Macroeconomics - Money, the Federal Reserve, and Interest Rates

Functions of Money

• Medium of exchange: Money is used to buy and sell goods and services.
• Unit of account: Goods are valued in terms of money (e.g., dollars).
• Store of value: Money can be held as a form of wealth due to its liquidity.

Components of the Money Supply

• M1:
  • Currency (coins and paper money)
  • Checkable deposits
  • Other liquid deposits
  • Institutions offering checkable deposits include:
    • Commercial banks
    • Thrift institutions:
      • Savings and loan associations
      • Mutual savings banks
      • Credit unions
• M2:
  • M1 plus near-monies.
  • Small-denominated time deposits.
  • Money market mutual funds (MMMF).

Currency

• Consists of coins and paper money.
• Federal Reserve Notes are a key component.
• Token money: The value of currency is unrelated to its intrinsic value.

What “Backs” the Money Supply?

• Guaranteed by the government's ability to keep the value stable.
• Money is considered debt.
• Why is money valuable?
  • Acceptability: People must accept it as a medium of exchange.
  • Legal tender: Government designation as valid for payment of debts.
  • Relative scarcity: Controlled supply to maintain value.

Money and Prices

• Prices affect the purchasing power of money.
• Hyperinflation renders money unacceptable.
• Stabilizing money’s purchasing power requires:
  • Intelligent management of the money supply (monetary policy).
  • Appropriate fiscal policy.

The Federal Reserve and the Banking System

• Historical background
• Board of Governors
• 12 Federal Reserve Banks:
  • Serve as the central bank.
  • Quasi-public banks.
  • Banker’s banks, holding reserve balances.

Federal Open Market Committee (FOMC), Commercial Banks, and Thrifts

• Federal Open Market Committee (FOMC):
  • Aids the Board of Governors in setting monetary policy.
  • Conducts open market operations.
• Commercial banks and thrifts:
  • Approximately 4,300 commercial banks.
  • Approximately 7,000 thrifts.

Federal Reserve Functions

• Issue currency.
• Hold reserves and set reserve requirements (though the Fed ended reserve requirements in 2020).
• Lend money to financial institutions.
• Collect checks.
• Act as a fiscal agent for the U.S. government.
• Supervise banks.
• Control the money supply.

Federal Reserve Independence

• Established by Congress as an independent agency.
• Protects the Fed from political pressures.
• Enables the Fed to take actions to increase interest rates to stem inflation as needed.

Fractional Reserve System

• Fractional reserve banking system
• The Goldsmiths:
  • Stored gold and gave receipts.
  • Receipts used as money by the public.
  • Made loans by issuing receipts.
• Characteristics:
  • Banks create money through lending.
  • Banks are subject to “panics.”

Fed Influence over Lending and Money Supply

• The Fed can alter the money supply by modulating incentives and restrictions it places on banks and thrifts.
• When Fed policy prompts banks to increase lending, access to credit is easier.
• Fed policy which prompts banks to decrease lending can result in a lesser volume of loans and higher interest rates.

Interest Rates Overview

• Interest: The price paid for the use of money.
• Many different interest rates exist.
• Typically discussed as if there is only one interest rate.
• Determined by the money supply and money demand.

Demand for Money

• Transactions demand for money ($D_t$):
  • Determined by nominal GDP.
  • Independent of the interest rate.
• Asset demand for money ($D_a$):
  • Money as a store of value.
  • Varies inversely with the interest rate.
• Total demand for money ($D_m$):
  • Total money demand.

Interest Rates

• Equilibrium interest rate: Changes with shifts in money supply and money demand.
• Interest rates and bond prices:
  • Inversely related.
  • A bond pays a fixed annual interest payment.
  • A lower bond price will raise the interest rate.

Cryptocurrencies

• Examples:
  • Bitcoin
  • Ether
• Blockchain: A sequence of updates that tracks the ownership of digital money.
• Central bank digital currencies may eclipse private cryptocurrencies.