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Money, Money, Money
Money, The Federal Reserve, and
Monetary Policy
Money is…
• A medium of exchange that sellers will
accept in the market.
• A unit of accounting to place a specific
price on products
• A store of value that you can set aside
for future purchases
• A liquid asset that can be easily used in
variety of transactions.
The Money Supply
• M1=Currency, Coins, Check Accounts,
Travelers Checks
• M2=“near money” such as savings deposits,
CD’s, Money Markets
• M3=CD’s over 100,000 and Euro dollars held
by Americans.
• (Credit Cards are not considered money but
loans from banks or financial institutions that
issue the cards)
Federal Reserve System
• Federal Reserve is the Central Bank of the
US
• The Federal Reserve is independent of the
three branches of government
• 7 Board of Governors serve for 14 years,
appointed by President
• 12 Federal Reserve Districts
Tasks of the Fed
•
•
•
•
Fed supplies the economy with currency
Provides a system of check clearing
Hold reserves of banks
Acts as the government fiscal agency for
government
• Supervises member banks
• Lender of last resort
• Regulates the money supply
Practice
• Look at each of the statements and identify if
it is monetary or fiscal policy
• President Obama strikes a compromise with
Republicans over taxes and spending
• Ben Bernanke announces increases in bond
purchases to expand the money supply
• Democrats and Republicans support a one
year cut in the payroll tax
• The Fed raises the reserve rate, which slows
bank lending
Fractional Reserve Banking
System
• Since the 1930’s the Fed requires member
banks to hold a fraction of their checking
deposits in reserve
• This is so there is always cash available to
customers and the bank remains solvent.
• Currently the Fed requires 10% of all deposits
to be held in reserve
• E.g. if a bank receives $100 deposit it must
keep $10 in reserve but it can loan $90
Reserve Requirements
• Required reserves - this is the ratio
established by the Fed (currently 10%)
• Excess reserves are all monies that
meet the legal reserve requirements,
over and above the required reserves.
• Excess reserves may be loaned by
bank
Assets and Liabilities
• Each bank has liabilities, primarily
money owed to depositors in
transaction accounts (checking
accounts)
• In addition, banks have assets, primarily
The reserves and loans they control
Expanding or Contracting
the Supply of Money
• Money expansion in one bank due to a new
deposit, is offset with money destruction due
to a lowering of reserves in another bank.
Therefore, this does not change the overall
money supply.
• The FED however, can increase or decrease
the total money supply through open market
operations.
Open Market Operations
• The FED can increase or decrease the
money supply quickly through the buying and
selling T-Bills (Treasury Bills) with its FED
Open Market Committee (FOMC)
• If the Fed buys bonds from T-Bill investors ,
they receive FED money. T-Bill investors
deposit funds in banks, increasing bank
reserves, therefore lowering interest rates.
• If the Fed sells bonds, investors pay fed for TBills. They take money out of bank reserves,
therefore raising interest rates.
Confusing Synonyms
• Government bonds = securities or Treasuries
or T Bills
• Federal Reserve Notes = Fiat Money (not
backed by metals)
• Bond market = open market or the secondary
market
• Expansionary monetary policy=“loose
money”
• Contractionary monetary policy = “tight
money”
Money Multiplier
• The money that banks loan is multiplied
through the system
• The equation for the money multiplier is
• 1/required reserve ratio (e.g. 10% reserve
ration means 1/.1 = 10
• The potential money multiplier is 10
• However, in the real economy there are
leakages, which include the currency people
hold in their wallet and the decision by banks
to maintain excess reserves that aren’t
loaned.
Money Supply Graph
Expansionary
Monetary Policy
The Federal Reserve can raise the money
supply three ways:
1. Buys bonds on the open market - infuses
cash into money supply (most common
method)
2. Lower the discount rate - the interest rate
that the Fed charges member banks
3. Lower reserve rate - (the amount banks
must keep and not loan out (least common
method)
Contractionary
Monetary Policy
•
The Federal Reserve can lower the
money supply three ways:
1. Sell bonds on the open market - takes
cash out of the money supply
2. Raise the discount rate
3. Raise reserve rate
Practice
• The FED sells 50 million dollars of TBills (bonds) with a reserve Rate of
10%. What is the total impact of this
sale on the economy?
• The economy is experiencing high
unemployment rates. What should the
FED do with the Federal Funds Rate?
More practice
• The Federal Reserve is expanding the
money supply.
• Draw a correctly labeled money supply
graph. Show the impact of the new MS
curve on the interest rate on your graph.
• Explain what impact money supply
expansion has on Real GDP and price
level. Why is this?
Impact of Monetary Policy
• According to Macro theory loose money,
during a contractionary gap will increase
aggregate demand, thereby increasing GDP
and price levels.
• Conversely tight money policy administered
by the FED during an expansionary gap will
decrease AD, thereby decreasing GDP and
price levels
• However, different economic schools have
differing views on the impact of monetary
policy.
The discount and federal
funds rates
• Discount rate - the interest rate at which the
Fed charges member banks to borrow money
• Banks may also borrow each other’s
reserves for short term purposes. The interest
rate at which banks borrow each other’s
reserves is called the Federal Funds Rate
• In recent years the FED has changed the
Federal Funds Rate more often than the
discount rate.
Discount and FED funds
rates continued
• If the government lowers the discount or
federal funds rates, then banks borrow
more and have more reserves to lend
--> expansionary monetary policy
• If the government raises the discount or
federal fund rates, then banks borrow
less, and have less reserves to lend
-->contractionary monetary policy
Practice
• If the reserve rate is 5%, what is the money
multiplier?
• Assume the FED buys 4 million dollars of
bonds, with a reserve rate of 10%. How much
will total reserves change in banks? What will
be the total dollar impact on the economy?
• Assume the FED decreases the money
supply. Draw a Money Supply graph, and
show the impact of the interest rate. How will
this impact GDP and price level?
Bonds
• A bond is a piece of paper which represents a private
or government debt. (e.g. IOU with interest)
• Private companies can sell bonds to raise money for
their company. They promise to pay back the
principle, with interest
• Local governments or State governments may issue
bonds to build a school, a rail system etc.
• The Federal government’s bonds are called
Treasuries (or T-Bills) because they are issued by the
Treasury
The Treasury and Treasury
Bills
• The Treasury is part of executive branch of
government (not independent like the FED)
• runs the Mints that make currency
• collects Taxes through the IRS
• Borrows money to fund government through
issuing Treasury Bills (T-Bills)
• Treasury Bills are also called government
securities
Today’s T-Bill Prices
• http://finance.sfgate.com/hearst.sfgate/market
s/treasury?
• T-Bills - short term debt 1-52 weeks
• T-notes - 2-10 years maturities
• T- bonds -30 years maturity
Loanable Funds vs. Money
Supply Graph
• Total increases and decreases in the Money
Supply are shown with a vertical MS curve
and a nominal interest rate.
• Increases or decreases just in loanable funds
in banks are shown with an upward sloping
diagonal supply curve and a real interest rate.
• The supply of loanable funds depends upon
how much people save
• The demand for loanable funds depend upon
consumer, business and government demand
for credit.
Nominal vs. Real Interest
rates
• The nominal interest rate depend upon how
much inflation is anticipated
• The rate of inflation is added to the real
interest rate to make the nominal interest
rate.
• Therefore: nominal interest rate = real interest
rate + inflation
• or
• Real interest rate = nominal rate - inflation
Practice
• When the FOMC of the FED sells
bonds, what happens to the loanable
funds and the real interest rate?
• Make a loanable funds graph and show
the results above.
The Equation of Exchange
• Developed by Irving Fischer.
• M= actual money balance held by public
• V = income velocity, or number of times each
dollar is spent on goods and services
• P= Price level
• Q = Real GDP (total quantity of goods and
services)
The equation of exchange is MV = PQ
Impact of theory
• The basic idea is that if you assume that
the velocity of money and the real GDP
are both stable, then the changes in the
money supply must lead to price
changes (e.g. increases or decreases)
• E.g. increases on money supply raises
the price level and decreases in money
supply decreases price level
Keynesianism and
Monetary Policy
• Keynesians believe that monetary policy
functions through the single channel of the
interest rate
• The FED’s expansion of the money supply
will lower the interest rate. This lower rate
will increase borrowing and spending, and
ultimately increase AD.
Keynesian continued
• However, Keynesians argue that the
increase in AD will be small during a
recession and will not result in large
increases in borrowing and spending.
• Therefore, Keynesians believe that fiscal
policy is more a MORE powerful stimulus
than monetary policy.
Classical Critique
Monetary Policy
• Classical economists believe in the equation
of exchange (MV = QP)
• Since they believe that Velocity and Real
GDP is constant, an increase in money
supply will increase price levels, thus
creating inflation
Classical Critique
• They also believe in the rational expectations
argument that if labor and businesses believe that
there will be future inflation the SRAS will
decrease.
• Therefore, Classical economists believe that a
change in the money supply will NOT increase
Real GDP, and monetary policy should NOT be
used.
Rational Expectations
A second criticism of monetary theory is called the
rational expectations theory.
According to the “rational expectations” theory workers
and businesses will adjust their wages and prices up
if they believe that expansionary monetary policy will
lead to inflation and increased price levels.
Therefore, higher prices of inputs for business will
decrease the short run aggregate supply curve, thus
offsetting the expansionary effect of monetary policy
Monetarism and
Monetary Policy
• Monetarists do not think that the Velocity of
Money or the Real GDP is constant. Both of these
have grown over time.
• The FED can lower the interest rates by increasing
the money supply and impact a variety of
economic indicators.
• Therefore FED policy will increase AD and
increase price levels and real GDP
Monetarism continued
• However, the Monetarists are highly critical
of the FED. They propose the FED not
engage in active Monetary policy, but
simply increase the money supply at a
smooth rate of the growth of GDP (e.g.
3%)
The Phillips Curve
• A British economist A. W. Phillips showed the
negative relationship between inflation and
unemployment
• For example if the rates of inflation increase,
we would expect the unemployment rate to
fall. The opposite is also true.
• This is shown on the “Phillips” curve.
• Policy makers use this curve to demonstrate
that they might choose between lower
unemployment rates or lower inflation.
Phillips Curve (2)
• Increases in AD lead to higher price levels
and lower levels of unemployment in the
short run
• Decreases in AD lead to lower price levels
and higher levels of unemployment in the
short run
• The Long Run Phillips Curve is vertical,
indicating that the economy gravitates back to
a line of the natural rate of unemployment
Natural Unemployment (1)
• Economist argue that there is a tendency of
the economy to gravitate toward the natural
rate of unemployment.
• The natural rate is when the economy is
operating on the LRAS
• Therefore, if the rate of unemployment is
above the natural rate, the economy is in
recession
• If the rate of unemployment is below the
natural rate, the economy is in expansion.
Natural Rate of
Unemployment (2)
• economists include wait unemployment to
determine the natural rate of unemployment.
• Wait unemployment include the variety of
factors that keep the labor market from
operating in a perfectly competitive market
including: union activities, government
licensing of occupations, minimum wages,
and unemployment insurance
• Therefore: the natural rate of unemployment
includes both frictional and wait
unemployment (e.g. 4-6%)
The Long Run
Phillips Curve
• The long run Phillips curve is vertical at
the natural rate of unemployment.
Rate relationships
• Discount rate set by Fed is most
important rate (currently 4.75%)
• Prime rate usually 3 points higher than
discount rate (7.75%)
• Federal Funds rate is currently 4.25%,
a little lower than the discount rate.
When do you use each?
• The money market graph includes M1 and
M2 and is controlled by FED
• The loanable funds market only includes
money used for making loans by commercial
banks and lending institutions
When you have a question regarding the loans
made by banks, use loanable funds graph.
When you have a question regarding the FED’s
overall control of the money supply use the
money market graph.
The impact on Net Exports
• Monetary Policy
• Fiscal Policy