AP Macroeconomics: Unit 3 Federal Reserve System and

Monetary Policy

Topic 1: Money

What makes money effective?

Generally Accepted - Buyers and sellers have confidence that it IS legal tender.

Scarce - Money must not be easily reproduced.

Portable and Divisable - Money must be easily transported and divided.

Functions of Money

1. Medium of Exchange

It is accepted as a form of payment

2. Unit of accounting

• helps to determine the value of an item and allows comparison

3. Store of value

• Money can be saved for use in future

Money Systems: 1. Barter system

• People trade one object for another

2. Commodity money system

• An item with intrinsic value is used as money

Examples:

Cigarettes used in prison

Animal furs used in colonial times

3. Representative Money System

Money “backed” by somethingExample: The Gold standard; people didn’t

carry around the gold, they had a gold certificate that represented the gold

*4. Fiat money system

• Money that is declared so by the government

• It is not “backed” by anything

Money in the U.S. economy

• Money stock = quantity of $ circulating in the U.S. economy

M1= coins, currency & checkable deposits (checking accounts)

M2 = M1 + savings

• Liquidity: ease with which an asset can be accessed and converted into cash

Topic 2: The Federal Reserve and the Banking System

The Federal Reserve System (the Fed)

- The Fed is the central bank of the U.S.

- Created in 1913

Jobs of the Fed

• Print money

• Clear checks

• Supervise banks

• Act as a bank to banks

• Manage money supply

Organization of the Fed

Member banks

Organization of the Fed

• Board of Governors: Head of the Fed

Janet Yellen = current chairman

• Federal Reserve Banks – 12 districts – see map

Federal Reserve Banks: 12 Districts

Member Banks

FDIC insured (Federal Deposit Insurance

Corporation)

Insures money in banks up to $250,000

60 minutes video: FDIC

Topic 3: Banks and the Money supply

Fractional Reserve Banking

If you have a bank account, where is your money?

Only a small percent of your money is in the safe. The rest of your money has been loaned

out.

This is called “Fractional Reserve Banking”

The Fed sets the amount that banks must hold

Demand Deposits

• Money placed in banks by customers

Required Reserve vs. Excess Reserve

Reserve requirement (reserve ratio)

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

Excess Reserve• Money that is not part of the required reserve

* Banks can loan out all of this money if they wish to do so; when they do, they “create” money

The process of how banks “create” money

Banks only influence the amount of $ in the economy if they make loans.

When a loan is taken out, it is spent and ends back up in the bankingSystem

Example: complete the chart assuming the reserve requirement is 10% Bank Deposit Reserve

requirement Loan

A $1000 $100 $900

B

C

The process of how banks “create” money – banks

“create” money by LOANS

Bank Deposit Reserve requirement

Loan

A $1000 $100 $900.00

B $900 $90 $810.00

C $810 $81.10 $728.90

MoneyMultiplier Reserve Requirement (ratio)

1=

The Money Multiplier

28

• Used to determine how much a loan can impact the overall economy

What is the Money multiplier on the following reserves?

• 10%

• 20%

• 5%

Maximum total change in Demand deposits

= Money multiplier X Deposit

Example: Billy deposits $400 in his bank and the reserverequirement is 10%.

What is the money multiplier? 1/.10 = 10

What is the multiple expansion of demand deposits? 10 X $400 = $4000

Maximum change in the money supply =

Money multiplier X Deposit = total - deposit

Example: Billy deposits $400 in his bank and the

reserve requirement is 10%.

What is the money multiplier?

1/.10 = 10

What is the maximum change in the money

supply?

10 X 400 = 4000

4000-400 = $3600

Maximum change in Loans =

Money multiplier X deposit = total - deposit

Example: Billy deposits $400 in his bank and the

reserve requirement is 10%.

What is the money multiplier?

1/.10 = 10

What is the maximum change in LOANS?

10 X $400 = $4000

4000-400 = $3600

THE MULTIPLE EXPANSION of money will be less if:

• 1. Banks DO NOT loan out all of their excess • 2. People DO NOT spend all the money that they

borrow • 3. When money is spent, it is NOT placed back

into a bank

Bank Balance Sheet central to the accounting practices of a

bank (also called a T account) • Assets = required reserves, excess

reserves, loans, securities

(anything of value to the bank)

• Liabilities = Deposits, borrowed reserves, stockholder’s (owner) equity

(anything the bank owes to someone else)

Balance Sheet – 2 sides must = each other

• Assets Liabilities

required reserves 10 deposits 100 excess reserves 10

Loans 80

________ __________

100 100

* Based on this chart, what is the banks required reserve ratio?

Balance Sheet

• Assets Liabilities

required reserves 6 deposits 100 excess reserves 40

Loans 54

________ __________

100 100

• Based on this chart, what is the banks required reserve ratio? • What happens on this balance sheet if a new deposit of $100 is made?

Balance Sheet

• Assets Liabilities

required reserves 12 deposits 200 excess reserves 134

Loans 54

________ __________

200 200

• Based on this chart, what is the banks required reserve ratio? • What happens on this balance sheet if a new deposit of $100 is made?

Topic 4: The Money Market

(Supply and Demand for Money)

The Demand for MoneyAt any given time, people demand a certain amount of liquid assets (money) for everyday purchases

Transaction demand for money = The demand for money as a medium of exchange

Asset demand for money = The demand for money to use it for savings

Transaction demand + asset demand = total money demand

Nominal Interest Rate

(ir)

Quantity of Money(billions of dollars)

20%

5%

2%

0

Md

Inverse relationship between interest rates and the quantity of money demanded

The Demand for Money

Increase in Money demand

• Curve shifts to the right

Nominal Interest rate

Decrease in Money demand

• Curve shifts to the left

Nominal Interest rate

The Demand for Money

Money Demand Shifters

1. Changes in price level

2. Changes in GDP

200

Ms

The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System

(FED)

The Supply for Money

20%

5%

2%

Quantity of Money(billions of dollars)

Interest Rate (ir)

Increasing the Money Supply

200

Ms

10%

5%

2%

Quantity of Money(billions of dollars)

Interest Rate (ir)

250

Ms1

Decreasing the Money Supply

200

Ms

10%

5%

2%

Quantity of Money(billions of dollars)

Interest Rate (ir)

150

Ms1

Money supply shifted by:

Fed action

200

Md

Ms

Money market graph

20%

5%

2%

Quantity of Money(billions of dollars)

Interest Rate (ir)

Draw a graph that shows: The Fed increases the money

supply ….

What will happen to nominal interest rates?

Draw a graph that shows: an increase in the price level…

What will happen to nominal interest rates?

Topic 5: Monetary Policy

• What the Fed does to regulate the money supply

• The Fed controls the money supply by adjusting Nominal interest rates

Video:

Monetary policy: Part Art, Part Science

The Fed Today

The nominal interest rate impacts other interest rates:

Prime Interest rate: interest rate banksgive to their least risky borrowers

Federal Funds Rate

54

The Federal funds rate = interest rate that banks charge one another for short term

(overnight) borrowing

The Fed can’t simply tell banks what interest rate to use. Banks decide on their own.

The Fed sets a target for the Federal funds rate and then implements policies to influence banks

Expansionary monetary policy

Implemented during Recession

Goal is to speed up the economy; they want people to get out and spend $ in economy

Contractionary Monetary Policy

• Implemented during INFLATION

• Goal = slow down the economy; want less spending to occur in the economy

Tools of monetary policyThe Fed adjusts the money supply by

changing any one of the following:

1.Setting Reserve Requirements (Ratios)

2. Changing the Discount rate of interest •Discount Rate- Interest rate the Fed charges banks to borrow money

**3. Open Market Operations•Buying and selling Bonds (securities)

1. Changing the Reserve Requirement

Expansionary monetary policy

Contractionary Monetary Policy

The Fed Decreases the Reserve RatioBanks required to hold less money - have more money available to loan

The Fed Increases the Reserve Ratio Banks required to hold more money – have less money available to loan

2. Changing The Discount Rate

The Discount Rate is the interest rate that the Fed charges banks to borrow $

Example:

• If a bank needs $10 million, they borrow it from the U.S. Treasury (which the FED controls) but they must pay it bank with 3% interest.

Changing the The Discount RateExpansionary Monetary Policy

The Fed will decrease the Discount rate; Banks will be encouraged to borrow more = more $

to loan

Contractionary Monetary Policy

The Fed will increase the Discount rate; banks will be discouraged from borrowing = less $ to loan

60

Open market operations

3. Open Market OperationsThe Fed buys or sells government bonds (securities).

• This is the most important and widely used monetary policy

(THIS IS THE TOOL USED TO INFLUENCE THE FEDERAL FUNDS RATE)

Expansionary monetary policyThe Fed will BUY (back) bonds = more

money in banks (buy = big)

Contractionary monetary policy The Fed will SELL bonds = less money in

banks (sell = small) 62

Graph of expansionary monetary policy

Graph of contractionary monetary policy

Review of multiple expansion

1. Tim deposits $300 into his bank. If the reserve requirement is 20%, the maximum amount the money supply can expand by is……

2. $400 is deposited into a bank. If the reserve requirement is 25%, what is the maximum potential of loans the banking system can give out?

ASSETS LIABILTIES

Required reserves $80 deposits $400

Excess reserves $ 20

Loans $ 300

______________________________________

$400 $400

What happens on this balance sheet when a new $200 deposit comes into the bank?

ASSETS LIABILTIES

Required reserves $120 deposits $600

Excess reserves $ 180

Loans $ 300

______________________________________

$600 $600

Open market operations: accounting for money

multiplier • The Fed has to account for the Money

Multiplier any time they take an action!!!

Examples: 1. The Fed sells $20 million of bonds. What is

the total change in the money supply if the reserve requirement is 10%. 1/.10 = 10 10 X 20 = $200 million

**$200 million DECREASE in money supply

Accounting for the Money multiplier

*Less money is always created when the Fed buys bonds from the public vs banks –

Buying from the public is subject to the reserve

requriement (the bank must hold part of the

money)

If the Fed buys bonds from banks, the bank

doesn’t have to hold any of the money in

reserve because it is THEIR money

Monetary policy: Fed buying from banks vs. the public

2. The Fed buys $10 million in bonds back from banks. If the reserve requirement is 20%, what is the total change in the money supply?

1/.20 = 5 5 X 10 = 50 million INCREASE

3. The Fed buys $10 million in bonds back from the public which is then deposited into bank accounts. If the reserve requirement is 20%, what is the total change in money supply?

1/.20 = 5 5 X 10 = 50 50 -10 = 40 million INCREASE

Topic 6: The Effects of Monetary Policy

The Fed influences:1. Interest rates (of saving and borrowing)

2. Bond Prices

inversely related to interest rates

if IR go up, price of bonds go down

if IR go down, bond prices go up

Monetarist view

• View based on the QUANTITY THEORY OF $

and

EQUATION OF EXCHANGE

MV=PQ

MV=PQ

 

Suppose the money supply in an economy is $200, velocity is 2 and price level is 2. What is Q? __________

Suppose money supply in an economy is $400, price level is 3 and Q is $400. What is the velocity of money? ________

Monetarist view

*The money supply of a nation has a DIRECT proportional relationship to output because spending is VERY sensitive to the interest rate

* Economic output will grow steadily as long as the money supply grows steadily

Expansionary monetary policy

• The Fed can:

____________ the reserve requirement

____________ the discount rate

____________ government bonds

If the Fed increases the money supply nominal

Interest rates fall

When NIR fall; price of bonds go UP

Expansionary monetary policy

77

200

Md

Ms

10%

5%

2%

Quantity of Money(billions of dollars)

Interest Rate (ir)

250

Ms1

Impact of expansionary monetary policy

INTEREST RATES GO DOWN!!!

As a result: 1. people are encouraged to borrow money instead of save it (which is what the Fed wants people to do!)

2. People also less likely to purchase bonds because the price of these go up

S&D of Money

79

200

DM

Ms10%

5%

2%

QuantityM

Interest Rate

(i)

250

Ms1

AD/AS

Qe

AD

AS

GDPR

PL

AD1

Q1

PLe

PL1

Expansionary Monetary policy

Money supply increase

Interest rates go down

Borrowing increases

Spending increases

AD shifts to the right

Contractionary monetary policy

• The Fed can:

____________ the reserve requirement

____________ the discount rate

____________ government bonds

If the Fed decreases the money supply, Interest

rates will go up

The price of bonds go down

Contractionary monetary policy

200

Md

Ms

10%

5%

Quantity of Money(billions of dollars)

Interest Rate (ir)

150

Ms1

Impact of Contractionary Policy

INTEREST RATES GO UP!!!!!

As a result: 1. people are encouraged to save money instead of borrow it (which is what the Fed wants people to do!)

2. people are more likely to buy bonds because their prices are low

S&D of Money

83

200

Md

Ms10%

5%

2%

QuantityM

Interest Rate

(i)

175

Ms1

AD/AS

Qe

AD

AS

GDPR

PL

AD1

Q1

PLe

PL1

Contractionary monetary policy

Money supply decreases

Interest rates decrease

Borrowing decreases

Spending decreases

AD shifts to the LEFT

Topic 7: Economic Theories

Keynesian View

Money supply has INDIRECT link to output because spending is NOT very sensitive to IR

• Favor FISCAL POLICY

Fiscal policy Monetary policy

Responsibility

Of

The government The Fed

Theory associated with

Keynesian theory

Monetarist theory

Theory based on C + I +G +XN Q theory of money

MV=PQ

Fiscal policy Monetary policy

View on investment demand

Not very sensitive to IR (impacted more by taxes)

Very sensitive to IR (strongly influenced by interest rates)

Tools Used Income taxes

G spending

Reserve requirement

Discount rate

Open market operations

Lag time Long Short

Graph used to illustrate

Fiscal policy

AD/AS

Monetary policy

Money market

Directly impacts Price level and Q of real GDP

Interest rates and money supply

Fiscal policy

The government can influence economic activity by

1. Changing government spending

2. Changing income taxes

• Use AD/AS graph to show FISCAL POLICY

Fiscal Policy shifts AD curve ONLY!!

Expansionary fiscal policy

• Implemented in times of recession

• Government can: 1. Increase G

spending

2. Decrease income taxes

Impact of:

price level ___

output ____

employment ___

Leads to DEFICIT budget

Contractionary Fiscal Policy Implemented during

times of INFLATION

To slow down economy, Government can: 1. Decrease government spending 2. Increase income taxes

• Impact of: Price level _____

Output _______

Employment ______Leads to SURPLUS budget

Monetary Policy

What the Fed does to regulate the money supply. The Fed directly impacts nominal interest rates.

The Fed can influence money supply in 3 ways: 1. open market operations 2. changing the reserve requirement 3. changing the discount rate of interest

Use Money market graph to show Monetary PolicyMonetary policy shifts MS curve ONLY!! – leads to a

change in AD

Expansionary Monetary Policy

To speed up economy, Fed can:

1. Buy (back) bonds (AKA securities)

2. Lower the discount rate

3. Lower the reserve requirement

Impact of:

interest rates ____

bond prices _____

Contractionary Monetary Policy

To slow down economy, Fed can: 1. Sell bonds (AKA securities)2. Raise the discount rate 3. Raise the reserve requirement Impact of:

interest rates __

bond prices ___