Monetary Policy1. Discount Rate2. Reserve Ratio3. Bonds

Ben Bernanke

There is $800$800 billionbillion in currency [notes & coins].

MoneyMoney = paper notes + coins + Demand Deposits= paper notes + coins + Demand Deposits [52%] [2%] [46%] [52%] [2%] [46%]

““Anything you can buyAnything you can buy a a candy bar candy bar with” with”

[2/3 is overseas][2/3 is overseas]

.

1. Three functions (roles) of moneyfunctions (roles) of money a. medium of exchange b. unit of account c. store of value 2. What constitutes moneyWhat constitutes money in our economy? (paper dollars-52%) (paper dollars-52%) (coins-2%) (coins-2%) b. DD-46%b. DD-46%

3. What “backs”“backs” the money supply the money supply? (gold/silver/the faith of the “G”)

4. Explanation of the demand for moneydemand for money.

Dt + Da = DM 5. The four-part make-up of the Federal Reservefour-part make-up of the Federal Reserve a. Board of Governors b. FOMC c. 12 Fed Banks d. Member banks

MoneyMoney – any good widely accepted for goods and services or repayment of debt. Money is anything generally acceptable as a medium of exchange.

““Faith” of the “G”Faith” of the “G”

aa.. CurrencyCurrency

77thth-G-Chicago (1)-G-Chicago (1)88thth-H-St. Louis (3)-H-St. Louis (3)99thth--II-Minneapolis (1)-Minneapolis (1)1010thth-J-Kansas City (3)-J-Kansas City (3)1111thth-K-Dallas (3)-K-Dallas (3)1212thth-L-San F-L-San Francisco (4)rancisco (4)

1st-A-Boston1st-A-Boston (0)(0)22ndnd-B-N-B-Newew York (1) York (1)33rdrd-C-P-C-Philadelphiahiladelphia (0)(0)44thth-D-Cleveland (2)-D-Cleveland (2)55thth-E-Richmond (2)-E-Richmond (2)66thth-F-Atlanta (5)-F-Atlanta (5)

Paper notes printedPaper notes printed at:at:1. FW Currency Center 2. Washington D.C.

Coins minted at:Coins minted at:1. Denver2. Philadelphia3. San Francisco

Fed bankFed bankthat issuedthat issued the bill the bill

[Chicago][Chicago]

Bills are crowded with numbers andletters that help the U.S. Treasury trackprinting errors & authenticate currency.Here’s what many of them mean:

Number corresponds to letter in Number corresponds to letter in circle indicating issuing Fed bank.circle indicating issuing Fed bank.First letter correspondsFirst letter corresponds

to issuing Fed bankto issuing Fed bank

Last letter tells how many Last letter tells how many times serial number has runtimes serial number has run

[Jackson’s portrait is larger, free from the oval]

New $20 colors are peachpeach, blueblue, and greengreen.

This is the 20’20’s s 2020thth new looknew look.

New backgroundNew backgroundcolors add anextra layer of complexitycomplexity forcounterfeiters

Ink appears eithercoppercopper or greengreen,depending uponthe angle at whichthe bill is viewed.

The first $20first $20 billwas introduced in18611861. Back then,$20 was about themonthly wage formanual laborers.

The average $20 bill lasts 3 years3 years.

There are 5 billion twenties5 billion twenties in circulation,enough to circle the earth 19 times.

An ATMATM can hold up to 7,500 bills,or $150,000$150,000 in twenties.

The $20 bill is themost counterfeitedmost counterfeitedin the U. S.in the U. S., whilethe $100 is most$100 is mostcounterfeited abroadcounterfeited abroad.

[They were not going to change the $5 $5 notenote but –counterfeiters were bleaching Abe & printing Ben on them as they had similar security features. It has2 new water marks and purple inkpurple ink. [no oval]

$100$100 Dollar Bill – Dollar Bill – Red Polymer ThreadRed Polymer Thread

$50 – Yellow $50 – Yellow

$20$20 – GreenGreen

$10$10 – OrangeOrange

$5 - Blue$5 - Blue Now the “5” screams, “I am a 5.”“I am a 5.”

No paper notes larger than $100 have been printedNo paper notes larger than $100 have been printed since 1946.since 1946.

There will be another new $100 bill in late 2008. It will combine There will be another new $100 bill in late 2008. It will combine micro-printing with tiny lenses micro-printing with tiny lenses – – 650,000 for a single bill650,000 for a single bill. The lenses. The lensesmagnify the micro-printing in a remarkable way. magnify the micro-printing in a remarkable way. Move the bill Move the bill side to sideside to side, and the image appears to , and the image appears to move up & downmove up & down..Move the bill Move the bill up and downup and down, and the image appears to , and the image appears to move from sidemove from sideto sideto side. It is a very complex optical structure on a microscopic . It is a very complex optical structure on a microscopic scale.scale.The government prints The government prints 38 million notes each business day 38 million notes each business day with a facewith a facevalue ofvalue of $750 million$750 million. [. [70%70% of the $800 million currency is of the $800 million currency is $100 bills$100 bills.].]

And the new $1 bill coming out Wednesday?

And – what about the new“Bush Dollar” coming out next week?

This phony Bushphony Bush $200 bil$200 billl showedup at a Kentucky Kentucky Dairy QueenDairy Queen.

The serial #:DUBYA402001DUBYA402001

Ronald ReaganRonald Reagansigned it assigned it asSec.Sec. of of TTreasuryreasury

A man bought a$2 sundae & got$2 sundae & got198.00198.00 in real in real cashcash

On some of thesigns were these:

““WWe likee like broccoli.” broccoli.”““WWe like ice cream.”e like ice cream.”

““U.S.A. deserves U.S.A. deserves a tax cut.”a tax cut.”

AAn n average average colonial worker colonial worker earned two bits a week. earned two bits a week.

Beaver skins [1600’s-1800] were traded to the Indians for wampum[clamshells].

TTobaccoobacco L Leaves became eaves became llegal egal tendertender in in 1642.1642.

Cut nails Cut nails were used aswere used as change. change.100 nails 100 nails werewere w worth orth 10 pence.10 pence.

Pine Tree Shilling Pine Tree Shilling [1642-1684][1642-1684] becamebecame the first minted American coin.the first minted American coin.

Spanish milled dollar was the Spanish milled dollar was the main coin of the 1770’s.main coin of the 1770’s. [“Piece of Eight”][“Piece of Eight”]

Many of you already understand the history of money.Many of you already understand the history of money.Your parents give you money and – it becomes “history”. Your parents give you money and – it becomes “history”.

State banks issued paper notes in denominations from $1 to $13.They lost their value the farther away you were, thus the name,““wildcat banking”wildcat banking”, only a wildcat could get back to a distantbank to verify its authenticity.

Over 3,000 3,000 banksbanks issued10,000 billsbut 5,000 5,000 werewere

counterfeitcounterfeit.

Because some banks were more sound than others, a $5 note at one$5 note at onerarely had the same purchasing power as a $5 note at another$5 note at another.

Wildcat BankingWildcat Banking 1790-1860 1790-1860

Civil War MoneyCivil War Money 1860-18651860-1865 Both the Union & the Confederacy paid troops with notes. In 1861, the nation issuednation issued GreenbacksGreenbacks [1st paper money issued by the federal G]. These $5’s, $10’s, & $20’s[total of $10 M] were redeemable in coins.In 1862, $450 M in U.S. notes$450 M in U.S. notes, from $1-$10,000$1-$10,000 replaced the Greenbacks. Because of widespread hoarding of coins, Congress issued 5, 10, 25, & 50 cent notes5, 10, 25, & 50 cent notes. They were called “paper coins”“paper coins” or ““shinplasters.”shinplasters.” Northern prices doubledprices doubled from 1861-1864. The SouthSouth issued Confederate notesConfederate notes. Note-holders were to be repaid in gold & silver after the Civil Wargold & silver after the Civil War. Northerners printed up counterfeit counterfeit confederate notesconfederate notes so these notes increased 20-fold from 1861-1865 and inflation increasedinflation increased 9,200%.9,200%. $2 billion$2 billion from .50 to $1,000.50 to $1,000 printed.

“Greenbacks”This $450 million

brought on severe inflation.

Gold CertificatesGold Certificates (1865-1933) (1865-1933) & Silver CertificatesSilver Certificates (1878-1964) (1878-1964) To increase its reserves of precious metals, the U.S. issued these. The largest was a$100,000 gold certificate which was not available to the public but was used only amongFed banks. Silver certificatesSilver certificates had denominations from $1 to $1,000$1 to $1,000.

Federal Reserve NotesFederal Reserve Notes (1914-Fed was established in 19131914-Fed was established in 1913) Modern coins are produced by mints in Phil., S.F., & Denvermints in Phil., S.F., & Denver. Federal Reserve Notesmake up more than 99.9% of today’s paper currency. Notes of denominations from $5 to$5 to$10,000 circulated until 1946$10,000 circulated until 1946. Since 1946, all notes greater than the $100 were retired.The $1 note was not introduced until 1963 [previously the $1 silver certificate served as$1 silver certificate served asthe $1 billthe $1 bill]. In 19291929, all notes were reall notes were reducedduced by about 1 inch in length and about ½ inchin width. $500 million of paper money is shredded each day.

Under the goldgoldstandardstandard, $35 $35 ofof

currencycurrency couldbe redeemed forone ounce of one ounce of goldgold. You could bring$35 of bills$35 of bills to theU.S. Treasury andexchange it foran an ounce ounce of of goldgold.

Yap Island is a tiny, U.S. trust territory in the S. Pacific, 500 miles from Guam. It is one of the 4 Federated States ofMicronesia & has 12,000 Yapese & 6,000 “rai” 12,000 Yapese & 6,000 “rai” limestone stoneslimestone stones..

BarterBarter – goods and services were – goods and services were

traded without the exchange of traded without the exchange of money.money.However, before trade could occur, there had to

be a “double coincidence“double coincidence of of wants”wants”. Each trader had to have something the other wanted.

I’ll trade you a I’ll trade you a chicken for a pair chicken for a pair

of shoes.of shoes.

I would love to sell you these I would love to sell you these shoes but I can’t eat chicken, shoes but I can’t eat chicken, due to my bad teeth, caused due to my bad teeth, caused by smoking.by smoking.

In a barter economybarter economy a chickenchicken

farmer who wants to buy shoesshoes

may have to first trade chickenschickens

for applesapples and then applesapples for

shoesshoes because the guy selling

shoesshoes wants only applesapples. Money eliminates this problem.

Or, a heart surgeon might accept only

certain goods (like pineapplespineapples ) but not others ( like

broccolibroccoli) because he doesn’t like broccoli.

You are lucky you are a pineapple farmer and not a broccoli farmer. I hate broccoli.

.

• It is less expensiveless expensive to use money.• Using money saves timesaves time and time istime is moneymoney.

The “calculation of exchange”“calculation of exchange” by bartering bartering is much slower than the “calculation of exchange”“calculation of exchange” in a monetary systemmonetary system.

It is less expensiveless expensive to use money. The “calculation“calculation of of exchange”exchange” is fast and easyfast and easy because whatever the price is, you pay that amount.

$3.00$3.00

Here’s $3.00 for one gallon.

• Money is also easier to tax. • So a monetary system is better than a

barter system.

The monetary system enables the “calculation of exchange” to go much faster.

Three FUNCTIONS OF MONEYThree FUNCTIONS OF MONEY

1.1. Medium of ExchangeMedium of Exchange[any asset that sellers will accept as payment for g/s]

Avoids “double coincidence of wants”Avoids “double coincidence of wants” that bartering requires.You would have to have a trading partner who “wants “wants to to sellsellyou goods you want to buy”you goods you want to buy” and “wants to buy “wants to buy goods you want to sell.”goods you want to sell.”LiquiditLiquidityy – how easily an asset can be converted into cash cash without any additional expense. [Cash has 100% liquidityCash has 100% liquidity]

MediumMedium means “something in the middle”“something in the middle”, so money is a “medium of trade “medium of trade between buyers and sellers”between buyers and sellers” because it can be exchanged for something else.

Three FUNCTIONS Three FUNCTIONS OF OF MONEYMONEY

2.2. Unit of AccountUnit of Account[measuring the relative value of goodsrelative value of goods by stating pricesstating prices]

MoneyMoney is like a yardstickyardstick. People use it to compare the worth of things that they buy and sell.

$249.00$249.00

Example: MicrosoftMicrosoft Stock is selling for $50$50 a a shareshare. The new JagJag is selling for $32,000$32,000.A $2 item $2 item is is twice twice as as valuable valuable as aas a $$1 item1 item.

Three FUNCTIONS OF MONEYThree FUNCTIONS OF MONEY

3. 3. Store of ValueStore of Value [storing wealthstoring wealth from one one point inpoint in time time to anotherto another]

[doesn’t wear out easily doesn’t wear out easily andand holds up to inflation holds up to inflation]

Ability of money to hold value over time hold value over time [Money that lacked durabilitydurability or did not hold up well tonot hold up well to inflationinflation would not make good money [would not not store valuestore value].

Other desirable qualitiesdesirable qualities for money are:A. ScarcityScarcity B. PortabilityPortability C. DivisibleDivisible D. Difficult to counterfeitDifficult to counterfeit

Greek CoinGreek Coin2,500 years old2,500 years old

Ice creamIce cream cones would suffer monetary meltdownmonetary meltdown, become a sticky puddlesticky puddle. If money suffers high inflationhigh inflation, it causes the value of money to “melt.”“melt.”

• Commodity MoneyCommodity Money: something that performs the function of money and has alternative, non-monetary usesalternative, non-monetary uses. Gold, silver, cigarettes, corn

• Fiat MoneyFiat Money: something that serves as money but has no other important usesno other important uses.

– Paper notes– Coins

Alternative usesAlternative usessuch as …such as …

M1M1 M2M2 M3M3

$1,375$1,375[billions][billions]

$6,934$6,934[Billions]

M1M1 + + savings deposits, small TDs savings deposits, small TDs [like CDs [like CDs

& & bonds] under bonds] under $$100,000,100,000, & & MMFs MMFs for individualsfor individuals==M2M2M2M2 + large institutional savings+ large institutional savings == M3M3

VV = GDP[Y]/M1 = 13 tr./1.3 tr. = = GDP[Y]/M1 = 13 tr./1.3 tr. = 1010

CurrencyCurrency + + DDDD equal equal M1M1 [Spendable Money][Spendable Money]

““VV”” – how many times a dollar changes hands in a year – how many times a dollar changes hands in a year

AAlso lso included here included here would bewould be Travelers checks, Travelers checks, Checklike depositsChecklike deposits [[NOW NOW and and Super NOW Super NOW Accts] Accts]

2% 52% 46% 2% 52% 46%

MM11CompletelyCompletely

LiquidLiquid

$6,758$6,758

They are not “plastic moneynot “plastic money.”.” They do serve as a: 1. medium of exchangemedium of exchange & the 2. credit card statementcredit card statement servesserves as a unit of accountunit of account. 3. but, they dodo not have a store of valuenot have a store of value.

If the credit card company goes out of business credit card company goes out of business or decides not to honor your cardnot to honor your card, it is worthlessworthless. They are not money not money because they don’t store valuebecause they don’t store value.

Debit cards areare moneymoney. They serve as a: 1. medium of exchangemedium of exchange; they also serve as a 2. store store of of valuevalue (not an extension of credit); and 3. debit card statementsdebit card statements serve as a unit of accountunit of account.

Debit CardDebit Card

The value of money goesvalue of money goes in the oppositeopposite directionof the general price levelgeneral price level. Or, the amount a dollar will buyamount a dollar will buy varies inverselyinversely with the price levelprice level.

ValueValue of of MoneyMoney Prices

1. The most important function of moneymost important function of money is as a: (unit of account/store of value/medium of exchange).2. If you are estimating that it will take $5,000estimating that it will take $5,000 to escort Suzie RahSuzie Rah RahRah to the prom so that you can demonstrate your talent with the “Econ Rap,”“Econ Rap,” you are using money as a: (unit of account/store of value/medium of exchange).3. If you place some of your Kroger’s earnings in a safety depositearnings in a safety deposit box so that you can get your boyfriend, Roger RocketRoger Rocket, a pair of roller blades for Christmas, you are using money as a: (unit of account/store of value/medium of exchange).4. Estimating expenses for FSU at $16,001Estimating expenses for FSU at $16,001 illustrates money serving as a (unit of account/store of value/medium of exchange).5. If Suzie Nomics writes a check for a new Hondawrites a check for a new Honda, she is using money as a (unit of account/store of value/medium of exchange).6. M1M1 [also called transactions money or medium of exchange money or “spendable money”] is comprised of coins, paper money and (gold certificates/checkable deposits).

7. The major component of M1major component of M1 is (currency/checkable deposits).8. The volume of M1volume of M1 is closer to ($1/$3/$4) trillion.9. (M1/M2) includes non-checkable savings accounts, MMA’s & TDs under $100,000.10. (Fiat/Commodity) money is money because the G says that it isG says that it is [G fiatG fiat].11. The value of money variesvalue of money varies (directly/inversely) with the price level.12. If the price index increases from price index increases from 100 to 120100 to 120, the value of the dollar will fall by (one third/one fifth/one fourth).13. The money supply is backedmoney supply is backed by (silver/gold/the government).

1. 1. Discount RateDiscount Rate – banks borrow from the Fed (symbolic)

2. 2. Required ReserveRequired Reserve - % of DD which cannot be loaned.3. BuyBuy//SellSell BondsBonds – government debt

- 3 mo., 6 mo., & 1 year; purchase price: $10,000$10,000

- 2 yr., 3 yr., 5 yr.,($5,000)($5,000), & 10 yr., ($10,000)($10,000)

- 30 years with purchase of $1,000$1,000

Federal Funds Target RateFederal Funds Target Rate – overnight lending rate between banks to correct a temporary imbalance in reserves.

PrimePrime RateRate-loan rate to the best (prime)best (prime) customers.

RRecessionecession

LowerLowerLowerLowerBuyBuy

InflationInflationRaiseRaiseRaiseRaiseSellSell

YYR R YY**

ADAD

ASASLRASLRAS

ASASADAD

YY**YYII

17 increases17 increases

AD

AD

Real GDP 2.3%Real GDP 2.3%

4%4%

10

8

6

0

YYRR Real GDPReal GDP

DDMM

InvestmentDemand

No

min

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10

8

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0Money MarketMoney Market QQIID1D1

MSMS11

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P1

MSMS22

P2

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BuyBuy

If there is If there is RECESSIONRECESSIONMS will beMS will beincreased.increased.

QQIID2D2

DDII

Y*Y*

““Easy Money”Easy Money” – (Buy/Sell) – (Buy/Sell) bonds,bonds,whichwhich (increase/decrease)(increase/decrease) MS, MS, which which (increase/decrease) interest rates, (increase/decrease) interest rates, which (appreciate/depreciate)which (appreciate/depreciate)the the dollar, dollar, whichwhich (increase/decrease)(increase/decrease)C, C, IIg,g, & & Xn, Xn, which which (increase/decrease(increase/decrease))AD & therefore, PL, GDP, & emp. AD & therefore, PL, GDP, & emp. EE11

EE22

ADAD22

Jobs are Jobs are tough to get.tough to get.

LRASLRAS

““Students, should the Fed Students, should the Fed buybuy or or sellsell bonds to bonds to jumpstart this economy?”jumpstart this economy?”

ADAD11

[[C+Ig+G+Xn]C+Ig+G+Xn]

InvestmentInvestmentDemandDemand

DDII

ADAD11

YYII

DDmm

Nom

inal In

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st

Rate

10

88

66

00Money MarketMoney Market QIDQID2 2 ASAS

10

8

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PP22

MSMS11

PP11

MSMS22

If there isIf there isINFLATIONINFLATION,,MS will beMS will bedecreased.decreased.

SellSell

QIDQID11

YY**

““Tight Money”Tight Money” – (Buy/Sell) – (Buy/Sell)bonds, bonds, whichwhich (incr/decr) the MS,(incr/decr) the MS,whichwhich (incr/decr) in. rates, (incr/decr) in. rates, whichwhich (apprec/deprec) the dollar,(apprec/deprec) the dollar,which (incr/decr) C, Ig, & Xn,which (incr/decr) C, Ig, & Xn,whichwhich (incr/decr) AD, PL, (incr/decr) AD, PL,&& GDP. GDP.

EE11

EE22

ADAD22

““Now, should Now, should I I buybuy or or sellsell?”?”

““I’ll get rid of I’ll get rid of some money.”some money.”

LRASLRAS

No

min

al

Inte

res

t R

ate

No

min

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Inte

res

t R

ate

Amount Amount of of moneymoneydemanded (billions)demanded (billions)

DDtt

1010

7.57.5

55

2.52.5

000 50 100 100 150 200 250 300

1010%%

8%8%

6%6%

4%4%

2%2%

00

Da [M2Da [M2]] – – storestore of of value moneyvalue moneyMoney that we don’t need for daily, weekly,or monthly transactions. We will invest moreof it the higher the interest rate. We will holdless because the opportunity cost increases.

++ ==TransactionsTransactionsDemand, DDemand, Dtt

THE Total DEMAND FOR THE Total DEMAND FOR MONEYMONEY

Ra

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Amount Amount of money of moneydemanded (billions)demanded (billions)

1010

7.57.5

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2.52.5

00 DDaa0 50 100100 150 200 250

Interest Rate

Opportunity Cost

Da [hold less]

Interest Rate

Opportunity Cost

Da [hold more]

0 50 100100 150 200

55%%

MM11

DaDa

DaDa varies inverselyinverselywith the interest rate.

AssetAssetDemand, DDemand, Daa

CDsCDs or or

11%%

DtDtIndependent

of the interest

rate

““Walking around”Walking around”moneymoney

Total demandTotal demandfor money, Dfor money, Dmm

“I’m losing more interest, the higher the I.R.”

++ ==TransactionsTransactionsDemand, DDemand, Dtt

AssetAssetDemand, DDemand, Daa

Total demandTotal demandfor money, Dfor money, Dmm

50 100100 150 200 250 300

No

min

al

Inte

res

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ate

No

min

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Inte

res

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Amount of moneyAmount of moneydemanded (billionsdemanded (billions

of dollars)of dollars)

DDtt

10

7.5

5

2.5

0 50 100 100 150 200 250 300

THE DEMAND FOR MONEYTHE DEMAND FOR MONEY

Ra

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Ra

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Amount of moneyAmount of moneydemanded (billionsdemanded (billions

of dollars)of dollars)

10

7.5

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2.5

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DDaa

Ra

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Amount of moneyAmount of moneydemanded (billionsdemanded (billions

of dollars)of dollars)

0 50 100100 150 200200 250 300

10

7.5

5

2.5

0DDmm

10%

7.5%

5%5%

2.5%

0

[independent][independent] [inverse][inverse]

MM

+ =TransactionsTransactionsDemand, DDemand, Dtt

AssetAssetDemand,Demand, DDaa

Total demandTotal demandfor money, Dfor money, Dmm

0 50 100100 150 200 250 300

No

min

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Inte

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Amount of moneydemanded [billions]

DDtt

10

7.5

55

2.5

0 50 100 100 150 200 250 300

Ra

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Amount of moneydemanded [billions]

10

7.5

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Money marketMoney market0 50 100 150 200 200 250 300

10

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MSMS11

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1. At equilibrium 5% I.R., the amount of money demanded for transactions is (0/50/100) and the amount demanded as an asset is (0/50/100).2. If the interest rate were 10%, the amount of money demanded for Dt would be (0/50/100) & the amount demanded as an asset would be (0/50/100).3. Da slopes down because lower in. rates (incr/decr) the cost of holding money.

DDmm

MSMS MSMS22

No

min

al I

nte

rest

Ra

te

50 100 150 200200 250 300

7.5

5

2.5

0

Dm

E

MS

[at “E”, money supplied ($200) = money demanded ($200)]

Due to a recessionrecession, suppose the money supply is increasedincreased from $200 billion to $250 billion.

Money Market

The The Dm Dm curve represents the quantity of money curve represents the quantity of money people are willing to hold at various interest rates.people are willing to hold at various interest rates.

# of Bonds

No

min

al In

tere

st R

ate

0 50 100 150 0 50 100 150 200200 250250 300 300

10

7.5

55

2.52.5

Dm

E

MS1

MSMS2

[at “E”, money supplied ($200) = money demanded ($200)]A temporary surplus ofsurplus of $50 billion$50 billion beyond which the people wish to hold, so money becomes a ““hot potato”hot potato”.

They react by buyingbuying bondsbonds [pushing bondpushing bond prices upprices up] to meet thedesired level of liquidity.

Money Market

Pri

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on

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P1

PP22

S1SS22

E

1%

GDPGDP

No

min

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0 500

DDmm

EE

MSMS11 MSMS22

Money MarketMoney Market

PLPL

SRASSRAS

ADAD

Liquidity TrapLiquidity Trap – in a stagnant economystagnant economy with interest rates near or at zerointerest rates near or at zero, anincrease in MSincrease in MS fails to stimulate AD, so recession or depression gets worserecession or depression gets worse.With low returns expected on financial investments, people hoard their moneypeople hoard their money.. Banks are unwilling to lend in a slack economy. Fiscal policy is needed hereFiscal policy is needed here.

YYDD

LRASLRAS

ADAD

7.5

55

2.5

Nom

inal In

tere

st

Rate

0 50 100 150 200 200 250 300

DDmm

EE

MSMS

[at “E”, money supplied ($200) = money demanded ($200)][at “E”, money supplied ($200) = money demanded ($200)]

Due to inflationinflation, suppose the money supply is

decreased from $200 billion$200 billion to $150 billion$150 billion.

Money MarketMoney Market

No

min

al In

tere

st R

ate

No

min

al In

tere

st R

ate

0 50 100 0 50 100 150150 200 250 300 200 250 300

10

7.57.5

55

DDmm

EE

MSMS11MSMS22

A temporary shortage of moneyshortage of money will require the sale of some assets [bonds-which will make their price fallbonds-which will make their price fall] to meet the money shortage need.

Money MarketMoney Market

SS11 SS22

Pri

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f B

on

ds

Pri

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f B

on

ds

PP11

PP22

# of T-bills# of T-bills

(a) Draw a correctly labeled graph of the money marketgraph of the money market and show the impact of the financial investors’ actions on each of the following. (i) Demand for money (ii) Nominal interest rate

 

1. 1. [3 pts][3 pts] Assume that Assume that declining stock market declining stock market prices prices in the U.S. cause many in the U.S. cause many U.S. financial investorsU.S. financial investors to to sell their stocks sell their stocks and and increase increase theirtheir money holdings money holdings..

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rr22Answers for 1. (a) (i) [2 points]Answers for 1. (a) (i) [2 points]1.1. (a) (i) (a) (i) In an effort to preserve wealth,In an effort to preserve wealth,

investors sell off stocks when market investors sell off stocks when market prices begin to decline. These newprices begin to decline. These newmoney holdings will increase the money holdings will increase the asset asset [speculative][speculative] demand for money. demand for money.In the volatile market, investors will In the volatile market, investors will

hold morehold more money while determining money while determining future needs. future needs. [2 pts: 1 pt for correct [2 pts: 1 pt for correct graph and 1 pt for Dm shifting right.]graph and 1 pt for Dm shifting right.]

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Answers for 1. (a) (ii) Answers for 1. (a) (ii) [1 point for saying the interest rate increases][1 point for saying the interest rate increases]1.1. (a) (ii) The nominal interest rate would increase because the demand(a) (ii) The nominal interest rate would increase because the demand

for money increases as the for money increases as the DDMM curve shifts up, as shown above. curve shifts up, as shown above.

MM Quantity of MoneyQuantity of MoneyTutorial: These Tutorial: These will will shift the real Dm curve.shift the real Dm curve.1. Changes in real aggregate spending, 2. Advances in banking technology. [ATMs available 24/7 decrease the need for cash (Dm)] 3. Changes in institutions [ability to get interest on

checking accounts lead to an increase in Dm], 4. Riskiness of alternative stores of value [stocks]. Dm increases when stocks are appealing.

A. BostonA. BostonB. New YorkB. New YorkC. PhillyC. PhillyD. ClevelandD. ClevelandE. RichlandE. RichlandF. AtlantaF. AtlantaG. ChicagoG. ChicagoH. St. LouisH. St. LouisI. MinneapolisI. MinneapolisJ. Kansas CityJ. Kansas CityK. DallasK. DallasL. San FranciscoL. San Francisco

77thth-G-Chicago (1)-G-Chicago (1)88thth-H-St. Louis (3)-H-St. Louis (3)99thth--II-Minneapolis (1)-Minneapolis (1)1010thth-J-Kansas City (3)-J-Kansas City (3)1111thth-K-Dallas (3)-K-Dallas (3)1212thth-L-San F-L-San Francisco rancisco (4)(4)

1st-A-Boston (0)1st-A-Boston (0)22ndnd-B-New York (1)-B-New York (1)33rdrd-C-P-C-Philadelphia hiladelphia (0)(0)44thth-D-Cleveland (2)-D-Cleveland (2)55thth-E-Richmond (2)-E-Richmond (2)66thth-F-Atlanta (5)-F-Atlanta (5)

Quasi-Public BanksQuasi-Public Banks .. [[in comboin combo]]Blend of [private ownershipprivate ownership (corporations) but publicpublic (government) controlcontrol]The 12 banks12 banks are instruments of the government but not owned by the government. The overover 5,000 banks5,000 banks in the 12 districts buy stock ($1$1 per shareper share)) in their district bank (& get 6% dividends6% dividends [no capital gains]) so the banks are privately owned. Serving the public, it is owned by citizensowned by citizens.The 12 banks are a corporation owned by the banks corporation owned by the banks in their districtsin their districts, but a publicpublic (GG) agencyagency directly responsible to Congress.They might make $30 billion$30 billion - 90% to Treasury90% to Treasury.

TThe he FedFed’s ’s 25 B25 Branchesranches FedFed

Four Part Structure of the FedFour Part Structure of the Fed Seven Board of GovernorsSeven Board of Governors most important body of the Fed appointed appointed by theby the President President and confirmed by the Senateconfirmed by the Senate 14-year terms14-year terms are staggeredstaggered (one replaced one replaced each each two yearstwo years) [they arethey are paid $162,100paid $162,100] isolationisolation from from political political pressurepressure (only one 14 year term)

the ChairmanChairman serves onlyserves only four yearsfour years but can be reappointedreappointed [4-year renewable term4-year renewable term] 4 times4 times His pay is $180,100pay is $180,100. EEvery very presidentpresident gets to appoint atappoint at least twoleast two. ClintonClinton appointed 8appointed 8 & Bush & Bush appointedappointed 4 4 in 11stst 2 2 yearsyears. One termOne term begins every 2 years on Feb. 1 of even numbered years. begins every 2 years on Feb. 1 of even numbered years.

2. Federal Open Market Committee Federal Open Market Committee [FOMC][FOMC]

-Fed’s mainmain policy-making arm policy-making arm

-includes 7 Board Board of Governorsof Governors, NY Fed PresidentNY Fed President, and 4 other4 other bank presidentsbank presidents (rotaterotate among the other 11 every 3 years)other 11 every 3 years)

-other 7 bank presidents areother 7 bank presidents are non-voting membersnon-voting members

-they meet every six weeksmeet every six weeks

-they make about $30 $30 bil. a yearbil. a year (90% goes to the Treasury90% goes to the Treasury)

TheThe FOMC Meeting RoomFOMC Meeting Room inin WashingtonWashington DCDCThe FOMC meets around a 27-foot oval mahogany table27-foot oval mahogany table in a room with a 23-foot ceiling23-foot ceiling with a 1,000-pound chandelier1,000-pound chandelier.

Home Home ofof 7 Board 7 Board of of GovernorsGovernors

• Typical Meeting• The entire committee [12 members + other 8 bank presidents] examine

regional, national and international economic info to assess the strengths and weaknesses of the economy.

• After discussing the economy, the voting members vote on the direction of monetary policy. A policy directive describes the committee’s

assessment of the economy and the new target fed funds rate.• An announcementannouncement is made about 1:15 p.m.1:15 p.m.

..

77thth-G-Chicago (1)-G-Chicago (1)88thth-H-St. Louis (3)-H-St. Louis (3)99thth--II-Minneapolis (1)-Minneapolis (1)1010thth-J-Kansas City (3)-J-Kansas City (3)1111thth-K-Dallas (3)-K-Dallas (3)1212thth-L-San F-L-San Francisco rancisco (4)(4)

1st-A-Boston (0)1st-A-Boston (0)22ndnd-B-New York (1)-B-New York (1)33rdrd-C-P-C-Philadelphia hiladelphia (0)(0)44thth-D-Cleveland (2)-D-Cleveland (2)55thth-E-Richmond (2)-E-Richmond (2)66thth-F-Atlanta (5)-F-Atlanta (5)

3. Twelve Fed Banks and 25 Branches4. Thousands of Member Banks

Destroy/Issue paper notesDestroy/Issue paper notes

The Fed clears 40%;The Fed clears 40%;Banks clear rest electronically.Banks clear rest electronically.

Cash ServicesCash ServicesCheck Check

ProcessingProcessingElectronic Electronic PaymentsPayments

Store cash and coinStore cash and coin Maintain currency’s qualityMaintain currency’s quality Detect counterfeitsDetect counterfeits

The Fed handled 42 The Fed handled 42 billion electronic billion electronic transactions in 2006transactions in 2006

Ben Bernanke BBen Bernanke Believes Inelieves In ““CoreCore” ” Inflation Inflation TargetingTargeting

[Here is How It would Work][Here is How It would Work]The Fed would choose and publish a targettarget goalgoal for core inflationfor core inflation of–say, 2% 2% a yeara year...

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The Fed publicly estimates how high it expects inflation to be in the coming year. It steers monetary policy to try to hit the targetinflation rate. The Fed, in effect, is an “inflation hawk”“inflation hawk”.

If inflation is getting above the targetabove the target, the bank raises interest bank raises interest rates to cool the economyrates to cool the economy. If inflation is too lowinflation is too low, the Fed Fed would lower interest rates to juice up growthwould lower interest rates to juice up growth..

The “Target Rate”“Target Rate” is used in BritainBritain, CanadaCanada, AustraliaAustralia, SwedenSweden,New ZealandNew Zealand, BrazilBrazil, and South KoreaSouth Korea, working well in all seven.

In a crisis likecrisis like 9/119/11, the Fed could still do what was necessary to stabilize the economy,that is, lower interest rates further.

EarthquakeEarthquake

14. The transaction demandtransaction demand [making daily, weekly, & monthly transactions] for moneyfor money is most closely related to money functioning as a (medium of exchange/store of value).

15. The asset demand for moneyasset demand for money is most closely related to money functioning as a (medium of exchange/store of value).

16. If nominalnominal (moneymoney) GDP is $900 billionGDP is $900 billion, and on the average, each dollar is spent three times per yearthree times per year, then the amount of money demanded for transaction purposestransaction purposes will be ($200/$300/$400).

17. The DDm m will shift to the rightwill shift to the right as a result of a(n)

(increase/decrease) in nominal GDPnominal GDP. The DDmm will will shift shift to theto the left left as a result of a[n] (increase/decrease) in nominal GDPnominal GDP. 18. The asset demand for moneyasset demand for money varies (directly/inversely) with the interest rate.19. The basic policy-making bodypolicy-making body in the American banking system is

the (Council of Economists/Board of Governors).

20. The FedFed was createdwas created in (1900/1913/1929/2004)

21. Commercial Banks and thriftsCommercial Banks and thrifts, since 1980, have become increasingly (similar/dissimilar).

22. The transaction demand for moneytransaction demand for money (“walking around” money“walking around” money) is

shown by (D1/D2/D3).

23. The asset demand for moneyasset demand for money (“betting” money“betting” money) is shown by (D1/D2/3).

24. The total demand for moneytotal demand for money is shown by (D1/D2/D3).

25. If each dollar held for transaction purposeseach dollar held for transaction purposes is spent 4 timesspent 4 times per yearper year,

nominalnominal [money] GDPGDP is ($200/$400/$600/$800).

26. If the Fed increased the MSFed increased the MS, the MS curve would shiftMS curve would shift (right/left) and the interest rateinterest rate would (rise/fall).

200200 400400200200

5%5% 5%5% 5%5%

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27. The (Fed/Council of Economic Advisors) hold the hold the deposits of commercial banksdeposits of commercial banks, provide for the collection provide for the collection of checksof checks, act as fiscal agent for the federal governmentact as fiscal agent for the federal government, and exercise supervisory power over member banksexercise supervisory power over member banks.

28. In the U.S. economy, it is the (President/Congress/Fed)

who controls the money supplycontrols the money supply..

29. The 12 Fed banks12 Fed banks are (privately/publicly) ownedowned and (privately/publicly) controlledcontrolled central banks whose basic goal is to control the money supply and interest rates in stabilizing the economy.

30. The term “thrift”“thrift” includes SS&&L’sL’s, credit uncredit unionsions, and

(mutual savings banks/ commercial banks).

The EndThe End