The Monetary System EQ: What is money?

Class Auction Want to have this piece of candy? What are you willing to trade for it? What is required for this trade (barter) to work? What is the solution for this “double coincidence of wants?”

With a partner, answer this question - What is money?

What is Money? Money is the set of assets in an economy that people regularly use to buy goods and services from other people.

Types of Money Commodity Money Fiat Money What type of money does the U.S. use?

Functions of Money Medium of Exchange

Functions of Money Standard of Value

Functions of Money Store of Value

Summary Draw the 3 functions of money – do not label each function Then with a partner, switch papers and each partner tries to identify each picture

Durable Limited Characteristics of Money Portable Divisible It is important that money is ___________ because………………………

Liquidity Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange. What is the most liquid asset? What are some less liquid assets?

Money in the U.S. Economy Currency is the paper bills and coins in the hands of the public. Demand deposits are balances in bank accounts that depositors can access on demand by writing a check.

Figure 1 Two Measures of the Money Stock for the U.S. Economy Billions of Dollars Currency ($699 billion) Demand deposits Traveler’s checks Other checkable deposits ($664 billion) Everything in M1 ($1,363 billion) Savings deposits Small time deposits Money market mutual funds A few minor categories ($5,035 billion) 0 M1 $1,363 M2 $6,398

CASE STUDY: Where Is All The Currency? In 2004 there was $699 billion of U.S. currency outstanding. – That is $3,134 in currency per adult. Who is holding all this currency? – Currency held abroad – Currency held by illegal entities

Review Video

What agency has authority to print currency in the U.S.?

The Federal Reserve System The Federal Reserve (Fed) serves as the nation’s central bank – created – It is designed to oversee the banking system. – It regulates the quantity of money in the economy (monetary policy). – It is the lender of last resort.

The FED Privately Owned- banks buy stock in the Fed like a corporation Board of Governors- 7 member board appointed by the Fed. Set policies for the Fed Federal Reserve District Banks- Nation is divided into 12 districts. Each district bank runs a district and has a president and board of directors

FED Chairman

Monetary Policy Tools 1.Federal Open Market Operations Committee (FOMC) 2.Reserve Requirement 3.Discount Rate/Federal Funds Rate

*******FOMC****** To increase the money supply, the Fed buys government bonds from the public. To decrease the money supply, the Fed sells government bonds to the public. The Fed uses OMO to control the Fed Funds rate (the rate banks charge each other for over night lending) What does an increase in the money supply do to the nominal interest rate and price levels? Decrease?

Reserve Requirement 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. The reserve ratio is the fraction of deposits that banks hold as reserves. What is the risk with this type of banking?

Banking Money Creation with Fractional-Reserve 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%. AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $ Total Assets $ Total Liabilities $ Owns Owes

T Accounts – assume 1/5 rr 1.$1000 deposit into checking 2.Bank issues $5000 in loans 3.FED buys $1000 worth of govt securities 4.FED sells $1000 worth of govt securities 5.What is the money multiplier? Assets Liabilities $2000 Required Reserves $6000 Excess Reserves $2000 Securities $ Deposits

Money Creation… out of thin air… Increase in the Money Supply = $190.00! AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $ Total Assets $ Total Liabilities $ AssetsLiabilities Second National Bank Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00

The Money Multiplier Original deposit = $ st Natl. Lending = (=.9 x $100.00) 2nd Natl. Lending = (=.9 x $ 90.00) 3rd Natl. Lending = (=.9 x $ 81.00) … and on until there are just pennies left to lend! Total money created by this $ deposit is $ (= 1/.1 x $100.00)

The Money Multiplier The money multiplier is the reciprocal of the reserve ratio: M = 1/R Example: – With a reserve requirement, R = 20% or.2: – The money multiplier is 1/.2 = 5.

1 – 5 on L4/A38 wksht

The Fed and the Reserve Requirement What does changing the reserve requirement from 10% to 20% do the money supply? Nominal interest rates? Show me the new multiplier. What does decreasing the reserve requirement do to the money supply? Nominal interest rates? Show me the new multiplier.

The Discount Rate (no longer used) 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. Discount rate now set higher than FFR… why does this make the discount rate obsolete?

FED REVIEW 4SmU 4SmU

6-12 on L4/A38 wksht finish remainder for HW

11/10 Warm up A-F on worksheet

Warm-up Scenario – high unemployment and low growth (show this on ASAD graph) 1.Action by FED – loose or tight? 2.OMO – Buy or sell bonds? Why? 3.What happens to money supply (graph)? Why? 4.What happens to nominal interest (same graph)? Why? 5.What happens to investment? Why? 6.What happens to aggregate demand? Why?

EQ: How do interest rates affect the macroeconomy?

Watch the video to complete the chart Demand Deposit RRMoney Multiplier Excess Reserves available for loans What is the max money created(not including original deposit)? $200005% $ % $ %

Review Video – Creating Money

Watch the video to complete the chart Demand Deposit RRMoney Multiplier Excess Reserves available for loans What is the max money created(not including original deposit)? $200005% $ % $ %

What are some potential problems with 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. – The Fed does not control the amount of money that bankers choose to lend.

RR _____ DR _____ OMO – Buy or Sell FF Target _____ MS _____ Excess Reserves _____ Nom interest rate _____ I_____ AD ______ Monetary policy in action Easy/Expansionary Policy Tight/Contractionary Policy RR _____ DR _____ OMO – Buy or Sell FF Target _____ MS _____ Excess Reserves _____ Nominal interest rate_____ I_____ AD ______

↓ RR= Banks can loan more $ Fed Buys OMO’s = bank have more $ fewer bonds ↓Discount Rate= Fed lowers cost of borrowing* ↓Federal Funds Rate Target = Fed lowers cost of bank borrowing and lending – done by OMO ↑RR = Banks have less $ to loan out. Fed Sells OMO’s = banks have less $ and more Bonds ↑Discount Rate = Fed lowers cost of borrowing* ↑Federal Funds Rate Target = Fed increases the cost of bank borrowing and lending – done by OMO Monetary policy in action Easy Money Tight Money

So…. How do monetary policies affect macroeconomic goals? Whiteboards

Draw a money market graph showing expansionary monetary policy. What happens to investment given the change in interest rates? Draw and AD/AS graph starting with a recessionary gap. What curve will shift? What will happen to employment, output, and prices?

What happens to investment given the change in interest rates? Draw a money market graph showing contractionary monetary policy. Draw and AD/AS graph starting with a inflationary gap. What curve will shift? What will happen to employment, output, and prices?

Review Video

So…. How do monetary policies affect macroeconomic goals? rman/ rman/