Money and Monetary Policy 1

FUNCTIONS OF MONEY Medium of Exchange Buying goods and services Unit of Account Prices are quoted in dollars and cents Store of Value Money allows us to transfer purchasing power from present to future. It is the most liquid (spendable) of all assets, a convenient way to store wealth.

MONEY SUPPLY is the total quantity of money in the economy at any given time.

MONEY SUPPLY Currency Token Money Federal Reserve Notes Intrinsic Value-The market value of the constituent metal within a coin Checkable Deposits Commercial Banks Thrift Institutions Definition…

MONEY SUPPLY = Plus... Near-monies * can be converted to currency (ex C. D.) Savings Deposits Money Market Deposit Accounts (MMDAs) Interest bearing account through which banks and thrifts pool individual deposits to buy interest bearing short term securities Smaller Time Deposits * smaller time deposits become available at their maturity * ex: mutual funds( higher interest than MMDA’s) Money Market Mutual Funds (MMMFs) *use combined funds of individual share- holders to buy interest bearing short term credit instruments like CD’s and government securities

MONEY SUPPLY = Plus... Large Time Deposits deposits of 100,000 dollars or more Usually owned by business as CD’s

Currency (coins & paper money) plus Checkable deposits equals M1 M1M2M3 $ Data (billions of dollars) MONEY SUPPLY

M1M2M3 $ Data (billions of dollars) $4827 MONEY SUPPLY Currency (coins & paper money) plus Checkable deposits equals M1 plus Savings deposits, including MMDA’s plus Small time deposits plus Money market mutual fund (MMMF) balances equals M2

M1M2M3 $ Data (billions of dollars) $4827 $6853 MONEY SUPPLY Currency (coins & paper money) plus Checkable deposits equals M1 plus Savings deposits, including MMDA’s plus Small time deposits plus Money market mutual fund (MMMF) balances equals M2 plus Large time deposits equals M3 Currency (coins & paper money) plus Checkable deposits equals M1 plus Savings deposits, including MMDA’s plus Small time deposits plus Money market mutual fund (MMMF) balances equals M2

WHAT ABOUT CREDIT CARDS? *This is a way of obtaining a short term loan - thereby reducing the cash and checkable deposits you must keep available

WHAT BACKS THE MONEY SUPPLY? Money as Debt *Debt – Money is a debt of the FED, checkable deposits are debts of the banks it is purely backed by the governments ability to keep the value of money stable Value of Money Acceptability Legal Tender-must be accepted as legal tender Relative Scarcity- value depends on demand Money and Prices Value of the Dollar- inverse with price level D = 1/Price Level (in hundredths) Inflation and Acceptability

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)

 Established in 1913 by Congress

 PART 1  The Twelve Federal Reserve Banks  Each being equal  Each has a President

 PART 2: The Board of Governors, the governing body  7 members (14 year alternating terms), The Fed Chairman is one of the BOG, appointed by the President – Janet Yellen(appointed by the President of the US, confirmed by the Senate)

 Part 3: Federal Open Market Committee (FOMC) – day to day decisions  12 members (4 rotating District Fed Presidents, the New York Fed President, and the BOG)

 Supply the economy with paper money and coins.  Hold bank reserves.  Provide check-clearing services  Supervise member banks  Serve as lender of last resort.  Control the money supply

“U.S. Mint” Bureau of Engraving and Printing

reserves at the Fed + vault cash =total reserves

 Facilitates check-cashing between commercial banks.  for example, Wells-Fargo and Bank of America

 EXAMPLE:  Pete pays Sue for a used car. He gives her a check for $2,000.  Sue deposits the check in her bank and is credited with $2,000 in her account.  Sue’s bank sends the check to FRB who increases the bank’s reserve account by $2,000.  FRB decreases Pete’s bank’s reserve by $2,000  FRB notifies Pete’s bank to reduce Pete’s account by $2,000.

 Fed may “audit” a bank  check that the loans it made are good  be sure it has followed banking rules  verify the accuracy of its accounting.  Fed can lend funds to struggling banks.  Glass-Steagall Act (1933) establishes FDIC

 Tools for changing the money supply  Reserve Requirement  Discount Rate  Open Market Operations Why is changing the money supply important? TO CONTROL INFLATION and/or UNEMPLOYMENT Monetary Policy

The Money Market (Supply and Demand for Money) 26

Interest Rates are important Way to protect our money from the effects of inflation Opportunity cost for holding money (keeping money in our wallets) is the interest your money would have earned if you put it in the bank. Interest rates that banks pay you for your deposits are related to the interest rates that banks charge when they loan money out. When we look at the relationship between the demand for money and interest rate we are looking at short- term rates 27

The Demand for Money At any given time, people demand a certain amount of liquid assets (money) for everyday purchases The Demand for money shows an inverse relationship between nominal interest rates and the quantity of money demanded 1. What happens to the quantity demanded of money when interest rates increase? Quantity demanded falls because individuals would prefer to have interest earning assets instead 2. What happens to the quantity demanded when interest rates decrease? Quantity demanded increases. There is no incentive to convert cash into interest earning assets 28

Nominal Interest Rate (ir) Quantity of Money (billions of dollars) 20% 5% 2% 0 D Money Inverse relationship between interest rates and the quantity of money demanded 29 The Demand for Money

Quantity of Money (billions of dollars) 20% 5% 2% 0 D Money What happens if price level increase? 30 The Demand for Money D Money1 Money Demand Shifters 1.Changes in price level 2.Changes in income/ Changes in Real GDP 3.Changes in taxation that affects investment 4.Changes in banking technology (ATMs) 5.Changes in banking institutions (interest on checking) Nominal Interest Rate (ir)

200 D Money S Money The FED is a nonpartisan government office that sets and adjusts the money supply to adjust the economy This is called Monetary Policy. The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED) 31 The Supply for Money 20% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir)

Supply and Demand is important The equilibrium interest rate is determined by the supply and demand for money 32

Monetary Policy 33 When the FED adjusts the money supply to achieve the macroeconomic goals

If the FED increases the money supply, a temporary surplus of money will occur at 5% interest. The surplus will cause the interest rate to fall to 2% Increasing the Money Supply Increase money supply Decreases interest rate Increases investment Increases AD DMDM SMSM 10% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir) How does this affect AD? 250 S M1

If the FED decreases the money supply, a temporary shortage of money will occur at 5% interest. The shortage will cause the interest rate to rise to 10% Decreasing the Money Supply Decrease money supply Increase interest rate Decrease investment Decrease AD DMDM SMSM 10% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir) How does this affect AD? 150 S M1

Showing the Effects of Monetary Policy Graphically 36 Three Related Graphs: Money Market Investment Demand AD/AS

Investment DemandS&D of Money The FED increases the money supply to stimulate the economy… DMDM SMSM 10% 5% 2% Quantity M Interest Rate (i) 250 S M1 DIDI Quantity of Investment 10% 5% 2% Interest Rate (i) AD/AS QeQe AD AS GDP R PL AD 1 Q1Q1 PL e PL 1 1.Interest Rates Decreases 2.Investment Increases 3.AD, GDP and PL Increases

Investment DemandS&D of Money The FED decreases the money supply to slow down the economy… DMDM SMSM 10% 5% 2% Quantity M Interest Rate (i) 175 S M1 DIDI Quantity of Investment 10% 5% 2% Interest Rate (i) AD/AS QeQe AD AS GDP R PL AD 1 Q1Q1 PL e PL 1 1.Interest Rates increase 2.Investment decreases 3.AD, GDP and PL decrease

39 The role of the Fed is to “take away the punch bowl just as the party gets going”

How the Government Stabilizes the Economy 40

How the FED Stabilizes the Economy 41 These are the three Shifters of Money Supply

3 Shifters of Money Supply The FED adjusting the money supply by changing any one of the following: 1. Setting Reserve Requirements (Ratios) 2. Lending Money to Banks & Thrifts Discount Rate 3. Open Market Operations Buying and selling Bonds The FED is now chaired by Janet Yellen. 42

#1. The Reserve Requirement If you have a bank account, where is your money? Only a small percent of your money is in the safe. The rest of your money has been loaned out. This is called “Fractional Reserve Banking” The FED sets the amount that banks must hold The reserve requirement (reserve ratio) is the percent of deposits that banks must hold in reserve (the percent they can NOT loan out) When the FED increases the money supply it increases the amount of money held in bank deposits. As banks keeps some of the money in reserve and loans out their excess reserves The loan eventually becomes deposits for another bank that will loan out their excess reserves. 43

Money Multiplier Reserve Requirement (ratio) 1 = The Money Multiplier Example: If the reserve ratio is.20 and the money supply increases 2 Billion dollars. How much the money supply increase? 44 Example: Assume the reserve ratio in the US is 10% You deposit $1000 in the bank The bank must hold $100 (required reserves) The bank lends $900 out to Bob (excess reserves) Bob deposits the $900 in his bank Bob’s bank must hold $90. It loans out $810 to Jill Jill deposits $810 in her bank SO FAR, the initial deposit of $1000 caused the CREATION of another $1710 (Bob’s $900 + Jill’s $810)

Using Reserve Requirement 1. If there is a recession, what should the FED do to the reserve requirement? (Explain the steps.) If there is inflation, what should the FED do to the reserve requirement? (Explain the steps.) Decrease the Reserve Ratio 1. Banks hold less money and have more excess reserves 2. Banks create more money by loaning out excess 3. Money supply increases, interest rates fall, AD goes up Increase the Reserve Ratio 1. Banks hold more money and have less excess reserves 2. Banks create less money 3. Money supply decreases, interest rates up, AD down

#2. The Discount Rate The Discount Rate is the interest rate that the FED charges commercial banks. Example: If Banks of America needs $10 million, they borrow it from the U.S. Treasury (which the FED controls) but they must pay it bank with 3% interest. To increase the Money supply, the FED should _________ the Discount Rate (Easy Money Policy). To decrease the Money supply, the FED should _________ the Discount Rate (Tight Money Policy). DECREASE INCREASE 46

#3. Open Market Operations Open Market Operations is when the FED buys or sells government bonds (securities). This is the most important and widely used monetary policy To increase the Money supply, the FED should _________ government securities. To decrease the Money supply, the FED should _________ government securities. How are you going to remember? Buy-BIG- Buying bonds increases money supply Sell-SMALL- Selling bonds decreases money supply BUY SELL 47

Practice Don’t forget the Monetary Multiplier!!!! 1.If the reserve requirement is.5 and the FED sells $10 million of bonds, what will happen to the money supply? 2.If the reserve requirement is.1 and the FED buys $10 million bonds, what will happen to the money supply? 3.If the FED decreases the reserve requirement from.50 to.20 what will happen to the money multiplier? 48

Federal Funds Rate 49 The federal funds rate is the interest rate that banks charge one another for one-day loans of reserves. The FED can’t simply tell banks what interest rate to use. Banks decide on their own. The FED influences them by setting a target rate and using open market operation to hit the target The federal funds rate fluctuates due to market conditions but it is heavily influenced by monetary policy (buying and selling of bonds)

Federal Funds Rate 50.25%

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2007B Practice FRQ (Do a. and b. only) 52

2007B Practice FRQ 53

2007B Practice FRQ 54

2009B Practice FRQ 55

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