Unit 4: Money, Banking, and Monetary Policy
Monetary policy refers to the methods government agencies, such as the U.S. Federal Reserve, use to convince banks, businesses, and individuals to change their interest rates, money supply, and demand for money. Money serves as a medium of exchange, a store of value, and a unit of account. These three functions enable individuals to avoid the bartering system – we pay businesses money for their services rather than offer a loaf of bread or another value item in exchange. The ways we define and measure money are important to managing an economy. Savings and investment are key elements within the circular flow model and function of interest rates.
Completing this unit should take you approximately 5 hours.
Upon successful completion of this unit, you will be able to:
- define money and identify its functions;
- show how money is measured and explain the role of banks in the money creation process;
- apply the money multiplier formula to calculate the change in money supply in a fractional reserve banking system;
- explain the structure, functions, and goals of the U.S. Federal Reserve;
- show the importance of the Fed's independence from the government and explain how the Fed's structure and decision-making process promotes independence;
- identify three tools of monetary policy and how they are used to change the economy's money supply;
- explain and illustrate how the bond market works and the relationship between bond prices and interest rates;
- explain how the foreign exchange market works and how changes in the interest rate affect the exchange rate for a country's currency;
- graphically represent the money demand and the money supply functions and determine the equilibrium interest rate and quantity of money in the money market;
- use graphs to analyze the effect of changes in the bonds and money markets on the equilibrium real GDP and the price level; and
- use the AD-AS model to illustrate the impact of monetary policy on the price level and real GDP.
4.1: Money
Before money was invented, the barter system was slow and burdensome because it depended on a double coincidence of wants – a baker must be interested in receiving a goat in exchange for the loaf of bread he gives a goat herder. Money has three functions: a store of value, a unit of account, and a medium of exchange. Banks create money when they issue loans and earn interest from their borrower. Neither the banks nor the economy earns anything from idle money in a savings account. Instead, they channel money from savers to borrowers to earn money from the loans they issue. Or they invest the money you deposited in your savings account to earn interest. The money supply increases when banks experience an increase in their reserves. Central banks, like the U.S. Federal Reserve, operate similarly, since they lend money to the banks. Money is created when a country's money supply increases.
Read this text on the various functions of money. It describes how the barter system must rely on a double coincidence of wants. Money is a medium of exchange, a store of value, and a unit of account. It also serves as a standard of deferred payment. What is the difference between commodities and fiat money? What is a commodity-backed currency?
In this text, we compare the M1 and M2 money supply. In May 2020, the Federal Reserve changed the definition of M1 and M2. M1 money supply is more liquid and includes cash, checkable (demand) deposits, and savings. Demand deposits are the amounts held in checking accounts – the bank must give the deposit holder their money "on demand." M1 money includes coins and currency in circulation. The M2 money supply is less liquid and is measured as M1 plus time deposits, certificates of deposit, and money market funds. How does "plastic money" (debit cards, credit cards, and smart cards) fit into this scenario?
This text explains how banks serve as financial intermediaries between savers and borrowers. Individuals and companies go to a bank to borrow money. They do not have to find someone who has money to lend. Reserves are the money the U.S. Federal Reserve requires banks to keep on hand – they are not allowed to lend this money out or invest it in bonds.
4.2. Creation of Money
Banks create money by approving loans – their business charges interest to people and businesses who take out loans to buy a house, office building, car, raw materials, or purchase the business inventory they plan to sell. Meanwhile, bank customers receive a portion of the interest the bank earned from the borrower for the money they deposit at the bank. Neither the bank nor the economy earns income if money sits idle in a savings account.
Read this text to learn how to formulate the money multiplier to see how banks create money. You should also be able to analyze and create a T-account balance sheet and evaluate the risks and benefits of money and banks.
Watch these videos on the three definitions of money and the money-creation process in a fractional reserve banking system. The money creation process is key to understanding how the Federal Reserve Bank controls the economy via changes in the money supply.
Watch these videos, which offer another perspective on fractional reserve banking. Note that total reserves are the checkable deposits the public keeps in a commercial bank. Required reserves are a percentage of the checkable deposits commercial banks must keep on hand, as required by the Federal Reserve. These reserves protect banks if customers "run" the bank (show up to collect their deposits), such as during periods of financial instability and panic. Excess reserves are the percentage of checkable deposits the Federal Bank allows banks to lend to their customers.
Since banks are only required to keep a fraction of their deposits as reserves, there is the risk that all of their depositors will show up simultaneously to withdraw their deposits, such as during unfavorable market conditions. This is called a "run" on the bank. How can banks assure their customers that they can withstand these pressures and fulfill their obligations? Watch this lecture on the concerns and weaknesses of fractional reserve lending.
4.3: Structure and Powers of the Federal Reserve System
Every industrialized nation has a central bank – Germany has the Bundesbank, the United Kingdom has the Bank of England, and the United States has the Federal Reserve Bank. The U.S. Federal Reserve system has three critical entities: the Board of Governors, 12 Federal Reserve Banks spread throughout the United States, and the Federal Open Market Committee. The Federal Reserve Act created the Federal Reserve in 1913 to serve as America's central bank and actively monitor the country's money supply. The Federal Reserve is an independent government agency. The Board of Governors, located in Washington, D.C., is an agency of the federal government and reports to and is directly accountable to Congress.
Read this text on the structure, functions, and goals of the Federal Reserve System. How do central banks affect monetary policy, promote financial stability and provide banking services?
Read this text on the relationship between bank regulation and monetary policy. How do central banks supervise individual banks throughout the country? Deposit insurance and lender of last resort are two strategies for protecting against bank runs.
Read this text, which describes the three traditional tools central banks have to implement monetary policy: open market operations, adjusting reserve requirements, and changing the discount rate.
Monetary policy is the critical macroeconomic policy created by the central bank. It involves managing the nation's money supply and interest rate. Governments use this demand-side economic policy to achieve macroeconomic objectives, such as inflation, consumption, growth, and liquidity. The Federal Reserve is the independent government agency in charge of monetary policy.
Watch this video for an overview of the three tools of monetary policy: open market operations (buying and selling government securities), changing the required reserve ratio, and manipulating the discount rate.
Read this article for more on the three tools of monetary policy. Pay attention to the difference between the federal funds rate, which banks set, and the targeted federal fund rate. Some of the reading describes how the Fed provides signals to the market to stimulate economic activity and goal achievement.
Read this text on the difference between expansionary and contractionary monetary policy. It describes how the Federal Reserve has used monetary policy to impact interest rates and aggregate demand during the past 40 years. Monetary policy should be countercyclical, which means it should counterbalance the business cycles or economic downturns and upswings. What is the significance of quantitative easing (QE)?
The central bank significantly influences inflation, unemployment, asset bubbles, and leverage cycles. Do you think monetary policy should be more democratic? Pay attention to the formulas economists use to calculate the velocity of money to determine the effects of monetary stimulus.
Watch this video for another perspective on the Federal Reserve system of banks. As you learn about the Fed's structure, consider how the decision-making authority of this institution is insulated from the nation's political processes.
This video discusses the history of the Federal Reserve from its creation through present-day banking. It explores the Fed's structure, its role in banking supervision and financial services, and its primary role in designing and carrying out monetary policy.
4.4: Financial Markets
Financial markets are any place or system that provides buyers and sellers the means to trade financial instruments, such as bonds, equities, international currencies, and derivatives. Financial markets transfer funds from savers to borrowers who need funding. They facilitate this interaction between people and businesses that need capital and those with capital to invest, which helps economic growth.
Read this text to understand foreign exchange markets and different types of investments, such as foreign direct investments (FDI), portfolio investments, and hedging. How do appreciating and depreciating currencies affect exchange rates? Who benefits when one currency is weaker or stronger than another?
Read this text on how supply and demand affect exchange rates. What is arbitrage? Why is purchasing power parity important when comparing the economies of different countries?
Read this text on how shifting exchange rates affect aggregate supply and demand and how they affect banks and loans.
Read this text to identify and compare the advantages and disadvantages of a floating exchange rate, a soft peg, a hard peg, and a merged currency.
Watch this video on the foreign exchange market and how we determine a currency's value through the demand and supply of currency. Be sure you can explain why countries manipulate the value of their currency. How do they do this?
Watch this lecture, which explains that we can think of interest as a form of rent for money. Note that equilibrium interest rates are the balance or combination of the market for money plus the investment demand for money. Consequently, the equilibrium real GDP and the price level determine the equilibrium based on transactional demand and investment demand.
Watch this lecture on how money supply and demand impact interest rates. Note that the interest rate is the price of money (as it is money's opportunity cost). When individuals consider the interest rate when deciding how much income to save and how much to spend, they are choosing how much money to hold (for spending).
Watch this lecture on the relationship between bond prices and interest rates. Both corporations and governments buy and sell bonds depending on the market price. Understanding these transactions will help you with your own investing and provide a lens on the global economy.
Read this article on the stock market and how expectations affect the price of a stock. Speculators tend to focus on price changes and try to sell at a price higher than they bought the stock. A stock is a share of ownership in an organization – its price is largely determined by the supply and demand for the stock in the stock market.
Unit 4 Assessment
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