(Mberiah Only ECO202) MONETARY POLICY: MONEY, CREDIT, THE FEDERAL RESERVE, AND INTEREST RATE

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Money and Monetary Policy

Macroeconomics

ECO202

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•Forms and Types of Money:

People invented money to overcome the limitations

of barter.

Early money was “commodity money.”

Commodity monies are items used as money that

also have intrinsic use value.

People invented fiat money and credit money to

overcome the limitations of commodity money.

Why do fiat money and credit money have value?

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Functions of Money:

Money regardless of form performs three

important functions in the economy.

Money serves as:

1. Medium of Exchange.

2. Store of Value.

3. Standard of Value.

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1. Medium of Exchange:

Barter requires the double coincidence of wants.

Money lowers the transactions costs of exchange

by serving as the means of payment.

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2. Store of Value:

Money is a convenient way to store part of one’s

wealth.

Any asset has three important features.

An advantage to money is its liquidity, but liquidity

has an opportunity cost.

During inflationary times it is dangerous to store

wealth in the form of money.

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Risk and Return:

The rate of return on an asset is the total dollar

gain from an asset measured as a % from the

beginning of the period.

The return combines any income with a capital

gain or loss.

Risk measures the variability of returns.

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3. Standard of Value:

Unit of account.

Money is a standard of value for quoting prices.

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M1: Narrow transactions money supply is

called “M1.”

M1= currency + demand deposits

(checking accounts) + traveler's checks.

M1 is currently around 1.1 Trillion $ and

often falling.

About 60% of M1 is demand deposits and

a about 40% is currency.

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M2:

Broad money.

M2 includes M1 + liquid assets.

M2 = M1 + smaller savings accounts + small time deposit accounts + money market accounts + other near monies.

M2 is about 4.5 T $.

The relationship between M2 and the economy broke down in the early 1990’s as people pulled money out of savings accounts and put it into financial investments outside of banks that are not included in the money supply.

M2 is no longer a target variable of the Fed.

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CURRENCY IN THE ECONOMY

$372 billion of currency amounts to over $1,430 for every man, woman and child in the U.S.

Most of the currency in the official statistics is not used in ordinary commerce in the U.S.

Much is held abroad by wealthy people

Some circulates in other countries along with local currencies

Currency is also used in illegal transactions

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BANKS AS FINANCIAL

INTERMEDIARIES

Help bring savers and investors together

By using expertise and powers of diversification, financial

intermediaries reduce risk to savers and allow investors

to obtain funds on better terms

A typical commercial bank accepts funds from savers in the

form of deposits

The bank then turns the money around and makes loans to

businesses

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BALANCE SHEET Has two sides -- assets and liabilities

Liabilities are the source of funds for the bank

-- Your deposits to a checking account are an example of

liabilities

Assets are the uses of the funds

-- Loans are an example of a bank’s assets

The difference between assets and liabilities is call its net worth

Net Worth = Assets - Liabilities

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RESERVES

Assets which are not lent out

Banks are required by law to hold a fraction of their deposits as reserves and not make loans with this fraction of deposits is called required reserves

Banks may choose to hold additional reserves beyond what is required; these are called excess reserves

A bank’s reserves are the sum of its required and excess reserves

Reserves can either be cash kept in a bank’s vaults or deposits with the Federal Reserve

Banks do not earn any interest on these reserves

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Monetary Policy:

Monetary policy influences the economy through

changes in the money supply, available credit, and

interest rates.

Monetary policy can be expansionary or

contractionary.

Keynesians see monetary policy working through

the effect of interest rates on investment.

The Fed has three major tools of monetary policy.

What macro goal does the Fed focus on?

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Keep in Mind:

Banks have a tremendous profit incentive to keep

their reserves as close to their required reserve

level as possible.

In most cases banks make loans first and worry

about required reserves later.

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1. Open Market Operations:

Expansionary Monetary Policy: Fed will buy securities, injecting reserves into the banking system. Banks can now create more money and the Federal Funds rate falls.

The Federal Funds rate is the rate of interest charged by banks on interbank loans of reserves.

If the Fed is pumping more reserves into the banking system, the federal funds rate will decline.

Typically the Fed buys securities from bond dealers or banks.

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The Fed Funds Rate:

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Selling Bonds:

How about contractionary policy?

Money multiplier works in reverse.

If the Fed is reducing bank reserves by selling

bonds, the federal funds rate will increase.

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Open-Market Purchases

Federal Open Market Committee

Regional Federal Reserve bank

Private bank

Step 2: Bond seller deposits Fed check

Step 3: Bank deposits check at Fed bank, as a reserve credit

Public

Step 1: FOMC purchases government bonds; pays for bonds with Federal

Reserve check

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–Interest Rates and Bond Prices:

An objective of OMO is to alter the price of

bonds and their yields.

The Fed induces people to sell bonds by

offering high prices for their bonds.

Suppose you own a $1000 Treasury bond that

matures in 30 years and pays $80 per year.

What would the yield of the bond be if the Fed

offers you $1100?

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Bond Yields:

Yield = annual interest payment / price paid for bond.

In example: Yield = 80/1100 = 7.3%.

Interest rates and bond prices move in opposite directions.

If you buy a bond at par ($1000) with an $80 interest payment, the yield is 8%.

If you buy bond at a discount price of $800, the yield is 10%.

If you buy bond at a premium price of $1200, the yield is 6.67%.

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Advantages of OMO:

1. OMO are flexible.

Fed can buy or sell small, medium, or large

amounts of securities and adjust size.

2. OMO can be reversed if Fed overshoots.

OMO can be implemented on a quick,

continuous basis as new information is

received.

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2. Changing Reserve

Requirements:

Affects the money multiplier and the amount of

reserves.

What should the Fed do to implement

expansionary and contractionary policy?

Powerful, seldom used.

Fed can vary rate on DD between 8% and 14%.

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Impact of a Change in the

Reserve Requirement Required Reserve Ratio

20 percent 25 percent

Total deposits $100 billion $100 billion

Total reserves 30 billion 30 billion

Required reserves 20 billion 25 billion

Excess reserves 10 billion 5 billion

Money multiplier 5 4

Unused lending capacity $ 50 billion $ 20 billion

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The Discount Rate:

The Discount Rate is the rate of interest the Fed

charges on loans it makes to banks.

Banks have two main sources of extra reserves for new

lending or to meet their reserve requirements in the

case of withdrawals.

The "Federal Funds" market is a market where other

banks lend reserves usually for short periods.

Many banks still go to the Fed Funds market even when

the Fed Funds rate is greater than the discount rate.

Why?

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Discount Rate:

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3. The Discount Rate, continued: Borrowing from the Fed is for need, not profit. Discount

window loans are a privilege, not a right.

The Fed's attitude toward banks' using the discount

window is often one of discouragement.

Borrowing from Fed is only done as a last resort .

Banks get only a small fraction of their reserves, called

"borrowed reserves" from the Fed.

The importance of the discount rate is as a confirming

signal of Fed policy.

When the discount rate is raised, it is a signal that the

Fed is tightening, and vice versa.

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To stimulate the economy, the

Fed can:

Lower reserve requirements.

Reduce the discount rate.

Buy bonds.

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To slow the economy, the Fed

can:

Raise reserve requirements.

Increase the discount rate.

Sell bonds.

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Problems of Monetary Policy:

1. The Fed lacks complete control over bank

lending.

2. Lags.

3. Political pressures on the Fed.

4. Conflicting international goals.

An expansionary monetary policy weakens

the $ and stimulates exports, but may lead

to a capital outflow.

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LIMITS TO EXTENT FEDERAL RESERVE CAN EFFECTIVELY

CONTROL THE ECONOMY

In the long run, increases in the money supply affect only

prices, not level of output

In the short run, when prices are fixed, our lack of

knowledge about the strength and timing of both

monetary and fiscal policy actions makes it difficult to

execute effective policies