Fixing an Economy: Monetary Policy Monetary Policy & Federal Reserve 2008-09 Fixing an Economy: Monetary Policy Federal Reserve, Money Supply, and Banking CHAPTERS 16 & 17

WHAT MAKES MONEY, MONEY? Since we are talking about Monetary policy, we should make sure we understand why money is important. SWS 2009

Monetary Policy & Federal Reserve WHAT MAKES MONEY, MONEY? 2008-09 History of US currency For centuries currency has been in the form of precious metals (gold, silver, copper) US currency was based on gold until 1973 President Nixon abolished the gold standard since no additional currency could be printed for a growing economy if that currency is based on a fixed commodity (product). So what backs the value of the currency in this country… Faith! SWS 2009

The 2 Categories of Money WHAT MAKES MONEY, MONEY? The 2 Categories of Money Fiat Money (representative money) is used as money because of government decree. It does not have intrinsic value. Examples: Present day coins, paper currency, check deposits, credit cards. SWS 2009

The 2 Categories of Money Monetary Policy & Federal Reserve WHAT MAKES MONEY, MONEY? 2008-09 The 2 Categories of Money Commodity Money takes the form of a product with intrinsic value. The material ITSELF has value! Examples: Gold, silver, cigarettes. SWS 2009

Monetary Policy & Federal Reserve WHAT MAKES MONEY, MONEY? 2008-09 Money has to have three functions in the economy: Medium of Exchange Unit of Account Store of Value SWS 2009

Monetary Policy & Federal Reserve 3 FUNCTIONS OF MONEY Monetary Policy & Federal Reserve 2008-09 1.) Medium of Exchange A medium of exchange is anything that is acceptable as payment for goods and services. IN EXCHANGE FOR A GOOD OR SERVICE OR SWS 2009

Monetary Policy & Federal Reserve 3 FUNCTIONS OF MONEY Monetary Policy & Federal Reserve 2008-09 2.) Unit of Account A unit of account is the yardstick people use to post prices, record debts, and compare values. We use it to COMPARE the value of two or more goods EXAMPLE: Measuring the WORTH of your chores DUTY $ WORTH TRADE VALUE CUT THE YARD $40.00 Video Game CUT THE YARD + WASH & WAX THE CAR $100.00 Video Game + Clothes CUT THE YARD, WASH & WAX THE CAR, & CLEAN THE WHOLE HOUSE $300.00 XBOX 360 SWS 2009

Monetary Policy & Federal Reserve 3 FUNCTIONS OF MONEY 2008-09 3.) Store of Value A store of value is an item that people can use to transfer purchasing power from the present to the future. IT WILL HOLD VALUE. SO THAT IT CAN BE USED SOMETIME LATER. SWS 2009

Monetary Policy & Federal Reserve 2008-09 The Federal Reserve The Federal Reserve (Fed) serves as the nation’s central bank. Regulates Banks Practices 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. Conducts Monetary policy by controlling the money supplied to the public. $ $ $ $ $ SWS 2009 $

The Federal Reserve and some clarification! Monetary Policy & Federal Reserve 2008-09 The Federal Reserve and some clarification! Monetary Policy: IS NOT PRINTING MONEY The Federal Reserve is NOT responsible for printing money! Federal Reserve SWS 2009

The Fed’s Organization Monetary Policy & Federal Reserve 2008-09 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 (Ben Bernanke) The chairman directs the Fed staff, presides over board meetings, and testifies about Fed policy in front of Congressional Committees. SWS 2009

The Federal Reserve System Monetary Policy & Federal Reserve 2008-09 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 (7 members) 2) The 12 Regional Federal Reserve Banks 3) The Federal Open-Market Committee SWS 2009

The 12 Federal Reserve Banks Monetary Policy & Federal Reserve The 12 Federal Reserve Banks 2008-09 Since each district has different money needs the various branches deal with each region independently.

What is Monetary Policy? Monetary Policy & Federal Reserve What is Monetary Policy? 2008-09 Monetary Policy: Controlling the economy through increasing or decreasing the money supply. Two Types of Monetary strategy: Tight Money: taking money out of the economy (decrease money supply) Easy Money: putting more money in the economy (increase money supply) SWS 2009

Fed’s Tools of Monetary Control Monetary Policy & Federal Reserve 2008-09 Fed’s Tools of Monetary Control The Fed has 3 “tools” in its monetary toolbox: Open-Market Operations (buying & selling government securities) Changing the Reserve Requirement Changing the Discount Rate SWS 2009

Monetary Policy & Federal Reserve 2008-09 Monetary Policy Tools REGULATING THE MONEY SUPPLY THROUGH BUYING/SELLING BONDS 1. OPEN-MARKET OPERATIONS The money supply is the quantity of money available in the economy. The primary way in which the Fed changes the money supply is through open-market operations. The Fed BUYS and SELLS U.S. Government Bonds and/or other U.S. Securities Let’s look at a graphic example… SWS 2009

GOVERNMENT SECURITIES Consumers, Banks, Businesses & Countries Monetary Policy Tools REGULATING THE MONEY SUPPLY THROUGH BUYING/SELLING US SECURITIES 1. OPEN-MARKET OPERATIONS MONEY SUPPLY = INCOME, INFLATION & GDP = INTEREST RATES = Federal Reserve SELLS GOVERNMENT SECURITIES SWS © 2009 Consumers, Banks, Businesses & Countries

GOVERNMENT SECURITIES Consumers, Banks, Businesses & Countries Monetary Policy Tools REGULATING THE MONEY SUPPLY THROUGH BUYING/SELLING US SECURITIES 1. OPEN-MARKET OPERATIONS MONEY SUPPLY = INCOME, INFLATION & GDP = INTEREST RATES = Federal Reserve BUYS (back) GOVERNMENT SECURITIES SWS © 2009 Consumers, Banks, Businesses & Countries

CONTROLLING THE MONEY SUPPLY THROUGH BANKS 2. THE RESERVE REQUIREMENT Monetary Policy & Federal Reserve 2008-09 Monetary Policy Tools CONTROLLING THE MONEY SUPPLY THROUGH BANKS 2. THE RESERVE REQUIREMENT Reserves are deposits that banks have received but have not loaned out. In the U.S. we have a fractional reserve banking system: banks hold a fraction of the money deposited as reserves and lend out the rest. SWS 2009

Monetary Policy & Federal Reserve 2008-09 Monetary Policy Tools CONTROLLING THE MONEY SUPPLY THROUGH BANKS 2. THE RESERVE REQUIREMENT The money supply in America is affected by the amount deposited in banks and the amount that banks loan out. The fraction of total deposits that a bank has to keep as reserves is called the reserve requirement ratio. Put another way, the reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out. SWS 2009

Peak: increase the reserve requirement in order to stop banks from lending so much. This stops $ entering economy. Trough: decrease reserve requirement in order to have banks lend more to stimulate economy. This allows $ to enter economy.

Changing the Discount Rate Monetary Policy & Federal Reserve 2008-09 Monetary Policy Tools CONTROLLING MONEY SUPPLY THROUGH THE INTEREST RATE 3. THE DISCOUNT RATE Changing the Discount Rate The Discount Rate is the interest rate the Fed charges banks for loans. Increasing the discount rate decreases the money supply (peak). Decreasing the discount rate increases the money supply (trough). Basically, if the Federal Reserve charges banks more interest to borrow money then the banks have to charge higher interest on all loans.

Monetary Policy Tools REVIEW: TOOLS OF MONETARY POLICY Open-Market Operations The Reserve Ratio The Discount Rate What will happen to the money supply in the following situations? Examples: Buy securities Increase Reserve Ratio Raise Discount Rate Sell Securities Decrease Reserve Ratio Lower Discount Rate MONEY DECREASES MONEY INCREASES MONEY DECREASES MONEY INCREASES MONEY DECREASES MONEY INCREASES

Monetary Policy Tools Open-Market Operations The Reserve Requirement The Discount Rate SWS 2009

Fiscal Policy Tools Taxes Government Spending Transfer Payments SWS 2009

END CHAPTERS 16 & 17 MONETARY POLICY, FEDERAL RESERVE & MONEY SWS 2009