Money, Federal Reserve, Monetary Policy

Previously… • Fiscal policy is the use of government spending [G] and taxes to influence the economy. • Increases in [G] and tax cuts must be paid for by borrowing. • Fiscal policy isn’t perfect because of time lags, crowding out, and savings adjustments. • A higher MPC means a larger spending multiplier in the economy. • The Laffer curve shows the relationship between tax rates and tax revenues collected.

Big Questions 1. What is money? 2. How does the Federal Reserve and commercial banks control the money supply? 3. What is the effect of monetary policy in the short run? 4. Why doesn’t monetary policy always work?

How Money Is Defined and Measured • Money is as a medium of exchange in the economy, i.e. a commodity or financial asset that is generally acceptable in exchange for goods and services. • Currency is part of modern money – Paper bills and coins used to buy services – However, we make many purchases without currency.

• Functions of money – Medium of exchange – A unit of account – A store of value

Main purposes of money

Medium of Exchange • Medium of exchange – Money is how we pay for goods and services – Other examples: tobacco in colonial times, cigarettes or mackerel in prison

Medium of Exchange • Why is a medium of exchange useful? – Often, you have good A, and want good B. To successfully trade, you must find someone with B who wants to trade for A. – This is called a double coincidence of wants, and doesn’t occur very often. – Having an accepted currency that is “legal tender” for goods greatly increases trade.

Medium of Exchange • Commodity money – Money that is an actual physical commodity, such as gold, silver, or tobacco

• Commodity-backed money – Money that can be exchanged for a commodity at a fixed rate – Silver certificates, first half of 20th century

• Fiat money – No value except as the medium of exchange – No intrinsic value; just green paper – Value comes from government mandate that money can be used as “legal tender”

Medium of Exchange Commodity vs. Fiat Money • Commodity money (past money) – Ties the value of money to something real, which limits inflation – Changes in the commodity value affect the whole economy – Suppose new gold or silver is discovered?

• Fiat money – today’s money – Can be subject to rapid monetary expansion and inflation without a commodity tied to it – Isn’t subject to macroeconomic risk by changing commodity value

Unit of Account • Unit of account – The measure in which prices are quoted

• Usefulness of having a unit of account – Creates a common language by placing a value on a good that everyone can understand – Creates a “measuring stick” by which we can compare purchases – Creates a consistent method of record keeping (think about debits and credits in a ledger) – Could apples be a unit of account?

Store of Value • Store of value – A means for holding wealth – Are apples a good store of value?

• Importance and usefulness? – Easier and more convenient to hold wealth in money rather than a large amount of goods – The “store of value” role of money has declined recently due to many other options to store wealth: • Stocks • Bonds – pay interest • Savings accounts

Measuring the Money Supply • Checkable deposits – another part of money – Bank deposits that allow depositors to withdraw money by writing checks

• M1 – The money supply measure composed of currency and checkable deposits. – Most used measure until 1970s, before ATMs, which allow easy access to savings deposits as well

• M2 – Money supply measure that includes M1 and savings deposits, money market mutual funds, and CDs

Measures of U.S. Money Supply, 2012

Measuring the Money Supply • Debit cards – Not part of money – Technology that allows access to your own checking and/or savings accounts to make a purchase

• Credit cards – Not part of money – A credit line - a loan, that allows paying for goods and services with the bank deposit of the credit card company (e.g. Visa, MasterCard, Amex, etc.)

The Fed, Banks and Money Creation • The Fed – Central Bank of the U.S. • The Fed creates the monetary base – all the coins and bills in the economy. • Some of this “base” money is deposited in commercial banks (Reserves). • Commercial banks multiply these deposits by giving out loans, and thereby contribute in the money supply

The Fed, Banks and Money Creation Money Supply Currency

Deposits

Currency

Reserves

Monetary Base (Fed controls)

Interest Rates on Bank Deposits and Loans • Figure 30.3 here

Bank Balance Sheet • Loans: primary interest-earning use of bank funds • Reserves: bank deposits set aside and not lent out – Include currency at the vault and holdings at their bank (the Federal Reserve)

Bank Reserves • Fractional reserve banking – Banks only hold a fraction of deposits on reserve. – An alternative would be 100% reserve banking, where banks don’t loan out deposits. – Typically, banks only keep 10% of deposits on reserve.

Bank Reserves

Bank Reserves • Two reasons banks hold reserves – Banks need to accommodate customer withdrawals. – Federal Reserve requires banks to hold a fraction of their deposits on reserve. • This fraction is called the required reserve ratio (rr). • The current rr is 10%

• Bank run – Occurs when many depositors attempt to withdraw funds from a bank at one time – Could be the result of word spreading that a bank is having trouble meeting withdraw requests – May end with bank in default

Bank Reserves • To determine the dollar amount of required reserves: Required reserves = rr × deposits

• Any reserves above the required level are called “excess reserves.” Excess reserves are typically small. Excess reserves = total reserves – required reserves

Moral Hazard and the FDIC • Is the reserve requirement necessary since banks have their own incentives to hold reserves? – Need to keep customers happy – Bank run (based on true or false info) would ruin the bank

• Federal Deposit Insurance Corporation (FDIC) – Government program that insures your bank deposits – Even if a bank goes bankrupt, you get your deposits back. – Goal: increase bank stability, decrease bank runs – Before FDIC: 9,000 bank failures from 1929 to 1933

How Banks Create Money • While they don’t mint currency, banks create money when they loan out part of their deposits. • Storyline: – – – – –

You deposit $1,000 in bank. Bank loans out part of that money (up to $900). You can still get your $1,000 deposit back. Someone else now has money from the bank. New money is created!

Example of Banks Creating Money • Start off with two simplifying (but very unrealistic) assumptions 1. All currency is deposited in a bank. 2. Banks hold no excess reserves (rr = .10).

• Example: – – – –

Alexis gets a $900 loan to pay for college tuition. The college deposits this money in its bank. This bank then lends out the money as well. We can examine the balance sheets of each bank.

Example of Banks Creating Money • In this simple example, the original $1,000 was turned into $1,900. It would be $2,710 ($1,900 + 810) if we included the next borrower. University Bank (the bank from which Alexis borrowed the $900) Assets

Liabilities and Net Worth

Reserves

+$100

Loans

+$900

Deposits

+$1,000

Township Bank (the bank the college uses) Assets

Liabilities and Net Worth

Reserves

+$90

Loans

+$810

Deposits

+$900

Example of Banks Creating Money

Money Multiplier • Simple money multiplier – Rate at which banks multiply money when all currency is deposited into banks and they hold no excess reserves m

1 m  rr

• Realistically… – Represents maximum size of money multiplier – If two assumptions do not hold, this reduces the real value of the money multiplier.

The Federal Reserve • Federal Reserve (Fed) established in 1913 as central bank of U.S. • Three responsibilities: 1. Monetary policy 2. Central banking 3. Bank regulation

• Current chairman of the Fed – Janet Yellen

Roles of the Federal Reserve • Central bank – Means that the Fed is a “bank for banks” – Offers support and stability for banking system

• Federal funds – Private bank deposits at the federal reserve – Banks keep reserves at the Fed so the Fed can clear loans between banks. Often very short-term loans.

• Federal funds rate – The interest rate on loans between private banks – Rate is negotiated between private banks, not set by the Fed

Roles of the Federal Reserve • Discount loans – Loans from the Fed to private banks – The method by which the Fed is the “lender of last resort” – Not prominent in macroeconomy, but reassuring during turbulent times

• Discount rate – The interest rate on discount loans

Roles of the Federal Reserve • Fed also regulates individual banks. – Sets and monitors reserve requirements, limits risks

• Why monitor private banks’ risks but not other private firms? – Due to the interconnectivity of assets, bank problems can quickly spread to the entire industry. – Moral hazard in banking industry (related to FDIC, discussed earlier)

Federal Reserve is a Bank for Banks

Monetary Policy Tools • Open market operations – Primary single tool of monetary policy – Fed created a new version in 2008

• Secondary tools – Reserve requirements – Discount rates

• Special case: 2008 – Fed implemented 9 new monetary policy tools

Open Market Operations

Quantitative Easing • End of 2008, worst quarter in U.S. in 50 years – Real GDP down 8.9%, unemployment up – Fed decided additional measures needed.

• Quantitative easing – Targeted use of open market operations where the central bank buys securities specifically targeted in certain markets – Targeted the housing market – Unprecedented; it amounts to the Fed printing trillions of new dollars and putting them in targeted sectors.

Quantitative Easing 2007–2012

Two Traditional Tools • Two traditional tools (not used recently, but historically important) – Reserve requirements – Discount rate

• Reserve requirements – The Fed sets the ratio of deposits banks must hold on reserve, rr = reserve requirement ratio. – The simple money multiplier mm depends on rr, and mathematically, mm = 1/rr – Implication: the Fed can change the money multiplier by changing the reserve requirement.

Reserve Requirements and the Simple Money Multiplier • Table 30.2 here…

Monetary Policy

Big Questions 1. What is the effect of monetary policy in the short run? 2. Why doesn’t monetary policy always work?

Short-Run Effects of Monetary Policy • Short run – Some prices are inflexible and do not adjust. – For example, wages and other resource prices are often set by contract and don’t change immediately.

• Long run – A period of time long enough for all prices to adjust

Expansionary Monetary Policy • Review of previous topics that will be used in this chapter 1. The Fed uses open market operations to implement monetary policy where it purchases or sells bonds, normally short-term Treasury securities (Chapter 17). 2. Treasury securities are one important part of the loanable funds market, where lenders buy securities and borrowers sell securities (Chapter 10). 3. The price in the loanable funds market is an interest rate. (Chapter 9). 4. Investment is one component of aggregate demand, and higher investment leads to increases in aggregate demand (Chapter 13). 5. In the short run, increases in aggregate demand increase output and lower the unemployment rate (Chapter 26).

Expansionary Monetary Policy • Expansionary monetary policy – Occurs when the central bank acts to increase the money supply – Done through open market purchases: central bank buys bonds – Increased supply of funds lowers the interest rate, and firms take more loans out

Expansionary Monetary Policy in the Short Run

Expansionary Policy ShortRun Result • Summary – In the short run, expansionary monetary policy increases real GDP and reduces unemployment. – Overall price level rises as flexible prices increase. – Real employment and real output expand as a result of simply increasing the money supply.

Real vs. Nominal Effects • If the Fed can increase real employment and output by increasing the money supply, why don’t we just keep printing money? – At first, not all prices adjust in the short run. Some prices adjust quickly, others do not. – Eventually (by definition of the long run when all prices adjust), the real value of money will be at a lower level. The real impacts of the monetary policy disappear.

• Important implication – In the long run, monetary policy does not affect real GDP or unemployment. The only effect will be on the price level, a nominal variable.

Unexpected Inflation Can Hurt • If inflation is higher than expected, suppliers who signed a fixed price contract are hurt by tomorrow’s unexpected inflation. – Workers who signed wage contracts – Resource suppliers who are contracted to sell goods at a given price

• Examples: – Dave’s paycheck doesn’t buy as many goods. – House builder put a bid price too low on a house, and materials are now too expensive.

Unexpected Inflation can Hurt • If inflation is lower than expected, demanders who signed a fixed price contract are hurt by tomorrow’s unexpectedly low inflation. – Employers who create wage contracts with a certain level of expected inflation – Resource purchasers who signed contracts to buy goods at a certain price

• Examples: – Bob gave his employees a 3% COLA raise, but inflation was only 1.4%. – A restaurant pays too much for food and cleaning supplies due to a contract it signed.

Contractionary Monetary Policy • Contractionary monetary policy – Occurs when a central bank takes action to reduce the money supply – Often done during times of rapid expansion in order to curb potential inflation – Performed through open market operations when the central bank sells bonds – This takes money out of the loanable funds market and raises the interest rate.

Contractionary Monetary Policy in the Short Run

Why Doesn’t Monetary Policy Always Work • Just like fiscal policy, monetary policy has its flaws that can decrease effectiveness. These include: – Diminished effects in the long run – Expectations reducing the effects of policy – Policy is limited if downturns are caused by AS shifts rather than AD shifts

Long-Run Effects of Monetary Policy • Micro level using our previous example: – In the short run, monetary policy can increase business investment. – In the long run, resource prices (including wages) rise, and other prices rise as well.

• Possible outcomes? – If demand for the product increases, the business will stay open and compete. – It is also possible that the store may not be able to afford the rising input prices (costs for the firm) and may close. – These effects happen throughout the macroeconomy.

Expansionary Monetary Policy in the Long Run

Short Run vs. Long Run • Long run – It seems odd that banks can’t do much in the long run to affect real economy. – It makes more sense by realizing that we can increase the money supply by just printing more paper. – Long-term productivity increases by changes in resources, technology, or institutions

• Monetary neutrality – The idea that the money supply does not affect real economic variables

Short Run vs. Long Run • Short run – Very real effects; many economists think we should focus on the short run. – Recessions and unemployment can be painful.

• Policy can smooth fluctuations in the business cycle. – Increasing the supply during recessions, and contracting the money supply during expansions

Adjustments in Expectations • People may expect inflation if they expect monetary policy changes. – This gives people time to adjust and prepare.

• Examples – Workers have an incentive to expect some inflation and negotiate wage contracts accordingly. – Other contracts have COLA clauses. – In addition, the Fed will often announce its plans with regard to policy.

Completely Expected Monetary Policy

Aggregate Supply Shifts and the Great Recession • Great Recession – A reminder that not all downturns are caused solely from a decrease in AD – LRAS and AD decreased in this recession.

• Dilemma – Monetary policy wears off in the long run. – Monetary policy is limited in its ability to move back to the original output level since it won’t shift LRAS. – Even after significant monetary policy interventions, the economy struggled with slow growth.

Aggregate Supply Induced Recession

Conclusion • Money doesn’t just mean currency—it also includes bank deposits. • Banks expand the money supply by extending loans. • The Fed’s job of monitoring the money supply is difficult, and actions taken may be offset by the actions of banks, and even individuals.

Conclusion • Monetary policy can be expansionary or contractionary. This occurs by taking action that increases or decreases the money supply, respectively. • In the short run, monetary policy affects the real variables of GDP and unemployment. • In the long run, monetary policy affects only the price level. • Different expectation theories have risen about people’s predictions for future inflation.

Practice What You Know Today in the United States, the dollar ($) is a. intrinsically valued money. b. fiat money. c. commodity money. d. commodity-backed money.

Practice What You Know Why is M2 currently a more monitored measure of the money supply than M1? a. ATMs have allowed easier access to savings deposits. b. M2 doesn’t include coins, which may be obsolete in a few years. c. Banks pressured the Fed to include savings in the money supply measure. d. People have increased use of credit cards.

Practice What You Know Banks increase the money supply by a. b. c. d.

printing (minting) money. controlling interest rates. lending out funds to borrowers. storing the money of savers.

Practice What You Know With a reserve requirement of 5% and an initial deposit of $400, what is the total amount of money that could be in the money supply? a. b. c. d.

$420 $780 $4,000 $8,000

Practice What You Know Discount loans are a. loans offered by private banks at a lower interest rate. b. cheap loans to individuals from non-bank businesses. c. loans from the Fed to private banks. d. loans private banks make to each other.

Practice What You Know How does the Fed engage in expansionary monetary policy? a. b. c. d.

It buys bonds from financial institutions. It sells bonds to financial institutions. It lowers the prices of goods. It raises the interest rate.

Practice What You Know Suppose the Fed engages in contractionary monetary policy to reduce the money supply. What is the result in the loanable funds market? a. There is a shift in the demand for loanable funds. b. The amount of loanable funds increases. c. Bank competition increases. d. The interest rate rises.

Practice What You Know According to the models studied in this chapter, monetary policy is a. more effective in the long run. b. more effective in the short run. c. equally effective in the long and short run.