Chapter 34 - Money, the Federal Reserve and Interest Rates - PDF

economics McConnell Brue Flynn Chapter 34 Money, the Federal Reserve, and Interest Rates © McGraw Hill LLC. All rights reserved. No reproduction or...

economics McConnell Brue Flynn Chapter 34 Money, the Federal Reserve, and Interest Rates © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Chapter Contents The Functions of Money The Components of the Money Supply What “Backs” the Money Supply? The Federal Reserve and the Banking System Fed Functions, Responsibilities, and Independence Fractional Reserve banking and the Money Supply Interest Rates 34-2 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  What is the purposes of money? To buy goods: 1 pack of To buy services: a haircut potatoes chips = RM 3.50 cost = RM 35 13-3 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Functions of Money (1) Medium of exchange: Used to buy and sell goods and services. (2) Unit of account: agreed measure for stating the prices of goods and services (Goods valued in dollars). (3) Store of value: Hold some wealth in money form (e.g., house, land, gold). Money has the advantage of liquidity (asset can be converted into cash quickly). 34-4 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Origin of money: Barter System 13-5 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Origin of money: Gold standard Later, people realized that this method of bartering could not preserve value, so they used precious metals as a medium of exchange. Gold, silver, and copper are all among the precious metals. 13-6 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Origin of money: First paper currency 13-7 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Origin of money: Paper currency Earlier banknote in US is used for military purposes. Colonial Notes, Continental Currency， 1690 1775 13-8 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Origin of money: USD The First $2 Note， 1776 was issued 9 days before US independence. 1785，Adoption of the Dollar Sign 13-9 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  First bank in America established The founding father of the United States, Alexander Hamilton, established the first bank in American history to provide loans to the nation. He created the American loan system. 13-10 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  13-11 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Bretton Wood Agreement Per ounce of gold Reserves USD 35 13-12 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  13-13 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  13-14 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Money Definition M1 M1 consists THREE component: 1. Currency – coins and paper money in the hands of the public. Currency consists of coins (e.g., token money like bank notes) and paper money (Federal Reserve Notes issued by the Federal Reserve Banks). 34-15 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Money Definition M1 2. Checkable deposits at commercial banks – bank account upon which checks can be drawn (e.g., checking, saving or money market accounts). 3. Other liquid deposits – checkable deposits held at credit unions (non-profit organization to serve customers financial needs) or thrift institutions (saving and loan association that specializes in accepting saving deposits and making mortgage and loans). 34-16 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Money Definition M2 M2 = M1 + two near-monies (small-denominated time deposits + money market mutual funds). Time deposit – an interest earning deposit in a commercial bank. Money market mutual funds – invest in short-term securities. Depositor can write checks in minimum amounts in their accounts. *Near-money means highly liquid financial assets that can be converted into money. 34-17 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Components of Money Supplies M1 and M2 Source: Board of Governors of the Federal Reserve System. 34-18 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  What “Backs” (Guaranteed) the Money Supply? Money supply in the U.S. is essentially “backed” which is guaranteed by government’s ability to keep value stable. Paper money as debt à promises to pay Why is money valuable? Acceptability – money accepted by people. Legal tender – any form of currency by law must be accepted by creditors/lenders for the settlement of a financial debts. Relative scarcity – depends on its supply and demand. 34-19 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Money and Prices Prices affect purchasing power of money. Purchasing power of money – amount of goods and services a unit of money will buy. If the price level of goods goes up, the value of a dollar goes down. Thus, hyperinflation happen because governments created/printed more money (increase money supply) that not supported by economic growth/economic’s production, causes to demand-pull inflation occurs. To conclude: higher prices à consumer pays more on goods à central bank prints more money à but the market unable to supply production à hyperinflation occurs. 34-20 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Hyper inflation The hyperinflation ended in early 2009, when Zimbabwe abandoned its domestic currency and fully dollarized. As inflation spiraled out of control, the population dropped the Zimbabwean dollar and opted to conduct transactions only in foreign currency or through barter. 13-21 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Money and Prices Stabilizing money’s purchasing power: governments need to stable money supply to keep the economy on a steady pace. Intelligent management of the money supply— monetary policy Appropriate fiscal policy 34-22 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  The Federal Reserve and the Banking System Federal Reserve System – central bank of the U.S. to control money supply. Board of Governors – central authority 12 Federal Reserve Banks implement: Serve as the central bank Quasi-public banks – mix with private and public ownership controlled by governments Banker’s banks – reserve balances (funds that commercial banks & thrift institutions hold on deposit at the central bank). 34-23 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Federal Reserve and Its Relationship to the Public This figure shows that Federal Open Market Committee (FOMC) is formed to help Board of Governors in setting monetary policy and 12 Federal Reserve Banks. Then, FOMC set up 12 individuals Federal Reserve Banks: (1) 7 members of the Board of Governors; (2) one president of the New York Federal Reserve Bank; (3) 4 presidents selected from the remaining Federal Reserve Banks, each serving on a one-year rotating basis. 34-24 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Federal Reserve and Its Relationship to the Public Under 12 Federal Reserve Banks, it divided into two: (1) commercial bank; (2) Thrift institutions. Each bank is privately owned by the private commercial banks in its district. Unlike private institutions look for profit, but they are not motivated by profit but rather seek to promote the well-being of the economy as a whole. 34-25 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  The 12 Federal Reserve Districts This figure shows the 12 Federal Reserve Bank was set up Source: Federal Reserve Bulletin, Board of Governors of the Federal Reserve System. 34-26 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Federal Open Market Committee, Commercial Banks, and Thrifts Federal Open Market Committee (FOMC): Help Board of Governors in setting monetary policy à make up 12-member group (12 Federal Reserve Banks) Conducts open market operations Commercial banks and thrifts: 4,300 commercial banks in U.S. 7,000 thrifts institutions 34-27 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Global Perspective THE WORLD’S 12 LARGEST COMMERCIAL BANKS, 2021 This bar chart represents the 12 largest commercial banks in 5 countries: China, France, Japan, U.K., and U.S. in the world as of 2021. Their assets have all been translated into U.S. dollars for comparison purposes. Source: "The World's Largest Public Companies 2021," Forbes. 34-28 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Federal Reserve Functions (1) Issuing currency – The Federal Reserve Banks issue Federal Reserve Notes, the paper currency used in the U.S. (2) Holding reserves and setting reserve requirements (3) Lend money to financial institutions (4) Providing for check collection (5) Act as a fiscal agent for U.S. government (6) Supervise banks (7) Control the money supply 34-29 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Federal Reserve Independence Established by Congress as an independent agency of the federal government. Objective of the independent agency: (1) Protects the Fed from political pressures à control money supply and maintain price stability. (2) Enables the Fed to take actions to increase interest rates in order to curb inflation as needed. 34-30 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Fractional Reserve Banking System Fractional reserve banking system – A system in which commercial banks and thrift institutions hold less than 100% of their checkable- deposit liabilities as reserves of currency held in bank vaults or deposits at the central bank. Characteristics of fractional reserve banking: Banks create money through lending. Banks are subject to panics (e.g., if every depositor demands their funds back all at the same time, it causes bank panic). 34-31 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Fed Influence over Lending and Money Supply Fed can change money supply by encouraging banks to increase /decrease lending. When Fed policy prompts banks to increase (decrease) lending, access to credit is easier (result in a lesser volume of loans and higher interest rates). Such decisions tend to change: 1. Total amount of checkable-deposit money 2. Overall money supply 3. Interest rates 4. Overall economic activity 34-32 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Interest Rates Interest: The price paid for the use of money. § There are many different interest rates § Determined by the money supply and money demand. 34-33 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Demand for Money (1) Transactions demand for money, Dt – the amount of money people want to hold for use as a medium of exchange (to make payments). It is determined by nominal GDP & independent of the interest rate. (2) Asset demand for money, Da – the amount of money people want to hold as a store of value. This amount varies inversely with the interest rate (e.g., if interest rates increase, the demand for money as an asset goes down). (3) Total demand for money, Dm – the sum of the transactions demand for money and the asset demand for money. 34-34 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Equilibrium Interest Rates Equilibrium interest rate: Changes with shifts in money supply and money demand. à This equilibrium interest rate will cause the supply of money available to equal the demand for money. 34-35 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Interest Rates & Bond Prices Interest rates and bond prices are inversely related. When the interest rate ↑ (↓), bond prices ↓ (↑). Bond pays fixed annual interest payment. Lower bond price will raise the interest rate. 34-36 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Cryptocurrencies Cryptocurrencies (e.g., Bitcoin) - a digital currency which is an alternative form of payment created using encryption algorithms. Digital currencies like Bitcoin use blockchain technology to track the ownership of digital money. Blockchain based digital currencies are referred to as cryptocurrencies because their consensus mechanisms use encryption algorithms. 34-37 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.