1. Money and Banking
The Fed
Monetary Policy
Academic Decathlon
Lesson 13
Berryhill

2. The Functions of Money
 Medium of Exchange
*usable for buying and selling goods and
services
*allows society to escape the
complications of bartering
*allows society to gain the advantages of
geographic and human specialization

3. The Functions of Money
 Unit of account
*acts a yardstick for measuring relative
worth of a wide variety of goods, services,
and resources
*enables buyers and sellers to easily
compare the prices of various goods,
services, and resources

4. The Functions of Money
 Store of Value
*enables people to transfer purchasing
power from the present to the future
*we have to store some of our income to
buy things later
*when inflation is low or
nonexistent, holding money is relatively
risk-free for preserving your wealth

5. Money Definition M1
 M1 consists of:
* currency (coins and paper money) in the
hands of public
* all checkable deposits

6. Money Definition M2
 M2 consists of:
* Everything in M1 plus
* Savings deposits, including money
market deposit accounts
* Small (less than $100,000) time deposits
(CDs)
* Money market mutual funds

7. Money Definition M3
 M3 Consists of
* Everything in M1 and M2 plus
* large (more than $100,000) time
deposits

8. What “backs” the money supply?
 The money supply in the US essentially is
“backed” (guaranteed) by the
government’s ability to keep the value of
money relatively stable. Nothing more!

9. Money as Debt
 Paper money and checkable deposits are
debts, or promises to pay
 They have no intrinsic value—they are just
pieces of paper or bookkeeping entries
 The gov’t will not redeem your paper
money for anything tangible, like gold
***Gold standard—not reliable
because harder to control the money
supply

10. Value of Money
Why are currency and checkable deposits
money, and Monopoly money is not?
 Acceptability—ppl accept them as money
 Legal tender—must be accepted in
payment of a debt
**fiat money—money because the
government has declared it so, not
because it can be redeemed for precious
metal

11. Value of Money (con’t.)
 Relative Scarcity—value of money
depends on supply and demand
**supply of money will determine the
value or “purchasing power” of the
monetary unit

12. Money and Prices
 The purchasing power of the dollar varies
inversely with the price level
 When CPI goes up, the value of the dollar
goes down, and vice versa
D = 1/P
(D=value of dollar, P=price level)

13. Money and Prices
 When the gov’t issues so much money
that the value of the money is undermined
 Runaway inflation can depreciate the
value of the money
 Rapid declines in the value of money may
cause it to cease being used as a medium
of exchange

14. Money and Prices
 Stabilization of the value of money
requires:
1. appropriate fiscal policy
2. Intelligent management or regulation of
the money supply (monetary policy)

15. The Demand for Money
 Transactions Demand (Dt)—the demand
for money for uses such as purchasing
goods and services or paying for factors of
production
* Main determinant of money demanded
for transactions is the level of nominal
GDP

16. The Demand for Money
 Asset demand (Da)—Derived from money’s
function as a store of value so people may hold
their financial assets in many forms, including
corporate stocks, private or government
bonds, or money
* Varies inversely with the rate of interest—
when interest rate is low, the public will choose
to hold a large amount of money assets
*When interest rate is high, amount of assets
held as money will be small

17. The Demand for Money
 Total Money Demanded (Dm)—Found by
adding Da and Dt—total amount of money
public wants to hold at each possible
interest rate
* will change with increases/decreases in
nominal GDP

18. Transactions Demand for Money
(Dt)

19. Asset Demand for Money (Da)
Interest Rate
10
7.5
5
2.5
Da
0 50 100 150 200 Amt of $ Demanded

20. Total Demand for Money and
Supply of Money
Dm = Dt + Da
Interest Rate
10 Sm
7.5
5
2.5
0 Dm
0 50 100 150 200 300 Amt of $ D and S

21. The Money Market
 Money Market—Combining the supply and
demand for money to determine the
equilibrium rate of interest
 Supply of Money (Sm) is a vertical line
because the economy has some particular
stock of money (such as M1) provided by
the monetary and financial institutions

22. Adjustment to a Decline and Incline
in the MS
Rate of Interest Sm1 Sm Sm2
10
7.5
5
Surplus of $
2.5 Shortage
of $ Dm
0
0 50 100 150 200 250 300
Amt of $ D and S

23. Federal Reserve System
or the “Fed”
 Federal Reserve System—the US’s
monetary authorities made up of the
Federal Reserve Banks and overlooked by
the Board of Governors

24. Historical Background
 Early in 20th century, Congress decided
that centralization and public control were
essential for an effective banking system
 Decentralization has fostered
inconvenience and confusion of numerous
bank notes being used as currency

25. Historical Background
 It had also resulted in episodes of
monetary mismanagement when the MS
was inappropriate to the needs of the
economy (too much $ led to rapid
inflation, too little $ stunted the economy’s
growth)
 This led to the Federal Reserve Act of
1913

26. Board of Governors
 Central authorities of the US money and
banking system
 The US president, with the confirmation of
the Senate, appoints the seven Board
members
 Terms are 14 years and are staggered so
that one member is replaced every 2 years

27. Board of Governors
 New members are also appointed when
resignations occur
 The president selects the chairperson and
vice-chairperson of the Board from among
the members

28. Assistance and Advice
 Several entities assist the Board of
Governors in determining banking and
monetary policy
 The Federal Open Market Committee
(FOMC) is made up the 7 members of the
Board plus five of the presidents of
Federal Reserve Banks

29. Assistance and Advice
 The FOMC sets the Fed’s monetary policy
and directs the purchase and sale of
government securities (bills, notes, and
bonds)
 Three Advisory Councils made up of
private citizens meet periodically with the
Board of Governors to voice their views on
banking and monetary policy

30. Assistance and Advice
 The Federal Advisory Council is composed
of 12 commercial bankers, one selected
annually by each of the 12 Federal
Reserve Banks
 The Thrift Institutions Advisory Council
consists of representatives from savings
and loan associations, savings banks, and
credit unions

31. Assistance and Advice
 The 30-member Consumer Advisory
Council includes representatives of
consumers of financial services and
academic and legal specialists in consumer
matters

32. The 12 Federal Reserve Banks
 The 12 Federal Reserve Banks collective
serve as the nation’s “central bank”; they
blend private ownership and public control
and mainly are so-called bankers’ banks
 The 12 Federal Reserve Banks serves
different districts and all implement the
basic policy of the Board of Gov.

33. Quasi-Public Banks
 12 Federal Reserve Banks are quasi-public
 Each Fed. Res. Bank is owned by the
private commercial banks in its district
(commercial banks are required to
purchase shares of stock in the Fed Res
Bank in their district)

34. Quasi-Public Banks
 But a gov’t body (the Board of Gov) sets
the basic policies that the Fed. Res. Banks
pursue
 Despite private ownership, the Banks are
in practice public institutions
 They are not motivated by profit

35. Bankers’ Banks
 Fed Res Banks perform the same
functions for banks and thrifts as those
institutions perform for the public
* Accept deposits and make loans to
banks and thrifts
*Issue currency

36. Fed Functions and the MS
 Issuing currency—issue Fed. Res.
Notes, the paper currency used in the US
 Setting reserve requirements and holding
reserves—sets the amount/fraction of
checking balances that banks must
maintain as currency reserves; accept and
portion of the reserves not held as vault
cash

37. Fed Functions and the MS
 Lending money to banks and thrifts—will
lend money to banks and thrifts and
charge them an interest rate called the
discount rate
 Providing for check collection—Adjusts
reserves to compensate for checks written

38. Fed Functions and the MS
 Acting as a fiscal agent—provides financial
services for the Federal government
 Supervising banks—makes periodic
examinations to assess bank profitability
and accordance to Fed regulations

39. Fed Functions and the MS
 Controlling the money supply—Fed
regulates supply of money, and in turn
enables it to influence interest rates;
makes amount of money available that is
consistent with high and rising levels of
output and employment and a relatively
constant price level

40. Federal Reserve Independence
 Congress purposely established the Fed as
an independent agency of government
 Political pressures on Congress may result
in inflationary fiscal policy
 If executive branch also controlled the
nation’s monetary policy, there could be
pressure to keep interest rates low even
when high interest rates are needed

41. Federal Reserve Independence
 Studies show that countries that have
independent central banks like the Fed
have lower rates of inflation, on
average, than countries that have little or
no central bank intelligence

42. Fed Functions
 Issuing currency
 Setting reserve requirements—the
percentage of each deposit that a bank
must keep on hand in their vault
 Lending money to banks when they don’t
have enough reserves in their vaults
 Check collection

43. Fed Functions—cont.
 Provides financial services to Federal
government
 Supervising banks
 Controlling the money supply

44. Interest Rates
 Interest is the price of money—how much
it costs to borrow money
Price of Money Supply of Money—vertical because it
(interest rate) Is a constant amount (how much is in
Circulation)
Interest rate
Demand of Money—how much
People desire/need/want to take
Out in a loan
Qm Quantity of Money

45. Monetary Policy
 The Fed controls the money supply, and
therefore the interest rate
 As they change the amount of money in
circulation, the price of money changes
(or the interest rate)

46. Change in Supply of Money
Sm1 Sm Sm2
Interest Rate
Int. Rate 1
Int.Rate
Int. Rate 2
Quantity of Money

47. Tools of Monetary Policy
 Open Market Operations—the buying of
bonds from, and the selling of bonds
to, the general public and commercial
banks
 Fed’s most important instrument for
influencing the money supply

48. Buying Bonds
 When the Fed buys bonds they are putting
money into circulation, thereby increasing
the money supply and decreasing i.r.
Sm Sm1
Int. rate
Ir
Ir1
Dm
Quantity of Money
Qm Qm1

49. Selling bonds
 When the Fed sells bonds they are taking
money out of circulation, thereby
decreasing the money supply and
increasing i.r.
Sm1 Sm
Int. rate
Ir 1
Ir
Dm
Quantity of Money
Qm 1 Qm

50. Tools of Monetary Policy
 The reserve requirement or reserve ratio—the
amount of each deposit the bank must keep in
their vaults
 Limits the amount of each deposit the bank may
loan out to another customer
 When the bank can loan out a lot, they can
increase the money supply
 When the banks can not loan out much, they
are decreasing the money supply

51. Reserve Ratio
 You deposit $1,000 in your bank account.
 The reserve ratio is 25%--that means they must
keep 25% of the deposit in the vault
 They set $250 in the vault, but use the other
$750 to loan out to another customer
 That $750 plus the interest they charge the
customer is increasing the money
supply, thereby decreasing interest rates

52. Reserve Ratio
 Say the same $1,000 is deposited in a
bank, but this time the reserve
requirement is lowered to 20%
 Now they must keep $200 in their vaults
and loan out $800
 This is an bigger increase in the money
supply because they can loan out more

53. Tools of Monetary Policy
 The discount rate—the interest rate the
Fed charges on loans to other banks
 Banks may nightly take out loans from the
Fed if they have loaned out more than
they are allowed to (determined by the
reserve ratio)
 The banks are still charged interest by the
Fed, called the Discount Rate

54. The Discount Rate
 When the discount rate is low, banks are
more willing to loan out their reserves
because they can just take out a loan from
the Fed later to cover that loan.
 This increases the money supply because
will be looser with their money and their
loans.

55. The Discount Rate
 When discount rate is high, banks don’t
want to take out a loan from the Fed.
 They will be less likely to loan out their
reserves, thereby decreasing the money
supply because of their unwillingness to
give out as many loans.

56. How does this affect the
economy?
 By increasing and decreasing the money
supply, the Fed is increasing or decreasing
the interest rates.
 When interest rates are high, people are
less willing to take out loans.
 When interest rates are low, people are
more willing to take out loans.

57. How does this affect the
economy?
 Remember the determinants of GDP (and AD)?
GDP (or AD) = C + I + G + X
 The I stands for Investment—money people
take out of a bank in the form of loans to
buy/invest in something.
 If we increase or decrease I, everything else
equal, we are increasing and decreasing GDP/AD

58. How does this affect the
economy?
Interest rates decrease—more people take out loans—AD increases because
I has increased—this increases the price level (inflation) and GDP (production)
Price Level AS
PL1 or new inf.
PL or inflation
AD 1
AD
GDP New GDP GDP

59. How does this affect the
economy?
Interest rates increase—people take out less loans, thereby decreasing I—as
I decreases, so does AD—that decreases inflation and GDP
Price Level AS
PL or inflation
PL1 or new inf.
AD
AD 1
New GDP GDP GDP

60. When to use what…
Problem: high unemployment
AD Increases
Buy bonds, lower rr, Investment
Or lower disct. rate Spending
GDP increases, Increases
Which will lower
unemployment
Interest Rate
Excess reserves Money Decreases
Increase (more Supply
Money to loan out) Increases

61. When to use what…
Problem: Inflation
AD decreases
Investment
Sell bonds, increase rr,
Spending
Or increase disct. rate
Decreases
Inflation
Decreases
Excess reserves
Decrease (less Interest Rate
Money to loan out) Money Increases
Supply
Decreases

62. Strengths of Monetary Policy
 Speed and Flexibility
 Isolation from political pressure
 Past success in the 1980s and 1990s
 Inflation from 13.5% in 1980 to 3.2% in 1983
 Recovery from recession of 1990-1991

63. Problems with monetary policy
 Less control with more electronic
transactions
 Changes in velocity of money (the number
of times per year the average dollar is
spent on goods and services)
 Less reliable in pushing the economy from
a recession (cannot force people to take
out loans)—think Japan 1990s