Macroeconomics7

Module 7 Lecture (Ch. 18): Money and the Monetary System

What Is Money?

The answer seems simple enough, yet there are some false illusions as to what is and what is not money. Basically, money is anything that is commonly accepted in an economy as a means of payment.

Money in an economy serves 3 specific purposes:

1. Medium of Exchange – it’s an object that may be used to trade for goods and services
2. Unit of Account – This takes a medium of exchange and translates the value of economic goods or services into the medium of exchange’s terms. For instance, a gallon of gas may be translated into the medium of exchange’s terms as $5 for one gallon.
3. Store of Value – just means that the medium of exchange will retain much of its value into the future.

There was a funny story back in 2001 about someone who printed up $200 dollar bills with George Bush’s picture on the front and then used this currency at a fast-food restaurant. This could make for a funny vignette about the fact that the clerk accepted this as currency and then made change for the food purchase (the customer paid for a $2 ice cream cone and received $198 in change!). Also, note that this is not counterfeiting because it doesn’t replicate an existing bill; although the perpetrator would likely face a charge of theft by deception (of a very slow ice cream clerk!). ( http://news.bbc.co.uk/1/hi/world/americas/1147246.stm Links to an external site.). Thus, students could print their own currency as long as others will accept their declaration that it is now the medium of exchange (though I wouldn’t recommend this…).

Money Today

Today, money is termed fiat money. This just means that it has value only because it is given legal status (the law makes it so). It only includes:

• Currency – pieces of paper manufactured by the government to put in your wallet (dollar bills)
• Deposits – money people put into bank accounts, credit unions etc.

Money does not include:

• Checks
• Credit Cards
• Debit Cards
• E-Checks
• Currency inside of the bank

The Federal Reserve System (Fed) and Its 4 Most Important Functions

The Fed serves many functions in the US economy, but its four most important are:

1. The Fed regulates the money supply in circulation
2. The Fed supplies the economy with paper currency and coins
3. The Fed provides a system for check collection and clearing (it acts just like your bank but instead of holding deposits for people, it holds the deposits of individual banks).
4. The Fed holds reserves for most of the nation’s banks, savings, and loans, credit unions etc. All depository institutions are required by law to keep a certain amount of their deposits on hand, held in an account at the Fed.

The Fed’s Use of Monetary Policies to Speed Up or Slow Down an Economy

NOTE: MONETARY POLICIES ARE ACTIONS BY THE FED (a private institution)
FISCAL POLICIES ARE ACTIONS BY THE FEDERAL GOVERNMENT (Ch. 20)

Most of the information in the text up to pg. 492 is fairly straightforward. What it’s necessary for you to understand, however; are the monetary policies the Fed uses to either speed up a sluggish economy or slow down an overheated economy (inflation). In the following portion of this lecture, I’ve attempted to simplify and explain in more detail the monetary policies of the Fed (pg. 493 & pg. 497) and then conclude with a much more detailed but more simplified explanation of the money multiplier.

The Fed’s 3 Monetary Tools To Speed Up or Slowdown Economic Activity

The Discount Rate – this is the percent interest rate that the Fed charges commercial banks for borrowing money from the Fed. When the discount rate is raised, the interest rate on loans throughout the entire economy (homes, cars, appliances etc.) are also raised by the lending institutions. This may be used in two ways:

• 1. Raise the discount rate to discourage borrowing which discourages investment, new jobs etc. Raising the discount rate is used to combat inflation.
  2. Lowering the discount rate to encourage borrowing, investment, higher employment levels etc. Lowering the discount rate is used to combat economic slumps, recessions, or depressions. Since the 2008 economic crash, this rate has been almost or exactly zero to help jump-start the economy.

The Required Reserve Ratio – this is a policy set by the Fed establishing a specific % of deposits as reserves (can’t use it to invest, lend etc.).

• 1. Example: the economy is overheated and inflation is becoming a problem. Assume that the reserve ratio is 5% (for a deposit of $100, the bank must keep $5 on hand with $95 left to invest or loan). Now the Fed increases the ratio to 10%. The bank must now keep $10 on hand and has only $90 to invest or loan. This decreases the amount of economic activity by holding that extra $5 in reserve (multiply that by the billions of dollars deposited in banks, and you can see the economic impact.
  2. Example: The exact opposite of the above. Assume the economy is in an economic recession. To help create more money for investment, loans, etc., the Fed will now lower the reserve requirement. Assume the reserve requirement is 10% (bank must hold $10 of a $100 deposit), but to increase economic activity, the Fed lowers the reserve requirement to 5% (bank must hold only $5 of the $100 deposit, adding an extra $5 to inject into the money supply.

Open Market Operations – this is when the Fed either purchases or sells government securities (bonds) in the open market. This accomplishes two goals:

• 1. Increase or decrease the money supply. If the Fed purchases bonds from individuals or banks, those individuals or banks now have the cash to spend (the money received for the sale of the government bonds they’ve been holding. This injection of cash can help speed up an ailing economy. (The Fed would do the exact opposite if it were contracting the money supply – sell government bonds on the open market, taking cash out of the economy.
  2. Increase or decrease the interest rates throughout the economy. By purchasing bonds in the open market, the Fed is also decreasing interest rates throughout the economy. Here’s how it works:
     1. Assume the face value of a government bond is $1000 with an interest rate of 6%. Whoever holds the bond gets $60 a year in interest (1000 x 6%). Note that $60 ÷ $1000 = 6%
     2. Now to entice bondholders to let the Fed purchase their government bonds, the Fed offers them a HIGHER price than the original $1000. Let’s say the Fed offers $1200 per bond.

• No matter what, the interest on the bond will always be 6% x $1000 = $60 (because that’s what’s printed on the bond. But look what’s happened to the EFFECTIVE interest rate throughout the economy)

1200. The interest received is still $60 after the purchase, but the amount paid for the bond is no longer $1000; it’s now $1200. The EFFECTIVE interest rate has gone from 6% to 5% ($60 ÷ $1200 = 5%).
      1. What a neat tool! By purchasing bonds, the Fed has increased the money supply AND decreased the interest rates throughout the economy – a double whammy to increase economic activity to help revive a sluggish economy.
      2. This is pointed out in your text on pg. 493, where the author describes the quantitative easing the Fed used following the 2008 economic crisis with huge purchases of government bonds by the Fed.

If the Fed feels the economy is becoming overheated with too much money and rising inflation rates, it would do the exact opposite of the above (sell bonds for less than their face value, contracting the money supply and increasing interest rates).

The Money Multiplier

The increase in the money supply combined with lower interest rates as outlined above should help jump-start an ailing economy, but there’s even another benefit to this: the amount that this new injection of money will eventually grow into. This is determined by the money multiplier. Let’s take a look at an example.

• Assume the Fed purchases a $1000 bond from Commercial Bank. Commercial now has added $1000 cash to its account.
• Assume that the reserve requirement is 10%.
• Commercial banks may now loan or invest $900 of that $1000 (10% of $1000 or $100 must be kept in reserves.
• Assume it loans $900 to John Smith. John Smith then deposits that $900 into his bank.
• His bank now has an extra $900 and can loan or invest $810 (it must keep 10% x $900 or $90 in reserves.
• The initial $1000 injection into the economy has now grown to $1810.
• We can calculate the total amount of money that the original $1000 increase will grow into by using the following formula (I’ve simplified the formula in your text to make sure you understand the concept):
• Potential Money Multiplier = 1 ÷ required reserve ratio.
• In this case, 1 ÷ 10% =10 or an initial injection of money into the spending stream will grow by 10x.
• In the above case, the $1000 injection will grow into a $10,000 injection (10 x $1000).

Let’s look at the first few rounds of the money multiplier:

If we followed this through to the finish we’d find an increase in the money supply of $10,000. We used $1000 to simplify things, but in reality, the Fed has been purchasing billions of dollars of bonds in the attempt to revive the US economy from the 2008 recession.

In theory, all of the above definitely shows a way in which an economy can bounce back from a recession or depression. The one thing it doesn’t take into consideration, however, is the cooperation of the financial institutions involved. After the 2008 crash banks tended to lean toward the DESIRED reserve ratio, actually keeping more money on hand in reserves because of the high level of risk. This, of course, put the brakes on the money multiplier. Let’s look at what occurred:

Banks pre-2008 desired reserve ratio was about 1.2%

After the crash, banks increased their desired reserve ratio to upwards of 12% even though the Fed’s required reserve ratios were between 0% and 3% and up to 10% on deposits exceeding a certain level.

This had the effect of limiting the multiplier from a normal value of 9 (a deposit would grow into 9x that amount) to a value of 5 (see pg. 503).

The Fed now has to wait until DESIRED reserve ratios decrease enough to allow injections of money (purchasing bonds) can take full advantage of the multiplier effect.

So What Does Monetary Policy Have To Do With Inflation?

There is quite a bit of evidence to support monetarists’ school of economic thought (pg. 447) concerning the relationship between the amount of money in circulation and inflation.

Let’s look at a simple fictitious example. Suppose the Fed decided to print up and give to each adult $2 million. When you first get your $2 million checks you can’t believe your luck. What a deal! Remember though that everyone will get $2 million. That means that, like you, everyone will go out and begin buying all of those items they couldn’t afford. The problem though is that those items are limited. Production levels have not increased, only the amount of money people have has increased. This takes us back to our aggregate supply and demand curves – the demand curve shifts outward and to the right with corresponding HIGHER prices. AS PEOPLE DEMAND MORE AND MORE OF A SCARCE RESOURCE OR PRODUCT, THE PRICE OF THAT RESOURCE OR PRODUCT WILL INCREASE. Put another way, the value of the money that people have has fallen. Before the $2 million injections, a basket of economic goods cost the consumer $10. After the injection, the amount of goods in the basket has not changed but its price has risen to $100. The purchasing power of the dollar has decreased by 900% ((100-10)÷10). What used to cost $10 now costs 9 times that much (900% as much).

I’ve drawn a chart (Chart 18-A) to illustrate the effect that an injection of money into the economy might have on inflation:

Notice that the ‘y’ vertical axis on the left (up and down) shows the value of the dollar starting at $1 and moving downward to $.20. Look all the way to the right side and you’ll see the price level starting at $5 and moving upward to $25.

• Now, look at the vertical line labeled ‘Money Supply 1’. Point ‘A’ is the initial equilibrium point where the value of the dollar is at $33, and the price level is at $15.
• Assume that the Fed decides to begin purchasing bonds, putting more money into the hands of the consumer as well as lowering effective interest rates throughout the economy.
• This pushes the supply of money from ‘Money Supply 1’ to ‘Money Supply 2’.
• With this increase in the money supply, the demand for money begins to decrease from point ‘A’ to point ‘B’.
• As this occurs, the value of money (excess supply) has decreased from $.33 at point ‘A’ to $.20 at point ‘B’.
• Coinciding with this is an increase in the price level from $15 to $25. This is because there is a larger supply of money for consumers to spend, but the actual amount of goods and services to spend the money upon has not increased. The extra spending money for consumers has just given them the opportunity to bid up the prices of goods and services, which have remained the same in terms of quantity supplied.

So Do the Fed’s Monetary Tools Help or Hurt the U.S. Economy?

Good question, and there’s considerable debate as to the answer. When you read the Policy Application, the answer at first seems fairly obvious, but the Fed’s policies have had mixed results. The 1990’s were a positive for Fed policies as opposed to its potential enhancement of the economic problems of the 30’s, 70’s, and early 80’s. Added to that are the three potential time lags (recognition, action, and effect) which tend to hinder the Fed’s use of its monetary tools to stimulate or slow down the economy.

It remains to be seen how positive the Fed’s use of discretionary monetary policy will be in the 21st century. The years 2008-2009 have already posed one of the biggest economic stabilization challenges the Fed has faced since the Great Depression. Only time will tell if its policies combined with the fiscal policy will be able to lift the U.S. out of a deep recession.