Monetary Policy

1. Monetary Policy Macroeconomics

2. Barter • Barter—literally trading one good or service for another—is highly inefficient for trying to coordinate the trades in a modern advanced economy • Requires a double coincidence of wants, a situation in which two people each want some good or service that the other person can provide

3. Functions of Money • medium of exchange- acts as an intermediary between the buyer and the seller. • store of value – holds value over time • unit of account – the standard by which other values are measured • a standard of deferred payment – allows for loans

4. Commodity vs. Fiat Money • Commodity money has value from use as something other than money (gold, cigarettes, rice) • Commodity-backed currencies are dollar bills or other currencies with values backed up by gold or other commodity held at a bank • Fiat money has no intrinsic value, but is declared by a government to be the legal tender of a country

5. Money Supply

6. Credit and Debt • Credit is money that is lent to you • Credit comes in many forms, including loans, bonds, notes, or lines of credit (like home equity loans) which must be repaid with interest • Debt is accumulated credit, less what has been repaid

7. Practice Question Maria would like to attend college to study economics to pursue a career in finance. In order to finish school she will need to borrow $25,000 at 3.5% interest. Is this a wise choice?

8. Banks as Financial Intermediaries

9. A Bank’s Balance Sheet

10. How do banks go bankrupt? • A bank that is bankrupt will have a negative net worth, meaning its assets will be worth less than its liabilities • unexpectedly high level of loan defaults • asset-liability time mismatch—a bank’s liabilities can be withdrawn in the short term while its assets are repaid in the long term

11. How Banks Create Money • The banking system can create money through the process of making loans • Making loans that are deposited into a demand deposit account increases the M1 money supply • Multiple banks are required to hold only a fraction of their deposits, and loans end up deposited in other banks, which increases deposits and, in essence, the money supply

12. Reserves • The reserve requirement is expressed as a required reserve ratio; it specifies the ratio of reserves to checkable deposits a bank must maintain • Banks earn relatively little interest on their reserves held on deposit with the Federal Reserve

13. What Does a Central Bank Do? The Federal Reserve, like most central banks, is designed to perform three important functions: • To conduct monetary policy • To promote stability of the financial system • To provide banking services to commercial banks and other depository institutions, and to provide banking services to the federal government

14. What Services Does the Fed Provide Banks? • All commercial banks have an account at the Fed where they deposit reserves • Banks can obtain loans from the Fed through the “discount window” facility • The Fed is also responsible for check processing • The Federal Reserve ensures that enough currency and coins are circulating through the financial system to meet public demands • The Fed is responsible for assuring that banks are in compliance with a wide variety of consumer protection laws including anti-discrimination laws

15. Money Multiplier Money Multiplier= Total change in the M1 Money Supply=1×Excess Requirement

16. Monetary Policy Monetary policy involves managing interest rates and credit conditions to influence the levels of economic activity and prices

17. Goals of Monetary Policy • The Fed both sets and carries out monetary policy • The goals of monetary policy include: • the maintenance of full employment • the avoidance of inflation or deflation • the promotion of economic growth

18. What if these Goals Conflict? When the inflation rate is within acceptable limits, the Fed will undertake stimulative measures in response to a recessionary gap or even in response to the possibility of a growth slowdown

19. Tools of a Central Bank A central bank has three traditional tools to implement monetary policy in the economy: • Open market operations • Changing reserve requirements • Changing the discount rate

20. Interest Rate An interest rate is the price of borrowing money or the reward for lending money

21. Interest Rates • The federal funds rate is the interest rate on overnight, interbank loans. The federal funds rate is possibly the best indicator of credit conditions on short term loans • The prime rate is the interest rate banks charge their very best corporate customers, borrowers with the strongest credit ratings. The prime rate is thus the floor on which a bank’s short term rates of different types are based. Additionally, variable interest rates like car loans or credit cards are often based on the prime rate • The discount rate, by contrast, is the interest rate charged by the Federal Reserve for discount loans. As such, it is not market determined, but rather set by the Federal Reserve

22. Demand and Supply for Borrowing Money with Credit Cards

23. The United States as a Global Borrower Before and After U.S. Debt Uncertainty The graph shows the demand for financial capital and supply of financial capital into the U.S. financial markets by the foreign sector before and after the increase in uncertainty regarding U.S. public debt. The original equilibrium (E0) occurs at an equilibrium rate of return (R0) and the equilibrium quantity is at Q0.

24. The Demand Curve for Money The demand curve for money shows the quantity of money demanded at each interest rate. Its downward slope expresses the negative relationship between the quantity of money demanded and the interest rate

25. An Increase in Money Demand An increase in real GDP, the price level, or transfer costs, for example, will increase the quantity of money demanded at any interest rate r, increasing the demand for money from D1 to D2. The quantity of money demanded at interest rate r rises from M to M′. The reverse of any such events would reduce the quantity of money demanded at every interest rate, shifting the demand curve to the left

26. Monetary Policy and Interest Rates The original equilibrium occurs at E0. An expansionary monetary policy will shift the supply of loanable funds to the right from the original supply curve (S0) to the new supply curve (S1) and to a new equilibrium of E1, reducing the interest rate from 8% to 6%. A contractionary monetary policy will shift the supply of loanable funds to the left from the original supply curve (S0) to the new supply (S2), and raise the interest rate from 8% to 10%

27. Expansionary Monetary Policy (a) The economy is originally in a recession with the equilibrium output and price level shown at Er. Expansionary monetary policy will reduce interest rates and shift aggregate demand to the right from AD0 to AD1, leading to the new equilibrium (Ep) at the potential GDP level of output with a relatively small rise in the price level

28. Contractionary Monetary Policy The economy is originally producing above the potential GDP level of output at the equilibrium Ei and is experiencing pressures for an inflationary rise in the price level. Contractionary monetary policy will shift aggregate demand to the left from AD0 to AD1, thus leading to a new equilibrium (Ep) at the potential GDP level of output

29. The Pathways of Monetary Policy (a) In expansionary monetary policy the central bank causes the supply of money and loanable funds to increase, which lowers the interest rate, stimulating additional borrowing for investment and consumption, and shifting aggregate demand right. The result is a higher price level and, at least in the short run, higher real GDP. (b) In contractionary monetary policy, the central bank causes the supply of money and credit in the economy to decrease, which raises the interest rate, discouraging borrowing for investment and consumption, and shifting aggregate demand left. The result is a lower price level and, at least in the short run, lower real GDP.

30. Monetary Policy, Unemployment, and Inflation Through the episodes shown here, the Federal Reserve typically reacted to higher inflation with a contractionary monetary policy and a higher interest rate, and reacted to higher unemployment with an expansionary monetary policy and a lower interest rate

31. Quick Review • What is money? What are the functions of money? What is liquidity? • What is credit and debt? • What do banks do? • How is money created by lending? • What is the structure, functions and responsibilities of the Federal Reserve System? • What is the difference between M1 and M2 (measures of the supply of money)? • What is monetary policy and how is it different from fiscal policy? • What are interest rates? • How is the equilibrium interest rate determined in the market for money? • How does monetary policy affect GDP and the price level? • What are the goals of monetary policy?