Macro unit 4

Unit 4: Monetary Policy & The Banking System

1. The Money Market

• Money: Anything that is accepted as a medium of exchange, unit of account, and store of value.

  • Types of Money:

    • Commodity Money: Has intrinsic value (e.g., gold, silver).

    • Fiat Money: No intrinsic value but is accepted as money by government decree (e.g., U.S. dollars).

  • Money Supply: The total amount of money available in the economy.

    • M1: Currency (coins and paper money) + checkable deposits (demand deposits).

    • M2: M1 + savings accounts, money market accounts, small time deposits, and other near-money assets.

• Money Market: A market where the supply and demand for money determine the interest rate.

  • Money Demand Curve:

    • Downward sloping: As the interest rate decreases, the quantity of money demanded increases.

    • Transaction Demand: People hold money for everyday transactions.

    • Precautionary Demand: People hold money for unexpected events.

    • Speculative Demand: People hold money instead of other assets if they expect interest rates to rise.

  • Money Supply Curve:

    • Vertical because the central bank controls the money supply. In the short run, it is fixed.

  • Equilibrium in the Money Market:

    • The interest rate adjusts to bring the demand and supply of money into balance.

2. The Federal Reserve (The Fed)

• Role of the Fed:

  • Monetary Policy: The Fed manages the money supply and interest rates to achieve economic objectives like full employment, price stability (low inflation), and economic growth.

  • Regulating Banks: Ensures that banks have enough reserves and are operating safely.

  • Providing Financial Services: Acts as a "bank for banks" and a "bank for the U.S. government."

• Structure of the Fed:

  • Federal Reserve Board of Governors: Seven members, including the Chairman, appointed by the President.

  • Federal Open Market Committee (FOMC): 12 members that set monetary policy, including 7 members of the Board of Governors and 5 regional bank presidents.

3. Tools of Monetary Policy

• Open Market Operations (OMOs):

  • The buying and selling of government bonds in the open market.

    • Buying Bonds: Increases the money supply, lowers interest rates (expansionary monetary policy).

    • Selling Bonds: Decreases the money supply, raises interest rates (contractionary monetary policy).

• Discount Rate:

  • The interest rate at which commercial banks can borrow from the Fed.

    • Lowering the discount rate encourages banks to borrow more and increase lending (expansionary).

    • Raising the discount rate discourages borrowing and reduces lending (contractionary).

• Reserve Requirements:

  • The percentage of deposits that commercial banks must hold in reserve and not lend out.

    • Lowering reserve requirements increases the money supply (expansionary).

    • Raising reserve requirements decreases the money supply (contractionary).

4. Money and Interest Rates

• Relationship Between Money Supply and Interest Rates:

  • When the money supply increases, interest rates fall because there is more money available for lending.

  • When the money supply decreases, interest rates rise because there is less money available for lending.

• Monetary Policy and Aggregate Demand:

  • Expansionary Monetary Policy (lowering interest rates, increasing money supply):

    • Increases investment and consumption, shifting aggregate demand (AD) to the right.

    • Used to combat recession.

  • Contractionary Monetary Policy (raising interest rates, decreasing money supply):

    • Reduces investment and consumption, shifting aggregate demand (AD) to the left.

    • Used to control inflation.

5. The Banking System

• Banks' Role in the Money Supply:

  • Banks lend out a portion of their deposits to borrowers. This process is called fractional reserve banking.

  • Required Reserves: The minimum amount of reserves a bank must hold by law.

  • Excess Reserves: The reserves a bank holds beyond the required reserves. These are available for lending.

• The Money Multiplier:

  • The amount of money the banking system can create with each dollar of reserves.

  • Formula:
    Money Multiplier=1Reserve Ratio\text{Money Multiplier} = \frac{1}{\text{Reserve Ratio}}Money Multiplier=Reserve Ratio1​

  • Example: If the reserve requirement is 10%, the money multiplier is 10. If banks have $1,000 in reserves, they can lend out $9,000, increasing the money supply.

6. Interest Rates and Aggregate Demand (AD)

• Interest Rate and Investment:

  • Lower interest rates stimulate investment by businesses and consumption by households (e.g., through lower mortgage rates).

  • Higher interest rates reduce investment and consumption, leading to a decrease in aggregate demand.

• Interest Rates and Net Exports:

  • Higher interest rates attract foreign capital, increasing the value of the domestic currency (appreciation).

  • An appreciation of the currency makes exports more expensive and imports cheaper, reducing net exports and aggregate demand.

7. Monetary Policy Challenges

• Time Lags:

  • Inside Lag: The time it takes for policymakers to recognize the need for a policy change and to implement it.

  • Outside Lag: The time it takes for a policy change to have an effect on the economy.

• Liquidity Trap:

  • A situation where interest rates are very low, and monetary policy becomes ineffective because people prefer holding cash over lending or investing.

• Crowding Out:

  • Occurs when government borrowing to finance its spending leads to higher interest rates, which crowds out private investment.

8. The Phillips Curve

• Short-Run Phillips Curve: Shows the inverse relationship between inflation and unemployment in the short run.

  • Lower unemployment tends to lead to higher inflation (and vice versa).

• Long-Run Phillips Curve: Vertical at the natural rate of unemployment, meaning there is no long-term trade-off between inflation and unemployment.

Key Formulas to Remember:

• Money Multiplier:
  Money Multiplier=1Reserve Ratio\text{Money Multiplier} = \frac{1}{\text{Reserve Ratio}}Money Multiplier=Reserve Ratio1​

• Velocity of Money:
  M×V=P×QM \times V = P \times QM×V=P×Q

  • M = money supply, V = velocity of money, P = price level, Q = quantity of output.