The Federal Reserve and Monetary Policy Money and Banking The Federal Reserve and Monetary Policy

Characteristics of Money 1. Recognizable (Uniform) 2. Durable 3. Portable 4. Divisible 5. Acceptable 6. Value (Stable) Characteristics of Money

Functions of Money 1. Medium of Exchange 2. Standard of Value/Unit of Account (comparing worth) 3. Storehouse of Value (saving) Functions of Money

Categories of money M-0 – coins and currency M-1 – money supply components conforming to money’s role as a medium of exchange; M-0 checks and other demand deposits, traveler’s checks M-2 – money supply components conforming to money’s role as a store of value; M1, savings deposits, time deposits. M-3 – M-2 plus large time deposits Categories of money

Purchasing Power of Money Inflation and Acceptability WHAT BACKS THE MONEY SUPPLY? Value of Money Acceptability Legal Tender Relative Scarcity Money and Prices Purchasing Power of Money Inflation and Acceptability

Stable Value! through... Appropriate Fiscal Policy WHAT BACKS THE MONEY SUPPLY? So, What Backs the Money Supply? Stable Value! through... Appropriate Fiscal Policy Intelligent Management of the Money Supply – Monetary Policy

The Federal Reserve Act of 1913 created the Federal Reserve System to stabilize the money supply and the banking system. The Federal Reserve

1. Supervises and regulates financial institutions 2. Issues coin and currency 3. Provides financial services to banks and the government. 4. Monetary Policy Functions of the Fed

THE FEDERAL RESERVE AND THE BANKING SYSTEM Open Market Committee Board of Governors 12 Federal Reserve Banks Commercial Banks Thrift Institutions (Savings & loan associations, mutual savings banks, credit unions) The Public (Households and businesses)

How does the banking system “create” money?

Fractional Reserve System The Goldsmiths stored gold and gave a receipt. Receipts used as money by public Made loans by issuing receipts Characteristics: Banks create money through lending Banks are subject to “panics” Fractional Reserve System LO1 32-12

The Monetary Multiplier = 1 required reserve ratio R The Monetary Multiplier LO5 32-13

A Single Commercial Bank Excess reserves Actual reserves - required reserves Required reserves Checkable deposits x reserve ratio Example: Checkable deposits $100,000 Reserve ratio 20% A Single Commercial Bank LO2 32-14

Demand for Money Why hold money? Transactions demand, Dt Determined by nominal GDP Independent of the interest rate Asset demand, Da Money as a store of value Varies inversely with the interest rate Total money demand, Dm Demand for Money LO1 33-15

+ = THE DEMAND FOR MONEY Transactions Demand, Dt Asset Demand, Da Total demand for money, Dm Rate of interest, i (percent) Amount of money demanded (billions of dollars) Dt 10 7.5 5 2.5 0 50 100 150 200 250 300 Rate of interest, i (percent) Amount of money demanded (billions of dollars) 10 7.5 5 2.5 Da Rate of interest, i (percent) Amount of money demanded (billions of dollars) 0 50 100 150 200 250 300 10 7.5 5 2.5 Dm 0 50 100 150 200 250 300

+ = THE DEMAND FOR MONEY ADD THE MONEY SUPPLY TO FIND THE Transactions Demand, Dt Asset Demand, Da Total demand for money, Dm ADD THE MONEY SUPPLY TO FIND THE EQUILIBRIUM RATE OF INTEREST Rate of interest, i (percent) Amount of money demanded (billions of dollars) Dt 10 7.5 5 2.5 0 50 100 150 200 250 300 Rate of interest, i (percent) Amount of money demanded (billions of dollars) 10 7.5 5 2.5 Da Rate of interest, i (percent) Amount of money demanded (billions of dollars) 0 50 100 150 200 250 300 10 7.5 5 2.5 Dm Sm 10 7.5 5 2.5 Rate of interest, i (percent) ie 0 50 100 150 200 250 300 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) Equilibrium Interest Rate

Rate of interest, i (percent) Amount of money demanded THE MONEY MARKET Sm 10 7.5 5 2.5 Suppose the money supply is decreased from $200 billion, Sm, to $150 billion Sm1. ie Rate of interest, i (percent) Dm 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

Rate of interest, i (percent) Amount of money demanded THE MONEY MARKET Sm1 Sm 10 7.5 5 2.5 A temporary shortage of money will require the sale of some assets to meet the need. ie Rate of interest, i (percent) Dm 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

Rate of interest, i (percent) Amount of money demanded THE MONEY MARKET Sm 10 7.5 5 2.5 Suppose the money supply is increased from $200 billion, Sm, to $250 billion Sm2. ie Rate of interest, i (percent) Dm 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

Rate of interest, i (percent) Amount of money demanded THE MONEY MARKET Sm Sm2 10 7.5 5 2.5 A temporary surplus of money will require the purchase of some assets to meet the de- sired level of liquidity. ie Rate of interest, i (percent) Dm 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

THE MONEY MARKET ie Sm Sm2 Bonds are assumed as a typical asset with lower prices associated with higher interest rates Sm Sm2 10 7.5 5 2.5 A temporary surplus of money will require the purchase of some assets to meet the de- sired level of liquidity. ie Rate of interest, i (percent) Dm 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars)

Tools of Monetary Policy Reserve Requirement – formula used to compute the amount of a depository institution’s required reserves. Open Market Operations – monetary policy in the form of U.S. treasury bills or bond sales and purchases, or both. Discount Rate – interest rate that the Federal Reserve System charges on loans to the nation’s financial institutions. Tools of Monetary Policy

Tools of Monetary Policy Open market operations are the most important Reserve ratio last changed in 1992 Discount rate was a passive tool Term auction facility is new Guaranteed amount lent by the Fed Anonymous Tools of Monetary Policy LO2 33-24

Expansionary Monetary Policy Lower interest rates Lower the reserve requirement Buy government securities Expansionary Monetary Policy

Problem: Unemployment and Recession CAUSE-EFFECT CHAIN Fed buys bonds, lowers reserve ratio, lowers the discount rate, or increases reserve auctions Excess reserves increase Federal funds rate falls Money supply rises Interest rate falls Investment spending increases Aggregate demand increases Real GDP rises LO4 33-26

Contractionary Monetary Policy Raise interest rates Raise the reserve requirement Sell government securities Contractionary Monetary Policy

Excess reserves decrease Problem: Inflation CAUSE-EFFECT CHAIN Fed sells bonds, increases reserve ratio, increases the discount rate, or decreases reserve auctions Excess reserves decrease Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Aggregate demand decreases Inflation declines LO4 33-28

Causes of the Great Recesssion If Monetary Policy works so well, why did the United States experience the Great Recession? Lack of Government regulation of the banking industry Subprime Mortgage Loans Mortgage-backed securities Effects of Interest Rate increase on ARM’s Causes of the Great Recesssion

Consequences Failures and Near-Failures of Financial Firms (2008) The Treasury Bailout: TARP, Troubled Asset Relief Program, $700 Billion Wall Street Reform and Consumer Protection Act (2010) Consequences