money and monetary policy 1 functions of money medium of exchange buying goods and services unit of...

Money and

Monetary Policy

1

FUNCTIONS OF MONEY

• Medium of ExchangeBuying goods and services

•Unit of AccountPrices are quoted in dollars and cents

• Store of ValueMoney 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 M1 M2 M3

$1101

2000 Data(billions of dollars)

MONEY SUPPLY

M1 M2 M3

$1101


$4827

MONEY SUPPLYCurrency (coins & paper money)


equals M1

plus Savings deposits,

including MMDA’s plus Small time deposits plus Money market mutual fund (MMMF) balances

equals M2

M1 M2 M3

$1101


$4827

$6853

MONEY SUPPLYCurrency (coins & paper money)


equals M1



equals M2 plus Large time deposits

equals M3

Currency (coins & paper money)


equals M1



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 stableValue 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 Supply the economy with paper money and coins.money and coins.

Hold bank reserves.Hold bank reserves. Provide check-clearing servicesProvide check-clearing services Supervise member banksSupervise member banks Serve as lender of last resort.Serve as lender of last resort. Control the money supplyControl the money supply

““U.S. Mint”U.S. Mint”Bureau of Engraving and PrintingBureau 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:EXAMPLE: Pete pays Sue for a used car. He gives her a Pete pays Sue for a used car. He gives her a

check for $2,000. check for $2,000. Sue deposits the check in her bank and is Sue deposits the check in her bank and is

credited with $2,000 in her account.credited with $2,000 in her account. Sue’s bank sends the check to FRB who Sue’s bank sends the check to FRB who

increases the bank’s reserve account by increases the bank’s reserve account by $2,000.$2,000.

FRB decreases Pete’s bank’s reserve by FRB decreases Pete’s bank’s reserve by $2,000$2,000

FRB notifies Pete’s bank to reduce Pete’s FRB notifies Pete’s bank to reduce Pete’s account by $2,000. 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 PolicyMonetary 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 MoneyAt 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 demanded1. What happens to the quantity demanded of money when interest rates increase?

Quantity demanded falls because individuals would prefer to have interest earning assets instead2. 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

DMoney

Inverse relationship between interest rates and the quantity of money demanded

29

The Demand for Money


20%

5%

2%

0

DMoney

What happens if price level increase?

30

The Demand for Money

DMoney1

Money Demand Shifters1. Changes in price level2. Changes in income/ Changes in Real

GDP3. Changes in taxation that affects

investment4. Changes in banking technology (ATMs)5. Changes in banking institutions (interest

on checking)

Nominal Interest Rate

(ir)

200

DMoney

SMoneyThe 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%


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 34

200

DM

SM

10%

5%

2%


Interest Rate (ir)

How does this affect AD?

250

SM1

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 35

200

DM

SM

10%

5%

2%


Interest Rate (ir)

How does this affect AD?

150

SM1

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…

37

200

DM

SM

10%

5%

2%

QuantityM

Interest Rate (i)

250

SM1

DI

Quantity of Investment

10%

5%

2%

Interest Rate (i)

AD/AS

Qe

AD

AS

GDPR

PL

AD1

Q1

PLe

PL1

1. Interest Rates Decreases2. Investment Increases 3. AD, GDP and PL Increases

Investment DemandS&D of Money

The FED decreases the money supply to slow down the economy…

38

200

DM

SM

10%

5%

2%

QuantityM

Interest Rate (i)

175

SM1

DI

Quantity of Investment

10%

5%

2%

Interest Rate (i)

AD/AS

Qe

AD

AS

GDPR

PL

AD1

Q1

PLe

PL11. Interest Rates increase2. Investment decreases3. 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 SupplyThe FED adjusting the money supply by

changing any one of the following:1. Setting Reserve Requirements (Ratios)2. Lending Money to Banks & Thrifts

•Discount Rate3. Open Market Operations

•Buying and selling BondsThe FED is now chaired by Janet Yellen.

42

#1. The Reserve RequirementIf 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 holdThe 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

MoneyMultiplier 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 bankBob’s bank must hold $90. It loans out $810 to JillJill deposits $810 in her bankSO FAR, the initial deposit of $1000 caused the CREATION of another $1710 (Bob’s $900 + Jill’s $810)

Using Reserve Requirement1. If there is a recession, what should the FED do to

the reserve requirement? (Explain the steps.)

45

2. If there is inflation, what should the FED do to the reserve requirement? (Explain the steps.)

Decrease the Reserve Ratio1. Banks hold less money and have more excess reserves2. Banks create more money by loaning out excess3. Money supply increases, interest rates fall, AD goes up

Increase the Reserve Ratio1. Banks hold more money and have less excess reserves2. Banks create less money3. 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 policyTo 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 supplySell-SMALL- Selling bonds decreases money supply

BUY

SELL

47

PracticeDon’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 targetThe 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

Target Federal Funds Rate

0

1

2

3

4

5

6

January

Febru

ary

Marc

h

April

May

June

July

August

Septe

mber

Octo

ber

Novem

ber

Decem

ber

January

Febru

ary

Marc

h

April

May

June

July

August

Septe

mber

Octo

ber

Novem

ber

Decem

ber

January

Febru

ary

Marc

h

April

May

June

July

August

Septe

mber

Octo

ber

Novem

ber

Decem

ber

2007 2008 2009

Perc

en

t

.25%

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

52

2007B Practice FRQ

53

2007B Practice FRQ

54

2009B Practice FRQ

55

money and monetary policy 1 functions of money medium of exchange buying goods and services unit of...

Documents

debt money

demand money

large time deposits

total quantity of money

small time deposits

cents store of value

m2 slide

acceptability slide