Money and the Monetary System

Money and the Monetary System

Money

• Definition: Assets regularly used to directly buy goods and services.
• Functions of Money:
  • Store of Value: Money holds its value over time.
  • Medium of Exchange: Accepted as payment for goods and services.
  • Unit of Account: Used to measure and record economic value.
• Characteristics of "Good" Money:
  • Stability of Value: Resists fluctuations in purchasing power.
  • Convenience: Easy to use and transport.
• Types of Money:
  • Commodity-Backed Money: Has intrinsic value (e.g., gold standard).
  • Fiat Money: No intrinsic value; declared legal tender by the government.

Measuring Money in the U.S. Economy

• Money Supply (M): The amount of money available in the economy.
• Managed by: The central bank (Federal Reserve System in the U.S.).
• Classification by Liquidity: Different assets are classified based on how easily they can be converted into cash.
  • M0 = Monetary Base: Cash + bank reserves.
  • M1 = M0 + Checking Account Balances + Savings Account Balances + Other Liquid Assets
  • M2 = M1 + Small-Denomination Time Deposits (e.g., CDs) + Retail Money Market Funds

Current Measures of the Money Stock for the U.S. Economy

• Monetary Base: $5.883 trillion (currency + reserves)$
• M1: $17.9975 trillion (currency + demand deposits + “other”)$
• M2: $20.8412 trillion (M1 + small time-deposits + money market funds)$

Banks and the Money Supply

• Money Multiplier Process: Banks create money through lending and re-depositing.
  • Savings and checking accounts are part of M1
  • These are demand deposits can be withdrawn at any time
• Money Multiplier Formula:
  • $Money\ Multiplier = \frac{Money\ supply}{Monetary\ base}$
• Fractional Reserve System: Banks hold a fraction of deposits as reserves and lend out the rest.
  • Reserves: Deposits that banks hold and don’t lend.
  • Reserve Ratio (R): $\frac{reserves}{deposits}$

Banks and the Money Supply (cont’d)

• Example:
  • Initial deposit: $100$
  • Reserve Ratio (R): $0.10$
  • Money Multiplier: $1/R$
  • Keep $10 (= 0.1 * 100) in reserves$
  • Loan $90 (= 100 - 10) to customer/recipient who redeposits it$
  • Keep $9 (= 0.1 * 90) in reserves$
  • Loan $81 (= 90 - 9) to customer/recipient who redeposits it$
  • Keep $8.10 (= 0.1 * 81) in reserves$
  • Loan $72.90 (= 81 - 8.10) to customer/recipient who redeposits it$

Money Multiplier Process (Continued)

• Assumptions:

  • People don’t hold money outside of banks.
  • Banks have the same reserve ratio (R).

• Change in Money Supply Formulas:

  1. $100 deposit made by depositor:

     • $New\ Money = \frac{1}{R} Initial\ Deposit - Initial\ Deposit = (\frac{1}{R} - 1) Initial\ Deposit$

  2. Central bank (the Fed) creates $100 of new money:

     • $New\ Money = \frac{1}{R} Initial\ Deposit$
     • These are maximum possible changes in money supply if both assumptions hold

Money Multiplier Practice

• Examples:
  • A. Reserve ratio = 10%, Money Multiplier = 10, Initial deposit of $300 from Fed$
    • Change in money supply: $3000$
  • B. Reserve ratio = 5%, Initial deposit of $200 from customer$
    • Money Multiplier = 20, Change in money supply: $4000$
  • C. Reserve ratio = 20%, Change in money supply of $5000 from customer$
    • Money Multiplier = 5, Initial deposit: $1250$

Managing the Money Supply

• Central Bank: Institution responsible for managing the nation’s money supply (monetary policy) and coordinating the banking system.
• Federal Reserve System (The Fed): The central bank of the U.S.
• Duties:
  1. Regulates the quantity of money.
  2. Monitors each bank’s financial condition.
  3. Facilitates bank transactions.
  4. Acts as a bank’s bank.

Federal Reserve System (Continued)

• Created in 1913.
• Federal Reserve Board: Located in Washington, D.C., with 7 members serving 14-year terms.
• Chairman: Jerome Powell (named chair in 2018).
• 12 Regional Federal Reserve Banks: Presidents chosen by each bank’s Board of Directors.
• Federal Open Market Committee (FOMC):
  • 7 members of the Board of Governors.
  • 5 of the twelve regional bank presidents (rotates, except NY president).
• Dual Mandate:
  1. Ensuring price stability.
  2. Maintaining full employment.

The Liquidity-Preference Model

• Money Demand: The amount of wealth held in the form of money (like M1), also known as "liquidity preference."
• Holding Money:
  • Benefit: Ability to make transactions.
  • Cost: Interest foregone.
• Shifts Caused By:
  • Change in price level (P).
  • Change in real GDP (Y).
  • Technological advances.
  • Foreign demand for domestic currency.

The Liquidity-Preference Model (Continued)

• Money supply is determined by monetary policy and bank lending
• Primary task of FOMC to achieve its desired interest rate
• Tools (Historically):
  • Open-Market Operations (OMOs): Main tool before the Great Recession.
  • Discount Rate (and Lending Facilities).
  • Required Reserve Ratio.

How the Fed Conducts Monetary Policy

• Before the Great Recession:
  • The Fed primarily used Open Market Operations (OMOs).
  • OMOs: Purchase or sale of U.S. government bonds to banks.
    • Sale → Decrease money supply → Increase interest rate.
    • Purchase → Increase money supply → Decrease interest rate.
  • "Targets" a range for the federal funds rate (FFR), then moves money supply until the target is reached.

How the Fed Conducts Monetary Policy (Continued)

• During and Since the Great Recession:
  • FFR reduced to zero, resulting in banks holding "ample reserves" (liquidity trap).
  • The Fed uses Interest on Reserve Balances (IORB) to target a range for FFR through reserves.
    • FFR converges to IORB.
    • If IORB increased → FFR increases (other interest rates increase).
    • If IORB decreased → FFR decreases (other rates follow).
  • Why?
    • Arbitrage (‘buy low, sell high’) between the federal funds market and reserves held on deposit at the Fed.

The Fed Paying Interest on Reserve Balances (IORB)

• Scenario 1:
  • Market for Bank Reserves: Bank loans funds to another bank and earns FFR (Federal Funds Market)
  • The Fed Pays Interest on Reserve Balances (IORB): Bank can deposit funds at the Fed and earn IORB.
  • Take out reserves earning only 2.0% Loan them for 2.5%
  • Banks see the opportunity to earn profits by supplying reserves in FF market, which drives down the cost of borrowing in the fed funds market.
  • Suppose that the Fed wants to lower the FFR to 2% from 2.5% (expansionary monetary policy)
• Scenario 2:
  • Borrow from FF market at 2.0% Hold as reserves to earn 2.5%
  • Banks see the opportunity to earn profits by borrowing in the fed funds market, which drives up the cost of borrowing in the fed funds market.
  • Suppose that the Fed wants to raise the FFR to 2.5% from 2% (contractionary monetary policy)

Monetary Policy Tools (Continued)

• The Fed 'targets' the nominal interest rates (i) by adjusting the IORB
• Reasons for announcing policy in terms of interest rates:
  • Main effects of monetary policy work through interest rates.
  • Interest rates are easier to monitor than money supply.
  • Investment and saving decisions are based on the real interest rate.
  • Real Interest Rate Formula: $Real\ interest\ rate = Nominal\ interest\ rate - Expected\ Inflation (πe)$
  • The Fed has good control over the nominal rate.
  • Inflation changes relatively slowly → Changes in nominal rate become changes in real rate.

Monetary Policy and Output Gaps

• Investment and saving depend on the real interest rate (r).
• Investment is an inverse function of r
• Consumption is an inverse function of r
• Contractionary monetary policy in SR
• Expansionary monetary policy in SR

Monetary Policy and Output Gaps (Expansionary)

• During recessions, expansionary monetary policy decreases the interest rate.
• Cheaper to borrow; less rewarding to save → increases in C and I.
• Aggregate demand curve shifts out.
• Price level and output increase.

Monetary Policy and Output Gaps (Contractionary)

• During overheating, contractionary monetary policy increases the interest rate.
• More expensive to borrow; encourages saving → decreases in C and I.
• Aggregate demand curve shifts in.
• Price level and output decrease.