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