Unit 4

1. Unit 4 Money, Monetary Policy and Economic Stability

2. Unit IV Lesson 1 Money • Before money, economies used a barter system • Problem – double coincidence of wants • Basic properties of any commodity used as money • Portability, uniformity, stability in value and acceptability

3. Unit IV Lesson 1 Functions of Money • Medium of Exchange function eliminates the need for the double coincidence of wants • The Store-of-value function permits money to be held for use at a later time • The Unit-of-Account, or Standard-of-Value function means there is an agreed-to measure for stating the prices of goods and services. This simplifies price comparisons.

4. Unit IV Lesson 1 Complete Activity 34 and review answers

5. Unit IV Lesson 1 Definitions of Money in the U.S. • M1 • Consists of currency, traveler’s checks, and checkable deposits • M2 • Includes M1 plus savings deposits, small time deposits, money market deposit accounts (MMDAs), noninstitutional money market mutual funds (MMMFs) and other deposits • M3 • Includes M2 plus large ($100,000 or more) time deposits

6. Unit IV Lesson 1 Complete Activity 35 and review answers

7. Unit IV Lesson 2 Equation of ExchangeMV=PQ • “M” – M1, stock of money • “V” – Income (GDP) velocity of circulation or average number of times $1 is spent on final goods and services in a particular time period • “P” – average price level of final goods and services in GDP, also known as the GDP deflator • “Q” – real output, the quantity of goods and services in GDP

8. Unit IV Lesson 2 • Evidence shows that income velocity (V) is highly predictable with its value remaining in a very narrow range over a multiyear period • Thus, changes in the money supply (M) result in changes in Nominal GDP (PxQ) • Depending on the state of the economy, the changes in the money supply can result in changes in prices, in output only or in some combination of both

9. Unit IV Lesson 2 Complete Activity 36 and review answers

10. Unit IV Lesson 3 Financial Intermediaries • Bringing people who want to borrow funds together with people who want to lend funds • Examples: commercial banks, savings and loans associations, savings banks, credit unions & money market mutual fund companies • Functions: • liquidity creation, minimization of the cost of borrowing, minimization of the cost of monitoring borrowers and risk reduction through pooling

11. Unit IV Lesson 3 Fractional ReserveSystem of Banking • Banks – any depository institution whose deposits are a part of M1. • Banks must hold a specific percentage of deposits as reserves; this percentage is called the required reserve ratio • The deposit that is not part of required reserves is called excess reserves

12. Unit IV Lesson 3 • Banks may loan excess reserves or buy government securities • A bank makes a loan by creating a a checkable deposit for the borrower; this results in an increase in the money supply

13. Unit IV Lesson 3 Money Expansion Multiplier • Exists because the reserves & deposits lost by one bank are received by another bank • It magnifies excess reserves into a larger creation of checkable-deposit money • Deposit expansion multiplier = ____1____ reserve requirement • Expansion of the money supply = • excess reserves x deposit expansion multiplier

14. Unit IV Lesson 3 • Higher reserves = lower money expansion multipliers and a decrease in the money supply • Total increase in money supply may be less than predicted by the money expansion multiplier if • Borrowers do not spend all the money they borrow • Banks do not lend out all their excess reserves • People hold part of their money as cash

15. Unit IV Lesson 3 Complete Activity 37 and review answers

16. Unit IV Lesson 4 The Federal Reserve System • Has the responsibility to control the money supply to promote the economic goals of full employment, price stability and stable economic growth • Board of Governors • Central authority, 7 member board, serve 14 year terms • Chairman – Alan Greenspan • Federal Open Market Committee (FOMC) • 7 members of the board and 5 of the presidents of the Federal Reserve Banks • Sets the Fed’s monetary policy and directs the purchase and sale of gov’t securities

17. Unit IV Lesson 4 Tools of the Fed • Open-Market Operations • The buying of bonds or securities from (increase money supply), or the selling of bonds to (decrease the money supply), commercial banks and the public • Fed’s most important instrument for influencing the money supply

18. Unit IV Lesson 4 • Reserve Ratio • Raising the reserve ratio = decrease in money supply • Lowering the reserve ratio = increases the money supply • The Discount Rate • Interest Rate charged on short-term loans from the Fed to commercial banks • Lower discount rate = increase in money supply • Higher discount rate = decrease in the money supply

19. Unit IV Lesson 4 Complete Activity 38 and review answers

20. Unit IV Lesson 5 The Money Market • The Demand for Money • Transactions demand – the demand for money to make purchases of goods & services • Precautionary (liquidity)demand – the demand for money to serve as protection against unexpected need • Speculative demand – the demand for money because it serves as a store of wealth • How much of your wealth do you want to hold as money & how much do you want to hold as interest-bearing assets?

21. Unit IV Lesson 5 Explain and Illustrate Visual 4.1

22. Unit IV Lesson 5 Explain and IllustrateVisual 4.2

23. Unit IV Lesson 5 Explain and Illustrate Visual 4.3

24. Unit IV Lesson 5 Complete Activity 39 and review answers

25. Unit IV Lesson 5 Explain and IllustrateVisual 4.4

26. Unit IV Lesson 5 Understand? • Fed purchases Treasury securities • Money supply increases • Interest rate decreases • Investment increase (& interest-sensitive components of consumption spending increase) • Aggregate Demand increases • Output increases and the Price Level increases

27. Unit IV Lesson 5 • Fed sells Treasury securities • Money supply decreases • Interest rate increases • Investment decreases (& interest-sensitive components of consumption spending decrease) • Aggregate Demand decreases • Output decreases and the Price Level decreases

28. Unit IV Lesson 5 Complete Activity 40 and review answers

29. Unit IV Lesson 6 Interest Rates and Monetary Policy in the Short Run & the Long Run • Nominal interest rate • Rate that appears on the financial pages of newspapers & ads for financial institutions • Not adjusted for inflation • Real interest rate • Increase in purchasing power the lender wants to receive to forego consumption now for consumption in the future • Adjusted for inflation • Real interest rate = Nominal interest rate – inflation rate “Fisher Equation”

30. Unit IV Lesson 6 Two Relationships between the real and nominal interest rates • Ex ante real interest rate (expected interest rate) • equals the nominal interest rate minus the expected inflation rate • Ex poste real interest rate (real interest rate actually received) • Equals the nominal interest rate minus the actual rate of inflation

31. Unit IV Lesson 6 Equation of exchangeMV=PQ • Looking at this equation, we see that changes in the money supply – holding velocity & real output constant – lead to changes in the price level • These changes in the price level change the nominal interest rate once they are anticipated

32. Unit IV Lesson 6 Complete Activity 41 and review answers

33. Unit IV Lesson 6 Complete Activity 42 and review answers

34. REVIEW FOR UNIT IV EXAM