Fed's Tools of Monetary Policy

This video goes into detail about the three tools that the Fed uses to indirectly manipulate the money supply. You must remember that these tools will be used differently for expansionary and contractionary policies.

Unit Four Notes

Money

• Any asset that could be used to purchase goods or services
• Uses of Money
• Medium of Exchange
• Used to determine value
• Unit of account
• How do you determine prices
• Store of value
• How money can be stored
• Types of Money
• Commodity Money
• Has value within itself
• Salt
• Olive Oil
• Gold
• Representative Money
• Represents something of value
• I.O.U.
• Fiat Money
• Money because the government says so
• Paper Currency
• Coins
• Characteristics of Money
• Durability
• Lasts long
• Portability
• Can put money everywhere
• Divisibility
• Can be broken down
• Uniformity
• Limited Supply
• Acceptability
• Taken everywhere
• Money Supply
• Total value of financial assets available in the US Economy
• M1 Money
• Liquid Assets (Liquidity)
• Easily to convert to cash
• Examples:
• Cash
• Paper Currency
• Coins
• Checkable Deposits or Demand Deposits (Checking Account)
• Travelers Checks
• M2 Money
• Consists of M1 money plus savings account and money market account
• No immediate use

• Purposes of Financial Institutions
• Store Money
• Save Money
• Loan Money
• Credit Cards
• Mortgages
• Ways to Save Money
• Savings Account
• Checking Account
• Money market Accounts
• Certificate of Deposit (CD)
• Loans
• Banks operate on a fractional reserve system
• Which is where they keep a fraction of the funds and loan out the rest
• What all banks do including federal reserve bank
• Interest Rates
• Principal
• Amount of money borrowed
• Interest
• Price paid for use of borrowed money
• Simple interest
• Paid on principal
• I = (P x R x T)/100
• Principal x Interest Rate x Time
• Compound interest
• Paid on principal plus accumulated interest
• Formulas
• Principal = (I x 100)/(R x T)
• Time = (I x 100)/(P x R)
• Interest Rate = (I x 100)/(T x P)
• Five Types of Financial Institutions
• Commercial Banks
• Savings and Loans Institutions
• Mutual Savings Banks
• Credit Unions
• Finance Companies

Investment

• Redirecting resources you would use now for the future
• Financial Assets
• Claims on property or income of a borrower
• Financial Intermediaries
• Institution that channels funds from savers to borrowers
• Savers → Financial Institutions → Investors
• Purposes of financial intermediaries
• Sharing Risk
• Diversification
• Spread out investment in order to reduce risk
• Providing Information
• Stock Brokers/Agents
• Pull up file and tell about companies
• Liquidity
• Returns
• Amount an investor receives above and beyond sum of money initially invested
• Stocks & Bonds
• Bonds you loan
• Stocks you own
• Bonds
• Loans or I.O.U.’s that represent debt that the government or a corporation must repay to an investor
• Low Risk Investment
• Components of A Bond:
• Coupon Rate
• Interest rate the issuer pays the bondholder
• Maturity
• Time at which payment to a bondholder is due
• Par Value
• Amount that an investor pays to purchase a bond and that will be repaid to the investor at maturity
• Yield
• Annual rate of return on a bond if the bond were held to maturity
• Time Value of Money
• Dollar today is worth more than dollar tomorrow
• Because of opportunity cost & inflation
• Reason for charging and paying interest
• v = future value of $
• p = present value of $
• r = real interest rate (nominal rate - inflation rate) expressed as a decimal
• n = years
• k = number of times interest is credited per year
• Simple Interest Formula
• v = ((1+r)^n)/p
• Compound Interest Formula
• v = ((1+r/k)^nk)/p
• Seven Functions of the FED
• Issues paper currency
• Sets reserve requirements and holds reserves of banks
• It lends money to banks and charges them interest
• They are a check clearing service for banks
• Acts as a personal bank for the government
• Supervises member banks
• Controls money supply in the economy

Types of Multiple Deposit Expansion

• Type 1: Calculate the initial change in excess reserves
• The amount a single bank can loan from the initial deposit
• Type 2: Calculate the change in loans in the banking system
• Type 3: Calculate change in money supply
• Sometimes Type 2 and Type 3 will have same result (If No FED Involvement)
• Type 4: calculate change in demand deposits

How Banks Work

• Assets
• Reserves
• Required Reserves (rr) - % Required by Fed. to keep on hand to meet demand
• Excess Reserves (er) - % reserves over and above the amount needed to satisfy the minimum reserve ratio set by Fed.
• Loans to firms, consumers, and other banks (earns interest)
• Loans to government = treasury securities
• Bank property - (if bank fails you could liquidate building/property)
• Liabilities + Equity
• Demand Deposits ($ put into bank)
• TImed Deposits (CD’s)
• Loans from: Federal Reserve & other banks
• Shareholders Equity- (To set up a bank, you must invest your own money in it to have a stake in the banks success or failure)
• (Reserve Ratio) = (Commercial bank’s required reserves)/(Commercial bank’s checkable-deposit liabilities)
• (Excess Reserves) = (Actual Reserves) - (Required Reserves)
• (Required Reserves) = (Checkable Deposits) x (Reserve Ratio)

Key Principles:

• A single bank can create money (through loans) by the amount of excess reserves
• The banking system as a whole can create money by a multiple (deposit on money multiplier) of the initial excess reserves

Initial Deposit	New or Existing $	Bank Reserves	Immediate Change in MS
Cash	Existing $	Increase	No; because the composition of money changes (cash to currency)
FED Purchase of bond from public	New	Increase	Yes; because money coming out of the FED is new money in circulation and becomes new DD
Bank purchase of bond from public	New	Increase	Yes; because money coming from bank reserves is considered new money in circulation

Factors that weaken the effectiveness of the deposit multiplier

1. If banks fail to loan out all of their excess reserves
2. If bank customers take their loans in cash rather than in new checking account deposits it creates a cash/currency drain

Money Market

• Inverse relationship between money demand and the interest rates
• DM (money demanded) increases, interest rate decrease
• DM (money demanded) decreases, interest rate increases
• Demand for money is downward sloping
• Money Demand Shifters

1. Changes in price level
2. Changes in income
3. Changes in taxation

Fiscal Policy

• Controlled by Congress and the President
• Either tax or spend

Monetary Policy

• Controlled by The FED (Federal Reserve Bank)
• OMO
• Discount Rate
• Federal Fund Rate
• Reserve Requirement

Tools of Monetary Policy

	Expansionary “Easy Money” Recession	Contractionary “Tight Money” Inflation
Open Market Operation (OMO) (Buy or sell Securities (bonds))	Buy Bonds; Increase money supply	Sell Bonds; Decrease money supply
Discount Rate (Interest Rate that the FED charges commercial banks for loans)	FED will decrease the discount rate	FED will increase the discount rate
Reserve Requirement	FED will decrease the RR	FED will increase RR

Bank Reserves & Money Supply have a direct relationship

Federal Fund Rate

• The interest rate that commercial banks charge each other for overnight loans
• Always the opposite of bank reserves and money supply

Prime Rate

• Interest rate that banks charge to their most creditworthy customers

Loanable Funds Market

• Market where savers and borrowers exchange funds at the real rate of interest
• Demand for loanable funds, or borrowing comes from households, firms, government and the foreign sector. The demand for loanable funds is in fact the supply of bonds.
• The supply of loanable funds, or savings comes from households, firms, government and the foreign sector. The supply of loanable funds is also the demand for bonds

Changes in the Demand for Loanable Funds

• Remember that demand for loanable funds = borrowing (i.e. supplying bonds)
• More borrowing = More demand for loanable funds →
• Less borrowing = Less demand for loanable funds ←
• Examples
• Government Deficit Spending = More Borrowing
• More Demand for Loanable Funds
• Less investment demand = less borrowing
• Less Demand for Loanable Funds

Changes in the Supply for Loanable Funds

• Remember that supply of loanable funds = saving (i.e. demand for bonds)
• More saving = more supply of loanable funds →
• Less saving = less supply of loanable funds ←
• Examples
• Government budget surplus = more saving
• More supply of loanable funds →
• Decrease in Consumers MPS = Less Saving
• Less supply of loanable funds ←

Loanable Funds

• When government does fiscal policy it will affect the loanable funds market
• Changes in the real interest rate will affect gross private investment