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Chapter 13 & 14 Money, banks, the Federal Reserve System and Monetary Policy

Money plays a very important role in an economy. 13.1 What Is Money, and Why Do We Need It? Money is defined as any assets that people are willing to accept in exchange for goods and services or for payment of debts. An asset is anything of value owned by a person or a firm. The Functions of Money Money has the following three roles: 1. Medium of exchange: Buyers exchange money for goods and services they purchase. Example: When you buy a cup of coffee, the money you hand to the cashier in exchange for the coffee, in this case the money is a medium of exchange. As medium of exchange, money creates efficiency in the economy. Without money, we would have a situation known as barter an exchange of a good or service for another. In this case exchange would only be possible with double coincidence of wants. 2. Unit of account: Money is also used as a measure the value of goods (prices), the economy (GDP), and debt and so on. Example: When you want to buy a laptop, one of the information you use is the price. In this case the price of the laptop is a typical usage of money as a unit of account. 3. Store of value: Money can also be used as a store of value for future consumption. Example: The money in your wallet or in your bank account is a typical example of usage of money as a store of value. Unlike the first two functions of money, money is not the only store of value. Jewelry, stocks, houses, and other assets can be used as a store of value. However, money allows value to be stored easily. Money has liquidity, which is the ease with which an asset can be converted into a medium of exchange. Different Types of Monetary System Commodity Money: This is the money with intrinsic value. Example: Gold coins, cigarettes. Gold standard: A monetary system in which gold backs up paper money. Fiat Money: Money with no intrinsic value. The value of this type of money derives from a government decree, and trust from the agents using it. Example: US dollar. Measuring Money in the US The most basic measure of Money is known as M1. M1 is composed of the most liquid type of money.

Another way of measuring money is M2. M2 is broader definition than M1. M2 = M1 + other assets including deposits in savings + loans accounts + money market mutual funds.

13.2 How Banks Create Money


To understand how banks create money lets look at a banks balance sheet. Balance sheet: An account statement for a bank that shows the sources of its funds (liabilities) as well as the uses of its funds (assets). Liabilities: The sources of funds for a bank, including deposits and owners equity. Assets: The uses of the funds of a bank, including loans and reserves.

Reserves: The portion of banks deposits set aside in either vault cash or as deposits at the Federal Reserve. Required reserves: The specific fraction of their deposits that banks are required by law to hold as reserves. Excess reserves: Any additional reserves that a bank holds above required reserves. How banks create Money? Example: Suppose you deposit $1000 at you bank. Lets call it first bank. Assume that banks keep 10% of their deposits as reserves. This means that the reserve ratio is 0.1. How much money will be created in the banking system?

How money multiplier works


Total increase in checking account balance throughout all banks = (initial deposit)*1/ Reserve Ratio

Example: How much money will be created in the banking sector from your initial deposit of $1000, taking into account that the reserve ratio is 0.1? 13.3 The FEDERAL RESERVE SYSTEM The Federal Reserve System (The FED) is the central bank in the US. The Fed like any other central banks controls the supply of money in the US. Lender of last resort: As a central Bank, the Fed is the lender of last resort, the last place, all others having failed, from which banks in emergency situations can obtain loans.

Functions of the Federal Reserve


THE FED SUPPLIES CURRENCY TO THE ECONOMY

Working through the banking system, the Federal Reserve is responsible for supplying currency to the economy. Although currency is only one component of the money supply, if individuals prefer to hold currency rather than demand deposits, the Federal Reserve and the banking system will facilitate the publics preferences.
THE FED PROVIDES A SYSTEM OF CHECK COLLECTION AND CLEARING

The Federal Reserve is responsible for making our system of complex financial transactions work.
THE FED HOLDS RESERVES FROM BANKS AND OTHER DEPOSITORY INSTITUTIONS AND REGULATES BANKS

As we have seen, banks are required to hold reserves with the Federal Reserve System. The Federal Reserve also serves as a regulator to banks to ensure they are complying with rules and regulations. Ultimately, the Federal Reserve wants to ensure the financial system is safe.
THE FED CONDUCTS MONETARY POLICY Monetary policy: The range of actions taken by the Federal Reserve to influence the level of GDP or inflation.

The Independence of the Federal Reserve


Countries differ in the degree to which their central banks are independent of political authorities. In the United States, the chairperson of the Board of Governors is required to report to Congress on a regular basis, but in practice, the Fed makes its own decisions and later informs Congress what it did.

Chapter 14 The Federal Reserve and the Monetary Policy


Here, we look at how monetary policy affects the economy in the short run. First, we present a model of the money market. By controlling the money supply, the Fed can change the level of interest rates. Changes in interest rates will in turn affect investment and output. In an open economy, exchange rates and net exports are also affected by interest rates. So, individuals who want to invest or purchase a new home also want to know what the Fed will do

about interest rate in the near future. Monetary policy refers to the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy goals. A. The Goals of Monetary Policy The Fed has set four monetary policy goals that are intended to promote a well-functioning economy: 1. Price Stability. Rising prices erode the value of money as a medium of exchange and a store of value. 2. High Employment or a Low Rate of Unemployment. Unemployed workers and underused factories and office buildings reduce GDP below its potential level. 3. Stability of Financial Markets and Institutions. Resources are lost when financial markets are not efficient in matching savers and borrowers. 4. Economic Growth. Policymakers aim to encourage stable economic growth because stable growth allows households and firms to plan accurately and encourages long-run investment. 14.1 The Money Market Money market: the market for money in which the amount supplied and the amount demanded meet to determine the nominal interest rate. Fig. 14.1

The Demand for Money I - Transaction demand for Money: The demand for money based on the desire to facilitate transaction. Factors that affect the demand for money a) Interest rate ( - ): The higher the interest rate the less likely people will demand money since you would rather hold your wealth in another way than money. Also interest rate is the opportunity cost of holding money. b) Price level (+): The higher the prices, the more people demand money.

c) GDP (+): The richer the citizens of a country the more money they demand. Why: Higher GDP implies higher consumption, hence higher demand for money. Fig 14.2

II Liquidity demand for money: The demand for money that represents the needs and desires individuals and firms have to make transactions on short notice without incurring excessive costs. III - Speculative demand for money: The demand for money that arises because holding money over short periods is less risky than holding stocks or bonds. Recall that by changing the money supply the Fed can change the interest rate. HOW THE FEDERAL RESERVE CAN CHANGE THE MONEY SUPPLY

I-

Open Market Operations

Open market operations: The purchase or sale of U.S. government securities by the Fed. Open market purchases: The Feds purchase of government bonds from the private sector. (Expansionary Monetary Policy) Open market sales: The Feds sale of government bonds to the private sector.( Contractionary Monetary Policy)

II-

Changing Reserve Requirements


If the Fed wishes to increase the Money Supply will reduce the reserve requirement, so the banks have more money to loan.

III-

Changing the discount Rate


Discount Rate is the rate at which banks can borrow from the Fed Federal Funds Rate: The interest rate on reserves that banks lend each other.

HOW INTEREST RATES ARE DETERMINED: COMBINING THE DEMAND AND SUPPLY OF MONEY Fig 14.3 Equilibrium in the money market occurs at an interest rate of r*, at which the quantity of money demanded equals the quantity of money supplied.

Fig 14.4 : Open Market Purchases Vs. Open Market Sale

Interest Rate and bond Price

HOW OPEN MARKET OPERATIONS DIRECTLY AFFECT BOND PRICES Bond prices rise as interest rates fall

GOOD NEWS FOR THE ECONOMY IS BAD NEWS FOR BOND PRICES Increased money demand will increase interest rates

Example: Suppose the promised payment next year is $106 and the interest rate is 6% per year. What is the price of the bond? Answer: 14. 4 INTEREST RATES AND HOW THEY CHANGE INVESTMENT AND OUTPUT (GDP) (contd) The equilibrium interest rate r* is determined in the money market. At that interest rate, investment spending is given by I*. ( figs 14.5 and 14.6)

Money Supply and Aggregate Demand When the money supply is increased, investment spending increases, shifting the AD curve to the right. Output increases and prices increase in the short run. ( See fig 14.7)

Monetary Policy and International Trade


Exchange rate: The rate at which currencies trade for one another in the market. Depreciation of a currency: A decrease in the value of a currency.

Appreciation of a currency: An increase in the value of a currency.

Lags in Monetary Policy Inside lags are the time it takes for policymakers to recognize and implement policy changes. Outside lags are the time it takes for policy to actually work