Money, Banking, and the Federal Reserve

Money

n Anything widely accepted for purposes of exchange and to repay debts.

n Functions:

n medium of exchange

n unit of account

n store of value

What Gives Money Value?

n Acceptability

n Purchasing power

Money Replaced Barter

n Barter – exchange one good for another

n requires finding someone who wants what you have and has what you want

n “the double coincidence of wants”

n Money – exchange your work for money; then exchange your money for goods

n makes daily transactions faster and easier

Money Supply (MS)

n Money in the hands of the people.

n Controlled by the Fed

n M1 – most liquid form

n Currency

n Checking accounts

n M2 – less liquid form

n M1 plus

n Savings Accounts

Size of M1 and M2

Credit and Debit Cards

n Credit Cards: not money but they substitute for money to make transactions.

n It is debt; use a credit card and you owe the credit card company.

n Debit Cards: act exactly like money

n Amount is deducted directly from your checking account, just like a check.

Money Supply

n The Federal Reserve has absolute control over the size and growth of the Money Supply.

Money Demand (MD)

n Money Demand (MD) is the amount of money the public WANTS to hold as M1.

n Money Supply (MS) is the amount the public HAS to hold as M1.

Money Demand (MD)

n Why do we want to hold M1?

n Transactions demand

n There is an opportunity cost (interest you could have earned in a savings account)

n Why do we want to hold M2?

n Asset demand

n Stock, savings account, real estate, other investments

M1 and the Interest Rate (i)

n The price to borrow money is the interest rate.

n At high interest rates, the opportunity cost of holding M1 is high, so the quantity of M1 we want to hold is low.

n At low interest rates, the opportunity cost of holding M1 is low, so the quantity of M1 we want to hold is high.

n Thus, MD is a downward sloping curve.

Making a Money Market

n MS and MD intersect

n This determines the interest rate (i)

n Interest rate (i):

n Payment to borrow money

n Opportunity cost to hold money as cash

Money Shortage

n Money market:

n MD > MS

n Interest rates will rise

n Increase the sale of assets to get more M1

n Reduce M2 to increase M1

n Bond market:

n Put bonds up for sale; supply increases

n Bond prices fall

Money Surplus

n Money market:

n MD < MS

n Interest rates will fall

n Increase the purchase of assets to get rid of M1

n Increase M2 to reduce M1

n Bond market:

n Buy bonds; demand increases

n Bond prices rise

Fed Can Increase MS

n Recession?

n Remedy: Need AD to shift right

n Increase spending?

n Increase MS

n Increase borrowing?

n Decrease interest rates

Fed Can Decrease MS

n Overheated economy?

n Inflation?

n Remedy: Need AD to shift left

n Decrease spending?

n Decrease MS

n Decrease borrowing?

n Increase interest rates

The Federal Reserve System

n Federal Reserve Act: Dec 23, 1913

n Chairman: Ben Bernanke (4-year term)

n There are 12 districts.

n Fed Board members

n 14-year terms

n staggered terms

The Federal Reserve System

n Duties of the Fed:

n Regulate the banking system.

n Provide check clearing services.

n Holds reserves for member banks.

n Control the size and growth of the money supply.

n Conduct monetary policy, mainly through its Federal Open Market Committee.

Federal Reserve Districts

“Creating” Money

n When a bank makes a loan:

n The money supply is increased.

n Money is “created”.

n Before the loan:

n The public has access to a certain amount of money in MS.

n After making the loan:

n The borrower’s checking account is increased, and the public has access to more money.

n MS is increased.

n Pay back the loan:

n MS is decreased.

n Money is “destroyed”.

Fractional Reserve Banking

n The Fed controls the size and growth of the money supply.

n It uses Fractional Reserve Banking to regulate the loan making process.

n All bank deposits are called reserves.

n Each bank is required to set aside a fraction of each deposit as required reserves.

Fractional Reserve Banking

n The fraction set aside is called the required reserve ratio (RRR).

n Reserves not set aside are called excess reserves.

n Excess reserves may be loaned out by the bank.

n Each new loan increases the money supply.

Money Multiplier

n People and firms borrow in order to buy something.

n So each loan is spent and put into a bank by the seller as a new deposit.

n The bank sets part aside as required reserves; the rest are excess reserves and are loaned out, generating another cycle.

Money Multiplier

Money Multiplier

n The cycle of deposit, loan, deposit continues.

n This multiplies the creation of new money in the money supply.

n The ultimate size of money supply increase is governed by the required reserve ratio (RRR).

Money Multiplier

n The money multiplier = 1/RRR.

n Calculate the maximum increase in MS

= (money multiplier) x (initial deposit)

Example:

RRR = 1/10; initial deposit = $20,000.

max increase in MS = (10) x ($20,000)

= $200,000

Money Multiplier

n Start with initial deposit of $20,000 and RRR is 1/10:

n The maximum increase in the money supply is $20,000 x 10 = $200,000.

n If the Fed increased RRR to 1/8:

n The maximum increase in the money supply would be $20,000 x 8 = $160,000.

n If the Fed decreased RRR to 1/12:

n The maximum increase in the money supply would be $20,000 x 12 = $240,000.

Controlling the Money Supply

n Tools:

n Change RRR

n Change the discount rate.

n Conduct Open Market Operations

To Increase the Money Supply

n Lower the RRR

n increases the amount of excess reserves

n Lower the discount rate

n increases the desire of banks to borrow reserves (to make more loans) from the Fed

n Fed buys government securities in the Open Market

n injects new money into the seller’s bank account

To Decrease the Money Supply

n Raise the RRR

n decreases the amount of excess reserves

n Raise the discount rate

n decreases the desire of banks to borrow reserves (to make more loans) from the Fed

n Fed sells government securities in the Open Market

n removes money from the buyer’s bank account

Monetary Policy

n Manipulate the size and growth of MS to move the economy to full-employment GDP.

n Done by the Federal Reserve System.

Monetary Policy

n Shifts the AD Curve

n Expansion (easy) monetary policy:

n Increase MS

n Shift AD right

n Fights a recession (underperforming economy)

n Use to close a recessionary gap

n Contraction (tight) monetary policy:

n Decrease MS

n Shift AD left

n Fights inflation (overheated economy)

n Use to close an inflationary gap

Monetary Policy

n How can the Fed increase MS?

n Buy government securities in Open Market

n Lower RRR

n Lower the discount rate

n How can the Fed decrease MS?

n Sell government securities in Open Market

n Raise RRR

n Raise the discount rate

Open Market Operations

n Fed buys/sells US Treasury Bonds in the open market

Expansion Policy

n To fight recession, increase MS

n Fed buys bonds from the public

n Fed pays for the bonds

n Checking account deposits rise

n More loans are made; spending increases

n AD shifts right

Expansion Policy

Contraction Policy

n To fight inflation, decrease MS

n Fed sells bonds to the public

n Public pays for the bonds

n Checking account deposits fall

n Fewer loans are made; spending decreases

n AD shifts left

Contraction Policy

Calculating How Big a Bond Buy/Sale

n Maximum change in MS =

n (money multiplier) x (size of bond buy/sale)

Calculating How Big a Bond Buy/Sale

n Maximum change in MS =

n (money multiplier) x (size of bond buy/sale)

n Example:

n Let RRR = 5% = 1/20

n Money multiplier = 1/RRR = 20

n Need $40 billion increase in MS?

n Fed buys $2 billion in bonds

Calculating How Big a Bond Buy/Sale

n Maximum change in MS =

n (money multiplier) x (size of bond buy/sale)

n Example:

n Let RRR = 5% = 1/20

n Money multiplier = 1/RRR = 20

n Need $40 billion decrease in MS?

n Fed sells $2 billion in bonds

Changing RRR

n Raise RRR?

n More required reserves

n Fewer excess reserves available for loans

n Fewer loans made

n MS decreases

n Lower RRR?

n Less required reserves

n More excess reserves available for loans

n More loans made

n MS increases

Changing the discount rate

n Raise discount rate?

n Banks borrow less from Fed

n Make fewer loans

n MS decreases

n Lower discount rate?

n Banks borrow more from Fed

n Make more loans

n MS increases

“Easy” money policy

n Fights recession

n Buy bonds in open market operations

n Lower RRR

n Lower discount rate

“Easy” Money Policy

“Tight” money policy

n Fights inflation

n Sell bonds in open market operations

n Raise RRR

n Raise discount rate

“Tight” Money Policy

Relating MS to Real GDP and Price Level

n All money in the hands of the people (MS) must be spent

n Spend it directly, or

n Save it, and the bank lends it to a borrower, who will spend it.

n Thus, MS relates to total spending.

n Total spending is Nominal GDP

n Nominal GDP = Price Level x Real GDP

Equation of Exchange

n M x V = P x Q, where:

n M is the money supply, M1

n V is velocity (how many times each $ in MS is spent)

n P is price level, CPI

n Q is Real GDP

n P x Q is Nominal GDP

Equation of Exchange

n M x V = P x Q, an identity:

n Left side is number of $ spent to buy all products

n Right side is number of $ needed to buy all products

Equation of Exchange

n Velocity?

n literally, the number of times each dollar is spent in a period of time

n represents our behavior toward the use of money

n changes when new ways of handling money come about

n in the short-run, can be considered as a constant

Equation of Exchange

n M x V = P x Q

n Money supply is directly related to inflation:

n Let both V and Q be constant (true in a very short-run).

n Then a M increase forces an increase in P.

Equation of Exchange

n M x V = P x Q

n Given a longer time, both P and Q can change when M is increased.

n Three possibilities:

n Overheated? P increase only

n Underperforming? Q increase only

n Near full employment? Some of each.

Equation of Exchange

n Rewrite M x V = P x Q in percent change form:

n %M + %V = %P + %Q

n Assume %V = 0.

n A 6% increase in M could lead to:

n a 6% increase in P, or

n a 6% increase in Q, or

n a 3% increase in P and a 3% increase in Q

n depending on where the economy is on the AD-AS diagram.

Monetarism

n Velocity does change, but predictably and slowly.

n A MS increase:

n increases AD

n increases Real GDP (Q)

n pushes up Price Level (P)

n The economy can self-regulate back to Full-Employment GDP

One-Shot Inflation

n One-Shot Inflation occurs when:

n AD is forced to shift right.

n Self-regulation causes SRAS to shift left.

n Economy goes back to full-employment at a higher price level.

n SRAS is forced to shift left.

n Self-regulation causes SRAS to shift back right.

n Inflation spikes up until economy goes back to full-employment at the old price level.

Continued Inflation

n Continued Inflation is caused by:

n AD is continually caused to shift right.

n Each time economy self-regulates by shifting SRAS left.

n Price level rises each time.

n The easiest way to have continued inflation is for the Fed to continuously increase the money supply.

What causes interest rates to fall?

n 1. An increase in the supply of bank deposits.

n 2. An decrease in the demand to borrow bank deposits.

n 3. An decrease in the expected inflation rate.

n Vice versa applies.

MS and Interest Rates

n Increase MS:

n reserves increase.

n saving increases.

n supply of loanable funds (lf) increases.

n Interest rate falls.

n Vice versa applies.

MS and Interest Rates

n MS increase:

n Spending increases.

n Real GDP increases.

n Borrowers demand for funds increases.

n Interest rates rise.

n Vice versa applies.

MS and Interest Rates

n Expected inflation rises.

n Borrowers increase demand for funds (1).

n Savers reduce supply of funds (2) because opportunity cost of saving rises.

n Interest rates rise (3) by the amount of expected inflation.

n Vice versa applies.

Nominal and Real Interest Rates

n Real interest rate is the cost of using someone else’s money for a period of time.

n Nominal interest rate = real interest rate PLUS inflation protection for the lender.

n = real interest rate + expected inflation rate.

So What Does the Fed Really Do?

n Inflation Targeting

n The Fed works to keep the inflation rate within a predetermined range.

n About 2 to 3 percent, currently.

n If inflation starts upward (top of the range), the Fed conducts a tight money policy.

n If inflation starts downward (bottom of the range), the Fed conducts an easy money policy.