Macroeconomics Notes 4

Weve already extensively discussed money, inflation and the banking system. For the few lectures we have left, well continue to discuss money. Why does money have value? Several answers: value of money is backed by debt, value of money is backed by laws, or money has no value since it is no longer backed by gold or other commodity. Some of these answers are technically correct, but if one stops at these definitions, one loses significant intuition about the role that money plays in our economy and civilization. Why do we have money? Why is money necessary? Why is money the greatest invention/discovery of them all (perhaps)? Money is a medium of exchange Money is a store of value Money is a unit of account BE ABLE TO DETAIL WHY EACH OF THESE PROPERTIES OF MONEY MAKES MONEY USEFUL!!!! Why do banks exist? http://en.wikipedia.org/wiki/Financial_intermediary Banks are firms in many ways they are firms like all othe rsthey match up sellers and buyers. Specifically, banks: are an economically advantageous way to match borrowers and lenders. They match based on size and time needs. They also

seem to be an economically advantageous way to provide information about credit risk. are also insurance companies in that they effectively (most of the time) are able to spread risk over large numbers of people. (In the current, and in fact most financial crises, there is a significant breakdown in this function of the banking system.) are agents that reveres the desired position of most individuals in the economy. Most people want their assets to be close and their liabilities to be far. Banks allow people to have these positions in their portfolios by taking opposite positions. (Banks keep their liabilities close and their assets far.) Banks, like all firms, are cost effective ways of matching buyers with sellers. They provide economies of scale and scope in the area of financial services and are able to experiment, like other firms, with what outputs can be made with the same inputs. Unfortunately, in the US and many parts of the world, banks have become too big and products of not the economic environment, but the political environment. This should not be.

Central Banks and the US Federal Reserve System. http://en.wikipedia.org/wiki/Federal_reserve

The role of the Fed has changed/expanded greatly esp. in the last few years. The primary responsibilities of the FED are: Address the problem of financial crises. Serve as the central bank of the US. To promote respect of the US economy in the world To protect consumers from banks Provide needed liquidity to financial sector Regulate banks and the broader financial sector Try to stabilze the business cycle my monetary policy. Monetary policy includes trying to achieve full employment, stable prices, and reasonable long term interest rates Contain systematic risk Provide check cashing services and other infrastructure for banks Conduct research in regional, national, and international economic issues Collect data necessary to conduct economic policy

Monetary Policy

Monetary policy is the Federal Reserves efforts to stabilize the business cycle and influence interest rates by manipulating the money supply.

What is the relationship between banking, the Federal Reserve and Monetary policy? (Take additional notes here to fill in the blanks.) The key to understanding how monetary policy works is to understand the fractional reserve banking system. With Fractional Reserve Banking, an economys money supply is created by banks when they receive deposits and make loans. (HOW?) The Federal Reserve sets Reserve Requirements. Banks are required by law to maintain proper reserves. If they fall below, they must borrow the money from other banks. Thus, the Federal Reserve can initiate a monetary expansion by lowering reserve requirements. The story of monetary policy: The Federal Reserve realizes that the economy is in trouble.

The Federal Open Market Committee (the policymakers of the Federal Reserve System) meets to decide what actions, if any the Fed should take. http://www.federalreserve.gov/monetarypolicy/fomc.htm

If the FOMC is confident that the economic is at significant risk of recession, and that a change in monetary policy is warranted, they will lower their target for the federal funds rate.

The Fed achieves its target for the federal funds rate by adjusting the amount of reserves in the banking system by conducting open market operations. http://www.federalreserve.gov/monetarypolicy/openmarket.htm

If the Federal Reserve wants to increase the monetary base, they will BUY bonds. This will increase the amount of money in the economy. (WHY?)

As the amount of money/reserves in the banking system increases, this should lower interest rates and encourage banks to lend money. This should increase investment and consumption.

Quantitative Easing is a new kind of monetary policy. about it here:

Lean

http://www.bankofengland.co.uk/education/inflation/qe/video.ht m http://www.bankofengland.co.uk/monetarypolicy/pdf/qepamphlet.pdf

With Quantitative easing, the central bank buys assets directly from businesses (that is, businesses outside the traditional banking sector). The idea is to inject money directly not in to the banking sector, but into the economy. As the money goes into the economy though the purchase of assets, the prices of assets goes up, driving yields down. The decrease in yields lowers the opportunity cost of buying new plant and equipment and other investments, so business spend more. This increased spending represents an increase in aggregate demand.

Contrast this with traditional monetary policy. With Traditional monetary policy, central banks buy bonds and put money not directly into the economy (as with QE) but put money into the banking system in the form of reserves. This lowers the federal funds rate and should lower the opportunity cost of lending by

banks. This should bring down interest rates and encourage more businesses and consumers to borrow and spend.

Why 2%? Central banks would like a zero percent inflation rate, but while they control the inflation rate (inflation is always and everywhere a monetary phenomenon), they cannot control it exactly. A little inflation is not bad, but a little deflation is devastating. So they target 2% thinking that inflation will be between 0 and 4 percent. (Think about William Tells apple.)

1. What gives money its value? 2. Characteristics of money/why is money a great invention? 3. Characteristics of money/why is money a great invention? 4. Why do banks exist? 5. Why do banks exist? 6. What is the role of the Federal Reserve? 7. What is the role of the Federal Reserve? 8. Monetary Policy..tools and goals 9. Monetary policytools and goals 10. Monetary fiscal policy compare and contrast 11. Monetary fiscal policy compare and contrast 12. Fractional reserve banking 13. Federal Funds Rate 14. Story of monetary policy 15. Story of monetary policy 16. Buying/selling bondswhat effect 17. Buying/selling of bonds...what effect 18. Impact of more/fewer reserves 19. Link between monetary policy and aggregate demand 20. Link between monetary policy and aggregate demand 21. Quantitative easing 22. Difference in QE and normal monetary policy 23. Why 2%? 24. Link between QE and aggregate demand 25. Why are central banks buying assets from firms as opposed to operating as normal in the banking system?