Unit 3 Macro

Value of money

- Acceptability: acceptable as a medium of exchange, currency and checkable deposits are money because they are accepted because confident exchangeable for real goods services and resources when we spend it - Legal Tender: strengthen confidence of acceptability because it is this. Each bill contains statement it is a legal tender meaning paper money is valid and legal means o payment of any debt that was contracted in dollars (private firms and gov not mandated to accept cash not illegal to specify payment). Checks are not legal tender but still accepted - Relative Scarcity: depends on supply and demand. Derives its value from sanity relative to utility. The utility of lies in its capacity to be exchanged for goods and services now or in the future. The economy's demand for money thus depends on total dollar volume of transactions in any given period plus the amount of money individuals and businesses want to hold for future transactions. With a reasonably constant demand for money, the supply of money proved by monetary authorities will determine the domestic value or purchasing power of monetary unit

Wall Street Reform and Consumer Protection Act

- Eliminate the Office of Thrift Supervision giving a broader authority to the Fed to regulate all large financial institutions. - Create a Financial Stability Oversight Council to lookout for risks to the financial system. - Establish a process for the government to sell off assets of failing non-bank financial institutions - Provide federal regulatory oversight of mortgage-backed securities and other derivatives and require that they be traded on public exchanges. - Require companies selling-asset backed securites to retain a portion of those securities so the sellers share a part of the risk. - Establish a stronger consumer protection role for the Fed through creation of the Bureau of Consumer Financial Protection. These will help practices in 2007-2008 to happen again. Promote home ownership. Critics of he new la sa impose heavy new regulatory costs on financial industry while doing little to prevent future government payout. Consolidated financial regulation, providing federal oversight of mortgage backed securities, and creating Bureau of Cosumer Financial Protection

Interest rates and bond prices

-Inversely related -Bond pays fixed annual interest payment -Lower bond price will raise the interest rate Bond prices fall when interest rate rise and rise when interest rate falls

multiple deposit expansion assumptions

-The reserve ratio for all commercial banks is 20% -Initially all banks are meeting the 20% required reserve exactly. No excess reserves exist;or in parlance of banking they are loaned up fully in terms of reserve requirement -if any bank can increase its loans as a result of acquiring excess reserves, an amount equal to those excess reserves will be lent to one borrower, who will write a check for the entire amount of the loan and give it to someone else who deposits it another bank. This means that the worst possible thing happens to every lending bank-a check for entire amount of the loan is drawn and cleared against it in favor of another bank

Money Definition M1

-currency (coins and paper money) in hands of public -checkable deposits (all deposits in commercial banks and "thrifts" or saving institutions on which checks of any size can be drawn) Government agencies supply coins and paper money while commercial banks and saving institutions ("thrifts") provide checkable deposits 45% currency 55% checkable deposits M1= currency+checkable deposits Checkable deposits of banks and thrifts known as demand deposits NOW, aTS and share draft accounts. Depositors can write checks whenever they want is what they share

Causes of mortgage default crisis

-gov programs for sub sized housing -decline in real estate values -bad incentives because banks made lax in their lending practices so people were given loans they were most likely never going to pay because they thought they did not bear risk . So people took on "too much mortgage" and soon failed to make monthly payments.

What does the Fed do?

-servers as a banker's bank and as the gov's bank -serves as a regular of financial institutions -serves as the nation's money manager performing a vast array of function that affect the economy, the financial system and ultimately each of us

Why banks would not deposit all its cash in Fed

1. Bank as a rule hold vault cash only in the amount of 1.5-2% of their total assets 2. Vault cash can be counted as reserves

Commercial banks and thrifts

6,000 commercial banks and 3/4 roughly are state These are private banks chartered (authorized) by individual states to operate within those states. 1/4 are private banks carted by fed gov to operate nationally;national banks. There are 8,500 thrifts institutions most of which are credit unions— are regulated by agencies in addition to the Board of Governors and Fed bank. Are subjected to monetary policy of Fed and must have a certain percentage of deposits as reserves

maximum checkable deposit creation

= excess reserves x monetary multiplier; D = E x m

Troubled Asset Relief Program (TARP)

A 2008 Federal government program that authorized the U.S. Treasury to loan up to $700 billion to critical financial institutions and other U.S. firms that were in extreme financial trouble and therefore at high risk of failure Saved several financial institutions whose bankruptcy would have caused a lot of secondary effects that would have brought down or foremen credit in economy Problem of moral hazard which is the tendency of financial investors and financial services firms to take on greater risks because they assume they are at least partially insured against those losses. Without TARP there would have been a lot of personal loses TARP and other bailouts of financial institutions receivers never had to pay a single cent in insurance premiums for massive bailouts to keep them afloat Assumption made by large firms that too big of risk to let them fail may have caused them to makers riskier investments

Transaction 3: Accepting Deposits

A person deposits into the bank. The bank recieves cash which is an asset to the bank. If it is a checkale deposit then it constitute claims that the depositor have against the asset of bank so it is a new liability. No CHANGE in economy's total supply of money but change in the composition of money supply. A cash withdrawal will reduce checkable deposit liabilities and its holding of cash by the amount of the withdrawal. This too changes compassion NOT total supply of money in economy. Assets: Cash 110,000, Property 240,000 Liabilities and Net worth: Checkable Deposits 100,000, Stock Shares 250,000

thrift institutions

A savings and loan association, mutual savings bank, or credit union. Accept the deposits of households and businesses then use the funds to finance mortgages and to produce other loans Credit unions accept deposits from and lend to members who are usually are a group of people who work for the same company

Selling Securities to the Public

A. The Fed bank sells gov bonds to public which pays with check drawn form commercial bank B. The Fed bank clears this check against the bank by reducing commercial bank's reserves C. The bank returns the canceled check to public reducing public's checkable deposits accordingly

Banks and lending

An individual bank can safely lend only an amount equal to is excess reserves, but the commercial banking system can lend a multiple of its collective excess reserves

Transaction 2: Acquiring Property and Equipment

Bank buys property Assets: Cash 10,000, Property 240,000 Liabilities and Net worth: Stock Shares 250,000

Main categories of U.S. financial services industry

Commercial banks, thrifts, insurance companies, mutual funds companies, pension funds, securities firms, and investment banks 2007-2008 has further consolidated already consolidating financial services industry and has further blurred some of the lines between subsets of the industry

What are the Fed's policy goals?

Full employment It is not easy to know what constitutes full employment Stable prices Healthy rate of inflation of 2-5% sometimes 2% is to low to promote economic growth

goldsmith (beginning of fraction reserve system of banking)

Gold was heavy and judge for purity so people decided to hold it in vault for a fee. The depositor would recieve a receipt after they deposited. Soon people were paying for goods with goldsmiths' receipts. Goldsmith found that now they could loan out the money to people and earn money since the receipts were accepted as a medium of exchange.

Reverse of money multiplier

Loan repayment in effect sets off a process of multiple description of money the opposite of money multiplier. Because learns are both made and paid off in any period the direction of loans, checkable deposits and money supply in a given period will depend on net effect of two processes. If dollar amount of loans excesses paid off checkable deposits will expand and money supply increase vice versa for dollar amount of loans less than dollar amount of paid off of loans

equilibrium interest rate

Market determined price that borrowers must pay for using someone else's money over some period of time Change in demand for money, supply of money can change both Increase in supply lowers it and decrease raises it Occurs when people are willing to hold the exact amount of money being supplied by monetary authorities Determined by money supply and demand

The Federal Reserve and the Banking System

Monetary authorities are embers of Board of governors of Federal Reserve System. The board directs activities of 12 Federal Reserve Banks, which in turn control the lending activity of nation's banks and thrift institutions. The fed's major goal is to control MONEY SUPPLy, but since checkable deposits in banks are such a a large part of money supply an important part of its duties involves assuring the stability of banking system.

Transaction 6: Granting a Loan part 2

Money from loan is paid to a different business and deposited in another bank. Assets: reserves: $10,000, loans $50,000, property 240,000 Liabilities and net worth: checkable deposits $50,000, stock share $250,000 Bank has no excess reserves but still reaches reserve requirement. Can't lend more than $50,000 A single commercial bank in a multi-bank banking system can lend only an amount equal to its initial preload excess reserves. Has liability loan can be checked and cleared against When loans are paid off money is destroyed. The Banks's checkable deposits decline by amount of loan repayment

Reserve ratio

Raising the reserve ratio: commercial banks have less excess reserves so they can loan less, causing a decrease in the money supply, causing interest rates to rise Lowering the reserve ratio: commercial banks have more excess reserves so they can loan more , causing a increase in the money supply, causing interest rates to fall It changes amount of excess reserves It changes size of the monetary multiplier

selling securities

Same result commercial banks reserves are reduced. When buy bonds interest rate lower and demand for them increases, increasing price Wiling to sell because the supply of bonds in bond market lowers bond prices and raises interest making bonds more attractive

Advantages of monetary policy over fiscal policy

Speed and flexibility Isolation from political pressures

How does the Fed achieve their goals?

The Fed functions primarily through the banking system and money market Influence the supply the credit and and the price people pay for credit Higher interest rates, less loans Price neutral value offering is actual value offerings 2008/2009 decreased interest rates to increase loans and purchases and make it seem like more money in economy

Securitization

The process of slicing up and bundling groups of loans, mortgages, corp bonds or other financial debts into new district securities. It was not new and was viewed well by gov regulators who thought it made banking system safer by allowing banks to shed risk Holders could buy insurance to risk American International Group issued billions of dollars of collateralized default swaps essentially insurance prices that were designed to compensate the holders of loan backed securities if default. This was another category highly exposed to mortgage risk. Referred to as shadow banking system because so widespread and critical to modern financial system Buyers of loans needed to ask the what ifs before investing. What if main insurer of these security was largest insurance company in U.S.? What happened if one of loans plunged? What if biggest holder of these loans were U.S. biggest financial institution running day to day operations of credit so economy runs smoothly

Board of Governors of the Federal Reserve System

The seven-member board that supervises the banking system of the United States Central authority of the U.S. money and banking system The U.S. President with confirmation of congress appoints boards members. Terms are 14 years and staggered so that one member is replaced every 2 years. New members are appointed when resignation occurs. The president selects the chairperson and vice chairperson of the Board among members. Those officers serve 4 year terms and can be reappointed to new 4 year terms by president. The long term appointments pride board with continuity, experienced membership, and independence form political pressure that could result from inflation

Weaknesses of monetary policy

Time lags: recognition and operational lags but Fed can decide and implemented policy changes within days avoids the long adm lag that hinder finically policy Recognition: normally monthly variations in economic activity and price level mean that Fed may not be able to quickly recognize when economy is starting a recession or inflation. Operation lag of 3-6 months affects monetary policy because that much time is typically required for interest rate changes to full impact on investment, real gdp, and ad. Cyclical asymmetry: monetary policy effective at pulling AD left but because ineffective at pulling it right. This has to do with asymmetry way in which people may act in response to changes in bank reserves Liquidity trap: cannot be certain of achieving its goal when it adds reserves to the banking system. Adding more laity to banks has little or no additional positive effect on lending, borrowing, investment or ad. Most recent recession example of this.

money supply curve

Vertical line because the monetary authorities and financial institutions have provided the economy with some certain stock of money

Money and prices

When money rapidly loses its purchasing power, it loses its role as money The purchasing power of the dollar: the amount of a dollar will buy varies inversely with price level. Higher prices lowered the value of dollar because more dollars needed to buy a good. $V=1/P value of dollar =1/price level expressed by index in hundreds Inflation and acceptability: hyperinflation is when a nation's currency becomes worthless and unacceptable. Purchasing power of one bill becomes undetermined. This may cause currency to cease to be medium of exchange because they do not want to bear loss in its value that will occur while it is in their possession. Economy goes back to bartering or at extreme adopt a more stable country's currency People will use money as store of value only as long as there is no sizable determination in value of money because of inflation. Only employ money as unit of account when purchasing power is relatively stable. When value rapidly declines sellers do not know what to charge and buyers do not know what to pay.

Checkable deposits

a large component of the M1 money supply Has security and is more convenient Checking accounts are regarded as part of money supply because checks are nothing more than a ay to transfer ownerships of deposits Can convert checks into paper money and coins

Excess reserves

actual reserves - required reserves Finding required reserve: Can find it by multiplying bank's checkable deposit liabilities by reserve ratio to find required reserves

Store of value

an item that people can use to transfer purchasing power from the present to the future Enables people to transfer purchasing power from present to the future People do not normally spend all their income on the day they receive it. To buy things later store some of their money as wealth. When inflation is nonexistent or mild holding money is relatively risk free way to store your wealth for later use

medium of exchange

anything that is used to determine value during the exchange of goods and services Useable for buying and selling goods and services Provides a convent way of exchanging goods, money enables society to gain the adv of geography and human specialization Eliminates need for bartering

reserve ratio

commercial bank's required reserves/commercial bank's checkable-deposit liabilities Varies ratio within limits of congress

Commercial banks

depository institutions that historically make short-term loans primarily to businesses Accept deposits of households nd businesses, keep money safe until demanded via checks and in meantime use it make loans

Total money demanded

horizontally adding the asset demand to the transaction demand. Downsloping and represents the total amount of money public wants to hold both for transactions and as an asset. At each possible interest rate. Increase in nominal GDP will shift total money right because public want to hold a larger amount of money vice versa for decrease

What is money?

medium of exchange, unit of account, store of value

fractional reserve banking system

only a portion (fraction) of bank checkable deposits is backed by reserves of currency in bank vaults or deposits in central banks U.s. collective reserves of bank usually are considerably less than 100% of their checkable deposit liabilities

Interest on Reserves

This is new as of 2008- the Fed pays interest on reserves that bank holds at fed The Fed does this because it is a way to print money without people reacting to it /panicking If Fed wants to reduce lending then it can raise interest rates on reserves This also gives the Fed more control over the bank's reserves Often do this instead of reserve ratio (ratio rarely changes) Only used in specific circum

Purpose of reserves: control

Idea that reserves provide security and liquidity breaks down when there is massive cash withdrawals because cash in fed or vault is not enough. This would led to bank panic because reserves are fractional, checkable deposits may be much greater than bank's required reserves. Banks protected by: -periodic examinations of piracies -insurance funds by FDIC and National credit union (NCUA) Reserves help control the lending albeit you of commercial banks. Fed can take action to increase or decrease reserves affect the ability of banks to provide loans. This helps avoid fluctuations and leads to clearing of checks

money multiplier

Relationship between any new excess reserves in banking system and the magnfed creation of new checkable deposits by bank as a group Exists because the reserves and deposit lost by one bank become reserves of another bank Money multiplier = 1/required reserve ratio M=1/R Higher reserve ratios mean lower monetary multiplier and there less creation of new checkable deposits money via loans, smaller reserve rations means higher monetary multiplier thus more creation of new checkable deposits money via loans Determines weight of each dollar added to the economy

Commercial banks two basic functions

Accept deposits of money Make loans

Goals of Monetary Policy

Achieve and maintain price-level stability, full employment, and economic growth

required reserves

An amount of funds equal to a specified percentage of the bank's own posit liabilities. A bank must keep required reserves with FED bank in its district or bank's vault

Currency + paper money

Metal coins and paper for U.S. U.S. Treasury issues coins Fed reserve System (U.S. Central Bank) issues federal reserve notes (paper money) U.S. Mint makes coins Bureau of engraving and printing prints money U.S. is a token currency meaning that face value of any piece of currency is unrelated to its intrinsic value (value of the physical paper) out of which currency is constructed. Money is worth more than what it is made out of

Tool of Monetary Policy

How Fed influence money making abilities of commercial banking system Open market operations, reserve ratio, discount rate, interest on reserves

Assets =

Liabilities +net worth Liabilities: claims by banks against firm's assets Net worth: claims by owners of firm against firm's assets

key advantage of money

Liquidity

Transaction 7: Buying Government Securities

Buys bonds from public same effect as lending Interest bearing bond appears as securities and gives the dealer an increase in its checkable deposit account Asset: reserve 60,000, securities $50,000, property 240,000 Liabilities and net worth: checkable deposits $100,000, stock shares $250,000 Increase supply of money (increase in checkable deposits to dealer) Dealer draws and clears check against bank the bank loses both reserves and deposits by amount of check same as 6b above but securities instead of loans. Assets: reserves: $10,000, securities $50,000, property 240,000 Liabilities and net worth: checkable deposits $50,000, stock share $250,000 Selling gov bonds to public reduces money supply. The securities buyer pays by check both secures and checkable deposits decline by amount of sale

2. Qualification

Currency held by the U.S. Treasury, Fed Reserve banks, commercial banks and thrifts is excluded from m1 and other means of money supply. Avoids problem of double counting. Checkable deposits of the gov (U.S. Treasury mostly) or the Federal Reserve that are held by commercial banks or thrifts institutions are excluded. Designed to enable better assessment of amount of money available to the private sector for potential spending.

History of Fed

Decentralized and unregulated banking created inconvenience and confusion of unmourned private bank notes being used as currency and led to some monetary mismanagement-such as money supply was inappropriate for need of economy and too much money was in supply so rapid inflation stunted economic growth. Problems occurred when banks closed or insisted on immediate repayment of loans to prevent their own failure. At these times individuals and businesses lost confidence in backs and all withdrew. In 1907 congress appoint National monetary commission to study monetary and banking problems of economy. This result was the Federal Reserve act of 1913.

Transaction 4: Depositing Reserves in a Federal Reserve Bank

-All commercial banks and thrift institutions that provide checkable deposits must by law keep required reserves. Banks required to have "required reserves" by law Can deposit reserve requirement in fed bank If bank anticipates holding of checkable deposits to grow in the future can send more than required reserve getting rid of inconvenience of sending more money. More checkable deposits more liabilities. The extra reserves allow banks to loan - Assets: Cash 0, Reserves 110,000, Property 240,000 - Liabilities and net worth: Checkable Deposits 100,000, Stock Shares 250,000

Fed functions, responsibilities, and independence

-Issuing currency: issues Federal Reserve Notes, the paper currency used in U.S> monetary system. Banks that issued a particular bill is identified in black in upper left front of newly designed bills -setting reserve requirements and holding reserves: Fed abets despots form banks and thrifts any portion of their mandated reserves not held in vault cash -lending to financial institutions and serving as emergency lender of last resort: makes loans to commercial banks and thrifts and charges them interest called the discount rate. Sometimes auctions off loans -providing for check collection: provides banking system which collects checks. Adjusts reserves of two banks -acting as fiscal agent: provider of financial services for federal gov. The gov colleges huge sums of through taxes and spends equally large amounts and sells and redeems bonds. Gov uses Fed's facilities to do this. -supervising banks: supervises operation of banks and makes periodic examination to assess bank profitability, to ascertain banks perform in accordance to regulation, and uncover practices or fraud. After 2007-2008 congress expanded Fed supervisory power over banks -controlling money supply: has the responsibility for regulating the supply of money, and this enables it to influence interest rates. The major task of Fed is to manage money supply according to needs of economy which involves making amount of money a viable constituency with ugh and rising evils of output and employment and relatively stable price levels. Congress purposely made the fed an independent agency to protect fed from political pressure so it could effectively control money supply and maintain price stability. This allows Fed to raise interest rates (unpopular with public) when inflation occurs.

Discount rate

-extension of credit to banks made by Fed (Fed changes discount rate) -influence federal funds rate (interbank lending) banks more trustworthy than customers -influence the prime rate which is the interest rate charged by banks to their most trustworthy customers (high credit ratings) Lenders of last resort so banks borrow from fed and are charged an interest rate called the discount rate Fed: Assets: loans Liabilities and net worth: reserves of bank Bank: Asset: reserves Liabilities and net worth: loans from Fed Borrowing increase commercial banks ability to loan. When they lend money supply increases. Higher discount rates discourage borrowing so Fed increase it to restrict money supply Only used in specific circumstances

12 Fed Reserve Banks

1. Boston 2. New York 3. Philadelphia 4. Cleveland 5. Richmond 6. Atlanta 7. Chicago 8. St. Louis 9. Minneapolis 10. Kansas City 11. Dallas 12. San Francisco Blend private and public control, collectively serve as nation's central bank. These are banks for banks. Quasi public banks: blend private ownership and public control. Each Fed bak is owned by private commercial bank in its distract (federally charted banks required to purchase stock of fed bank in district). Board of Governors sets basic polices that Fed banks pursue. Practice as public institutions and unlike private banks they not motivated by profit. They follow polices are designed by the Board of Governor to promote the well-being of the economy as a whole. At odds of profit motive. Do not compete with commercial banks and in general do not deal with public rather they interact with gov, commercial banks and thrifts Bankers bank: accept deposits and make loans to the public. In emergencies Fed bank is lender of last resort to banking system and can lend out as much as needed to ensure that banks and thrifts can meet their cash obligation. They issue currency (Fed reserve notes), which banks do not do Central bank: most nations have one central bank but due to U.S. large geography and economic diversity there are 12

Transaction 1: Creating a Bank

A bank gets a share of stock (equity shares) to help finance the bank. The cash gotten by selling share of stock are an asset to the bank. Cash held by the bank is sometimes allied vault cash or till money. The outstanding shares are equal to the claims against banks assets Assets: Cash $250,000 Liabilities and net worth: stock shares $250,000

Asset and liability

A checkable deposit is an asset to depositor and liability to a bank Reserves are an asset to bank and a liability to the Fed.

Taylor rule

A modern monetary rule proposed by economist John Taylor that would stipulate exactly how much the Federal Reserve should change real interest rates in response to divergences of real GDP from potential GDP and divergences of actual rates of inflation from a target rate of inflation. Assumes that the Fed has 2% "target rate of inflation" that it is willing to tolerate and that FOMC will follow 3 rules when setting its target for federal funds rate - when real GDP equals potential GDP and inflation is at its target rate of 2%, the fed funds target rate should be 4%, implying a real federal funds rate of 2% (4% normal federal funds rate minus 2% inflation) - for each 1% increase of real GDP above potent GDP, the Fed should raise the real fed funds rate by 1/2 percentage point -for each 1% increase in the inflation rate above its 2% target rate, the Fed should raise the real fed funds rate by 1/2 percentage point (this will require a 1.5 percentage point increase in nominal rate to account for 1% underlying increase in inflation The last two rules are applied independent of each other so that if real GDP is above potential output at the same time inflation is above 2% the Fed will apply both rules and raise real interest rates in response to both facets The last to rules are reversed when GDP falls below potential or inflation falls below 2%. Each 1% decline in real GDP below potential GDP or fall in inflation below 2% calls for a decline of the real federal funds rate by 1/2 percentage point Fed uses discretion in setting the Fed's funds target rate, but its decision regarding monetary pollution and the target rate appear to be broadly consistent with the Taylor rule over many time periods

selling securities to commercial banks

A. The Fed banks give up securities that commercial bank acquire B. The commercial bank pay for those securities by drawing checks against their deposits— that is against their reserves in Fed bank. The fed collects on those checks by reducing commercial bank reserves. Fed: Asset: - securities (a) Liabilities and net worth: - reserves of commercial banks (b) Commercial bank: Asset: -reserves (b), + securities (a)

Buying securities from commercial banks

A. The commercial banks give up part of their holdings of securities to the Fed B. The Fed in paying for these securities places nelly created reserves in the account of the commercial banks at the Fed. The reserves of the commercial banks go up by the amount of the purchase of the securities Banks can now loan more Fed: Assets: + securities (a) Liabilities and net worth: + reserves from bank (b) Bank: Asset: -Securities (a) and + reserves (b)

Transaction 6: Granting a Loan part 1

Bank gives a loan to a business. In return a business gives a promissory note (IOU) to bank. The business increases their checkable deposits in that bank. This is liability to the bank. Assets: reserves: $60,000, loans $50,000, property $240,000 Liabilities and net worth: Checkable deposits: 100,000, stock shares 250,000 When bank lends money is created, so total money supply changes. The IOU isn't money (not medium of exchange) but the claim by business to bank is money. Checkable deposit money like this is 1/2 of M1 and 10% of M2. Checks drawn against a checkable deposit are acceptable as medium of exchange. Much of money is created by credit of commercial banks. This checkable deposits money may be though of as "debt" of commercial banks and thrift institutions.

Characteristics of fractional reserve banking

Banks can create money through lending (goldsmith did this by giving receipts as loans since it wasn't backed by currency). Today checkable deposits money by banks (via lending) is limited by the amount of currency reserves that banks feel obligated or are required by law to keep Fractional reserves are vulnerable to "panics" or "runs" . U.S. has a system of insurance deposits to prevent this. Bank runs are called bank runs because depositors would run to the bank trying to be one of the lucky few to withdraw their money while the bank hand any reserves left.

open market operations

Bond markets are "open" to all buyers and sellers of corporate and gov bonds (securities). The fed is the largest single holder of gov securities. The U.S. gov not the fed issues treasury bills, Oates, and bonds. Consists of buying or selling gov bonds to banks or general public The founding for Fed is NY Fed bank and a group of 21 or so large financial firms called "primary dealers" . These financial institutions in turn buy the bonds and sell the bonds to commercial banks or general public. MOST IMPORTANT day-to day instrument for influencing the money supply. Buying securities: reserves increased. When the banks lend out an amount equal to excess reserves the nation's money supply will rise Fed's monetary control mechanism of choice for routine increases or decreases in bank reserves over the business cycle

federal funds rate

Direct influence of monetary policy Rate of interest that bank charge one another on overnight loans made from temporary excess reserves Fed manipulates the supply of reserves that are offered in the federal funds rate. By buying and selling bonds Fed can change the reserves. These changes in total reserves in turn affect the amount of excess reserves that are available for supply to the federal funds market by whichever banks end up with them for a day. FOMC meets regularly to determine the desired federal funds rate. It then directs NY Fed to undertake any open market operations necessary to do this. The demand for federal funds is downsloping because lower interest rates give the banks with reserve defieicenes a greater incentive to borrow federal funds rather than reduce loans to meet reserve requirements. Supply for Fed funds is horz because the Fed uses open market operations to manipulate the supply of federal funds so that quantity supplied of fed is exactly equal to quantity demanded of federal funds at the target interest rate.

expansionary monetary policy

Easy money policy Economy faces a recession • Lower target for Federal funds rate • Fed buys securities • Expanded money supply • Downward pressure on other interest rates This policy will lower the interest rate to bolster borrowing and spending which will increase AD and expand real output. Fed immediate step will be to announce a lower target for fed funds rate. To achieve this the Fed will use open market operations to buy bonds from banks and the public. This will increase reserves in banking system. The Fed could expand reserves by lowering the reserve require or lowering the discount rate (less frequently used) The Fed could also lower interest rates on that it pays on reserves so banks have more to lend out Greater reserves produce: -supply of federal funds increasing, lowering the federal funds rate to the new target rate. The eq fed funds rate falls and quantity rises -a multiple expansion of nation's money supply occurs. Given the demand for money the larger money supply places a downward pressure on other interest rate One of these rate is the price interest rate- benchmark interest rate used by banks as a reference point for wide range of interest rates charged on loans to businesses and individuals. It is higher than fed fund rat because prime rate involves other more riskier loans. They closely track one another.

Forward commitment

Exactly how much it was going to buy during QE2 and how long the buying would last. This was a major change in monetary policy because up to that time Fed stuck to a policy of being vague about how long any particular policy initiative would last. Vague because wanted flexibility however this came at of cost of reduced credibility Banks would know that the resulting increases in reserves would not suddenly be reversed and were more likely to lend those reverses with less doubts.

effects of an expansionary monetary policy

Inflationary ratchet effect where the real world price levels tend to be downwardly inflexible, thus with our economy starting at initial eq the price level will be downward inflexible so the As will be horz to the left where there is a recessionary gap Increase money supply 1. Buy gov securites from bank and public 2. Lower reserve rate 3. Lower discount rate 4. Reduce the interest rate that it pays on reserves The outcome will be an increase in excess reserves and a decline in federal funds rate. Because the excess reserves on the basis that they can \\earn money by lending thus money supply increase. Interest rate falls, investment spending increases, AD increase, Real GDP rises

Credit cards are

Loans from financial institutions NOT money. Checking accounts used to pay for it is money.

Money as debt

Major components of money supply - paper money and checkable deposits are deb or promises to pay. Paper one his circulating debt of Fed. Checkable deposits are circulating debt of commercial banks and thrift institutions Paper currency and checkable deposits have no intrinsic value Gov does not back money in gold because then it would be constrained by supply o gold and receives a key freedom— the ambility to provide as much or as little money as needed to maintain the value of money and to best suit the economic needs of a country. Able to "freely" manage nations money supply. Economist agree this is better than gold. Money is not able to convert gold or precious commodity in short run money is only exachangable for paper money same for checkable deposits. Gov doesn't redeem for anything tangible

Money definition M2

Near monies: certain highly liquid financial assets that do not function directly or fully as a medium of exchange but can be readily converted into currency or checkable deposits -Savings deposits including money market depot accounts: can easily withdraw funds from savings account or request funds to be transfer from savings account to checking. A person can also withdraw money market deposit account which is an interest bearing account containing a variety of interest bearing short term securities. They have am in balance requirement and a limit on how often a person can withdraw funds -Small denominated (less than $100,000) time deposits: funds from time deposits become available at maturity. In return for this withdrawal limitation the financial institution pays higher interest rate on such deposits than MMDAS. A person can cash in a CD at any time but must pay a severe penalty. Money market mutual funds held by individuals: can redeem money market mutual fund offered by mutual fund company which combined funds of individual shareholder to buy interest bearing short term credit instruments such as CD and U.S. gov securities and can offer interest on MMMF accounts of depositors (shareholders) who jointly own those financial assets. The MMMF in M2 include only MMMF accounts held by individual; those held by business and other institutions EXCLUDED M1 plus near-monies Savings deposits including money market deposit accounts (MMDA) Small-denominated time deposits Money market mutual funds (MMMF) M2 money supply is about five times larger than M1 money supply M2 included immediate medium of exchange items (currency and checkable deposits) and certain nearmones that can easily be converted into currency and checkable deposits 24% M1 of money supply 64% is saving deposits, including money market deposits accounts of the money supply

lender of last resort

One of the functions of the Fed: It provides funds to troubled banks that cannot find any other sources of funds. In 2007-2008 Fed made and implemented several highly creative new lender of last resort facilities to pump liquidity into the financial system Purpose was to increase liquidity in financial institutions by exchanging illiquid bods for cash Primary Dealer Credit Facility (PDCF): overnight loans to primary dealers who were willing to post loan—backed securities as collateral. Primary dealers are 21 major financial institutions that Fed uses to buy and sell U.S. securities. Term Securities Lending Facility (TSLF): lent U.S. securities to primary dealers for one-month term to promote liquidity in markets for these U.S. securities. The financial institutions obtained the securities from the Fed through participating in competitive single big auctions Asset-backed commercial paper money market mutual fund liquidity facility: provided loans to U.S> banks and thrifts to finance their purchases of commercial paper from money market funds. Commercial paper consists of asset backed, sort term IOUs that are mainly issued by corporations. These short term loans are vital for financial gain the day to day operations of businesses Commercial paper funding facility. (CPFF): purchased commercial paper to support commercial paper market and therefore short term credit needs of businesses Money market investor funding facility (MMIFF): provided funding support to private sector initiative designed t ensure the liquidity of U.S> money market mutual funds. Many Americans rely on money market mutual funds as low risk investments. Term asset backed securities loan facility (TALF): helped households and business with their credit needs by pro diving funding support for asset backed securities collaerized by student loans, auto loans, credit card loans, loans by Small Business Administration (SBA). Interest payments on reserves: bolstered the profitability of banks by paying interest on reserve they hold in their vaults or in the Fed banks These programs intensified the moral hazard problem by greatly limiting the resulted from bad financial assumptions and decisions

Restrictive monetary policy effects

Problem; inflation Federal reserve sells bonds, increases reserve ration, raises discount rate, or increases the interest rate on reserves Excess reserves decreases Federal funds rate rises Money supply falls Interest rate rises Investment spending decreases Ad decrease Inflation declines

The asset items on a commercial bank's balance sheet reflect the banker's pursuit of two conflicting goals:

Profit: why banks make loans and by securities— two manor earning assets of commercial banks Liquidity: safety which lies in liquidity specifically such liquid assets as cash and excess reserves. A bank must be on guard for depositors who want to transform their checkable deposits into cash and checks clearing. Thus banks seek a balance between prudence and profit. The compromise is between assets that earn higher returns and highly liquid assets that earn no returns. Can achieve both goals by lending temporary access reserves he'd in Fed to other commercial banks. Normal day-to-day flows of funds to bank rarely leave all banks it's exact levels of required reserves. Excess held in fed is highly liquid but they draw less interest than loans, so banks lend overnight to other banks in order to earn additional interest without sacrifice of long term liquidity. Banks borrow from federal funds market do so because they are temporary short of required reserves. The interest rate on these overnight loans is called federal funds rate.

zero interest rate policy (ZIRP)

The Fed aimed to keep short-term interest rates near zero to stimulate the economy. To that end open market operations were used to keep federal funds rate between 0-0.25% Problem: economic growth weakened. That implied the Fed would have to figure out a way to deal with the zero lower bound problem under which a central bank is constrained in its ability to stimulate the economy through lower interest rates by the fact that nominal interest rates cannot be driven lower than zero because if they were people wold not want to put there money into bankers (balances would shrink over time)

interest rate

The Fed's primary influence on economy in normal economic times is through its ability to change the money supply (M1 and M2) and therefore change interest rates Interest is the price paid for use of money. Price borrowers need to pay lenders for transferring purchasing to the future

Mortgage Default Crisis 2007-2008

Properly functioning monetary system supports the continuous circular flows of income and expenditures in the economy. Malfunctions causes major problems in credit markets and cause severe fluctuations in the economy's levels of output, employment and prices. Too gentle to call 2007-2008 malfunctioning There was a major wave of defaults on home mortgage loans that threatened the health of original lenders and any financial institution that had made such loans or invested in such loans directly or indirectly A majority were subprime mortgage loans: high interest rate loans to home buyers with higher than average credit risk. Fed gov encouraged bank to make these types of loans to make housing more accessible. Many of the indirect investors in these loans were banks to investment companies. Banks had to write off the investment companies by reducing their bank reserves and limiting their ability to loan threatening the economy becomes both consumers and businesses relied on these loans. False idea of "mortgage backed security" had eliminated most of the bank exposure to mortgage default. These are bonds backed by mortgage payments and to create them banks and other mortgage lenders first make mortgage loans , but they sell these off and right to collect from them. This seemed smart to bank because transfer all risk of loan to buyer of bond, but they lend portions of money receive from selling these bonds to investment funds invested in these bonds. They also purchased large amounts of mortgage backed securities as financial securities to help meet bank capital requirements. Indirect exposure to risk. Lost money made to investors and on mortgage backed security they owned. Consisted of unprecedented rise in mortgage loan defaults, collapse or near collapse of several major financial institutions, and the generalized freezing up of credit availability The crisis resulted from bundling and then sale of bad mortgage loans together with declining real estate prices The crisis exposed the underestimation of risk by holders of mortgage backed securities as well as faulty insurance securities that had been signed to protect holders of mortgage backed securities from risk of default

Stabilizing money's purchasing power

Rapid inflation and consequent erosion of purchasing power of ones typically result form imprudent economic policy. Since purchasing power and price levels vary inversely stabilization of purchasing power of nation's money supply requires stabilization of price levels. Such price level stability (2-3% annual inflation) mainly necessities intelligent management or regulation of nation's money supply and interest rates (monetary policy). It also requires appropriate fiscal policy supportive of efforts of the nations monetary authorizes to hold down inflation. In U.S. a combo of gov policy, social practice, legislation of money supply might jeopardize purchasing power

Liabilities of Fed

Reserves of commercial banks: requires commercial banks to hold these against checkable deposits. The Fed pays interest on these required reserves and also excess held in Fed. Asset to commercial banks. Treasury Deposits: U.S. Treasury keeps deposits in Fed and draws checks on them to pay obligations. Treasury create ad replenish those deposits by depositing tax receipts and money borrowed from public or from the commercial banks through the sale of bonds. Federal Reserve Notes Outstanding: money circulating is claims against the Fed

restrictive monetary policy

Rising inflation "tight money policy This policy will increase interest rate to reduce borrowing and spending which will curtail the expansion of Ad and hold down price level increases. The Fed's immediate step will be to announce a higher target for federal funds rate. Through open market oeprions the Fed wi sell bonds to the bank and public and the sale of those bonds will absorb the reserves in banking system. The fed could absorb reserves by raising reserve requirements, raising discount rate or raising interest rate pays on reserves. But open market operations are usually sufficient to accomplish the goal The smaller reserves in banking produce two results opposite to expansionary -the supply of fed funds decreases, raising the fed funds rate to the new target rate. The eq fed funds rate rises and quantity falls - a multiple contraction of nation's money supply will occur. Given the demand for money, the smaller money supply places an upward pressure on other interest rates. For example prime rates.

Assets of Fed

Securities: largely of Treasury bills (short term securities), Treasury notes (mid-term securities), and Treasury bonds (long term securities) issued by U.S. gov to finance past budget deficits. Part of public debt. Bought these from banks and public through open market operations. They are an important source of interest income to Fed bank they are mainly bought and sold to influence the size of commercial bank reserves and therefore their ability to lend Loans to commercial banks: commercial banks borrow money from Fed. The IOUs that commercial banks give to Fed. Liabilities to commercial banks

Operation twist

Selling short-term Treasury bills and buying long-term Treasury bonds without creating more new money Maturity Extension Program Fed would buy long term gov bonds while simultaneously selling an equi last dollar amount of short term bonds. The Fed's motivation for doing so was to spur investment and consumption by reducing long term interest would were sometimes several points higher than short term interest. This was accomplished by buying long term bonds and driving up their prices. The money ended for those purchases was provided by selling short term. This was not nearly enough to alter short term interest so stayed near zero After this policy in 2012: QE3 fed would purchase 85 billion per month in bonds but that purchases had no specific end date and would fact continue until employment situation improved. The federal funds target rate would remain exceptionally low as long as unemployment was high and inflation was less than 2%. Fed used ZIRP until either job or inflation situation improved. This gave people a sense of how long policy would last.

transaction 5: clearing a check drawn against the bank

Someone deposits a check to someone who has another bank and it clears. The person who receives the check bank increase liabilities and assets by amount of check and person who wrote check bank decreases assets and liabilities by amount of check. Whenever a check is drawn against one bank and deposited in another, collection of that check will reduce both the reserves and the checkable deposits of the bank on which the check is drawn. If a bank receives a check from another bank, the bank receiving the check will collect it and in that process have reserves and deposits increased by the amount of that check Assets: Reserves $60,000, property $240,000 Liabilities and net worth: checkable deposits $50,000, stock shares $250,000

Liquidity

The Eastern with which it can be converted quickly into most widely accepted and easily spent form of money, cash, with little or no loss of purchasing power. The more liquid an asset is the more quickly it can be converted into cash ad used for either purchases of goods and services or purchases of other assets. Can vary radically. Cash is perfectly liquid. House is highly illiquid because it takes several months to sell and their is a loss of purchasing power for fees Other forms of money are highly liquid but less liquid than cash

quantitative easing

The Fed's response to the zero lower bound problem Fed purchases in order to increase the amount of reserves in banking systems. Differs from ordinary open market operations in that it is NOT intended to lower interest rates. Fed buys bonds to increasing quantity of reserves in banking system. Interest rates remain at the same levels to avoid the zero lower bound problem. But with the increase in bank reserves be economy will hopefully be stimulated through increased lending Involves the purchases of u.s. gov bonds but also debt issued by gov agencies or gov by corps

FOMC

The Federal Open Market Committee is the most powerful committee of the FED, because it makes the decisions that affect the economy as a whole by manipulating the money supply. AIDS board of Governors in conducting monetary policy an is made of 12 individuals -seven members of Board of Governors -the president of NY Federal Reserve Bank - four of the remaining presidents of Fed reserve Banks on a 1 year rotating basis FOMC meets regularly to direct the purchase and sale of gov securities (bills, notes, bonds)

What backs the money supply

The U.S. government's ability to keep the value of money relatively stable

Buying securities from the public

The public gives up securities to the Fed bank and gets in a check payment drawn by the Fed on themselves The public deposits check into the bank The bank sends this check against the Fed for collection. Bank reserves increase. Increases actual bank reserves and increase checkable deposits from public. There will be less money for bank to lend compared to buying from bank since checkable deposits but same increase in money supply

unit of account

a means for comparing the values of goods and services As a yardstick for measuring the relative worth of a wide variety of goods, services and resources Prices needed to be stated only in monetary units do to this Aids rational decision making by enabling buyers and sellers to easily compare the prices of various goods, services, and resources. It allows us to define debt obligations, determine taxes owed, and calc nations's GDP

Balance Sheet

a statement of the assets, liabilities, and capital of a business or other organization at a particular point in time, detailing the balance of income and expenditure over the preceding period. Every balance sheet must be balance, this means that the value of assets must equal the amount of claims against them. Summarize the financial position of banks at certain times

demand for money

to make purchases with it (transaction demand), to hold it as an asset (asset demand) Transaction demand: transaction demand for money as a medium of exchange. The level of NOMINAL GDP is main determinant of amount of money demanded for transactions. The larger the total money value of all goods and services exchanged in the economy the larger amount of money needed to negotiate those transactions. Transactions demand for money varies direct with nominal GDP. We use nominal because household and firm will want more money for transactions if prices rise or real output increases. In both cases larger dollar volume well need to be to accomplish the desired transaction. Vertical line because amount demanded only depends on nominal GDP and is independent of interest rates. Asset demand: store of value. To the extent they want to hold money is asset demand for money. like to hold money apart from other goods because it is most liquid asset also attractive when price of other assets rise. Disadvantage is money holds no interest or lower interest than bonds. Amount of money demanded as an asset varies inversely with rate of interest (opportunity cost of holding money as an asset). When interest rates rise having liquid money becomes more costly and public reacts by reducing holding of money as an asset vice versa for interest rate falls.