Money and Monetary Policy

• Federal Reserve Board: the governing organization of the Federal Reserve System; also known as the Board of Governors. The Board consists of 7 members who are appointed by the president and confirmed by the Senate to serve 14-year terms of office

• Consists of 12 Federal Reserve Districts

  • The majority of Federal Reserve banks are located in the eastern half of the country. 

  • The Federal Reserve System consists of 12 Federal Reserve Banks in 12 geographic regions or districts.

• Board of Governors (Federal Reserve Board): oversees the Federal Reserve

  • Has 7 governors who serve 14-year terms

  • Responsibilities: Directing Monetary Policy, Setting Reserve Requirements, Setting the Discount Rate

• Federal Open Market Committee (FOMC): a committee of the federal reserve system that is responsible for open market operations for the Federal Reserve System.

  • Consists of: (Federal Reserve Board) Board of Governors, President of the NY FED and  4 of the other 11 regional bank Presidents

  • The part of the Federal Reserve that determines and implements the nation's monetary policy and controls the money supply to promote stable prices and economic growth 

• Central bank: a bank that provides financial services to a country's government and is responsible for the nation's monetary policy. The central bank of the US is the Federal Reserve

• Automated Clearinghouse Services (ACH services): system that enables institutions to make small transfers (like payroll deposits, corporate payments to vendors and social Security payments)

• Federal funds rate: the rate of interest banks pay when borrowing monetary reserves from other banks

• Wire transfers: an electronic system that allows institutions to transfer large amounts of money in a timely and efficient manner

• Monetary policy (limited reserves): the actions taken by a country’s central bank to influence the supply of money and credit in the economy

• Monetary policy (ample reserves): the actions taken by a country’s central bank to influence output, process, and employment by managing certain key interest rates in the economy

  • Monetary Policy Affects:

    • Interest Rates

    • Prices

    • Investment

    • Economic Growth

    • Inflation

    • Employment

• Open Market operations: the purchase or sale of govt securities by a central bank; a key tool of monetary policy used to influence the money supply and interest rates

• Discount rate: the interest rate at which banks can borrow money directly from the Federal Reserve

• Reserve Requirement (rr): the fraction of checkable deposits that banks must keep on hand as reserves either as currency or on deposit with the Federal Reserve

• Excess reserves: the amt. Of reserves that a bank can lend out to earn interest; equal to total reserves - required reserves

  • Excess reserves:  = Total Reserves - Required Reserves

• Required Reserves (rr): the amt. Pf reserves that a bank must keep on hand to meet regulatory requirements; equal to deposits times the reserve requirement

  • Required reserves = Deposits x Reserve Requirement (rr)

• Total reserves: the total amount of reserves that a bank has, some of which it is required to keep on hand. Total reserves = rr + excess reserves

• Asset: any item of value that is owned by an individual or corporation

• Liability: a monetary debt or obligation

• Balance sheet: a statement of assets, liabilities and net worth

• Fractional Reserve Banking: a banking system in which banks have to keep only a fraction of checkable deposits on hand and available for withdrawal

  • Banking supervision: supervise and regulate member banks to prevent banking panics or disruptions

  • Financial services: provide banks with financial services by clearing checks, transferring funds and receiving and delivering the currency that banks need to operate

• Fed manages wire transfers (large amounts of money, quickly) and automated clearinghouse services (payroll deposits, corporate payments, social security payments)

  • Manages Fiscal Policy

• Banks:  organizations that connect people with money who want it

  •  are businesses that provide financial services to the marketplace and try to make a profit along the way.

• More loans = more interest it earns

• Money Multiplier: the amount by which $1 change in reserves will change the money supply

  • Money Multiplier = Change in Ms / Change in Reserves

  • Monsey Multiplier - 1/rr

  • △Ms = 1/rr x △Reserves

  • Total Money Supply Increase = initial reserve increase x money multiplier

• The larger the reserve requirement the smaller the money multiplier

• Actual money multiplier tends to be smaller than the one calculated (bc people do hold cash, and banks sometimes hold excess reserves)

  • If banks have to increase their required reserves, they can’t lend as much money, so less money is created.

• Interest: a fee for the use of money overtime; the payment made to agents that lend or save money

• Interest rate: the payment made to agents that lend or save money, expressed as an annual % of the monetary amount lent or saved. Sometimes called nominal interest rate or price of money

  • Interest rate: opportunity cost or price of money

• Money market: a market in which the demand for and supply of money determine an interest rate or opportunity cost of holding money balances

• Money supply: the relationship between the interest rate and the quantity supplied in an economy usually given value. In the US the money supply = M2

• Money Supply Curve: a graphical representation of the relationship btw. The quantity of money supplies in an economy and the interest rate. Generally, the money supply curve is a vertical line representing a given money supply 

• Money Demand: the relationship between the interest rate and the quantity of money demanded, all else held constant; the sum of the transaction demand (vertical line)  and asset demand for money

• Surplus: a situation in which the quantity supplied is greater than the quantity demanded at the current market price. Also called excess supply

• Shortage: a situation in which the quantity demanded is greater than the quantity supplied at the current market price. Also called excess demand

• Yield: the effective interest rate earned on a bond or another asset; = to the net profit earned divided by the amt. Invested

• Transaction demand: the demand for money to be used in daily transactions

• Asset Demand: the demand for money to be saved for future use

• Bond: a financial agreement that obligates a borrower (such as an individual, firm, or govt.) to repeat the amount borrowed (principal) and interest on a specific date in the future → certificates of debt that usually specify a dollar amount to be repaid plus interest at some future date.

• Bond market: a financial market in which participants can buy and sell new bonds (primary market) or trade bonds already in circulation (secondary market) 

• Supply of bonds: the relationship between the interest rate and the quantity of bonds supplied in an economy, all else held constant

• Demand for bonds: the relationship between the interest rate and the quantity of bonds demanded in an economy, all else held constant

• Face value: the nominal or dollar value of a security, generally printed on the face (front) of the security. For bonds, it is the amt Paid to the bondholder when the bond is repaid in full

• Coupon rate: the interest rate stated on a bond, as a % of the bonds face value

• Bond Yield: Yield = ib = Interest payment / Bond Cost

• Interest rate on Vertical Axis and Money Supply on the horizontal: Money Supply Graph

• Nominal Interest Rate: the interest rate or cost of borrowing money, expressed in a % terms, usually, the interest rate stated on a loan or other asset

• Real interest rate: paid to lenders and savers when the expected rate of inflation = 0; the inflation-adjusted return. Equal to the nominal interest rate - the inflation rate

• Expected inflation: the rate of inflation, expressed as a % anticipated by market participants

• Fisher equation: an equation relating the nominal interest rate to the real interest rate and the expected inflation rate

  • Without inflation: nominal interest rate ≈ real interest rate 

    • i ≈ r

  • With inflation: i ≈ r + pi^e 

  • pi^e = expected inflation rate

 12 - Monetary Policy (limited reserve)

• Interest rate: the payment made or agents that lend or save money, expressed as an annual percentage of the monetary amount or lent or saved. Sometimes called nominal interest rate or price of money

• Money Market: a market in which the demand for and supply of money determine an interest rate, or opportunity cost of holding money balances

• Monetary Policy (limited reserve): the actions taken by a country's central bank to influence the supply of money and credit in the economy

• Investment demand: the negative relationships btw. The quantity of new physical capital demanded by firms and the prevailing interest rate

• Expansionary monetary policy (limited reserves): the actions taken by a country’s central bank to expand the money supply and lower interest rates w/ the objective of increasing rGDP and reducing unemployment. Sometimes referred to as “easy money”

  • Due to the severity of the recession, the Federal Reserve decided to use expansionary monetary policy (limited reserves) to help reduce unemployment and put more ppl back to work

  • Investment demand is downward sloping

  • Increases AD, Expand rGDP and reduce unemployment

• Contractionary monetary policy (limited reserves): the actions taken by a country's central bank to contract the money supply and raise interest rates with the objective of decreasing rGDP and controlling inflation. Sometimes referred to as “tight money”

  • After data revealed that prices and wages were rising sharply for the last 6 months, the Fed decided to use contractionary monetary policy (limited reserves) to make sure inflation didn't rise beyond acceptable levels.

  • Decrease AD, contract rGDP and control inflation (opposite of expansionary monetary policy above)

  • Helps to keep inflation under control and smooth the business cycle

• Yield: the effective interest rate earned on a bond or another asset; = to the net profit earned divided by the amt. Invested

• Aggregate Demand: a schedule or curve that represents the relationship between the quantity of rGDP demanded in the economy and the price level, all else held constant

  • total demand for all final g/s in an economy

• Real gross domestic products (real GDP, Y): a measure of the constant dollar value of all final g/s produced in a country during a fixed period of time; sometimes called inflation-adjusted GDP. When an economy is in equilibrium, real GDP = income, Y

  • An increase in expenditure results in an increase in rGDP

• I (gross investment): The dollar value of all new capital purchased (as investment) and the expansion of inventories in an economy during a given time period. Gross investment is classified into three categories: business fixed investment, residential investment, and inventory investment. Sometimes referred to simply as investment.

• Aggregate Supply (AS): a schedule or curve that represents the relationship between the quantity of rGDP supplied in the economy and the price level. Short-run aggregate supply

• Real GDP Expenditures: Y = C + I + G + NX | NX = X-M 

• Open Market Operations: the purchase or sale of govt securities by a central bank; a key tool of monetary policy used to influence the money supply and interest rates

  • Bond is a financial instrument that obligates a borrower to pay money with interest to a lender

  • Buying bonds creates new money and additional reserve which expands the money supply

    • Lowers interest rates

  • Sells bonds: takes money out of economy and reduces reserves which contracts the money supply 

    • Rise in Interest rates 

  • More loans increase money supply

  • Fewer reserves mean fewer loans

  • Ms is equal to Money supply (without interest rate)

• Reserve Requirement (rr): the fraction of checkable deposits that banks must keep on hand as reserves either as currency or on deposit with the Federal Reserve

• Discount rate: the interest rate at which banks can borrow money directly from the Federal reserve

  • Bigger deposits = more loans the bank can make

  • If bank does not have enough money supply (reserves) they will borrow from the federal reserve (that interest rate must be lower than the one they are charging to the person receiving a loan)

  • If fed lowers discount rate, banks borrow more reserves and make more loans raising the money supply (and vice versa)

• Interest rate on reserves: the interest rate that the federal Reserve pays when banks hold reserves at the Fed

• Required Reserves:The amount of reserves that a bank must keep on hand to meet regulatory requirements; equal to deposits times the reserve requirement

• Excess reserves: the amount of reserves that a bank can lend out to earn interest; equal to total reserves - required reserves

  • Change in Money Supply (excess reserves): △Ms = -1/rr x △Excess Reserves

• Spread: the difference btw. The interest rate a bank earns on a loan and the interest rate it pays

• Money Market Eq: Ms = Md

Video Notes:

• What happens to interest rates and investment when the Federal Reserve increases the money supply? Interest rates decrease and investment increases.

• Expansionary Monetary Policy: increase in MS, Decrease in i Increase in I, Increase in AD, Increase in rGDP

• Contractionary Monetary policy: decrease in MS, Increase in i, Decrease in I, Decrease in I, Decrease in AD, Decrease in rGDP

• Federal reserve can increase or decrease the money supply by raising the reserve requirement

  • Rr is rarely used for monetary policy though bc it can disrupt the banking sector and credit market

• When banks fall short in reserves they'll call another bank (for a slightly higher interest rate

• Federal Funds market (limited reserves): the interest rate that banks pay when borrowing reserves from other banks

• Required Reserves = Deposits x rr

• Excess Reserves = Total Reserves - Required Reserves

  • overnight process where banks lend money to other banks

• Federal Funds Rate: the interest rate that banks pay to each other within these transactions

  • Helps determine interest rate charge on other loans

• If federal funds rate is low: lend less and  If federal funds rate is high: lend more (less cautious)

• When Sff decrease, the federal funds rate decreases → Ms increases the interest rate decreases

• When Sff increases the federal funds rate increases →  Ms decreases the interest rate increases

• Prime rate: the lowest commercially available interest rate

• Limitations of monetary policy:

• Recognition lag: the time between when an event affects an economy and when we recognize that effect in the data collected

• Implementation lag: the time between when a policy is enacted and when it has its full effect on the economy

  • shorter than fiscal policy

• Cyclical asymmetry: the idea that the aggregate demand for goods and services is more responsive to contractionary monetary policy than to expansionary monetary policy. As a result, monetary policy may be more effective when used to control inflation than to reduce unemployment

  • expansionary monetary policy may be less effective then contractionary monetary policy

• Liquidity trap: a situation in which increasing the money supply does not lower interest rates, due to a flattening of the money demand curve