Fixing an Economy:Fixing an Economy:Monetary PolicyMonetary Policy

Federal Reserve, Money Federal Reserve, Money Supply, and BankingSupply, and Banking

CHAPTERS 16 & 17CHAPTERS 16 & 17

WHAT MAKES WHAT MAKES MONEY, MONEY?MONEY, MONEY?

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Since we are talking about Monetary policy, Since we are talking about Monetary policy, we should make sure we understand why we should make sure we understand why

money is important.money is important.

History of US currencyHistory of US currencyFor centuries currency has been in the form of For centuries currency has been in the form of precious metals (gold, silver, copper)precious metals (gold, silver, copper)

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WHAT MAKES MONEY, MONEY?WHAT MAKES MONEY, MONEY?

US currency was based on gold until 1973 US currency was based on gold until 1973 President Nixon abolished the gold President Nixon abolished the gold standard since no additional currency standard since no additional currency could be printed for a growing economy if could be printed for a growing economy if that currency is based on a fixed that currency is based on a fixed commodity commodity (product)(product)..

So what backs the value of the So what backs the value of the currency in this country…currency in this country…

Faith!Faith!

Fiat MoneyFiat Money (representative money)(representative money) is used as money because of is used as money because of government decree.government decree. It It does notdoes not have have intrinsic valueintrinsic value.. Examples:Examples: Present day coins, paper Present day coins, paper

currency, check deposits, credit cards.currency, check deposits, credit cards.

The 2 Categories of The 2 Categories of MoneyMoney

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WHAT MAKES MONEY, MONEY?WHAT MAKES MONEY, MONEY?

The 2 Categories of The 2 Categories of MoneyMoney

Commodity MoneyCommodity Money takes the takes the form of a product with form of a product with intrinsic intrinsic valuevalue.. The material The material ITSELFITSELF has value! has value! Examples:Examples: Gold, silver, cigarettes. Gold, silver, cigarettes.

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WHAT MAKES MONEY, MONEY?WHAT MAKES MONEY, MONEY?

Money has to have Money has to have threethree functionsfunctions in the economy:in the economy:

1)1) Medium of ExchangeMedium of Exchange

2)2) Unit of AccountUnit of Account

3)3) Store of ValueStore of Value

WHAT MAKES MONEY, MONEY?WHAT MAKES MONEY, MONEY?

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1.) 1.) Medium of ExchangeMedium of Exchange

AA medium of exchangemedium of exchange is is anything that is anything that is acceptableacceptable as as

payment for goods and payment for goods and services.services.

ORORIN IN

EXCHANGEXCHANGE FORE FOR

A GOOD OR A GOOD OR SERVICESERVICE

3 FUNCTIONS OF MONEY3 FUNCTIONS OF MONEY

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2.)2.) Unit of AccountUnit of AccountA A unit of accountunit of account is the is the yardstickyardstick people use to post prices, record people use to post prices, record

debts, and compare values.debts, and compare values.We use it to We use it to COMPARECOMPARE the value of two or more the value of two or more

goodsgoodsEXAMPLE:EXAMPLE: Measuring the Measuring the WORTHWORTH of your of your choreschoresDUTYDUTY $ WORTH$ WORTH TRADE VALUETRADE VALUE

CUT THE YARDCUT THE YARD $40.00$40.00 Video GameVideo Game

CUT THE YARD + WASH & CUT THE YARD + WASH & WAX THE CARWAX THE CAR $100.00$100.00 Video Game + Video Game +

ClothesClothes

CUT THE YARD, WASH & CUT THE YARD, WASH & WAX THE CAR, & CLEAN WAX THE CAR, & CLEAN

THE WHOLE HOUSETHE WHOLE HOUSE$300.00$300.00 XBOX 360XBOX 360

3 FUNCTIONS OF MONEY3 FUNCTIONS OF MONEY

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3.)3.) Store of ValueStore of Value

A A store of valuestore of value is an item is an item that people can use to transfer that people can use to transfer

purchasing power from the purchasing power from the presentpresent to the to the futurefuture..

IT WILL HOLD IT WILL HOLD VALUE. SO THAT VALUE. SO THAT IT CAN BE USED IT CAN BE USED

SOMETIME SOMETIME LATER.LATER.

3 FUNCTIONS OF MONEY3 FUNCTIONS OF MONEY

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The Federal The Federal ReserveReserveTheThe Federal Reserve (Fed)Federal Reserve (Fed)

serves as the nation’s central serves as the nation’s central bank.bank.

1)1) Regulates BanksRegulates Banks Practices Practices to ensure they to ensure they follow federal laws intended to promote follow federal laws intended to promote safe and sound banking practices. safe and sound banking practices.

2)2) Acts as a Banker’s BankActs as a Banker’s Bank, making loans to , making loans to banks and as a lender of last resort.banks and as a lender of last resort.

3)3) ConductsConducts Monetary policyMonetary policy by controlling by controlling the the money suppliedmoney supplied to the public. to the public.

$$

$$

$$ $$$$

$$

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The Federal Reserve and The Federal Reserve and some clarification!some clarification!

Monetary Policy:Monetary Policy: IS IS NOTNOT PRINTING MONEY PRINTING MONEY The Federal Reserve is The Federal Reserve is NOTNOT

responsible for printing responsible for printing money!money!

Federal ReserveFederal Reserve

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The Fed’s The Fed’s OrganizationOrganization

The Fed is run by aThe Fed is run by a Board of Board of GovernorsGovernors,, which has which has sevenseven members members appointed by the President and appointed by the President and confirmed by the Senate.confirmed by the Senate. Among the seven members, the most Among the seven members, the most

important is the important is the chairmanchairman (Ben Bernanke)(Ben Bernanke) The chairman directs the Fed staff, presides The chairman directs the Fed staff, presides

over board meetings, and testifies about Fed over board meetings, and testifies about Fed policy in front of Congressional Committees.policy in front of Congressional Committees.

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The Federal The Federal Reserve SystemReserve System

The Structure of the Federal The Structure of the Federal Reserve System:Reserve System: The primary elements in the Federal The primary elements in the Federal

Reserve System areReserve System are::

1) 1) The Board of GovernorsThe Board of Governors (7 members)(7 members)

2) 2) The 12 Regional Federal Reserve The 12 Regional Federal Reserve BanksBanks

3) 3) The Federal Open-Market CommitteeThe Federal Open-Market CommitteeSWS 2009SWS 2009

The 12 Federal Reserve The 12 Federal Reserve BanksBanks

Since each district has different money needs the various branches deal with each region

independently.

What is Monetary What is Monetary Policy?Policy?

Monetary Policy:Monetary Policy: Controlling the economy through increasing Controlling the economy through increasing

or decreasing the money supply.or decreasing the money supply. Two Types of Monetary strategy:Two Types of Monetary strategy:

1)1) Tight Money:Tight Money: taking taking money outmoney out of the economy of the economy (decrease money supply)(decrease money supply)

2)2) Easy Money:Easy Money: putting putting more money inmore money in the economy the economy (increase money supply)(increase money supply)

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Fed’s Tools of Fed’s Tools of Monetary ControlMonetary Control

The Fed has The Fed has 3 “tools”3 “tools” in its monetary in its monetary toolbox:toolbox:

1)1) Open-Market Operations Open-Market Operations (buying & (buying & selling government securities)selling government securities)

2)2) Changing theChanging the Reserve Requirement Reserve Requirement

3)3) Changing theChanging the Discount Rate Discount Rate

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TheThe money supplymoney supply is the quantity of is the quantity of money available in the economy.money available in the economy.

The primary way in which the Fed The primary way in which the Fed changes the money supply is throughchanges the money supply is through open-market operationsopen-market operations.. The Fed The Fed BUYSBUYS and and SELLSSELLS U.S. Government U.S. Government

Bonds and/or other U.S. SecuritiesBonds and/or other U.S. Securities

Let’s look at a graphic example…

Monetary Policy ToolsMonetary Policy ToolsREGULATING THE MONEY SUPPLY THROUGH BUYING/SELLING BONDSREGULATING THE MONEY SUPPLY THROUGH BUYING/SELLING BONDS

1. 1. OPEN-MARKET OPERATIONSOPEN-MARKET OPERATIONS

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Federal ReserveFederal Reserve

GOVERNMENT SECURITIES

SELLSSELLS

Consumers, Banks, Consumers, Banks, Businesses & CountriesBusinesses & Countries

MONEY SUPPLY MONEY SUPPLY ==

Monetary Policy ToolsMonetary Policy ToolsREGULATING THE MONEY SUPPLY THROUGH BUYING/SELLING US REGULATING THE MONEY SUPPLY THROUGH BUYING/SELLING US

SECURITIESSECURITIES

1. OPEN-MARKET OPERATIONS1. OPEN-MARKET OPERATIONS

INTEREST RATES =INTEREST RATES =

INCOME, INFLATION & INCOME, INFLATION & GDP =GDP =

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REGULATING THE MONEY SUPPLY THROUGH BUYING/SELLING US REGULATING THE MONEY SUPPLY THROUGH BUYING/SELLING US SECURITIES SECURITIES

1. OPEN-MARKET OPERATIONS1. OPEN-MARKET OPERATIONS

Federal ReserveFederal Reserve

GOVERNMENT SECURITIES

BUYS BUYS (back)(back)

MONEY SUPPLY MONEY SUPPLY ==

Monetary Policy ToolsMonetary Policy Tools

INTEREST RATES =INTEREST RATES =

INCOME, INFLATION & INCOME, INFLATION & GDP =GDP =

SWS © 2009SWS © 2009Consumers, Banks, Consumers, Banks,

Businesses & CountriesBusinesses & Countries

ReservesReserves are deposits that are deposits that banks have received but have banks have received but have not loaned out.not loaned out.

In the U.S. we have aIn the U.S. we have a fractional fractional reserve bankingreserve banking system:system: banks hold a fraction of the banks hold a fraction of the

money deposited as reserves and money deposited as reserves and lend out the rest.lend out the rest.

Monetary Policy ToolsMonetary Policy ToolsCONTROLLING THE MONEY SUPPLY THROUGH CONTROLLING THE MONEY SUPPLY THROUGH

BANKSBANKS2. THE RESERVE REQUIREMENT2. THE RESERVE REQUIREMENT

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The The money supplymoney supply in America is affected in America is affected by the amount deposited in banks and by the amount deposited in banks and the amount that banks loan out.the amount that banks loan out. The fraction of total deposits that a bank The fraction of total deposits that a bank

hashas to keep as reserves is called the to keep as reserves is called the reserve requirement ratioreserve requirement ratio..

Put another way, thePut another way, the reserve reserve requirementrequirement is the amount (%) of a is the amount (%) of a bank’s total reserves that may not be bank’s total reserves that may not be loaned out.loaned out.

Monetary Policy ToolsMonetary Policy ToolsCONTROLLING THE MONEY SUPPLY THROUGH CONTROLLING THE MONEY SUPPLY THROUGH

BANKSBANKS2. THE RESERVE REQUIREMENT2. THE RESERVE REQUIREMENT

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• Peak: increase the reserve requirement in order to stop banks from lending so much. This stops $ entering economy.

• Trough: decrease reserve requirement in order to have banks lend more to stimulate economy. This allows $ to enter economy.

CONTROLLING MONEY SUPPLY THROUGH THE INTEREST CONTROLLING MONEY SUPPLY THROUGH THE INTEREST RATERATE

3. THE DISCOUNT RATE3. THE DISCOUNT RATE

Changing the Discount RateChanging the Discount Rate TheThe Discount RateDiscount Rate is the is the interest rateinterest rate the Fed the Fed

charges banks for loans.charges banks for loans. IncreasingIncreasing the discount ratethe discount rate decreasesdecreases the the

money supply (peak).money supply (peak). DecreasingDecreasing the discount ratethe discount rate increasesincreases the the

money supply (trough).money supply (trough). Basically, if the Federal Reserve charges banks Basically, if the Federal Reserve charges banks

more interest to borrow money then the banks more interest to borrow money then the banks have to charge higher interest on all loans.have to charge higher interest on all loans.

Monetary Policy ToolsMonetary Policy Tools

REVIEW: TOOLS OF MONETARY POLICYREVIEW: TOOLS OF MONETARY POLICYOpen-Market OperationsOpen-Market Operations

The Reserve RatioThe Reserve RatioThe Discount RateThe Discount Rate

Examples:Examples:•Buy securitiesBuy securities

•Increase Reserve RatioIncrease Reserve Ratio

•Raise Discount RateRaise Discount Rate

•Sell SecuritiesSell Securities

•Decrease Reserve RatioDecrease Reserve Ratio

•Lower Discount RateLower Discount Rate

What will happen to the money What will happen to the money supply in the following situations?supply in the following situations?

MONEY DECREASES

MONEY DECREASES

MONEY INCREASESMONEY INCREASES

MONEY INCREASESMONEY INCREASES

MONEY DECREASES

MONEY INCREASESMONEY INCREASES

Monetary Policy ToolsMonetary Policy Tools

Open-Market OperationsOpen-Market Operations

The Reserve RequirementThe Reserve Requirement

The Discount RateThe Discount Rate

Monetary Policy ToolsMonetary Policy Tools

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Fiscal Policy ToolsFiscal Policy Tools

TaxesTaxesGovernment SpendingGovernment Spending

Transfer PaymentsTransfer Payments

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END CHAPTERS 16 & END CHAPTERS 16 & 1717

MONETARY POLICY, FEDERAL MONETARY POLICY, FEDERAL RESERVE & MONEYRESERVE & MONEY

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