economics 2 part

ECO 2302, Principles of Macroeconomics 1

Course Learning Outcomes for Unit VII Upon completion of this unit, students should be able to:

7. Illustrate monetary theory using the supply and demand model. 7.1 Identify the three functions of money and six qualities of ideal money. 7.2 Summarize tools of monetary policy that are used by the Federal Reserve. 7.3 Describe contractionary and expansionary monetary policy and when they are used.

Course/Unit Learning Outcomes

Learning Activity

7.1 Unit Lesson Chapter 13 Unit VII Assignment

7.2 Unit Lesson Chapter 14 Unit VII Assignment

7.3 Unit Lesson Chapter 15 Unit VII Assignment

Required Unit Resources Chapter 13: Money and the Financial System Chapter 14: Banking and the Money Supply Chapter 15: Monetary Theory and Policy

Unit Lesson Unit VII is the largest unit in this course in terms of the number of textbook chapters that are covered; however, the material in Unit VII tends to be easier to understand. In this unit, you will be learning about money and the Federal Reserve. The discussion below focuses first on money itself. This is followed by a discussion of the Federal Reserve and its functions. Finally, different types of monetary policy are addressed, including when they are used.

Money Money is a term that virtually everyone has heard. Dire Straits sang about money for nothing in 1985. Ed Sheeran sang about not wanting your money in 2019. Even Emily Dickenson wrote about being rich with money until she was taught what true wealth was in the poem Your Riches Taught Me Poverty. However, have you ever stopped to think about what money actually is? As you move through this section, think about your own perception of money. Chances are, the formal definitions of money will closely resemble your thoughts. For more information, watch the brief video Money. A transcript and closed captioning are available once you access the video.

UNIT VII STUDY GUIDE

Monetary Policy and Banking

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Barter Before money existed, people used bartering to exchange goods and services. For example, someone may have had five horses but did not have firewood. Another person may have had an abundance of firewood but did not have a horse. The person with the horses could trade one for some firewood. This type of exchange is called a barter. This sounds like it worked well. However, we would have to ask, how much firewood is worth one horse? The two people involved would have to negotiate this exchange rate. Now, add in the fact that the person with the horse may also need corn from someone else, cloth to make clothes from another, and milk from yet another person. As McEachern (2019) points out, increasing the number of goods that are traded increases the exchange rates. Further, if the person who has firewood wants to purchase a house, he or she might be hard pressed to find someone with a house who needs a massive amount of firewood. This last problem is an example of high transaction costs, and this is what brought about the creation of money.

Functions of Money Money refers to anything that is widely accepted for payment throughout an economy (McEachern, 2019). However, the functions of money narrow this definition. This definition is focused on the first function of money, which is as a medium of exchange. When you watch the videos for this section, notice how my dog accepted a treat in exchange for her ball. In this instance, the treat is the medium of exchange for my dog. Because the treat is a commodity and also money, McEachern (2019) explains that it is called commodity money. The second function of money is as a unit of account. When an economy begins to accept commodity money, it becomes a unit of account. If there ever comes a time when all the dogs in the world rule, and all dogs are willing to accept one treat for one ball, prices will have been established. As McEachern (2019) suggests, the treats will be the yardstick for measuring the value of things that will be purchased. In other words, every item that is purchased in this dog world will be paid for in dog treats. Maybe it will take 1,000 dog treats to purchase a dog house, 100 dog treats to purchase a new collar, and 25 dog treats to go for a ride. The point is that dog treats will be the common denominator for pricing goods and services. The final function of money is to store value (McEachern, 2019). This means that money holds its value over time. The longer money can hold its value, the more acceptable it is to serve as, well, money. For example, my dog will eat a dog treat as soon as it is put in front of her. In this instance, dog treats do not serve the function of storing value as they are consumed right away. However, coins that were minted 50 years ago can still be found today and can still be used as money.

Properties of Ideal Money The money in our pockets has properties that we inherently know. The first two properties of money relate to the physical attributes of the coin or bill itself. First, money that we carry around is durable. Going back to dog treats, they have to be stored properly. If not, these dog treats will become stale and spoil. This is not the case with money in your pocket. Coins and even paper money have a long useful life. Thus, one characteristic of ideal money is that it is durable (McEachern, 2019). Next, money should be easy to carry around. Coins and bills can easily fit into your pocket. That means they serve the function of being portable. The third property of ideal money is that it is easily divisible (McEachern, 2019). We see this property every time we pay cash for a good or service. If the cost of a good is $19.99, and you pay with a $20 bill, you will receive one penny in change. Also, money should be of uniform quality. For instance, dog treats used as money would become stale over time. Newer, fresh dog treats would have the same value as older, stale dog treats, but my dog would begin to question whether the older, stale dog treats had the same value as newer ones. That suggests dog treats are not of uniform quality. However, take any two $1 bills out of your wallet—both of them are of uniform quality.

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For the fifth property of ideal money, we will revisit opportunity costs. In our hypothetical dog world where dog treats are used as money, my dog could eat the treat or use it to pay for other goods. If my dog chose to purchase goods with the treat, she would give up eating it. The value of what she gave up is the opportunity cost of making the purchase (which would be very high for my dog). On the other hand, there are not many uses other than money for the paper bills or coins in your pocket. That means there is a low opportunity cost associated with the money you have (McEachern, 2019). Finally, the value of money should be relatively stable. Unpredictable fluctuations in the supply and demand of money would result in unpredictable changes in prices. Again, going back to my dog’s treats, a sudden increase in the demand to eat her dog treats would affect the exchange rate of the treats and reduce the usefulness of these treats as money. That is why the money we carry around in our pockets is supplied by the federal government. The federal government’s supply of money is not dependent on uncontrollable forces of nature, making the value of the bills and coins you carry more stable (McEachern, 2019).

Federal Reserve Have you ever wondered what happens to a check after your write it to pay for something? The person or business that receives that check will deposit it in their own bank. That bank will send the check to the Federal Reserve, which will clear the check and then send it to your bank. The Federal Reserve has far more duties than to just clear checks, though. The Federal Reserve has the responsibilities of issuing bank notes, buying and selling government securities, loaning money to member banks, clearing checks in the banking system, and requiring member banks to hold a specified fraction of their deposits in reserve (McEachern, 2019). This suggests that the Federal Reserve is involved with much of the daily transactions in the economy. However, the Federal Reserve is involved with much more than the daily transactions of consumers.

Regulating the Money Supply The Federal Reserve is in charge of manipulating the money supply in the United States in an attempt to create price stability and maximum employment. Beyond that, McEachern (2019) explains that the goals of the Federal Reserve have been expanded to include economic growth, stable interest rates, stable financial markets, and stable exchange rates. To effectively achieve all these goals, the Federal Reserve attempts to control inflation and promote economic growth. Below is a discussion of the tools the Federal Reserve has at its disposal to achieve these goals. To learn more about Federal Reserve responsibilities and activities, view the video Monetary Policy and the Federal Reserve. A transcript and closed captioning are available once you access the video.

Open Market Operations One tool the Federal Reserve can use to help fight inflation or stimulate economic growth is open market operations. Open market operations consist of the Federal Reserve either buying or selling government securities (McEachern, 2019). It is important to understand that buying government securities has a much different impact than selling government securities. Buying government securities is considered to be expansionary monetary policy, while selling government securities is considered to be contractionary monetary policy (Federal Reserve Bank of St. Louis, n.d.-a). As we learned with fiscal policy, expansionary monetary policy attempts to expand economic growth. On the other hand, contractionary monetary policy slows down (or contracts) the economy. When the economy is facing rising inflation, the Federal Reserve may choose to sell government securities in an attempt to slow the economy down and lower inflation. The reason selling government securities contracts the economy is that money in the economy is given to the Federal Reserve for these securities. Since this money is no longer in the economy, the reserve funds that banks have available to lend is decreased (Federal Reserve Bank of St. Louis, n.d.-a). With less money flowing through the economy, less spending will result. Lower spending results in a decrease in prices, and inflation is lowered.

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Just the opposite occurs when the Federal Reserve choses to purchase government securities. When the Federal Reserve purchases government securities, the Federal Reserve is giving the economy money for the securities. More money in the economy means banks have more money to lend (Federal Reserve Bank of St. Louis, n.d.-a). More loans mean more spending in the economy. More spending in the economy suggests the economy will be stimulated to grow. While news reports often do not focus on this tool of the Federal Reserve, open market operations are the easiest tool the Federal Reserve has in its toolbox. Because of this simplicity and ease of use, open market operations are the preferred tool of the Federal Reserve (McEachern 2019).

Discount Rate The Federal Reserve does not deal directly with the public. The Federal Reserve can be thought of as the banks’ bank. The Federal Reserve regulates banks and can even make loans to member banks (McEachern, 2019). Money borrowed from the Federal Reserve by member banks is then loaned to consumers for purchases. As with any loan, member banks borrowing money from the Federal Reserve will be charged interest. The interest that is charged to the member bank is called the discount rate (Board of Governors of the Federal Reserve System, 2020). When these member banks turn the money around and loan it to consumers and firms, the member banks base the interest rate they will charge borrowers on the discount rate that is charged by the Federal Reserve. This suggests that the discount rate directly influences the interest rate for loans, savings accounts, certificates of deposits, and other types of similar accounts. The Federal Reserve can make changes to the discount rate in an attempt to either stimulate economic growth or fight inflation. A lower discount rate means that it is cheaper for banks to borrow money from the Federal Reserve. With member banks having to pay a lower rate for money borrowed from the Federal Reserve, these member banks can lower the interest rate that borrowers in the economy will pay for loans. At the same time, these member banks will lower the interest rates paid for savings, certificates of deposit, and other types of similar accounts. When consumers see these lower interest rates, they are encouraged to borrow more money and save less. More borrowing and less saving means more money is being used for purchases in the economy. More purchases in the economy results in a stimulated economy where economic growth occurs. Again, stimulating economic growth is called expansionary monetary policy. On the other hand, the Federal Reserve may choose to increase the discount rate. The Federal Reserve may choose to increase the discount rate because inflation is on the rise and becoming a problem in the economy, or the Federal Reserve may fear that inflation could rise in the near future. Increasing the discount rate results in an increased interest rate that is charged by member banks for loans as well as an increased rate paid to consumers for savings accounts, certificates of deposits, and other types of similar accounts. Increasing interest rates encourages consumers to save money rather than spend it. Further, increasing interest rates discourages consumers and firms from borrowing money. Both result in a decrease in money in the economy. A decreased supply of money in the economy slows down economic growth, which lowers inflation. Basic logic would suggest that a lower interest rate would result in more spending in the economy. If you were given $10,000 and told you could put that money in a savings account and earn 0.5% interest over the next year, you could quickly determine that you could earn $50 over the next year from investing that $10,000. That kind of return on your savings is not a big incentive to save. However, if interest rates were 10% for saving that money, you would earn $1,000 in interest from saving that $10,000 over the next year. In this instance, you would be more inclined to save that money than spend it. The same logical reasoning is found with interest rates on loans. Let’s say you want a $10,000 loan for your business so you can invest in improvements like purchasing more machinery or remodeling the store. You could open a credit card account for the loan or get a small business loan. Let’s take a closer look at each option.

• Credit Card: The credit card has a 21% interest rate. Opening the credit card account and charging $10,000 in purchases on that card would result in your having to pay $2,100 in interest back at the end of the year plus the loan of $10,000. That would mean you have to pay a total of $12,100 at the end of the year.

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• Small Business Loan: The small business loan, on the other hand, has an associated 2.5% interest rate. If you accept the small business loan, you will accrue $250 in interest over the entire year. This would mean you would have to pay back $10,250 in principal plus interest at the end of the year.

If the only option to get the loan were to take the credit card loan, you might decide not to even borrow the money, as the interest rate is just too high. Not taking this loan would mean you do not purchase that new machinery or remodel the store. Because you are not going to spend that money, the economy will not see as much activity. However, the small business loan is a much more attractive offer since the interest rate on the loan is lower. If you decided to take the small business loan, you would spend money on the new machinery or on the remodeling of the store. The rest of the economy sees an increase in activity, and the economy grows. While simplified, the example above shows you how the Federal Reserve can influence the money supply and economic activity through making changes to the discount rate.

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Reserve Requirements

The final tool the Federal Reserve has at its disposal to manipulate the money supply of the United States is making changes to reserve requirements of member banks. Reserve requirements represent the minimum amount of money member banks must hold in reserve to back up deposits (McEachern, 2019). When the Federal Reserve decreases reserve requirements, they are engaging in expansionary monetary policy (Federal Reserve Bank of St. Louis, n.d.-b). For example, banks lend money for investment. The money that is required to be held in reserve cannot be used for these loans. When the reserve requirements are decreased, member banks have more money available that they are allowed to lend for investment. More loans being made means more money is flowing through the economy when the investment is made. As more money flows through the economy, the economy grows. Reserve requirements can also be used to contract an economy that is growing too fast (i.e., the economy is facing inflation). If the Federal Reserve wants to fight inflation, the economy will need to contract. Increasing the reserve requirements of banks can help contract the economy. With increased reserve requirements, member banks must hold a larger portion of money in reserve. Larger reserves mean that less money is available to make loans for investment. With less money available for loans, less money is flowing through the economy. The economy will contract, and inflation will decrease. Learn more about this by viewing the video Contractionary and Expansionary Monetary Policy. A transcript and closed captioning are available once you access the video.

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Interest Rates and the Demand for Money Consumers have a choice when it comes to money—they can save it, or they can spend it. When making this decision, consumers will weigh the opportunity cost of spending money. The opportunity cost associated with spending money is the interest that could have been earned if the money were saved. As mentioned above, a higher interest rate encourages consumers to save money because the opportunity cost of spending money is higher. A lower interest rate discourages saving because the opportunity cost of saving money is lower. In other words, consumers will want to hold on to their money (they will demand more money) for other purposes when interest rates are low. Effectively, consumers are weighing the opportunity cost of holding money when making decisions of whether to save or spend. As the interest rate increases, the opportunity cost of holding money increases as well. Similar to all other demand curves, the demand for money slopes downward and to the right. The quantity of money is on the horizontal axis, and the interest rate is on the vertical axis. The downward slope of the demand curve suggests at higher interest rates, less money is demanded. At lower interest rates, more money is demanded.

The Federal Reserve, through monetary policy, is primarily responsible for determining the supply of money. At a given point in time, the supply of money is fixed at the level determined by the Federal Reserve. Regardless of the level of interest rates, the supply of money is fixed, meaning that it is a vertical line (McEachern, 2019).

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The intersection of the supply of money (Sm) and demand for money (Dm) represents the equilibrium interest rate (i).

As mentioned above, the Federal Reserve can engage in expansionary or contractionary monetary policy. If the Federal Reserve engaged in contractionary monetary policy through buying government securities, the money supply would shift to the left (Sm

’). Equilibrium between the demand for money and the supply of money would move from Point A to Point B. The result of this movement from Point A to Point B would be a higher interest rate (i’). The opposite result would occur if the Federal Reserve engaged in expansionary monetary policy.

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Interest Rates, Aggregate Demand, and Aggregate Supply From above, we know that interest rates affect investment. As interest rates decrease, firms are encouraged to borrow money to make investments in the operations of their business. The investment shifts the aggregate demand curve to the right (AD1 to AD2). An increase in aggregate demand was the goal of the Federal Reserve as decreasing interest rates is considered to be expansionary monetary policy. As aggregate demand shifts to the right, the equilibrium price level in the economy increases from P1 to P2. That means that expansionary monetary policy will result in some inflation (the increase in aggregate prices).

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If the Federal Reserve wanted to fight inflation, a contractionary monetary policy would be enacted. Contractionary monetary policy would result in an increase in interest rates. The increase in interest rates would cause the aggregate demand curve to shift to the left (AD2 to AD1). The shift of the aggregate demand curve would cause equilibrium to move from Point B to Point A. The end result would be a decrease in aggregate prices from P2 to P1.

References Board of Governors of the Federal Reserve System. (2020, February 25). Policy tools: The discount rate.

https://www.federalreserve.gov/monetarypolicy/discountrate.htm Federal Reserve Bank of St. Louis. (n.d.-a). A closer look at open market operations.

https://www.stlouisfed.org/in-plain-english/a-closer-look-at-open-market-operations Federal Reserve Bank of St. Louis. (n.d.-b). How monetary policy works. https://www.stlouisfed.org/in-plain-

english/how-monetary-policy-works McEachern, W. A. (2019). Macro ECON6: Principles of macroeconomics (6th ed.). 4LTR Press.