Money and Monetary Policy Objectives Examine

Money and Monetary Policy

Objectives • Examine the characteristics and functions of money • Identify three tools used to control with value of a given currency • Explain how monetary policy tools are used to control the macroeconomic environment • C 3 Po 5&6

Before money we had Barter • Barter is a voluntary exchange of items which are not alike or set in value • Barter is alive and well, but has drawbacks

Drawbacks of Barter • Uncertain connection of producers & consumers • Uncertain valuation of barter goods • Indivisibility of some barter goods • Storage of excess

Money is… • 6 characteristics (U. P. A. D. D. L) – Uniform – Portable – Acceptability – Durable – Divisible – Limited Supply

U. P. Uniform Portable • Looks the same over time • Changes well publicized • Light and Flexible • Metals, Cotton, Plastic • Yap Islander Coins

A. D. Acceptability • US Dollar is int’l reserve currency (used by smaller countries to store value) • Accepted worldwide except (officially) by Cuba and N. Korea Durable • Average life of a $1 bill • 6 months • Average life of a $1 coin • 13 years! • Made of metals, cotton, plastic, shell,

D. L. Divisible Limited Supply • Available in various denominations • • • Mexico= Pesos & Centavos Russia= Rubles & Kopeks UK= Pounds & Pence India= Rupees & Paistres China= Yuan & Jiao • Small supply= High Value • Old bills shredded • Counterfeits increase Q Supply • http: //www. newmoney. gov /newmoney/flash/interactiv e 100/index. html

Who’s on the Money Matching US Historical Figure • • A. Jackson B. Lincoln C. Jefferson D. Washington E. Grant F. Franklin G. Hamilton Denomination • • $1 $2 $5 $10 $20 $50 $100

Three Functions of Money • Money Does… – Medium of exchange • I trade 1 hour labor for $31. 25/hr + benefits – Unit of account • I check prices at several stores – Store of Value • I have $2000 in my savings

Monetary Policy (Simplified)

Monetary Policy • Monetary policy manipulates the Q Supply of money in circulation to lessen bad effects of business cycles • M Policy is controlled through – Interest Rates – Reserve Ratios – Bond Sales

Interest • Interest is a % fee paid to borrow money • The Federal Reserve set the Prime Interest Rate, – PIR= the interest Federal Reserve charge large banks for large loans via the “Discount Window” • The Federal Reserve can speed up borrowing by lowering the Prime Interest Rate • The Federal Reserve can slow borrowing by raising the Prime Interest Rate

US Federal Reserve • The Federal Reserve is the Central Banking System of the United States – Run by Board of Governors – Divided into 12 regions ($1 letters A-L) – Made up of member banks • Bank of America, Chase

From Interest to Demand

Prime Interest Rate Practice Up Or Down? Up or Down • The US economy is going to fast and prices are feeling inflationary pressures (going up) hurting consumers. The Fed should… • The US economy is falling fast into recession. Prices are deflating (dropping), hurting businesses. The Fed should…. • Raise Interest Rates to increase borrowing costs • Lower Interest Rates to increase borrowing costs • Raise Interest Rates to decrease borrowing costs • Lower Interest Rates to decrease borrowing costs

Reserve Ratio • Banks work by loaning out depositors money and collecting interest – Assuming few depositors will need money daily – Assuming loans will be repaid on time with interest • Reserve Ratio is the amount of money banks must keep on hand to cover withdrawals. • Set by Federal Reserve • Lower reserves=Faster economy • Higher reserves=Slower economy

$Money Multiplier Effect • Formally called fractional reserve banking • Money Multiplier is the$

Money Multiplier Effect • Formally called fractional reserve banking • Money Multiplier is the effect of a cycle of deposits and loans in money creation

Reserve Ratio Practice Increase or Decrease? • Banks are making riskier and • Despite Record Low Interest riskier loans, and home rates, Home prices continue prices are spiking higher. to drop. The Fed should… • Increase the Reserve Ratio to cover possible losses • Decrease the Reserve Ratio to cover possible losses • Increase the reserve ratio to stimulate demand • Decrease the reserve ratio to stimulate demand

Bond Sales • Bond Sales- Also Called Open Market Operations, this is the most used monetary policy tool • US Bonds borrow money from public for US gov. use. • Federal Reserve Eases Monetary Policy though buying US Treasury bonds from investors • Federal Reserve Tightens Monetary Policy through selling US Treasury bonds to investors. • The Fed Can fight inflation by Selling Bonds

Easing and Tightening Example Easing • I spend $50, 000 to buy a $100, 000 US Treasury Bond, due in 2030. • Fed Reserve wants me to spend more money right now-speed up economy • Fed offers to buy the bond from me today for $75, 000. • I accept, and can now spend principle (50 k) + profit (25 k) tomorrow on a Corvette. • Fed can cash in bond in 20 yrs for a $25, 000 profit Tightening • Fed owns $100, 000 US Treasury Bond, due in 2020 yrs. Purchase price was $75 k • Fed wants me to stop spending-slow economy • Fed offers to sell me bond today for $80, 000. Profit? • I accept and tie up my money for 10 years. Economy slows. • I cash in bond in 2020. Profit?

Easing/Tightening Practice E or T? • Economy is going too fast and inflation is starting to drive up prices. Should the Fed… • Economy is slowing and unemployment is starting to rise. Should the Fed… • BUY Bonds to take money out of circulation • SELL Bonds to take money out of circulation • BUY Bonds to put money back into circulation • SELL Bonds to put money back into circulation

Fed Reserve Chairman Game • http: //www. frbsf. o rg/education/activi ties/chairman/inde x. html

• So where is the most money in the banking system? – M 1 • Cash and Cash instruments – M 2 • Small Value, Short Time Deposits – M 3 • Large Value, Longer Time Deposits (best rates of interest M 1 -M 3

Summary • Money is a tool • The Federal Reserve Controls Money Supply in the USA • Interest Rates, Reserve Ratios and Bond Sales are three main monetary Tools • Most of the money in the economy is in investments, land other long term assets