Unit 4

Money, Monetary Policy and Economic

Stability

MoneyBefore money, economies used a barter system

Problem – double coincidence of wants

Basic properties of any commodity used as money

Portability, uniformity, stability in value and acceptability

Unit IV Lesson 1

Functions of MoneyMedium of Exchange function eliminates the need for the double coincidence of wantsThe Store-of-value function permits money to be held for use at a later timeThe Unit-of-Account, or Standard-of-Value function means there is an agreed-to measure for stating the prices of goods and services. This simplifies price comparisons.

Unit IV Lesson 1

Complete Activity 34 and review answers

Unit IV Lesson 1

Definitions of Money in the U.S.

M1Consists of currency, traveler’s checks, and checkable deposits

M2Includes M1 plus savings deposits, small time deposits, money market deposit accounts (MMDAs), noninstitutional money market mutual funds (MMMFs) and other deposits

M3Includes M2 plus large ($100,000 or more) time deposits

Unit IV Lesson 1

Complete Activity 35 and review answers

Unit IV Lesson 1

Equation of ExchangeMV=PQ

“M” – M1, stock of money“V” – Income (GDP) velocity of circulation or average number of times $1 is spent on final goods and services in a particular time period“P” – average price level of final goods and services in GDP, also known as the GDP deflator“Q” – real output, the quantity of goods and services in GDP

Unit IV Lesson 2

Evidence shows that income velocity (V) is highly predictable with its value remaining in a very narrow range over a multiyear periodThus, changes in the money supply (M) result in changes in Nominal GDP (PxQ)Depending on the state of the economy, the changes in the money supply can result in changes in prices, in output only or in some combination of both

Unit IV Lesson 2

Complete Activity 36 and review answers

Unit IV Lesson 2

Financial IntermediariesBringing people who want to borrow funds together with people who want to lend funds

Examples: commercial banks, savings and loans associations, savings banks, credit unions & money market mutual fund companies

Functions: liquidity creation, minimization of the cost of borrowing, minimization of the cost of monitoring borrowers and risk reduction through pooling

Unit IV Lesson 3

Fractional ReserveSystem of Banking

Banks – any depository institution whose deposits are a part of M1.Banks must hold a specific percentage of deposits as reserves; this percentage is called the required reserve ratioThe deposit that is not part of required reserves is called excess reserves

Unit IV Lesson 3

Banks may loan excess reserves or buy government securitiesA bank makes a loan by creating a a checkable deposit for the borrower; this results in an increase in the money supply

Unit IV Lesson 3

Money Expansion Multiplier

Exists because the reserves & deposits lost by one bank are received by another bankIt magnifies excess reserves into a larger creation of checkable-deposit moneyDeposit expansion multiplier = ____1____ reserve requirement Expansion of the money supply =

excess reserves x deposit expansion multiplier

Unit IV Lesson 3

Higher reserves = lower money expansion multipliers and a decrease in the money supplyTotal increase in money supply may be less than predicted by the money expansion multiplier if

Borrowers do not spend all the money they borrowBanks do not lend out all their excess reservesPeople hold part of their money as cash

Unit IV Lesson 3

Complete Activity 37 and review answers

Unit IV Lesson 3

The Federal Reserve System

Has the responsibility to control the money supply to promote the economic goals of full employment, price stability and stable economic growthBoard of Governors

Central authority, 7 member board, serve 14 year termsChairman – Alan Greenspan

Federal Open Market Committee (FOMC)7 members of the board and 5 of the presidents of the Federal Reserve BanksSets the Fed’s monetary policy and directs the purchase and sale of gov’t securities

Unit IV Lesson 4

Tools of the Fed Open-Market Operations

The buying of bonds or securities from (increase money supply), or the selling of bonds to (decrease the money supply), commercial banks and the publicFed’s most important instrument for influencing the money supply

Unit IV Lesson 4

Reserve RatioRaising the reserve ratio = decrease in money supplyLowering the reserve ratio = increases the money supply

The Discount RateInterest Rate charged on short-term loans from the Fed to commercial banksLower discount rate = increase in money supplyHigher discount rate = decrease in the money supply

Unit IV Lesson 4

Complete Activity 38 and review answers

Unit IV Lesson 4

The Money MarketThe Demand for Money

Transactions demand – the demand for money to make purchases of goods & servicesPrecautionary (liquidity)demand – the demand for money to serve as protection against unexpected needSpeculative demand – the demand for money because it serves as a store of wealth

How much of your wealth do you want to hold as money & how much do you want to hold as interest-bearing assets?

Unit IV Lesson 5

Explain and Illustrate Visual 4.1

Unit IV Lesson 5

Explain and IllustrateVisual 4.2

Unit IV Lesson 5

Explain and Illustrate Visual 4.3

Unit IV Lesson 5

Complete Activity 39 and review answers

Unit IV Lesson 5

Explain and IllustrateVisual 4.4

Unit IV Lesson 5

Understand?Fed purchases Treasury securitiesMoney supply increases Interest rate decreasesInvestment increase (& interest-sensitive components of consumption spending increase)Aggregate Demand increasesOutput increases and the Price Level increases

Unit IV Lesson 5

Fed sells Treasury securitiesMoney supply decreases Interest rate increasesInvestment decreases (& interest-sensitive components of consumption spending decrease)Aggregate Demand decreasesOutput decreases and the Price Level decreases

Unit IV Lesson 5

Complete Activity 40 and review answers

Unit IV Lesson 5

Interest Rates and Monetary Policy in the Short Run & the

Long RunNominal interest rate

Rate that appears on the financial pages of newspapers & ads for financial institutionsNot adjusted for inflation

Real interest rateIncrease in purchasing power the lender wants to receive to forego consumption now for consumption in the futureAdjusted for inflationReal interest rate = Nominal interest rate – inflation rate “Fisher Equation”

Unit IV Lesson 6

Two Relationships between the real and nominal interest

ratesEx ante real interest rate (expected interest rate)

equals the nominal interest rate minus the expected inflation rate

Ex poste real interest rate (real interest rate actually received)

Equals the nominal interest rate minus the actual rate of inflation

Unit IV Lesson 6

Equation of exchangeMV=PQ

Looking at this equation, we see that changes in the money supply – holding velocity & real output constant – lead to changes in the price levelThese changes in the price level change the nominal interest rate once they are anticipated

Unit IV Lesson 6

Complete Activity 41 and review answers

Unit IV Lesson 6

Complete Activity 42 and review answers

Unit IV Lesson 6

REVIEW FOR UNIT IV EXAM