Unit IV: Monetary Policy

Unit IV: Monetary Policy

This unit was all about money, how it flows through our economy, how the Federal Reserve can manipulate the money supply, as well as policies, and how banks and banking systems work. I think it is best to start with breaking down what "money" really is.

I. Uses of money:

    a. Medium of exchange - as we all know, money is well known for exchanging goods and services, (remember that from the beginning of the year?).

    b. Unit of account - since money is very important to the economy, or let's better say, most important for the economy, it establishes economic growth.

    c. Store of value - in present time, money holds a certain value, or "stores" a certain value over a period of time.

Besides the uses of money, there are also types of money...

II. Types of money:

    a. Fiat money - this simply means it is money because the government says so.

    b. Commodity money - a commodity gets its value from the type of material it is made of.

    c. Representative money - this could be anything ranging from gold to paper, and even peanuts.

There are also some characteristics of money...

III. Characteristics of money

    a. Durability - money is durable.

    b. Portability - in the form of bills, coins, etc.

    c. Divisibility - divided into many bills, coins, etc. 

    d. Uniformity - no matter where you go in the US, money has some value.

    e. Scarcity - 2 dollar bill.

    f. Acceptability - money is accepted in foreign countries.

IV. Money supply

    a. M1 money - this consists of currency in circulation, plus checkable deposits, or "checks" and travel checks.

    b. M2 money - consists of M1 money, plus savings accounts, plus money market accounts, plus deposits, plus deposits held by banks outside of the US.

The United States has a fractional reserved banking system, which means that a certain reserve requirement exists, meaning that these banks have to keep a certain amount of money, and are able to lend out the rest. The required reserves can be calculated by taking the reserve ratio, let's say 10%, times the checkable deposits / demand deposits, let's say $1,000. In this case, the bank has to keep $100, and the excess reserves are $900. The reserve ratio can also be calculated by the total reserves, which are excess reserves plus required reserves, over the required reserves.

Most economists and business people in finance use a balance sheet so they won't lose track of all the math involved. There is something called assets and liabilities, wherein assets are all things that have value and you own, in this case the bank, and liabilities are the claims of the non-owners against the banking firm's assets. Let's apply this to our example above.

The supply of money (of one commercial bank!) can be calculated by finding the required reserves, and subtracting them from the initial deposit, which are in fact excess reserves. This is different for a banking system. In a banking system, we can find the money supply by using the monetary multiplier, which is 1/reserve ratio, in our case per say, 1/0.10, where the reserve ratio is 10%. If the initial deposit in Bank A was $1,000, then deposited in Bank B, we can find the money supply by multiplying the monetary multiplier by the $1,000, giving us $10,000 of money supply of the banking system.

The Federal Reserve Bank has 3 tools of money that can be used, such as increasing the reserve ratio, but also manipulating the discount rate, and open market operations.

Discount rate - this rate is the interest rate charged by the Fed for overnight loans to commercial banks. It doesn't change money supply directly.

Open market operations - the Fed can buy or sell bonds (securities), it is a very preferred tool of monetary policy, as we shall see in a more visual example.

Federal funds rate - this is the interest rate charged by one commercial bank for overnight loans to another commercial bank. The rate is negotiated.

Money Market

There is also expansionary and contractionary monetary policy, and this table shows how each affects the money supply, etc.

Loanable Funds Market

The loanable funds market is where savers and borrowers exchange funds at the real rate of interest.

I. The demand for loanable funds, or borrowing comes from households, firms, government, and the foreign sector.

II. The demand for loanable funds, or savings comes from households, firms, government, and the foreign sector. The supply of bearable funds is also the demand for bonds. 

III. Changes in the demand for loanable funds

    a. Demand for loanable funds = borrowing (i.e. supplying bonds)

    b. More borrowing = more demand for loanable funds (-->)

    c. Less borrowing = less demand for loanable funds (<--)

        ex) government deficits spending= more borrowing= more demand for loanable funds.

IV. Change in the supply of loanable funds

    a. Remember that supply of loanable funds = saving (i.e. demand for bonds)

    b. More saving = more supply of loanable funds (-->)

    c. Less saving = less supply of loanable funds (<--)

       ex) Government budget surplus = more saving= more supply of loanable funds.

Prime rate - the rate that banks charge to their most credit worthy customers.