Money and Monetary Policy

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AN OVERVIEW OF MONEY

3 primary functions of money:1) medium of exchange - What sellers generally accept and buyers generally use to pay for goods and services.

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A Store of Value

2) store of value An asset that can be used to transport purchasing power from one time period to another; maintains value overtime; leads to ability to save

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A Unit of Account

3) unit of account A standard unit that provides a consistent way of quoting prices.

WORKBOOK PAGE 184…we are not going to complete…you can look at to look at different items to see if they have the same functions as money

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FIAT MONIES

Fiat Money: has value because it has been declared to have value by government; has no intrinsic value

Token Money: silver or gold coins; has value beyond that by government

Characteristics of Money1) Portability2) Uniformity3) Acceptability4) Durability5) Stability in Value6) Divisibility

WORKBOOK PG. 185…you can look at but we are not going to complete (you are comparing different products to see if they have characteristics of money)

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AN OVERVIEW OF MONEY (workbook pg. 187)

MEASURING THE SUPPLY OF MONEY IN THE UNITED STATES

M1: Transactions MoneyM1, or transactions money Money that can be directly used for transactions (LIQUID forms of money) – includes items that are primarily used for MEDIUM OF EXCHANGE.

Includes: currency/coin, checkable deposits, traveler’s checks•Currency/coin – small % of money supply•Checkable deposits – largest % of money supply

M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits

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M2: Broad Money

M2 ≡ M1 + savings accounts + money market accounts + other short-term money market assets

M2, or broad money •M2 less liquid•Includes items used as a STORE OF VALUE

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M3

•Broader, includes M2 and M1•Includes large denomination time deposits (excess of $100,000)…financial assets and instruments generally employed by large businesses and financial institutions•Includes items that serve as a UNIT OF ACCOUNT

***credit cards not money***

FEDERAL RESERVE BANK

Fractional Reserve System

• Definition: portion (fraction) of checkable deposits are backed up by cash in bank vaults or deposits at central bank

• 2 significant characteristics:– Banks can create money through lending– Banks vulnerable to “panics” or “runs”

• Why we have FDIC• Basis of good policies and reserve system

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HOW BANKS CREATE MONEY

THE MODERN BANKING SYSTEM

Federal Reserve Bank (the Fed) The central bank of the United States.

A Brief Review of Accounting (see handout)

Assets − Liabilities ≡ Net Worth,or

Assets ≡ Liabilities + Net Worth

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reserves The deposits that a bank has at the Federal Reserve bank plus its cash on hand.

required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Federal Reserve.

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excess reserves The difference between a bank’s actual reserves and its required reserves.

Banks are any institutions holding deposits. People deposit money in a bank. Banks must hold a specific percentage of the deposit as reserves; this percentage is called the required reserve ratio. The deposit that is not part of the required reserves is called excess reserves. The bank may loan excess reserves or buy government securities. A bank makes a loan by creating a checkable deposit for the borrower; this results in an increase in the money supply (M1).

THE CREATION OF MONEY

excess reserves ≡ actual reserves − required reserves

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An increase in bank reserves leads to a greater than one-for-one increase in the money supply. Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multiplier. Stated somewhat differently, the money multiplier is the multiple by which deposits can increase for every dollar increase in reserves.

THE MONEY MULTIPLIER

ratio reserve required

1 multiplier money

TURN TO WORKBOOK PG. 195-198 AND COMPLETE (AS A CLASS)

DEMAND FOR MONEY

Federal Reserve• Central bank of the United States

– Represent public and private control – Decentralized (different than other countries)

• Created by Federal Reserve Act of 1913 by Woodrow Wilson• Board of Governors: (located in D.C.)

– Includes 7 members• Appointment: nominated by President and confirmed by Senate

– Term length: 14 years; staggered (one member replaced every 2 years)– Chairman/vice-chairman: selected from among the members; appointed

to 4 year terms and can be appointed to new 4 year terms by president• 2 goals: (promote economic stability and growth – low inflation and low

unemployment)– Supervise commercial banking system (set rules/regulations)– Regulate supply of money

• Ownership of Fed:– Owned by private commercial banks in its district (federally chartered

banks required to purchase shares of stock in Federal Reserve)

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THE FEDERAL RESERVE SYSTEM

Federal Open Market Committee (FOMC) •A group composed of the seven members of the Fed’s Board of Governors, the president of the New York Federal Reserve Bank, and four of the other eleven district bank presidents on a rotating basis•All presidents attend meeting but on FOMC members have voting power on monetary policy• it sets goals concerning the money supply and interest rates and directs the operation of the Open Market Desk in New York.

Open Market Desk The office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed.

Functions of Federal Reserve• Issuing currency• Setting reserve requirements and holding

reserves (accept deposits from banks any portion of mandated reserves not held in vault)

• Lending money to banks/thrifts– Lender of last resort– Charges DISCOUNT RATE if banks borrow money from

Fed• Providing for check collection• Acting as fiscal agent (provides financial services

to federal government)• Supervising banks• Controlling money supply

Independence of Fed• Fed is independent of federal government• This is to protect the Fed from political pressure from

politicians• Owned by commercial banks

– Buys shares of stock in Federal Reserve• Commercial banks: receives license in 2 ways: from Federal

government (“national” in title) or from State government (“state” in title)

• Banks in Federal government (“national”) must belong to Fed (required to buy stock in Fed)…State banks may/may not join Fed (many do not)

• Costs of belonging to Fed: buy stock, under regulatory authority• Benefits of belonging to Fed: have stability/confidence, can

borrow from FED!!!

• Not financed through government money but interest they earn off their investments

VIDEO – Federal Reserve

Monetarists

Why Demand Money? 3 motives

• Transaction demand: demand for money to make purchases of goods/services

• Precautionary demand: demand for money to serve as protection against an unexpected need

• Speculative demand: demand for money because it serves as a store of wealth

Unit 4 : MacroeconomicsNational Council on Economic Education

Money Demand


Factors Affecting Money Demand


The Money Market


The Money Market, Investmentand Aggregate Demand

THE BIG PICTURE…

• Increase in MS…leads to decrease in interest rates…leads to increase investment spending…leads to economic growth (EXPANSIONARY POLICY)

• Decrease in MS…leads to increase in interest rates…leads to decrease investment spending (CONTRACTIONARY POLICY)

WORKBOOK PG. 205…COMPLETE AS A CLASS

Tools of Monetary Policy

Monetarists• form of classical economics (price and wage flexibility would cause

fluctuations in AD to alter product and resource prices rather than output and employment… thus market system would provide substantial macroeconomic stability WERE IT NOT FOR GOVERNMENT INTERFERENCE IN THE ECONOMY)– Focuses on money supply– Holds that markets are highly competitive– Says that a competitive market system gives the economy a high degree of

macroeconomic stability– Believe that government has promoted downward wage inflexibility through:

minimum wage laws, pro-union legislation, guaranteed prices for farm products, pro-business monopoly legislation…

• Milton Friedman• Believe changes in MONEY SUPPLY affects rate of interest but this leads to

broader changes in spending• Believe Federal Reserve should not increase/decrease money supply but set

a constant growth (3-4% growth rate appropriate)• Against fiscal policy…says it destabilizes economy (sends mixed signals to

decision makers and distorts picture of economy); leads to crowding out

QUANTITY THEORY OF MONEY• QUANTITY THEORY OF MONEY: based on equation of exchange

– Equation attempts to show balance between “money” (left side) and goods/services (right side)

– For given level of income velocity (V), if supply of money grows faster than rate of real output (change in Q), then there will be inflation

– ***money should increase at a constant rate equal to growth of output to prevent inflation from growing***

– If economy is operating at full employment and there is a substantial increase in money supply, this theory predicts an increase in the price level

• MV = PQ• M – money supply• V – velocity of money (how quickly changes hands)• P – average price level• Q – national output, real GDP • P*Q: nominal value of GDP (how much * prices)• Must be enough money circulating fast enough to support the overall level of

economic activity• V – fairly constant overtime…Y – also constant (fixed) in the short run• The two that are always changing…

• Money supply directly affects prices• If money increases, prices increase• Mismanagement of money creates inflation

Theory of Rational Expectations• New classical economists tend to be either monetarists

or adherents of RATIONAL EXPECTATIONS THEORY – the idea that businesses, consumers, and workers expect changes in policies or circumstances to have certain effects on the economy and, in pursuing their own self-interest, take actions to make sure those changes affect them as little as possible

• Believe that when the economy occasionally diverges from its full-employment output, internal mechanisms within the economy will automatically move it back to that output; policymakers should stand back and let the automatic correction occur, rather than engaging in active fiscal and monetary policy

MONEY CREATION

Purpose and Goal of Monetary Policy

• Purpose: to promote employment, stable prices, and moderate long-term interest rates

• Primary goal since 1979: to stabilize prices• Reason for this goal: over time, evident that

monetary policy’s long-term influence over prices is strong and predictable but its influence over real output and real interest rates is mostly short-term and not predictable

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HOW THE FEDERAL RESERVE CONTROLSTHE MONEY SUPPLY

Three tools are available to the Fed for changing the money supply:

(1) changing the required reserve ratio

(2) changing the discount rate

(3) engaging in open market operations

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HOW THE FEDERAL RESERVE CONTROLSTHE MONEY SUPPLYTHE REQUIRED RESERVE RATIO

•Decreases in the required reserve ratio allow banks to have more deposits with the existing volume of reserves. •As banks create more deposits by making loans, the supply of money (currency + deposits) increases. •The reverse is also true: If the Fed wants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce their deposits by “calling in” some of their loans. The result is a decrease in the money supply.

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THE DISCOUNT RATE

discount rate Interest rate that banks pay to the Fed to borrow from it.

Only interest rate Fed has direct control over

Bank borrowing from the Fed leads to an increase in the money supply.

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The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do.

The Fed can influence bank borrowing, and thus the money supply, through the discountrate:

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HOW THE FEDERAL RESERVE CONTROLSTHE MONEY SUPPLY OPEN MARKET

OPERATIONS•open market operations The purchase and sale by the Fed of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply.

•The Federal Reserve purchases government securities , consisting of securities issued by the federal government to finance past budget deficits•securities are part of the public debt (money borrowed by federal government)•Federal Reserve banks bought these securities from commercial banks and the public through open market operations

• although important source of interest income to Fed., mainly done to impact money supply

• TARGETS THE FEDERAL FUNDS RATE!!! This is interest rate that banks charge one another for overnight loans made from temporary excess reserves• Banks reserves deposited in Fed. Res. does not earn

interest; therefore, they desire to lend out their temporary excess reserves overnight to other banks that temporarily need them to meet their reserve requirements; the funds being lent and borrowed overnight are called “federal funds”

• Banks can lend excess reserves to one another but Federal Reserve is the only supplier of Federal funds (currency used by banks as reserves)

Federal Funds RateFederalFundsRate (%)

Supply of federal funds

Demand for federal fundsQuantity of Federal Funds

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■ An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves.

■ An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.

We can sum up the effect of these openmarket operations this way:

Federal Funds Market

• Way you borrow money from Fed or from other banks (2 ways to borrow)

• ½ of all banks belong to Fed; tend to be the largest banks– 70-75% of bank deposits are located in banks who

belong to Fed (small banks don’t belong to Fed)

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Two Branches of Government Deal in Government Securities

The Treasury Department is responsible for collecting taxes and paying the federal government’s bills.

The Treasury cannot print money to finance the deficit.

The Fed is not the Treasury. Instead, it is a quasi-independent agency authorized byCongress to buy and sell outstanding (preexisting) U.S. government securities on the open market.

Nominal and Real Interest Rates• Interest-sensitive components of GDP – consumer and

investment spending (interest rates will increase/decrease spending habits)

• Real interest rates – determines the level of investment– Nominal rate-inflation rate = real rate– Investment demand curve (shows the amount of investment

forthcoming at each real interest rate)• Nominal interest rates – determines the demand for money

– Rate that appears on the financial pages of newspapers and on the signs and ads of financial institutions

– Fischer Effect: demonstrates how changes in the money supply affect the nominal interest rate in the long run

• Equation of exchange: see that changes in money supply, holding velocity and real output constant, lead to changes in the price level

• In SHORT RUN, increases in money supply decrease nominal interest rate and real interest rate

• In LONG RUN, increases in money supply will result in an increase in the price level and the nominal interest rate

Interest Rates and Bond Prices• Closely related• When interest rate increases, bond prices fall• When interest rate decreases, bond prices rise• Why?

– Bonds bought and sold in financial markets– Price of bonds is determined by bond demand and

bond supply

EXAMPLE• Suppose a bond with no expiration date pays a fixed $50

annual interest and is selling for its face value of $1000. Interest yield on this bond is 5% ($50/$1000 = 5%).

• Now suppose the interest rate in the economy rises to 7 ½ % from 5%. Newly issued bonds will ay $75 per $1000 lent. Older bonds paying only $50 will not be salable at their $1000 face value. To compete with the 7 ½% bond, the price of this bond will need to fall $667 to remain competitive. The $50 fixed annual interest payment will then yield 7 ½ % to whoever buys the bond ($50/$667 = 7 ½ %)…vice versa situation

• KNOW: there is an inverse relationship between interest rates and bond prices!!!!

Loanable Funds Market

Interest rates

Definition

• Explains interest rates in terms of supply and demand for funds available for lending (or borrowing)

Supply of Loanable Funds

• Represented by upward sloping curve (households will make available more funds at high interest rates)

Demand for Loanable Funds

• Represented by downward sloping demand curve (borrow money to buy goods at lower interest rates)

• Businesses borrow loanable funds primarily to add to their stock of capital goods (new plants, warehouses, etc.)

Changes in Supply• Anything that causes households to be thriftier

will prompt them to save more at each interest rate, shifting supply curve rightward– Example: interest earned on savings were to be

suddenly exempted from taxation• Decline in thriftiness would shift curve leftward

and increase interest rates– example: government expanded social insurance to

cover the costs of hospitalization, prescription drugs, and retirement living more fully, the incentive of households to save might diminish.

Changes in Demand

• Anything that increases the rate of return on potential investment will increase the demand for loanable funds (vice versa)

Other participants

• Households – suppliers of funds but can be demanders of funds (buy houses, cars, etc.)

• Governments – demand funds when they borrow to finance budgetary deficits

• Businesses – demand funds but also can be suppliers

• Additional powerpoint on loanable funds market

Money and Monetary Policy

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