Bank Reserves
Functions of Money
What is money, and how is money regulated?
Money has three main functions:
1. medium of exchange,
2. store of value, and
3. unit of account.
In economics, we classify money into two main measures or aggregates: M1 and M2.
M1, which consists of money in circulation in the public and checkable deposits, is the most liquid form; M2, which consists of M1, savings deposits, time deposits, and money markets, is a broader and less liquid form.
Money creation and credit are the results of a banking system, which ultimately is regulated by the Federal Reserve System.
They banking system in the U.S. is a fractional reserve system. The Federal Reserve Bank of the U.S. regulates this system via required reserves, thus requiring member banks to keep a fraction of their deposits in reserves at the Fed (Federal Reserve).
· Those fractional reserves are considered required reserves, and any monies leftover after the required reserves, which are set by the Fed, are referred to as excess reserves.
· Excess reserves can be loaned out by banks, and when those excess reserves are loaned out, additional deposits are created, as well as new M1 money, thereby expanding the money supply.
How much activity in the banking system is transpiring and how fast the money supply is expanded is referred to as the "velocity of money creation."
If the economy is at full employment and potential GDP, the higher the velocity of money creation will also put stronger upward pressure on prices in the market; in a sluggish, recessionary economy, the velocity of money creation tends to be relatively slow, implying downward pressure on prices.
· Whenever the velocity of money and upward pressure on prices is high, action in the form of monetary policy of the Fed normally occurs, as does it also under sluggish conditions of inward aggregate demand shifting and deflationary pricing.
What kinds of actions can be expected to be implemented by the Fed in monetary policy during inflationary and deflationary periods? The Fed has three main tools:
1) Required reserves,
2) Discount window, and
3) Open market operations:
1) Required reserves: By mandating a certain percentage of reserves to be kept at the Fed, the amount of allowable excess reserves can be regulated. To slow economic activity, the Fed would increase the required reserves, thereby reducing excess reserves, and thereby increasing interest rates. To increase economic activity, the Fed would decrease required reserves.
2) Discount window: The Fed can extend loans to member banks who seek to augment, normally seasonally, their excess reserves. Member banks borrowing from the Fed pay interest to the Fed. To slow economic activity, the Fed would raise the interest rate borrowing banks must pay; to increase economic activity, the Fed would decrease the rate.
3) Open market operations: Banks buy government securities (bonds) from the Fed, and sell them back too. The buying and selling of government securities is all done in the Federal Funds Market, where banks borrow from other banks. If the Fed seeks to slow economic activity, they will sell government securities at an attractive rate to banks, thereby reducing member banks' excess reserves, causing interest rates to rise; if the Fed desires to increase economic activity, they will buy, thereby injecting and augmenting excess reserves, causing interest rates to fall.
W7 Lecture 2 "Monetary Policy"
Content
Macroeconomics
Monetary Policy
In Week #7: Lecture #1, we discussed how the Federal Reserve Bank of the U.S. regulates economic activity to bring about stability in prices and output.
We also discussion that how much activity in the banking system is transpiring and how fast the money supply is expanded is referred to as the "velocity of money creation."
· If the economy is at full employment and potential GDP, the higher the velocity of money creation will also put stronger upward pressure on prices in the market; in a sluggish, recessionary economy, the velocity of money creation tends to be relatively slow, implying downward pressure on prices.
Whenever the velocity of money and upward pressure on prices is high, action in the form of monetary policy of the Fed normally occurs, as does it also under sluggish conditions of inward aggregate demand shifting and deflationary pricing. So, what the Fed's monetary policy is at any given time is going to be determined whether they are incorporating expansionary monetary policy or restrictive monetary policy.
When the Fed is carrying out expansionary monetary policy, the goal is to decrease interest rates for borrowing by augmenting excess reserves at banks.
· The Fed will tend to utilize open market operations to buy securities from banks to transfer funds from the Fed to the banks' reserves, thereby increasing the supply of loanable funds in the market; the Fed will make it attractive for banks to relinquish ownership of government securities, and thus selling them back to the government.
· Interest rates fall, and aggregate demand increases. This action and result in lowered interest rates tends to be unanticipated by the market.
When the Fed is carrying out restrictive monetary policy, the goal is to increase interest rates for borrowing by draining excess reserves at banks. The Fed will make it attractive for banks to desire more ownership of government securities, thereby releasing reserves to pay for the securities to the Fed. Less in excess reserves means a shift leftward in loanable funds, causing interest rates to rise and output to fall in the aggregate economy.
What is the relationship between the housing collapse of 2008 and Fed monetary policy? Due to relative low interest rates and government-mandated loan programs during the years of 2002 through 2004, demand for housing soared, as did the inflationary pricing in housing. Abrupt response to the inflationary pricing was a restrictive policy carried out by the Fed via the open market operations.
The Fed swiftly began selling government securities, thereby drying up much of the loanable funds in the market, and interest rates soared by 2006.
Due to the extensive number of ARMS (adjustable rate mortgages), variable rates exponentially rose by 400%, leading to destructively high numbers of foreclosures throughout the latter years 2006 through 2011. After 2008, quick softening of monetary policy sought to lower interest rates was carried out to counteract the abrupt and extensive shifts upward in interest rates between 2006 and 2008.
· In conclusion, the Federal Reserve has tools to implement and regulate economic activity, with price stabilization and low employment the goals.
· In the model, Phillips Curve, unemployment can be reduced by the government creating unanticipated inflation; the more the market underestimates inflation (unanticipated), the more unemployment falls, and eventually below the natural rate of unemployment.
· However, according to the Phillips Curve model, correctly anticipated and implemented policies of inflation (right amount) can bring about the natural rate of unemployment. Fed's policies of expansionary and restrictive monetary policy seek to achieve a good balance between inflation/deflation and unemployment.