Macro Unit IV: The Financial Sector Financial System, the Federal Reserve Bank, and Monetary Policy Chapters 12, 13, 14, and 15

THE MEANING OF MONEY Money is the set of assets in an economy that people regularly use to buy goods and services from other people. Three functions Medium of exchange Unit of account Store of value

The Functions of Money Functions of Money A medium of exchange is an item that buyers give to sellers when they want to purchase goods and services. A medium of exchange is anything that is readily acceptable as payment. A store of value is an item that people can use to transfer purchasing power from the present to the future. A unit of account is the yardstick people use to post prices and record debts.

The Functions of Money Liquidity Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange.

The Kinds of Money Commodity money takes the form of a commodity with intrinsic value. Examples: Gold, silver, cigarettes. Fiat money is used as money because of government decree. It does not have intrinsic value. Examples: Coins, currency, check deposits.

Money in the U.S. Economy M0 M1 M2 M3 Currency is the paper bills and coins in the hands of the public. M1 M0 + Demand Deposits, passbook savings, and traveler’s checks Demand deposits are balances in bank accounts that depositors can access on demand by writing a check. M2 M1 + Small time savings deposits and money market shares M3 M2 + Large time deposits (over $100,000) As you go down the list, the money becomes less liquid, so it is harder to convert to cash. We cannot account for all the money in the economy Illegal activities, foreign markets

Money in the U.S. Economy Billions of Dollars M2 • Savings deposits Small time deposits Money market mutual funds A few minor categories M1 • Currency (M0) Demand deposits Traveler ’ s checks Other checkable deposits • Everything in M1 Copyright©2003 Southwestern/Thomson Learning

http://www.federalreserve.gov/releases/h6/current/H6.pdf

http://www.federalreserve.gov/releases/h6/current/H6.pdf

The Financial System The financial system matches one person’s saving with another person’s investment. It moves the economy’s scarce resources from savers to borrowers. We must have savers in order to borrow

FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY The financial system is made up of financial institutions that coordinate the actions of savers and borrowers. Helps address 3 problems Transaction costs Makes it easier for savers to find borrowers Risk Reduces risk by making it easier to diversify Provides liquidity Provides access to cash for borrowers Financial institutions can be grouped into two different categories: financial markets and financial intermediaries.

FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY Financial Markets Stock Market Bond Market Financial Intermediaries Banks Mutual Funds

FINANCIAL INSTITUTIONS IN THE U.S. ECONOMY Financial markets are the institutions through which savers can directly provide funds to borrowers. Financial intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.

Financial Markets IOU The Bond Market A bond is a certificate of indebtedness that specifies obligations of the borrower to the holder of the bond. Characteristics of a Bond Term: The length of time until the bond matures. Credit Risk: The probability that the borrower will fail to pay some of the interest or principal. Tax Treatment: The way in which the tax laws treat the interest on the bond. Municipal bonds are federal tax exempt.

Financial Markets The Stock Market Stock represents a claim to partial ownership in a firm and is therefore, a claim to the profits that the firm makes. The sale of stock to raise money is called equity financing. Compared to bonds, stocks offer both higher risk and potentially higher returns. The most important stock exchanges in the United States are the New York Stock Exchange, the American Stock Exchange, and NASDAQ.

Financial Intermediaries Banks take deposits from people who want to save and use the deposits to make loans to people who want to borrow. pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. Banks help create a medium of exchange by allowing people to write checks against their deposits. A medium of exchanges is an item that people can easily use to engage in transactions.

Financial Intermediaries Mutual Funds A mutual fund is an institution that sells shares to the public and uses the proceeds to buy a portfolio, of various types of stocks, bonds, or both. They allow people with small amounts of money to easily diversify.

Financial Intermediaries Other Financial Institutions Credit unions Pension funds Insurance companies Loan sharks

SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS Recall that GDP is both total income in an economy and total expenditure on the economy’s output of goods and services: Y = C + I + G + NX

Some Important Identities Assume a closed economy – one that does not engage in international trade: Y = C + I + G

Some Important Identities Now, subtract C and G from both sides of the equation: Y – C – G =I The left side of the equation is the total income in the economy after paying for consumption and government purchases and is called national saving, or just saving (S).

Some Important Identities Substituting S for Y - C - G, the equation can be written as: S = I

Some Important Identities National saving, or saving, is equal to: S = I S = Y – C – G S = (Y – T – C) + (T – G)

The Meaning of Saving and Investment National Saving National saving is the total income in the economy that remains after paying for consumption and government purchases. National saving = Public + Private Private Saving Private saving is the amount of income that households have left after paying their taxes and paying for their consumption. Private saving = (Y – T – C) Public Saving Public saving is the amount of tax revenue that the government has left after paying for its spending. Public saving = (T – G)

The Meaning of Saving and Investment Surplus and Deficit If T > G, the government runs a budget surplus because it receives more money than it spends. The surplus of T - G represents public saving. If G > T, the government runs a budget deficit because it spends more money than it receives in tax revenue.

The Meaning of Saving and Investment For the economy as a whole, saving must be equal to investment. S = I

Future vs. Present Value of Money Time value of money Money loses value over time due to inflation This means that when you loan out money, you want to get paid back a value, at minimum, equal to the loan Money lent is money you cannot spend, so you give up some satisfaction or utility you could have gained by spending it as consumption or invested it otherwise The opportunity cost of a loan is reflected in interest rates Present value refers to the amount of money today that would be needed to produce, using prevailing interest rates, a given future amount of money.

PRESENT VALUE: MEASURING THE TIME VALUE OF MONEY The concept of present value demonstrates the following: Receiving a given sum of money in the present is preferred to receiving the same sum in the future. In order to compare values at different points in time, compare their present values. Firms undertake investment projects if the present value of the project exceeds the cost.

Future vs. Present Value of Money Interest paid on savings and interest charged on borrowing is designed to equate the value of dollars today with the value of future dollars FV = PV x (1 + r)n The future value of $1 invested one year from now is $1 x (1 + r)1 PV = FV / (1 + r)n The present value of $1 received one year from now is $1 / (1 + r)1

BANKS AND THE MONEY SUPPLY Banks can influence the quantity of demand deposits in the economy and the money supply.

BANKS AND THE MONEY SUPPLY Reserves are deposits that banks have received but have not loaned out. In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest. Started as a reaction to the Great Depression

BANKS AND THE MONEY SUPPLY Reserve Ratio The reserve ratio is the fraction of deposits that banks hold as reserves. Reserve Requirement % set by the Fed that all banks must meet. Paying Interest on Reserves New policy began in during the financial crisis of 2008 Fed pays interest on Reserves held by banks at the Fed Raise Rate would raise reserve ratio Lower Rate would lower reserve ratio Read about it here…

Money Creation with Fractional-Reserve Banking When a bank makes a loan from its reserves, the money supply increases. The money supply is affected by the amount deposited in banks and the amount that banks loan. Deposits into a bank are recorded as both assets and liabilities. The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio. Loans become an asset to the bank.

Money Creation with Fractional-Reserve Banking This T-Account shows a bank that… accepts deposits, keeps a portion as reserves, and lends out the rest. It assumes a reserve ratio of 10%. Assets Liabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets Total Liabilities

Money Creation with Fractional-Reserve Banking Prepare to have your mind blown… When one bank loans money, that money is generally deposited into another bank. This creates more deposits and more reserves to be lent out. When a bank makes a loan from its reserves, the money supply increases. Therefore, the more loans given out, the faster the money supply grows.

Money Creation with Fractional-Reserve Banking Let’s say a bank receives a deposit $100. Let’s say the required reserve ratio is 10%. They loan out $90 and need to keep $10 on reserve. The next bank loans out $81.00 and needs to keep $9 on reserve. The next bank loans out $72.90 and keeps $8.10 on reserve. And so on… What determines the amount of money that is loaned out, and therefore the size of the expansion of the money supply? Could we be using some sort of multiplier to work out how much money will be loaned out?

The Money Multiplier How much money is eventually created in this economy? The money multiplier is the amount of money the banking system generates with each dollar of reserves.

The Money Multiplier Money Supply = $190.00! First National Bank Assets Liabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets Total Liabilities Second National Bank Assets Liabilities Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00 Money Supply = $190.00!

The Money Multiplier The money multiplier is the reciprocal of the reserve ratio: M = 1/R With a reserve requirement, R = 20% or 1/5, The multiplier is 5.

THE MARKET FOR LOANABLE FUNDS Financial markets coordinate the economy’s saving and investment in the market for loanable funds. The market for loanable funds is the market in which those who want to save supply funds and those who want to borrow to invest demand funds. Loanable funds refers to all income that people have chosen to save and lend out, rather than use for their own consumption.

Supply and Demand for Loanable Funds The supply of loanable funds comes from people who have extra income they want to save and lend out. The demand for loanable funds comes from households and firms that wish to borrow to make investments.

Supply and Demand for Loanable Funds The interest rate is the price of the loan. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. The equilibrium of the supply and demand for loanable funds determines the real interest rate.

The Market for Loanable Funds Real Interest Supply Rate Demand 5% $1,200 Loanable Funds (in billions of dollars) Copyright©2004 South-Western

Supply and Demand for Loanable Funds Government Policies That Affect Saving and Investment Taxes and saving Taxes and investment Government budget deficits

Policy 1: Saving Incentives Taxes on interest income substantially reduce the future payoff from current saving and, as a result, reduce the incentive to save.

Policy 1: Saving Incentives A tax decrease increases the incentive for households to save at any given interest rate. The supply of loanable funds curve shifts to the right. The equilibrium interest rate decreases. The quantity demanded for loanable funds increases.

An Increase in the Supply of Loanable Funds Real Supply, S1 S2 Interest Rate Demand 1. Tax incentives for saving increase the supply of loanable fund s . . . 5% $1,200 2. . . . which reduces the equilibrium interest rat e . . . 4% $1,600 Loanable Funds 3. . . . and raises the equilibrium quantity of loanable funds. (in billions of dollars) Copyright©2004 South-Western

Policy 1: Saving Incentives If a change in tax law encourages greater saving, the result will be lower interest rates and greater investment.

Policy 2: Investment Incentives An investment tax credit increases the incentive to borrow. Increases the demand for loanable funds. Shifts the demand curve to the right. Results in a higher interest rate and a greater quantity saved.

Policy 2: Investment Incentives If a change in tax laws encourages greater investment, the result will be higher interest rates and greater saving.

An Increase in the Demand for Loanable Funds Real Interest Supply D2 1. An investment tax credit increases the demand for loanable fund s . . . Rate Demand, D1 6% $1,400 2. . . . which raises the equilibrium interest rate . . . 5% $1,200 Loanable Funds 3. . . . and raises the equilibrium quantity of loanable funds. (in billions of dollars) Copyright©2004 South-Western

Policy 3: Government Budget Deficits and Surpluses When the government spends more than it receives in tax revenues, the short fall is called the budget deficit. The accumulation of past budget deficits is called the government debt.

Policy 3: Government Budget Deficits and Surpluses Government borrowing to finance its budget deficit reduces the supply of loanable funds available to finance investment by households and firms. This fall in investment is referred to as crowding out. The deficit borrowing crowds out private borrowers who are trying to finance investments.

Policy 3: Government Budget Deficits and Surpluses A budget deficit decreases the supply of loanable funds. Shifts the supply curve to the left. Increases the equilibrium interest rate. Reduces the equilibrium quantity of loanable funds.

The Effect of a Government Budget Deficit Real S2 Interest Supply, S1 Rate Demand 1. A budget deficit decreases the supply of loanable fund s . . . $800 6% 2. . . . which raises the equilibrium interest rat e . . . $1,200 5% Loanable Funds 3. . . . and reduces the equilibrium quantity of loanable funds. (in billions of dollars) Copyright©2004 South-Western

Policy 3: Government Budget Deficits and Surpluses When government reduces national saving by running a deficit, the interest rate rises and investment falls.

Policy 3: Government Budget Deficits and Surpluses A budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment.

The U.S. Government Debt Percent of GDP 120 World War II 100 80 60 Revolutionary War Civil War World War I 40 20 1790 1810 1830 1850 1870 1890 1910 1930 1950 1970 1990 2010 Copyright©2004 South-Western

Money Supply, Money Demand, and Monetary Equilibrium The money supply is a policy variable that is controlled by the Fed. Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied. Bullet 2: Mankiw has removed the word, “directly”

Money Supply, Money Demand, and Monetary Equilibrium Money demand has several determinants, including interest rates and the average level of prices in the economy.

Money Supply, Money Demand, and Monetary Equilibrium People hold money because it is the medium of exchange. The amount of money people choose to hold depends on the prices of goods and services. Opportunity cost of holding money: forgone interest potentially earned on the money in an interest-bearing asset

Money Supply, Money Demand, and Monetary Equilibrium Demand for money also dependent on price level, level of real GDP, and level of real income If prices double, a person will need twice as much money to buy groceries or other goods and services. People are most concerned with the real value of income: what the income can buy or its purchasing power. As income rises, the demand for money increases.

Money Supply, Money Demand, and Monetary Equilibrium In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

Money Supply, Money Demand, and the Equilibrium Price Level Nominal Interest Rate Quantity fixed by the Fed Money supply Money demand Equilibrium value of money Quantity of Money Copyright © 2004 South-Western

The Effects of Monetary Injection MS1 M2 MS2 Money demand Quantity of Money Copyright © 2004 South-Western

THE FEDERAL RESERVE SYSTEM The Federal Reserve (Fed) serves as the nation’s central bank. Created in 1914 after a series of bank failures convinced Congress that the United States needed a central bank to ensure the health of the nation’s banking system. It is designed to oversee the banking system. It regulates the quantity of money in the economy.

THE FEDERAL RESERVE SYSTEM The Structure of the Federal Reserve System: The primary elements in the Federal Reserve System are: 1) The Board of Governors 2) The Regional Federal Reserve Banks 3) The Federal Open Market Committee 4) The Federal Advisory Council

The Fed’s Organization The Fed is run by a Board of Governors, which has seven members appointed by the president and confirmed by the Senate. Among the seven members, the most important is the chairman. The chairman directs the Fed staff, presides over board meetings, and testifies about Fed policy in front of Congress. Current Chairman: Janet Yellen

The Fed’s Organization The Board of Governors Seven members Appointed by the president Confirmed by the Senate Serve staggered 14-year terms so that one comes vacant every two years. President appoints a member as chairman to serve a four-year term.

The Fed’s Organization The Federal Reserve System is made up of the Federal Reserve Board in Washington, D.C., and twelve regional Federal Reserve Banks. Decentralized to limit power and make it more responsive to local needs 12 Regional Banks The New York Fed implements some of the Fed’s most important policy decisions. Nine directors Three appointed by the Board of Governors. Six are elected by the commercial banks in the district. The directors appoint the district president, which is approved by the Board of Governors.

The Federal Reserve System Copyright©2003 Southwestern/Thomson Learning

The Fed’s Organization The Federal Open Market Committee (FOMC) Serves as the main policy-making organ of the Federal Reserve System. Meets approximately every six weeks to review the economy. Can meet if there is an economic emergency at any time September 11, 2001 Lehman Brothers collapse in 2008 Always important when they meet.

The Fed’s Organization The Federal Open Market Committee (FOMC) is made up of the following voting members: The chairman and the other six members of the Board of Governors. The president of the Federal Reserve Bank of New York. The presidents of the other regional Federal Reserve banks (four vote on a yearly rotating basis).

The Fed’s Organization Monetary policy is conducted by the Federal Open Market Committee. Monetary policy is the setting of the money supply by policymakers in the central bank The money supply refers to the quantity of money available in the economy.

The Fed’s Organization Federal Advisory Council 12 members appointed by the 12 regional banks Offer advice on the overall health of the economy

The Federal Open Market Committee Primary Functions of the Fed Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices. Acts as a banker’s bank, making loans to banks and as a lender of last resort. It is the US governments bank Conducts monetary policy by controlling the money supply.

The Fed’s Tools of Monetary Control The Fed has three tools in its monetary toolbox to manipulate the money supply: Open-market operations Changing the reserve requirement Changing the discount rate

The Fed’s Tools of Monetary Control Open-Market Operations The primary way in which the Fed changes the money supply is through open-market operations. The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public: When the Fed buys government bonds, the money supply increases. The money supply decreases when the Fed sells government bonds.

The Fed’s Tools of Monetary Control Reserve Requirements The Fed also influences the money supply with reserve requirements. Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits.

The Fed’s Tools of Monetary Control Changing the Reserve Requirement The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out. Increasing the reserve requirement decreases the money supply. Decreasing the reserve requirement increases the money supply.

The Fed’s Tools of Monetary Control Changing the Discount Rate and The discount rate is the interest rate the Fed charges banks for loans. Increasing the discount rate decreases the money supply. Decreasing the discount rate increases the money supply.

Summary Expansionary Money Policy (Increasing the Money Supply and Inflation) Buy Bonds Lower Reserve Requirement Lower Discount Rate Contractionary Money Policy (Decreasing the Money Supply and Inflation) Sell Bonds Raise Reserve Requirement Raise Discount Rate

Problems in Controlling the Money Supply The Fed’s control of the money supply is not precise. The Fed must wrestle with two problems that arise due to fractional- reserve banking. The Fed does not control the amount of money that households choose to hold as deposits in banks. Currency Drains Withdrawing deposits to hold as cash The Fed does not control the amount of money that bankers choose to lend.

Monetary Policy Chapter 14

Monetary Policy Monetary policy is the combined actions of the Federal Reserve (the Fed) to prevent or address extreme economic fluctuations. The Fed uses monetary policy to influence equilibrium interest rates through its control of bank reserves. The Fed lowers interest rates through expansionary monetary policy to prevent or address recessions, and it raises interest rates through contractionary monetary policy to prevent or address inflation.

Monetary Policy and the Economy Monetary policy is transmitted to the economy through changes in aggregate demand. Monetary policy will have both short-run and long-run effects in the economy.

Monetary Policy in Action Expansionary Policy Expansionary policy (e.g., Fed buys bonds) → MS↑ → i↓ → I/C↑ → AD↑ → rGDP and PL↑. Expansionary monetary policies are often referred to as easy money Contractionary Policy Contractionary policy (e.g., Fed sells bonds)→ MS↓→i↑→I/C↓→AD↓→real GDP and PL↓. Contractionary monetary policy is often called tight money. How would these actions play out in money market and AD/AS graphs?

INTEREST RATES AND MONETARY POLICY IN SHORT AND LONG RUN Nominal Interest Rate versus Real Interest Rate Nominal Interest Rate: rate that appears on the financial pages of newspapers and on the signs and ads of financial institutions Real Interest Rate: increase in purchasing power the lender wants to receive to forego consumption now for consumption in the future

Nominal vs. Real Interest Rates Two relationships between real and nominal interest rates: Ex ante real interest rate: the expected interest rate; equals the nominal interest rate minus the expected inflation rate Ex poste real interest rate: the real interest rate actually received; equals the nominal interest rate minus the actual rate of inflation

Real versus Nominal Interest Rates The real interest rate determines the level of investment (loanable fund market), whereas the nominal interest rate determines the demand for money (money market). The real interest rate is the increase in purchasing power the lender wants to receive to forego consumption now for consumption in the future. The nominal interest rate is the rate that appears on the financial pages of newspapers and on the signs and ads of financial institutions.

How do changes in money supply affect aggregate demand and aggregate supply? Changes in money supply result in changes in price level, but not output Remember, monetary policy is neutral…

Real vs. Nominal Interest Rates The actual real interest rate will equal the expected real interest rate if people accurately anticipate the inflation rate. Known as the Fisher Equation 𝑟=𝑖−𝑝 r = real interest rate i = nominal interest rate p = inflation rate

Fisher Effect In the short run, increases in the money supply decrease the nominal interest rate and real interest rate. However, in the long run, an increase in the money supply will result in an increase in the price level and only the nominal interest rate.

THE CLASSICAL THEORY OF INFLATION The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate. Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange. When the overall price level rises, the value of money falls.

THE CLASSICAL THEORY OF INFLATION The Quantity Theory of Money How the price level is determined and why it might change over time is called the quantity theory of money. The quantity of money available in the economy determines the value of money. The primary cause of inflation is the growth in the quantity of money.

Velocity and the Quantity Equation The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

Velocity and the Quantity Equation V = (P  Y)/M Where: V = velocity P = the price level Y (or Q) = the quantity of output M = the quantity of money in circulation Velocity shouldn’t be in bold. Maybe move V down and align equal signs--it’s not..

Velocity and the Quantity Equation Rewriting the equation gives the quantity equation: M  V = P  Y

Velocity and the Quantity Equation The quantity equation relates the quantity of money (M) to the nominal value of output (P  Y). Nominal value of output = nominal GDP

Velocity and the Quantity Equation The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: the price level must rise, the quantity of output must rise, or the velocity of money must fall.

Nominal GDP, the Quantity of Money, and the Velocity of Money Indexes (1960 = 100) 2,000 Nominal GDP 1,500 M2 1,000 500 Velocity 1960 1965 1970 1975 1980 1985 1990 1995 2000 Copyright © 2004 South-Western

Velocity and the Quantity Equation The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money The velocity of money is relatively stable over time. When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P  Y). Changes in the money supply affect nominal variables but not real variables. The irrelevance of monetary changes for real variables is called monetary neutrality. Because money is neutral, money does not affect output.

Case Study: WIN Campaign Whip Inflation Now (WIN) Created by the Ford Administration in 1974 Attempt to lower Velocity to stop inflation Encouraged people to save money by changing personal habits Really bad idea…total failure Alan Greenspan’s thoughts when he originally heard the idea: “This is unbelievably stupid”