Money and
Monetary Policy
1
FUNCTIONS OF MONEY
• Medium of Exchange
Buying goods and services
•Unit of Account
Prices are quoted in dollars and cents
• Store of Value
Money allows us to transfer purchasing power
from present to future.
It is the most liquid (spendable) of all assets,
a convenient way to store wealth.
MONEY SUPPLY
is the total quantity of
money in the economy at
any given time.
MONEY SUPPLY
Definition…
Currency
•Token Money
•Federal Reserve Notes
•Intrinsic Value-The market value of the
•constituent metal within a coin
Checkable Deposits
•Commercial Banks
•Thrift Institutions
MONEY SUPPLY
=
Plus...
Near-monies
* can be converted to currency (ex C. D.)
Savings Deposits
• Money Market Deposit Accounts (MMDAs)
• Interest bearing account through which banks and thrifts
pool individual deposits to buy interest bearing short term
securities
Smaller Time Deposits
* smaller time deposits become available at their maturity
* ex: mutual funds( higher interest than MMDA’s)
Money Market Mutual Funds (MMMFs)
*use combined funds of individual share- holders to buy interest
bearing short term credit instruments like CD’s and government
securities
MONEY SUPPLY
=
Plus...
Large Time Deposits
• deposits of 100,000 dollars or more
• Usually owned by business as CD’s
MONEY SUPPLY
Currency (coins & paper money)
plus Checkable deposits
equals M1
M1 M2 M3
$1101
2000 Data
(billions of dollars)
MONEY SUPPLY
Currency (coins & paper money)
plus Checkable deposits
M1 M2 M3
equals M1
plus Savings deposits,
including MMDA’s
plus Small time deposits
plus Money market mutual
fund
(MMMF) balances
equals M2
$1101
$4827
2000 Data
(billions of dollars)
MONEY SUPPLY
M1 M2 M3
Currency (coins & paper money)
plus Checkable deposits
equals M1
plus Savings deposits,
including MMDA’s
plus Small time deposits
plus Money market mutual fund
(MMMF) balances
$1101
equals M2
plus Large time deposits
equals M3
$4827
2000 Data
(billions of dollars)
$6853
WHAT ABOUT CREDIT CARDS?
*This is a way of obtaining a
short term loan
- thereby reducing the
cash and checkable deposits
you must keep available
WHAT BACKS THE MONEY SUPPLY?
Money as Debt
*Debt – Money is a debt of the FED, checkable
deposits are debts of the banks it is purely backed by
the governments ability to keep the value of money
stable
Value of Money
• Acceptability
• Legal Tender-must be accepted as legal tender
• Relative Scarcity- value depends on demand
Money and Prices
• Value of the Dollar- inverse with price level
• D = 1/Price Level (in hundredths)
Inflation and Acceptability
WHAT BACKS THE MONEY SUPPLY?
So, What Backs the Money
Supply?
Stable Value!
through...
• Appropriate Fiscal Policy
• Intelligent Management of the
Money Supply (monetary policy)
Section 1: The Federal Reserve System
A. How did the panic of 1907 affect
U.S. banking?
1. no way to expand the amount
of money in circulation; because
there was a fixed amount of
loanable money, people withdrew
their savings causing “runs” on
banks
2. pyramid reserves – small banks
deposit reserves in larger banks
3. to keep these two situations
from recurring, Congress passed
the Federal Reserve Act in 1913;
created a central bank known as
the Federal Reserve or the Fed
B. Role of the Fed
1. supervises member banks
2. holds cash reserves
3. moves money in and out of circulation
C. Organization of the Fed
1. National level
a. Board of Governors
1.) seven members; appointed by the
President, confirmed by the Senate
2.) 14 year term; staggered every two
years
3.) Why do they serve so long?
a.) free them from political
influence
b.) to limit the influence of any one
governor
b. Federal Open Market Committee
(FOMC)
1.) comprised of the Board of
Governors, president of the Federal
Reserve of New York + four other Fed bank
presidents who rotate for one year terms
2. District level
a. 12 Federal Reserve district banks
b. 25 branch banks
3. Local level
Chairman of the Fed, Janet Yellen
a. member banks
th-G-Chicago (1)
7
1st-A-Boston (0)
2nd-B-New York (1) 8th-H-St. Louis (3)
3rd-C-Philadelphia (0) 9th-I-Minneapolis (1)
th-J-Kansas City (3)
th
10
4 -D-Cleveland (2)
5th-E-Richmond (2) 11th-K-Dallas (3)
th-L-San Francisco (4)
th
12
6 -F-Atlanta (5)
Section 2: The Federal Reserve at Work
A. Services to banks
1. clearing checks
2. loans to banks
B. Services to the
Government
1. serving as the
government’s bank
2. supervising the Fed’s
member banks
3. regulating the
national money supply
– the amount of money
in circulation
C. Money Supply
1. M1 = traveler’s checks, currency, demand
deposits, other checking accounts
2. M2 = M1 + money market funds, savings
deposits, small time deposits
3. M3 = M2 + large time deposits, repurchase
agreements, and Eurodollars
Section 3: Monetary Policy Strategies
A. Monetary Policy and Aggregate Demand
1. monetary policy – the plan to expand or
contract the money supply
a. easy-money policy – designed to expand
the money supply, increase
aggregate demand, create jobs
b. tight-money policy – slows business
activity and helps stabilize prices
B. Components of monetary policy
1. open-market operations – buying and selling
of government securities (FOMC)
2. discount rate – the interest rate the Fed
charges member banks to the use of its
reserves – which in turn affects the prime rate
3. reserve requirement – the money that must
be held by banks
4. margin requirement - the percentage of cash
an investor must have to buy stocks, options, and
other investments
5. credit regulation – length, down payment, only
in times of national emergency
6. moral suasion – unofficial pressures that Fed
policy makers can exert on the banking system
C. Policy Limitations
1. economic forecasting
2. time lags in developing and carrying out
monetary policy
3. priorities and trade-offs
4. lack of coordination among government
agencies
5. conflicting opinions
Money and
Monetary Policy
24
How the Government Stabilizes the Economy
25
How the FED Stabilizes the Economy
These are the three Shifters of
Money Supply
26
3 Shifters of Money Supply
The FED adjusting the money supply by
changing any one of the following:
1. Setting Reserve Requirements (Ratios)
2. Lending Money to Banks & Thrifts
•Discount Rate
3. Open Market Operations
•Buying and selling Bonds
The FED is now chaired by Janet Yellen.
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#1. The Reserve Requirement
If you have a bank account, where is your money?
Only a small percent of your money is in the safe. The
rest of your money has been loaned out.
This is called “Fractional Reserve Banking”
The FED sets the amount that banks must hold
The reserve requirement (reserve ratio) is
the percent of deposits that banks must hold in
reserve (the percent they can NOT loan out)
• When the FED increases the money supply it increases the
amount of money held in bank deposits.
• As banks keeps some of the money in reserve and loans out
their excess reserves
• The loan eventually becomes deposits for another bank that
will loan out their excess reserves.
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The Money Multiplier
Example: Assume the reserve ratio in the US is 10%
You deposit $1000 in the bank
The bank must hold $100 (required reserves)
The bank lends $900 out to Bob (excess reserves)
Bob deposits the $900 in his bank
Bob’s bank must hold $90. It loans out $810 to Jill
Jill deposits $810 in her bank
SO FAR, the initial deposit of $1000 caused the
CREATION of another $1710 (Bob’s $900 + Jill’s $810)
Money
Multiplier
1
= Reserve Requirement (ratio)
Example:
• If the reserve ratio is .20 and the money supply increases
2 Billion dollars. How much the money supply increase?
29
Using Reserve Requirement
1. If there is a recession, what should the FED do to
the reserve requirement? (Explain the steps.)
Decrease the Reserve Ratio
1.
2.
3.
Banks hold less money and have more excess reserves
Banks create more money by loaning out excess
Money supply increases, interest rates fall, AD goes up
2. If there is inflation, what should the FED do to the
reserve requirement? (Explain the steps.)
Increase the Reserve Ratio
1. Banks hold more money and have less excess reserves
2. Banks create less money
3. Money supply decreases, interest rates up, AD down
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#2. The Discount Rate
The Discount Rate is the interest rate that the
FED charges commercial banks.
Example:
• If Banks of America needs $10 million, they borrow it
from the U.S. Treasury (which the FED controls) but
they must pay it bank with 3% interest.
To increase the Money supply, the FED should
_________ the Discount Rate (Easy Money Policy).
DECREASE
To decrease the Money supply, the FED should
_________ the Discount Rate (Tight Money Policy).
INCREASE
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#3. Open Market Operations
• Open Market Operations is when the FED buys
or sells government bonds (securities).
• This is the most important and widely used
monetary policy
To increase the Money supply, the FED should
BUY
_________
government securities.
To decrease the Money supply, the FED should
SELL government securities.
_________
How are you going to remember?
Buy bonds-BIG BUCKSBuying bonds increases money supply
Sell Bonds-SMALL BUCKSSelling bonds decreases money supply
32
The Money Market
(Supply and Demand for Money)
33
Interest Rates are important
• Way to protect our money from the effects of inflation
• Opportunity cost for holding money (keeping money in
our wallets) is the interest your money would have
earned if you put it in the bank.
• Interest rates that banks pay you for your deposits are
related to the interest rates that banks charge when
they loan money out.
• When we look at the relationship between the demand
for money and interest rate we are looking at shortterm rates
34
The Demand for Money
At any given time, people demand a certain amount of
liquid assets (money) for everyday purchases
The Demand for money shows an inverse
relationship between nominal interest rates
and the quantity of money demanded
1. What happens to the quantity demanded of
money when interest rates increase?
Quantity demanded falls because individuals
would prefer to have interest earning assets instead
2. What happens to the quantity demanded when
interest rates decrease?
Quantity demanded increases. There is no incentive
to convert cash into interest earning assets
35
The Demand for Money
Inverse relationship between interest rates and
the quantity of money demanded
Nominal
Interest Rate
(ir)
20%
5%
2%
0
DMoney
Quantity of Money
(billions of dollars)
36
The Demand for Money
What happens if price level increases?
Nominal
Interest Rate
(ir)
20%
Money Demand Shifters
1. Changes in price level
2. Changes in income/ Changes in Real
GDP
3. Changes in taxation that affects
investment
4. Changes in banking technology (ATMs)
5. Changes in banking institutions (interest
on checking)
5%
2%
0
DMoney1
DMoney
Quantity of Money
(billions of dollars)
37
The Supply for Money
The U.S. Money Supply is set by the Board of
Governors of the Federal Reserve System (FED)
Interest
Rate (ir)
20%
The FED is a nonpartisan
government office that sets and
adjusts the money supply to
adjust the economy
5%
This is called Monetary
Policy.
SMoney
2%
DMoney
200
Quantity of Money
(billions of dollars)
38
Supply and Demand is
important
• The equilibrium interest rate is
determined by the supply and demand
for money
39
Monetary Policy
When the FED adjusts the money supply to
achieve the macroeconomic goals
40
Increasing the Money Supply
Interest
Rate (ir)
SM SM1
10%
5%
If the FED increases the
money supply, a temporary
surplus of money will
occur at 5% interest.
The surplus will cause the
interest rate to fall to 2%
2%
DM
200
Increase
money supply
250
How does this
affect AD?
Quantity of Money
(billions of dollars)
Decreases
interest rate
Increases
investment
Increases
AD
41
Decreasing the Money Supply
Interest
Rate (ir)
SM1 SM
10%
5%
2%
If the FED decreases the
money supply, a temporary
shortage of money will occur
at 5% interest.
The shortage will cause the
interest rate to rise to 10%
How does this
affect
AD?
D
M
150
Decrease
money supply
200
Quantity of Money
(billions of dollars)
Increase
interest rate
Decrease Decrease AD
investment
42
Showing the Effects of
Monetary Policy Graphically
Three Related Graphs:
• Money Market
• Investment Demand
• AD/AS
43
Interest
Rate (i)
Interest
Rate (i)
S&D of Money
SM SM1
10%
10%
5%
5%
2%
2%
DM
200
PL
250
QuantityM
AD/AS
PL1
PLe
Qe
Q1
DI
Quantity of Investment
The FED increases the
money supply to
stimulate the economy…
AS
AD
Investment Demand
AD1
GDPR
1. Interest Rates Decreases
2. Investment Increases
3. AD, GDP and PL Increases
44
Interest
Rate (i)
Interest
Rate (i)
S&D of Money
SM1 SM
10%
10%
5%
5%
2%
2%
DM
175
PL
200
QuantityM
AD/AS
PLe
Quantity of Investment
1. Interest Rates increase
2. Investment decreases
3. AD, GDP and PL decrease
PL1
AD
AD1
Qe
DI
The FED decreases the
money supply to slow
down the economy…
AS
Q1
Investment Demand
GDPR
45
The role of the Fed is to “take away the punch bowl just as the
party gets going”
46
Practice
Don’t forget the Monetary Multiplier!!!!
1. If the reserve requirement is .5 and the FED
sells $10 million of bonds, what will happen
to the money supply?
2. If the reserve requirement is .1 and the FED
buys $10 million bonds, what will happen to
the money supply?
3. If the FED decreases the reserve requirement
from .50 to .20 what will happen to the
money multiplier?
47
Federal Funds Rate
The federal funds rate is the interest rate that
banks charge one another for one-day loans of
reserves.
The FED can’t simply tell banks what interest
rate to use. Banks decide on their own.
The FED influences them by setting a target rate
and using open market operation to hit the
target
The federal funds rate fluctuates due to market
conditions but it is heavily influenced by
monetary policy (buying and selling of
bonds)
48
2007
2008
December
November
October
September
August
July
June
May
April
March
February
January
December
November
October
September
August
July
June
May
April
March
February
January
December
November
October
September
August
July
June
May
April
March
February
January
Percent
Federal Funds Rate
Target Federal Funds Rate
6
5
4
3
2
1
0
.25%
2009
49
50
2007B Practice FRQ (Do a. and b. only)
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2007B Practice FRQ
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2007B Practice FRQ
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2009B Practice FRQ
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