The Monetary System and Policies

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The Monetary System and Policies

• Chapter 16 and chapter 13

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Structures of this chapter

• Money
• U.S. monetary system
• Saving
• Financial markets and intermediaries
• Banks and money supply
• Fed and monetary policy
• Challenges of monetary policy
• Government deficit and its impacts

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Money

• Functions of Money
• Liquidity
• Kinds of Money
• Commodity money
• Fiat money

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• Money in the U.S. economy
• Currency and demand deposits (M1)
• M1 plus every else less liquid (M2)

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Monetary System in U.S.
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Saving

• Consumers face trade off Save or consume?
• Saving Investment
• The definition of investment in economics is very
  narrow.

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• Saving and interest rate
• Interest rate Return of your saving
• Interest rate increases gt more incentive for
  depositors

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Financial markets and Financial intermediaries

• Financial markets
• The Bond and Stock market
• Financial intermediaries
• Banks and mutual funds

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• Which one is more important?
• Banks and financial intermediaries are more
  important and especially in terms of for
  effectiveness of monetary policy

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Federal Reserve and its monetary policy

• Fed organization
• Founded in 1913 and designed
• to be independent
• Run by Board of governors
• 12 branches and one of them is the most important

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12 branches
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Functions of Fed
FED
Federal Open Market Committee (FOMC)
Regional branches
Control money supply (Monetary Policy)
Regulate banks
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FOMC

• Board of Directors (seven members) five
  regional branch presidents
• FOMC determines money supply by increasing or
  decreasing interest rate (Federal Funds Rate)
  (borrowers side)
• http//www.federalreserve.gov/monetarypolicy/fomc.
  htmcalendars

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How interest rate can influence the economy?

• Lower interest (money supply increases) gt
  stimulate production gt higher inflation
• Higher interest (money supply decreases) gt
  reduce production gt lower inflation

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How FOMC control money supply

• Open market operation purchase or sell U.S.
  government bonds.
• Purchase gt increase money supply (interest rate
  decrease)
• Sell gt decrease money supply (interest increase)

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However, banks are hard to control

• Because banks can create money
• Thus, Fed has no absolute control of money supply

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How banks create money?

• Fractional-reserve banking
• Reserve Ratio
• Money Multiplier
• The amount of money the banking system can
  generate with each dollar from Fed
• Equal to the reciprocal of the reserve ratio

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Fed Monetary Policies

• FFR (FOMC)
• Reserve Requirement
• Discount Window

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Federal Funds Rate
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• Reserve requirement (for depositary institutions)
• 10
• Source Federal Reserve Bulletin Board (Feb 2008)

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Discount Rate

• Discount rate was lowered from 4-3/4 to 4
  percent.
• Board of Director meeting minutes (Jan 21)

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Challenges for Monetary Policies

• Uncertainty of money supply comes from
• Household saving
• Banks lending

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Example Could Fed save the day?

• 1930 Great Depression

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Could Fed save the day? (contd)

• 1930s Great Depression
• Housing market bubble burst (plus a deflation)
• Banks collapsed (Bank panic)
• Economy then was doomed

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Could Fed save the day? (contd)

• Feds response
• Tighten credits of banks (increase interest rate)
• Allow banks to close (Free market may not be the
  best choice sometimes)

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Could Fed save the day? (contd)

• Todays economy greatly resembles years before
  the Great Depression.
• Will the Great Depression happen again?
• Has Fed learned how to deal with current economic
  problems from its own history?

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Government Deficit and the Economy

• What are the consequences of maintaining a large
  government deficit?
• We know I S
• Saving public saving (government saving)
  private saving

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• From a simple model (the loanable funds market)
  to tell how a huge government deficit may ruin
  your day. (note real interest rate for the
  loanable funds marekt.)

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• Impacts of a huge government deficit
• crowding out effect
• when the government reduces national saving
  by running a budget deficit, the interest rate
  rises, and investment falls.