Central Banks
The Federal Reserve System:
The Federal Reserve System (the FED) is the central banks of the united states.
A central bank is the public authority that regulates a nation’s depository institutions and controls the quantity of money.
The FED regulates and monitors private banks and depository institutions to make sure they are complying with banking laws and regulations. The 12 regional federal reserve banks regulate and monitor the banks in their geography.
The FED is the lender of last resorts: The FED stands ready to lend reserves to depository institutions that are short of reserves.
The FED implements the nation’s monetary policy: Monetary Policy is the use of money and interest rates to achieve macroeconomics objectives.
Stable prices
High employment
Economic growth
The Federal Funds rate is the interest rate that banks use to borrow and lend excess reserves from one another on an overnight basis. The FED sets a target federal funds rate eight times a year, based on prevailing economic conditions.
FED, Monetary Policy and Banks:
The FED implement monetary policy by setting interest rate targets and conducting open market operations. An open market operation is the purchase or sale of government securities by the FED to/ from commercial banks.
Open Market Operations influence banks’ reserves.
More reserves=More loans=More money
Less reserves=Less loans = Less money
The Money Market: The demand for money is the relationship between the quantity of real money demanded and the nominal interest rate. A rise in the interest rate brings a decrease in the quantity of real money demanded. A fall in the interest rate brings an increase in the quantity of real money demanded.
Shifts in the Demand Curve for Money: An increase in real GDP increases the demand for money and shifts the demand curve rightward. A decrease in real GDP or a financial innovation decreases the demand for money and shifts the demand curve leftward.
Money Market Equilibrium: Money market equilibrium occurs when the quantity of money demanded equals the quantity of money supplied. The price level adjusts to make the quantity of real money supplied equal to the quantity demanded.
The Quantity Theory of Money: In the short-run, increasing the quantity of money may increase output, employment, real interest rates. In long-run, if the Fed increases the quantity of money, the price level changes to move the money market to a new long-run equilibrium...
… but nothing real has changed -- Real GDP, Employment & the real interest rate are unchanged.
In the long run, the price level rises by the same percentage as the increase in the quantity of money
The Quantity Theory of Money is based on the Equation of Exchange
(M*V = P*Y Money Used in the Economy = Output Produced in the Economy)
M is the quantity of money. V is the velocity of money1. P is the price level. Y is the real GDP. The velocity of money, is the number of times in a year a dollar is used to purchase goods and services in GDP.
The equation of exchange becomes the quantity theory of money if M influences P, but does not influence V or Y.
If we express the equation of exchange in growth rates
money growth + change in velocity = inflation rate + real GDP growth
ΔM + ΔV = ΔP + ΔY
rearranging… [subtract ΔY from both sides]
inflation rate = money growth + change in velocity − real GDP growth
ΔP = ΔM + ΔV - ΔY
[assumption] In the long run, velocity does not change : ΔV = 0
ΔP = ΔM - ΔY
In the long run, an increase in the quantity of money creates a proportional change in the price level.