Lesson 13---banking-fed-monetary[1]

Money and BankingThe Fed

Monetary Policy

Academic Decathlon Lesson 13Berryhill

The Functions of Money

Medium of Exchange*usable for buying and selling goods and services*allows society to escape the complications of bartering*allows society to gain the advantages of geographic and human specialization

The Functions of Money

Unit of account*acts a yardstick for measuring relative worth of a wide variety of goods, services, and resources*enables buyers and sellers to easily compare the prices of various goods, services, and resources

The Functions of Money

Store of Value*enables people to transfer purchasing power from the present to the future*we have to store some of our income to buy things later*when inflation is low or nonexistent, holding money is relatively risk-free for preserving your wealth

Money Definition M1

M1 consists of:* currency (coins and paper money) in the hands of public* all checkable deposits

Money Definition M2

M2 consists of:* Everything in M1 plus* Savings deposits, including money market deposit accounts* Small (less than $100,000) time deposits (CDs)* Money market mutual funds

Money Definition M3

M3 Consists of* Everything in M1 and M2 plus* large (more than $100,000) time deposits

What “backs” the money supply?

The money supply in the US essentially is “backed” (guaranteed) by the government’s ability to keep the value of money relatively stable. Nothing more!

Money as Debt

Paper money and checkable deposits are debts, or promises to pay

They have no intrinsic value—they are just pieces of paper or bookkeeping entries

The gov’t will not redeem your paper money for anything tangible, like gold

***Gold standard—not reliable because harder to control the money supply

Value of Money

Why are currency and checkable deposits money, and Monopoly money is not?

Acceptability—ppl accept them as money

Legal tender—must be accepted in payment of a debt**fiat money—money because the government has declared it so, not because it can be redeemed for precious metal

Value of Money (con’t.)

Relative Scarcity—value of money depends on supply and demand**supply of money will determine the value or “purchasing power” of the monetary unit

Money and Prices

The purchasing power of the dollar varies inversely with the price level

When CPI goes up, the value of the dollar goes down, and vice versa

D = 1/P(D=value of dollar, P=price level)

Money and Prices

When the gov’t issues so much money that the value of the money is undermined

Runaway inflation can depreciate the value of the money

Rapid declines in the value of money may cause it to cease being used as a medium of exchange

Money and Prices

Stabilization of the value of money requires:

1. appropriate fiscal policy2. Intelligent management or

regulation of the money supply (monetary policy)

The Demand for Money

Transactions Demand (Dt)—the demand for money for uses such as purchasing goods and services or paying for factors of production* Main determinant of money demanded for transactions is the level of nominal GDP

The Demand for Money

Asset demand (Da)—Derived from money’s function as a store of value so people may hold their financial assets in many forms, including corporate stocks, private or government bonds, or money* Varies inversely with the rate of interest—when interest rate is low, the public will choose to hold a large amount of money assets*When interest rate is high, amount of assets held as money will be small

The Demand for Money

Total Money Demanded (Dm)—Found by adding Da and Dt—total amount of money public wants to hold at each possible interest rate* will change with increases/decreases in nominal GDP

Transactions Demand for Money (Dt)

Asset Demand for Money (Da)

Interest Rate10

7.5

5

2.5 Da

0 50 100 150 200 Amt of $ Demanded

Total Demand for Money and Supply of Money

Dm = Dt + Da

Interest Rate10 Sm

7.5

5

2.5

0 Dm0 50 100 150 200 300 Amt of $ D

and S

The Money Market

Money Market—Combining the supply and demand for money to determine the equilibrium rate of interest

Supply of Money (Sm) is a vertical line because the economy has some particular stock of money (such as M1) provided by the monetary and financial institutions

Adjustment to a Decline and Incline in the MS

Rate of Interest Sm1 Sm Sm2

10

7.5

5Surplus of $

2.5 Shortageof $ Dm

00 50 100 150 200 250 300

Amt of $ D and S

Federal Reserve Systemor the “Fed”

Federal Reserve System—the US’s monetary authorities made up of the Federal Reserve Banks and overlooked by the Board of Governors

Historical Background

Early in 20th century, Congress decided that centralization and public control were essential for an effective banking system

Decentralization has fostered inconvenience and confusion of numerous bank notes being used as currency

Historical Background

It had also resulted in episodes of monetary mismanagement when the MS was inappropriate to the needs of the economy (too much $ led to rapid inflation, too little $ stunted the economy’s growth)

This led to the Federal Reserve Act of 1913

Board of Governors

Central authorities of the US money and banking system

The US president, with the confirmation of the Senate, appoints the seven Board members

Terms are 14 years and are staggered so that one member is replaced every 2 years

Board of Governors

New members are also appointed when resignations occur

The president selects the chairperson and vice-chairperson of the Board from among the members

Assistance and Advice

Several entities assist the Board of Governors in determining banking and monetary policy

The Federal Open Market Committee (FOMC) is made up the 7 members of the Board plus five of the presidents of Federal Reserve Banks

Assistance and Advice

The FOMC sets the Fed’s monetary policy and directs the purchase and sale of government securities (bills, notes, and bonds)

Three Advisory Councils made up of private citizens meet periodically with the Board of Governors to voice their views on banking and monetary policy

Assistance and Advice

The Federal Advisory Council is composed of 12 commercial bankers, one selected annually by each of the 12 Federal Reserve Banks

The Thrift Institutions Advisory Council consists of representatives from savings and loan associations, savings banks, and credit unions

Assistance and Advice

The 30-member Consumer Advisory Council includes representatives of consumers of financial services and academic and legal specialists in consumer matters

The 12 Federal Reserve Banks

The 12 Federal Reserve Banks collective serve as the nation’s “central bank”; they blend private ownership and public control and mainly are so-called bankers’ banks

The 12 Federal Reserve Banks serves different districts and all implement the basic policy of the Board of Gov.

Quasi-Public Banks

12 Federal Reserve Banks are quasi-public

Each Fed. Res. Bank is owned by the private commercial banks in its district (commercial banks are required to purchase shares of stock in the Fed Res Bank in their district)

Quasi-Public Banks

But a gov’t body (the Board of Gov) sets the basic policies that the Fed. Res. Banks pursue

Despite private ownership, the Banks are in practice public institutions

They are not motivated by profit

Bankers’ Banks

Fed Res Banks perform the same functions for banks and thrifts as those institutions perform for the public* Accept deposits and make loans to banks and thrifts*Issue currency

Fed Functions and the MS

Issuing currency—issue Fed. Res. Notes, the paper currency used in the US

Setting reserve requirements and holding reserves—sets the amount/fraction of checking balances that banks must maintain as currency reserves; accept and portion of the reserves not held as vault cash

Fed Functions and the MS

Lending money to banks and thrifts—will lend money to banks and thrifts and charge them an interest rate called the discount rate

Providing for check collection—Adjusts reserves to compensate for checks written

Fed Functions and the MS

Acting as a fiscal agent—provides financial services for the Federal government

Supervising banks—makes periodic examinations to assess bank profitability and accordance to Fed regulations

Fed Functions and the MS

Controlling the money supply—Fed regulates supply of money, and in turn enables it to influence interest rates; makes amount of money available that is consistent with high and rising levels of output and employment and a relatively constant price level

Federal Reserve Independence

Congress purposely established the Fed as an independent agency of government

Political pressures on Congress may result in inflationary fiscal policy

If executive branch also controlled the nation’s monetary policy, there could be pressure to keep interest rates low even when high interest rates are needed

Federal Reserve Independence

Studies show that countries that have independent central banks like the Fed have lower rates of inflation, on average, than countries that have little or no central bank intelligence

Fed Functions

Issuing currency Setting reserve requirements—the

percentage of each deposit that a bank must keep on hand in their vault

Lending money to banks when they don’t have enough reserves in their vaults

Check collection

Fed Functions—cont.

Provides financial services to Federal government

Supervising banks Controlling the money supply

Interest Rates

Interest is the price of money—how much it costs to borrow money

Supply of Money—vertical because itIs a constant amount (how much is inCirculation)

Demand of Money—how muchPeople desire/need/want to takeOut in a loan

Quantity of Money

Price of Money(interest rate)

Interest rate

Qm

Monetary Policy

The Fed controls the money supply, and therefore the interest rate

As they change the amount of money in circulation, the price of money changes (or the interest rate)

Change in Supply of Money

Interest Rate

Quantity of Money

SmSm1 Sm2

Int.Rate

Int. Rate 1

Int. Rate 2

Tools of Monetary Policy

Open Market Operations—the buying of bonds from, and the selling of bonds to, the general public and commercial banks

Fed’s most important instrument for influencing the money supply

Buying Bonds

When the Fed buys bonds they are putting money into circulation, thereby increasing the money supply and decreasing i.r.

Int. rateSm Sm1

Dm

Quantity of MoneyQm Qm1

Ir1

Ir

Selling bonds

When the Fed sells bonds they are taking money out of circulation, thereby decreasing the money supply and increasing i.r.

Int. rate

Dm

Quantity of MoneyQm 1 Qm

Ir

Ir 1

SmSm1

Tools of Monetary Policy

The reserve requirement or reserve ratio—the amount of each deposit the bank must keep in their vaults

Limits the amount of each deposit the bank may loan out to another customer

When the bank can loan out a lot, they can increase the money supply

When the banks can not loan out much, they are decreasing the money supply

Reserve Ratio

You deposit $1,000 in your bank account. The reserve ratio is 25%--that means they

must keep 25% of the deposit in the vault They set $250 in the vault, but use the

other $750 to loan out to another customer

That $750 plus the interest they charge the customer is increasing the money supply, thereby decreasing interest rates

Reserve Ratio

Say the same $1,000 is deposited in a bank, but this time the reserve requirement is lowered to 20%

Now they must keep $200 in their vaults and loan out $800

This is an bigger increase in the money supply because they can loan out more

Tools of Monetary Policy

The discount rate—the interest rate the Fed charges on loans to other banks

Banks may nightly take out loans from the Fed if they have loaned out more than they are allowed to (determined by the reserve ratio)

The banks are still charged interest by the Fed, called the Discount Rate

The Discount Rate

When the discount rate is low, banks are more willing to loan out their reserves because they can just take out a loan from the Fed later to cover that loan.

This increases the money supply because will be looser with their money and their loans.

The Discount Rate

When discount rate is high, banks don’t want to take out a loan from the Fed.

They will be less likely to loan out their reserves, thereby decreasing the money supply because of their unwillingness to give out as many loans.

How does this affect the economy?

By increasing and decreasing the money supply, the Fed is increasing or decreasing the interest rates.

When interest rates are high, people are less willing to take out loans.

When interest rates are low, people are more willing to take out loans.

How does this affect the economy?

Remember the determinants of GDP (and AD)?GDP (or AD) = C + I + G + X

The I stands for Investment—money people take out of a bank in the form of loans to buy/invest in something.

If we increase or decrease I, everything else equal, we are increasing and decreasing GDP/AD

How does this affect the economy?

Interest rates decrease—more people take out loans—AD increases becauseI has increased—this increases the price level (inflation) and GDP (production)

Price Level

GDP

AD

AD 1

AS

PL or inflation

PL1 or new inf.

GDP New GDP

How does this affect the economy?

Price Level

GDP

AD 1

AD

AS

PL1 or new inf.

PL or inflation

New GDP GDP

Interest rates increase—people take out less loans, thereby decreasing I—as I decreases, so does AD—that decreases inflation and GDP

When to use what…

Problem: high unemployment

Buy bonds, lower rr,Or lower disct. rate

Excess reservesIncrease (moreMoney to loan out)

Money SupplyIncreases

Interest Rate Decreases

InvestmentSpendingIncreases

AD Increases

GDP increases, Which will lowerunemployment

When to use what…

Problem: Inflation

Sell bonds, increase rr,Or increase disct. rate

Excess reservesDecrease (lessMoney to loan out) Money

SupplyDecreases

Interest RateIncreases

InvestmentSpendingDecreases

AD decreases

Inflation Decreases

Strengths of Monetary Policy

Speed and Flexibility Isolation from political pressure Past success in the 1980s and 1990s

Inflation from 13.5% in 1980 to 3.2% in 1983

Recovery from recession of 1990-1991

Problems with monetary policy

Less control with more electronic transactions

Changes in velocity of money (the number of times per year the average dollar is spent on goods and services)

Less reliable in pushing the economy from a recession (cannot force people to take out loans)—think Japan 1990s