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

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

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

4. 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

5. 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

6. 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

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

8. 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

9. 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)

11. How does the banking system “create” money?

12. 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

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

14. 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

15. 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

16. + = 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
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) 10
7.5 5
2.5 Dm

17. + = 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
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) 10
7.5 5
2.5 Dm Sm 10
7.5 5
2.5
Rate of interest, i (percent) ie
Amount of money
demanded (billions
of dollars)
Equilibrium
Interest Rate

18. 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
Amount of money demanded
(billions of dollars)

19. 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
Amount of money demanded
(billions of dollars)

20. 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
Amount of money demanded
(billions of dollars)

21. 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
Amount of money demanded
(billions of dollars)

22. 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
Amount of money demanded
(billions of dollars)

23. 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

24. 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

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

26. 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

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

28. 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

29. 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

30. 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