Chapter 11 - Money, Banking, and Monetary Policy

A certificate that represents a claim to, or share of the ownership of a firm

The firms method of raising funds for investment by issuing shares of stock to the public

A certificate of indebtedness from the issuer to the bondholder

A firms way of raising investment funds by issuing bonds to the public

The paper and coin money used today

• Medium of exchange

• Unit of account

• Store of value

It follows the logic that your labor hours turn into money, the money turns into apples, the farmer then exchanges the money for an orchards apple crop, and so on

Units of currency measure the relative worth of goods and services

Money is a relatively good way to store value, when theres no inflation, because it keeps its value

The quantity of money in circulation as measured by the Federal Reserve (the Fed) as M1 and M2. It is assumed to be fixed at a given point in time.

A measure of how easily an asset can be converted to cash

The most liquid of money definitions and the basis for all other more broadly defined measures of money

• M1 = Cash + Coins + Checking deposits + Traveler’s checks.

It is less liquid than M1

• M2 = M1 + Savings deposits + Small time deposits + Money market deposits + Money market mutual funds.

The amount of money held in order to make transactions. This is not related to the interest rate, but it increases as nominal GDP increases.

The amount of money demanded as an asset. As nominal interest rates rise, the opportunity cost of holding money begins to rise and you are more likely to lessen your asset demand for money.

Plotted against the nominal interest rate, the transaction demand for money is a constant MDt. Adding this constant needed to make transactions to a downward-sloping asset demand for money (MDa) creates the total money demand curve.

The demand for money is the sum of money demanded for transactions and money demanded as an asset. It is inversely related to the nominal interest rate.

Keynes theory that says that the equilibrium price of money is the interest rate where money supply intersects money demand.

It says that the interest rate adjusts to bring the money market into equilibrium.

Shortage occured, price must rise

Surplus happened, the price must fall

The supply of loanable funds comes from saving whilst the supply of money includes savings, currency and checkings deposits.

The demand of loanable funds comes from investment demand, but the demand for money inclused the money used for investment, consumption (transaction demand), and for holding an asset (asset demand).

• Classical economists believe that for any level of GDP, the interest rate adjusts to balance the supply and demand for loanable funds, and the price level adjusts to keep the money market in equilibrium. Basically they say the price level is flexible.

• Keynesian economists believe that for any price level, the interest rate adjusts to balance the supply and demand for money, and this interest rate influences aggregate demand and the short-run level of GDP. So, the price level is sticky.

The vertical axis of th emoney market should be labeled with a nominal interest rate and the vertical axis of the loanable funds with the real interest rate.

There’s a temporary surplus at the original equilibrium price. When there’s surplus money, people find other assets, such as bonds, to invest their money in. With more people looking for bonds, its demand raises as well as its price and the effective interest rate paid on bonds is lowered.

The money increased by the Fed in the money supply at the original interest rate.

• An increase in the money supply decreases the interest rate.

• A shortage of money sends some bondholders to sell their bonds so that they have money for transactions.

• An increase in the supply of bonds in the bond market decreases the price and increases the rate of interest earned on those assets.

Decreasing the money supply increases interest rates

A system in which only a fraction of the total money deposited in banks is held in reserve as currency

The fraction of a banks total deposits that are kept on reserve.

• Reserve ratio (rr) = Cash reserves/Total deposits.

Regulation set by the Fed that states the minimum reserve ratio for banks

The cash reserves held by banks above and beyond the minimum reserve requirement

A tabular way to show the assets and liabilities of a bank. Total assets must equal liabilities.

Anything owned by the bank or owed to the bank is an asset of the bank

Anything owned by depositors or lenders is a liability to the bank

This measures the maximum amount of new checking deposits that can be created by a single dollar of excess reserves.

M = 1/(reserve ratio) = 1/rr.

• At any stage the banks keep more than the required dollars in reserve

• At any stage borrowers do not redeposit funds into the bank and keep some as cash

• Customers are not willing to borrow.

• Engaging in open market operations

• Changing the discount rate

• Changing the required reserve ratio

Designed to fix a recession by lowering interest rates to increase aggregate demand, lower the unemployment rate, and increase real GDP, which may increase the price level

• By increasing the money supply, the interest rate gets lower. Lower interest increases private consumption and investments, which shifts the AD curve to the right.

Designed to avoid inflation by increasing interest rates to decrease aggregate demand, which lowers the price level and decreases real GDP back to full employment

• When the money supply is decreased, the interest rate increases causing a decrease in private consumption and investment shifting AD to the left.

A traditional tool of monetary policy, it involves the Feds buying (or selling) of securities from (or to) commercial banks and the general public

• BB = BB → Buying Bonds = Bigger Bucks.

• SB = SB → Selling Bonds = Smaller Bucks.

The interest rate paid on short-term loans made from one bank to another

It buys bonds

Sells bonds

The interest rate commercial banks pay on short-term loans from the Fed

Increases excess reserves in banks and expands the money supply.

Decreases excess reserves in commercial banks and contracts the money supply.

Increases excess reserves in commercial banks and expands the money supply.

Decreases excess reserves in commercial banks and contracts the money supply.

The current framework for the Federal Reserves monetary policy

IOR and ON RRP

The interest rate that is paid to banks that deposit excess reserves with the Fed. Primary tool of current monetary policy. The federal fund rates rise and fall along with the IOR.

"Borrow low and save high" technique

This is a secondary tool of current monetary policy. The interest rate paid to a financial institution on an overnight transaction in which the Federal Reserve sells a U.S. government security to the financial institution while agreeing to buy the security back the next day.

Created to avoid arbitrage

Expansionary monetary policy could be used to assist expansionary fiscal policy to quickly move to full employment. The risk then becomes a burst of inflation.

Contractionary monetary policy could be used to offset expansionary fiscal policy to gradually move to full employment. The risk then becomes rising interest rates.

Contractionary monetary policy could be used to assist contractionary fiscal policy to put downward pressure on the price level. The risk then becomes a rising unemployment rate.

They argue against active open market purchases of Treasury securities on the grounds that such expansions of the money supply will not create more economic growth in the long run and will only create inflation.

The relationship between changes in money supply, the real interest rate, and the level of private investment.

A theory that asserts that the quantity of money determines the price level and that the growth rate of money determines the rate of inflation.

It predicts that any increase in the money supply only causes an increase in the price level.

A way to view the quantity theory of money

The equation says that nominal GDP (P × Q) is equal to the quantity of money (M) multiplied by the number of times each dollar is spent in a year (V). MV = PQ.

The average number of times that a dollar is spent in a year

V = PQ/M.

The velocity of money must fall, the price level must rise, or the economy’s output of goods and services must increase.