Unit 4: Money, Monetary Policy and Economic Stability

1. Unit 4: Money, Monetary Policy and Economic Stability

2. Vocabulary Ch 13 6. Measure of Value – same as Unit of Account; agreed to measure for stating prices of goods and services Ch 14 6. Money (Monetary) multiplier Ch 15 5. (Total) Demand for money 6. Liquidity preference function – the relation between the quantity of money demanded and the rate of interest

3. Lesson 1: Money

4. I. Types of Money • Commodity Money • Example – tobacco, tea, salt, musket balls • Representative Money • Backed by a commodity • Example – gold and silver certificates • Fiat Money • Money because the government says it has value • Example – U.S. dollars – • Checkbook Money • Checkable deposits

5. II. Properties of Money • Portability • Uniformity • Durability • Stability in value • Acceptability

6. III. Functions of Money • Medium of Exchange • Eliminates the need for the “double coincidence of wants” • Example – if you work at Starbucks you don’t want to be paid in only coffee • Store of Value • Money can be held for use at a later time • Standard of Value (Unit of Account) • There is an agreed to measure for stating prices of goods and services • Simplifies price comparisons • Example – dollar units

7. IV. Monetary Supply A. The Monetary Supply is defined and measured in 3 ways • M1 • Items that are primarily used as a medium of exchange. • Includes currency and coins (held by the public), demand deposits, other checkable deposits

8. 2. M2 • Includes M1 • PLUS the amount held in savings and small time deposits, money market deposit accounts (MMDA), noninstitutional money market mutual funds (MMMFs), and other short-term money market assets 3. M3 • Includes M2 • PLUS financial assets employed by large businesses and financial institutions

9. V. Growth of the Money Supply • Why is it important for the Fed to know the size and rate of growth? - It has a significant impact on the country

10. B. What are the effects if the money supply grows too slowly? - Increases the likelihood of a recession because interest rates are driven up

11. C. What are the effects if the money supply grows too rapidly? -It could lead to inflation

12. VI. Tracking the Money Supply • Why is it difficult for the Fed to get an accurate measure of the money supply? -The volume of transactions in the U.S. range into the trillions every day

13. B. Why must the Fed continue to develop new ways to track the money supply? -Technology innovations and profit maximizing behavior of banks

14. Practice! Checkable Deposits $850 Currency $200 Large Time Deposits $800 Noncheckable Savings Deposits $302 Small Time Deposits $1,745 M1 = Currency + Checkable Deposits M1 = $200 + $850 M1 = $1050

15. Practice! Checkable Deposits $850 Currency $200 Large Time Deposits $800 Noncheckable Savings Deposits $302 Small Time Deposits $1,745 M2 = M1 + Noncheckable Savings Deposits + Small Time Deposits M2 = $1050 + $302 + $1,745 M2 = $3097

16. Practice! Checkable Deposits $850 Currency $200 Large Time Deposits $800 Noncheckable Savings Deposits $302 Small Time Deposits $1,745 M3 = M2 + Large Time Deposits M3 = $3097 + $800 M3 = $3897

17. Lesson 2: Money Creation and Monetary Policy

18. I. How is Money Created? • Fractional Reserve Banking • Required Reserve Ratio – percentage of deposits held as reserves • Excess Reserves • Deposits not part of required reserves. • These may be used for loans or to buy government securities.

19. I. How is Money Created? B. Money Creation 1. T-Accounts can be used to show how loans turn into new money 2. Money is shown as: • Assets – cash on reserve and loans made to citizens • Liabilities – checking deposits of citizens

20. I. How is Money Created? C. The Money Multiplier • The amount of new deposits that can be created by a dollar of excess reserves • Formula: M = 1 = ___1____ reserve ratio rr

21. II. Tools of Monetary Policy The Fed has three tools of monetary policy. A. Open Market Operations (OMO) • The Fed can buy and sell Treasury bonds from (or to) commercial banks and the public. • If the Fed buys bonds: • the banks have excess cash reserves • The money supply increases • The interest rate falls • If the Fed sells bonds to banks: • the banks would have fewer cash reserves • The money supply decreases • The interest rate rises

22. II. Tools of Monetary Policy B. Change the Discount Rate • When commercial banks borrow money from the Fed, they pay an interest rate called the Discount Rate • Lowering the Discount Rate • Increases excess reserves in commercial banks • Expands the money supply • Raising the Discount Rate • Decreases excess reserves in commercial banks • Contracts the money supply

23. II. Tools of Monetary Policy C. Change the Reserve Ratio • Lowering the Reserve Ratio: • Increases excess reserves in commercial banks • Expands the money supply • Increasing the Reserve Ratio: • Decreases excess reserves in commercial banks • Contracts the money supply

24. Current Event!! Bernanke Sees Good 2013 if U.S. “Fiscal Cliff” Avoided • Write a one paragraph summary of the article. • Write one paragraph explaining how the article relates to what we have been studying in class this week.

25. Recap: The Money Multiplier!!! • The amount of new deposits that can be created by a dollar of excess reserves • Formula: M = 1 = ___1____ reserve ratio rr

26. Lesson 3: The Money Market and Monetary Policy

27. I. The Demand for Money • People must decide: • How much wealth to hold as money? - The opportunity cost of holding money is the forgone interest • How much to hold as interest-bearing assets?

28. I. The Demand for Money B. Other factors • Price Level -If prices double, people need twice as much money to buy goods • Level of Real GDP • Real Income -As income rises, the demand for money increases

29. II. The Supply of Money A. When prices rise: • Interest rates rise • MD (Monetary Demand) rises

30. II. The Supply of Money B. When income increases: • Interest rates rise • MD increases

31. II. The Supply of Money C. When the money supply increases: • Interest rates decrease • MD decreases

32. III. What happens when the Fed increases the money supply? Fed purchases Treasury securities  Bond prices increase to entice households and businesses to sell Treasury securities  Money supply increases and interest rates decrease  Investment increases (and interest-sensitive components of consumption increase)  Aggregate demand increases  Output increases and the price level increase

33. Study for Ch. 14&15 Vocab Quiz

34. IV. The Money Market The Demand for Money

35. IV. The Money Market The Demand for Money

36. IV. The Money Market The Demand for Money

37. IV. The Money Market • The demand for money is determined by 3 motives: • Transactions demand – the demand for money to make purchases of goods and services. • Precautionary demand – the demand for money to serve as protection against an unexpected need. 3. Speculative demand – the demand for money because it serves as a store of wealth

38. IV. The Money Market B. Suppose the Fed increases the money supply by buying Treasury securities • What happens to the interest rate? The Interest rate decreases • What happens to the quantity of money demanded? The quantity of money demanded increases 3. Explain what happens to loans and interest rates and the Fed increases the money supply. The Fed buys Treasury securities from the public  Demand deposits in banks increase  Banks have more money to make loans  To encourage people to take out the loans, financial institutions lower the interest rate.

39. IV. The Money Market C. Suppose the demand for money increases. • What happens to the interest rate? The Interest rate increases • What happens to the quantity of money demanded? The quantity of money remains the same 3. If the Fed wants to maintain a constant interest rate when the demand for money increase, explain what policy the Fed needs to follow and why. It must increase the money supply to meet the increase in the demand for money 4. Why might the Fed want to maintain a constant interest rate? To stabilize the amount of investment in the economy

40. IV. The Money Market D. Suppose there are two money demand curves and the Fed increases the money supply? • What happens to the interest rate? The Interest rate increases • What happens to the quantity of money demanded? The quantity of money remains the same 3. If the Fed wants to maintain a constant interest rate when the demand for money increase, explain what policy the Fed needs to follow and why. It must increase the money supply to meet the increase in the demand for money 4. Why might the Fed want to maintain a constant interest rate? To stabilize the amount of investment in the economy

41. Happy Thursday!

42. V. Alternative Money Demand Curves A. How would you describe, in economic terms, the difference between the two money demand curves? MD1 is more interest inelastic than MD Interest Rate MS MS1 r r1 MD MD1 M M1

43. The interest rate declines further with the more inelastic money demand curve (MD1) than with the more elastic money demand curve (MD). B. Compare what happens to the interest rate with each MD curve. Interest Rate MS MS1 r r1 MD MD1 M M1 Money

44. The fed would prefer the more inelastic money demand curve because a given increase in the money supply will lead to a grater decrease in interest rates, which should stimulate the economy. C. If the federal Reserve is trying to get the economy out of a recession, which money demand curve would it want to represent the economy? Explain. Interest Rate MS MS1 r r1 MD MD1 M M1

45. The Federal Reserve: Monetary Policy and Macroeconomics: Activity 40 • What is monetary policy? • From 1998 to 2002, what was the dominant focus of monetary policy and why? Monetary policy is action by the federal Reserve to increase or decrease the money supply to influence the economy. From 1998 to 2001, the focus of monetary policy was to slow the growth of the economy to prevent an increase in inflation. In 2001 and 2002, the focus was to stimulate the economy w/out stimulating inflation. (Much like 2009!)

46. Explain why the money supply and short-term interest rates are inversely related. When the fed buys Treasury securities from the public, bank reserves increase. To decrease excess reserves and make loans, banks lower the interest rate to entice consumers and businesses to borrow

47. What are some reasons for lags and imperfections in data used by central banks? Financial institutions report at specified periods, and the reporting time is not necessarily when the central bank can use the data. For short periods of time, the central bank collects data from only a sample of banks, and this leads to a certain amount of error in the data.

48. 5. Real output is determined by the level of capital stock and productivity of workers. Changes in MS affect prices more than real output.

49. What might cause velocity to change? Some factors that might cause velocity to change are changes in how money is transferred (institutional changes), changes in interest rates and changes in the price level.

50. If velocity were extremely volatile, why would this complicate the job of making monetary policy? One of the rules of monetary policy is stabilization of the price level. Thus, based on the equation of exchange (MV = PQ), changes in the money supply will yield a given change in PQ if velocity (V) is constant. If velocity is volatile, changes in the money supply may be either too small or too large, leading to inflation.