Monetary Policy

Monetary Policy

3 Tools of Monetary Policy

1. Reserve Requirement 

•     - Only small % of deposit is in the safe. The rest is loaned out. Fractional Reserve Banking
•     - RR is % deposits that must not be loaned out
•     - If fed increases money supply it increases money held in bank deposits 
• - During recession, fed decreases RR to increase money supply, decrease interest, increasing AD
• - During inflation, fed increases RR, decreasing money supply, increasing interest, and decreasing AD
• . Discount Rate
• - interest rate Fed charges commercial banks
• - To increase money supply, decrease discount rate (easy money)
• - To decrease money supply, fed increases discount rate (tight money)
• . Open Market Operations (OMO)
• - Fed buys and sells bonds
• - Most widely used monetary policy
• - To increase money supply, Fed buys securities (bonds)
• - To decrease money supply, Fed sells bonds

Expansionary (recession) v. Contractionary (inflation) Policy

Expansionary 

- Buy Bonds (omo)

- Decrease Discount Rate

- Decrease RR

- MS Increase

- AD increase

- GDP increase

- interest decrease

- Loans increase

Contractionary

- Sell bonds

- Increase discount rate

- RR increase

- MS decreases 

- AD decrease

- GDP decrease

- Interest increase

- Loans decrease

Federal Fund Rate - FDIC member banks make overnight loans to other 

banks

Prime Rate - interest rate banks charge to most credit worthy customers

FED

FED

The Fed

1. control money supply
2. issue paper currency
3. set reserve requirements and hold reserves of banks
4. lend money to banks & charge them interests
5. acts as personal bank for government
6. supervises member banks

Reserve Requirement
- The FED requires banks to always have some money readily available to meet consumers' demand for cash
- The amount set by the FED is required reserve ratio
- The RRR is the % of demand deposits (checking account balances) that must not be loaned out
- typical RRR = 10%

 Types of Multiple Deposit Expansion Question

1. Type 1 - Calculate initial change in excess reserves, aka amount a single bank can loan from initial deposit
2. Type 2 - Calculate change in loans in banking system
3. Type 3 - Calculate change in money supply

Type 2 & 3 may have same results ( no FED involvement)

Bank Liabilities

• Demand Deposits (DD) are cash deposits from the public
• Owner's Equity or Stock Shares are values of bank stocks as held by the public

Bank Assets

• Required Reserve (RR), the percentage of DD required to be stored in the Vault
• Excess Reserves (ER), the remaining % of DD after RR, that is used for loans
• Property, or bank property value statement

Fed Bonds can move in two ways:

1. The Fed sells them to banks and increases amount
2. The Fed buys them from banks and decreases amount

time money value

Time Value of Money

Is a dollar today worth more than a dollar tomorrow?
-Yes because of inflation/opportunity cost; this is the reason for charging & paying interest

Let v = future value of $$, p = present value of $$, r = real interest rate (nominal - inflation) expressed as a decimal, n = years, k = # of times interest is credited per year

The Simple Interest Formula
v = ( 1 + r ) ^ n x P

The Compound Interest Formula
v = (1 + r/k) ^ nk x P

-Assume that inflation is expected to be 3 % and nominal interest rate on simple is 1%. Calculate future value of 1$ after a year.
r% = i% - #%     1 = ( 1 - .02)^1 x 1

1. Calculate interest rate first
2. Use compound interest formula

-Demand for money has an inverse relationship between nominal interest rates and quantity of money demanded

 What happens to quantity demanded of $ when interest rates increase?
-Quantity demanded falls (interest earning assets instead of borrowed)

 What happens to quantity demanded when interest rates decrease?
-Quantity demanded increases, no incentives to convert cash

What happens if PL increase?
Money Demand Shifter
1). Changes in price level
-increase money supply --> decrease interest rate --> investment increases --> increase AD
-decrease money supply --> increase interest rate --> investment decreases --> decrease AD

Financial Assets (own; bank holds, legal claim, uses of funds) vs Financial liabilities ( claims against bank, sources of funds)
-interest rate: cost of borrowing money
-stocks vs. bonds

What banks Do
- A bank is a financial intermediary

• uses liquid assets to finance investments of borrowers
• process is known as Frictional Reserve Banking ( a system in which depository institutions hold liquid assets < amount of deposits
• can take form of : currency in bank vaults; bank reserves deposits held at federal reserve
• T- account ( balance sheet ) statements of assets and liabilities

Unit 4 - money

Money

1) Uses of money

1. medium of exchange (trade)
2. unit of account (establishes economic worth in exchange process)
3. store of value (money holds is value over period of time whereas products may not)

2) Types of money

1. Commodity money (it gets its value from type of material from which it is made)
2. Representative money- paper money that is backed by something tangible that gives it value
3. flat money- it has its value because government says so

3) Characteristics of money

• durable
• portable
• scarce
• acceptable
• uniform
• divisible

4) Money Supply

1. M1 money- currency, checkable deposits (demand deposits, checking accounts), traveler's checks. Easy to convert in cash (most liquid)
2. M2 money- consists of M1 money + savings accounts + deposits held by banks outside the U.S.
3. M3 money- includes M2 money + certificates of deposits

Unit 4 video