Money Supply and Interest Rates Monetary Policy Money Supply and Interest Rates

What is Money? Money is a medium of exchange. It is used to facilitate trades. Money can be also used as a store of value to help facilitate future trades.

Why do people use money? Before people used money, they traded one good or service for another – this was called barter Barter was hard because it required a double coincidence of wants

Barter example You have eggs to sell and are trying to get milk. I have a cow and can sell milk. For us to trade, I need to want eggs. If I don’t want eggs, we don’t trade.

Money works better than barter Money does not require a double coincidence of wants. You and I can trade even if I don’t want eggs because I can use your money to buy the things I do want. $

Valuation – two problems Money can cause two problems: How much is the good or service worth in terms of money? (prices) This problem is solved with markets How much is the money worth in one country or place compared to the money in another country of place?

What is a dollar worth? The U.S. dollar is subject to supply and demand. When people in Japan want dollars to make purchases of U.S. goods, the demand for dollars rises and the price of the dollar goes up. If people in the U.S. need Yen to buy Japanese goods, the price of the Yen in U.S. dollars goes up.

Currency exchange How much is the dollar worth today in …. $$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$$

What is Monetary Policy? Monetary policy is an attempt to control the economy by changing the money supply and interest rates. Monetary policy changes affect the economy faster than fiscal policy changes. Monetary policy changes have smaller effects than fiscal policy changes. Change

Who makes Monetary Policy Monetary policy is established by the Board of Governors of the Federal Reserve System (The “Fed”). The board of governors is made up of the heads of the 12 regional banks (look at a dollar bill and see where it was printed). The leader of the “Fed” is the chairman of the Federal Reserve.

What is the “money supply” The money supply is the total amount of money in circulation. It is made-up of three parts Checking accounts Deposits Travelers checks Actual currency

Why does the supply of money affect the economy? The supply of money helps determine how much money is available for loans. Loans affect business activity. The greater the money supply, the lower the price of borrowing - meaning businesses will expand and people will be more likely to buy new products.

How does the Fed change the money supply? Changing the reserve requirement Making open market operations (purchases and sales) Changing the federal funds interest rate

P – price of money (interest rates) Q – Money supplied

Bank Reserves Reserve requirement 10% $100 to bank Bank lends $90 Banks can not lend out every dollar they collect in deposits. The amount they are required to keep on hand is called a reserve. Higher reserve = less money Lower reserve = more money The problem is that banks don’t always lend to the max Reserve requirement 10% $100 to bank Bank lends $90 If you want more money in the system change the reserve requirement to 5% Bank lends $95

Open Market Operations The Fed can buy and sell government bonds (T-bills) from the public. If the Fed makes an open market purchase, it buys bonds from the public. The purchase gives the old owner of the bond cash to spend now instead of needing to wait until the term of the bond is over. Open market purchase = more money

Open Market Operations The Fed can also make sales of government securities. When the Fed sells a bond and accepts currency in exchange, it takes the money out of the system. Open market sale = less money

Federal Funds Rate The Fed can lend money to banks for temporary shortages. The interest rate it charges banks for very short terms loans (overnight loans) is call the discount rate. Changes in the discount rate produce the quickest but smallest results. Raise rates = less money Lower rates = more money

Side effects from the Federal Funds Rate Changes in the federal funds rate can but don’t always affect the interest rates banks charge consumers for loans and credit cards. Because of the connection between consumer credit and the federal funds rate, the Fed’s decisions can often have a much larger effect on the economy.

Policy Choices Expansionary Monetary Policy – to increase economic activity (lower unemployment/increase demand) by any combination of Lowering reserve requirements Making open market purchases Lowering the discount rate Contractionary Monetary Policy – to reduce inflationary pressures (lower demand) by any combination of Increase reserve requirements Making open market sales raising the discount rate

What would happen to demand if….? The Fed lowered the discount rate Made an open market purchase Raised the reserve requirement by 3% Raised the discount rate.25% Stopped buying treasury bonds