D.  The Role of Money in the Macro Economy

• Money - stock of financial assets that can be easily used to make market transactions

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1.  Measures of the money supply

• Based on liquidity - ability to be used to immediately make market transactions

a.  C: Currency (coins and paper money)

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b.  M1: C plus:

• Checkable deposits - deposits in checking accounts (demand deposits)

• Travelers' checks - checks that can be used as cash

• Other checkable deposits - negotiable orders of withdrawal (NOW) and automatic transfer service (ATS) account balances

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c.  M2:  M1 plus:

• Money market mutual fund shares - shares of funds that invest in short-term financial assets and have check-writing privileges

• Savings accounts - interest bearing accounts with no check-writing privileges

• Small time deposits - accounts of less than $100,000 with fixed maturities and penalties for early withdrawal

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• Data on monetary aggregates

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2.  Banking system

• Fractional reserve banking system - only a fraction of total deposits need to be kept on hand as reserves

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a.  Money creation

• Money supply - currency plus demand deposits (M1)

• Monetary base - currency plus reserves

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b.  Simple deposit multiplier

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c.  Money multiplier

• People hold some assets in cash instead of deposits

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3.  Federal Reserve System (Fed)

• Central bank of the United States

• List of world central banks

• Implements U.S. monetary policy, regulates and operates financial system, provides economic information (Beige Book)

a.  Structure

- 7 members of Board of Governors

• 14-year non-renewable terms

• One appointed every two years by the President

• Chair and vice chair appointed by President, confirmed by Senate, for four-year terms

- 12 Federal Reserve District Banks

• Involved in bank regulation

• Handles some check clearing

• Provides regional economic information

- Federal Open Market Committee (FOMC)

• Primary responsibility for conducting monetary policy

• 7 members of Board of Governors, president of the Federal Reserve Bank of New York, 4 other Federal Reserve Bank presidents

- 4000 member banks

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b.  Monetary policy

• Expansionary monetary policy - use money supply and interest rates to try to increase growth of real GDP

• Contractionary monetary policy - use money supply and interest rates to try to decrease growth of real GDP

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(1)  Open market operations

• Federal Reserve Bank of New York buys and sells government securities

• Affects money supply and federal funds rate (rate banks charge each other for reserves)

(a)  Increasing money supply

• FRB New York buys securities => bank reserves increase => money supply increases as more loans are made
  
   => need of banks to borrow decreases => federal funds rate decreases => other short-term interest rates decrease 

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(b)  Decreasing money supply

• FRB New York sells securities => bank reserves decrease => money supply decreases as fewer loans are made
  
   => need of banks to borrow increases => federal funds rate increases => other short-term interest rates increase 

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(c)  Securities' prices and interest rates

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(d) Other interest rates

• Prime rate - rate banks charge best customers

• London Interbank Offered Rate (LIBOR) - foreign equivalent of the fed funds rate, but based on estimates

- LIBOR calculated for 10 different currencies, 15 different maturities

• Interest rates

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(2)  Discount rate

• Interest rate Fed charges member banks that borrow reserves

- Increase discount rate => less borrowing from Fed => less reserves => fewer loans => money supply decreases

- Decrease discount rate => more borrowing from Fed => more reserves => more loans => money supply increases

• Largely symbolic as discount borrowing low, open market operations more important

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(3)  Reserve requirement

• Amount banks must keep in reserve

- Increase reserve requirement => less reserves can be loaned => money supply decreases

- Decrease reserve requirement => more reserves can be loaned => money supply increases

• Used rarely because minor change can have major impact

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4.  Money market

a.  Supply of money

• Look at real money supply

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b.  Demand for money

• Holding money means interest not earned

• More transactions as income increases => more money needed

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c.  Equilibrium

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d.  Changes

(1)  Changes in money supply

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(2)  Changes in money demand

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