Unit 4: Money, Monetary Policy and Economic Stability

Vocabulary Ch 13 6. Measure of Value – same as Unit of Account; agreed to measure for stating prices of goods and services Ch 14 6. Money (Monetary) multiplier Ch 15 5. (Total) Demand for money 6. Liquidity preference function – the relation between the quantity of money demanded and the rate of interest

Lesson 1: Money

I. Types of Money Commodity Money Representative Money Fiat Money Example – tobacco, tea, salt, musket balls Representative Money Backed by a commodity Example – gold and silver certificates Fiat Money Money because the government says it has value Example – U.S. dollars – Checkbook Money Checkable deposits

II. Properties of Money Portability Uniformity Durability Stability in value Acceptability

III. Functions of Money Medium of Exchange Store of Value Eliminates the need for the “double coincidence of wants” Example – if you work at Starbucks you don’t want to be paid in only coffee Store of Value Money can be held for use at a later time Standard of Value (Unit of Account) There is an agreed to measure for stating prices of goods and services Simplifies price comparisons Example – dollar units

IV. Monetary Supply A. The Monetary Supply is defined and measured in 3 ways M1 Items that are primarily used as a medium of exchange. Includes currency and coins (held by the public), demand deposits, other checkable deposits

2. M2 Includes M1 PLUS the amount held in savings and small time deposits, money market deposit accounts (MMDA), noninstitutional money market mutual funds (MMMFs), and other short-term money market assets 3. M3 Includes M2 PLUS financial assets employed by large businesses and financial institutions

V. Growth of the Money Supply Why is it important for the Fed to know the size and rate of growth? - It has a significant impact on the country

B. What are the effects if the money supply grows too slowly? - Increases the likelihood of a recession because interest rates are driven up

C. What are the effects if the money supply grows too rapidly? -It could lead to inflation

VI. Tracking the Money Supply Why is it difficult for the Fed to get an accurate measure of the money supply? -The volume of transactions in the U.S. range into the trillions every day

B. Why must the Fed continue to develop new ways to track the money supply? -Technology innovations and profit maximizing behavior of banks

Practice! Checkable Deposits $850 Currency $200 Large Time Deposits $800 Noncheckable Savings Deposits $302 Small Time Deposits $1,745 M1 = Currency + Checkable Deposits M1 = $200 + $850 M1 = $1050

Practice! Checkable Deposits $850 Currency $200 Large Time Deposits $800 Noncheckable Savings Deposits $302 Small Time Deposits $1,745 M2 = M1 + Noncheckable Savings Deposits + Small Time Deposits M2 = $1050 + $302 + $1,745 M2 = $3097

Practice! Checkable Deposits $850 Currency $200 Large Time Deposits $800 Noncheckable Savings Deposits $302 Small Time Deposits $1,745 M3 = M2 + Large Time Deposits M3 = $3097 + $800 M3 = $3897

Lesson 2: Money Creation and Monetary Policy

I. How is Money Created? Fractional Reserve Banking Required Reserve Ratio – percentage of deposits held as reserves Excess Reserves Deposits not part of required reserves. These may be used for loans or to buy government securities.

I. How is Money Created? B. Money Creation 1. T-Accounts can be used to show how loans turn into new money 2. Money is shown as: Assets – cash on reserve and loans made to citizens Liabilities – checking deposits of citizens

I. How is Money Created? C. The Money Multiplier The amount of new deposits that can be created by a dollar of excess reserves Formula: M = 1 = ___1____ reserve ratio rr

II. Tools of Monetary Policy The Fed has three tools of monetary policy. A. Open Market Operations (OMO) The Fed can buy and sell Treasury bonds from (or to) commercial banks and the public. If the Fed buys bonds: the banks have excess cash reserves The money supply increases The interest rate falls If the Fed sells bonds to banks: the banks would have fewer cash reserves The money supply decreases The interest rate rises

II. Tools of Monetary Policy B. Change the Discount Rate When commercial banks borrow money from the Fed, they pay an interest rate called the Discount Rate Lowering the Discount Rate Increases excess reserves in commercial banks Expands the money supply Raising the Discount Rate Decreases excess reserves in commercial banks Contracts the money supply

II. Tools of Monetary Policy C. Change the Reserve Ratio Lowering the Reserve Ratio: Increases excess reserves in commercial banks Expands the money supply Increasing the Reserve Ratio: Decreases excess reserves in commercial banks Contracts the money supply

Current Event!! Bernanke Sees Good 2013 if U.S. “Fiscal Cliff” Avoided Write a one paragraph summary of the article. Write one paragraph explaining how the article relates to what we have been studying in class this week.

Recap: The Money Multiplier!!! The amount of new deposits that can be created by a dollar of excess reserves Formula: M = 1 = ___1____ reserve ratio rr

Lesson 3: The Money Market and Monetary Policy

I. The Demand for Money People must decide: How much wealth to hold as money? - The opportunity cost of holding money is the forgone interest How much to hold as interest-bearing assets?

I. The Demand for Money B. Other factors Price Level Level of Real GDP -If prices double, people need twice as much money to buy goods Level of Real GDP Real Income -As income rises, the demand for money increases

II. The Supply of Money A. When prices rise: Interest rates rise MD (Monetary Demand) rises

II. The Supply of Money B. When income increases: Interest rates rise MD increases

II. The Supply of Money C. When the money supply increases: Interest rates decrease MD decreases

III. What happens when the Fed increases the money supply? Fed purchases Treasury securities  Bond prices increase to entice households and businesses to sell Treasury securities  Money supply increases and interest rates decrease  Investment increases (and interest-sensitive components of consumption increase)  Aggregate demand increases  Output increases and the price level increase

Study for Ch. 14&15 Vocab Quiz

IV. The Money Market The Demand for Money

IV. The Money Market The Demand for Money

IV. The Money Market The Demand for Money

IV. The Money Market The demand for money is determined by 3 motives: Transactions demand – the demand for money to make purchases of goods and services. Precautionary demand – the demand for money to serve as protection against an unexpected need. 3. Speculative demand – the demand for money because it serves as a store of wealth

IV. The Money Market B. Suppose the Fed increases the money supply by buying Treasury securities What happens to the interest rate? The Interest rate decreases What happens to the quantity of money demanded? The quantity of money demanded increases 3. Explain what happens to loans and interest rates and the Fed increases the money supply. The Fed buys Treasury securities from the public  Demand deposits in banks increase  Banks have more money to make loans  To encourage people to take out the loans, financial institutions lower the interest rate.

IV. The Money Market C. Suppose the demand for money increases. What happens to the interest rate? The Interest rate increases What happens to the quantity of money demanded? The quantity of money remains the same 3. If the Fed wants to maintain a constant interest rate when the demand for money increase, explain what policy the Fed needs to follow and why. It must increase the money supply to meet the increase in the demand for money 4. Why might the Fed want to maintain a constant interest rate? To stabilize the amount of investment in the economy

IV. The Money Market D. Suppose there are two money demand curves and the Fed increases the money supply? What happens to the interest rate? The Interest rate increases What happens to the quantity of money demanded? The quantity of money remains the same 3. If the Fed wants to maintain a constant interest rate when the demand for money increase, explain what policy the Fed needs to follow and why. It must increase the money supply to meet the increase in the demand for money 4. Why might the Fed want to maintain a constant interest rate? To stabilize the amount of investment in the economy

Happy Thursday!

V. Alternative Money Demand Curves A. How would you describe, in economic terms, the difference between the two money demand curves? MD1 is more interest inelastic than MD Interest Rate MS MS1 r r1 MD MD1 M M1

B. Compare what happens to the interest rate with each MD curve. The interest rate declines further with the more inelastic money demand curve (MD1) than with the more elastic money demand curve (MD). Interest Rate MS MS1 r r1 MD MD1 M M1 Money

C. If the federal Reserve is trying to get the economy out of a recession, which money demand curve would it want to represent the economy? Explain. The fed would prefer the more inelastic money demand curve because a given increase in the money supply will lead to a grater decrease in interest rates, which should stimulate the economy. Interest Rate MS MS1 r r1 MD MD1 M M1

The Federal Reserve: Monetary Policy and Macroeconomics: Activity 40 What is monetary policy? From 1998 to 2002, what was the dominant focus of monetary policy and why? Monetary policy is action by the federal Reserve to increase or decrease the money supply to influence the economy. From 1998 to 2001, the focus of monetary policy was to slow the growth of the economy to prevent an increase in inflation. In 2001 and 2002, the focus was to stimulate the economy w/out stimulating inflation. (Much like 2009!)

Explain why the money supply and short- term interest rates are inversely related. When the fed buys Treasury securities from the public, bank reserves increase. To decrease excess reserves and make loans, banks lower the interest rate to entice consumers and businesses to borrow

What are some reasons for lags and imperfections in data used by central banks? Financial institutions report at specified periods, and the reporting time is not necessarily when the central bank can use the data. For short periods of time, the central bank collects data from only a sample of banks, and this leads to a certain amount of error in the data.

5. Real output is determined by the level of capital stock and productivity of workers. Changes in MS affect prices more than real output.

What might cause velocity to change? Some factors that might cause velocity to change are changes in how money is transferred (institutional changes), changes in interest rates and changes in the price level.

If velocity were extremely volatile, why would this complicate the job of making monetary policy? One of the rules of monetary policy is stabilization of the price level. Thus, based on the equation of exchange (MV = PQ), changes in the money supply will yield a given change in PQ if velocity (V) is constant. If velocity is volatile, changes in the money supply may be either too small or too large, leading to inflation.

What role does the money multiplier play in enabling the Fed to conduct monetary policy? The money multiplier times the change in excess reserves yields the change in the money supply. Thus, if the Fed wants to change the money supply by a given amount, the money multiplier indicates by how much the excess reserves need to be changed.

What is the fed funds rate? What happens to the fed funds rate if the fed follows a contractionary (tight money) policy? The interest rate that financial institutions charge other financial institutions for short-term borrowing The federal funds rate increases.

Why do observers pay close attention to the federal funds rate? What happens to the fed funds rate if the Fed follows an expansionary (easy money) policy? Why do observers pay close attention to the federal funds rate? The federal funds rate decreases. It is an early indicator of monetary policy and provides a forecast of the direction for other interest rates and the Fed policy.

HAPPY FRIDAY!!!!

Unit 4 Review

M1 Legal Reserve Requirement Simple deposit expansion multiplier Standard of value Federal Funds rate Impact of buying/selling securities/bonds Calculate required reserves How the Fed combats recession How the Fed reduces inflation Velocity of money (causes of increase) Characteristics of money Vault cash vs. reserve accounts Expansionary policy in the long run and short run Impact of policy on Aggregate Demand/Supply

Review for Tuesday’s Test!!! Make sure you can work the following: If the legal reserve requirement is 15 percent, the value of the simple deposit expansion multiplier is??? Suppose the Federal Reserve buys $400,000 worth of securities from the securities dealers on the open market. If the reserve requirement is 15% and the banks hold no excess reserves, what will happen to the total money supply? An individual deposits $8,000 into a bank. If the multiplier is 10, how much could the (M1) money supply potentially expand by?