Introduction to Economics: Social Issues and Economic Thinking Wendy A. Stock PowerPoint Prepared by Z. Pan CHAPTER 22 MONETARY POLICY AND THE FEDERAL RESERVE Copyright © 2013 John Wiley & Sons, Inc. / Photo Credit: Camera Press/Redux Pictures

 Define the concept of money  Explain how the fractional reserve banking system allows banks to create money  Explain how the market for loans functions  Describe the structure of the Federal Reserve System  Summarize the roles of the Federal Reserve  Explain how monetary policy takes place  Illustrate the impact of monetary policy on the economy  Assess the tradeoffs associated with monetary policy Copyright © 2013 John Wiley & Sons, Inc. 2 AFTER STUDYING THIS CHAPTER, YOU SHOULD BE ABLE TO:

 Barter Exchange is the trading of goods and services directly for other goods or services, without using money.  Medium of Exchange is an item that is widely accepted as payment for goods and services. Copyright © 2013 John Wiley & Sons, Inc. 3 THE EVOLUTION OF THE MONETARY SYSTEM

The three primary functions of money: (1) medium of exchange; (2) unit of account; (3) store of value.  A Unit of Account is a standard measure of the value of goods and services.  A Store of Value is something that can be saved and used at a later time. Copyright © 2013 John Wiley & Sons, Inc. 4 THE FUNCTIONS OF MONEY

 The standard definition of money supply is money in circulation called M1.  M1 includes: cash, demand deposits, traveler ’s checks, and other checkable deposits. Copyright © 2013 John Wiley & Sons, Inc. 5 THE MONEY SUPPLY

Copyright © 2013 John Wiley & Sons, Inc. 6 MONEY SUPPLY IN THE U.S.

 Balance Sheet is a statement of assets (things owned) and liabilities (things owed).  Total Reserves are a bank’s deposits that it has received but has not lent out.  Required Reserve Ratio (rrr) is the percentage of deposits that a bank must hold as reserves by law.  Required Reserves is the dollar amount that a bank is required to hold as reserves. Copyright © 2013 John Wiley & Sons, Inc. 7 THE BANKING SYSTEM

 Fractional Reserve Banking is a system under which banks are required to hold only a fraction of their deposits as reserves.  Excess Reserves are the difference between a bank’s total reserves and its required reserves. Total reserves = required reserves + excess reserves Copyright © 2013 John Wiley & Sons, Inc. 8 THE BANKING SYSTEM

Copyright © 2013 John Wiley & Sons, Inc. 9 AN EXAMPLE OF BALANCE SHEET

 The supply of loans (S) comes primarily from savings accounts. As the interest rate increases, the amount of money people decide to save rises.  The demand for loans (D) comes from individuals and businesses who want to borrow money. When the interest rate on loans falls, the demand for loans increases. Copyright © 2013 John Wiley & Sons, Inc. 10 THE MARKET FOR LOANS

Copyright © 2013 John Wiley & Sons, Inc. 11 THE MARKET FOR LOANS

Money creation can be illustrated by the following simple example:  you make a deposit of $10mi. in Econobank  bank’s total reserves increase by $10mi.  assuming rrr = 10%, bank’s excess reserves increase by $9mi.  bank makes a loan of $9mi.  bank has recreated $9mi. more money  starting another and more rounds … Copyright © 2013 John Wiley & Sons, Inc. 12 BANKS AND MONEY CREATION

Initial Status of the bank’s balance sheet: Copyright © 2013 John Wiley & Sons, Inc. 13 BANKS AND MONEY CREATION

After you made a $10mi. deposit: Copyright © 2013 John Wiley & Sons, Inc. 14 BANKS AND MONEY CREATION

After Econobank made a loan of $9mi. and borrower deposited the loan in the same bank: Copyright © 2013 John Wiley & Sons, Inc. 15 BANKS AND MONEY CREATION

 M oney Multiplier (MM) tells the maximum amount that the money supply can increase for a given increase in deposits.  MM is equal to the reciprocal of the required reserve ratio. MM = 1/rrr In our example MM = 1/0.1 = 10 Copyright © 2013 John Wiley & Sons, Inc. 16 BANKS AND MONEY CREATION

 The maximum amount of money creation equals the initial increase in deposit times the money multiplier. Max Money Creation = Initial Increase in Deposits x MM In our example: $10 mi. x 10 = $100 mi. Copyright © 2013 John Wiley & Sons, Inc. 17 BANKS AND MONEY CREATION

After you made a withdrawal of $5mi. Copyright © 2013 John Wiley & Sons, Inc. 18 MONEY MULTIPLIER IN REVERSE: MONEY DESTRUCTION

 A Bank Run occurs when a large number of customers withdraw their deposits from the bank because they worry that their bank might fail.  Federal Deposit Insurance Corporation (FDIC), 1933  Federal Reserve System Copyright © 2013 John Wiley & Sons, Inc. 19 BANK REGULATION

 Board of Governors  Chair (Ben Bernanke), 4-year terms  7 members, 14-year term  12 Federal Reserve District Banks  The Federal Open Market Committee (FOMC), 12 members Copyright © 2013 John Wiley & Sons, Inc. 20 THE STRUCTURE OF THE FEDERAL RESERVE SYSTEM

 Two primary missions of the Federal Reserve are to promote price stability and to promote employment and economic growth.  Monetary Policy is the use of regulations or actions by the central bank to influence the money supply. Copyright © 2013 John Wiley & Sons, Inc. 21 FEDERAL RESERVE AND MONETARY POLICY

Three tools for monetary policy:  Open Market Operations  Discount Rates  Reserve Requirements Copyright © 2013 John Wiley & Sons, Inc. 22 MONETARY POLICY

 Open Market Operations are the purchases and sales of federal government securities by the Fed.  If the Fed ’s objective is to increase the money supply, it will conduct open market purchases of securities from banks and investors.  If the objective is to decrease the money supply, it will sell securities to banks and investors. Copyright © 2013 John Wiley & Sons, Inc. 23 MONETARY POLICY

Initial Status of the bank’s balance sheet: Copyright © 2013 John Wiley & Sons, Inc. 24 MONETARY POLICY: OPEN MARKET PURCHASE TO INCREASE MONEY SUPPLY After Fed purchased $10mi. securities:

 Discount Rate is the interest rate that the Federal Reserve charges banks for loans.  Federal Funds Rate is the interest rate that banks charge one another for loans to cover required reserve shortfalls.  A higher discount rate discourages banks from borrowing from the Fed and from each other, thus less funds available for loans and less money supply created. Copyright © 2013 John Wiley & Sons, Inc. 25 MONETARY POLICY

 A third tool of monetary policy is setting reserve requirements.  Changing the required reserve ratio instantly impacts banks’ excess and required reserves.  Increasing required reserve ratio will reduce the money supply.  Decreasing required serve ratio will increase the money supply. Copyright © 2013 John Wiley & Sons, Inc. 26 MONETARY POLICY

 Expansionary Monetary Policy involves Fed actions to increase the money supply.  Contractionary Monetary Policy involves Fed actions to decrease the money supply. Copyright © 2013 John Wiley & Sons, Inc. 27 MONETARY POLICY AND THE ECONOMY

Copyright © 2013 John Wiley & Sons, Inc. 28 IMPACTS OF EXPANSIONARY MONETARY POLICY

Copyright © 2013 John Wiley & Sons, Inc. 29 IMPACTS OF CONTRACTIONARY MONETARY POLICY

 Advantages:  Flexibility  Nonpolitical  Disadvantages:  Tradeoff between fighting inflation & unemployment  Market expectations Copyright © 2013 John Wiley & Sons, Inc. 30 ADVANTAGES AND DISADVANTAGES OF MONETARY POLICY

QUESTIONS/DISCUSSIONS Copyright © 2013 John Wiley & Sons, Inc Describe the actions the Federal Reserve could take to increase the money supply. 2.Describe the functions of money. How well does cash fit these functions? How well does a checking account that earns zero interest fi t these functions? How well does an interest- earning savings account fit these functions?

Copyright © 2013 John Wiley & Sons, Inc. 32 KEY CONCEPTS Barter exchange Medium of exchange Primary functions of money Unit of account Store of value M1 money supply Balance sheet Total reserves Required reserve ratio Required reserves Fractional reserve banking Excess reserves Money multiplier Bank run Monetary policy Open market operations Discount rate Federal funds rate Expansionary monetary policy Contractionary monetary policy