

ratio is constant.

Bank credit is the amount of bank loans(=demand deposits-reserves).

Bank credit multiplier is the change in bank credit due to a

dollar change in high-powered money under the assumptions that

there may be excess reserve, and currency demand-deposit ratio is

constant.

Chapter 18: Financing of federal government spending

Financing of government spending: tax financing

debt financing

inflation financing

Monetizing the debt is when the FED buys government securities

from the general public converting government debt into money in

the general public's hand.

Chapter 19: The Federal Reserve Bank

The Federal Reserve Bank and the Federal Reserve Act of 1913

Consolidated balance sheet of the FED

ASSETS LIABILITIES

S1 US gov't securities U1 Federal Reserve notes

S2 Discount loans U2 Bank deposits

S3 Gold & SDR certificates S5 US Treasury deposits

U3 Coin S6 Foreign & other deposits

S8 Cash items in process of S9 Deferred availability cash

collection items

S4 Other Federal Reserve assets S7 Other Federal Reserve

liabilities & capital accounts

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

A float is equivalent to an interest-free loan from the FED to the

depository institutions.

Goals of the FED -price stability

-economic growth

-full employment

-interest rate stability/affordability

-financial market stability

-foreign exchange mkt stability

Two types of targets of the FED

-intermediate targets: monetary aggregates(M1,M2,M3)

short or long term interest rate

-operating targets: reserve aggregates(reserve, monetary base)

daily interest rate(federal funds rate)

Criteria for choosing targets -measurability

-data availability

-controllability

-predictability of outcomes

Desirability of anticyclical monetary policy

Sources of procyclical monetary policy -targeting on free reserves

-targeting on interest rate

Chapter 20: Tools of the Federal Reserve Bank in controlling money supply

Open market operation(OMO) is the buying and selling of federal

government securities by the FED to control money supply.

The Banking Act of 1933

Two types of OMO

Dynamic OMO is open market operation when the Federal Reserve Bank

wants to permanently change the volume of money supply.

Defensive OMO is open market operation when the Federal Reserve

Bank wants to temporarily change the volume of money supply.

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

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 periods (from Tuesday of week one to Monday of week

three) and reserve daily average calculated over a reserve

maintenance period (from Thursday of week five to Wednesday of week

seven).

Part VI: Macroeconomic theories of the effect of changes in

money supply on the economy

Chapter 21: Classical model and the neutrality of money

Velocity of money is the number of times money changes hand in

an economy in one year. In notation, it reads as V = Py/M.

Since there are different measures of money supply, M, there are

different measures of velocity of money. If we use M1 as our

measure of money supply, we have V1 as our velocity of money,

where V1 = Py/M1. Similarly, if we use M2 as our measure of

money supply, we have V2 as our measure of velocity of money,

where V2 = Py/M2.

If we take the definition of the velocity of money and multiply

both sides by money supply, we have the equation of exchange:

MV = Py. On the left hand side of the equation of exchange we

have dollar value of the flow of money and on the right hand

side of the equation of exchange we have the dollar value of the

flow of money.

The Simple Quantity Theory of Money assumes that velocity of

money is constant. This in turn means general price level is

directly proportionate to money supply but inversely related to

real income. In notation, we have P = MV/y.

Assumptions of the Classical Model

-flexible real interest rate means real interest rate is free to

move up or down.

-flexible product prices mean product prices are free to move up

or down.

-flexible real wages mean real wages are free to move up or

down.

-certainty means everyone knows everything, especially prices.

-competitive labor market means there is a supply curve of labor

and a demand curve for labor. Intersection point of the supply

of and the demand for labor curves will determine the

equilibrium real wages and the number of workers employed.

-production function is the mapping of input to output when

inputs are used efficiently.

-Say's Law: supply creates its own demand. This means that we

need only model supply of products and we don’t need to model

demand for product because supply will creates its own demand.

In this sense the Classical Model is the grandfather of supply

side economics. Unfortunate, modern understanding of economics

tells us that the Say’s Law is incorrect. Supply and demand

are independent because the decision makers behind the supply

curve and the decision makers behind the demand curve are

different groups of people.

-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 means there is a supply curve

of bank loans, which is given by the Classical savings

function, and there is a demand curve for bank loans, which is

given by the investment function plus government budget

deficits financed by borrowing. The

-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 government 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.

Chapter 22: Second generation Keynesian model

Assumptions of the 2nd generation Keynesian Model

-flexible interest rates mean interest rates are free to move

up or down.

-fixed product prices and fixed wages mean product prices and

wages cannot be adjusted up or down in a short period of time.

-certainty means everyone knows everything, including prices.

-product market equilibrium means real product demand equals

real product supply. It also means intended real investment,

I, plus government expenditures, G, equals real savings, S,

plus taxes, T. In notation, it reads as I(i ) + G = S(y-T) + T.

-money market equilibrium means real money demand equals real

money supply.

-production function is the mapping of input to output when the

input is used efficiently.

-investment function is the inverse relation between real

investment and real interest rate.

-Keynesian savings function: real saving is positively related

to real income.

-the five endogenous variables are real interest rate, real

income, number of workers employed, real investment and real

savings.

IS curve is the combinations of real interest rate and real income

that yield an equilibrium in the product market.

The IS curve is downward sloping because as real interest rate goes

up, real investment goes down. Real investment is a component of

real product demand. The reduction in real product demand will

create an excess supply in the product market. To restore

equilibrium in the product market, real product supply must go

down. This means real savings plus taxes must go down, which in

turn means real income has to go down. In summary, higher real

interest rate corresponds to lower real income as we move from

one point of the IS curve to a new point further up to the left

of the IS curve.

Motives for money demand

-transactional demand for money is holding real money as a

medium of exchange for both regular and unexpected

expenditures. Transactional demand for money should be

positively related to real income.

-speculative demand for money is holding real money for the

purpose of unforeseeable great investment opportunities.

Speculative demand for money should be negatively related to

real interest rate. Real interest rate is the opportunity cost

of holding money. The higher the real interest rate the higher

is the opportunity cost of holding money and the less is

speculative demand for money.

LM curve is the combinations of real interest rate and real income

that yield an equilibrium in the money market.

The LM curve is upward sloping because as real income increases,

transactional demand for money increases. This creates excess

demand in the money market since there is no change in real

money supply. To restore equilibrium in the money market,

speculative demand for money must decrease and real interest

must increase to make room for the higher transactional demand

for money. In summary, higher real income corresponds to higher

real interest rate as we move from one point of the LM curve to

a new point further up to the right of the LM curve.

Simultaneous equilibrium in the product and the money market

determines the equilibrium real interest rate and real income.

Graphically this is given by the intersection point of the IS

curve and the LM curve. Once the equilibrium real income is

determined, we make use of the Keynesian savings function to

to determine the equilibrium real savings and the production

function to determine the equilibrium number of workers

employed. Also with the equilibrium real interest rate

determined, we make use of the investment function to determine

the equilibrium real investment. In total this gives us the five

endogenous variables of the Second Generation Keynesian model.

Chapter 23: Monetary transmission mechanisms

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

Chapter 24: The debate on the effectiveness of monetary vs fiscal

policy among Keynesians vs monetarists

Keynesian(Monetarist) theory assumes inelastic(elastic) investment

& elastic(inelastic) speculative demand for money leading to

the conclusions that fiscal policy is effective(ineffective) but

monetary policy is ineffective(effective) in the short run.

Chapter 25: Fourth generation Keynesian model

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

Aggregate demand is the combinations of general price level &

real income that yield simultaneous equilibrium in the product

and money market.

Why is the aggregate demand curve downward sloping?

Determinants of aggregate demand

-investment

-government 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.

Short-run vs long-run aggregate-supply curve

Supply side shocks, stagflation vs deflationary growth

Demand side shocks, recession vs inflationary growth

Anticipated vs unanticipated policies

Part VII: Determinants of foreign exchange rates

Chapter 26: Long run determinants of foreign exchange rate

Foreign exchange rate is the rate of conversion of one national

currency for another national currency. There are two ways to

express foreign exchange rates. First, we can express it as number

of units of a foreign currency per unit of the domestic currency.

This is the most common way to quote foreign exchange rate.

Secondly, we can express it as number of units of the domestic

currency per unit of a foreign currency. The British pound is

commonly quoted on the basis.

Appreciation vs depreciation

Price of gold

Devaluation vs up-valuation(revaluation)

The Law of One Price is based on four assumptions:

1) Homogeneous product.

2) Perfect information.

3) Competitive markets.

4) No transaction cost.

Purchasing Power Parity is a generalization of the Law of One Price. It is based on five assumptions:

1) Homogeneous products.

2) Perfect information.

3) Competitive markets.

4) No trnsaction cost.

5) All goods are tradable.

Absolute vs Relative

There are four long run determinants of foreign exchange rates

-domestic vs foreign prices

-tariffs & quotas

-preferences of domestic vs foreign goods & services

-domestic vs foreign productivity growth rates

Chapter 27: Short run determinants of foreign exchange rates

Covered Interest Rate Parity assumes that investors cover their

foreign exchange rate risk by a forward contract. Hence the

principal and interest from a dollar invested for a year at the

domestic interest rate must be equal to the current foreign

exchange rate times the principal and interest invested for a year

at a foreign interest rate divided by the forward foreign exchange

rate.

Open Interest Rate Parity assumes investors do not cover their

foreign exchange rate risk. Instead it assumes investors are risk

neutral and form rational expectations

There are three short run determinants of foreign exchange rates

-domestic vs foreign interest rates

-expected future foreign exchange rate

-gov't intervention

Chapter 28: Current accounts and capital accounts

Trade balance is the sum of net export of merchandise and net

export of services.

Current account balance is the sum of trade balance, net investment

income and net unilateral transfer.

Capital account balance is the sum of capital inflows and capital

outflows.

Official reserve transaction balance(balance of payment) is the

sum of current account balance and capital account balance.

Chapter 29: Equilibrium foreign exchange rate

Export is inversely related to foreign exchange rate. Import is

positively related to foreign exchange rate. Trade balance foreign

exchange rate is that foreign exchange rate where export equals

imports.

Capital inflows are financial investment in the domestic country

by foreign investors. They are positively related to the domestic

interest rate and negatively related to foreign exchange rate.

Capital outflows are financial investment overseas by domestic

investors. They are negatively related to domestic interest rate

and positively related to foreign interest rate.

The determinants of the demand for US dollars in the foreign

exchange market are US export and capital inflows. The determinants

of the supply of US dollars in the foreign exchange market are

imports and capital outflows. Equilibrium foreign exchange rate is

that foreign exchange rate where demand for US dollars equals

supply of US dollars in the foreign exchange market.

From 1946 to 1970, every year in United States of America we

have trade surplus. Even with the two energy crises of skyrocketing

oil prices in the 1970s, the trade deficit in the United States of

America was in the tens of billion of dollar. The hundreds of

billion of dollar of trade deficit began in 1983 after the Reagan

tax took full force. The Reagan tax cut generated hundreds of

billion of dollar in federal government budget deficit. Reagan did

not like inflation. With inflation financing ruled out, the

hundreds of billion of dollar of budget deficit were financed by

debt. Annually the US Treasury had to borrow hundreds of billion of

dollar driving up the US interest rate. The high US interest rate

encouraged capital inflows but discouraged capital outflows. The

imbalance drove the equilibrium foreign exchange rate above the

trade balance foreign exchange rate, leading to import greater than

export, hence the hundreds of billion of dollars of trade deficit.

National income identities of a four-sector economy

-Flow of product (expenditures) approach

-Disposal of income approach

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