Money, Money, Money Money, The Federal Reserve, and Monetary Policy.
Unit 4 Money, Monetary Policy and Economic Stability.
Transcript of Unit 4 Money, Monetary Policy and Economic Stability.
MoneyBefore money, economies used a barter system
Problem – double coincidence of wants
Basic properties of any commodity used as money
Portability, uniformity, stability in value and acceptability
Unit IV Lesson 1
Functions of MoneyMedium of Exchange function eliminates the need for the double coincidence of wantsThe Store-of-value function permits money to be held for use at a later timeThe Unit-of-Account, or Standard-of-Value function means there is an agreed-to measure for stating the prices of goods and services. This simplifies price comparisons.
Unit IV Lesson 1
Definitions of Money in the U.S.
M1Consists of currency, traveler’s checks, and checkable deposits
M2Includes M1 plus savings deposits, small time deposits, money market deposit accounts (MMDAs), noninstitutional money market mutual funds (MMMFs) and other deposits
M3Includes M2 plus large ($100,000 or more) time deposits
Unit IV Lesson 1
Equation of ExchangeMV=PQ
“M” – M1, stock of money“V” – Income (GDP) velocity of circulation or average number of times $1 is spent on final goods and services in a particular time period“P” – average price level of final goods and services in GDP, also known as the GDP deflator“Q” – real output, the quantity of goods and services in GDP
Unit IV Lesson 2
Evidence shows that income velocity (V) is highly predictable with its value remaining in a very narrow range over a multiyear periodThus, changes in the money supply (M) result in changes in Nominal GDP (PxQ)Depending on the state of the economy, the changes in the money supply can result in changes in prices, in output only or in some combination of both
Unit IV Lesson 2
Financial IntermediariesBringing people who want to borrow funds together with people who want to lend funds
Examples: commercial banks, savings and loans associations, savings banks, credit unions & money market mutual fund companies
Functions: liquidity creation, minimization of the cost of borrowing, minimization of the cost of monitoring borrowers and risk reduction through pooling
Unit IV Lesson 3
Fractional ReserveSystem of Banking
Banks – any depository institution whose deposits are a part of M1.Banks must hold a specific percentage of deposits as reserves; this percentage is called the required reserve ratioThe deposit that is not part of required reserves is called excess reserves
Unit IV Lesson 3
Banks may loan excess reserves or buy government securitiesA bank makes a loan by creating a a checkable deposit for the borrower; this results in an increase in the money supply
Unit IV Lesson 3
Money Expansion Multiplier
Exists because the reserves & deposits lost by one bank are received by another bankIt magnifies excess reserves into a larger creation of checkable-deposit moneyDeposit expansion multiplier = ____1____ reserve requirement Expansion of the money supply =
excess reserves x deposit expansion multiplier
Unit IV Lesson 3
Higher reserves = lower money expansion multipliers and a decrease in the money supplyTotal increase in money supply may be less than predicted by the money expansion multiplier if
Borrowers do not spend all the money they borrowBanks do not lend out all their excess reservesPeople hold part of their money as cash
Unit IV Lesson 3
The Federal Reserve System
Has the responsibility to control the money supply to promote the economic goals of full employment, price stability and stable economic growthBoard of Governors
Central authority, 7 member board, serve 14 year termsChairman – Alan Greenspan
Federal Open Market Committee (FOMC)7 members of the board and 5 of the presidents of the Federal Reserve BanksSets the Fed’s monetary policy and directs the purchase and sale of gov’t securities
Unit IV Lesson 4
Tools of the Fed Open-Market Operations
The buying of bonds or securities from (increase money supply), or the selling of bonds to (decrease the money supply), commercial banks and the publicFed’s most important instrument for influencing the money supply
Unit IV Lesson 4
Reserve RatioRaising the reserve ratio = decrease in money supplyLowering the reserve ratio = increases the money supply
The Discount RateInterest Rate charged on short-term loans from the Fed to commercial banksLower discount rate = increase in money supplyHigher discount rate = decrease in the money supply
Unit IV Lesson 4
The Money MarketThe Demand for Money
Transactions demand – the demand for money to make purchases of goods & servicesPrecautionary (liquidity)demand – the demand for money to serve as protection against unexpected needSpeculative demand – the demand for money because it serves as a store of wealth
How much of your wealth do you want to hold as money & how much do you want to hold as interest-bearing assets?
Unit IV Lesson 5
Understand?Fed purchases Treasury securitiesMoney supply increases Interest rate decreasesInvestment increase (& interest-sensitive components of consumption spending increase)Aggregate Demand increasesOutput increases and the Price Level increases
Unit IV Lesson 5
Fed sells Treasury securitiesMoney supply decreases Interest rate increasesInvestment decreases (& interest-sensitive components of consumption spending decrease)Aggregate Demand decreasesOutput decreases and the Price Level decreases
Unit IV Lesson 5
Interest Rates and Monetary Policy in the Short Run & the
Long RunNominal interest rate
Rate that appears on the financial pages of newspapers & ads for financial institutionsNot adjusted for inflation
Real interest rateIncrease in purchasing power the lender wants to receive to forego consumption now for consumption in the futureAdjusted for inflationReal interest rate = Nominal interest rate – inflation rate “Fisher Equation”
Unit IV Lesson 6
Two Relationships between the real and nominal interest
ratesEx ante real interest rate (expected interest rate)
equals the nominal interest rate minus the expected inflation rate
Ex poste real interest rate (real interest rate actually received)
Equals the nominal interest rate minus the actual rate of inflation
Unit IV Lesson 6
Equation of exchangeMV=PQ
Looking at this equation, we see that changes in the money supply – holding velocity & real output constant – lead to changes in the price levelThese changes in the price level change the nominal interest rate once they are anticipated
Unit IV Lesson 6