Economics for Managersby Paul Farnhamy

Chapter 13:The Role of Money in theThe Role of Money in the

Macro Economy

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Money and the U. S. Fi i l S tFinancial System

Money: financial assets that can easily be used to make market ytransactions and that serve as a medium of exchange and a store

f lof valueBarter system: when goods and y gservices are exchanged directly without a common unit of account

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Measures of theM S lMoney Supply

Liquidity: ability to immediately make market transactionsM1 is the money supply (includes most liquid components)most liquid components)Demand deposits: checkable deposits and a component of thedeposits and a component of the M1 measure of the money supply

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Commercial Banks Commercial Banks

Depository institution backed by the FDIC, which protects deposits up to $100 000$100,000Fractional reserve system (rr): banks need only keep a fraction of their eed o y eep a act o o t ereservesReserve requirement: required

di id d b d d d itreserves divided by demand depositsMoney supply: currency plus demand deposits

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deposits

Monetary Base andM S lMoney Supply

M S l

Currency Demand Deposits

Money Supply

Currency Demand Deposits

M M lti liMoney Multiplier

Currency Reserves

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Monetary Base

The Federal ReserveThe Federal Reserve

Acts as central bank of U.S. that implements monetary policy and p y p yregulates U.S. financial system12 district banks and 25 branches12 district banks and 25 branchesIndependent within the government

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Open Market OperationsOpen Market Operations

Buying and selling of government securities in open marketInfluences amount of reserves held by commercial banks, which i t i fl f d l f din turn influences federal funds rateF d l f d k t i tFederal funds market: private market where banks borrow to meet reserve requirements

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meet reserve requirements

Open Market OperationsOpen Market Operations

Expansionary monetary policy: increases rate of Real GDP by increasing amount of bank reserves inincreasing amount of bank reserves in system and lowering federal funds and other interest ratesOther interest rates tend to fall along with federal funds rate

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ContractionaryM t P liMonetary Policy

Fed decreases rate of growth of real GDP by increasing bank reserves and

i i f d l f d d th i t traising federal funds and other interest ratesFOMC l i iti d ilFOMC also engages in securities daily after analyzing economic conditions

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Discount RateDiscount Rate

Interest rate Fed charges banks that borrow reserves at Fed’s discount windowIndicates contractionary monetaryIndicates contractionary monetary policyCommercial banks have beenCommercial banks have been reluctant to borrow at the discount window

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discount window

Reserve RequirementsReserve Requirements

Monetary Control Act of 1980: made all depository institutions p ysubject to reserve requirements established by the FedRaising reserve requirements has contractionary effect on economyy yEven small changes have major impact on reserve requirements

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impact on reserve requirements

Managerial Rule of Thumb: d l liFederal Reserve Policy

Managers must• Watch Fed policy statements and• Watch Fed policy statements and

actionsDecide how monetary policy will• Decide how monetary policy will influence economic activityB id d b th ti f th• Be guided by the actions of the Federal Open Market Committee regarding federal funds rates

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regarding federal funds rates

Supply of MoneySupply of Money

N i l l (M )Nominal money supply (MS): money supply (M1) controlled by the Federal Reservethe Federal ReserveReal money supply: (M / P) nominal money supply divided by the pricemoney supply divided by the price level (influences individuals’ behavior)An increase in the nominal money supply results in an increase in the real money supply all else

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real money supply, all else constant

Real MoneyS l F tiSupply Function

Figure 13.3

RLMS1 Increase in MS by Fed or decrease in price level (P)

RLMS2

in price level (P) will cause real money supplymoney supply function to shift from RLMS1 to RLMS2

0

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M / P0 (MS / P)1 (MS / P)2

Real Money S l F tiSupply Function

R MS / PRLMS = MS / P

whereRLMS = MS / P = f (r MS P) where

RLMS = real money supply

RLMS = MS / P = f (r, MS, P)

y pp y

MS = nominal money supply

P = the price level

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r = real interest rate

Demand for MoneyDemand for MoneyFigure 13.4

AAr1

Br2 C

RLMD1

0RLMD2

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(M / P)0 (M / P)3(M / P)2(M / P)1

Demand for MoneyDemand for Money

whereRLMD = MD / P = f (r, Y)

RLMD = real money demandMD = nominal money supplyP = the price levelpr = real interest rateY l l f l i

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Y = level of real income

Demand for MoneyDemand for Money

Demand for money focuses on decisions individuals make regarding their assetsregarding their assetsIndividuals hold money because it is liquid and enables them to conductliquid and enables them to conduct transactionsHigher interest rates cause gindividuals to hold fewer assetsReal demand depends on level of

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preal income (Y) in economy

Change in the R l M S lReal Money Supply

Figure 13.5

A A’

RLMS1 RLMS2

Ar1

A’

Br2

RLMD

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(M / P)0 (M / P)2(M / P)1

Change in the D d f MDemand for Money

Figure 13.6

RLMS

r1

B

r2

r1

A A’

RLMD1 (Y1)RLMD2 (Y2)

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(M / P)0

Summary of Key TermsSummary of Key Terms

Barter systemBarter systemCommercial banksContractionary monetary policyDemand depositsDiscount rate and prime rateExpansionary monetary policyExpansionary monetary policyFDIC

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Summary of Key TermsSummary of Key Terms

F d l f d k t d f d lFederal funds market and federal funds rate FOMCFOMCThe Fed/ Czech National Bank, etc.Fractional reserve systemLiquidityLiquidityMoney

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Summary of Key TermsSummary of Key Terms

Money supplyMoney supplyOpen market operationsP i tPrime rateReserve requirement

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