Monetary Policy

Conducted by the FED; comprised of 3 tools

Reserve Requirement

• Small % of deposit in bank, rest is loaned out (Fractional Reserve Banking)
• Inc. in MS -> Inc. in amt of $ held in bank deposits
• Recession - Dec. RR -> More ER; More loans; MS up, interest rates down; AD up (Easy)
• Inflation - Inc. RR -> Less ER; Less loans; MS down, interest rates up; AD down (Tight)

Discount Rate

• Interest rate FED charges to banks
• MS up needs decrease in Dis. Rate (Easy)
• MS down needs increase in Dis. Rate (Tight)

Open Market Op

• FED buys/sells bonds (securities)
• MS up needs buy bonds (easy)
• MS down needs sell bonds (tight)

Easy monetary policy: Buy Bonds; Decrease Dis. R & RR

Loans increase; AD up; GDP up; MS up; Interest rates down

Tight monetary policy: Sell Bonds; Increase Dis. R & RR

Loans decrease; AD down; GDP down; MS down; Interest rates up

• Fed Fund Rate - FDIC banks loan each other overnight funds (Opposite of Dis. Rate)
• Prime Rate - Interest rate banks give to most credit worthy customers 

Countercyclical Policies: Keynesian Fiscal Policy vs. Monetary Policy

In the early 21st century, here in the USA, an efficient, "full employment" economy will probably have:

• Annual unemployment rate 4%
• Annual inflation rate 4%

If the economy goes into a recession:

• The real GDP drops for at least 6 months
• Unemployment rate increases to 6% or more
• Inflation rate decreases to 2% or less

If Congress enacts Keynesian Fiscal Policies to attempt to slow/stop the recession, then:

• The policy will try to improve C or G (parts of AD)
• Congress will decrease federal taxes
• Congress will increase job and spending programs
• The federal budget will probably create a deficit
• Due to changes in Money Demand, interest rates will increase (Crowding out might occur, but Keynesians don't care)

If the Federal Reserve employs Monetary Policy options to slow/stop the recession, then: 

• The policy will target improvement in Ig (part of AD)
• The Fed will target a lower Fed Fund Rate
• The Fed can lower the discount rate
• The Fed can buy bonds (Open Market Operations)
• The Fed can (theoretically) lower the reserve requirement, but probably won't because it is too complex for the banks.
• These Fed policies will lower the interest rates through changes in the Money Supply
• These options should increase Ig

If the economy suffers from too much demand-pull inflation or cost-push inflation, then:

• The unemployment rate will go to 4% or less 
• The inflation rate will probably go to 4% or more

If Congress enacts Keynesian Fiscal Policies to attempt to slow/stop the inflation problems, then: 

• The policy will try to decrease C or G (parts ofAD)
• Congress will increase federal taxes
• Congress will decrease job and spending programs
• The federal budget will probably create a surplus
• Due to changes in Money Demand, interest rates will decrease

If the Federal Reserve employs Monetary Policy options to slow/stop the inflation problems, then:

• The policy will target decreases in Ig (part of AD)
• The Fed will target a higher Fed Fund Rate
• The Fed can increase the discount rate
• The Fed can sell bonds (Open Market Operations)
• The Fed can (theoretically) raise the reserve requirement, but probably won't because it is too complex for banks
• These Fed policies will raise the interest rates through changes in the Money Supply
• These options should decrease Ig

Graphs and Banking Systems

Demand Graph

• Demand for money increase inverse w/nominal interest rate and quantity of money (Q decreases, I increases and vice versa)
• Shifters: Change in
• PL
• Income
• in taxation after investment

Money Supply

• Affects AD when increased: -> r down, Ig up, AD up (Vertical)
• Decreases - Goes Left: MS down, r up, Ig down, AD down

Financial Sector

• Fin. Assets - Stocks and bonds provide expected future benefits
• Benefits owner from issuer of asset meeting certain obligations
• Fin. Liabilities - Incurred by issuer of fin. asset to stand behind issued asset
• Interest Rate - $ paid to use fin. asset
• Stocks - Fin. asset that represent ownership in a company
• Bonds - Promise to pay $ and interest in the future

Banks

• Fin. Intermediary - use liquid assets to fund investments of borrowers -> Fractional Reserve Banking
• Liquid assets include currency in bank vaults and bank reserves
• Banks create money by lending out deposits that are used multiple times
• When a customer deposits cash or withdraws cash from their demand deposit account, it has NO EFFECT ON THE MONEY SUPPLY
• It only changes...
• The composition of money
• Excess Reserves
• Required Reserves
• Changes in Money Supply for....
• Single Bank
• Loan money from ER
• Banking System
• ER x Money multiplier (1/RR) -> Total Money Supply
• When the FED buys or sells bonds, ER is created

Basic Accounting Review

• T-Account (Balance Sheet) - Lists assets and liabilities
• Assets (Amounts owned) - Items claimed legally by bank; use of funds by fin. intermediary
• Included in assets
• Required Reserves - % of DD in vault
• Excess Reserves - Remaining % of DD used for loans
• Property - Statement of a bank's property values
• Securities or Bonds - Previously purchased bonds held by the banks as investments
• Loans - Previously loaned funds now owed back to the bank
• Liabilities (Amounts owed) - Legal claims against a bank; sources of funds.
• Included in liabilities
• Demand Deposits - Cash deposits from the public to the bank
• Part of MS if from person's cash holdings
• Becomes new $ if from a bond -> MS up
• Owner's equity or stock shares - Values of the bank stocks as held by the public
• DD = RR + ER

Federal Reserve Banks

• Functions
1. Uses paper $
2. Set reserve requirement and holds bank reserves
3. Lends $ to banks and charges interest
4. Check-clear service for banks
5. Personal bank for government
6. Supervises member banks
7. Controls money supply in the  economy
• Reserve Requirement - Fed needs banks to always have $ to meet demand
• Amount = Reserve Ratio - % of DD locked to bank

Scenario 1

A private citizen takes cash that they possess and put it into a bank account

• The cash placed into the bank is already part of the money supply
• The deposit is counted as a bank liability
• A % must be placed into required reserve
• The remainder is placed into excess reserve
• The bank will want to lend all of the ER, if possible
• The amount in ER is multiplied by the monetary multiplier
• This will be assumed to become new loans in the banking system
• This will be counted as the change in money supply

Scenario 2

• The Fed buys bonds back from the public
• The public now has new cash
• This new cash is new loans
• Assume that the public puts the cash into demand deposits
• A set percentage is placed into required reserve
• The remainder becomes excess reserve
• Excess reserve is multiplied by the money multiplier (1/RR)
• This amount becomes new loans and is new money supply
• The total change in money supply is the amount of demand deposits plus the new loan amounts

Scenario 3

• The Fed buys bonds back from the member banks
• The banks now have new ER
• No money is needed to be placed in RR, since this is not owed to the public
• All of these ER are multiplied by the monetary multiplier
• This amount becomes new loans
• This amount is the change in the money supply

Unit 4 - Money

Uses of Money

• Medium of Exchange - Trade or barter
• Unit of Account - Estimate economic worth in exchange process
• Store of Money - Money holds value over period of time; products do not.

Types of Money

• Commodity Money - Value from material type from which it was made.
• Ex: Gold coins, silver
• Representative Money - Paper money that represents tangible things which gives value
• Ex: IOU
• Fiat Money - Value declared by government 
• Ex: U.S.  Money

Characteristics of Money 

• Portable
• Durable
• Uniform
• Scarce
• Acceptable
• Divisible

Money Supply

• M1 Money = Currency (Cash and coins); Checkable deposits/accounts; traveler's checks
• 75% of money; most liquid (convertible to cash)
• M2 Money = M1 money + Savings Account; deposits held by foreign banks
• Not as liquid
• M3 Money = M2 money + Certificate of Deposit (CD) 
• Early Penalty if drawn

Time Value

Is $ worth more today or tomorrow? TOMORROW

• Because opportunity cost and inflation -> charge and pay interest
• Simple Interest Formula = V = (1+P)^n x P
• Compound Interest Fornula = V = (1+(r/k))^(nk) x P
• V=Future value of $
• P = Present value of $
• r = Real interest rate as decimal
• n = years
• k = # of times interest is credited per year.