Lecture Introduction to economics: Social issues and economic thinking: Chapter 22

Chapter 22 - Monetary policy and the federal reserve. After completing this unit, you should be able to: Define the concept of money, explain how the fractional reserve banking system allows banks to create money, explain how the market for loans functions, describe the structure of the federal reserve system.

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Introduction to Economics: Social Issues and Economic Thinking

Wendy A Stock

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Ø Define the concept of

money

Ø Explain how the fractional

reserve banking system

allows banks to create

money

Ø Explain how the market for

loans functions

Ø Describe the structure of

the Federal Reserve

System

the Federal Reserve

policy takes place

monetary policy on the economy

associated with monetary policy

After studying this chapter, you should be

able to:

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Ø Barter Exchange is the trading of goods and

services directly for other goods or services,

without using money

accepted as payment for goods and services

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THE EVOLUTION OF THE MONETARY

SYSTEM

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The three primary functions of money: (1) medium

of exchange; (2) unit of account; (3) store of

The Functions of Money

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Ø The standard definition of money supply is

money in circulation called M1

checks, and other checkable deposits

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THE MONEY SUPPLY

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Money supply in the U.S.

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Ø Balance Sheet is a statement of assets (things owned) and liabilities (things owed).

Ø Total Reserves are a bank’s deposits that it has received but has not lent out

of deposits that a bank must hold as reserves by law

bank is required to hold as reserves

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THE BANKING SYSTEM

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Ø Fractional Reserve Banking is a system under which banks are required to hold only a fraction

of their deposits as reserves

bank’s total reserves and its required reserves

Total reserves = required reserves + excess

reserves

THE BANKING SYSTEM

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An example of balance sheet

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Ø The supply of loans (S) comes primarily from

savings accounts As the interest rate increases, the amount of money people decide to save

rises

individuals and businesses who want to borrow money When the interest rate on loans falls, the demand for loans increases

The market for loans

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The Market for Loans

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Money creation can be illustrated by the following simple example:

increase by $9mi

Banks and Money Creation

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Initial Status of the bank’s balance sheet:

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After you made a $10mi deposit:

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After Econobank made a loan of $9mi and

borrower deposited the loan in the same bank:

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Ø Money Multiplier (MM) tells the maximum

amount that the money supply can increase for

a given increase in deposits

reserve ratio

MM = 1/rrr

In our example MM = 1/0.1 = 10

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Ø The maximum amount of money creation equals the initial increase in deposit times the money

multiplier

Max Money Creation = Initial Increase in Deposits

x MM

In our example: $10 mi x 10 = $100 mi

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After you made a withdrawal of $5mi.

Money multiplier in reverse:

Money destruction

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Ø A Bank Run occurs when a large number of

customers withdraw their deposits from the bank because they worry that their bank might fail

1933

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Bank Regulation

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Ø Board of Governors

Ø Chair (Ben Bernanke), 4-year terms

Ø 7 members, 14-year term

12 members

The Structure of the Federal Reserve System

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Ø Two primary missions of the Federal Reserve

are to promote price stability and to promote

employment and economic growth

Ø Monetary Policy is the use of regulations or

actions by the central bank to influence the

money supply

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Federal Reserve and Monetary Policy

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Three tools for monetary policy:

Monetary Policy

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Ø Open Market Operations are the purchases and sales of federal government securities by the

Fed

supply, it will conduct open market purchases of securities from banks and investors

it will sell securities to banks and investors

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Monetary Policy

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Initial Status of the bank’s balance sheet:

Monetary policy: Open market purchase to

increase money supply

After Fed purchased $10mi securities:

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Ø Discount Rate is the interest rate that the

Federal Reserve charges banks for loans

Ø Federal Funds Rate is the interest rate that

banks charge one another for loans to cover

required reserve shortfalls

borrowing from the Fed and from each other,

thus less funds available for loans and less

money supply created

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Monetary Policy

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Ø A third tool of monetary policy is setting reserve requirements.

impacts banks’ excess and required reserves

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Ø Expansionary Monetary Policy involves Fed

actions to increase the money supply

actions to decrease the money supply

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Monetary Policy and the Economy

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Impacts of Expansionary

Monetary Policy

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Impacts of Contractionary

Monetary Policy

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Advantages and Disadvantages of Monetary

Policy

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1 Describe the actions the Federal Reserve

could take to increase the money supply.

2 Describe the functions of money How well

does cash fit these functions? How well does a checking account that earns zero interest fi t these functions? How well does

an interest-earning savings account fit these functions?

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• Federal funds rate

• Expansionary monetary policy

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