Class Lecture Notes Week 4 Monetary Economics
Professor Shari Lyman, Ph.D.
This module introduces and discusses monetary economics. a We will discuss the difference
between the monetary policy tools and fiscal policy tools. a We will continue to discuss
macroeconomic theory, model, and issues relevant to managerial decision making. a We will
discuss the issues concerning the Keynesian Multipliers based on the work of John Maynard
Keynes. a 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. a 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. a 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: a 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: a 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. a In the US, the accepted currency is the US Federal Reserve note. a In Japan, the
accepted currency is the Japanese Yen. a In most European countries, the accepted currency is the
Euro.
3.Store of Value: a 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. a 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. a Each package had at least one package of cigarettes. a 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. a 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: a the demand for money for short run transactions such as food, gas,
rent, etc. a This money is used to cover expected expenses in the short run.
2.Precautionary demand: a the demand for money in case of emergencies. a This money is set
aside, to cover unexpected expenses in both the short run and long run.
3. Assets/Speculative demand: a 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. a 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. a 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. a
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. a L is the least liquid
category. a This category includes precious metals, works of art, collectibles, antiques, property, etc.
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 tools—the 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. a 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. a 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. a 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. a 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. a 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. a a 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. a
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. a 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. a 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. a 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. a 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. a 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. a a 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. a 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. a 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. a 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. a a 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. a 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: a 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.
