Final Macro Exam Hcc

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functions of money

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a. medium of exchange: an item that sellers generally accept and buyers generally use to pay for goods and services
b. unit of account: a standard measurement unit in terms of which prices can be stated and the relative value of goods and services compared
c. store of value: an asset set aside to purchase items in the future; allows people to transfer purchasing power from the present to the future

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M1

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the most narrowly defined money supply, equal to currency (outside banks) plus the commercial bank and thrift institutes; = currency + checkable deposits:
a. currency (coins and paper money) in the hands of the nonbank public
b. all checkable deposits (all deposits in commercial banks and “thrift” or savings institutions on which checks of any size can be drawn)

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M2

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a more broadly defined money supply, equal to M1 + savings deposits, including MMDAs + small (less than $100,000) time deposits + MMMFs
a. noncheckable savings accounts: an interest-earning account from which funds normally can be withdrawn at any time
b. money market deposit account (MMDA): an interest-earning account consisting of short-term securities and on which a limited number of checks can be written each year
c. small (less than $100,000) time deposits: interest-earning deposits such as certificates of deposit (CDs) that depositors can withdraw without penalty after the end of a specified period
d. money market mutual funds (MMDF): an interest-earning account at an investment company, which pools the funds of depositors to purchase short-term securities

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What backs the money supply

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by government’s ability to keep the value of money relatively stable
a. acceptability: currency and checkable deposits perform the basic function of money; they are acceptable as a medium of exchange; we are confident it will be exchangeable for real goods, services, and resources when we spend it
b. legal tender: a legal designation of a nation’s official currency (bills and coins)
c. relative scarcity: the value of money depends on its supply and demand

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federal reserve system

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a central component of the U.S. banking system, consisting of the Board of Governors, and 12 regional Federal Reserve Banks
*function of the Fed = control the money supply, in order to assure the stability of the banking system

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board of governors

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the 7 member group that supervises and controls the money and banking system of the United States; the Board of Governors

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Federal Open Market Committee (FOMC)

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the 12-member Federal Reserve group that determines the purchases and sale policies of the Federal Reserve Banks in the market for U.S. government securities

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Federal Reserve Banks

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the 12 banks chartered by the U.S. government to control the money supply and perform other functions.

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depository institutions

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firms that accept deposits of money from the public (business and persons); commercial banks, savings and loan associations, mutual savings banks, and credit unions

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fractional reserve system

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a banking system in which banks and thrifts are required to hold less then 100% of their checkable-deposit liabilities at reserves
a. banks can create money through lending
b. banks are vulnerable to “panics” or “runs”

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how banks create money

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founders of the bank must sell a certain amount of money’s worth of shares of stock in the bank. The cash earned from selling those shares is an asset to the bank. Cash held by the bank aka “vault cash” or “till money”
* a bank creates money by making loans (the IOU)

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actual reserves

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the funds that the bank has on deposit at the Federal Reserve Bank of its district (plus its vault cash)

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required reserves

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the funds that banks and thrifts must deposit with the Federal Reserve Bank (or hold as vault cash) to meet the Fed’s reserve requirement
*required reserves = bank’s checkable deposit liabilities X reserve ratio

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excess reserves

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actual reserves – legally required reserves

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reserve ratio

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the legally required percentage of reserves for every $1 of a bank or thrift’s checkable deposits
* reserve ratio = (commercial bank’s required reserves) / (commercial bank’s checkable-deposit liabilities)

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the monetary multiplier

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the multiple of its excess reserves by which the banking system can expand checkable deposits and thus the money supply by making new loans
*M = 1 / required reserve ratio = 1/R

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monetary policy

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a central bank’s changing of the money supply to influence interest rates and assist the economy in achieving price-level stability, full employment, and economic growth

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money supply

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is not related to the interest rate (vertical curve) and is only determined by the Fed. When the Fed buys bonds, the supply curve shifts to the R. When the Fed sells bonds, the supply curve shifts to L

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money demand

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negative slope because money (in the form of cash or checking deposit) does not make you any money when the interest rate increases

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transactions demand

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the amount of money people want to hold for use as a medium of exchange; the transactions demand curve is vertical because it is assumed to depend solely on nominal GDP rather than on the interest rate

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asset demand

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the amount of money people want to hold as a store of value; the asset demand curve varies inversely with the interest rate because of the opportunity cost involved in holding currency and checkable deposits that pay no interest or very low interest

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4 tools of the monetary policy (how it can change the supply of money in the economy):

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1. open- market operations
2. reserve ratio
3. discount rate
4. term auction facility

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open-market operations

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: the buying and selling of U.S. government securities by the Fed for purposes of carrying out monetary policy. When the Fed buys bonds→ increases the money supply; shifts curve to R. when the Fed sells bonds→ decrease money supply; curve shifts to L.

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reserve ratio

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: if reserve ratio increases→ bank’s lending ability would decrease, leading to a decrease in money supply. If reserve ratio decreases→ bank’s lending ability would increase, leading to an increase in money supply

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discount rate

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: the interest rate the Fed Banks charge on the loans they make to commercial banks. If the discount rate increases→ money supply decreases

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term auction facility

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a monetary policy tool used to expand reserves thru auctioning off loans (reserves) anonymously to commercial banks. Fairly new tool began in response to the mortgage debt crisis where tens of thousands of homeowners defaulted on mortgage loans when they experienced higher mortgage interest rates and falling home prices

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expansionary (easy) monetary policy

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the Fed must increase the excess reserves of commercial banks to make bank loans less expensive and more available to increase the money supply needed to increase AD, employment, and output by:
a. buying securities
b. lowering the reserve ratio
c. lowering the discount rate
d. auction more reserves

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contractionary (tight) monetary policy

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the Fed action to reduce the growth of the nation’s money supply, increase interest rates, and restrain inflation by reducing the reserves of commercial banks by:
a. selling securities
b. increasing the reserve ratio
c. raising the discount rate
d. auction fewer reserves

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federal funds rate

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the interest rate banks and thrifts charge one another on overnight loans made out of their excess reserves. When the Fed wants to increase the Federal funds rate, it sells securities in the open market to reduce (or withdraw) bank reserves (this is a “tighter” or “more restrictive” monetary policy). When it wants to reduce the Federal funds rate, it buys securities in the open market to increase reserves (this is an “easier” or “more accommodating” monetary policy)

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problems and complications with monetary policy

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1. cyclical asymmetry
2. lags (recognition and operational)

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cyclical asymmetry (monetary policy)

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the potential problem of monetary policy successfully controlling inflation during the expansionary phase of the business cycle but failing to expand spending and real GDP during the recessionary phase of the cycle

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lags in monetary policy

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monetary policy faces a recognition lag and operational lag. But because the Fed can decide and implement policy changes within days, it avoids the long administrative lag that hinders fiscal policy. Recognition lag affects monetary policy because normal monthly variations in economic activity and the price level mean that the Fed may not be able to quickly recognize when the economy is truly starting to recede or when inflation is really starting to rise

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equation of exchange (LR of monetary policy):

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M x V = P x Q,, V = (P x Q) / M where:
M is the total nominal amount of money in circulation in an economy
V is the velocity of money, the average frequency with which a unit of money is spent
P is the Price level
Q is an index of real expenditures (on newly produced goods and services)
*in the Long Run, monetary policy ONLY affects price level. If the money supply increases→ inflation increases