fiscal policy
congress/president trying to change AD through changed in taxes and spending
monetary policy
the federal reserve trying to change AD through changes in money supply
by changing money supply, Fed can change
interest rates
by changing interest rates, the fed can change
investment and consumer spending (I and C)
by changing I and C fed can change
AD
by changing AD fed can change
equilibrium GDP, employment, price level
board of governors
seven members appointed for 14 year terms with the president of the federal reserve appointed for a 4 year term
federal open market committee
the board of governors plus five of the presidents of the regional federal reserve bank
responsibilities of the fed
-issue currency
-set reserve requirement and holding reserves
-lend money to banks
- supervise banks
-control money supply
money
anything that is generally accepted as a medium of exchange for goods and services
-portable
-uniform
-acceptable
-stable
-familiar
-divisble
functions of money
1) medium of exchange
2) unit of account
3) store of value
time value of money
- a dollar today is worth more than a dollar one year from now
- the opportunity cost of not having use of that dollar is the foregone interest that could have been earned
FV=
PV x (1+i) ^n
money supply
-anything can be considered money
- economists divide things used as money into 3 categories based liquidity
M1
the most liquid type of money
- currency and coins (token money, federal reserve notes)
-checkable deposits (aka demand deposits)
- travelers checks
M2
a little bit more difficult to spend (less liquid)
- everything in M1 plus
-savings accounts
-money market accounts
- small time deposits (CD)
M3
even less liquid
- everything in M2 plus
-large time deposits (CD)
credit cards are what
loans not money
stocks
firms raise money by selling shares of their company. this is known as equity financing. avoid debts but relinquishes some control
bonds
another way for films/govt to raise money. essentially an IOU. "debt financing" no loss of control. important for monetary policy
securities
stocks and bonds
what backs the money supply
-federal reserve note (a debt of government)
-acceptability
-legal tender
-relative scarcity
-stable value through appropriate fiscal policy (no inflation) and intelligent management of the money supply
2 reasons people demand money
1)use for transactions (medium of exchange) "transaction demand"
2) keep as an asset (store of value) "asset demand
transaction demand
varies directly with nominal GDP and is independent of the interest rate
asset demand
riskless to hold (unlike stock/ bonds) but does not earn interest. varies inversely with the interest rate
total demand
transaction demand +asset demand (graph is just added together)
changes in the money supply
by changing the money supply, the federal reserve can change interest rates in economy
-changing interest rates affect bond prices
decreasing the money supply
increases interest rates, and the temporary shortage of money creates a sell off of bonds, decreasing bond prices
interest rates and bond prices are inversely
related and vice versa
increasing the money supply decreases
interest rates and the temporary surpluses of money causes people to buy bond increasing bond prices
t account
a kind of balance sheet
assets
what a bank owns
liabilities
what a bank owes to its owners
assets=
liabilities+ net worth
reserve ratio
banks are subject to a reserve ratio requirement (set by fed). a percentage of peoples deposits they must keep
-in vault
-im fed vault
actual reserves
cash the bank has in its vault or at the fed
required reserves
cash the bank has to keep there
excess reserves
actual reserves -required reserves
- this money can be loaned by the bank
when banks loan
they make money
when loans get repaid
money is destroyed
banks pursue two conflicting goals
1) profits ( make as many loans as possible)
2) liquidity (have money available when people need it
how can the fed control how many loans are created
by changing how much excess reserves a bank has, by changing the reserve ratio (a reserve ratio of 100% would mean no loans are possible)
when banks fond that they are short on required reserves
they can borrow money from other banks on a short term basis
when banks borrow money from other banks, they pay the lending bank
the federal funds rate
federal funds rate
this interest rate is important because its the interest rate the Federal Reserve focuses on when doing monetary policy
the money multiplier
when banks make loans , they create money. that money can get multiplied, creating even more money
money multiplier formula
1/ reserve ratio
maximum checkable deposit expansion
- the maximum amount of new money that can be created by the banking system as a whole
= excess reserves x money multiplier
limitations to process
1) the reserve ratio (set by fed)
2) leakages (currency drains, banks choose to hold excess reserves)
the discount rate
the interest rate the fed charged to banks when banks borrow money from the fed (different than federal funds rate)
reserve requirement
by changing the reserve requirement the fed can change the amount of excess reserves which again changes banks money creation potential
open market operations
the feds buying and selling govt securities (bond) in order to change the money supply
buying securities from individuals / banks
- people/banks hand over money
- in exchange fed hands over money
- that money is deposited into banks which loan it out creating more money
selling securities from individuals banks
- people/ banks hand money
- in exchange fed hands over bonds
- banks now have less excess reserves, so can make fewer loans, less money created
importance of discount rate
used as a signal
importance of reserve requirement
rarely altered
importance of open market operations
- most important
- used every day
- can be done large/small amounts
-can be reversed easily
easy expantionary monetary policy
-used if economy is in a recession (AD is too low)
- combination of
-lowering discount rate
- lowering reserve requirement
-buying bonds and securities
tight contractionary monetary policy
- used if the economy is experiencing inflation (AD is too high)
-a combination of
- raising discount rate
- raising reserve requirement
- selling bonds / securities
monetary policy cause and effect chain
if pursue easy money policy
- all of these will increase excess reserves
- banks will lend more money increasing the money supply
- increased money supply will result in lower interest rates
- lower interest rates will increase I and C
- more I and C mean
federal funds rate is basis for
many other interest rate
strengths of monetary policy
- speed and flexibility
-isolation from political pressure
- dont have worry about crowding out or net exports effect ( monetary policy helps with these)
- can be used to cancel out crowding out effect (bc not increasing demand, increasing supply
weakness of monetary policy
- increasingly less control as
-different things are used as money
- the world becomes more global
- changes in velocity
-cyclical assymetry
- tight money policy is more dependable than easy money policy
-the fed cant force banks to make loans