Money and Monetary Policy

1. Money and Monetary Policy

2. 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.

3. 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

4. AN OVERVIEW OF MONEY A Unit of Account 3) unit of account A standard unit that provides a consistent way of quoting prices.

5. 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

6. 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

7. 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)

8. 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

9. 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

10. 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***

11. FEDERAL RESERVE BANK

12. 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

13. 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.

14. 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.

15. 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

16. 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.

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

18. DEMAND FOR MONEY

19. 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)

21. 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.

22. 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

23. 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

24. VIDEO – Federal Reserve

25. Monetarists

26. 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

27. Money Demand Unit 4 : Macroeconomics National Council on Economic Education

28. Factors Affecting Money Demand Unit 4 : Macroeconomics National Council on Economic Education

29. The Money Market Unit 4 : Macroeconomics National Council on Economic Education

30. The Money Market, Investmentand Aggregate Demand Unit 4 : Macroeconomics National Council on Economic Education

31. 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)

32. WORKBOOK PG. 205…COMPLETE AS A CLASS

33. Tools of Monetary Policy

34. 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

35. 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

36. 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

37. MONEY CREATION

38. 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

39. 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

40. HOW THE FEDERAL RESERVE CONTROLSTHE 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.

41. HOW THE FEDERAL RESERVE CONTROLSTHE 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.

42. HOW THE FEDERAL RESERVE CONTROLSTHE 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.

43. 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

44. 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)

45. Federal Funds Rate Federal Funds Rate (%) Supply of federal funds Demand for federal funds Quantity of Federal Funds

46. HOW THE FEDERAL RESERVE CONTROLSTHE 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.

47. 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)

48. HOW THE FEDERAL RESERVE CONTROLSTHE 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 quasi-independent agency authorized by Congress to buy and sell outstanding (preexisting) U.S. government securities on the open market.

49. 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

50. 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