Chapter 11 - Money, Banking, and Monetary Policy

Stock

A certificate that represents a claim to, or share of the ownership of a firm

Equity financing

The firms method of raising funds for investment by issuing shares of stock to the public

Bond

A certificate of indebtedness from the issuer to the bondholder

Debt financing

A firms way of raising investment funds by issuing bonds to the public

Fiat money

The paper and coin money used today

Functions of money

* Medium of exchange
* Unit of account
* Store of value

Medium of exchange

It follows the logic that your labor hours turn into money, the money turns into apples, the farmer then exchanges the money for an orchards apple crop, and so on

Unit of account

Units of currency measure the relative worth of goods and services

Store of value

Money is a relatively good way to store value, when theres no inflation, because it keeps its value

Money supply

The quantity of money in circulation as measured by the Federal Reserve (the Fed) as M1 and M2. It is assumed to be fixed at a given point in time.

Liquidity

A measure of how easily an asset can be converted to cash

M1

The most liquid of money definitions and the basis for all other more broadly defined measures of money

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* M1 = Cash + Coins + Checking deposits + Traveler’s checks.

M2

It is less liquid than M1

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* M2 = M1 + Savings deposits + Small time deposits + Money market deposits + Money market mutual funds.

Transaction demand

The amount of money held in order to make transactions. This is not related to the interest rate, but it increases as nominal GDP increases.

Asset demand

The amount of money demanded as an asset. As nominal interest rates rise, the opportunity cost of holding money begins to rise and you are more likely to lessen your asset demand for money.

Total demand

Plotted against the nominal interest rate, the transaction demand for money is a constant MDt. Adding this constant needed to make transactions to a downward-sloping asset demand for money (MDa) creates the **total money demand curve.**

Money demand

The demand for money is the sum of money demanded for transactions and money demanded as an asset. It is inversely related to the nominal interest rate.

Theory of liquidity preference

Keynes theory that says that the equilibrium price of money is the interest rate where money supply intersects money demand.

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It says that the interest rate adjusts to bring the money market into equilibrium.

Price below equilibrium

Shortage occured, price must rise

Price above equilibrium

Surplus happened, the price must fall

Breadth of scope

The supply of loanable funds comes from saving whilst the supply of money includes savings, currency and checkings deposits.

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The demand of loanable funds comes from investment demand, but the demand for money inclused the money used for investment, consumption (transaction demand), and for holding an asset (asset demand).

Different philosophies

* Classical economists believe that for any level of GDP, the interest rate adjusts to balance the supply and demand for loanable funds, and the price level adjusts to keep the money market in equilibrium. Basically they say the price level is flexible.
* Keynesian economists believe that for any price level, the interest rate adjusts to balance the supply and demand for money, and this interest rate influences aggregate demand and the short-run level of GDP. So, the price level is sticky.

Graphing

The vertical axis of th emoney market should be labeled with a nominal interest rate and the vertical axis of the loanable funds with the real interest rate.

Money supply increases

There’s a temporary surplus at the original equilibrium price. When there’s surplus money, people find other assets, such as bonds, to invest their money in. With more people looking for bonds, its demand raises as well as its price and the effective interest rate paid on bonds is lowered.

Supply money

The money increased by the Fed in the money supply at the original interest rate.

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* An increase in the money supply decreases the interest rate.

Decrease in the money supply

* A shortage of money sends some bondholders to sell their bonds so that they have money for transactions.

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* An increase in the supply of bonds in the bond market decreases the price and increases the rate of interest earned on those assets.

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Decreasing the money supply increases interest rates

Fractional reserve banking

A system in which only a fraction of the total money deposited in banks is held in reserve as currency

Reserve ratio (rr)

The fraction of a banks total deposits that are kept on reserve.

* Reserve ratio (rr) = Cash reserves/Total deposits.

Reserve requirement

Regulation set by the Fed that states the minimum reserve ratio for banks

Excess reserves

The cash reserves held by banks above and beyond the minimum reserve requirement

T-account or balance sheet

A tabular way to show the assets and liabilities of a bank. Total assets must equal liabilities.

Asset of a bank

Anything owned by the bank or owed to the bank is an asset of the bank

Liability of a bank

Anything owned by depositors or lenders is a liability to the bank

Money multiplier

This measures the maximum amount of new checking deposits that can be created by a single dollar of excess reserves.

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M = 1/(reserve ratio) = 1/rr.

Money multiplier is smaller if

* At any stage the banks keep more than the required dollars in reserve
* At any stage borrowers do not redeposit funds into the bank and keep some as cash
* Customers are not willing to borrow.

Three general tools of monetary policy managed by the Federal Reserve

* Engaging in open market operations
* Changing the discount rate
* Changing the required reserve ratio

Expansionary monetary policy

Designed to fix a recession by lowering interest rates to increase aggregate demand, lower the unemployment rate, and increase real GDP, which may increase the price level

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* By increasing the money supply, the interest rate gets lower. Lower interest increases private consumption and investments, which shifts the **AD curve to the right.**

Contractionary monetary policy

Designed to avoid inflation by increasing interest rates to decrease aggregate demand, which lowers the price level and decreases real GDP back to full employment

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* When the money supply is decreased, the interest rate increases causing a decrease in private consumption and investment **shifting AD to the left**.

Open market operations (OMOs)

A traditional tool of monetary policy, it involves the Feds buying (or selling) of securities from (or to) commercial banks and the general public

When Fed buys

* **BB = BB** → **B**uying **B**onds = **B**igger **B**ucks.

When Fed sells

* **SB = SB** → **S**elling **B**onds = **S**maller **B**ucks.

Federal funds rate

The interest rate paid on short-term loans made from one bank to another

FOMC wants to lower interest rates

It buys bonds

FOMC wants to rise interest rates

Sells bonds

Discount rate

The interest rate commercial banks pay on short-term loans from the Fed

Lowering the discount rate

Increases excess reserves in banks and expands the money supply.

Raising the discount rate

Decreases excess reserves in commercial banks and contracts the money supply.

Lowering the reserve ratio

Increases excess reserves in commercial banks and expands the money supply.

Increasing the reserve ratio

Decreases excess reserves in commercial banks and contracts the money supply.

Ample reserves regime

The current framework for the Federal Reserves monetary policy

They make changes to two administered interest rates

IOR and ON RRP

Interest on reserves (IOR)

The interest rate that is paid to banks that deposit excess reserves with the Fed. **Primary tool of current monetary policy.** The federal fund rates rise and fall along with the IOR.

Arbitrage

"Borrow low and save high" technique

Overnight reverse repurchase agreement (ON RRP)

This is a secondary tool of current monetary policy. The interest rate paid to a financial institution on an overnight transaction in which the Federal Reserve sells a U.S. government security to the financial institution while agreeing to buy the security back the next day.

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Created to avoid arbitrage

In a deep recessionary gap

Expansionary monetary policy could be used to assist expansionary fiscal policy to quickly move to full employment. The risk then becomes a **burst of inflation**.

In a mild recessionary gap

Contractionary monetary policy could be used to offset expansionary fiscal policy to gradually move to full employment. The risk then becomes **rising interest rates**.

In an **inflationary gap**

Contractionary monetary policy could be used to assist contractionary fiscal policy to put downward pressure on the price level. The risk then becomes a **rising unemployment rate.**

Monetarists

They argue against active open market purchases of Treasury securities on the grounds that such expansions of the money supply will not create more economic growth in the long run and will only create inflation.

Critical link between monetary policy and real GDP

The relationship between changes in money supply, the real interest rate, and the level of private investment.

Quantity theory of money

A theory that asserts that the quantity of money determines the price level and that the growth rate of money determines the rate of inflation.

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It predicts that any increase in the money supply only causes an increase in the price level.

Equation of exchange

A way to view the quantity theory of money

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The equation says that nominal GDP (P × Q) is equal to the quantity of money (M) multiplied by the number of times each dollar is spent in a year (V). **MV = PQ.**

Velocity of money

The average number of times that a dollar is spent in a year

**V = PQ/M.**

To accommodate an increase in the money supply

The velocity of money **must fall**, the price level **must rise**, or the economy’s output of goods and services **must increase**.