Principles of Macroeconomics

Principles of Macroeconomics

3 0 Money and the Federal Reserve Previously Fiscal policy: Use of government spending [G] and taxes to influence the economy Increases in [G] and tax cuts are paid for by borrowing

Fiscal policy is not perfect because of lags, crowding out, and savings adjustments. A higher MPC means a larger spending multiplier. The Laffer curve: Shows the relationship between tax rates and tax revenues collected Big Questions

1. What is money? 2. How do banks create money? 3. How does the Federal Reserve control the money supply? How Money Is Defined and Measured Currency Paper bills and coins All currency is money,

but not all money is currency Functions of money Medium of exchange A unit of account A store of value Medium of Exchange1 Medium of exchange

Money is how we pay for goods and services Other examples: tobacco in colonial times, cigarettes or mackerel in prison Medium of Exchange2 The alternative to money is barter. A medium of exchange is preferred to bartering. Consider an example: Suppose you have two blank notebooks with you in class, but you forgot a pen.

Without money, you would have to find a classmate that has two pens and no notebook to trade. Referred to as a double coincidence of wants. It would be much easier to just pay someone currency for an extra pen. Medium of Exchange3 Commodity money Actual physical commodity (e.g., gold, silver, or tobacco)

Commodity-backed money Can be exchanged for a commodity at a fixed rate Fiat money No value except as the medium of exchange No intrinsic value; just green paper Value comes from government decree Medium of Exchange:

Commodity vs. Fiat Money Commodity money Links money to something tangible Limits inflation Fluctuations in the commodity value change all prices New gold discovery inflation

Fiat money Not backed with a commodity Not subject to macroeconomic risk by changing commodity value Subject to rapid monetary expansion

and inflation Practice What You Know1 Today in the United States, the dollar ($) is: A. intrinsically valued money. B. fiat money. C. commodity money. D. commodity-backed money. Unit of Account

Unit of account Measure in which prices are quoted Usefulness: Creates a common language and unit of measurement Creates a consistent method of record keeping Consider this: Could apples be a unit of account? Store of Value

Store of value A means for holding wealth Consider this: Are apples a good store of value? Usefulness: More convenient to hold wealth in money rather than a large amount of goods This role of money has declined recently due to: Stocks Bonds

Savings accounts Measuring the Money Supply1 Checkable deposits Bank deposits that allow withdrawal of money by writing checks M1 Composed of currency and checkable deposits Most used measure until 1970s, before ATMs M2

Includes M1, savings deposits, money market mutual funds, and CDs Measures of U.S. Money Supply: 2015 Practice What You Know2 Why is M2 currently a more monitored measure of the money supply than M1? A. ATMs have allowed easier access to savings

deposits. B. M2 doesnt include coins, which may be obsolete in a few years. C. Banks pressured the Fed to include savings in the money supply measure. D. People have increased use of credit cards. Measuring the Money Supply2 Debit cards Access checking and/or savings accounts

Checking and savings accounts are included in M2 Credit cards Technically not a part of the money supply Involve a loan made at the cash register Bank deposits from elsewhere pay for the purchase Business of Banking

Banks do not print money, but their actions affect the total money supply. Interest Rates on Bank Deposits and Loans Bank Balance Sheet Loans: Primary interest-earning use of bank funds Reserves: Bank deposits set aside and not lent out Include currency at the vault and holdings at the Federal Reserve

Bank Reserves1 Fractional reserve banking Banks only hold a fraction of deposits on reserve. Typically, banks only keep 10% on reserve. Cost of holding reserves

Before 2008, reserves earned no interest The opportunity cost of holding reserves is the interest payments on loans Fractional Reserve Banking Bank Reserves2 Reasons banks hold reserves:

1) To accommodate customer withdrawals 2) Requirements by the Federal Reserve Required reserve ratio (rr): proportion of deposits banks are required to keep on reserve The current rr is 10% Bank run: Many depositors attempt to withdraw funds from a bank at one time May end with bank in default

Bank Reserves3 The dollar amount of required reserves: Required reserves = rr deposits Excess reserves: Reserves over the required level Generally small Excess reserves = total reserves required reserves

How Banks Create Money1 Some important notes: The money supply includes both currency and deposits Our modern banking system is a fractional reserve system Banks function as financial intermediaries Banks do not mint currency How Banks Create Money2

Storyline: Example of Banks Creating Money1 Two simplifying (but unrealistic) assumptions: 1. All currency is deposited in a bank 2. Banks hold no excess reserves (rr = .10) Example: Alexis gets a $900 loan to pay for college tuition

The college deposits this money in its bank This bank then lends out the money Lets examine the balance sheets of each bank. Example of Banks Creating Money2 University Bank (the bank from which Alexis borrowed the $900) Assets

Liabilities and Net Worth Reserves +$100 Loans +$900 Deposits

+$1,000 Township Bank (the bank the college uses) Assets Liabilities and Net Worth Reserves

+$90 Loans +$810 Deposits +$900

Example of Banks Creating Money3 Practice What You Know3 Banks increase the money supply by: A. B. C. D.

printing (minting) money. controlling interest rates. lending out funds to borrowers. storing the money of savers. Money Multiplier Simple money multiplier Rate at which banks multiply money when All currency is deposited into banks Banks hold no excess reserves

1 m rr m Realistically: Represents maximum size of money multiplier Practice What You Know4

With a reserve requirement of 5% and an initial deposit of $400, what is the total amount of money that could be in the money supply? A. B. C. D. $420

$780 $4,000 $8,000 The Federal Reserve The Federal Reserve (Fed): central bank of United States Three responsibilities: 1. Monetary policy 2. Central banking

3. Bank regulation Current chairman of the Fed Janet Yellen Roles of the Federal Reserve1 Central bank The Fed is a bank for banks Offers support and stability for the banking system

Federal funds Private bank deposits at the federal reserve Federal funds rate The interest rate on loans between private banks Negotiated between private banks, not set by the Fed Roles of the Federal Reserve2 Discount loans Loans from the Fed to private banks

The Fed is the lender of last resort Not used frequently, but reassuring during crises Discount rate The interest rate on discount loans Regulates individual banks Sets and monitors reserve requirements, limits risks

Federal Reserve: A Bank for Banks Monetary Policy Tools Open market operations Primary single tool of monetary policy Fed created a new version in 2008 Secondary tools

Reserve requirements Discount rates Special case: 2008 Fed implemented 9 new monetary policy tools Open Market Operations1 Open market operations The purchase or sale of bonds by a central bank Buys securities increase money supply Sells securities decrease the money supply

Why Treasury securities? Funds go directly into the market for loanable funds. Can buy and sell large volumes daily ($500 billion) Open Market Operations2 Reserve Requirements

Two additional tools (not used recently) Reserve requirements Discount rate Reserve requirements The Fed sets the reserve requirement ratio = rr The simple money multiplier mm depends on rr The Fed can change the money multiplier by changing the reserve requirement

Reserve Requirements and the Simple Money Multiplier Discount Rate Discount rate: Original monetary policy tool The interest rate charged on loans to banks from the Fed Historically Fed would increase the discount rate discourage borrowing by banks

decrease money supply (or vice versa) Used actively until Great Depression era Today No longer considered useful Practice What You Know5 Discount loans are: A. loans offered by private banks at a lower interest rate.

B. cheap loans to individuals from nonbank businesses. C. loans from the Fed to private banks. D. loans private banks make to each other. Excess Reserves, 19902013 Conclusion Money includes currency and bank deposits Banks expand the money supply by issuing loans

The Fed influences the macroeconomy using: Open market operation Discount loans Reserve requirements Since 2008, the Fed has new policy tools

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