Money, the Money Market, the Federal Reserve, and Monetary Policy

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Money, the Money Market, the Federal Reserve,
and Monetary Policy

• Ms. Flora
• AP Macroeconomics

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The Meaning of Money

• Money is any commodity or token that is generally
  accepted as means of payment.

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Three Functions of Money

• Money has three functions in the economy
• Medium of exchange
• Unit of account
• Store of value

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Medium of Exchange

• A medium of exchange is anything that is readily
  acceptable as payment.
• Without money, you would have to exchange goods
  and services directly for other goods and
  services an exchange called barter.

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Unit of Account

• A unit of account is the yardstick people use to
  post prices and record debts.
• It simplifies price comparisons.

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This table shows how a unit of account simplifies
price comparisons.
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Store of Value

• A store of value is an item that people can use
  to transfer purchasing power from the present to
  the future.
• It can be held and exchanged later for goods and
  services. The more stable the value of a
  commodity or token, the better it can act as a
  store of value and the more useful it is as money.

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Money works best if it is.
Durable Objects used as money must withstand
physical wear and tear. Portable People need to
be able to take money with them as they go about
their business. Divisible To be useful, money
must be easily divided into smaller
denominations, or units of value.
Uniform Any two units of money must be uniform,
that is, the same, in terms of what they will
buy. In Limited Supply Money must be available
only in limited quantities. Acceptable Everyone
must be able to exchange the money for goods and
services.
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Liquidity

• Liquidity is the ease with which an asset can be
  converted into the economys medium of exchange.

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The Kinds of Money

• Commodity money takes the form of a commodity
  with intrinsic value.
• Examples Gold, silver, cigarettes.
• Fiat money is used as money because of government
  decree.
• It does not have intrinsic value.
• Examples Coins, currency, check deposits.
• Federal Reserve Notes (paper money) are money
  because the government declares them to be with
  the words printed on every dollar This note is
  legal tender for all debts, public and private.

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Important Definitions

• Currency is the paper bills and coins in the
  hands of the public.
• Demand deposits (sometimes called checkable
  deposits) are balances in bank accounts that
  depositors can access on demand by writing a
  check. Deposits are money because they can be
  converted into currency on demand and are used
  directly to make payments.

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Official Measures of Money M1 and M2
NOTE M3 M2 Large Time Deposits
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The Federal Reserve

• The Federal Reserve (Fed) serves as the nations
  central bank.
• It is designed to oversee the banking system.
• It regulates the quantity of money in the economy
  and promotes price stability.

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The Structure of the Federal Reserve System

• The Board of Governors
• The Regional Federal Reserve Banks
• The Federal Open Market Committee

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The Board of Governors

• The Fed is run by a Board of Governors, which has
  seven members appointed by the President and
  confirmed by the Senate.
• Among the seven members, the most important is
  the chairman. The chairman directs the Fed
  staff, presides over board meetings, and
  testifies about Fed policy in front of
  Congressional Committees.

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Ben Bernanke was sworn in on February 1, 2006,
for a four-year term as Chairman. He began his
second term on February 1, 2010 Experience?
Chairman of Presidents Council of Economic
Advisors, served the Federal Reserve System in
several different roles, Professor of Economics
at Princeton since 1985, and at Stanford from
1979-85. Education? B.A. from Harvard and a
Ph.D. in economics in 1979 from Massachusetts
Institute of Technology.
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The Regional Federal Reserve Banks

• There are 12 Federal Reserve banks, one for each
  of the 12 Federal Reserve districts.
• Each Regional Bank has nine directors, three of
  whom are appointed by the Board of Governors and
  six of whom are elected by the commercial banks
  in the district.
• The Federal Reserve Bank of New York implements
  some of the Feds most important policy decisions

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The Federal Reserve System
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The Federal Open Market Committee (FOMC)

• Serves as the main policy-making organ of the
  Federal Reserve System. It determines monetary
  policy.
• Made up of the following members
• The chairman and the Board of Governors.
• The president of the Federal Reserve Bank of New
  York.
• The presidents of the other regional Federal
  Reserve banks
• Meets approximately every six weeks to review the
  economy

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Primary Functions of the Federal Reserve System

• Maintains price stability in the economy.
• ECB Cartoon on price stability for schools
• Regulates banks to ensure they follow federal
  laws intended to promote safe and sound banking
  practices.
• Acts as a bankers bank, making loans to banks
  and as a lender of last resort.
• Conducts monetary policy by controlling the money
  supply.

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Other Functions of the Fed

• Holds reserves of member banks
• Provides for check collection
• Acts as fiscal agent for the Federal Government
• 12 Reserves Banks issue currency when directed to
  do so by the Federal Reserve Board

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The Fed can control the economy through its
control over the money supply and interest rates.
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The Money Market

• The market where the Fed and the users of money
  interact thus determining the nominal interest
  rate (i).
• Money Demand (MD or Dm) comes from households,
  firms, government and the foreign sector.
• The Money Supply (MS or Sm) is determined only by
  the Federal Reserve.

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What Creates the Demand for Money?

• Transaction Demand demand for money as a medium
  of exchange (independent of the interest rate).
• Asset Demand demand for money as a store of
  value (dependent on the interest rate).

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Why is the Money Demand Curve Downward Sloping?

• Total Money Demand (DM or MD) is downward
  sloping because at high interest rates people are
  less inclined to hold money and more inclined to
  hold stocks bonds. At lower interest rates
  people sacrifice less when they hold money.

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Money Supply

• The money supply is determined by the Federal
  Reserve because the Fed has monopoly control over
  the supply of money.

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The Money Market
i
MS
i
MD
QM
Q
The equilibrium of MS MD determines the nominal
interest rate (i). MD is downward sloping
because the nominal interest rate is the
opportunity cost of holding money. MS is vertical
because it is independent of the interest rate.
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Changes in Money Demand

• Money Demand is dependent on both the Price Level
  and Real GDP which together comprise the Nominal
  GDP. If the price level increases, people will
  need more money to buy goods and services. If
  real GDP increases, people will receive more
  income and will increase spending.
• Nominal GDP? . MD? . i?
• Nominal GDP? . MD? . i?

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Increase in Money Demand
i
MS
?
i1
?
MD1
?
i
MD
QM
Q
MD? . i?
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Decrease in Money Demand
i
MS
?
i
?
MD
?
i1
MD1
QM
Q
MD? . i?
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Changes in the Money Supply

• Only the Fed determines the money supply
• Expansionary Monetary Policy
• MS? . i?
• Contractionary Monetary Policy
• MS? . i?

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Increase in Money Supply
i
MS
MS1
?
i
?
?
i1
MD
QM
Q
Q1
MS? . i?
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Decrease in Money Supply
i
MS
MS1
?
i1
?
?
i
MD
QM
Q
Q1
MS? . i?
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Feds Tools of Monetary Policy(Note During
the recent financial crisis, the Fed expanded
its tools of Monetary Policy. For the AP exam,
you need to understand the main tools.)

• The Fed has three tools in its monetary toolbox
• Changing the reserve requirement
• Changing the discount rate
• Open-market operations

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Changing the Reserve Requirement

• The reserve requirement is the amount () of a
  banks total reserves that may not be loaned out.
• Increasing the reserve requirement decreases the
  money supply.
• Decreasing the reserve requirement increases the
  money supply.

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Changing the Discount Rate

• The discount rate is the interest rate the Fed
  charges banks for loans.
• Increasing the discount rate decreases the money
  supply.
• Decreasing the discount rate increases the money
  supply.

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Open-Market Operations

• The Fed conducts open-market operations when it
  buys government bonds from or sells government
  bonds to the public
• When the Fed buys government bonds, the money
  supply increases. Buy bonds, bigger supply.
• The money supply decreases when the Fed sells
  government bonds. Sell bonds, smaller supply

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What is the Federal Funds Rate? The Federal funds
rate is the interest rate that banks charge one
another on overnight loans of reserves held at
the Federal Reserve Banks. The Fed currently
focuses monetary policy on altering the Federal
funds rate. Interest rates in general rise and
fall with the Federal funds rate. The Fed will
buy bonds, increasing excess reserves, which
decreases the demand for overnight loans, which
lowers interest rate.
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Problems in Controlling the Money Supply

• The Feds control of the money supply is not
  precise.
• The Fed must wrestle with two problems that arise
  due to fractional-reserve banking.
• The Fed does not control the amount of money that
  households choose to hold as deposits in banks.
• The Fed does not control the amount of money that
  bankers choose to lend.

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Summary

• Monetary Policy Expansionary Contractionary
• Open Market Operations Buy bonds
  Sell bonds
• Discount rate Lower rate
  Raise rate
• Reserve requirement Lower ratio
  Raise ratio

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Federal Actions and Their Effects
Fed Action Bank Reserves Money Supply Fed Funds Rate
Sell bonds Up or Down Up or Down Up or Down
Buy bonds Up or Down Up or Down Up or Down
Raise Discount R. Up or Down Up or Down Up or Down
Lower Discount R. Up or Down Up or Down Up or Down
Raise Reserve R. Up or Down Up or Down Up or Down
Lower Reserve R. Up or Down Up or Down Up or Down