Monetary Policy (OMO)

3 tools of monetary policy:
1. Reserve Requirement: If you have a bank account, where is your money?
The FED sets the amount that banks must hold
The reserve requirement (reserve ratio) is the percent of deposits that banks must hold in reserve (the percent they can NOT loan out)

• bank deposits- when someone (public or private) deposits money in the bank
• banks keep some of the money in reserve and loans out their excess reserves 
• The loan eventually becomes deposits for another bank that will loan out their excess reserves 

If there is a recession:

• Decrease the Reserve Ratio
• Banks hold less money and have more excess reserves 
• Banks create more money by loaning out excess 
• Money supply increases, interest rates fall AD goes up 

If there is an inflation: 

• Increase the Reserve Ratio
• Banks hold more money and have less excess reserves 
• Banks create less money 
• Money supply decreases, interest rates up, AD down 

2. Open Market Operations (OMO): when the FED buys or sells government bonds/securities

• This is the most important and widely used monetary policy
• If the fed BUYS bonds- takes out bonds from economy and replace with money MS (up)
• IF the fed SELLS bonds - takes the money and gives the security to the investor. MS (down)

IT matters who buys/ sells the bonds and what they do with the cash!

3.  Discount Rate: MANY different interest rates, but they tend to all rise and fall together

• It is the interest rate that the FED charges commercial banks for short-term loans.

Federal Funds Rate: the interest rate that bank charges another for overnight loans 

Money Creation Formula

• A Single bank can create $ by the amount of its excess reserves. 
• The banking system as a whole can create $ by a multiple of the excess reserves. 
• MM ( Money Multiplier)  X ER = Expansion of money
• Money Multiplier (MM) = 1/RR 

New vs Existing $

• If the initial deposit in a bank comes from the FED or bank purchase of a bond or other money out of circulation, the deposit immediately increases the money supply. 
• The deposit then leads to further expansion of the money supply through the money creation process 
• Total change in MS if initial deposit is new $ = Deposit (DD) + $  created by banking system (Money Multiplier X ER) *must add the initial deposit as well

• If a deposit in a bank is existing $ (already counted in M1; ex: Currency or checks), depositing the amount does NOT change the MS immediately because it is already counted. 
• Existing currency deposited into a checking account changes only the composition of the money supply from coins/paper $ to checking account deposits
• Total change in the MS if deposit is existing $ = banking system created money only. 

Click the link below to watch a video on money multiplier:

Money and Money Multiplier Effect

Extra Notes

Demand deposit: created through the fractional reserve system
Fractional reserve system: it is the process in which banks hold a small portion of their deposits in reserves and they loan out the excess.
Required Reserves: the cash that banks keep on hand
Total Reserves/ Actual Reserves= Required Reserves + Excess Reserves

The Money Market

Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded

What happens to the quantity demanded of money when interest rates increases?
Quantity demanded falls because individuals would prefer to have interest earning assets instead of borrowed liabilities

What happens to the quantity demanded when interest rates decrease?
Quantity demanded increases. there is no incentive to convert cash into interest earning assets.

Money Demand Shifters:

1. Change in price level 
2. Changes in income 
3. Changes in taxation that affects investment. 

Money Supply:

• If the FED increases the money supply, a temporary surplus of money will occur at 5% interest. 
• The surplus will cause the interest rate to fall to 2%. 

Increase money supply -> decreases interest rates -> Increases inv

Stocks vs Bonds

Bonds are loans, or IOUs, that represent debt that the government or a corporation must repay to an investor. The bond holder has NO OWNERSHIP of the company

• First: if a corporation issue and then sells a bond, 
• Is it a liability or an asset for the corporation? Liability
• Is it an asset or a liability for the buyer? Asset

If that corporation issues a 10k bond with a 10 yr term and a 5% interest.

• If the nominal interest rate falls to 3% what happens to the value of the bond? increases
• If the nominal interest rate rises to 8%, what happens to the value of the bond? Decreases

But now you need money.

To get more money, you sell half of your company for $50 to your brother Tom. 

Stock owners can earn a profit in two ways: 

• Dividends, which are portions of a corporation's profits, are paid our to stockholders
• The higher the corporate profit, the higher the dividends
• A capital gain is earned when a stockholder sells stock more than he or she paid for it. 
• A stockholder that sells stock at a lower price than the purchase price suffers a capital loss. 

Federal Reserve Banks= The Feds= central bank

2 goals: 

• maintain economy
• full employment 

Money and Monetary Policy

Why use money?

What would happen if we didn't have money?
The Barter System: goods and services are traded directly store value
.  There is no money exchanged.

Money?
It is anything that is generally accepted in payment for goods and services.
NOT the same as wealth and income

Wealth is the total collection of assets that store value
Income is a flow of earnings per unit of time

Money can be used as

1. Medium of Exchange
1. Buy Goods and Services
2. Unit of account
1. measuring the value of goods and services 
3. Store of value 

3 types of money: 

• Representative money: money that represents something of value 
• Ex: IOU's 
• Commodity money: something that performs the function of money and has alternative uses 
• Ex: Salt, Gold, Silver, Cigarettes 
• Fiat money: money because the government says so
• Ex: coins, paper money

6 characteristics of money: 

1. Durability
2. Portability
3. Divisibility
4. Uniformity
5. Limited Supply 
6. Acceptability 

3 types of money supply 

1. Liquidity- ease with which an asset can be accessed and converted into cash (liquidized) 
1. M1 (high liquidity) - Coins, Currency, and Checkable deposits (aka check) ( personal and corporate checking accounts which are the largest component of M1). AKA demand deposits. 
2. M2 (Medium Liquidity) - M1 plus savings deposits (money market accounts), time deposits (CDs = certificates of deposit), and Mutual Funds below $100k. 
3. M3 (Low Liquidity) - M2 plus time deposits above $100k 

Fiscal Policy

How does the Government Stabilize the Economy?

The Government has two different tool boxes it can use:

1. Fiscal Policy - Actions by Congress to stabilize the economy

• changes in the expenditures or tax revenues of the federal government 
• 2 tools of the Fiscal policy: 
• Taxes- government can increase or decrease taxes
• Spending- government can increase or decrease spending 
• Fiscal Policy is enacted to promote our nation's economic goals: full employment, price stability, economic growth

Deficits, Surpluses, and Debt

• Balanced budget
• Revenues = Expenditures
• Budget deficit
• Revenues < Expenditures 
• Budget surplus
• Revenues > Expenditures 
• Government debt
• Sum of all deficits - Sum of all surpluses 

• Government must borrow money when it runs a budget deficit 
• Government borrows from: 
• Individuals
• Corporations
• Financial Institutions 
• Foreign entities or foreign governments 

Fiscal Policy Two Options

• Discretionary Fiscal Policy (action)
• Expansionary fiscal policy - think deficit 
• Contractionary fiscal policy - think surplus 
• Non-Discretionary Fiscal Policy (no action)

Three types of Taxes 

• Progressive Taxes - takes a larger percent of income from high-income groups (takes more from rich people) Ex: Current Federal Income Tax System 
• Proportional Taxes (flat rate) - takes the same percent of income from all income groups.         Ex: 20% flat income tax on all income groups
• Regressive Taxes - takes larger percentage from low-income groups (takes more from poor people) Ex: Sales tax; any consumption tax

Contractionary Fiscal Policy (The BRAKE)

Laws that reduce inflation, decrease GDP

(Close a Inflationary Gap)

• Decrease Government Spending 
• Tax Increases 
• Combinations of the Two

Expansionary Fiscal Policy (The GAS)

Laws that reduce unemployment and increase GDP (Close a Recessionary Gap)

• Increase Government Spending
• Decrease Taxes on consumers

How much should the Government Spend?

Automatic or Built-In Stabilizers

• Anything that increases the government's budget deficit during a  recession and increases its budget surplus during inflation without requiring explicit action by policymakers

1. Transfer Payments

• Welfare checks 
• Food Stamps
• Unemployment checks 
• Corporate dividends 
• Social Security 
• Veteran's benefits