Chapter 10: Money, the Federal Reserve, and the Interest Rate Study Notes

Focus: Shows how the money market works in the macroeconomy.
Related Themes: Interactions in the goods market explored in previous chapters.

An Overview of Money
- Define money and discuss its functions.
How Banks Create Money
- Explain how banks create money.
The Federal Reserve System
- Describe the functions and structure of the Federal Reserve System.
The Demand for Money
- Describe the determinants of money demand.
Interest Rates and Security Prices
- Define interest and discuss the relationship between interest rates and security prices.
How the Federal Reserve Controls the Interest Rate
- Understand how the Fed can change the interest rate.
Expanded Fed Activities Beginning in 2008
- Understand how Fed behavior changed beginning in 2008.
The Federal Reserve Balance Sheet
- Explain the main items in the Fed’s balance sheet.

Functions of Money:
   - Means of Payment: Serves as a medium of exchange and a method for transactions.
   - Store of Value: Assets used to transport purchasing power over time.
   - Unit of Account: A standard unit of measurement for prices.

Means of Payment (or Medium of Exchange)
- Definition: What sellers accept and buyers use to pay for goods/services.
- Barter System: Exchange of goods and services; requires a double coincidence of wants (each party has to both want what the other has).
Store of Value
   - Definition: An asset that can be used to transport purchasing power from one time period to another.
   - Liquidity: Property of money making it easily exchanged for goods; reflects portability and acceptability.
   - Disadvantage: Value of money falls with rising prices (inflation).
Unit of Account
- Definition: A standard unit that provides a consistent method of quoting prices.

Case Study: Rolls of red feathers from the Scarlet Honeyeater bird used as currency in the 19th century suggests that effective currency must have intrinsic value.
Critical Thinking Question: Examining why certain commodity monies were chosen (red feather rolls, dolphin teeth) over others (coconut shells).

Commodity Monies
- Items with intrinsic value beyond their function as money.
Fiat (or Token) Money
- Items designated as money that are not intrinsically valuable; accepted by government decree.
Legal Tender
- Money that must be accepted if offered in payment of a debt.
Currency Debasement
- Decrease in the value of money caused by rapid increases in supply.

M1: Transactions Money
- Definition: Directly usable for transactions; a stock measure (snapshotted at a point in time).
- Current Example: At the end of January 2024, M1 was $17,989.3 billion.
M2: Broad Money
   - Definition: Includes M1 plus near monies (savings accounts, money market accounts).
   - Current Example: M2 at the end of March 2018 was $13,918.1 billion.
Beyond M2
- Broader definitions of money can include available credit from credit cards, reflecting the fluidity of money definition.

Historical Perspective: Origins with goldsmiths in the 15th and 16th centuries—people stored gold with goldsmiths for safety.
Paper Receipts: Issued as a form of paper currency; initially backed 100% by gold.
Banking Mechanism: Goldsmiths realized they could increase money circulation by lending more than what was deposited.
Risk of Bank Runs: When confidence wanes, depositors rush to withdraw funds—potential collapse of bank; termed a "run on a bank."
Modern Banking Differences:
- Banks today have a required reserve ratio that mandates a percentage of deposits to be kept in reserve, preventing unlimited lending as in early goldsmithing.

Assets of Banks
- Primarily loans made.
- Conversion of loans into deposits increases money supply.
Liabilities of Banks
- Most significant liabilities are deposits made by customers.
Key Terms:
- Reserves: Deposits banks hold at the Federal Reserve plus cash on hand.
- Required Reserve Ratio: Percentage of deposits banks must keep as reserves.
T-Account Analysis:
   - T-Account Example:
      - Assets = Reserves (20) + Loans (90)
      - Liabilities = Deposits (100) + Net Worth (10)

Excess Reserves: Difference between actual reserves and required reserves; banks can lend this out, increasing money supply.
Money Multiplier: The concept that an increase in reserves leads to a proportionally larger increase in deposits/revenue; calculated as:
- Formula: $ext{Money Multiplier} = rac{1}{ ext{Required Reserve Ratio}}$

Establishment: Founded in 1913 with subsequent reforms in the 1930s.
Independence: Operates independent of the government (president or Congress).
Key Components:
   - Board of Governors: Main governing body.
   - Federal Open Market Committee (FOMC): Composed of Board governors, the president of New York Fed, and 4 rotating bank presidents; responsible for monetary policy.
   - Open Market Desk: Trading office for government securities.
Functions of the Federal Reserve:
- Control the money supply; serve as a “bankers’ bank”; manage payment clearing for interbank activities.
- Lender of Last Resort: Provides funds to struggling banks without other funding sources.

Determinants:
   - Positively related to transaction sizes.
   - Negatively related to interest rates (the opportunity cost of holding money).
Graphical Representation:
- As interest rates decline, the demand for money increases. An increase in transactions shifts the money demand curve rightward.

Interest-Bearing Securities: Bonds and bills are issued by entities to raise capital; bear significance in interest movements.
Price Relationships: When interest rates increase, existing security prices tend to fall, leading to a negative correlation.

Crisis Response: Fed's active participation in private banking during financial troubles; methods included purchasing securities from Fannie Mae, Freddie Mac, and extended mortgage-backed securities acquisitions.

Example (as of March 6, 2024):
   - Assets:
      - Gold: $11 billion
      - U.S. Treasury securities: $4,632 billion
      - Mortgage-backed securities: $2,403 billion
   - Liabilities:
      - Currency in circulation: $2,339 billion
      - Reserve balances: $3,621 billion

Interest Rates on Reserves: After 2008, began paying small interest on the reserves held by banks.
Limitations of Traditional Tools: Traditional methods became ineffective; importance of direct control over banks increased.

The Fed maintains control over short-term interest rates, evolving methods post-2008, including changes in interest rate compensation for reserves held.