Unit Four

1. Unit Four Monetary Policy

2. The Federal Reserve U.S. Central Bank - Bank that manages the money and banking system in U.S. - Controls monetary policy in U.S. (impacts global economy) - Most control over global economy: the head of the U.S. Federal Reserve **Almost every national economy has a national bank - Bank of Japan - Bank of Germany

3. Money What is money? - The automatic answer is cash - “Cash” is a relatively recent construct in world history - To POWs, cigarettes served as money - Cattle, shells, stones, and gold have all served as money - What would serve as money if our grid went down?

4. Money • Not defined by its physical form (paper, coins, shells, cigarettes) • Defined by its function(s) • Money is defined by economists as performing three particular functions

5. Three Functions of Money • Serves as a Medium of Exchange • Buy and sell stuff throughout the economy • “this bill is legal tender for all debts” • Serves as a Store of Value • You can store up dollars and they hold their value (not perfectly) • A dollar from the bank is a dollar at the mall • Serves as a Unit of Account • Serves as a yardstick • GDP, wages, prices – we are talking about dollars • Billions of dollars of oil, cars, homes, steel– we use $ as a unit of comparison

6. Non-examples of Money • Your home • It stores value but it is not a medium of exchange • Casino chips • Chips store value, they can be a medium of exchange within a casino, but not a widely recognized monetary yardstick

7. Money • Does not have intrinsic value • For much of human history, money did hold intrinsic value (gold or tobacco)

8. Money Modern money – “fiat money” • Fiat – “Because I told you so” • A dollar bill is worth something because the government says it is (and society agrees with the government) • If you hold a debt, the government says that the dollars can be used to pay off that debt

9. Money Economists belief that the definition of money works in layers M1, M2, and M3

10. First Definition of Money, M1 M1: “narrow money” or a narrow conception of money Designated as M1 by the Federal Reserve M1 Currency Traveler’s Checks Checking Accounts Total M1 in 2012: 2.3 trillion

11. M1 (1/8 of GDP) Dollars (M1) are spent over and over in a year – circulation (you spend $50 at a salon, your stylist spends the $50 at Publix, Publix spends $50 buying fruit, farmer spends $50 at the seed store) That speed of money (M1) as it is spent and re-spent throughout the economy is referred to as the “velocity of money”

12. Calculating the velocity of M1 Velocity of money = GDP/M1

13. M2 (3/5 GDP) There is also an expanded definition of money: M2 2012 M2 – 9.3 trillion M2 Everything in M1 (currency, Traveler’s checks, checking accounts) AND Money market accounts (mutual funds) Savings Accounts

14. M2 The Velocity of M2 is slower than that of M1 because it includes money market accounts and savings accounts.

15. M3 (2/3 of GDP) M1 M2 and Time Deposits (Money you deposit for a certain amount of time) Certificates of Deposits (CDs – Money locked up for a certain amount of time)

16. Money When we talk about money, we are usually talking about M1 - spendable income - liquidity

17. Money and Banking • Money and Banks are inextricably tied • We depend on the banking system’s willingness to send money through the U.S. economy • 1.17 trillion is actually currency (although most is just sitting in a drawer because of the overwhelming amount of electronic transactions)

18. Money and Banking System How does the government control the banking system? The Federal Reserve (U.S. Central Bank)

19. The Federal Reserve • Bank for Banks • Where banks can deposit their money • You cannot deposit your paycheck into the Federal Reserve 2. A Corporation - Owned by all of the federally chartered banks 3. Quasi-Public Corporation - Board of Governors appointed by President - Public officials working for the public good

20. Review Question What is the real interest rate if the nominal interest rate is 10% and the inflation rate is 9% • 19% • 22% • 2% • 1% • 10%

21. The Federal Reserve Possesses a great deal of independence - Has its own funding - Officials have decision-making power Design of Federal Reserve - Chairman (4 year terms, can be re-appointed) - 6 Members of Board of Governors (14 year term, cannot be re-appointed) - Seven members appointed by president - Open-Market Committee (12 members) - Board of Governors - Five members selected from the regional Federal Reserve Banks

22. Question of the Day Velocity of money measures: • Money 1 • The rate of money circulation in one year • Consumer spending as part of GDP • Money 2 • The time is takes for a stack of cash to fall from the Empire State Building

23. So what does the Fed do? • Distributes and updates coin and currency • Moves checks long distances • Sells treasury bonds (U.S. Bonds) • Processes government payments • The “lender of last resort” • If a bank does not have enough cash on hand, the federal reserve provides that bank with cash • Importance because of “bank runs”

24. Our Focus: The Fed and Monetary Policy • The Fed has power over the supply of money and the supply of credit that is out there in the economy • The Fed has this power because of the control that the Fed has over the banking system

25. The Federal Reserve (any central bank) Three Tools for Affecting the Money Supply (Expansionary and Contractionary) 1. Reserve Requirement 2. The Discount Rate 3. Open-Market Operations

26. The Reserve Requirement • Each bank is required to take a certain percentage of the money that it has and put it at the Fed. • The Fed can adjust the percentage • The bank not receive interest on that money while it is at the Fed • The Fed can use that money to purchase treasury bonds and make interest on those bonds. • Currently set at 10% • (0% on savings, CDs, time deposits)

27. The Reserve Requirement • The interest made is one of the ways that the Fed gets money to support itself • Acts as a safety valve – if the bank is losing money, the Fed can give back some their reserve requirement

28. The Reserve Requirement and Monetary Policy • How does the reserve requirement affect the amount of money in the economy? • If the Fed raises the requirement? • Banks have less money • They lend out less money • The amount of money and credit in the economy will go down • Contractionary

29. The Reserve Requirement and Monetary Policy • If the Fed lowers the requirement? • Banks have more money on hand • More loans • More money and credit in the economy • Expansionary **The reserve requirement is one way that the Fed can control the amount of money in the economy

30. The Discount Rate • The Interest Rate that the Fed charges if it has to loan money to a particular bank • A bank may not have enough money on hand to meet the reserve requirement at the Fed • What do they do?

31. The Discount Rate The Fed can lend money to the bank and charge an interest rate on the loan (The interest rate is the discount rate)

32. The Discount Rate Fed increases discount rate (contractionary) - Banks would not want to borrow from the Fed so they would be more hesitant to loan out money - Effect: Raises interest rates across the economy Fed decreases discount rate (expansionary) - Banks will lend right up to their limit - Borrowing from the Fed would not be too expensive -Effect: Lowers interest rates across the economy Discount rate = .75% (set every 14 days)

33. Open-Market Operations • Open Market Committee (12) conducts open-market operations • Single most important tool of monetary policy • Buying and selling of Treasury bonds

34. Review questions of the Day What are the three functions of money? (M.S.U.) What are the three types of money? What are the three tools that the Fed uses to influence the supply of money?

35. Learning Goal The student will understand how the Fed uses OMO (open-market operations) to adjust the money supply.

36. Open-Market Operations • Fed owns treasury bonds • They can buy or sell treasury bonds on the open market

37. Open-Market Operations • Fed can go to any banks that hold treasury bonds and buy the bonds • The Fed pays the banks money (cash) • So – banks receive a flush of cash • Bonds are not M1, M2, or M3 – they are a financial instrument • Expansionary policy – more money is dumped into the economy • What happens to interest rates???

38. Open-Market Operations • The Fed sells bonds • Take bonds and sell them on the open market (to banks, to you, to your grandparents) • Banks (and households) giving M1 to the Fed • Fed soaks up cash in the economy by selling bonds • Contractionary policy

39. Open-Market Operations Where does the Fed get the money to buy bonds? When the Fed goes to a bank to buy a bond, to pay the bank, the Fed can credit the bank with that amount. By touching a button “PRESTO” – the Fed gives the bank that money. In essence, the Fed “creates” money

40. Open-Market Operations When the Fed sells bonds, it can hit the delete key and that money can disappear. In a very broad sense, the Fed has the power to create and reduce the money supply. Fed increases money supply, interest rates go down (V/V)

41. Open-Market Operations So how do we know what the Fed is doing? We know by watching interest rates fluctuate. On the news, you hear “Will the Fed raise or lower interest rates” This really means, will the Fed buy or sell government bonds?

42. Economic Goals and Monetary Policy • Economic Growth • Low inflation • Low unemployment • Favorable trade balance How do contractionary/expansionary monetary policies address each one of these goals?

43. Learning Goal II The student will understand how the Fed influences unemployment and inflation.

44. Low Unemployment (cyclical) and Monetary Policy To reduce cyclical unemployment, the government must increase AD. Fed runs an expansionary money policy - Lower RR - Decrease DR - Buy bonds on open market

45. Low Unemployment + Monetary Policy More money in the economy will push down interest rates Low interest rates will encourage people to buy houses and cars (C) Low interest rates will encourage firms to invest in their businesses (I) Businesses will hire, cyclical unemployment will be reduced.

46. Low Inflation and Monetary Policy Fighting Inflation Reduce AD (so that you do not have too many dollars chasing too few goods which will cause prices to increase) Fed runs a contractionary (tight) money policy - Increase RR - Increase DR - Sell bonds on open market

47. Low Inflation and Monetary Policy Reduce amount of money and credit Interest rates go up High interest rates will reduce consumer spending (C) High interest rates will reduce investment spending (I) Less money, less inflation

48. Quick Summary • To fight off inflation – Fed contracts money supply • To fight off recession – Fed expands money supply

49. Group work 1. AD and AS analysis suggests that, in the short run, an expansionary monetary policy will shift: • AD to the left • AS to the left • AD to the right • AS to the right • Both AS and AD will shift to the left

50. 2. If the Federal Reserve sells a significant amount of government securities (treasury bonds) in the open market, which of the following will occur? A. The total amount of loans made by commercial banks will decrease. B. The total amount of loans made by commercial banks will increase. C. The money supply will increase. D. Rates of interest will decrease. E. Rates of interest and amount of loans made by commercial banks will remain unchanged.