Tools of Monetary Policy

• Reserve Requirement 
• Fractional reserve systems 
• The Fed sets the amount that the 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) 
• Using Reserve Requirement 
• Recession, what should the FED do to the reserve requirement 
• Decrease the reserve ration 
• 1. 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
• Opposite during Inflation Times 
• Open Market Operation
• When the FED buys or sells government bonds (secretes)
• This is the most important and widely used monetary policy 
• If FED buys bonds- it takes bonds out of the economy and replaces them with money; MS increases
• If the FED sells bonds- it takes money and gives the security to the investors; MS decrease 
• Discount Rate
• There are many different interest rates, but they tend to all rise and fall together 
• The Discount Rate is the interest rate that the fED charges commercial banks for short-term loans 
• Federal Funds Rate 
• The Federal Funds rate is the interest rate that banks charge one another for overnight loans 

Money Creation

• A single bank can create money by the amount of its excess reserves 
• The banking system as a whole can create money by a multiple of the excess receivers 

• MM x ER= Expansion of money 

• Money Multiplier = 1/rr

New vs Existing $ 

• If the initial deposit in a bank comes from the FED or bank purchase of bond or other money out of circulation (buried treasure), the deposits 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 + $ created by banking system 
• If a deposit in the bank is existing $ (already counted in M1), deposition 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 deposit 
• Total change in the MS if deposits is existing $ = banking system c

Fractional Reserve System

Fractional Reserve System
The process in which banks hold a small portion of their deposits in reserves and they loan out the excess.
Demand Deposits
Created through the Fractional Reserve System
Required Reserves
Cash that banks keep on hand
Total Reserves (TR) or Actual Reserves (AR)
*Required Reserves (RR) + Excess Reserves (ER)

Money Market

• Demand for money has an inverse relationship between nominal interest rates and the quantity of money demanded 
• When the interest rate increases, the quantity demanded of money falls because individuals would prefer to have interest earring instead of borrowed liabilities
• When interest rates decrease, the money quantity demanded increase. There is no incentive to convert cash into interest earning assets 
• Money demand is downward sloping 
• Money Demand Shifters 
• Change inn price levels 
• Change in income 
• Changes in taxation that affects investment 
• Increasing the Money Supply 
• If the FED increase the money supply, a temporary surplus of money will occurs at 5% interest. 

The Federal Reserve Bank

Nickname: The FED

The Central Bank 

Job: The promote economic growth  and maximum employment 

Stocks & Bonds

• Bonds are loans
• Stocks you own 
• Bonds: are loans, or IOUs, that represent debt that the government or a corporation must repay to an investor. The bondholder has no ownership of the company 

Bonds 

• First: if a corporation issues and then sell a bond its a 
• Liability for the corporation 
• Asset for the buyers 
• If that corporation issues a 10k bond with a 10 yr. term and a 5% interest………..
• Nominal interest rate at the time of issue = 5%
• Increases if the nominal interest rate falls to 3%
• Decreases if the nominal interest rate rises to 8%

Stocks 

• Stockowners can earn a profit in two ways
• Dividends, which are portions of a corporation’s profits, are paid out to stockholders 
• the higher the corporation profit, the higher the dividends 
• A capital gain is earned when a stockholder sells stock for more than he or she paid for it 
• A stockholder that sells stock at a lower price that the purchase price suffers a capital loss

Money

The Barter System: Goods and services are traded directly. There is no money exchanged.
Money
Anything that is generally accepted in payment for goods and services.
*Not wealth or income
Wealth: the total collection of assets that store value.
Income: A flow of earnings per unit of time.
Money can be used as:
1. Medium of Exchange
*Buy goods and services
2. Unit of Account
*Measuring the value of goods and services
3. Store of Value

3 Types of Money:
1. Representative Money: Money that represents something of value
Ex: IOU's

2. Commodity Money: Something that performs the function of money and has alternative uses
Ex: Salt, Gold, Silver, Cigarettes

3. Fiat Money: Money because the government says so
Ex: Paper Money, Coins

Six Characteristics of Money:
1. Durability
2. Portability
3. Visibility
4. Uniformity
5. Limited Supply
6. Accessibility

3 Types  of Money Supply:
•Liquidity: Ease with which an asset can be accessed and converted into cash (liquidized)
•M1 (High Liquidity): Coins, currency, and checkable deposits (Checks; Personal and corporate checking accounts which are the largest component of M1)
*Demand Deposit or Money Supply
•M2 (Medium Liquidity): M1 plus saving deposits (money market accounts), time deposits (CD's=Certificates of Deposit), and Mutual funds below $100k
•M3 (Low Liquidity): M2 plus time deposits above $100k

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

·      Transfer Payments 

• Welfare Checks
• Food Stamps
• Unemployment Checks
• Corporate Dividends
• Social Security 
• Veteran's Benefits 

Fiscal Policy

How does the government stabilizes the economy?
Fixed Policy: actions by Congress to stabilize the economy or

Fiscal Policy

·Changes in the expenditures or tax revenues of the federal government

•   Two tools of 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, and 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 on a budget deficit

•   Government borrows money from
•   Individuals
• Corporations
•  Financial Institutions
• Foreign Entities or foreign government

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 a larger percentage from low income groups (takes more from poor people)

• Ex: sales tax; any consumption taxes

·      Contractionary Fiscal Policy (The BRAKE): laws that reduce inflation, decrease GDP (close a inflationary gap)

•   Decrease government spending
•  Tax increases
•  Combination of the two

·      Expansionary Fiscal Policy (The GAS): laws that reduce unemployment and increase GDP (close a recession gap)

•  Increase government spending
•   Decrease taxes on consumers