UNIT 4- Money and Monetary Policy

Definition of Money

• Money = anything that society accepts as payment for goods and services

Functions of Money

1. Medium of Exchange

   • used by people when they buy and sell goods and services

2. Unit of Measurement (Account)

   • money specifies the value of something

3. Store of Value

   • money is a way to store value from the time people receive it to the time people spend it

   • putting money away for future use

Characteristics of Money

• Money should be portable, divisible, durable, familiar, acceptable, not easily reproduced, stable in value (limited supply)

Types of Money

1. Commodity

   • money that has value apart from its use as money

   • gold, silver, etc.

2. Representative

   • money that can be exchanged for something else of value

3. Fiat

   • money that has no value except as its use as money

     • dollar bills

4. Demand Deposits/Debit Cards

   • checking account money

Money Supply Measurements

1. M1

   • narrowest definition of money supply

   • consists of currency in circulation (largest part), demand deposits, and travelers checks

2. M2

   • everything in M1 plus near money

     • near money = savings accounts, small time deposits (deposits less than $100,000), money market mutual funds held by individuals

3. M3

   • everything in M2 plus large time deposits (deposits over $100,000), money market mutual funds held by institutions

   • most broad definition of money supply

4. Liquidity = the ease with which assets can be turned into money

   • M1 is most liquid because your cash, checking account, and travelers checks are all liquid cash

5. Money Supply Curve

   

• vertical because interest rate is controlled by Federal Reserve System

Money Demand

1. Determinants of Money Demand

   1. Aggregate price level → as price level increases, demand for money increases

   2. Changes in Real GDP → real GDP increases, demand for money increases

   3. Changes in technology → Venmo… less money is needed

   4. Changes in regulations → interest rates on checking accounts… people put more money into checking accounts

2. Money Demand Curve

   

3. Time Value of Money

   • the earlier you start saving, the more you’ll have in the future

Other Financial Instruments

1. Stocks

   • own part of a company through owning shares

2. Bonds

   • loans to the government or corporations

Equation of Exchange

• MV = PQ

  • M = money supply

  • V = velocity

    • number of times money is spent

  • P = price level

  • Q = quantity real (output)

• P x Q = nominal GDP

  • MV = nominal GDP

How is Money Created?

1. Loans

   • when money is loaned, the money supply increases

   • when loans are paid off, the money supply goes down

2. Reserves

   1. Required Reserves → quantity of reserves (or money) banks are required to hold

   2. Excess Reserves → quantity of reserves (or money) banks hold in excess of required reserves

      • “fully loaned” or “loaned up” → zero excess reserves

      • banks get ability to lend money by excess reserves

   3. Total Reserves → required reserves + excess reserves

Federal Reserve System

1. Organization

   • 12 regional banks - each one has a President

   • Washington D.C. - 7 Member Board of Governors (serve 14 year terms)

     • every 2 years, someone’s term expires

     • President of U.S. nominates someone for the seat when a spot is open

     • one chairman of the seven → serves a 4 year term

       • current: Jerome Powell

2. Functions

   1. to serve the banking needs of the federal government

   2. to act as a bankers bank

   3. controls the supply of money (most important)

      • looks at unemployment rate, inflation rate, economic growth, etc… uses that to control supply

3. Money Market Equilibrium

   

4. Investment Demand Curve

   

   • gross private domestic investment

   • low interest rate, increase investment

   • high interest rate, less investment

5. Monetary Policy

   • the deliberate actions on the part of the Federal Reserve to either increase or decrease the supply of money

   • Expansionary:

     • “easy” money

     • increase money supply, used to fight a recession (unemployment)

       • money market graph, supply curve shifts to the right → interest rate decreases, aggregate demand increases

   • Contractionary:

     • “tight” money

     • decrease money supply, used to fight inflation

       • money market graph, supply curve shifts to the left → interest rate increases, aggregate demand decreases

6. Tools of the Federal Reserve System

   1. Reserve Requirements

      • most powerful tool of the FED

      • least often adjusted

      • defined as a specific percentage of bank deposit liabilities

        • a deposit to the bank is a liability to them

        • someone deposits $1,000 and RR is 10%, bank is required to hold $100, $900 goes into excess reserves can be loaned out

      • expansionary policy: decrease RR

      • contractionary policy: increase RR

      • money multiplier = 1 / required reserves

      • multiple expansion of money supply = money multiplier x initial excess reserves

      • T-Account (Bank Balance Sheet)

        

   2. Discount Rate

      • rate the FED charges banks to borrow money from the Federal Reserve

      • expansionary: decrease discount rate

      • contractionary: increase discount rate

   3. Open Market Operations

      • FOMC (Federal Open Market Committee)

        • 7 member board of governors

        • New York Federal Reserve Bank President

        • 4 Federal Reserve Bank Presidents that serve on a rational basis

      • most common tool of the FED

      • FED purchase or sale of government securities (bonds/T-bills)

        • expansionary: FED purchases (increase bank reserves)

        • contractionary: FED sells (decreases bank reserves)

      • Federal Funds Rate: the rate of interest one bank charges another for loans

        • Open Market Operations influences the Federal Funds Rate

        • buying securities → lower federal funds rate

        • selling securities → raise federal funds rate

Money Market Graph v. Loanable Funds Graph

• Money Market Graph

  

  • deals with short term loans

• Loanable Funds Graph

  

  • deals with real rate of interest

  • primary source of loanable funds is savings

  • deals with long term loans

Limited vs. Ample Reserves

1. Limited Reserves

   • reserves are scarce

   • a small change in supply of reserves shifts the money supply and will change the interest rates

     

2. Ample Reserves

   • banks hold high levels of excess reserves, so changes in supply of reserves won’t change the interest rate

     

   • Interest on Reserved Balances (IORB) — the interest paid by the Fed on balances held on reserve

     • increasing the IORB will lead to banks holding more reserves and lending less

     • lowering the IORB will lead to banks holding less reserves and lending more

     • changing the IORB will change the policy rate

Differing Views of Monetary Policy

1. Keynes

   • output is determined by the level of AD

   • Monetary Policy affects AD indirectly through its effect on interest rates

   • Expansionary Monetary Policy decreases interest rates, which increases investment, which increases AD

   • Contractionary Monetary Policy increases interest rates, which decreases investment, which decreases AD

   • Keynesians believe that Fiscal Policy is more effective than Monetary Policy - Fiscal Policy works directly whereas Monetary Policy affects AD indirectly through its effect on interest rates

2. Monetarist Theory

   • Milton Friedman

   • Importance of the Equation of Exchange: MV = PQ

     • increase M by 3%-5%, real GDP will increase by 3%-5%

       • velocity must be constant

     • increase M by <3%, real GDP will fall and may cause a recession

     • increase M by >5%, leads to inflation

   • upward sloping AS curve

   • Monetarists believe money has the most direct effect on the economy; Fed should target money growth rates and not interest rates