Money, The Federal Reserve, and Monetary Policy 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 T-Bills. 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: 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 banks 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: Sell bonds on the open market - takes cash out of the money supply Raise the discount rate Raise reserve rate

Practice The 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?

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/markets/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