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Banking system
Central
Bank
B
A
N
K
S
Households and firms
The role of commercial banks is to
•Serve as a financial intermediary between savings
and investments;
•Assist the process of money circulation, connect
lenders to borrowers, in other words, “create
money”.
Money in the economy is represented not only by
Federal Reserve notes (a.k.a. dollar bills) but also
by loans made and taken out.
It is in this sense that commercial banks are able to
“create money”.
Central Bank and monetary policy
The functions of a Central Bank are to:
• serve as the last resort for commercial banks
experiencing cash flow problems;
• maintain the rules under which the banking system
operates;
• by doing so, regulate the amount of money in the
economy (often referred to as “money supply”).
In the U.S., the role of a Central Bank is performed by
the Federal Reserve System, or the Fed for short.
The mission of the Fed is to promote economic
stability and economic growth.
• It does so by affecting money supply (methods are
to be discussed below).
• The chair is appointed by the President/Congress
• Other than that, it is independent of the government
(can conduct any policy it wants)
• Consists of 12 regional banks
The Fed performs its main mission, promoting
economic stability and growth, by regulating money
supply and therefore compensating economic forces
within a business cycle.
The idea :
Money supply up 
 interest rate down
 easier to get a loan
 a boost to investment and consumption
 an overall stimulus to the economy
… and vice versa.
Therefore when the economy is in a recession, the Fed
should __________ the money supply.
When the economy is growing too fast, the Fed should
__________ the money supply.
The Fed performs its main mission, promoting
economic stability and growth, by regulating money
supply and therefore compensating economic forces
within a business cycle.
The idea :
Money supply up 
 interest rate down
 easier to get a loan
 a boost to investment and consumption
 an overall stimulus to the economy
… and vice versa.
Therefore when the economy is in a recession, the Fed
should increase the money supply.
When the economy is growing too fast, the Fed should
__________ the money supply.
The Fed performs its main mission, promoting
economic stability and growth, by regulating money
supply and therefore compensating economic forces
within a business cycle.
The idea :
Money supply up 
 interest rate down
 easier to get a loan
 a boost to investment and consumption
 an overall stimulus to the economy
… and vice versa.
Therefore when the economy is in a recession, the Fed
should increase the money supply.
When the economy is growing too fast, the Fed should
decrease
the money supply.
The Fed performs its main mission, promoting
economic stability and growth, by regulating money
supply and therefore compensating economic forces
within a business cycle.
The idea :
Money supply up 
 interest rate down
 easier to get a loan
 a boost to investment and consumption
 an overall stimulus to the economy
Expansionary
… and vice versa.
monetary policy
Therefore when the economy is in a recession, the Fed
should increase the money supply.
When the economy is growing too fast, the Fed should
decrease
the money supply.
The Fed performs its main mission, promoting
economic stability and growth, by regulating money
supply and therefore compensating economic forces
within a business cycle.
The idea :
Money supply up 
 interest rate down
 easier to get a loan
 a boost to investment and consumption
 an overall stimulus to the economy
Expansionary
… and vice versa.
monetary policy
Therefore when the economy is in a recession, the Fed
should increase the money supply.
When the economy is growing too fast, the Fed should
decrease
the money supply.
Contractionary
monetary policy
Tools of monetary policy
“Fractional reserve banking”:
(assume 10% reserve requirement)
RESERVES
$50
John
$40.50
$45
Bank 1
$500
deposit
RESERVES
RESERVES
Bank 3
Bank 2
$450
loan
Jane
$450
purchase
$405
loan
$450
dep.
Acme, Inc.
Jared
$405
purchase
$405
dep.
SUBWAY
etc.
What happens if the reserve ratio requirement is raised?
________ money is put in reserves, __________ money
returns back to the economy. As a result, the overall amount of
money in the economy (loans included) _____________.
This causes the interest rate to _____________ ,
and the economy to _______________ .
Conversely, a lower reserve ratio requirement would
______________ the money supply, ___________ the interest
rates, and ________________________
the economy.
What happens if the reserve ratio requirement is raised?
_ MORE _ money is put in reserves, _ LESS __ money
returns back to the economy. As a result, the overall amount of
money in the economy (loans included) _____________.
This causes the interest rate to _____________ ,
and the economy to _______________ .
Conversely, a lower reserve ratio requirement would
______________ the money supply, ___________ the interest
rates, and ________________________
the economy.
What happens if the reserve ratio requirement is raised?
_ MORE _ money is put in reserves, _ LESS __ money
returns back to the economy. As a result, the overall amount of
money in the economy (loans included) _ decreases _.
This causes the interest rate to _____________ ,
and the economy to _______________ .
Conversely, a lower reserve ratio requirement would
______________ the money supply, ___________ the interest
rates, and ________________________
the economy.
What happens if the reserve ratio requirement is raised?
_ MORE _ money is put in reserves, _ LESS __ money
returns back to the economy. As a result, the overall amount of
money in the economy (loans included) _ decreases _.
This causes the interest rate to increase ,
and the economy to _______________ .
Conversely, a lower reserve ratio requirement would
______________ the money supply, ___________ the interest
rates, and ________________________
the economy.
What happens if the reserve ratio requirement is raised?
_ MORE _ money is put in reserves, _ LESS __ money
returns back to the economy. As a result, the overall amount of
money in the economy (loans included) _ decreases _.
This causes the interest rate to increase ,
and the economy to slow down .
Conversely, a lower reserve ratio requirement would
______________ the money supply, ___________ the interest
rates, and ________________________
the economy.
What happens if the reserve ratio requirement is raised?
_ MORE _ money is put in reserves, _ LESS __ money
returns back to the economy. As a result, the overall amount of
money in the economy (loans included) _ decreases _.
This causes the interest rate to increase ,
and the economy to slow down .
Conversely, a lower reserve ratio requirement would
increase
the money supply, ___________ the interest
rates, and ________________________
the economy.
What happens if the reserve ratio requirement is raised?
_ MORE _ money is put in reserves, _ LESS __ money
returns back to the economy. As a result, the overall amount of
money in the economy (loans included) _ decreases _.
This causes the interest rate to increase ,
and the economy to slow down .
Conversely, a lower reserve ratio requirement would
increase
the money supply,
lower
the interest
rates, and ________________________
the economy.
What happens if the reserve ratio requirement is raised?
_ MORE _ money is put in reserves, _ LESS __ money
returns back to the economy. As a result, the overall amount of
money in the economy (loans included) _ decreases _.
This causes the interest rate to increase ,
and the economy to slow down .
Conversely, a lower reserve ratio requirement would
increase
the money supply,
lower
the interest
rates, and boost
the economy.
What happens if the reserve ratio requirement is raised?
_ MORE _ money is put in reserves, _ LESS __ money
returns back to the economy. As a result, the overall amount of
money in the economy (loans included) _ decreases _.
This causes the interest rate to increase ,
and the economy to slow down .
Conversely, a lower reserve ratio requirement would
increase
the money supply,
lower
the interest
rates, and boost
the economy.
A change in the reserve ratio requirement is a very powerful
instrument. That’s why it is used only under extreme
circumstances.
Instrument #2. Discount rate
Banks may borrow money from the Fed at the interest
rate set by the Fed. That rate is called the discount rate.
When the discount rate is raised, the cost of getting
money from the Fed for the bank
__________________.
As a result, the supply of money ___________.
The interest rates in the economy ___________
Economic activity ______________
Instrument #2. Discount rate
Banks may borrow money from the Fed at the interest
rate set by the Fed. That rate is called the discount rate.
When the discount rate is raised, the cost of getting
money from the Fed for the bank
increases.
As a result, the supply of money ___________.
The interest rates in the economy ___________
Economic activity ______________
Instrument #2. Discount rate
Banks may borrow money from the Fed at the interest
rate set by the Fed. That rate is called the discount rate.
When the discount rate is raised, the cost of getting
money from the Fed for the bank
increases.
As a result, the supply of money decreases.
The interest rates in the economy ___________
Economic activity ______________
Instrument #2. Discount rate
Banks may borrow money from the Fed at the interest
rate set by the Fed. That rate is called the discount rate.
When the discount rate is raised, the cost of getting
money from the Fed for the bank
increases.
As a result, the supply of money decreases.
The interest rates in the economy go up.
Economic activity ______________
Instrument #2. Discount rate
Banks may borrow money from the Fed at the interest
rate set by the Fed. That rate is called the discount rate.
When the discount rate is raised, the cost of getting
money from the Fed for the bank
increases.
As a result, the supply of money decreases.
The interest rates in the economy go up.
Economic activity slows down.
Current federal discount rate = 0.75%
A different concept:
Federal funds rate – the rate at which large financial
institutions borrow from and lend to each other their reserve
funds in the most short-term (overnight) transactions. This is
the rate that is announced after Federal Reserve meetings.
Currently, the federal funds rate = 0.25%
….
It is important to understand that the Fed funds rate is
largely determined by market forces (supply and demand
for such loans), so the rate announced by the Fed is just a
target. However, given the amount of Fed reserves is
sufficiently large and sufficiently diversified, the Fed is a
large enough player in the market to be able to maintain the
rate with a fairly high accuracy, and it does so by…
#3. Buying and selling paper assets (usually U.S. Treasury
bills/bonds), also known as “open-market operations”.
The reserves held by the Fed are both in dollar bills and in
other assets, such as Treasury bills.
A Treasury bill is basically a bond issued by the
government. It promises to pay back a certain amount of
money at a certain future date.
A Treasury bill is an asset but it is NOT money!
The Fed can enter the market for financial assets and buy
or sell U.S. Treasury bills.
When the Fed sells Treasury bills, it receives money
and stores it.
Some money gets withdrawn from the economy.
Money supply decreases.
The equilibrium interest rate increases.
When the Fed buys Treasury bills, it pays for them
with dollars.
Money gets injected in the economy, thus money
supply increases.
The equilibrium interest rate decreases .
Other rates we may encounter :
LIBOR, or London InterBank Offered Rate – the rate
at which large London banks borrow unsecured funds
from each other. Used as a reference for a wide variety
of transaction (including those in the U.S.).
Prime rate – the rate of interest at which banks lend to
favored customers, i.e., those with high credibility. Most
importantly, it is a reference rate that serves as an
indicator of a situation in the national money market.
3.25%
As of August 18, 2010, the U.S. prime rate is …
Limitations of monetary policy:
Monetary policy is very effective in slowing down an
economic boom. When firms and households spend
money too fast, a decrease in money supply may limit
their ability to do so.
During a recession, firms and households are reluctant
to spend money. Increasing the money supply and
making money more readily available will not
necessarily have a positive effect on spending.
Thus, other (non-monetary) instruments are sometimes
needed.
Latest events in the financial system
•Imprudent practices in the financial sector and some
decisions made by the Fed;
•Causing a financial crisis and an economic recession;
•The resulting questioning of principles and policies
governing the financial system.
The overhaul plan proposed by Obama/Geithner:
•Giving the Fed more power to oversee the financial
system (supervise, take over, or break up (large)
financial companies);
•Creating a new agency, “Financial Stability Oversight
Council”, that would coordinate policy and help resolve
disputes among regulators
Fiscal policy – the basics
“Fiscal policy” is the short name for decisions that
involve government spending and taxation policy.
The government receives money from taxes.
This money can be spent on various government
programs.
Recall the expression for the Gross Domestic Product,
GDP = C + I + G + (X – M)
An increase in any of the (positive) terms would
stimulate the economy.
Monetary policy attempts to affect C and I, which are
determined by households and firms’ decisions.
If households and firms refuse to increase their
spending even after the Fed has eased its monetary
policy, then the government has to step in and inject
some money in the economy directly (G) in hopes of
getting it going.
How it works:
An increase in government spending increases “aggregate
demand” and therefore stimulates the economy.
A decrease in government spending decreases “aggregate
demand” and slows the economy down.
LESS
A tax increase leaves firms and households with ________
SLOWING DOWN
money they can spend, thus _______________
the economy.
STIMULATES the
Conversely, a decrease in tax rates _______________
economy.
Example: the tax cut by the Bush administration.
Problems/limitations of fiscal policy:
1. Timing – unlike in the case of monetary policy, approval of
any fiscal measure takes substantial amounts of time. This
makes fiscal policy more effective in the long term than in
the short term.
2. The government can spend only what it earns through
taxes, or its budget will not balance.
Sometimes, situation calls for strong expansionary
measures (increasing spending AND cutting taxes
simultaneously), causing a budget deficit.
The government can get the missing amount of money by
• printing money (a BAD decision!),
• borrowing money (borrow today, promise to pay back in
the future) – leads to budget deficits
Why the deficit is a problem:
• Money spent on paying interest on the debt could be
used on some government programs;
• By borrowing money, the government competes with
banks and pushes up the interest rate
(“Crowding- out effect” – replacing investments)
• The country may need higher taxes in the future to meet
the claims, esp. those by foreign creditors
• Higher fiscal debt restricts the government’s ability to
respond to other possible challenges
• In the worst-case scenario, potential borrowers may lose
faith in U.S. government repaying the debt and refuse to
further lend money to it
(a fall in the value of the dollar  inflation)
“government budget deficit” = the annual budget shortfall
Annual deficits add up to make the total amount of
government debt accumulating over the years.
“Public debt” (a.k.a. “the national debt”) = part of the
total (“gross”) debt that is held by the public, i.e.
states, corporations, individuals, and foreign
governments.
The rest is held by the government itself (i.e. the Trust
for Social Security, Federal Disability Insurance, etc.).
Interesting and important facts about the debt:
•As of January 25, 2010, the total government debt is
$14 trillion, or 95.6% of the annual GDP ($14.7 trillion).
•Of this, the public debt accounts for $8.6 trillion, or 60% of the
GDP (ranked 5th among the G8 countries)
•Approximately $4.4 trillion is held by foreign citizens and
institutions.
Biggest foreign lenders – PR China ($1 tril), Japan ($0.8 tril)
For more information, see www.usdebtclock.org
Automatic stabilizers - Instruments that somewhat
dampen the fluctuations in economic activity
•Tax system
•Unemployment benefits
•Welfare programs
•International trade, to some extent