L5 Money and the Federal Reserve

3 ways central banks influence economy

manipulating the growth rate of the money supply

manipulating short term money market interest rates

influencing the value of the currency

milton friedman quantity theory equation

MV = PY

M is money supply

V is velocity of money

P is overall price level

Y is real GDP

What is PY equal to (P is overall price level, Y is real GDP)

PY = nominal GDP

what is money velocity

the rate at which a given stock of money supports spending over a period

The amount of times a single dollar bill or coin is spent over a year

growth rate equation with money supply and velocity. What can we assume?

g_M + g_V = pi + g_y

g_M is growth in money supply

g_V is growth in money velocity

pi is inflation

g_Y is real GDP growth

most of the time we can assume g_V = 0

so gM = pi + gY

or use this version for exact calc:

how do we calculate money velocity

hard to track every transaction

so we use

V = nominal GDP / M

why might velocity decline

People and businesses may choose to hold more money rather than spend it.

For example, during economic uncertainty, households may accumulate bank deposits while businesses delay investment.

The measured money supply rises, but nominal spending doesn't increase proportionally.

FOMC

makes monetary policy decisions like the target range for the federal funds rate

federal funds rate

the interest rate on loans banks make to one another

why do banks lend reserves to one another

to settle payments, manage liquidity

Some institutions have more available reserve balances than they need at a particular moment, while others may seek additional balances.

IORB

interest on reserve balances

the federal reserve pays interest in some reserve balances that banks maintain at the Fed

what happens if Fed adjusts IORB

if banks get high interest rates by keeping their reserves at the Fed, they will do so instead of lending funds elsewhere at lower rates.

this puts upward pressure on short term market interest rates

lowering IORB stimulates lower interest rates

how are the federal funds rate and iorb related

federal funds rate closely tracks iorb

overall affect of Fed increasing short term interest rates

financing becomes more expensive everywhere else as well

C, I go down

what is a bank run

the deposits you make to the bank are a liability for them because they have to be able to give that money back to you

but they might not have that much liquid if too many people want their deposits back they can’t give it back because maybe all their assets are tied up in mortgages

how to calculate a bank’s equity

assests - liabilities

liquidity vs solvency

liquididty means having sufficient cash or readily convertible assets

solvency means the value of assets is sufficient to cover liabilities

what was one reason the federal reserve was created

serve as a lender of last resort when everyone starts asking for their deposits back

when banks face liquidity shortages, the central bank provides emergency lending. they give discount loans at a discount rate.

FDIC

federal deposit insurance coporation

FDIC insured bank accounts, if the bank fails, eligible deposits are protected, reducing your incentive to withdraw everything

why is the Fed’s job. totake the punch bowl away as the party gets going

suppose times are good and spending is high this can lead to inflation if spending exceeds productive capacity

so the Fed can pre emptively increase interest rates so that spending goes down before it exceeds productive capacity

keeps growth sustainable

what does it mean to credit a deposit account

you ask the bank for a loan

the bank doesnt have to hand you the loan instead it just increases your checking account balance by the amount so that the bank still gave you that money and owes it to you through a deposit