Monetary Policy, Money, + the Fed

3 functions of money

1. Unit of account: provides a means for comparing values of goods and services

   1. You know something is a good price relative to other stores and their prices

2. Medium of exchange: anything that is used to determine value during the exchange of goods and services

   1. w/o, ppl would barter

3. Store of value: money keeps its value when it is saved

   1. EXCEPT during inflation, money loses its value as the price for goods and services goes up

Currency: coins and paper bills used as money 

Key features of money

1. Durability: money must withstand physical wear and tear

   1. If destroyed or worn out, cannot be trusted to serve as a store of value

2. acceptability/uniformity: all units of money must be uniform (at least 2)

   1. Must be accurately counted and measured

3. fungibility/divisibility: can be divided into many units of value

   1. Necessary for exchange

4. Portability: can be transported and easily transferred

5. Scarcity/limited amount: if it's not limited it is not useful

   1. Fed keeps supply in control

6. Money is acceptable payment: everyone in the economy must be able to take the objects that serve as money and exchange them for goods and services

Sources of Money’s Value

Commodity money: objects that have inherent value and can be used as money

• Ie: salt, cattle, stones

• Usefulness gives them value

• Not always portable, durable, or divisible

Representative money: makes use of objects that have value solely bcs the holder can exchange them for something of value

• IOU of 20, promise that your chores for a moth will get done

Flat money: legal tender, has more value bcs a govt has decreed that it is an acceptable means to pay debts

• Confidence that the money will be accepted, remains in limited supply (valuable)

• If money supply grows too large, the currency can become worthless (bcs of inflation)

Key events

• 1st national bank- mcculloch v maryland

  • Feds: centralized banking is key to promoting industry and trade

  • Anti: the wealthy would gain control of bank and use its resources to increase their power--- decentralized banking: states est and regulate all banks w/in their borders

  • Brought stability BUT opponents said that ordinary ppl who needed a loan (to expand or maintain their farms + small businesses) were being denied

    • Argued that this was unconstitutional

  • 2nd bank: 20yr charter, slowly managed to rebuild public's confidence in national banking system

    • Restored stability

• 19th: free banking

  • # of state-chartered banks tripled

  • Bank runs: widespread panics in which people tried to redeem their paper money at the same time--- public confidence dwindled

  • Wildcat banks: banks located on the frontier-- remote and thus only populated by wildcats

  • Fraud was rampant--- issued bank notes, gold + silver money from those who bought notes and disappeared

  • Different currencies across states, cities, private banks, railroads, cstores, churches, individuals

• 20th: moving away from the gold standard

  • Cross of gold speech: 1896

  • Move to federal reserve banks

  • Representative money: backed by something of value

  • Flat money: backed by govt

  • Moved off by FDR in the GD

  • Rise of alternative currencies

Federal reserve banks: 12 regional reserve banks

• Member banks store SOME  their case reserves at the fed reserve bank in their district

• Supervised by fed reserve board (appointed by POTUS)

• Each regional bank is allowed member banks to borrow money to meet short-term demands

Glass-steagall act: separated commercial banking from investment banking

• Est federal deposit insurance corp (insures customer deposits if bank fails)

• FDR exec order ended gold standard

• US dept of treasury is responsible for manufacturing money

• Fed reserve is responsible for putting money into circulation

Money creation: carried out by the fed and by banks all around the country

• Similar to multiplier effect in fiscal policy (every one dollar change in fiscal policy creates a greater than 1 dollar change in fiscal policy)

Banks: financial intermediaries that extend credit from depositors to borrowers

• Interest rates: cost changed by banks to borrow money 

  • Smaller interest: paid to depositors (savings/checking)

  • Larger interest: charged to borrowers so banks make money

Required reserve ratio: the fraction of deposits that banks are required to keep in reserve

• Est by fed

• Ensures that banks will have enough funds to supply customers’ withdrawal

Fractional banking:

Money multiplier: determines the total amount of new money that can be created and added to money supply

• Formula: 1/RRR x initial cash deposit

• Est 2-3

• Both based on the Fed’s Reserve requirement

• Sometimes, banks hold excess reserves: bank reserves greater than the amount required by the fed

• Fed chair: appointed by POTUS + confirmed by senate (after senate banking committee hearings)

  • 4 yr terms and can be reappointed

• Monetary policy decisions are made through consensus

  • Fed chair has the most power and can override

• 2x a year the fed chair appears in front on congressional committees that oversee the fed

• Federal reserve board governors: staggered 14 yr terms w/ no reappointment

  • Members alternate when making monetary policy decisions

  • They're decision DO NOT require the approval of the executive and legislative branch

3 tools of the fed

Open market operations: central bank purchases and sales of securities in the open market as a way to implement monetary policy

• Most commonly used tool to adjust the money supply

• Helps the fed promote stable prices via maximum employment + changing supply of reserves in the banking system (influences interest rates + supply of credit)

Discount rate: what the fed charges banks when they borrow from the fed

• 2nd most commonly used tool 

• Higher than federal funds rate 

Federal funds rate: the rate used when banks borrow from each other

Prime rate: rate banks charge on short-term loans to their best customers

• Usually large companies w/good credit ratings

• Other interest rates follow

• Making adjustments to the reserve requirement

How monetary policy is made

1. FOMC meets and uses one (or more) of the 3 monetary policy tools to adjust the nation’s money supply

2. The supply of money goes up or down as a result

   1. Ex: Buying bonds increases the money supply; selling bonds decreases it)

3. If money supply goes up, interest rates go down; if money supply goes down interest rates go up

   1. since money is more “scarce” (this reflects simple supply + demand concepts

4. Lower interest rates spur increased borrowing, spending + investment; higher interest rates does the opposite

Easy money policy: increase money supply-- lower interest rates--- encourage more spending

• Encourages overborrowing + overinvestment

• Layoffs + cutbacks

Tight money policy: reduce money supply-- push interest rates up -- reduce money supply

• Investment spending declines + brings real d=gdp down

• Fiscal policymakers prefer a contractionary monetary policy when trying to manage inflation

  •  cool down the economy by raising interest rates and reducing the money supply, 

  • which can offset potential inflationary pressures caused by expansionary fiscal policies like increased government spending

• ,monetary policy: fights inflation and measured by the fed

• Fiscal policy: fights unemployment and measured by congress and the prez