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Class Lecture Notes Week 4 Monetary Economics
Professor Shari Lyman, Ph.D.
This module introduces and discusses monetary economics. f We will discuss the difference between
the monetary policy tools and fiscal policy tools. f We will continue to discuss macroeconomic theory,
model, and issues relevant to managerial decision making. f We will discuss the issues concerning the
Keynesian Multipliers based on the work of John Maynard Keynes. f John Maynard Keynes is
considered by many economists to be the father of Macroeconomics just as Adam Smith is considered
by many economists to be the father of Economics and Sir Alfred Marshall is considered by many
economists to be the father of Microeconomics and marginal analysis.
Barter
Throughout human history, humans have made exchanges of goods for goods, services for services,
and goods for services. f Without the use of money, exchanges take place using barter.
Barter is the exchange of goods and services without involving currency or monetary units. For
example, if a dairy farmer needs a pair of shoes, he will go to the shoe cobbler and ask if he can trade 5
pounds of cheese for a pair of shoes. f If the cobbler wants cheese at the same time the dairy farmer
wants shoes, then a trade will take place.
With barter, the double coincidence of wants creates the problem in which you must find a person who
has what you want and wants what you have at the same time for the trade to place and for each
trading partner to benefit from the trade.
Due to the problem of the double coincidence of wants, money came into being as a more efficient
method of exchange.
Money
Characteristics of Money
The four primary characteristics of money are: (1) durability, (2) divisibility, (3) transportability, and (4)
non-counterfeitability.
Functions of Money
In order to be considered money, an object must meet the three of the following functions of money:
1.Medium of Exchange: f Producers, consumers, and government must be willing to accept the
currency in trade for goods and services and as payment of debt.
2.Unit of Account: f The currency is a yardstick by which the value of all other goods and services are
measured. When a trade takes place, all values are based on the currency accepted in the market. f In
the US, the accepted currency is the US Federal Reserve note. f In Japan, the accepted currency is the
Japanese Yen. f In most European countries, the accepted currency is the Euro.
3.Store of Value: f The currency is capable of maintaining its value over time for future consumption and
investment. For example, if I can buy a bag of groceries for $50 this week, then next week, I should be
able to buy the same bag of groceries for $50. In 6 months, if the currency is acting as a store of value,
then the bag of groceries will be $50.
Types of Money
Money can take the form of (1) commodity money or (2) fiat money.
Commodity money and fiat money both serve the functions of money.
Commodity money is a form of money that can be used for the exchange of other goods and
services, as well as serve a function as a good itself.
The textbook refers to Cowrie Shells: http://www.theperfectcurrency.org/main-history-of-
money/history-of-money
During WWII, cigarettes met the criteria of the 3 functions of money when other items in the Red Cross
packages did not due to the problems of short-term deterioration, perceived value, and difficulty
relating value of one item to others.
However, commodity money is a currency that holds value as a commodity or is backed by a
commodity. f Examples of commodity money are seashells, beads, giraffe tails, cattle, salt, women,
cigarettes, gold coins, and gold-backed currency.
During World War II, US military personnel held in Prisoner of War camps by the Axis powers,
developed a system of currency based on the products available to them in their Red Cross packages. f
Each package had at least one package of cigarettes. f As a result, a single cigarette, several
cigarettes, or a pack of cigarettes could buy any other item such as a chocolate bar, bar of soap,
magazine, etc.
Fiat money is a currency that holds value based on the fact that the government issuing the currency
accepts the currency as payment of debt. f Fiat money is not supported by any precious metal or any
other valuable commodity. Fiat money simply has value based on the government’s willingness to
accept their own currency as payment of debt.
International Currency
For a currency to be considered an international currency it may be either commodity money or fiat
money; however, it must be accepted across borders for imports, exports, and domestic exchanges.
Historically, the Swiss Franc, British Pound, Japanese Yen, Euro, and US Dollar have been considered
international currencies.
However, with the stability issues and Brexit, the British Pound is losing status as an international
currency.
For example, firms in Japan are required the British firms to sign contracts with either Yen, Euro, or
Dollars, not Pounds as the exchange currency.
In some countries, you might be able to directly pay for items with an international currency instead of
the domestic currency.
The Demand for Money is based on the need connected to the money.
1.Transactions demand: f the demand for money for short run transactions such as food, gas, rent,
etc. f This money is used to cover expected expenses in the short run.
2.Precautionary demand: f the demand for money in case of emergencies. f This money is set aside,
to cover unexpected expenses in both the short run and long run.
3. Assets/Speculative demand: f the demand for money for long run investment and return.
The Supply of Money is based on liquidity and the source of the money available and the way it is
measured.
In the US economy, the money supply is measured officially as M1 by the Federal Reserve and the US
Government. f However, there are additional categories of money supply including M1, M2, and L1.
Liquidity is how fast an item can be used as currency for exchange.
In the US economy, currency and coin are 100% liquid. f It does not take time or any transactions prior
to the exchange to change currency and coin into a medium of exchange.
The Federal Reserve considers M1 to be the most liquid items in the US economy.
M1 consists of currency, coin, demand deposit accounts (checking accounts), and traveler’s checks.
The Federal Reserve considers M2 to be liquid, but may take time, incur penalties, or other exchanges
to change an item into a medium of exchange.
M2 = M1 + savings account (there are time and withdrawal limits) + certificates of deposit + mutual
funds + money market funds
The Federal Reserve considers L1 to be less liquid, but to still have value in order to become a medium
of exchange given enough time, transactions, etc.
L1 = M2 + precious metals + property + art + jewelry + collectibles + antiques + vehicles + etc.
US Central Bank is the Federal Reserve Bank
The U.S. Central Bank or Federal Reserve directs 3 main functions: monetary policy, a bank for banks,
and a bank for the U.S. government. Monetary policy is in place to promote economic stability in terms
of prices, employment and economic growth. To reach these goals, the Federal Reserve has
the power to raise or lower reserve levels that banks are required to have, which directly affects the
amount of money in circulation in the economy. By doing this, it keeps control of how much money
private banks have available to loan to people. The Federal Reserve is a bank that banks use to
securely process payments, process checks and supply cash to individual banks.
Due to the fact that the Federal Reserve is a bank for the U.S. government, it is able to create money to
put into the economy by buying and selling U.S. government securities, like bonds and treasury bills.
Also, when we pay taxes or receive Social Security payments, they are processed through the Central
Bank.
The Federal Reserve System was created in 1913 following an era marked by financial panics and
economic depressions. Its principal goal then was economic stability. This goal is still important today,
along with current objectives such as stable prices, high employment, and economic growth. In
addition to working toward these aims through its conduct of monetary policy, the Federal Reserve (the
Fed) is a bank for banks, a bank for the U.S. government, and a supervisor and regulator of banks.
The supply of money is categorized into 3 categories by the Federal Reserve Bank. f
M1, M2, and L.
M1 includes coins, paper currency, money deposited into demand deposit accounts (a.k.a. DDA or
bank accounts), and traveler’s checks.
M1 is considered very liquid in that it does not involve time or cost to exchange M1 money into money
for exchange for consumption, investment, or savings.
M2 consists of M1 and savings deposits, money market funds, and certificates of deposit.
M2 is less liquid in that time requirements exist that may incur penalties for early withdraw from these
products making M2 less liquid than M1.
L consists of M2 plus all other products that may be transferred into money. f L is the least liquid
category. f This category includes precious metals, works of art, collectibles, antiques, property, etc. f It
may take several transactions or time to transfer the item into money for consumption, investment, or
savings.
Monetary Policy
The Federal Reserve (the Fed) defines monetary policy as its actions to influence the availability and
cost of money and credit. Because the expectations of market participants play an important role in
determining prices and economic growth, monetary policy can also be defined to include the directives,
policies, statements, and actions of the Fed that influence future perceptions. However, the Feds
cannot control the inflation directly; instead, indirectly by affecting the money supply, it is theorized that
monetary policy can establish ranges for inflation, unemployment, interest rates, and economic growth.
The Fed’s primary mission is to ensure that enough money and credit are available to sustain
economic growth without inflation. If there is an indication that inflation is threatening our purchasing
power, the Fed may need to slow the growth of the money supply. It does this by using three toolsthe
discount rate, reserve requirements and, most important, open market operations.
Monetary Policy Tools
Open market operation: This is the tool that the Federal Reserve uses the most frequently (on a daily
basis) monetary policy tool to involves the buying and selling of government securities in order to
influence short-term interest rates and the growth of the money and credit aggregates. Whenever an
increase in the growth rate of the money supply and credit is needed, or if downward pressure on short-
term interest rates is desired, the Fed sends securities to brokers and dealers electronically and takes
payment by debiting the accounts of banks with which the brokers and dealers do business. These
reserves leave the banking system, thereby reducing the money supply and curtailing the expansion of
credit.
To stimulate the economy that is experiencing a contraction, the Fed will increase the money supply by
buying securities.
To slow down an overheating economy that is experiencing an inflationary expansion, the Fed will
decrease the money supply by selling securities.
This is done on a daily basis and makes incremental changes to the money supply. f In a sense, open
market operations tweak the money supply.
Reserve Requirements: Are the requirements regarding the amount of funds that the bank must hold
in reserve against deposits made by their customers. This money must be in the bank's vaults or at the
closest Federal Reserve Bank. This tool is used to maintain the minimum amount of physical funds in
their reserve.
Reserve requirement changes are not made very often at all. f They are a policy used in an extreme
economic situation.
To stimulate the economy that is experiencing a contraction, the Fed will increase the money supply by
decreasing the reserve requirement allowing banks and other financial institutions to loan out a greater
fraction of the deposits.
To slow down an overheating economy that is experiencing an inflationary expansion, the Fed will
decrease the money supply by increasing the reserve requirement restricting even more the amount of
money banks and other financial institutions are allowed to loan out.
Discount Rate: interest rate charged commercial banks and other depository institutions for loans that
are received by the Federal Reserve Banks. This tool is important because it is a visible
announcement of change in the Fed's monetary policy and it will give insight to the Fed's plans.
Like the reserve requirement, the discount rate changes are not made very often at all. f This policy is
not used very often; however, the Fed is increasing the discount rate today.
To stimulate the economy that is experiencing a contraction, the Fed will decrease the discount rate
which makes borrowing for consumption and investment friendlier.
To slow down an overheating economy that is experiencing an inflationary expansion, the Fed will
increase the discount rate making savings more attractive than consumption and investment.
Most important of the Fed's responsibilities is monetary policy, the means by which the Fed influences
the growth of money and credit in the U.S. economy. f When the supply of money grows too rapidly in
relation to the economy's ability to produce goods and services, inflation may result. It is a case of too
many dollars in the hands of buyers chasing the same amount of goods. f On the other hand, too little
growth in the money supply can lead to such problems as recession and unemployment. As the money
flow slows down, people have fewer dollars to spend for various goods and services. Businesses, in
turn, receive less money for the goods and services they produce and have less to spend for the
resources they use.
Through monetary policy, the Fed tries to avoid either of these extremes. To do so, the Fed analyzes
the national economy and seeks to influence growth in money and credit that will contribute to stable
prices, high employment, and growth in the economy. f f The Fed can put more money in the economy -
actually create money - by buying U.S. government securities on the open market. The Fed pays
sellers for the securities. They, in turn, deposit the money in various financial institutions. While these
institutions are required by law to keep a certain percentage of this money on reserve, they are free to
loan out the remainder.
Let us see how this works. Suppose Jane Smith is holding a U.S. Treasury bond, one she can sell at
any time. Through a broker, she sells this bond to the Fed for $1,000. At this point the Fed, using power
granted to it by the U.S. Congress, pays Ms. Smith by creating $1,000 that did not exist before. If we
were to write a check for $1,000, that money would come out of our bank account. But the Fed's check
creates new money by adding to banking reserves. Ms. Smith deposits the $1,000 in Trustworthy
Bank. Trustworthy must keep a certain amount on reserve. f We'll suppose the bank's reserve
requirement is 10 percent. Of the $1,000 deposit, then, Trustworthy can loan out $900, known as its
excess reserves. Joe Jones, an insurance salesman, needs to borrow $900 for new computer
equipment for his office. Trustworthy Bank credits Jones' bank account with $900, money he will later
repay. In turn, Jones writes a check to Computerwise Co. for $900. This company, in turn, deposits the
check in Reliable Savings and Loan. Reliable must hold back 10 percent on reserve and can loan out
$810. This process goes on and on, increasing the amount of money in the economy. While each
financial institution can only lend an amount equal to its excess reserves, the financial system as a
whole can expand the amount of money in the economy.
As you can see, money is created in our economy in two ways that are different but related. The Fed
begins the process by creating "raw money" when it buys a Treasury security on the open market. The
banking system can then expand this amount of money by lending it. f On the other hand, if the Fed
sees the nation is threatened with inflation, it may some of the securities in its portfolio. Buyers pay the
Fed for these securities out of their bank accounts. At this point, places like Trustworthy Bank and
Reliable Savings and Loan have less money to lend. In this way, the Fed removes money from the
economy since the money paid to the Fed does not go back into any sort of bank account.
A second way in which the Fed can influence the economy is by raising or lowering the discount rate,
the interest rate charged financial institutions when they borrow reserves from the Fed. Although
seldom used, discount rate changes can be powerful signals of the direction of monetary policy.
The Fed can also have a powerful impact on the flow of money and credit by either raising or lowering
reserve requirements, the percentage of their deposits that financial institutions must keep on reserve.
If the Fed lowers reserve requirements, this can lead to more money being injected into the economy
since it frees up funds that were previously set aside. On the other hand, if the Fed raises reserve
requirements, it reduces the amount of money that institutions are free to loan out or invest. However,
the Fed is cautious about changing reserve requirements and has done so only occasionally because
of the dramatic impact it can have on both financial institutions and the economy.
Federal Reserve is A Bank for Banks
A second responsibility, the Fed is a bank for banks. In today's society it is very important to have a
secure, effective, and efficient means of making and processing payments. f Such payments include,
for example, payroll checks, insurance premiums, and large payments made by companies when they
order new equipment.
One of the original objectives of the Fed Act was to improve the nation's check collection system, an
important way of making payments at that time. Today, in our more sophisticated economy, that
responsibility has been expanded to include the transfer of funds electronically.
The Fed also supplies cash to financial institutions as they need it, charging them for money they
order. On the other hand, the Fed credits financial institutions for cash they send in when they have too
much on hand, have worn currency that needs to be taken out of circulation, or want to use it to meet
their reserve requirement.
Federal Reserve is A Bank for the U.S. Government
A third responsibility, the Fed is a bank for the government. When we pay taxes, our payments
eventually go into an account at a Fed bank. These accounts, which are much like the ones we have at
financial institutions, are used by various agencies to make payments such as military payrolls and
Social Security benefits.
Finally, the Fed helps the Treasury by selling and redeeming Treasury securities: savings bonds as
well as Treasury bills, notes, and bonds.
Federal Reserve Supervision and Regulation
The Fed is also responsible for supervising and regulating many financial institutions. f Other regulatory
agencies, such as the Comptroller of the Currency and the Federal Deposit Insurance Corporation
(FDIC), are responsible for overseeing institutions not regulated by the Fed. f It is all done to make sure
financial institutions are safe, sound, competitive places in which to deposit money. It also works to
ensure that people, as consumers of credit, are treated fairly.
As it carries out its responsibilities, the Fed is independent within the government and generally
insulated from day-to-day political pressures. On the one hand, the Fed was created by and reports to
Congress; its highest officials, the members of the Board of Governors, are appointed by the President
and confirmed by the Senate. Most of the Fed's earnings are returned to the U.S. Treasury. But the
Fed is, indeed, broadly involved in the nation's political processes because the Fed's basic purpose is
to help the nation meet its long-run economic goals, and it must be responsive to the nation's needs as
expressed by the public. However, the Fed was designed to be insulated from short-run political and
economic pressures. f For example, if the Fed were subject to political influences, political
office-holders might try to fulfill campaign promises through monetary policy that is not in the best
interests of the nation over the long run. This insulation has several elements: (1) the Fed operates on
its own earnings rather than money appropriated by Congress; these earnings come from interest
earned on the Fed's portfolio of securities and money received in payment for services provided to
financial institutions such as check clearing; (2) the terms of the members of the Board of Governors
are long (14 years) and staggered so no one President can pick the entire board; and (3) the Fed is
separate from the U.S. Treasury.
Federal Reserve Facts
Between 1863 and 1914, the United States saw a series of banking panics - in 1873, 1884, 1890,
1893, and 1907. It was the last panic - occurring in a time of general prosperity - that led to the creation
of the Fed. f f President Woodrow Wilson signed the Federal Reserve Act shortly after 6 p.m. on
December 23, 1913. He and his wife left immediately afterward for a Gulf Coast vacation, having had
their bags packed since mid-December in anticipation of final action on the bill. f When the 12 Federal
Reserve Banks opened on November 16, 1914, none had permanent quarters. In most of the Banks a
clerk or two oversaw the small trickle of business. f Twice a year the Board of Governors of the Federal
Reserve System submits a written report to Congress on the state of the economy and the course of
monetary policy, and the Fed Chairman often is called to consult with Congress on this report.
Only one member of the Board of Governors can be selected from any one of the 12 Federal Reserve
Districts. As a result, the governors represent various regions of the country. f Alan Greenspan became
Chairman of the Federal Reserve Board of Governors in 1987. He was originally appointed by
President Reagan and represents the New York Fed District. Mr. Greenspan was appointed to his
fourth consecutive four-year term in 2000.
Before the Fed, check clearing was an antiquated, costly process. One check drawn on a bank in Sag
Harbor, Long Island, and deposited in Hoboken, N.J., 93 miles away, traveled for 10 days, covered
1,223 miles, and passed through 10 banks before it cleared. f f Although banks are operated for profit
and bankers are free to make many decisions in their daily operations, banking has commonly been
treated as a matter of public interest. Thus, banking laws and regulations have been extended to many
aspects of banking. f The Fed often finds itself walking a tight rope between different sets of social costs
and priorities. To do its job successfully, the Fed must remain focused on long-run national interests
and avoid being thrown off balance by short-run political concerns.
There are 12 Federal Reserve Banks whose head offices are located in Boston, New York,
Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and
San Francisco. Together with the Board of Governors in Washington D.C., they form the nation's
central bank.
Retrieved from wysiwyg://99/http://www.kc.frb.org/infofrs/ifrsmain.htm on September 21, 2002.
Lag times for Fiscal Policy and Monetary Policy
Economists must consider the concept of lag times with respect to economic behavior and policy
responses when developing and implementing economic policy.
Three Lag Times for Fiscal Policy and Monetary Policy
Recognition Lag the lag time between a change on the business cycle and the time it takes for
analysts to see the change in the data.
Implementation Lag the lag time between seeing a change on the business cycle and the time it
takes for fiscal policymakers and/or monetary policymakers to determine a resolution and to implement
the resolution. In the US, fiscal policy has a greater implementation lag time than monetary policy does.
Response Lag the lag time between the policy implementation and the response by consumers and
firms to change behavior.
As a result, a downturn beginning in one administration or board of governors’ watch may not be fully
realized or resolved until the new policymakers take office.
Fiscal v. Monetary Policy Lag times
Fiscal Policy in the US economy involves the gathering of data, discussion of both Houses, deals, and
vote in the legislative branch which is both the House of Congress and the House of Senate.
Monetary Policy in the US economy involves the gathering of data, discussion of the Federal Reserve
Board of Governors, and determination of the policy by the Chair of the Federal Reserve.
On the business cycle, the lag times are not the same for Fiscal Policy and the Monetary Policy.
Fiscal policy has much longer recognition lag times because the legislative branch has many different
sources gathering data on quarterly and annual basis: f Bureau of Labor Statistics (BLS), Bureau of
Economic Research (BER), Bureau of Economic Analysis, Federal Reserve, diverse lobbyists
sources, diverse private and public institutions of higher education, and internal research.
Monetary policy has much shorter recognition lag times because the Federal Reserve gathers data
daily with open market operations, as well as weekly, monthly, quarterly, semi-annually, and annually.
Fiscal policy has a very long implementation lag time because of the process involving both Houses of
the Legislative Branch, the deals that take place, and the discussion and vote intricacies.
Monetary policy has a very short implementation lag time because once the Federal Reserve Chair
has determined the necessary policy (whether democratically with significant input or autocratically
without any input), the policy can be implemented immediately.
Fiscal policy has an unpredictable response lag time because households and firms need to know
about the policy change, then they must accept that this change is a long run change, not a short run
temporary change, and that the change is beneficial for them personally.
Monetary policy has a relatively short response lag time because changes in interest rates and the
money supply can be observed and included in decision making daily by households and firms.
However, both fiscal policy and monetary policy must be implemented and responded to on the right
phase of the business cycle or risk exacerbating the inflation or recession.
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