Key Concept and Functions of the FED

Functions of the FED: 

• Presidential appointment
• Issues paper money
• Sets Reserve Requirements and holds reserves of the bank
• Lends money to the banks and charges them interest
• Check clearing service for banks
•  Acts as personal bank for the government
• Supervises member banks
• Controls the Money Supply

·         Reserve Requirement - Only a small % of your bank deposit is in the safe. The rest of your money has been loaned out. 

·         Fractional Reserve Banking- FED sets amount banks must hold -RR is the % of deposits that banks must hold in reserve and NOT loan out –

·         FED increases the MS by increases in the amount of money held in bank deposits

                                   

• Recession- what should FED do to RR?
•  Decrease the RRatio, banks hold less money which means more ER.
• Banks create more money loaning out excess MS increases, interest rate fall, AD increases
• Inflation-
• Banks hold more money which  measn less ER
• Banks create less money MS decreases, interest rate increases, AD decreases 
• Discount Rate - is the interest rate that the FED charges commercial banks
• To increase the MS, the FED should decrease the discount Rate (Ex:Monetary Policy)
• To decrease the MS, the FED should increase the Discount Rate (Ex:Tight Money Policy)

Open Market Operations (OMO)

• FED buys/sells gov't bonds (securities)
• This is money important and widely used monetary policy
• Increase the MS- FED should BUY government securities
• Decrease the MS- FED should SELL government securities

Value of Money

·         Is a dollar today worth more than a dollar tomorrow? - Yes

·         Why? - Opportunity costs & inflation

Let :

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

Formulas

• Simple Interest Formula - -v = (1 + r)^n x p 
• Compound Interest Formula - - v = (1 + r / k)^nk x p

Money demand has an inverse relationship between nominal interest rates and the quantit of money demanded

·         What happens to the quantity demanded of money when interest rates increases? Quantity demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities

·         What happens to quantity demanded when interest rates decrease? Quantity demanded increases, there is no incentive to convert cash into interest earning assets

What happens if price level increases?

• Money demand Shifters that affects investment
• Changes in Price Level
• Changes in Income
• Changes in Taxation

Increasing the Money Supply

- If the FED increases the money supply a temporary surplus of money will occur at 5% interest. The Surplus will cause the interest rate to fall to 2%

 

How this affect AD:

Money supply (increase) -> interest rate(decrease) -> Investment (increases) -> Increases AD

Decreasing the Money Supply:

Money supply (decreases) -> interest rate (increase) -> investment (decrease) -> Decrease AD

Financial Sector:

• Financial Assets (Own) vs Financial Liabilities (Owe)
• Financial Assets:-
• Stocks or bonds that provide expected future benefits
• Benefits the owner only if the issuer of the asset met certain obligations
• Financial Liabilities:
• Incurred by the issuer of a financial asset to stand behind/by the issued asset

Interest Rate - price paid for use of a financial asset

Stocks vs Bonds

• Stocks:
• Financial assets that convey ownership in a corporation
• Bonds:
• Promise to pay a certain amount of money plus interest in the future

What Banks do

·         A bank is a financial intermediary - uses liquid assets (i.e. bank deposits) to finance the investment of borrowers

·         Process kown as Fractional Reserve Banking - system which depository institutions hold liquid assets less than the amount of deposits

·         Can take the form of:

• Currency in bank vaults.
• Bank Reserves- deposits held at the Federal Reserve

 

Basic accounting review

·         T- Account (Balance sheet) - statement of assets and liabilities

·         Assets (Amounts owned) - items to which a bank holds legal claim - the uses of funds by financial intermediaries

·         Liabilities (Amounts owed) - the legal claims against a bank - the sources if funds for financial intermediaries

Banking System

Money Supply

• Affects AD when increased: - r down, Ig up, AD up (Vertical)
• Decreases - MS down, r up, Ig down, AD down

Financial Sector

• Financial. Assets - Stocks and bonds provide expected future benefits
• Benefits owner from issuer of asset meeting certain obligations
• Fin. Liabilities - Incurred by issuer of financial asset to stand behind issued asset
• Interest Rate - $ paid to use financial asset
• Stocks – Financial asset that represent ownership in a company
• Bonds - Promise to pay $ and interest in the future

Banks

Financial Intermediary - use liquid assets to fund investments of borrowers -> Fractional Reserve Banking

Liquid assets include currency in bank vaults and bank reserves

Banks creates money by lending out deposits that are used multiple times

When a customer deposits cash or withdraws cash from their demand deposit account, it has NO EFFECT ON THE MONEY SUPPLY

Only changes

The composition of money

• Excess Reserves
• Required Reserves

Changes in Money Supply for

• Single Bank
•  Loan money from ER
• Banking System
•  ER x Money multiplier (1/RR) -> Total Money Supply
• When the FED buys or sells bonds, ER is created
• Basic accounting
• Assets (Amounts owned) - Items claimed legally by bank; use of funds by fin. intermediary
• Included in assets
• Required Reserves - % of DD in vault
• Excess Reserves - Remaining % of DD used for loans
• Property - Statement of a bank's property values
• Securities or Bonds - Previously purchased bonds held by the banks as investments
• Loans - Previously loaned funds now owed back to the bank
• Liabilities (Amounts owed) - Legal claims against a bank; sources of funds.
• Included in liabilities
• Demand Deposits- Cash deposits from the public to the bank
• Part of MS if from person's cash holdings
• Becomes new $ if from a bond -> MS up
• Owner's equity or stock shares - Values of the bank stocks as held by the public
• DD = RR + ER
• Reserve Requirement- Fed needs banks to always have $ to meet demand
• Amount = Reserve Ratio - % of DD locked to bank

Scenario 1

A private citizen takes cash that they possess and put it into a bank account

• The cash placed into the bank is already part of the money supply
• The deposit is counted as a bank liability
•  A % must be placed into required reserve
• The remainder is placed into excess reserve
• The bank will want to lend all of the ER, if possible
• The amount in ER is multiplied by the monetary multiplier
• This will be assumed to become new loans in the banking system
• This will be counted as the change in money supply
•  

Scenario 2

The Fed buys bonds back from the public

• The public now has new cash
• This new cash is new loans
• Assume that the public puts the cash into demand deposits
• A set percentage is placed into required reserve
• The remainder becomes excess reserve
• Excess reserve is multiplied by the money multiplier (1/RR)
• This amount becomes new loans and is new money supply
• The total change in money supply is the amount of demand deposits plus the new loan amounts

Scenario 3

The Fed buys bonds back from the member bank

• The banks now have new ER
• No money is needed to be placed in RR, since this is not owed to the public
• All of these ER are multiplied by the monetary multiplier
• This amount becomes new loans
• This amount is the change in the money supply

Money

Uses of Money Vocabulary

•  Medium of Exchange - To barter/trade
•  Unit of Account - Establishes economic worth in the exchange process
•  Store of Value - Money holds its value over a period of time, whereas products do not

Types of Money Vocabulary:

• Commodity Money - Gets its value from the type of material from which it is made. EX: Gold/Silver coins
• Representative Money - Paper money backed up by something tangible that gives it value EX: IOU
• Fiat Money - Money because the gov't says so EX: US Money

Characteristics of Money:

• Portable - Money is portable
• Durable - Money is durable
• Scarce - Bills
• Divisible - Dollar - breaks down
•  Acceptable - Everywhere in [US]
• Uniform - Everywhere you go

Money Supply:

• M1 [75% most liquid] <- (easy to convert to cash) - (Currency) [cash/coins] (checking accounts) -> Checkable deposits/Demand deposits + Travelers checks
• M2 [Not as liquid to convert to cash] - Consists of M1 money along w/ saving accounts, common market accounts, and deposits held by banks outside of US.
• M3 [withdraw early = penalty] - Consists of M2 money + Certificates of Deposits (CD's) Held by private institutions

AP Monetary Policy Video