1. Monetary Policy Money, Interest & Money Supply

2. History of The Federal Bank First Bank of the United States (1BUS) –Alexander Hamilton –Objective was to create stability & provide young nation with ability to deal with foreign entities. –Charter was for 20 years (1791 - 1811) Second Bank of the United States (2BUS) –Result on inflation during War of 1812 –Privately owned with public obligations. –20 year charter (1816 - 1836) –President Jackson ended bank in 1833.

3. History of Federal Banks No National bank until 20th Century Panic of 1907 –Money supply got tight –Pressure on banks –Pyramid reserves Small banks reserves at larger banks Federal Reserve Act of 1913 Created the “Fed”

4. The Federal Reserve Responsibilities include –Supervising member banks Interesting point that member banks technically own & control Federal Reserve. Creates a political buffer. Reports to Congress –Cash Reserves –Money Supply Moves money in & out of circulation.

5. The Federal Reserve What does the Fed do? –Check Clearing –Loans for banks Maintains reserves through S-T loans & loans to banks in trouble. –Federal Government’s Bank (The Treasury) –Supervises Member Banks Reserves, Charters & Mergers. –Regulates the Money Supply Replaces old money & monitors supply

6. What is Money? 3 Components –Medium of exchange Usable for buying and selling of goods & services –Unit of account Allows for easy accounting of value & comparisons –Store of Value Retains value over time

7. What is the Money Supply? Money supply (MS) –Measures amount of money in circulation –4 different Kinds M1 – Most liquid M2 M3 L – Least liquid

8. Federal Reserve Types of Monetary Measures M1 –Currency in circulation + Checking accounts + travellers checks M2 –M1 + Money Market accounts & mutual funds + other S-T saving deposits M3 –M2 + L-T savings deposits L –M3 + Savings bonds + S-T treasuries

9. Money Supply & Interest Rates Interest rate r1r1 r2r2 rere Md2Md2 Md1Md1 MdeMde Money supply Money demand Quantity of money Quantity (supply) set by the Fed

10. Money Supply & Interest Rates Interest rate r1r1 r2r2 MdeMde Money supply MD 1 Quantity of money Increases in demand: MD shifts, MS constant so results in r increases MD 2

11. Money Supply & Interest Rates Interest rate r1r1 r2r2 MdeMde Money supply MD 1 Quantity of money Higher r leads to Higher price levels & lower outputs MD 2 AD Quantity of output Y1Y1 Y2Y2 P2P2 P1P1

12. Money Supply & Interest Rates Interest rate r1r1 r2r2 M d e1 Money supply MD 1 Quantity of money Increased MS leads to increase AD & higher output MS 2 AD 1 Quantity of output Y1Y1 Y2Y2 P1P1 M d e2 AD 2

13. How the Fed Can Change MS Fed Tools 1.Open Market Operations 2.Fed Funds Rate & Discount Rate 3.Reserve Requirements for investors 4.Regulation of consumer credit 5.Moral suasion

14. 1. Open Market Transactions To Increase the money supply –Fed buys US securities on the market Money exchanged for bonds which increases the Money Supply. Money used by Fed to buy bonds was not in circulation but now it is. Increasing supply known as Easy-money policy Consequences include –Easier credit –Lower interest rates initially –Higher aggregate demand –Leads to inflation –Tool for fighting recessionary times

15. 1. Open Market Transactions To Decrease the money supply –Fed sells US securities on the market Bonds exchanged for money which decreases the Money Supply. Money used to purchase bonds in the hands of Government so out of circulation. Decreasing supply known as Tight-money policy Consequences include –Tighter credit –Higher interest rates initially –Lower aggregate demand –Fights inflation –Greenspan used policy to manage growth

16. 1. Open Market Transactions Effects of decreasing the money supply –Fed sells bonds for dollars –More bonds in market, fewer dollars –Fewer dollars = less loanable funds –Less $ available for loans = higher interest rates –Higher r = Lower C & I in GDP –Result is a shift in GDP results Khan video on increasing MS through open market –http://www.khanacademy.org/humanities--- other/finance/core-finance/v/fed-open-market-operationshttp://www.khanacademy.org/humanities--- other/finance/core-finance/v/fed-open-market-operations

17. 2. Fed Funds Rate & Discount Rate Fed Funds Rate –Rate member banks charge each other –Lower than Discount rate Discount rate –Rate Fed Charges member banks Prime rate –Rate commercial banks charge their best customers. Effects –Lowering discount rate Encourages borrowing because the price of money or cost of borrowing decreases Increases loans, investments & money supply. –Raising discount rate Decreases amount of loans, investments & MS.

18. 2. Effects of Rate Changes Effects –Lowering Fed Funds Rate & Discount Rate Encourages borrowing because the price of money or cost of borrowing decreases Increases loans, investments & money supply. –Raising Fed Funds Rate & Discount Rate Decreases amount of loans, investments & MS. Khan Academy – Discount Rate –http://www.khanacademy.org/humanities--- other/finance/banking-and-money/v/the-discount-ratehttp://www.khanacademy.org/humanities--- other/finance/banking-and-money/v/the-discount-rate

19. 2. Taylor Rule Economist John Taylor rules for the Fed’s target Fed Funds Rate (assumes target of 2% inflation GDP real = GDP pot + Inflation If GDP real up 1%, then Fed Funds up ½ %. If Inflation 1% > target, then Fed Funds up ½ %.

20. 3. Reserve Requirements Amount of money banks must keep on hand. If reserve requirement changes, amount available for loans change with it. Example –if a bank has 10,000,000 in deposits & reserve ratio is 10%, then bank must have $1,000,000 in the bank. –Rest can be used for loans. In this case $9,000,000.

21. 3. Reserve Requirements Lowering reserve requirement –Increases amount available for loans –Increases MS –Reduces rates because of greater supply –Increases investments Raising reserve requirement –Decreases amount available for loans –Decreases MS

22. 3. Reserve Requirements Reserve ratio = (Bank’s Required Reserves). (Bank’s Liabilities {deposits}) Monetary Multiplier = 1 / (required reserve ratio)

23. Effects of multipier Beleagured State Bank (BSB) –.10% RR25% RR –Deposits $100M$100M –RR10%25% –Reserves$10M$25M –Funds – Loans$90M$75M –Effects of raising RR in this case is reduction in funds available for loans of $15M for BSB alone. Multipler1/.1 = 10X1/.25 = 4X

24. Other Controls 4. Credit Card rates –Revoked in 1952 –Set rates on consumer credit cards 5. Moral Suasion –Unofficial pressures placed on banks –“you don’t have to do this but …”

26. Limitations Forecasts If forecast is wrong, then so is the policy Timing Time lags with implementing changes in policy Trade-offs Monetary policy a tool to fight inflation or recession

27. Trade-Offs Growth – Good. Inflation – Bad. Easy Money –Increases growth (good) –Increases inflation (bad) Tight Money –Decreases growth (bad) –Decreases inflation (good) Easy Money Tight Money

28. Summary – Expansionary MP Problem: unemployment & recession –Fed buys bonds, lowers RR, lowers DR –Money supply –Excess reserves up –Fed Funds rate falls –Interest rates falls –Investment spending up –Aggregate Demand up –Real GDP up Opposite is true for restrictive MP

29. Expansionary Policy GDP R up Imports down Price Level up Exports up Unemploy -ment down GDP N up Exchange rates down Invest- ments up AD up Interest Rates down Money Supply up Inflation up

30. Determining Nominal Interest Rates MS MD Rate of interest, i Quantity Money ieie MeMe

31. Determining Real Interest Rates S D Rate of interest, r Quantity of funds rere QeQe If Quantity of funds represents all funds, Govt. debt affects demand. If only private funds, Govt. debt affects supply

32. Phillip’s Curve Annual rate of inflation, % Unemployment rate, % PC sr PC lr Trade-off between inflation & unemployment. As economy heats up, unemployment drops & inflation goes up Long-run unemployment Set by LRAS & potential GDP, therefore long-run Phillip’s curve is vertical

33. Investment Demand IDID Rate of interest, r Investment i I Relationship between Nominal interest rates & Investment (GDP)

34. Graph Relationships i Money Market M MD MS Investment Demand i I I GDP R ii I I Y MS MM ii Y I I Contraction of MS leads to higher i, which reduces I, causing GDP to fall Graph reversed so GDP is falling

35. Laffer Curve Tax rate, % 0 100 Tax revenue, $ Maximum Tax Revenue Shape of curve subject of debate

36. Inflation & the Economy Khan Videos on Inflation & Economy Moderate inflation in a good economy –Good visual presentation of relationships (3 minutes) – http://www.khanacademy.org/humanities--- other/finance/microeconomics- macroeconomics/v/moderate-inflation-in-a-good- economyhttp://www.khanacademy.org/humanities--- other/finance/microeconomics- macroeconomics/v/moderate-inflation-in-a-good- economy Stagflation –Low growth with high inflation –Short video (3 minutes) built on prior video –http://www.khanacademy.org/humanities--- other/finance/microeconomics- macroeconomics/v/stagflationhttp://www.khanacademy.org/humanities--- other/finance/microeconomics- macroeconomics/v/stagflation

37. Inflation & Deflation Tutorials Khan Academy –Inflation, Deflation & Capacity Utilization, part 1 (12:32) http://www.khanacademy.org/humanities---other/finance/current- economics/v/inflation--deflation---capacity-utilizationhttp://www.khanacademy.org/humanities---other/finance/current- economics/v/inflation--deflation---capacity-utilization –Inflation, Deflation & Capacity, part 2 (11:49) http://www.khanacademy.org/humanities---other/finance/current- economics/v/inflation--deflation---capacity-utilization-2http://www.khanacademy.org/humanities---other/finance/current- economics/v/inflation--deflation---capacity-utilization-2 –Effects of Obama’s stimulus bill (13:20) http://www.khanacademy.org/humanities---other/finance/current- economics/v/inflation---deflation-3--obama-stimulus-planhttp://www.khanacademy.org/humanities---other/finance/current- economics/v/inflation---deflation-3--obama-stimulus-plan