Download Money and Monetary Policy

Money and Monetary Policy
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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AN OVERVIEW OF MONEY
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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AN OVERVIEW OF MONEY
A Unit of Account
3) unit of account A standard unit
that provides a consistent way of
quoting prices.
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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
AN OVERVIEW OF MONEY
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
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Characteristics of Money
1) Portability
2) Uniformity
3) Acceptability
4) Durability
5) Stability in Value
6) 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)
AN OVERVIEW OF MONEY (workbook pg. 187)
MEASURING THE SUPPLY OF MONEY IN THE UNITED
STATES
M1: Transactions Money
M1, 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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AN OVERVIEW OF MONEY
M2: Broad Money
M2, or broad money
•M2 less liquid
•Includes items used as a STORE OF VALUE
M2 ≡ M1 + savings accounts + money market accounts +
other short-term money market assets
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AN OVERVIEW OF MONEY
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***
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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
HOW BANKS CREATE MONEY
THE MODERN BANKING SYSTEM
A Brief Review of Accounting (see handout)
Assets − Liabilities ≡ Net Worth,
or
Assets ≡ Liabilities + Net Worth
Federal Reserve Bank (the Fed) The central
bank of the United States.
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HOW BANKS CREATE MONEY
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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HOW BANKS CREATE MONEY
THE CREATION OF MONEY
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).
excess reserves The difference between a
bank’s actual reserves and its required
reserves.
excess reserves ≡ actual reserves − required reserves
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HOW BANKS CREATE MONEY
THE MONEY MULTIPLIER
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.
1
money multiplier 
required reserve ratio
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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.
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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
Money Demand
Unit 4 : Macroeconomics
National Council on Economic
Education
Factors Affecting Money Demand
Unit 4 : Macroeconomics
National Council on Economic
Education
The Money Market
Unit 4 : Macroeconomics
National Council on Economic
Education
The Money Market, Investment
and Aggregate Demand
Unit 4 : Macroeconomics
National Council on Economic
Education
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
HOW THE FEDERAL RESERVE CONTROLS
THE 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 CONTROLS
THE MONEY SUPPLY
THE 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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HOW THE FEDERAL RESERVE CONTROLS
THE MONEY SUPPLY
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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HOW THE FEDERAL RESERVE CONTROLS
THE MONEY SUPPLY
The Fed can influence bank borrowing, and thus
the money supply, through the discount
rate:
The higher the discount rate, the higher the cost of borrowing,
and the less borrowing banks will want to do.
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HOW THE FEDERAL RESERVE CONTROLS
THE 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
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• 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 Rate
Federal
Funds
Rate (%)
Supply of federal funds
Demand for federal funds
Quantity of Federal Funds
HOW THE FEDERAL RESERVE CONTROLS
THE MONEY SUPPLY
We can sum up the effect of these open
market operations this way:
■
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.
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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)
HOW THE FEDERAL RESERVE CONTROLS
THE MONEY SUPPLY
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 quasiindependent agency authorized by
Congress to buy and sell outstanding
(preexisting) U.S. government securities on the
open market.
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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)
Interest
rate
supply of funds
demand for funds
Quantity of Loanable Funds
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