Money and the Fed

Unit 4 Notes
 MONEY
• Task!
– What is money?
– What is the function of money?
– What has served as money
throughout history?
 Money
• Money has Three Basic Functions:

– 1. Medium of Exchange- enables us to

carry out trade and commerce easily

– 2. Standard of Value- allows us to

measure and compare value using one
scale

– 3. Store of Value- it (usually) holds its

value over time
 Money
• Money also has Six Main
Characteristics:

– 1. Acceptability- in order for you to buy something, the

seller must be willing to accept what you offer as payment

– 2. Scarcity- needs to be scarce enough to be

valued by buyers and sellers
• 3. Portability- in order to
be convenient as a medium
of exchange it must be
portable

– 4. Durability- if money is
to serve as a store of
value, it must be durable
– 5. Divisibility- to be useful as
a medium of exchange,
money must be easily divided
into smaller amounts

– 6. Uniformity- a dollar is a
dollar is a dollar. We take for
granted that each dollar is
the same as the next.
 What Serves as Money?
– Throughout history, many items such as: salt,
shells, cattle, beads, fur, tobacco, gold, and silver
have served as money
– These are examples of commodity money– form of money that
has some intrinsic value or alternate use

• Gold and silver have generally been preferred because they hold many of
the characteristics of money
 What about today?
• However, our money is no longer backed by precious metals
such as gold and silver

• Fiat money- paper money decreed as legal tender, but not

representing anything of intrinsic worth

– Rather, money is accepted solely

because we believe that it is worth
something, and is backed by the
“full faith and credit” of the United States
government
Trust me!
 What is Currency and Money Supply?

• Currency- the bills and coins

currently in circulation in the
economy

• However, currency is only a part

of the total money supply in the
country

• Money Supply – total amount of

currency, loans/credit, and other
liquid instruments available in the
economy at a given time
 M1& M2 Money Supply
• M1 Money Supply is made up
of:
– Coins and bills (currency)
– Checkable deposits (liquid assets)
– Travelers Checks

• M2 Money Supply is made up

of:
– All of M1
Discussion: Do we want a
– Less liquid assets such as savings
deposits, money market larger or smaller total
accounts, etc. money supply?
• So how is that money (M1 and M2)
transferred between people and managed?
– By banks!
 The Regional Banks of the Federal
Reserve
• http://
www.youtube.com/watch?v=8Hq5zw4YaZQ&li
st=PL2EVBfEJ5a_JPvnd463lXOKmqdzL19ygR
• http://
www.youtube.com/watch?v=M5drSk6EkHk&f
eature=c4-overview-vl&list=PL2EVBfEJ5a_JPvn
d463lXOKmqdzL19ygR
 The Banking System in a Nutshell:

• Fractional Reserve Banking- a system

whereby banks keep a fraction of deposits in
reserves but loan out the rest to businesses
and consumers

• System allows our MONEY SUPPLY TO

EXPAND!
 Federal Reserve Reading
• Pg. 282-285 – Read 14.4 “What Tools Does
Monetary Policy Use to Stabilize the
Economy”

• Complete Sections A-D of “The Federal

Reserve” Notes
Follow-Up Questions – Reread Pgs. 282-284

• What is the Federal Reserve System?

• What is monetary policy?

• Why does the Fed use…

– An easy-money policy?

– A tight-money policy?
 Catch Me If You Can
• http://
www.youtube.com/watch?v=DCOm4osfWn8
• http://
www.youtube.com/watch?v=dK2LZarpNek
 Monetary Policy- what is it?
• Monetary Policy-
central bank policy
aimed at regulating
interest rates and the
amount of money in
circulation to influence
the health and
direction of the
economy
 The Federal Reserve (Fed)
• The Federal Reserve is America’s central bank,
established in 1913
• Congress gave the Fed enough power to act
independently in regards to monetary policy
 Structure of the Fed
• 1. Board of Governors
– 7 member board that oversees the Fed from
Washington D.C.
– Appointed by the president and confirmed by the
Senate for one 14 year term in office
– President selects one governor to serve as
chairman for 4 years
– Responsible for the overall direction of monetary
policy
 Structure of the Fed
• 2. Regional Federal
Reserve Banks

– 12 regional banks
– Carry out many of
the day-to-day
duties
– Each regional bank
overseen by a
president
 Structure of the Fed
• 3. Federal Open Market
Committee (FOMC)
– Consists of:
• All 7 governors from the Board of
Governors
• 5 rotating regional fed presidents
– **But always New York’s
president

– FOMC is the policymaking body

of the Fed
– Study economic information
and decide what changes (if
any) to make to monetary policy
 Policies followed by Fed
• Easy Money Policy (Expansionary)
– Fed expands the money supply trying to cause cheaper lending to
stimulate economic growth

– Interest rates lower but too much easy money policy leads to INFLATION

• Tight Money Policy (Contractionary)

– Fed shrinks the money supply trying to cause lending to be more
expensive to slow the economy

– Interest rates rise but too much tight money policy leads to a RECESSION
 Federal Reserve Reading
• Pg. 286-288 – Read the rest of14.4 “What
Tools Does Monetary Policy Use to Stabilize
the Economy”

• Complete Section E & F of “The Federal

Reserve” Notes
 Follow-Up Questions
• What are open-market operations?

• What is the reserve requirement?

• What is the discount rate?

• What is the purpose of these tools?

 3 Main Tools of the Fed
• 1. Open Market Operations- the
buying and selling of government
securities in the bond market
(most used tool)

– Easy-Money Policy:
• Fed bond traders BUY government
securities, which increases the money
supply

– Tight-Money Policy:
• Fed bond traders SELL government
securities, which decreases the money
supply
• 2. Reserve requirement-
the minimum percentage of
deposits that banks must
keep in reserve at all times
(least used tool)

– Easy-Money Policy:
• Fed LOWERS REQUIREMENT,
which increases the money
supply

– Tight-Money Policy:
• Fed INCREASES
REQUIREMENT, which
decreases the money supply
• 3. The Discount Rate- the interest rate
the Fed charges on loans to private banks
(last tool in their toolbox)
– This tool leads to the Fed being known as the
“lender of last resort”
– Controlled by the Board of Governors

– Easy-Money Policy:
• Fed LOWERS rate, which increases the money supply

– Tight-Money Policy:
• Fed RAISES rate, which decreases the money supply
 The Fourth “Tool”
• 4. Federal Funds Rate- the interest rate that banks charge
one another for quick (overnight) loans

• Banks set this rate, so this is NOT a monetary policy tool

• HOWEVER, the Fed sets a target rate based on its view of

the economy & uses OMO to nudge the rate towards the
target!
– The Federal Funds Rate affects the interest rate on everything:
credit cards, mortgages, savings accounts, bonds, etc.
 Review of Monetary Policy
• How does the Fed stimulate the economy?
 UNIT #5 Fed REVIEW:

• Define monetary policy in your own words.

• If the Fed wanted to increase the money supply using the discount rate, what
would they do? Would the Fed be attempting to stimulate or slow down the
economy?

• If the Fed wanted to decrease the money supply using reserve requirement,
what would they do? What would happen to interest rates?

• If the Fed wanted to increase the money supply using open market
operations, what would they do? Would this be considered easy or tight
money policy?

• What is the relationship between interest rates and the amount of credit
demanded?
 How much do banks need to keep on
reserves?
LOAN
Dave’s $640 for
LOAN New TV
Kim’s $800 for
School books
Pat’s $1000
Deposited PSU deposits
$800 –
$160 in reserve
Pat’s $1000 -
$200 in reserve

Pat’s $1000 –
**In a sense, as banks continuously lend $200 in reserve
money that is not in reserves, they are
“creating money” in the money supply. This
lending is increasing the flow of money that
ordinarily wouldn’t be able to happen!**