Money and Monetary Policy

Money and Monetary Policy

• Money is anything generally accepted as payment for goods and services
• Money is not the same as wealth or income
• Wealth is the total collection of assets storing value
• Income is the flow of earnings per unit of time
• Commodity money performs the function of money and has alternative uses, such as gold, silver, or cigarettes
• Fiat money serves as money but lacks other important uses

Functions of Money

• Medium of exchange: Money is easily used to buy goods and services without the complications of a barter system
• Unit of account: Money measures the value of all goods and services, acting as a measurement of value
• Example: 1 goat = $50 = 5 chickens; 1 chicken = $10
• Store of value: Money allows storing purchasing power for the future; it does not die or spoil

Measures of Money Supply

• Liquidity: Ease with which an asset can be accessed and converted into cash
• M1 (High Liquidity): Coins, currency, and checkable deposits (personal and corporate checking accounts), generally considered the money supply
• M2 (Medium Liquidity): M1 plus savings deposits (money market accounts), time deposits (CDs), and mutual funds below $100K
• M3 (Low Liquidity): M2 plus time deposits above $100K

Demand for Money

• At any time, people demand a certain amount of liquid assets for everyday purchases
• Demand for money is the desired holding of financial assets in the form of money (cash or bank deposits)
• Demand for money illustrates how a person's wealth is held

Law of Demand

• The law of demand applies to money; there is an inverse relationship between nominal interest rates and the quantity of money demanded
• The nominal interest rate is the "price" of money
• When interest rates increase, the quantity demanded falls because the "price" of money is too high, so people save more
• When interest rates decrease, the quantity demanded increases because the "price" of money is low, so people hold more

Types of Demand

• Transactional demand: Needing money to buy things
• Precautionary demand: Needing money "just in case"
• Speculative demand: Thinking prices or interest rates might change, affecting money needs

Money Demand Shifts

• Changes in the price level
• Changes in output
• Changes in transaction costs

Monetary Policy

• Actions by the Federal Reserve (FED) adjusting the money supply to achieve macroeconomic goals

Supply for Money

• The U.S. money supply is set by the Board of Governors of the Federal Reserve System (FED)

Increasing Money Supply

• When the FED increases the money supply, a temporary surplus of money occurs, causing the interest rate to fall
• Lower interest rates lead to increased investment and aggregate demand (AD)

Decreasing Money Supply

• If the FED decreases the money supply, a temporary shortage of money occurs, causing the interest rate to rise
• Higher interest rates lead to decreased investment and aggregate demand (AD)

Shifters of Money Supply

• The FED adjusts the money supply by changing:
• Setting Reserve Requirements
• Lending Money to Banks & Thrifts (Discount Rate)
• Open Market Operations (Buying and selling Bonds)
• The current chair of the FED is Jerome Powell

Tools of the Federarl Reserve (FED)

• Reserve Requirement Ratio
• Discount/Federal Funds Rate
• Open Market Operations

The Reserve Requirement

• Banks loan out most customer money, keeping only a small percentage in the safe
• The FED sets the amount that banks must hold; this is called "Fractional Reserve Banking"
• The reserve requirement (reserve ratio) is the percentage of deposits that banks must hold (cannot loan out)
• Increased reserve requirement decreases the money supply
• Decreased reserve requirement increases the money supply
• Assets are what banks OWNS : required reserves, excess reserves, loans, securities, physical assets
• Liabilities are what banks OWES : demand deposits, other deposits, other liabilities, owner's equity
• A balance sheet MUST always balance

Using Reserve Requirement

• In a recession, the FED should decrease the reserve requirement ratio
• 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
• In inflation, the FED should increase the reserve requirement ratio
• Banks hold more money and have less excess reserves
• Banks create less money
• Money supply decreases, interest rates rise, AD goes down

The Discount Rate

• Discount Rate: The interest rate the FED charges commercial banks
• Example: Banks of America borrows $10 million from the U.S. Treasury (controlled by the FED) and pays it back with 3% interest
• To increase the money supply, the FED should DECREASE the Discount Rate (Easy Money Policy)
• To decrease the money supply, the FED should INCREASE the Discount Rate (Tight Money Policy)

Open Market Operations

• Involves the FED buying or selling 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
• Buy-BIG: Buying bonds increases the money supply
• Sell-SMALL: Selling bonds decreases the money supply

Why Shifts of Money Supply matter

• Shifting the money supply curve affects aggregate demand (AD) and remedies a gap

Keynesian Transmission

• Money Market
• Investment Demand
• Long-Run Macro Model

The Money Multiplier

• Money Multiplier is the reserve requirement ratio and .
• The total deposit is the Bob deposit and Jill deposit.

Federal Fund Rates

-The rate that the Federal Reserve charges other banks for one night loans or reserves -The Federal Reserve cannot directly state what interest rate to use but instead they influence them by hitting a target rate

Practice

Tight Monetary Policy

• The Federal Reserve sells treasury securities removing money and making it tight
• This creates upward pressure
• Short term rates go up since banks have less money to lend
• Consumers borrow less
• Employment eases
• Inflation pressures go down

Loose Monetary Policy

• The Federal Reserve buys treasurer securities adding more money in
• Downward pressure occurs
• Short term rates may go down since banks have more to lend
• Consumers borrow more
• Employment increases
• Inflationary pressures go up

Real vs Nominal Interest Rates

• Nominal Interest Rates: the percentage increase in money that the borrower pays
• Nominal = real interest rate + expected inflation
• Real Interest Rates: the percentage increase in purchasing power that a borrower pays.
• Real = nominal interest rate - expected inflation

Loanable Funds Market

• Show the effect on real interest rate.
• Demand ineres is an inverse relationship between the real rate and the quantity demand loan.
• Supply is a vertical relationship.
• Governments borrows from private sector. Increasing the damand for loans and increasing the interest rate.

Demand Shifters

• Changes business expectations
• Change the government borrowing
• Budget Deficit
• Budget Surplus

Supply

-Changes in Savings Behavior -Changes in savings in public

-Loans Private sector that supplies and demand loans between each party.

The equailibrium real interest rate equals amount borrowers wanting to borrow from the lender.

Understand the functions of money as a medium of exchange, unit of account, and store of value. Learn about the measures of money supply, including M1 and liquidity.