1. AP Macroeconomics: Unit 3 Federal Reserve System and Monetary Policy

2. Topic 1: Money

3. What makes money effective?
Generally Accepted - Buyers and sellers have confidence that it IS legal tender.
Scarce - Money must not be easily reproduced.
Portable and Divisable - Money must be easily transported and divided.

4. Functions of Money

5. 1. Medium of Exchange
It is accepted as a form of payment

6. 2. Unit of accounting
helps to determine the value of an item and allows comparison

7. 3. Store of value
Money can be saved for use in future

8. Money Systems: 1. Barter system
People trade one object for another

9. 2. Commodity money system
An item with intrinsic value is used as money
Examples:
Cigarettes used in prison
Animal furs used in colonial times

11. 3. Representative Money System
Money “backed” by something
Example: The Gold standard; people didn’t carry around the gold, they had a gold certificate that represented the gold

12. *4. Fiat money system Money that is declared so by the government
It is not “backed” by anything

13. Money in the U.S. economy
Money stock = quantity of $ circulating in the U.S. economy
M1= coins, currency & checkable deposits (checking accounts)
M2 = M1 + savings
Liquidity: ease with which an asset can be accessed and converted into cash

14. Topic 2: The Federal Reserve and the Banking System

15. The Federal Reserve System (the Fed)
The Fed is the central bank of the U.S.
Created in 1913

16. Jobs of the Fed Print money Clear checks Supervise banks
Act as a bank to banks
Manage money supply

17. Organization of the Fed
Member banks

18. Organization of the Fed
Board of Governors: Head of the Fed
Janet Yellen = current chairman
Federal Reserve Banks – 12 districts – see map

19. Federal Reserve Banks: 12 Districts

20. Member Banks FDIC insured (Federal Deposit Insurance Corporation)
Insures money in banks up to $250,000
60 minutes video: FDIC

21. Topic 3: Banks and the Money supply

22. Fractional Reserve Banking
If you have a bank account, where is your money?
Only a small percent of your money is in the safe. The rest of your money has been loaned out.
This is called “Fractional Reserve Banking”
The Fed sets the amount that banks must hold

23. Demand Deposits
Money placed in banks by customers

24. Required Reserve vs. Excess Reserve
Reserve requirement (reserve ratio)
the percent of deposits that banks must hold in reserve (the percent they can NOT loan out)
Excess Reserve
Money that is not part of the required reserve
* Banks can loan out all of this money if they wish to do so; when they do, they “create” money

26. The process of how banks “create” money
Banks only influence the amount of $ in the economy if they make loans.
When a loan is taken out, it is spent and ends back up in the banking
System
Example: complete the chart assuming the reserve requirement is 10%
Bank
Deposit
Reserve requirement
Loan A
$1000
$100
$900 B C

27. The process of how banks “create” money – banks “create” money by LOANS
Deposit
Reserve requirement
Loan A
$1000
$100
$900.00 B
$900
$90
$810.00 C
$810
$81.10
$728.90

28. The Money Multiplier
Used to determine how much a loan can impact the overall economy
Money
Multiplier
Reserve Requirement (ratio) 1 = 28

29. What is the Money multiplier on the following reserves?
10%
20% 5%

30. Maximum total change in Demand deposits = Money multiplier X Deposit
Example: Billy deposits $400 in his bank and the reserve
requirement is 10%.
What is the money multiplier?
1/.10 = 10
What is the multiple expansion of demand deposits?
10 X $400 = $4000

31. Maximum change in the money supply =
Money multiplier X Deposit = total - deposit
Example: Billy deposits $400 in his bank and the
reserve requirement is 10%.
What is the money multiplier?
1/.10 = 10
What is the maximum change in the money
supply?
10 X 400 = 4000
= $3600

32. Maximum change in Loans = Money multiplier X deposit = total - deposit
Example: Billy deposits $400 in his bank and the
reserve requirement is 10%.
What is the money multiplier?
1/.10 = 10
What is the maximum change in LOANS?
10 X $400 = $4000
= $3600

33. THE MULTIPLE EXPANSION of money will be less if:
1. Banks DO NOT loan out all of their excess
2. People DO NOT spend all the money that they borrow
3. When money is spent, it is NOT placed back into a bank

34. Bank Balance Sheet central to the accounting practices of a bank (also called a T account)
Assets = required reserves, excess reserves, loans, securities
(anything of value to the bank)
Liabilities = Deposits, borrowed reserves, stockholder’s (owner) equity
(anything the bank owes to someone else)

35. Balance Sheet – 2 sides must = each other
Assets Liabilities required reserves deposits
excess reserves
Loans
________ __________
* Based on this chart, what is the banks required reserve ratio?

36. Balance Sheet Assets Liabilities required reserves 6 deposits 100
excess reserves
Loans
________ __________
Based on this chart, what is the banks required reserve ratio?
What happens on this balance sheet if a new deposit of $100 is made?

37. Balance Sheet Assets Liabilities required reserves 12 deposits 200
excess reserves
Loans
________ __________
Based on this chart, what is the banks required reserve ratio?
What happens on this balance sheet if a new deposit of $100 is made?

38. Topic 4: The Money Market (Supply and Demand for Money)

39. The Demand for Money
At any given time, people demand a certain amount of liquid assets (money) for everyday purchases
Transaction demand for money = The demand for money as a medium of exchange
Asset demand for money = The demand for money to use it for savings
Transaction demand + asset demand = total money demand

40. Nominal Interest Rate (ir)
The Demand for Money
Inverse relationship between interest rates and the quantity of money demanded
Nominal Interest Rate (ir)
20% 5% 2% Md
Quantity of Money
(billions of dollars)

41. Increase in Money demand
Curve shifts to the right
Nominal
Interest
rate

42. Decrease in Money demand
Curve shifts to the left
Nominal
Interest
rate

43. The Demand for Money Money Demand Shifters Changes in price level
Changes in GDP

44. The Supply for Money
The U.S. Money Supply is set by the Board of Governors of the Federal Reserve System (FED)
Interest Rate (ir) Ms
20% 5% 2%
200
Quantity of Money
(billions of dollars)

45. Increasing the Money Supply
Interest Rate (ir) Ms
Ms1
10% 5% 2%
200
250
Quantity of Money
(billions of dollars)

46. Decreasing the Money Supply
Interest Rate (ir)
Ms1 Ms
10% 5% 2%
150
200
Quantity of Money
(billions of dollars)

47. Money supply shifted by: Fed action

48. Money market graph Ms Md Interest Rate (ir) 20% 5% 2%
200
Quantity of Money
(billions of dollars)

49. Draw a graph that shows: The Fed increases the money supply ….
What will happen to nominal interest rates?

50. Draw a graph that shows: an increase in the price level…
What will happen to nominal interest rates?

51. Topic 5: Monetary Policy
What the Fed does to regulate the money supply
The Fed controls the money supply by adjusting Nominal interest rates

52. Video:
Monetary policy: Part Art, Part Science
The Fed Today

53. The nominal interest rate impacts other interest rates:
Prime Interest rate: interest rate banks
give to their least risky borrowers

54. Federal Funds Rate
The Federal funds rate = interest rate that banks charge one another for short term (overnight) borrowing
The Fed can’t simply tell banks what interest rate to use. Banks decide on their own.
The Fed sets a target for the Federal funds rate and then implements policies to influence banks 54

55. Expansionary monetary policy
Implemented during Recession
Goal is to speed up the economy; they want people to get out and spend $ in economy

56. Contractionary Monetary Policy
Implemented during INFLATION
Goal = slow down the economy; want less spending to occur in the economy

57. Tools of monetary policy
The Fed adjusts the money supply by changing any one of the following:
Setting Reserve Requirements (Ratios)
2. Changing the Discount rate of interest
Discount Rate- Interest rate the Fed charges banks to borrow money
**3. Open Market Operations
Buying and selling Bonds (securities)

58. 1. Changing the Reserve Requirement
Expansionary monetary policy
The Fed Decreases the Reserve Ratio
Banks required to hold less money - have more money available to loan
Contractionary Monetary Policy
The Fed Increases the Reserve Ratio
Banks required to hold more money – have less money available to loan

59. 2. Changing The Discount Rate
The Discount Rate is the interest rate that the Fed charges banks to borrow $
Example:
If a bank needs $10 million, they borrow it from the U.S. Treasury (which the FED controls) but they must pay it bank with 3% interest.

60. Changing the The Discount Rate
Expansionary Monetary Policy
The Fed will decrease the Discount rate;
Banks will be encouraged to borrow more = more $ to loan
Contractionary Monetary Policy
The Fed will increase the Discount rate;
banks will be discouraged from borrowing = less $ to loan 60

61. Open market operations

62. 3. Open Market Operations
The Fed buys or sells government bonds (securities).
This is the most important and widely used monetary policy
(THIS IS THE TOOL USED TO INFLUENCE THE FEDERAL FUNDS RATE)
Expansionary monetary policy
The Fed will BUY (back) bonds = more money in banks (buy = big)
Contractionary monetary policy
The Fed will SELL bonds = less money in banks (sell = small) 62

63. Graph of expansionary monetary policy

64. Graph of contractionary monetary policy

65. Review of multiple expansion
1. Tim deposits $300 into his bank. If the reserve requirement is 20%, the maximum amount the money supply can expand by is……

66. 2. $400 is deposited into a bank
2. $400 is deposited into a bank. If the reserve requirement is 25%, what is the maximum potential of loans the banking system can give out?

67. ASSETS LIABILTIES Required reserves $80 deposits $400 Excess reserves $ 20 Loans $ 300 ______________________________________ $400 $400 What happens on this balance sheet when a new $200 deposit comes into the bank?

68. ASSETS LIABILTIES Required reserves $120 deposits $600 Excess reserves $ 180 Loans $ 300 ______________________________________ $600 $600

69. Open market operations: accounting for money multiplier
The Fed has to account for the Money Multiplier any time they take an action!!!
Examples:
1. The Fed sells $20 million of bonds. What is the total change in the money supply if the reserve requirement is 10%.
1/.10 = X 20 = $200 million
**$200 million DECREASE in money supply

70. Accounting for the Money multiplier
*Less money is always created when the Fed buys bonds from the public vs banks –
Buying from the public is subject to the reserve
requriement (the bank must hold part of the
money)
If the Fed buys bonds from banks, the bank
doesn’t have to hold any of the money in
reserve because it is THEIR money

71. Monetary policy: Fed buying from banks vs. the public
2. The Fed buys $10 million in bonds back from banks. If the reserve requirement is 20%, what is the total change in the money supply?
1/.20 = X 10 = 50 million INCREASE
3. The Fed buys $10 million in bonds back from the public which is then deposited into bank accounts. If the reserve requirement is 20%, what is the total change in money supply?
1/.20 = X 10 = = 40 million INCREASE

72. Topic 6: The Effects of Monetary Policy
The Fed influences:
Interest rates (of saving and borrowing)
Bond Prices
inversely related to interest rates
if IR go up, price of bonds go down
if IR go down, bond prices go up

73. Monetarist view MV=PQ View based on the QUANTITY THEORY OF $ and
EQUATION OF EXCHANGE
MV=PQ

74. MV=PQ
Suppose the money supply in an economy is $200, velocity is 2 and price level is 2. What is Q? __________ Suppose money supply in an economy is $400, price level is 3 and Q is $400. What is the velocity of money? ________

75. Monetarist view
*The money supply of a nation has a DIRECT proportional relationship to output because spending is VERY sensitive to the interest rate
* Economic output will grow steadily as long as the money supply grows steadily

76. Expansionary monetary policy
The Fed can:
____________ the reserve requirement
____________ the discount rate
____________ government bonds

77. Expansionary monetary policy
Interest Rate (ir) Ms
Ms1
If the Fed increases the money supply nominal Interest rates fall
When NIR fall; price of bonds go UP
10% 5% 2% Md
200
250
Quantity of Money
(billions of dollars) 77

78. Impact of expansionary monetary policy
INTEREST RATES GO DOWN!!! As a result: 1. people are encouraged to borrow money instead of save it (which is what the Fed wants people to do!) 2. People also less likely to purchase bonds because the price of these go up

79. Ms Ms1 DM S&D of Money AD/AS Expansionary Monetary policy
Interest Rate (i)
S&D of Money Ms
Ms1
10% 5% 2%
Expansionary Monetary policy
Money supply increase
Interest rates go down
Borrowing increases
Spending increases
AD shifts to the right DM
200
250
QuantityM
AD/AS PL AS
PL1
PLe AD
AD1 79 Qe Q1
GDPR

80. Contractionary monetary policy
The Fed can:
____________ the reserve requirement
____________ the discount rate
____________ government bonds

81. Contractionary monetary policy
Interest Rate (ir)
Ms1 Ms
If the Fed decreases the money supply, Interest rates will go up
The price of bonds go down
10% 5% Md
150
200
Quantity of Money
(billions of dollars)

82. Impact of Contractionary Policy
INTEREST RATES GO UP!!!!! As a result: 1. people are encouraged to save money instead of borrow it (which is what the Fed wants people to do!) 2. people are more likely to buy bonds because their prices are low

83. Ms1 Ms Md S&D of Money AD/AS Contractionary monetary policy
Interest Rate (i)
S&D of Money
Ms1 Ms
Contractionary monetary policy
Money supply decreases
Interest rates decrease
Borrowing decreases
Spending decreases
AD shifts to the LEFT
10% 5% 2% Md
175
200
QuantityM
AD/AS PL AS
PLe
PL1 AD
AD1 83 Q1 Qe
GDPR

84. Topic 7: Economic Theories

85. Keynesian View
Money supply has INDIRECT link to output because spending is NOT very sensitive to IR
Favor FISCAL POLICY

86. Fiscal policy
Monetary policy
Responsibility Of
The government
The Fed
Theory associated with
Keynesian theory
Monetarist theory
Theory based on
C + I +G +XN
Q theory of money
MV=PQ

87. Fiscal policy
Monetary policy
View on investment demand
Not very sensitive to IR (impacted more by taxes)
Very sensitive to IR (strongly influenced by interest rates)
Tools Used
Income taxes
G spending
Reserve requirement
Discount rate
Open market operations
Lag time
Long
Short

88. Graph used to illustrate
Fiscal policy
AD/AS
Monetary policy
Money market
Directly impacts
Price level and Q of real GDP
Interest rates and money supply

89. Fiscal policy The government can influence economic activity by
1. Changing government spending
2. Changing income taxes
Use AD/AS graph to show FISCAL POLICY
Fiscal Policy shifts AD curve ONLY!!

90. Expansionary fiscal policy
Implemented in times of recession
Government can:
1. Increase G spending
2. Decrease income taxes
Impact of:
price level ___
output ____
employment ___
Leads to DEFICIT budget

91. Contractionary Fiscal Policy
Implemented during times of INFLATION To slow down economy, Government can: 1. Decrease government spending 2. Increase income taxes
Impact of:
Price level _____
Output _______
Employment ______
Leads to SURPLUS budget

92. Monetary Policy
What the Fed does to regulate the money supply. The Fed directly impacts nominal interest rates.
The Fed can influence money supply in 3 ways:
1. open market operations
2. changing the reserve requirement
3. changing the discount rate of interest
Use Money market graph to show Monetary Policy
Monetary policy shifts MS curve ONLY!! – leads to a change in AD

93. Expansionary Monetary Policy
To speed up economy, Fed can:
Buy (back) bonds (AKA securities)
Lower the discount rate
Lower the reserve requirement
Impact of:
interest rates ____
bond prices _____

94. Contractionary Monetary Policy
To slow down economy, Fed can:
1. Sell bonds (AKA securities)
2. Raise the discount rate
3. Raise the reserve requirement
Impact of:
interest rates __
bond prices ___