I.          Functions of Money

A.  Medium of exchange:  Money can be used for buying and selling goods and services.

B.     Unit of account:  Prices are quoted in dollars and cents.

C.     Store of value:  Money allows us to transfer purchasing power from present to future. It is the most liquid (spendable) of all assets, a convenient way to store wealth.

II.        Components of the Money Supply

            A.  Narrow definition of money:  M1 includes currency and checkable deposits

                  (see Figure       15.1).

1.   Currency (coins + paper money) held by public.

a.   Coins are “token” money, which means its intrinsic value is less than actual value.  The metal in a dime is worth less than 10¢.

b.   All paper currency consists of Federal Reserve Notes issued by the Federal Reserve.

2.   Checkable deposits are included in M1, since they can be spent almost as readily as currency and can easily be changed into currency.

a.   Commercial banks are a main source of checkable deposits for households and businesses.

b.   Thrift institutions (savings & loans, credit unions, mutual savings banks) also have checkable deposits.

3.   Qualification:  Currency and checkable deposits held by the federal government, Federal Reserve, or other financial institutions are not included in M1.

B.   Money Definition: M2 = M1 + some near-monies which include: (See Figure 15.1)

1.      Savings deposits and money market deposit accounts.

2.      Certificates of deposit (time accounts) less than $100,000.

3.      Money market mutual fund balances, which can be redeemed by phone calls, checks, or through the Internet.

C.   Which definitions are used?  M1 will be used in this text, but M2 is watched closely by the Federal Reserve in determining monetary policy.

III.       The Federal Reserve and the Banking System

A.     The Federal Reserve System (the “Fed”) holds power over the money and banking system.

1.      Figure 15.2 gives the framework of the Fed and its relationship to the public.

2.      The central controlling authority for the system is the Board of Governors, which has seven members appointed by the President for staggered 14‑year terms.  The chairperson is appointed for 4-year terms.

3.      The Fed is the “central bank” of the U.S., just like the central bank of most nations, but comprised of 12 Federal Reserve banks instead of one.

4.   The system has twelve districts, each with its own district bank.  They help implement Fed policy and are advisory.  (See Figure 15.3)

a.   Each is quasi‑public:  It is owned by member banks but controlled by the government’s Federal Reserve Board, and any profits go to the U.S. Treasury.

b.   They act as bankers’ banks by accepting reserve deposits and making loans to banks and other financial institutions.  In making loans, the Federal Reserve is the “lender of last resort,” meaning that the Fed is available to lend money should other avenues (e.g. other commercial banks) not be available.

                  5.   The Federal Open Market Committee (FOMC) includes the seven governors plus five                 regional Federal Reserve Bank presidents whose terms alternate (except for the president of the NY Fed).  They set policy on buying and selling of government bonds, the most  used monetary policy, and meet several times each year.

6.   About 7,800 commercial banks existed in 2005.  They are privately owned and consist of state banks (three‑fourths of total) and large national banks (chartered by the Federal government).

7.   Thrift institutions such as credit unions (the most common), are regulated by different agencies than commercial banks, but are still subject to monetary control by the Fed.  There are approximately 11,400 thrift institutions in the U.S.

B.   Functions of the Fed and money supply:

1.   The Fed issues “Federal Reserve Notes,” the paper currency used in the U.S. monetary system.

2.   The Fed sets reserve requirements and holds the reserves of banks and thrifts not held as vault cash.

3.   The Fed may lend money to banks and thrifts, charging them an interest rate called the discount rate.

4.   The Fed provides a check collection service for banks (checks are also cleared locally or by private clearing firms).

5.   Federal Reserve System acts as the fiscal agent for the Federal government.

6.   The Federal Reserve System supervises member banks.

7.   Monetary policy and control of the money supply is the “major function” of the Fed.

C.   Federal Reserve independence is important but is also controversial from time to time.  Advocates of independence fear that more political ties would cause the Fed to follow expansionary policies and create too much inflation, leading to an unstable currency such as that in other countries.

IV.        The Fractional Reserve System

            A.  In a fractional reserve system banks can loan out a portion of the money deposited, allowing     them to increase the amount of money in circulation.

            B.  Significance of fractional reserve banking:

1.   Banks can create money by lending more than the original reserves on hand.  (Note that :  today gold is not used as reserves).

2.   Lending policies must be prudent to prevent bank “panics” or “runs” by depositors worried about their funds.  Also, the U.S. deposit insurance system discourages panics.

V.       Money Creation Potential by a Single Bank in the Banking System

A.  Formation of a commercial bank: Following is an example of the process.

1.   Somewhere Bank is formed with $250,000 worth of owners’ shares of stock (see Balance Sheet 1).

2.   This bank obtains property and equipment with $240,000 of its funds (see Balance Sheet 2).

3.   The bank begins operations by accepting deposits worth $100,000 (see Balance Sheet 3).

4.   Bank must keep a percentage of deposits as required reserves.

a.   Banks can keep reserves at a Federal Reserve Bank or as cash in vaults.

b.   The required reserve is determined by the reserve ratio – the percentage of deposit liabilities that must be held as cash or as reserves with the Fed.

c.   Congress sets the limits on the reserve ratio, the Fed sets that actual ratio.

d.   Banks tend to keep some of their reserves as vault cash to satisfy customers’ daily demands for withdrawals.

e.   For convenience, the cash and reserve deposits with the Fed will be combined into “reserves” for the remainder of the chapter (Balance Sheet 4 and beyond).

                  5.   Actual reserves are the total funds the bank has on deposit with the Fed or in the vault as                                    cash, regardless of whether or not they are required to hold it in reserve.

                  6.   Excess reserves are reserves beyond what the bank must hold to satisfy the reserve                                       requirement.

                        a.   Excess reserves are found by subtracting required reserves from actual reserves.

                        b.   Excess reserves are the key to money creation.

                  7.   The Fed requires banks to hold reserves so that it can control the amount of money                                      created through lending, not because holding reserves would be sufficient to stop a bank                                          panic.  Deposit insurance helps discourage bank panic

VI.     Multiple‑Deposit Expansion and the Money Multiplier

A.  The entire banking system can create an amount of money which is a multiple of the system’s excess reserves, even though each bank in the system can only lend dollar for dollar with its excess reserves.

B.   Monetary multiplier is illustrated in Table 15.1.

1.   Formula for monetary or checkable deposit multiplier is:

      Monetary multiplier = 1/required reserve ratio or m = 1/R or 1/.20 in our example.

2.   Maximum deposit expansion possible is equal to:  excess reserves times the monetary multiplier, or D = E x m.

3.   The money creation process is reversible.  Loan repayment destroys money and destroys money creation potential through the money multiplier process.

VII.          Introduction to Monetary Policy

A.  Reemphasize Chapter 15’s points:  The Fed’s Board of Governors formulates policy, and twelve Federal Reserve Banks implement policy.

B.   The fundamental objective of monetary policy is to aid the economy in achieving full‑employment output with stable prices.

1.   To do this, the Fed changes the nation’s money supply.

2.   To change money supply, the Fed manipulates size of excess reserves held by banks.

            C.   Monetary policy has a very powerful impact on the economy, and the Chairman of the Fed’s Board of Governors, Alan Greenspan in 2005, is sometimes called the second most powerful person in the U.S.

VIII.        Interest Rates

            A.     There are a variety of interest rates in the economy (Table 16.1)

                  1.   Variation results from differences in purpose, size, risk, maturity, and taxability.

                 2.   For discussion purposes, the text assumes a single interest rate determined by the demand for and supply of money.

            B.   The Demand for Money: Two Components

      1.   Transactions demand, Dt, is money kept for purchases and will vary directly with GDP        (Figure 16.1a).

      2.   Asset demand, Da, is money kept as a store of value for later use.  Asset demand varies       inversely with the interest rate, the price of holding idle money (Figure 16.1b).

      3.   Total demand will equal quantities of money demanded for assets plus that for         transactions (Figure 16.1c).

            C.   The Equilibrium Interest Rate (Figure 16.1c)

                  1.   Money supply is vertical because it is determined by the Fed and financial institutions.

                  2.   Equilibrium interest rate is found at the intersection of money supply and demand.

IX.       Tools of Monetary Policy

A.  Monetary authorities have three tools with which they can shift money supply to affect interest rates, which in turn affect investment, consumption and aggregate demand and,    ultimately, output, employment, and prices. 

B.   Open‑market operations refer to the Fed’s buying and selling of government bonds.

1.   Buying securities will increase bank reserves and the money supply.

      a.   If the Fed buys directly from banks, then bank reserves go up by the value of the           securities sold to the Fed. 

      b.   If the Fed buys from the general public, people receive checks from the Fed and then     deposit the checks at their bank.  Bank customer deposits rise and therefore bank           reserves rise by the same amount. 

      i.    Banks’ lending ability rises with new excess reserves.

      ii.   Money supply rises directly with increased deposits by the public.

      c.   As excess reserves are lent out, the money multiplier process begins and the        expansion of the money supply exceeds the initial increase in bank reserves. 

2.   When the Fed sells securities, points a‑c above will be reversed.  Bank reserves will go down, and eventually the money supply will go down by a multiple of the banks’ decrease in reserves.

C.   The reserve ratio is another tool of monetary policy.  It is the fraction of reserves required relative to their customer deposits.

1.   Raising the reserve ratio increases required reserves and shrinks excess reserves.  Any loss of excess reserves shrinks banks’ lending ability and, therefore, the potential money supply by a multiple amount of the change in excess reserves.

2.   Lowering the reserve ratio decreases the required reserves and expands excess reserves.  Gain in excess reserves increases banks’ lending ability and, therefore, the potential money supply by a multiple amount of the increase in excess reserves.

3.   Changing the reserve ratio has two effects.

a.   It affects the size of excess reserves.

b.   It changes the size of the monetary multiplier.  For example, if ratio is raised from 10 percent to 20 percent, the multiplier falls from 10 to 5.

4.   Changing the reserve ratio is very powerful since it affects banks’ lending ability immediately.  It could create instability, so Fed rarely changes it (last time was 1992).

5.   Table 16.2 illustrates the effect of different reserve ratios on money creation potential.

D.  The third tool is the discount rate, which is the interest rate that the Fed charges to commercial banks that borrow from the Fed.

      1.   An increase in the discount rate signals that borrowing reserves is more difficult and will      tend to shrink excess reserves.

2.   A decrease in the discount rate signals that borrowing reserves will be easier and will tend to expand excess reserves.

3.   The Fed is a “lender of last resort” for commercial banks (so a change in the discount rate has more of an “announcement effect” than any significant impact on actual borrowing at the discount rate).

E.   “Easy” money policy occurs when the Fed tries to increase money supply by expanding excess reserves in order to stimulate the economy.  The Fed will enact one or more of the following measures.

1.   The Fed will buy securities.

2.   The Fed may lower the reserve ratio, although this is rarely changed because of its powerful impact.

3.   The Fed could reduce the discount rate. 

F.   “Tight” money policy occurs when the Fed tries to decrease money supply by decreasing excess reserves in order to slow spending in the economy during an inflationary period.  The Fed will enact one or more of the following policies:

1.   The Fed will sell securities.

2.   The Fed may raise the reserve ratio, although this is rarely changed because of its powerful impact.

3.   The Fed could raise the discount rate. 

            G.  Relative Importance

1.   Open‑market operations are most important.  Decisions are flexible because securities can be bought or sold quickly and in great quantities.  Reserves change quickly in response.

2.   The reserve ratio is rarely changed since even small changes could destabilize bank’s lending and profit positions.

3.   Changing the discount rate has become a passive tool, set at 1 percentage point above the Federal funds rate (covered later in the chapter).

X.       Monetary Policy, Real GDP, and the Price Level:  How Policy Affects the Economy

A.  Cause‑effect chain:

1.   Money market impact is shown in Figure 16.2.

a.   Demand for money is comprised of two parts.

i.  Transactions demand is directly related to GDP.

ii. Asset demand is inversely related to interest rates, so total money demand is inversely related to interest rates.

b.   Supply of money is assumed to be set by the Fed.

c.   Interaction of supply and demand determines the market rate of interest, as seen in Figure 16.2a.

                  2.   Interest rate determines amount of investment businesses will be willing to make.                                          Investment demand is inversely related to interest rates, as seen in Figure 16.2b.

                        a.   Interest rate changes may also affect consumer durable spending.

                        b.   Effect of interest rate changes on level of investment is great because interest cost of                                          large, long-term investment is sizable part of investment cost.

                  3.   As investment rises or falls, aggregate demand shifts and equilibrium GDP rises or falls                                      by a multiple amount, as seen in Figure 16.2c.

            B.   Expansionary or easy money policy:  The Fed takes steps to increase excess reserves, which                              lowers the interest rate and increases investment which, in turn, increases GDP by a multiple                                    amount.  (See Column 1, Table 16.3)

            C.   Contractionary or tight money policy is the reverse of an easy policy:  Excess reserves fall,                                which raises interest rate, which decreases investment, which, in turn, decreases GDP by a                           multiple amount of the change in investment.  (See Column 2, Table 16.3)

XI.        Monetary Policy in Action

A.  Strengths of monetary policy:

1.   It is speedier and more flexible than fiscal policy since the Fed can buy and sell securities daily.

2.   It is less political.  Fed Board members are isolated from political pressure, since they serve 14‑year terms, and policy changes are more subtle and not noticed as much as fiscal policy changes.  It is easier to make good, but unpopular decisions.

            B.   Focus on the Federal Funds Rate

      1.   Currently the Fed communicates changes in monetary policy through changes in its target for the Federal funds rate. 

2.   The Fed does not set either the Federal funds rate or the prime rate; (see Figure 16.3) each is established by the interaction of lenders and borrowers, but rates generally follow the Fed funds rate.