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Chapter 17 money and federal reserve

Three functions of money


1) Medium of exchange
a) Trade for G/S
b) Barter: G/S for G/S
i) Requires double coincidence of wants
c) Commodity money: involves use of a good in the place of money (tobacco)
i) Problems: transportation costs, divisibility problem, inherent price risks
d) Commodity backed money: money that can be exchanged for a commodity at a fixed rate (gold
backed money)
e) Fiat money: no value except as a medium of exchange
i) No intrinsic value or commodity backing
2) Unit of account
a) Def. measure in which prices are quoted
3) Store of value
a) Means of holding wealth
4) Two observations
a) If price level is highly variable, money will NOT serve well as a store of value/unit of account
b) Absence of money; need barter system (double coincidence of wants)
Measuring the quantity of money
1) M1 and M2
a) M1 (medium of exchange): currency + checkable deposits
i) Checkable deposits: deposits in bank accounts from which depositors may make
withdrawals by writing checks
b) M2 (store of value): M1 + savings + money market mutual funds + small-denomination time
deposits (CD)
c) M = currency + deposits
Banking
1) Roles
a) Market for loanable funds
b) Money supply
2) Balance sheet
a) A = L + E
b) Assets: reserves, securities, loans
c) Look up in book
3) Reserves: (asset) portion of deposits that are NOT lent out
a) Fractional reserve banking: banks hold only a fraction of deposit in reserve
i) Kept as currency in vault
ii) Or deposits in central bank (fed)
b) Bank run: many depositors try to withdraw at once
c) Required reserve ratio (RR): portion of deposits that banks are required to keep in reserve
i) Required reserves = RR X deposits
d) Excess reserves = total required
4) FDIC and moral hazard
a) FDIC guarantees deposits up to 250k (stop bank runs)
b) Moral hazard: party behaves differently since it is protected from full risk
i) Incentivizes riskier behavior (higher returns)
How banks create money
1) 2 assumptions
a) All currency is deposited in bank
b) No excess reserves
2) Simple money multiplier = M = 1/rr
Fed and money supply
1) Primary roles
a) Monetary policy: increases/decreases MS using interest rate
b) Central banking: bank for banks
i) Federal funds: deposits that private banks hold on reserve at the Fed
ii) Federal funds rate: interest rate on interbank loans
iii) Discount loans: loans from fed to private banks
(1) Lender of last resort
(2) Discount rate: interest rate Fed charges private banks
c) Bank regulation
i) Sets and monitors reserve requirements
Monetary policy tools
1) Open market operations: Purchase or sale of bonds (short term treasury securities) by the central
bank (used everyday)
i) Increase MS: buy securities
ii) Decrease MS: sell securities
b) Small changes multiply
c) OMO = trades with banks and other financial institutions in the loanable funds market
d) First effect of OMO: change in the supply of loanable funds
2) Quantitative easing: targeted use of open market ops in which central bank buys securities
specifically targeted in certain markets (recent tool)
a) New type of OMO
b) QE = other types of securities such as
i) long term treasury securities
ii) troubled markets (mortgage backed securities)
iii) toxic assets
iv) bailout
c) 3 phases now starting to wind down
3) Reserve requirements and discount rates (least used)
a) Reserve requirements have unpredictable effects, not used often
b) Used as last resort
i) Unpredictable and not precise
ii) Banks may NOT actually change reserves
c) Currently about 10%

chapter 18 monetary policy

Short run effects
1) Expansionary monetary policy
a) Buy treasury securities from banks > increases reserves
i) Results = supply of loanable funds increases > interest rates fall > Investment increases > AD
increases > real GDP increases, unemployment falls
b) Page 549
c) Real vs. nominal effects
i) Initially, new money has same real value but eventually begins to fall in real value
ii) Unexpected inflation hurts contracted workers, suppliers, and lenders
2) Contractionary monetary policy
a) Central bank decreases MS by selling bonds
b) Supply of loanable funds falls, interest rates rise, I decreases, AD decreases, real GDP decreases,
unemployment rises
Problems with monetary policy
1) Long run adjustments
a) All prices adjust in the long run
b) Only lasting result is increase in Price level
c) Monetary neutrality: money supply does not affect real economic variables
2) Adjustments in expectations
a) If inflation is expected, there is NO short run stimulation to real GDP and unemployment
i) No real change, only increase in Price level
3) AS shifts and Great recession
a) Monetary policy does not enable us to avoid every economic downturn
Phillips Curve
1) Traditional short run definition: Inverse short run relationship btwn inflation and unemployment
a) Phillips: original theory based on wage rates and unemployment in 1860s
b) Samuelson and solow (1960): believed that unemployment could be CHOSEN based on
monetary policy
i) Tradeoff btwn I and u
ii) Implicit assumption: inflation is always unexpected, ignores expectations
2) Long run: vertical line = inflation is only result of monetary expansion in LR
3) Modern view
a) Incentive to predict inflation so that it does not harm economy
b) Inflation does not always reduce unemployment because Pcurve shifts for each level of
expected inflation

Adaptive expectations
1) Expectations and the phillips curve (Friedman and phelps)
a) Inflation is powerful when it is a surprise
b) Some are harmed by surprise inflation
c) They have incentives to adjust expectations
d) If inflation is expected, it should NOT affect unemployment
2) Adaptive expectations theory: expectations of future inflation are based on most recent experience
a) Inflation and expectations chart
i) When expected inflation = actual, u = u*
b) Stagflation: combo of high unemployment and inflation
3) Implications
a) Inflation is not always a surprise
b) Steady inflation is predictable
i) Unemployment not affected
c) To reduce unemployment, inflation must accelerate
d) Phillips curve is short run
i) Depends on expected inflation
e) If expected I < actual I, U decreases
f) If expected I > actual I, U increases
4) Flaw
a) AE assumes we expect tomorrow what occurred today
b) Some predictable errors are still made
Rational expectations theory
1) people form expectations of the basis of all available info
2) expectations based on more than just current inflation, pick up on trends
3) much fewer errors made
4) expectations should be unbiased
a) *does not imply zero forecasting errors
b) Errors are not predictable but RANDOM
5) Phillips curve under rational expectations
a) No correlation between I and U
b) Depends on many other factors besides inflation
c) Monetary policy Is not powerful
d) U is randomly distributed around U*

Implications for monetary policy
1) Active monetary policy: strategic use of monetary policy to counteract business cycle
a) Used a lot in 1960s, more cautious today
b) Using monetary policy to lower unemployment can lead to inflation AND more unemployment
in the long run
2) Passive monetary policy: central banks use monetary policy to stabilize money and price levels
3) Bernankes Fed
a) Transparent: held press conferences
i) No surprises
b) Do no harm: keep inflation low
c) Why is inflation so low given massive expansionary policy?
i) Banks are holding excess reserves, money supply does NOT multiply as quickly
ii) ^MS shrinks
iii) A lot of G spending is held in reserves because FED is paying interest on reserves