The Money Supply and the Federal Reserve System

WHAT IS MONEY? Money is anything that is generally accepted as a medium of exchange A Means of Payment, or Medium of Exchange barter The direct exchange of goods and services for other goods and services. medium of exchange, or means of payment What sellers generally accept and buyers generally use to pay for goods and services. A Store of Value store of value An asset that can be used to transport purchasing power from one time period to another. liquidity property of money The property of money that makes it a good medium of exchange as well as a store of value: It is portable and readily accepted and thus easily exchanged for goods. A Unit of Account unit of account A standard unit that provides a consistent way of quoting prices. COMMODITY AND FIAT MONIES commodity monies Items used as money that also have intrinsic value in some other use. fiat, or token, money Items designated as money that are intrinsically worthless legal tender Money that a government has required to be accepted in settlement of debts. currency debasement The decrease in the value of money that occurs when its supply is increased rapidly. MEASURING THE SUPPLY OF MONEY IN THE UNITED STATES M1: Transactions Money M1, or transactions money Money that can be directly used for transactions. M1 currency held outside banks + demand deposits + travelers checks + other checkable deposits M2: Broad Money near monies Close substitutes for transactions money, such as savings accounts and money market accounts. M2, or broad money M1 plus savings accounts, money market accounts, and other near monies. M2 M1 + savings accounts + money market accounts + other near monies Beyond M2 There are no rules for deciding what is money and what is not. This poses problems for economists and those in charge of economic policy. THE PRIVATE BANKING SYSTEM financial intermediaries Banks and other institutions that act as a link between those who have money to lend and those who want to borrow money A HISTORICAL PERSPECTIVE: GOLDSMITHS run on a bank Occurs when many of those who have claims on a bank (deposits) present them at the same time.

THE MODERN BANKING SYSTEM A Brief Review of Accounting Assets Liabilities Net or Assets Liabilities + Net Worth Federal Reserve Bank (the Fed) The central bank of the United States. HOW BANKS CREATE MONEY

Worth,

T-Account for a Typical Bank (millions of dollars) reserves The deposits that a bank has at the Federal Reserve bank plus its cash on hand. required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Federal Reserve. When some item on a banks balance sheet changes, there must be at least one other change somewhere else to maintain balance. THE CREATION OF MONEY Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction. excess reserves The difference between a banks actual reserves and its required reserves. excess reserves actual reserves required reserves

Balance Sheets of a Bank in a Single-Bank Economy

The Creation of Money When There Are Many Banks THE MONEY MULTIPLIER

An increase in bank reserves leads to a greater than one-for-one increase in the money supply. Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multiplier. Stated somewhat differently, the money multiplier is the multiple by which deposits can increase for every dollar increase in reserves. money multiplier The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio.

1 required reserve ratio THE FEDERAL RESERVE SYSTEM money multiplier

Federal Open Market Committee (FOMC) A group composed of the seven members of the Feds Board of Governors, the president of the New York Federal Reserve Bank, and four of the other eleven district bank presidents on a rotating basis; it sets goals concerning the money supply and interest rates and directs the operation of the Open Market Desk in New York. Open Market Desk The office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed. FUNCTIONS OF THE FEDERAL RESERVE Clearing Interbank Payments The Fed does it. The funds move at the speed of electricity from one computer account to another. Other Duties of the Fed lender of last resort One of the functions of the Fed: It provides funds to troubled banks that cannot find any other sources of funds. THE FEDERAL RESERVE BALANCE SHEET TABLE 10.1 Assets and Liabilities of the Federal Reserve System, August 3, 2005 (Millions of Dollars) ASSETS LIABILITIES

Gold

4,037

$729,601

Federal Reserve notes (outstanding) Deposits:

Loans to banks U.S. Treasury securities

3,330 724,700 26,130

Bank reserves (from depository institutions) U.S.

4,813

Treasury All other assets Total $ 60,366 81,843 820,910 $820,910 All other liabilities and net worth Total

Source: Board of Governors of the Federal Reserve System. HOW THE FEDERAL RESERVE CONTROLS THE MONEY SUPPLY Three tools are available to the Fed for changing the money supply: (1) changing the required reserve ratio; (2) changing the discount rate; and (3) engaging in open market operations. THE REQUIRED RESERVE RATIO TABLE 10.2 A Decrease in the Required Reserve Ratio from 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars) PANEL 1: REQUIRED RESERVE RATIO = 20% Federal Reserve Assets Government securities $200 Liabilities $100 $100 Reserves Currency Commercial Banks Assets Reserves Loans $100 $400 Liabilities $500 Deposits

Note: Money supply (M1) = Currency + Deposits = $600. PANEL 2: REQUIRED RESERVE RATIO = 12.5% Federal Reserve Assets Government securities $200 Liabilities $100 $100 Reserves Currency Commercial Banks Assets Reserves Loans (+ $300) $100 $700 Liabilities $800 Deposits (+ $300)

Note: Money supply (M1) = Currency + Deposits = $900. THE DISCOUNT RATE discount rate Interest rate that banks pay to the Fed to borrow from it. HOW THE FEDERAL RESERVE CONTROLS THE MONEY SUPPLY

The Fed can influence bank borrowing, and thus the money supply, through the discount rate: moral suasion The pressure that in the past the Fed exerted on member banks to discourage them from borrowing heavily from the Fed. OPEN MARKET OPERATIONS open market operations The purchase and sale by the Fed of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply. Two Branches of Government Deal in Government Securities The Treasury Department is responsible for collecting taxes and paying the federal governments bills. The Fed is not the Treasury. Instead, it is a quasi-independent agency authorized by Congress to buy and sell outstanding (preexisting) U.S. government securities on the open market. We can sum up the effect of these open market operations this way: An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves. An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves.

Money Demand, the Equilibrium Interest Rate, and Monetary Policy

The Keynes Demand for money

MONEY DEMAND, THE EQUILIBRIUM INTEREST RATE, AND MONETARY POLICY monetary policy The behavior of the Central Bank Reserve concerning the money supply. interest The fee that borrowers pay to lenders for the use of their funds. interest rate The annual interest payment on a loan expressed as a percentage of the loan. Equal to the amount of interest received per year divided by the amount of the loan.

Interest rate

interest received per year x100 amount of the loan

The demand for money When we speak of the demand for money, we are concerned with how much of your financial assets you want to hold in the form of money, which does not earn interest, versus how much you want to hold in interest-bearing securities, such as bonds. THE TRANSACTION MOTIVE transaction motive The main reason that people hold moneyto buy things. Assumptions There are only two kinds of assets liquid available to households: bonds and money. The typical households income arrives once a month, at the beginning of the month. Spending occurs at a completely uniform ratethe same amount is spent each day. Spending is exactly equal to income for the month. nonsynchronization of income and spending The mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses MONEY MANAGEMENT AND THE OPTIMAL BALANCE

THE SPECULATION MOTIVE When market interest rates fall, bond values rise; when market interest rates rise, bond values fall. speculation motive One reason for holding bonds instead of money: Because the market value of interest-bearing bonds is inversely related to the interest rate, investors may wish to hold bonds when interest rates are high with the hope of selling them when interest rates fall. When market interest rates fall, bond values rise; when market interest rates rise, bond values fall. If someone buys a 10-year bond with a fixed rate of 10%, and a newly issued 10-year bond pays 12%, then the old bond paying 10% will have fallen in value.| Higher bond prices mean that the interest a buyer is willing to accept is lower than before. When interest rates are high (low) and expected to fall (rise), demand for bonds is likely to be high (low) thus money demand is likely to be low (high). THE TOTAL DEMAND FOR MONEY The total quantity of money demanded in the economy is the sum of the demand for checking account balances and cash by both households and firms. At any given moment, there is a demand for moneyfor cash and checking account balances. Although households and firms need to hold balances for everyday transactions, their demand has a limit. For both households and firms, the quantity of money demanded at any moment depends on the opportunity cost of holding money, a cost determined by the interest rate. TRANSACTIONS VOLUME AND THE PRICE LEVEL An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve to the Right For a given interest rate, a higher level of output means an increase in the number of transactions and more demand for money. The money demand curve shifts to the right when Y rises. Similarly, a decrease in Y means a decrease in the number of transactions and a lower demand for money. The money demand curve shifts to the left when Y falls. The amount of money needed by firms and households to facilitate their day-to-day transactions also depends on the average dollar amount of each transaction. In turn, the average amount of each transaction depends on prices, or instead, on the price level. Increases in the price level shift the money demand curve to the right, and decreases in the price level shift the money demand curve to the left. Even though the number of transactions may not have changed, the quantity of money needed to engage in them has. THE DETERMINANTS OF MONEY DEMAND: REVIEW The interest rate: r (negative effect causes downward-sloping money demand) The dollar volume of transactions (positive effects shift the money demand curve)

A. Aggregate output (income): Y (positive effect: money demand shifts right when Y increases) B. The price level: P (positive effect: money demand shifts right when P increases) Some Common Pitfalls Money demand is not a flow measure. Instead, it is a stock variable, measured at a given point in time. Many people think of money demand and saving as roughly the samethey are not. Recall the difference between a shift in a demand curve and a movement along the curve. Changes in the interest rate cause movements along the curvechanges in the quantity of money demanded. THE EQUILIBRIUM INTEREST RATE We are now in a position to consider one of the key questions in macroeconomics: How is the interest rate determined in the economy? The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy. SUPPLY AND DEMAND IN THE MONEY MARKET

Adjustments in the Money Market CHANGING THE MONEY SUPPLY TO AFFECT THE INTEREST RATE

The Effect of an Increase in the Supply of Money on the Interest Rate INCREASES IN Y AND SHIFTS IN THE MONEY DEMAND CURVE

LOOKING AHEAD: THE CENTRAL BANK AND MONETARY POLICY The Feds use of its power to influence events in the goods market, as well as in the money market, is the center of the governments monetary policy. tight monetary policy Fed policies that contract the money supply in an effort to restrain the economy. easy monetary policy Fed policies that expand the money supply in an effort to stimulate the economy.

Money, the Interest Rate, and Output: Analysis and Policy

goods market The market in which goods and services are exchanged and in which the equilibrium level of aggregate output is determined money market The market in which financial instruments are exchanged and in which the equilibrium level of the interest rate is determined.

THE LINKS BETWEEN THE GOODS MARKET AND THE MONEY MARKET There are two key links between the goods market and the money market: Link 1: Income and the Demand for Money Income, which is determined in the goods market, has considerable influence on the demand for money in the money market. Link 2: Planned Investment Spending and the Interest Rate The interest rate, which is determined in the money market, has significant effects on planned investment in the goods market. Links Between the Goods Market and the Money Market

INVESTMENT, THE INTEREST RATE, AND THE GOODS MARKET

When the interest rate falls, planned investment rises. When the interest rate rises, planned investment falls.

The effects of a change in the interest rate include: High interest rate (r) discourages planned investment (I). Planned investment is a part of planned aggregate expenditure (AE). Thus, when the interest rate rises, planned aggregate expenditure (AE) at every level of income falls. Finally, a decrease in planned aggregate expenditure lowers equilibrium output (income) (Y) by a multiple of the initial decrease in planned investment.

Using a convenient shorthand:

r I AE Y r I AE Y
The equilibrium level of the interest rate is not determined exclusively in the money market. Changes in aggregate output (income) (Y), which take place in the goods market, shift the money demand curve and cause changes in the interest rate. With a given quantity of money supplied, higher levels of Y will lead to higher equilibrium levels of r. Lower levels of Y will lead to lower equilibrium levels of r, as represented in the following symbols:

Y M

Y M d r
EXPANSIONARY POLICY EFFECTS expansionary fiscal policy An increase in government spending or a reduction in net taxes aimed at increasing aggregate output (income) (Y). expansionary monetary policy An increase in the money supply aimed at increasing aggregate output (income) (Y).

COMBINING THE GOODS MARKET AND THE MONEY MARKET Expansionary Fiscal Policy: An Increase in Government Purchases (G) or a Decrease in Net Taxes (T) crowding-out effect The tendency for increases in government spending to cause reductions in private investment spending. interest sensitivity or insensitivity of planned investment The responsiveness of planned investment spending to changes in the interest rate. Interest sensitivity means that planned investment spending changes a great deal in response to changes in the interest rate; interest insensitivity means little or no change in planned investment as a result of changes in the interest rate.

Effects of an expansionary monetary policy:

M s r I Y M d
r decreases less than if M d did not increase

CONTRACTIONARY POLICY EFFECTS Contractionary Fiscal Policy: A Decrease in Government Spending (G) or an Increase in Net Taxes (T) contractionary fiscal policy A decrease in government spending or an increase in net taxes aimed at decreasing aggregate output (income) (Y).

Effects of a contractionary fiscal policy:

G or T Y M d r I
Y decreases less than if r did not decrease
THE MACROECONOMIC POLICY MIX policy mix The combination of monetary and fiscal policies in use at a given time. OTHER DETERMINANTS OF PLANNED INVESTMENT The determinants of planned investment are The interest rate Expectations of future sales Capital utilization rates Relative capital and labor costs

Aggregate Demand, Aggregate Supply, and Inflation

THE AGGREGATE DEMAND CURVE aggregate demand The total demand for goods and services in the economy. Money demand is a function of three variables: the interest rate (r), the level of real income (Y), and the price level (P). (Remember, Y is real output, or income. It measures the actual volume of output, without regard to changes in the price level.) Money demand will increase if the real level of output (income) increases, the price level increases, or the interest rate declines. DERIVING THE AGGREGATE DEMAND CURVE THE AGGREGATE DEMAND CURVE: A WARNING Aggregate demand falls when the price level increases because the higher price level causes the demand for money (Md) to rise. With the money supply constant, the interest rate will rise to reestablish equilibrium in the money market. It is the higher interest rate that causes aggregate output to fall. The AD curve is not the sum of all the market demand curves in the economy. It is not a market demand curve. OTHER REASONS FOR A DOWNWARD-SLOPING AGGREGATE DEMAND CURVE The Consumption Link Planned investment does not bear all the burden of providing the link from a higher interest rate to a lower level of aggregate output. Decreased consumption brought about by a higher interest rate also contributes to this effect. The Real Wealth Effect real wealth, or real balance, effect The change in consumption brought about by a change in real wealth that results from a change in the price level. An increase in the price level lowers the real value of some types of wealth.

SHIFTS OF THE AGGREGATE DEMAND

Factors That Shift the Aggregate Demand Curve THE AGGREGATE SUPPLY CURVE aggregate supply The total supply of all goods and services in an economy. THE AGGREGATE SUPPLY CURVE: A WARNING aggregate supply (AS) curve A graph that shows the relationship between the aggregate quantity of output supplied by all firms in an economy and the overall price level. An aggregate supply curve in the traditional sense of the word supply does not exist. What does exist is what we might call a price/output response curvea curve that traces out the price decisions and output decisions of all the markets and firms in the economy under a given set of circumstances. AGGREGATE SUPPLY IN THE SHORT RUN Capacity Constraints Even if firms are not holding excess labor and capital, the economy may be operating below its capacity if there is cyclical unemployment. Output Levels and Price/Output Responses An increase in aggregate demand when the economy is operating at low levels of output is likely to result in an increase in output with little or no increase in the overall price level. That is, the aggregate supply (price/output response) curve is likely to be fairly flat at low levels of aggregate output. When the economy is producing at its maximum level of outputthat is, at capacity the aggregate supply curve becomes vertical. The Response of Input Prices to Changes in the Overall Price Level If input prices changed at exactly the same rate as output prices, the AS curve would be vertical. Wage rates may increase at exactly the same rate as the overall price level if the price level increase is fully anticipated. Input pricesparticularly wage ratestend to lag behind increases in output prices for a variety of reasons. Shifts in aggregate supply in the short run

THE EQUILIBRIUM PRICE LEVEL equilibrium price level The price level at which the aggregate demand and aggregate supply curves intersect.

THE LONG-RUN AGGREGATE SUPPLY CURVE If wage rates and other costs fully adjust to changes in prices in the long run, then the long-run AS curve is vertical. POTENTIAL GDP

LONG-RUN AGGREGATE SUPPLY AND POLICY EFFECTS If the AS curve is vertical in the long run, neither monetary policy nor fiscal policy has any effect on aggregate output in the long run. CAUSES OF INFLATION INFLATION VERSUS SUSTAINED INFLATION: A REMINDER inflation An increase in the overall price level. sustained inflation Occurs when the overall price level continues to rise over some fairly long period of time. DEMAND PULL INFLATION demand-pull inflation Inflation that is initiated by an increase in aggregate demand. COST-PUSH, OR SUPPLY-SIDE, INFLATION EXPECTATIONS AND INFLATION

Cost Shocks Are Bad News for Policy Makers MONEY AND INFLATION

Sustained Inflation from an Initial Increase in G and Fed Accommodation

The Labor Market, Unemployment, and Inflation

THE LABOR MARKET: BASIC CONCEPTS The labor force (LF) is the number of employed plus unemployed: LF = E + U unemployment rate The number of people unemployed as a percentage of the labor force. Unemployment rate = U/LF frictional unemployment The portion of unemployment that is due to the normal working of the labor market; used to denote short-run job/skill matching problems. structural unemployment The portion of unemployment that is due to changes in the structure of the economy that result in a significant loss of jobs in certain industries. cyclical unemployment The increase in unemployment that occurs during recessions and depressions. Employment tends to fall when aggregate output falls and to rise when aggregate output rises. A decline in the demand for labor does not necessarily mean that unemployment will rise. THE CLASSICAL VIEW OF THE LABOR MARKET The Classical Labor Market labor supply curve A graph that illustrates the amount of labor that households want to supply at each given wage rate. labor demand curve A graph that illustrates the amount of labor that firms want to employ at each given wage rate. THE CLASSICAL LABOR MARKET AND THE AGGREGATE SUPPLY CURVE The classical idea that wages adjust to clear the labor market is consistent with the view that wages respond quickly to price changes. This means that the AS curve is vertical. When the AS curve is vertical, monetary and fiscal policy cannot affect the level of output and employment in the economy. THE UNEMPLOYMENT RATE AND THE CLASSICAL VIEW The unemployment rate is not necessarily an accurate indicator of whether the labor market is working properly. The measured unemployment rate may sometimes seem high even though the labor market is working well. EXPLAINING THE EXISTENCE OF UNEMPLOYMENT STICKY WAGES sticky wages The downward rigidity of wages as an explanation for the existence of unemployment.

Social, or Implicit, Contracts social, or implicit, contracts Unspoken agreements between workers and firms that firms will not cut wages. relative-wage explanation of unemployment An explanation for sticky wages (and therefore unemployment): If workers are concerned about their wages relative to other workers in other firms and industries, they may be unwilling to accept a wage cut unless they know that all other workers are receiving similar cuts. Explicit Contracts explicit contracts Employment contracts that stipulate workers wages, usually for a period of 1 to 3 years. cost-of-living adjustments (COLAs) Contract provisions that tie wages to changes in the cost of living. The greater the inflation rate, the more wages are raised

EFFICIENCY WAGE THEORY efficiency wage theory An explanation for unemployment that holds that the productivity of workers increases with the wage rate. If this is so, firms may have an incentive to pay wages above the marketclearing rate. IMPERFECT INFORMATION Firms may not have enough information at their disposal to know what the market-clearing wage is. In this case, firms are said to have imperfect information. If firms have imperfect or incomplete information, they may set wages wrongwages that do not clear the labor market. MINIMUM WAGE LAWS minimum wage laws Laws that set a floor for wage ratesthat is, a minimum hourly rate for any kind of labor. AN OPEN QUESTION The aggregate labor market is very complicated, and there are no simple answers to why there is unemployment. In the short run, the unemployment rate (U) and aggregate output (income) (Y) are negatively related When Y rises, the unemployment rate falls, and when Y falls, the unemployment rate rises. THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION

The Relationship Between the Price Level and the Unemployment Rate inflation rate The percentage change in the price level. Phillips Curve A graph showing the relationship between the inflation rate and the unemployment rate.

THE PHILLIPS CURVE: A HISTORICAL PERSPECTIVE

Unemployment and Inflation, 19601969

Unemployment Inflation, 19702004

and

The Role of Import Prices

EXPECTATIONS AND THE PHILLIPS CURVE Expectations are self-fulfilling. This means that wage inflation is affected by expectations of future price inflation. Price expectations that affect wage contracts eventually affect prices themselves. Inflationary expectations shift the Phillips Curve to the right

IS THERE A SHORT-RUN TRADE-OFF BETWEEN INFLATION AND UNEMPLOYMENT? There is a short-run trade off between inflation and unemployment, but other factors besides unemployment affect inflation. Policy involves much more than simply choosing a point along a nice, smooth curve. THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL GDP, AND THE NATURAL RATE OF UNEMPLOYMENT THE NONACCELERATING INFLATION RATE OF UNEMPLOYMENT (NAIRU) NAIRU The non accelerating inflation rate of unemployment