Lesson 14: Money, Banks and the Federal Reserve System + Lesson 15: Monetary Policy
Suppose you withdraw $1,000 from a money market mutual fund and deposit the funds in your bank checking account. How will this action affect M1 and M2?
M2 will not be affected, but M1 will increase.
The use of money
a) Reduces the transaction costs of exchange. b) Eliminates the double coincidence of wants. c) Allows for greater specialization.
When interest rates on Treasury bills and other financial assets are low, the opportunity cost of holding money is _________, so the quantity of money demanded will be _________.
low; high.
Which of the things above are NOT included in the M1 definition of the money supply?
a) The funds in your savings account. b) Your Citibank Platinum MasterCard.
What is the disadvantage of holding money?
Money, in the form of currency or checking account deposits, earns either no interest or a very low rate of interest.
Suppose you deposit $1,400 cash into your checking account. By how much will checking deposits in the banking system increase as a result when the required reserve ratio is 0.20?
$1,400/0.20 = $7,000
If the required reserve ratio is 0.05, the maximum increase in checking account deposits that will result from an increase in bank reserves of $10,000 is
$10,000/0.05 = $2,00,000
Which of the following is not one of the monetary policy goals of the Federal Reserve ("the Fed")?
A high foreign exchange rate of the U.S. dollar relative to other currencies.
Suppose the reserve requirement is 15%. What is the effect on total checkable deposits in the economy if bank reserves increase by $40 billion?
= $40b/0.15 = %267b
Real World Deposit Multiplier
= 1.6
"Price stability" means
A low and stable inflation rate.
What is a banking panic?
A situation in which many banks experience runs at the same time.
Banks accept ___________ and make ____________.
Accept deposits; Make loans. This in turn, increases checking account deposits (Increases M1).
Which of the following is NOT a function of money?
Acceptibility
Excess Reserves (ER)
Any reserves held by banks that are not RR.
The economic definition of money is
Assets that people are willing to accept in exchange of goods and services or for payment of debts.
Distinguish among money, income, and wealth.
A person's money is the currency held and the checking account balance, income is the earning and wealth is equal to value of assets minus all debts.
Required Reserves (RR)
Banks must hold 10% of checking account deposits.
Why does the Fed use an intermediate target?
Because of lags and economic forecast uncertainty.
The most important role of the Federal Reserve in today's U.S. economy is
Controlling the money supply to pursue economic objectives.
Why were banks holding on to ERs?
Credit crunch: Banks hesitated to lend. The Fed started paying interest (0.25%) on ER.
Reserves
Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve (not loaned out or invested).
Congress passed legislation to create the Federal Reserve System in 1913 in order to
End the instability created by bank panics by acting as a lender of last resort.
Open Market Sale (OMS)/What is Monetary Policy in the case of inflationary situation?
Inflationary Boom: To increase the interest rates. The Fed decreases the money supply by selling the Treasury securities to the public (in the Bond Market). OMS shifts the Money Supply (Ms) to the left (increasing interest rate). If the FOMC orders the trading desk to sell Treasury securities, the money supply curve will shift to the left, and the equilibrium interest rate will rise. Fed <- Money - Public Public <- Bonds - Fed
Which of the following is a monetary policy target used by the Fed?
Interest rates.
Deposits are a
Liability to a bank.
Is the U.S. economy back to full employment output? Why or why not?
No.
Are Bitcoins money?
No. Bitcoins is not considered to be part of either M1 or M2.
Expansionary monetary policy
The Fed's strategy of increasing the money supply and lowering interest rates in order to increase real GDP.
If the Fed believes the inflation rate is about to increase, it should
Use a contractionary monetary policy to increase the interest rate and shift AD to the left.
Money Market
y-axis: Nominal interest rate (i) x -a xis: Quantity of money supplied (M1)
Functions of money
1) Must act as a medium of exchange: eg: when a grocery store accepts your $5 bill in exchange for bread. 2) Must serve as a unit of account: eg: this Dell laptop costs $1,200. 3) Must serve as a store of value: If you don't use it now, you can use it later in the future. 4) Must offer a standard of deferred payment: eg: A computer manufacturer may buy hard drives from another firm in exchange for the promise of making payments in 60 days.
The opportunity cost of holding money is ______________.
Interest rate. If money is not in the bank, it is not earning interest. The opportunity cost of holding money depends on short-term interest rates, not long-term interest rates.
The Fed uses policy targets of interest rate and/or money supply because
It can affect the interest rate and the money supply directly and these in turn can affect unemployment, GDP growth, and the price level.
Liquid
Liquidity refers to the ease with which people can convert an asset into the medium of exchange. Because money is the medium of exchange, it is the most liquid asset.
Typically, a bank's largest asset is it's
Loans
If the U.S. economy is heading toward recession, the Federal Reserve will
Lower interest rates.
The Federal Reserve uses two definitions of the money supply, M1 and M2, because
M1 is a narrow definition focusing more on liquidity, whereas M2 is a broader definition of the money supply.
Does the Fed control interest rates?
Yes.
Suppose you decide to withdraw $100 in currency from your checking account. What is the effect on M1? Ignore any actions the bank may take as a result of your having withdrawn the $100.
M1 remains unchanged (Remember: currency in circulation!).
Are credit cards money?
No. Credit cards are not considered to be part of either M1 or M2. Credit cards are not included in the definition of the money supply.
Which of the following best explains how the Federal Reserve/a Central bank acts to help prevent banking panics?
The Fed acts as a lender of last resort, making loans to banks so that they can pay off depositors.
Required Reserves Ratio (rr)
The minimum fraction of deposits banks are required by law to keep as reserves = 10% or 0.1
The central bank of a country controls the money supply, which equals the currency held by
The public plus their checking account balances.
Suppose you decide to withdraw $100 in cash from your checking account. Which one of the following choices accurately shows the effect of this transaction on your bank's balance sheet.
Your bank's balance sheet shows a decrease in reserves by $100 and a decrease in deposits by $100.
What are the main goals of monetary policy?
1) Price stability (low inflation) 2) High employment ( U = Ü) at potential output. 3) Stability of financial markets and institutions (to promote the official flow of funds from savers to borrowers). 4) Economic growth
M2
A broader definition of the money supply. It includes M1 plus saving account deposits, small denomination time deposits (such as Certificates of Deposits (CDs)), balances in the money market deposit accounts in banks, and non-institutional money market fund shares. = M1, savings accounts, small time deposits, and money markets.
Why does the Fed use an interest rate target as the intermediate target?
Because it is reliably and predictably related to output and inflation. When the Fed changes the target rate, usually, other interest rates move in the same direction.
Why is the supply of money vertical?
Because the Federal Reserve completely controls the money supply. Thus, the changes in the interest rates (y-axis) have no effect on the quantity of money supplied (x-axis).
Which of the following is not a policy tool the Federal Reserve uses to manage the money supply?
Changing Income tax rates.
Evaluate the following statement: Banks use deposits to make consumer loans to households and commercial loans to businesses. Banks will loan out every penny of their deposits in order to make a profit.
False. Banks must hold a fraction of their deposits as vault cash or with the Federal Reserve.
With an expansionary monetary policy, investment, consumption, and net exports all ________, which results in the aggregate demand curve shifting to the ________, increasing real GDP and the price level.
Increase; right.
If Fed lowers the RR, then this
Increases the ER, encourages banks to make more loans, and increases the money supply.
Money demand has a negative slope because as interest rates rise, the opportunity cost of holding money
Increases. Thus, the quantity of money supplied (M1) falls.
What is the advantage of holding money?
Money can be used to buy goods, services, or financial assets.
Which of the following is included in M2 but not M1?
Money market deposit accounts in banks.
How did the Fed respond to the Great Recession: Interest rates (short-term) practically went down to zero, yet this did little to stimulate the economy and restore full employment. Why?
OMP Banks were holding onto ER (rather than lending them out). Total bank reserves went from $50 billion (8/08) to $900 billion (5/09)
A baseball fan with a Mike Trout baseball card wants to trade it for a Giancarlo Stanton baseball card, but everyone the fan knows who has a Stanton card doesn't want a Trout card. Economists characterize this problem as a failure of the
Principle of a double coincidence of wants.
Open Market Purchase (OMP)/What is Monetary Policy in the case of a recession?
Recession: To lower interest rates. The Fed increases the money supply by buying the Treasury securities from the public (in the Bond Market). OMP shifts the Money Supply (Ms) to the right (lowering interest rate). If the Federal Open Market Committee (FOMC) decides to increase the money supply, it orders the trading desk at the Federal Reserve Bank of New York to buy U.S. Treasury securities. Fed -Money-> Public Public -Bonds->Fed
What is the estimated time lag between a monetary policy action and its impact on the economy?
Recognition lag, policy lag and Impact lag
Barter economics
Refers to the economies where the goods and services are traded directly for other goods and services. For a barter trade to take place between two people, each person must want what the other has. (double coincidence of wants).
Suppose American Bank has $500 in deposits and $200 in reserves and that the required reserve ratio is 10 percent. In this situation, American Bank has
Reserves = Deposits * rr = $500 * 0.10 = $50 in RR ER = $200 - $50 = $150
If banks don't loan out all their excess reserves, then, the real world multiplier is
Smaller than 1/rr
Why would the Fed intentionally use contractionary monetary policy to reduce real GDP?
The Fed intends to reduce inflation, which occurs if RGDP is greater than potential GDP.
Open Market Operations (OMO) How do Open Market Operations (OMO) affect interest rates?
The Federal Open Market Committee (FOMC) engineers OMO to control the size of the money supply, by buying and selling the Treasury securities. The results: Case 1: OMP Case 2: OMS
When the Federal Reserve sells Treasury securities in the open market,
The buyers of these securities pay for them with checks and bank reserves fall.
Federal fund rates
The interest rate that banks charge each other for overnight loans. It is very important for the Fed's monetary policy because the Fed uses the federal funds rate as a monetary policy target since it can control the rate through open market operations.
M1
The narrow definition of the money supply. The sum of currency in circulation (all the paper money and coins held by households and firms), checking account, deposits in bank, and holding of traveler's checks (smallest component).
Money Multiplier/Simple deposit multiplier
The ratio of the amount of deposits created by banks to the amount of new reserves. = 1/rr = = (delta checking account deposit)/(delta reserves) or rr = (delta reserves)/(delta checking account)
When the Federal Reserve purchases Treasury securities in the open market
The sellers of such securities deposit the funds in their banks and bank reserves increase.
Why should the Fed be clear about its monetary policy objectives?
To avoid recessions, lags and economic uncertainties.
What did the Fed do to stimulate the housing market and increase AD ? Ans: Quantitative Easing (QE)
To simulate the demand for housing and increase AD (C and I), the Fed's new policy was QE, which meant that Fed had to purchase securities to lower long-term interest rates (e.g.: 10-year rate).
An article in the Wall Street Journal quoted a Federal Reserve economist as referring to "the Fed's existing dual mandate to achieve maximum sustainable employment in the context of price stability." Source: Pedro Nicolaci Da Costa, "Fed Should Make Bond Buys a Regular Policy Tool, A Boston Fed Paper Finds," Wall Street Journal, April 23, 2015. "Maximum sustainable employment" means the economy is producing at its potential where
Unemployment includes frictional and structural unemployment.
If the Fed believes the economy is about to fall into recession or the potential GDP is forecasted to be higher than the equilibrium GDP, it should
Use an expansionary monetary policy to lower the interest rate and shift AD to the right.
How do banks create money?
When there is an increase in checking account deposits, banks gain reserves and make new loans, and the money supply expands.
