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Lesson 13---banking-fed-monetary[1]
1. Money and Banking
The Fed
Monetary Policy
Academic Decathlon
Lesson 13
Berryhill
2. The Functions of Money
Medium of Exchange
*usable for buying and selling goods and
services
*allows society to escape the
complications of bartering
*allows society to gain the advantages of
geographic and human specialization
3. The Functions of Money
Unit of account
*acts a yardstick for measuring relative
worth of a wide variety of goods, services,
and resources
*enables buyers and sellers to easily
compare the prices of various goods,
services, and resources
4. The Functions of Money
Store of Value
*enables people to transfer purchasing
power from the present to the future
*we have to store some of our income to
buy things later
*when inflation is low or
nonexistent, holding money is relatively
risk-free for preserving your wealth
5. Money Definition M1
M1 consists of:
* currency (coins and paper money) in the
hands of public
* all checkable deposits
6. Money Definition M2
M2 consists of:
* Everything in M1 plus
* Savings deposits, including money
market deposit accounts
* Small (less than $100,000) time deposits
(CDs)
* Money market mutual funds
7. Money Definition M3
M3 Consists of
* Everything in M1 and M2 plus
* large (more than $100,000) time
deposits
8. What “backs” the money supply?
The money supply in the US essentially is
“backed” (guaranteed) by the
government’s ability to keep the value of
money relatively stable. Nothing more!
9. Money as Debt
Paper money and checkable deposits are
debts, or promises to pay
They have no intrinsic value—they are just
pieces of paper or bookkeeping entries
The gov’t will not redeem your paper
money for anything tangible, like gold
***Gold standard—not reliable
because harder to control the money
supply
10. Value of Money
Why are currency and checkable deposits
money, and Monopoly money is not?
Acceptability—ppl accept them as money
Legal tender—must be accepted in
payment of a debt
**fiat money—money because the
government has declared it so, not
because it can be redeemed for precious
metal
11. Value of Money (con’t.)
Relative Scarcity—value of money
depends on supply and demand
**supply of money will determine the
value or “purchasing power” of the
monetary unit
12. Money and Prices
The purchasing power of the dollar varies
inversely with the price level
When CPI goes up, the value of the dollar
goes down, and vice versa
D = 1/P
(D=value of dollar, P=price level)
13. Money and Prices
When the gov’t issues so much money
that the value of the money is undermined
Runaway inflation can depreciate the
value of the money
Rapid declines in the value of money may
cause it to cease being used as a medium
of exchange
14. Money and Prices
Stabilization of the value of money
requires:
1. appropriate fiscal policy
2. Intelligent management or regulation of
the money supply (monetary policy)
15. The Demand for Money
Transactions Demand (Dt)—the demand
for money for uses such as purchasing
goods and services or paying for factors of
production
* Main determinant of money demanded
for transactions is the level of nominal
GDP
16. The Demand for Money
Asset demand (Da)—Derived from money’s
function as a store of value so people may hold
their financial assets in many forms, including
corporate stocks, private or government
bonds, or money
* Varies inversely with the rate of interest—
when interest rate is low, the public will choose
to hold a large amount of money assets
*When interest rate is high, amount of assets
held as money will be small
17. The Demand for Money
Total Money Demanded (Dm)—Found by
adding Da and Dt—total amount of money
public wants to hold at each possible
interest rate
* will change with increases/decreases in
nominal GDP
19. Asset Demand for Money (Da)
Interest Rate
10
7.5
5
2.5
Da
0 50 100 150 200 Amt of $ Demanded
20. Total Demand for Money and
Supply of Money
Dm = Dt + Da
Interest Rate
10 Sm
7.5
5
2.5
0 Dm
0 50 100 150 200 300 Amt of $ D and S
21. The Money Market
Money Market—Combining the supply and
demand for money to determine the
equilibrium rate of interest
Supply of Money (Sm) is a vertical line
because the economy has some particular
stock of money (such as M1) provided by
the monetary and financial institutions
22. Adjustment to a Decline and Incline
in the MS
Rate of Interest Sm1 Sm Sm2
10
7.5
5
Surplus of $
2.5 Shortage
of $ Dm
0
0 50 100 150 200 250 300
Amt of $ D and S
23. Federal Reserve System
or the “Fed”
Federal Reserve System—the US’s
monetary authorities made up of the
Federal Reserve Banks and overlooked by
the Board of Governors
24. Historical Background
Early in 20th century, Congress decided
that centralization and public control were
essential for an effective banking system
Decentralization has fostered
inconvenience and confusion of numerous
bank notes being used as currency
25. Historical Background
It had also resulted in episodes of
monetary mismanagement when the MS
was inappropriate to the needs of the
economy (too much $ led to rapid
inflation, too little $ stunted the economy’s
growth)
This led to the Federal Reserve Act of
1913
26. Board of Governors
Central authorities of the US money and
banking system
The US president, with the confirmation of
the Senate, appoints the seven Board
members
Terms are 14 years and are staggered so
that one member is replaced every 2 years
27. Board of Governors
New members are also appointed when
resignations occur
The president selects the chairperson and
vice-chairperson of the Board from among
the members
28. Assistance and Advice
Several entities assist the Board of
Governors in determining banking and
monetary policy
The Federal Open Market Committee
(FOMC) is made up the 7 members of the
Board plus five of the presidents of
Federal Reserve Banks
29. Assistance and Advice
The FOMC sets the Fed’s monetary policy
and directs the purchase and sale of
government securities (bills, notes, and
bonds)
Three Advisory Councils made up of
private citizens meet periodically with the
Board of Governors to voice their views on
banking and monetary policy
30. Assistance and Advice
The Federal Advisory Council is composed
of 12 commercial bankers, one selected
annually by each of the 12 Federal
Reserve Banks
The Thrift Institutions Advisory Council
consists of representatives from savings
and loan associations, savings banks, and
credit unions
31. Assistance and Advice
The 30-member Consumer Advisory
Council includes representatives of
consumers of financial services and
academic and legal specialists in consumer
matters
32. The 12 Federal Reserve Banks
The 12 Federal Reserve Banks collective
serve as the nation’s “central bank”; they
blend private ownership and public control
and mainly are so-called bankers’ banks
The 12 Federal Reserve Banks serves
different districts and all implement the
basic policy of the Board of Gov.
33. Quasi-Public Banks
12 Federal Reserve Banks are quasi-public
Each Fed. Res. Bank is owned by the
private commercial banks in its district
(commercial banks are required to
purchase shares of stock in the Fed Res
Bank in their district)
34. Quasi-Public Banks
But a gov’t body (the Board of Gov) sets
the basic policies that the Fed. Res. Banks
pursue
Despite private ownership, the Banks are
in practice public institutions
They are not motivated by profit
35. Bankers’ Banks
Fed Res Banks perform the same
functions for banks and thrifts as those
institutions perform for the public
* Accept deposits and make loans to
banks and thrifts
*Issue currency
36. Fed Functions and the MS
Issuing currency—issue Fed. Res.
Notes, the paper currency used in the US
Setting reserve requirements and holding
reserves—sets the amount/fraction of
checking balances that banks must
maintain as currency reserves; accept and
portion of the reserves not held as vault
cash
37. Fed Functions and the MS
Lending money to banks and thrifts—will
lend money to banks and thrifts and
charge them an interest rate called the
discount rate
Providing for check collection—Adjusts
reserves to compensate for checks written
38. Fed Functions and the MS
Acting as a fiscal agent—provides financial
services for the Federal government
Supervising banks—makes periodic
examinations to assess bank profitability
and accordance to Fed regulations
39. Fed Functions and the MS
Controlling the money supply—Fed
regulates supply of money, and in turn
enables it to influence interest rates;
makes amount of money available that is
consistent with high and rising levels of
output and employment and a relatively
constant price level
40. Federal Reserve Independence
Congress purposely established the Fed as
an independent agency of government
Political pressures on Congress may result
in inflationary fiscal policy
If executive branch also controlled the
nation’s monetary policy, there could be
pressure to keep interest rates low even
when high interest rates are needed
41. Federal Reserve Independence
Studies show that countries that have
independent central banks like the Fed
have lower rates of inflation, on
average, than countries that have little or
no central bank intelligence
42. Fed Functions
Issuing currency
Setting reserve requirements—the
percentage of each deposit that a bank
must keep on hand in their vault
Lending money to banks when they don’t
have enough reserves in their vaults
Check collection
43. Fed Functions—cont.
Provides financial services to Federal
government
Supervising banks
Controlling the money supply
44. Interest Rates
Interest is the price of money—how much
it costs to borrow money
Price of Money Supply of Money—vertical because it
(interest rate) Is a constant amount (how much is in
Circulation)
Interest rate
Demand of Money—how much
People desire/need/want to take
Out in a loan
Qm Quantity of Money
45. Monetary Policy
The Fed controls the money supply, and
therefore the interest rate
As they change the amount of money in
circulation, the price of money changes
(or the interest rate)
46. Change in Supply of Money
Sm1 Sm Sm2
Interest Rate
Int. Rate 1
Int.Rate
Int. Rate 2
Quantity of Money
47. Tools of Monetary Policy
Open Market Operations—the buying of
bonds from, and the selling of bonds
to, the general public and commercial
banks
Fed’s most important instrument for
influencing the money supply
48. Buying Bonds
When the Fed buys bonds they are putting
money into circulation, thereby increasing
the money supply and decreasing i.r.
Sm Sm1
Int. rate
Ir
Ir1
Dm
Quantity of Money
Qm Qm1
49. Selling bonds
When the Fed sells bonds they are taking
money out of circulation, thereby
decreasing the money supply and
increasing i.r.
Sm1 Sm
Int. rate
Ir 1
Ir
Dm
Quantity of Money
Qm 1 Qm
50. Tools of Monetary Policy
The reserve requirement or reserve ratio—the
amount of each deposit the bank must keep in
their vaults
Limits the amount of each deposit the bank may
loan out to another customer
When the bank can loan out a lot, they can
increase the money supply
When the banks can not loan out much, they
are decreasing the money supply
51. Reserve Ratio
You deposit $1,000 in your bank account.
The reserve ratio is 25%--that means they must
keep 25% of the deposit in the vault
They set $250 in the vault, but use the other
$750 to loan out to another customer
That $750 plus the interest they charge the
customer is increasing the money
supply, thereby decreasing interest rates
52. Reserve Ratio
Say the same $1,000 is deposited in a
bank, but this time the reserve
requirement is lowered to 20%
Now they must keep $200 in their vaults
and loan out $800
This is an bigger increase in the money
supply because they can loan out more
53. Tools of Monetary Policy
The discount rate—the interest rate the
Fed charges on loans to other banks
Banks may nightly take out loans from the
Fed if they have loaned out more than
they are allowed to (determined by the
reserve ratio)
The banks are still charged interest by the
Fed, called the Discount Rate
54. The Discount Rate
When the discount rate is low, banks are
more willing to loan out their reserves
because they can just take out a loan from
the Fed later to cover that loan.
This increases the money supply because
will be looser with their money and their
loans.
55. The Discount Rate
When discount rate is high, banks don’t
want to take out a loan from the Fed.
They will be less likely to loan out their
reserves, thereby decreasing the money
supply because of their unwillingness to
give out as many loans.
56. How does this affect the
economy?
By increasing and decreasing the money
supply, the Fed is increasing or decreasing
the interest rates.
When interest rates are high, people are
less willing to take out loans.
When interest rates are low, people are
more willing to take out loans.
57. How does this affect the
economy?
Remember the determinants of GDP (and AD)?
GDP (or AD) = C + I + G + X
The I stands for Investment—money people
take out of a bank in the form of loans to
buy/invest in something.
If we increase or decrease I, everything else
equal, we are increasing and decreasing GDP/AD
58. How does this affect the
economy?
Interest rates decrease—more people take out loans—AD increases because
I has increased—this increases the price level (inflation) and GDP (production)
Price Level AS
PL1 or new inf.
PL or inflation
AD 1
AD
GDP New GDP GDP
59. How does this affect the
economy?
Interest rates increase—people take out less loans, thereby decreasing I—as
I decreases, so does AD—that decreases inflation and GDP
Price Level AS
PL or inflation
PL1 or new inf.
AD
AD 1
New GDP GDP GDP
60. When to use what…
Problem: high unemployment
AD Increases
Buy bonds, lower rr, Investment
Or lower disct. rate Spending
GDP increases, Increases
Which will lower
unemployment
Interest Rate
Excess reserves Money Decreases
Increase (more Supply
Money to loan out) Increases
61. When to use what…
Problem: Inflation
AD decreases
Investment
Sell bonds, increase rr,
Spending
Or increase disct. rate
Decreases
Inflation
Decreases
Excess reserves
Decrease (less Interest Rate
Money to loan out) Money Increases
Supply
Decreases
62. Strengths of Monetary Policy
Speed and Flexibility
Isolation from political pressure
Past success in the 1980s and 1990s
Inflation from 13.5% in 1980 to 3.2% in 1983
Recovery from recession of 1990-1991
63. Problems with monetary policy
Less control with more electronic
transactions
Changes in velocity of money (the number
of times per year the average dollar is
spent on goods and services)
Less reliable in pushing the economy from
a recession (cannot force people to take
out loans)—think Japan 1990s