Three Tools of Monetary Policy

1. Reserve Requirement

Only small % of your bank is safe.

• ER is loaned out  "Fractional Reserve Banking"
• FED sets the ER. 
• When FED increases MS, it increases the amount of money held in bank deposits. 

Recession

• Decrease RR
• Banks have less money and more ER.
• Banks create more money by loaning out excess reserves.
• Money supply increases, interest rate decreases, and AD increases.

Inflation

• Increase RR
• Banks hold more money and less ER.
• Banks create less money.
• Money supply decreases, interest rate increases, and AD decreases. 

2. Discount Rate

Interest rate that the FED charges commercial banks.

• To increase money supply, FED should lower discount rate (Expansionary)
• To decrease money supply, FED should increase discount rate (Contractionary)

3. Open Market Operations

The FED buys/sells government bonds (securities).

• To increase MS, FED should buy government securities.(Expansionary)
• To decrease MS, FED should decrease government securities.(Contractionary

Expansionary (Easy Money)

• OMO: Buy bonds
• Discount Rate: Decrease
• Reserve Requirement: Decrease

Contractionary (Tight Money)

• OMO: Sell bonds
• Discount Rate: Increase
• Reserve Requirement: Increase

Federal Fund Rate: 

• Where FDIC member banks loan each other overnight funds.

Prime Rate:

• Interest rate that banks give to their most credit-worthy customers. 

The Value of Money

The Value of Money

Simple Interest Formula

• V = ((1 + r) ^ n) * p 
• V = future value of $
• P = present value of $
• r = real interest rate (nominal rate - inflation rate)
• n = year
• k = number of times interest is credited per year

Compound Interest Formula:

 V = ((1 + r/k)^ nk)*p

Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded. 

Money Demand Factors

1. Change in price level
2. Change in income
3. Changes in taxation hat affect investment

Financial Assets vs. Financial Liabilities

Asset

• stocks and bonds whose benefits to the owner depends on the issuer of the asset meeting certain obligations
• (what you get)

Liabilities

• incurred by the issuer of a financial  asset to stand behind the issued asset
• (risk gain or lose)

Stocks vs. Bonds

Stocks

• Financial asset that can vague ownership in a cooperation

Bonds

• Promise to pay certain amount of money plus interest in the future

Bank: A financial intermediary

• Uses liquid assets (i.e. bank deposits) to finance investment to borrowers
• Process is known as Fractional Reserve Banking.

Fractional Reserve Banking

• A system in which depository institutions hold liquid assets less than the amount of deposits. 
• Can take the form of:
1. Currency in bank vaults
2. Bank Reserves: deposits held at the federal reserve. 

T-Account (Balance Sheet)

• Statement of assets and liabilities. 

Federal Reserve Bank

• 12 district federal banks
• each one is quanzi owned .7 members

Functions

1. Issues paper currency
2. sets reserve requirement and holds reserves of banks
3. Lends money to banks ( charges interest)
4. check clearing service for banks
5. act as personal band for government
6. supervise member banks
7.  control money supply in banks

I. Uses of Money

As a medium of exchange- for barter
Unit of Account- established economic worth
Storage Value- money holds its value for a period of time
II. Types of Money Commodity money:

• gets value from type of material from which it is made

Representative money:

• paper money backed by something tangible, giving it value

Fiat money:

• money because the government says so.

III. Characteristics of moneyPortableDurableDivisibleLimited SupplyAcceptableUniformIV. Money SupplyM1 Money - 75% of all money and most liquid (easy to convert)

• currency in circulation, medium of exchange

 M2 Money

• consist of M1 money along with saving account, money market accounts, and deposits held by banks outside U.S.

M3 Money

• encompasses M2 money and certificate deposits (CDs) 

Unit 4 Monetary Policy

Unit 4 Monetary Policy
Unit 4 Monetary Policy

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