Presentation on theme: "Money, The Federal Reserve, and Monetary Policy"— Presentation transcript:
1 Money, The Federal Reserve, and Monetary Policy Money, Money, MoneyMoney, The Federal Reserve, and Monetary Policy
2 Money is… A medium of exchange that sellers will accept in the market. A unit of accounting to place a specific price on productsA store of value that you can set aside for future purchasesA liquid asset that can be easily used in variety of transactions.
3 The Money Supply M1=Currency, Coins, Check Accounts, Travelers Checks M2=“near money” such as savings deposits, CD’s, Money MarketsM3=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)
4 Federal Reserve System Federal Reserve is the Central Bank of the USThe Federal Reserve is independent of the three branches of government7 Board of Governors serve for 14 years, appointed by President12 Federal Reserve Districts
5 Tasks of the Fed Fed supplies the economy with currency Provides a system of check clearingHold reserves of banksActs as the government fiscal agency for governmentSupervises member banksLender of last resortRegulates the money supply
6 PracticeLook at each of the statements and identify if it is monetary or fiscal policyPresident Obama strikes a compromise with Republicans over taxes and spendingBen Bernanke announces increases in bond purchases to expand the money supplyDemocrats and Republicans support a one year cut in the payroll taxThe Fed raises the reserve rate, which slows bank lending
7 Fractional Reserve Banking System Since the 1930’s the Fed requires member banks to hold a fraction of their checking deposits in reserveThis 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 reserveE.g. if a bank receives $100 deposit it must keep $10 in reserve but it can loan $90
8 Reserve RequirementsRequired 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
9 Assets and Liabilities Each bank has liabilities, primarily money owed to depositors in transaction accounts (checking accounts)In addition, banks have assets, primarilyThe reserves and loans they control
10 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.
11 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 T-Bills. They take money out of bank reserves, therefore raising interest rates.
12 Confusing SynonymsGovernment bonds = securities or Treasuries or T BillsFederal Reserve Notes = Fiat Money (not backed by metals)Bond market = open market or the secondary marketExpansionary monetary policy=“loose money”Contractionary monetary policy = “tight money”
13 Money MultiplierThe money that banks loan is multiplied through the systemThe equation for the money multiplier is1/required reserve ratio (e.g. 10% reserve ration means 1/.1 = 10The potential money multiplier is 10However, 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.
15 Expansionary Monetary Policy The Federal Reserve can raise the money supply three ways:Buys bonds on the open market - infuses cash into money supply (most common method)Lower the discount rate - the interest rate that the Fed charges member banksLower reserve rate - (the amount banks must keep and not loan out (least common method)
16 Contractionary Monetary Policy The Federal Reserve can lower the money supply three ways:Sell bonds on the open market - takes cash out of the money supplyRaise the discount rateRaise reserve rate
17 PracticeThe FED sells 50 million dollars of T-Bills (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?
18 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?
19 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 levelsHowever, different economic schools have differing views on the impact of monetary policy.
20 The discount and federal funds rates Discount rate - the interest rate at which the Fed charges member banks to borrow moneyBanks 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 RateIn recent years the FED has changed the Federal Funds Rate more often than the discount rate.
21 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 policyIf the government raises the discount or federal fund rates, then banks borrow less, and have less reserves to lend-->contractionary monetary policy
22 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?
23 BondsA 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 interestLocal 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
24 The Treasury and Treasury Bills The Treasury is part of executive branch of government (not independent like the FED)runs the Mints that make currencycollects Taxes through the IRSBorrows money to fund government through issuing Treasury Bills (T-Bills)Treasury Bills are also called government securities
25 Today’s T-Bill PricesT-Bills - short term debt 1-52 weeksT-notes years maturitiesT- bonds -30 years maturity
26 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 saveThe demand for loanable funds depend upon consumer, business and government demand for credit.
27 Nominal vs. Real Interest rates The nominal interest rate depend upon how much inflation is anticipatedThe rate of inflation is added to the real interest rate to make the nominal interest rate.Therefore: nominal interest rate = real interest rate + inflationorReal interest rate = nominal rate - inflation
28 PracticeWhen 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.
29 The Equation of Exchange Developed by Irving Fischer.M= actual money balance held by publicV = income velocity, or number of times each dollar is spent on goods and servicesP= Price levelQ = Real GDP (total quantity of goods and services)The equation of exchange is MV = PQ
30 Impact of theoryThe 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
31 Keynesianism and Monetary Policy Keynesians believe that monetary policy functions through the single channel of the interest rateThe FED’s expansion of the money supply will lower the interest rate. This lower rate will increase borrowing and spending, and ultimately increase AD.
32 Keynesian continuedHowever, 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.
33 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
34 Classical CritiqueThey 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.
35 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
36 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
37 Monetarism continuedHowever, 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%)
38 The Phillips CurveA British economist A. W. Phillips showed the negative relationship between inflation and unemploymentFor 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.
39 Phillips Curve (2)Increases in AD lead to higher price levels and lower levels of unemployment in the short runDecreases in AD lead to lower price levels and higher levels of unemployment in the short runThe Long Run Phillips Curve is vertical, indicating that the economy gravitates back to a line of the natural rate of unemployment
40 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 LRASTherefore, if the rate of unemployment is above the natural rate, the economy is in recessionIf the rate of unemployment is below the natural rate, the economy is in expansion.
41 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 insuranceTherefore: the natural rate of unemployment includes both frictional and wait unemployment (e.g. 4-6%)
42 The Long Run Phillips Curve The long run Phillips curve is vertical at the natural rate of unemployment.
43 Rate relationshipsDiscount 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.
44 When do you use each?The money market graph includes M1 and M2 and is controlled by FEDThe loanable funds market only includes money used for making loans by commercial banks and lending institutionsWhen 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.
45 The impact on Net Exports Monetary PolicyFiscal Policy