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What is money?
Anything that is generally accepted as payment for goods and services or in the settlement of debt.
What are the 3 functions of money?
Medium of exchange
Store of value
Unit of Account
What does it mean that money is a medium of exchange?
You can use it to purchase goods and services.
It’s more efficient than the barter system
What does it mean that money is a store of value?
It retains a certain amount of purchasing power over time.
Most convenient way to hold onto wealth over time
What does it mean that money is a unit of account?
It is a standard unit of comparison
Allows for more informed decisions
What are the characteristics of good money?
Stability of value - wide acceptance
Convenience - more convenient than the gold standard
What is fiat money?
Money that has no value apart from its use as money.
Money is really based upon trust
What is commodity-backed money?
Paper currency that can be exchanged for a commodity
Ex: $1 = 1/20 oz gold
What is an advantage of a fiat system?
The government has the ability to manage the money supply.
What is a central bank NOT?
A commercial bank
The government’s financial arm
That is the Treasury Department
What type of policy does the Treasury Department conduct?
Fiscal
What type of policy do central banks conduct?
Monetary
What is the dual mandate of the Fed?
Price stability
Maintain stable money supply while keeping prices constant over time
Maximum sustainable employment
What does it mean when the Fed is called a Lender of Last Resort?
It financially supports banks that no longer have other available means of borrowing.
What is the central bank?
A government institution that is charged with:
Achieving macroeconomic stability
Achieving financial stability
Regulating commercial banks
What is a district bank?
A joint venture between the private sector and the government sector
What are the activities of district banks?
Manage check clearing
Hold reserves
Manage currency in circulation
Make discount loans
Collect data and engage in research
How is the Fed organized?
12 regional banks headed by Board of Governors
What is the Federal Market Open Committee responsible for?
Setting monetary policy
What is the Board of Governors?
7 members
Appointed by President and confirmed by Senate for 14-year terms
Experts in finance, banking, and monetary policy
Who makes up the FOMC?
The Board of Governors
5/12 of the Presidents of District Banks
The President of the New York regional bank is always a member
What makes the Fed independent?
It does not need the permission of the President or Congress to make and implement changes.
Is also financially independent
How does the Fed primarily influence the economy?
By changing interest rates
What is expansionary monetary policy?
Actions that increase the money supply in order to increase aggregate demand
When would the Fed want to use expansionary monetary policy?
When economy is in a recession and when there’s a concern about unemployment
How does expansionary monetary policy impact the following: Interest rates, money supply, component(s) of aggregate demand, aggregate demand, prices, real GDP, and employment?
Interest rate - Decreases
Money supply - Increases
Investment and consumption - Increase
Aggregate Demand - Increases
Prices - Increase
Real GDP - Increases
Employment - Increases
What is contractionary monetary policy?
Actions that reduce the money supply in order to decrease aggregate demand
When would the Fed want to use contractionary monetary policy?
When economy is in a boom and when inflation is high
How does contractionary monetary policy impact the following: Interest rates, money supply, component(s) of aggregate demand, aggregate demand, prices, real GDP, and employment?
Interest rate - Increases
Money supply - Decreases
Investment and consumption - Decrease
Aggregate Demand - Decreases
Prices - Decrease
Real GDP - Decreases
Employment - Decreases
What are reserve balance accounts?
The accounts in which banks hold cash at the Fed
What are federal funds transactions?
The transfer of funds from one bank’s reserve account to another bank’s reserve account.
What is the federal funds rate (FFR)?
The interest rate banks charge each other to borrow.
How would the Fed alter the FFR during expansionary monetary policy?
Lowers target for FFR
How would the Fed alter the FFR during contractionary monetary policy?
Increases target for FFR
How does the Fed influence the federal funds rate?
Expansionary policy - decreases it
Contractionary policy - increases it
What are the monetary policy tools?
Interest Rate on Reserve Balances (IORB)
Overnight Reserve Repurchasing Facility Offering Rate (ON RRP)
Discount Rate
Open Market Operations
Reserve Requirement Ratio (RRR)
What is the IORB?
The interest rate that banks earn from the Fed on the funds they deposit in their reserve balance accounts
How would the Fed alter the IORB during expansionary monetary policy?
Decrease IORB
How would the Fed alter the IORB during contractionary monetary policy?
Increase IORB
What is the ON RRP?
The interest rate at which different market participants swap treasuries for cash to cover short-term cash needs
For financial institutions that aren’t eligible to receive IORB
Should be a floor on the FFR
Currently = 5.30%
How would the Fed alter the ON RRP during expansionary monetary policy?
Decrease ON RRP
How would the Fed alter the ON RRP during contractionary monetary policy?
Increase ON RRP
What is the discount rate?
The interest rate the Fed charges banks to borrow
Should be a ceiling on the FFR
Currently = 5.50%
How would the Fed alter the discount rate during expansionary monetary policy?
Decrease discount rate
How would the Fed alter the discount rate during contractionary monetary policy?
Increase discount rate
What are open market operations?
The Fed’s buying and selling of U.S. government bonds in the secondary market
How would the Fed alter open market operations during expansionary monetary policy?
Fed should buy bonds from banks
Banks have more money to lend
How would the Fed alter open market operations during contractionary monetary policy?
Fed should sell bonds to banks
Banks have less money to lend
What is the RRR?
The percent of a deposit banks are required to hold
How would the Fed alter the RRR during expansionary monetary policy?
Decrease RRR
How would the Fed alter the RRR during contractionary monetary policy?
Increase RRR
What are some advantages of monetary policy?
Speed and flexibility
Isolated from political pressure
Doesn’t make decisions based on who will get votes
What are some disadvantages of monetary policy?
Fed can’t control behavior of banks, businesses, and households
Lower bound on interest rates
When interest rates are close to zero, or even negative, central banks may run out of room to stimulate the economy in times of recession or deflation.
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