Money, Money Markets, and Monetary Policy

1
Money, MoneyMarkets, and Monetary Policy

• Chapter 16

2
Functions of Money

• Medium of exchange facilitates payment to
  others for goods and services
• Unit of accounting assessing profitability of
  businesses, household budgets and aggregate
  variables like GDP
• Store of value money is a liquid asset which
  has value in investment portfolios and cash flow
  decisions of businesses and households

3
Functions of the Fed

• Supply the economy with paper currency
• Supervise member banks
• Provide check collection and clearing services
• Maintain the reserve balances of depository
  institutions
• Lend to depository institutions
• Act at the federal governments banker and fiscal
  agent
• Regulate the money supply

4
The Feds Policy Instruments

• Reserve requirements depository institutions
  are required to maintain a specific fraction of
  their customers deposits as reserves.
• Discount rate rate depository institutions pay
  when they borrow from the Fed
• Open market operations Fed can buy or sell
  government securities to alter the money supply

5
Role of the Board of Governors of the Federal
Reserve System
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Key role played by the Federal Open
Market Committee or FOMC
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Role of the 12 District Federal Reserve
Banks located throughout the country
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Location of the 12 District Federal Reserve Banks
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Existing money supply curve. Note it
is perpendicular to the quantity axis,
implying it is invariant to the interest rate.
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Expansionary monetary policy actions will shift
the MS curve to the right over a period of 12
months or so.
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Contractionary monetary policy actions, on
the other hand, will shift the money supply curve
to left over a similar time period.
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Suppose a depositor in Bank Ag sells 1 million
in government securities to the Fed. He then
deposits the proceeds from the sale in his bank.
If the fractional reserve requirement ratio is 20
percent, Bank Ag can increase the volume of its
loans by 800,000. Suppose the proceeds of
these loans are deposited in Bank B. Follow the
trail to the Total line.
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Change in the Money Supply
We can skip tracing deposits through the economy
by using the following money supply (MS)
equation MS (1.0 RR) x TR where TR
represents total reserves and RR is the reserve
requirement ratio. The expression with
the brackets is known as the money multiplier.
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Change in the Money Supply
We can skip tracing deposits through the economy
by using the following money supply (MS)
equation MS (1.0 RR) x TR where TR
represents total reserves and RR is the reserve
requirement ratio. The expression with
the brackets is known as the money
multiplier. Using the example of the 1 million
deposit in the previous slide and 20 reserve
requirements ratio, ?MS (1.0 .20) x ?TR
5.0 x 1 million 5 million
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Effects of Changing Policy
Expansionary actions Effects of action Fed
buys securities in open market total reserves
increase Fed lowers the discount rate total
reserves increase Fed lowers required reserve
ratio money multiplier increases Contractionary
actions Effects of action Fed sells
securities in open market total reserves
decrease Fed raises the discount rate total
reserves decrease Fed raises required reserve
ratio money multiplier decreases
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Demand for Money

• Transactions demand for money carry cash to pay
  for normal expenditures
• Precautionary demand for money carry cash to
  cover unexpected expenditures
• Speculative demand for money hold cash as an
  asset in investment portfolios since the value of
  cash does not decline during periods of falling
  asset prices.

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The money demand curve in both panels above is
given by MD c d(R) e(NI) where R is the
rate of interest and NI is national income. The
coeffi- cient d is the slope of the curve and e
represents ?MD ?NI.
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MSE
Expansionary monetary policy lowers interest rates
0.06
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MSC
Contractionary monetary policy raises
interest rates
0.14
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The full effects of this change could take 12
months or more to register in bank deposits
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A change in the money supply will alter
the equilibrium interest rate in the money market
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We know from Chapter 14 that a change in interest
rates will lead to movement along the planned
investment function.increasing or decreasing new
investment
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We also know from Chapter 14 that increased
investment expenditures, a component of GDP,
increases the demand for labor, lowers
unemployment and thus fuels further growth in
national income
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The use of expansionary monetary policy
actions to push aggregate demand from AD1 to AD3
increases real GDP from Y1 to Y3 while only
increasing the general price level to P3.
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The further use of expansionary monetary policy
to push aggregate demand from AD3 to AD4
increases real GDP from Y3 to YFE (full
employment GDP), but increases the general price
level to P4. This is almost an even trade-off
in terms of the Phillips curve discussed in
Chapter 15.
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The use of expansionary monetary policy to
attain YPOT by shifting aggregate demand to AD5
will increase the general price level to P5. This
trade-off would make no sense to the Fed.
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