Money and Monetary Policy: Understanding Money Supply

Money and Monetary Policy

• Unit 4 will cover money supply and monetary policies

Money

• Money is anything generally accepted as payment for goods and services.
• Money differs from wealth and income.
• Wealth is a total collection of assets storing value, while income is a flow of earnings per unit of time.
• Commodity money performs the function of money and has alternative uses; examples are gold, silver, and cigarettes
• Fiat money serves as money but has no other important uses; examples are paper money and coins.

Functions of Money

• Money is a medium of exchange to buy goods and services without the barter system's complications.
• Money acts as a unit of account, measuring the value of all goods and services.
• One goat equals $50, which equals 5 chickens; one chicken costs $10.
• As a store of value, money allows the storage of purchasing power.
• Money does not die or spoil.

Measures of Money Supply

• Liquidity is the ease an asset can be accessed and converted into cash.
• M1 (high liquidity) includes coins, currency, and checkable deposits.
• M1 is considered the money supply.
• M2 (medium liquidity) includes M1, savings deposits, time deposits (CDs), and mutual funds below $100K.
• M3 (low liquidity) includes M2 plus time deposits above $100K.

Money Market

• The money market involves supply and demand for money
• People demand liquid assets (money) for everyday purchases, illustrating wealth holdings.
• The demand for money shows an inverse relationship between nominal interest rates and the quantity of money demanded.
• The nominal interest rate serves as the "price" of money.
• Quantity demanded falls when interest rates increase, as people prefer to save.
• Quantity demanded increases when interest rates decrease, as people prefer to hold money.

Types of Demand for Money

• Transactional demand involves needing money to buy things.
• Precautionary demand involves needing money "just in case."
• Speculative demand considers that prices or interest rates might change, impacting money needs.

Shifts in the Demand for Money

• A money demand curve shows the interest rate on the Y axis and the quantity of money on the X axis Changes in the demand for money can cause shifts of the demand money curve.
• Money demand shifters include changes in price levels, output, and transaction costs.

Monetary Policy

• Monetary policy involves actions by the FED to adjust the money supply, achieving macroeconomic goals.
• The U.S. money supply is controlled by the Board of Governors of the Federal Reserve System (FED).

Money Supply

• Setting reserve requirements, lending to banks/thrifts (discount rate), and open market operations are ways to adjust and control money supply.
• Jerome Powell currently chairs the FED.

Tools of the FED

• FED tools include the reserve requirement ratio, discount/federal funds rate, and open market operations.
• The reserve requirement dictates the percentage of deposits banks must hold in reserve, unable to loan.
• If the reserve requirement increases, the loan amount decreases, decreasing the money supply.
• A decreased reserve requirement increases the loan amount, increasing the money supply.
• In a recession, the FED decreases the reserve requirement ratio.
• Lower reserve requirements lead to banks holding less money and having more excess reserves.
• Banks create more money by loaning out excess reserves.
• The money supply increases, interest rates fall, and AD goes up.
• In inflation, the FED increases the reserve requirement ratio.
• Banks hold more money and have fewer excess reserves.
• This leads to banks create less money.
• The money supply decreases, interest rates increase, and AD goes down.
• Assets are what the banks owns and liabilities are what the banks owes.
• The assets of a Typical Bank Balance Sheet include, Required reserves, Excess Reserves, Loans, Securities (aka bonds), and Physical assets.
• LIABILITIES, things the banks OWES, and DEBT, include, Demand Deposits, Other Deposits, Other liabilities, and Owner's Equity.
• The golden rule is that a balance sheet must ALWAYS balance; changes to one side must have an equal and opposite change on the other.
• The Discount Rate is the interest rate that the FED charges commercial banks.
• Banks of America requires a $10 million loan, they borrow from the U.S. Treasury which the FED controls, but they must pay with 3% interest to the bank.
• The FED should DECREASE the discount rate in order to increase the money supply (Easy Money Policy).
• The FED should INCREASE the discount rate in order to decrease the money supply (Tight Money Policy).
• Open Market Operations happen when the FED buys or sells government bonds (securities),
• This is the most important and widely used monetary policy
• The FED should BUY government securities, to increase the Money supply.
• The FED should SELL government securities to decrease the Money supply.
• Buy-BIG means buying bonds increases money supply.
• Sell-SMALL means selling bonds decreases money supply.
• Shifting the money supply curve affects aggregate demand and remedies a gap.
• The Keynesian Transmission has 3 steps: Money Market, Investment Demand, Long -Run Macro Model

Keynesian Transmission

• In a recessionary gap, the FED increases the money supply to stimulate the economy.
• Interest rates decrease.
• Investment increases.
• AD, GDP, and PL increase.
• In an inflationary gap, the FED decreases the money supply to slow down the economy
• Interest rates increase.
• Investment decreases.
• AD, GDP, and PL decreases.

Money Multiplier

• Assuming a 10% reserve ratio in the US
• Deposit $1000 in the bank
• The bank will hold $100 in required reserves
• The remaining $900 turns into excess reserves available for loans to others, such as Bob, who then deposits the $900.
• Bob’s bank must hold $90 from the $900 deposit, then Bob loans out $810 to Jill, who deposits $810.
• The initial deposit of $1000 has caused creation of another $1710, which is Bob’s $900 and Jill’s $810.
• Money Multiplier = 1/Reserve Requirement Ratio
• Banks each other use Federal funds rate which are Overnight / one-day loans of reserves.
• A target that it is trying to hit is set up by the FED. This is done using bank's open market operations
• The FOMC can lower the target rate and buy securities to back this up. These securities are paid by crediting the reserve accounts of the banks which sold them.
• Extra cash in the banks' reserve accounts means there is less pressure on them to borrow money from other banks.
• This brings down Lack of demand, causing the actual Fed Funds Rate gets lowered.
• The FED sell government securities to instead RAISE the target rate.
• Pressure increases to borrow from other banks (to make up their reserves).
• The actual Fed funds rate gets lowered because there is an increased demand.
• This also leads to a tight monetary policy.

Tight Monetary Policy

• The Fed sells Treasury securities, taking money out of the economy.
• This creates upward pressure on the federal funds rate
• Short-term interest rates may go up because banks have less money to lend.
• There is less money that consumers and businesses may borrow.
• Consumers' and businesses' spending ends up decreasing
• Inflationary pressures decrease.
• Employment and economic growth may decrease in the short term.

Loose Monetary Policy

• The Fed buys Treasury securities, adding money to the economy.
• Downward pressure is created which leads to a lowering of the fed funds rate.
• There is short term interest rates that can also drop due to money available that banks can lend.
• more money is available to Consumers and businesses, in terms of available loans to borrow.
• Spending gets increased by consumers and businesses
• Inflation may build up. The positive side is, Employment and also the economic growth may increase in the short term.

Real and Nominal Interest Rates

• The nominal interest rate is the percentage increase in money that the borrower pays, including inflation.
• Calculation: Nominal = real interest rate + expected inflation
• The real interest rates, adjusted for inflation, show the real interest rates - The percentage increase in purchasing power that a borrower pays.
• Calculation: Real = nominal interest rate - expected inflation
• So far, you have you only been looking at NOMINAL interest rates
• Loanable Funds Market

Loanable Funds Market

• Loanable Funds rate is determined through interaction between lenders and borrowers.
• 50% interestrate can beBad for borrowers but good for lenders:
• The loanable funds market the private sector supply and demand of loans.
• This shows the effect on REAL INTEREST RATE, not nominal.
• An inverse relationship exists between real interest rate and quantity loans demanded for the Demand.
• A direct relationship exists between real interest rate and quantity loans supplied for the Supply
• Loan surplus is not the same as in the money market as supply is not vertical.
• Equilibrium is where at the "equilibrium real interest rate the amount borrowers who want to borrow", equals "the amount lenders want to lend".
• Government borrowing results in increasing demand for loans and interest rate.
• Real interest rates increase, so the crowding out happens!!

Loanable Funds Market Shifters

• Budget Surplus and Budget Deficits happen in government borrowing.
• There are two types of Shifters, Demand and Supply.

Loanable Funds Demand Shifters

• Demand Shifters include, Changes in perceived business opportunities & Changes in government borrowing

Loanable Funds Supply Shifters

• Supply Shifters include, Changes in private savings behavior, Changes in public savings, Changes in foreign personal investment and Changes in expected profitability

Explore the basics of money, its functions as a medium of exchange, unit of account, and store of value. Differentiate between commodity and fiat money, and discover how the money supply is measured. This unit provides a foundation for understanding monetary policy.