ECON102: Principles of Macroeconomics (2024.A.01)

4a. Define money and identify its functions

• What are the three functions of money: medium of exchange, unit of account, and store of value?
• What kind of money describes most major currencies, such as the dollar, Euro, rupee, yen, etc.?
• Are these currencies backed by gold or another precious commodity?

An item needs to serve three functions to be suitable for use as money: a medium of exchange, a unit of account, and a store of value.

Commodity money describes money that has its own intrinsic value. For example, prisoners may use cigarettes for money or payment. Fiat money does not have intrinsic value. It is backed solely by the trust the money holder places in the institution that issues it.

To review, see:

• Money and Banking
• Defining Money by Its Functions
• What Is Money?

4b. Show how money is measured and explain the role of banks in the money creation process

• Why do banks consider checkable deposits a liability?
• What happens to a bank when loans go bad during a financial crisis?
• What does it mean when a bank's net worth is too low?
• Describe the relationship among assets, liabilities, and net worth.

A bank is a financial intermediary – an institution that facilitates the flow of money among borrowers and lenders. When you deposit money into a savings or checking account, you essentially lend your money to a bank. In turn, the bank will lend your deposit out to other individuals and businesses as a loan. The bank charges these individuals and businesses interest for the privilege of being able to borrow money.

The bank reimburses you with a portion of the proceeds it earns from its borrowers in the form of an interest rate. A higher interest rate is a form of encouragement – it encourages you to make more deposits so the bank can offer even more loans and earn even more money).

This table illustrates the components of a bank's balance sheet.

Assets		Liabilities and Net Worth
Reserves	$1,592.90	Checkable deposits	$8,517.90
Other assets	$1,316.20	Borrowings	1,588.10
Loans	$7,042.00	Other liabilities	1,049.40
Securities	$2,546.10	0.0	0.0
Total assets	$12,497.20	Total liabilities	$11,155.40
0.0		Net worth	$1,341.80

This balance sheet for U.S. commercial banks shows their seasonally adjusted financial situation in billions of dollars in January 2012.

To review, see:

• Money and Banking
• The Role of Banks
• What Is Money?
• How Banks Create Money
• Creating Money

 

4c. Apply the money multiplier formula to calculate the change in money supply in a fractional reserve banking system

• How do we calculate the total change in the money supply by using an initial deposit value and the money multiplier?
• How can banks increase or reduce money creation?
• How do individuals participate in the money-creation process? Can they influence the final outcome?
• What kinds of policies can the government and the central bank impose to affect the money multiplier?

Money Multiplier = 1 / Required Reserves Ratio

To understand the money creation process, you should study the structure of a bank's balance sheet. Notice the reserves category under the assets side of the balance sheet. Banks must keep a certain percentage of their deposits as reserves (or required reserves). Bankers call any reserves they hold in excess of the required reserves excess reserves.

Study the money creation process by following the money path through the banking system from an initial new deposit. Analyze the bank's balance sheet and how it reflects the money flow.

For example, a bank splits an initial deposit into required and excess reserves. Excess reserves become a source for money lending. Once the bank lends this money out, the next bank in the banking system (or possibly the same bank) will categorize it as a new deposit, and so on. When the same money circulates between deposits and loans multiple times, it leads to a multiplication of money. The money multiplier (or deposit multiplier) is a variable that helps us measure the total amount of money created from the initial deposit.

To review, see:

• Fractional Reserve Banking
• Full Reserve Banking
• Weaknesses of Fractional Reserve Lending

4d. Explain the structure, functions, and goals of the U.S. Federal Reserve

• How does the U.S. Federal Reserve use each of these three monetary policy tools to affect the money supply?
• Which of these three monetary policy tools does the U.S. Federal Reserve use most widely?
• How does the U.S. Federal Reserve structure support its independence from politics and government?

The U.S. Federal Reserve (the Fed) serves as the central bank for the United States government. The system includes 12 regional banks located in different regions of the country. We do not consider the Federal Reserve System part of the federal government. It is a semi-private institution not financed nor regulated by the U.S. government.

As with most central banks, the U.S. Federal Reserve performs the following functions:

• Serves as the central bank for the federal government;
• Serves as the bank for its member banking institutions;
• Regulates banks in the United States;
• Conducts U.S. monetary policy; and
• Oversees and stabilizes the U.S. financial system.

The U.S. Federal Reserve has three main tools at its disposal to control the U.S. money supply: the reserve requirement, the discount rate, and open market operations.

To review, see:

• Monetary Policy and Bank Regulation
• How a Central Bank Executes Monetary Policy
• Monetary Policy and the Federal Reserve
• The Fed Today

4e. Show the importance of the Fed's independence from the government and explain how the Fed's structure and decision-making process promote independence

• What is the structure of the Federal Reserve System?
• How does this structure help to promote independent decision-making?
• Why does the Chairman of the Fed have such power and influence in economic policy-making?

The mission of the Federal Reserve is to establish and maintain confidence in the public's monetary and banking system. Obviously, this cannot be accomplished without a great deal of trust. Consequently, it is important that the public believes the Fed is independent and not subject to outside pressures, such as politics, when making decisions. Today, the Fed plays an even greater role in preserving our nation's healthy economy.

The Federal Reserve's roles in conducting monetary policy, supervising banks, and providing payment services to depository institutions help it maintain the financial system's stability.

The Federal Reserve System (the central bank of the United States) has 12 districts throughout the United States. A subset of this larger group is a seven-member Board of Governors that is appointed by the U.S. president and approved by the Senate. Each member serves a 14-year term.

The U.S. president appoints one member of this seven-member board as chair of the Federal Reserve for a four-year term. They can serve multiple terms. The larger 12-member Federal Open Market Committee (FOMC), the policy-making group within the Fed, conducts all open market operations (the buying and selling of government securities).

The terms of the Board of Governors are staggered. This helps insulate the Board from political pressures so they can base their policy decisions on economic merits. Each member (except the Fed chair) only serves one term to further ensure independent decision-making. Finally, the Fed's policy decisions do not require Congressional approval. The U.S. president cannot force a Federal Reserve Governor to resign.

The chair of the Federal Reserve only has one vote, but they control the agenda and are the public voice of the Fed. These responsibilities bestow great power and influence on the Fed chair position.

To review, see:

• Bank Regulation
• Monetary Policy and the Federal Reserve
• The Federal Reserve System
• The Fed Today

4f. Identify three tools of monetary policy and how they are used to change the economy's money supply

• How do open market operations, reserve requirements, and changing the discount rate influence the money supply?

The central bank has three tools to implement monetary policy: 1. open market operations, 2. changing reserve requirements, and 3. changing the discount rate. Open market operations occur when the central bank buys or sells U.S. Treasury bonds. This influences the quantity of bank reserves and the level of interest rates. Decisions are made by the Federal Open Market Committee (FOMC). The Fed can also raise or lower the discount rate, which is the interest rate banks pay for loans from the Fed. Finally, the central bank can raise or lower the reserve requirement, that is, the percentage of each bank's deposits that it is legally required to hold either as cash in its vault or on deposit with the central bank.

To review, see:

• Monetary Policy and Bank Regulation
• How a Central Bank Executes Monetary Policy
• Monetary Policy
• Monetary Policy and the Federal Reserve

4g. Explain and illustrate how the bond market works and the relationship between bond prices and interest rates

• How does the bond market work?
• What is the relationship between bond prices and interest rates?
• What happens to demand when interest rates are lowered because of the sale of bonds by the Fed?

Open market operations are the most widely used monetary policy tool of the U.S. Federal Reserve. Be sure to review how the U.S. Federal Reserve affects the following interconnected markets: bond market, money market, goods and services market, and foreign exchange market.

In the information below, we review the effect the U.S. Federal Reserve's buying and selling of bonds has on demand, bond prices, and interest rates. Note the diagrams, Panels a, b, c, and d, that graphically explain the effect of expansionary monetary policy to close a recessionary gap.

Expansionary Monetary Policy

The U.S. Federal Reserve starts the process by buying government bonds on the bond market. This increases demand for bonds on the bond market – a shift of demand for bonds to the right. The increased demand causes bond prices to increase and interest rates to decrease (bond prices and interest rates are negatively related). See panel b.

When the U.S. Federal Reserve buys bonds, it essentially adds reserves to the banking system (the U.S. Federal Reserve prints the extra money it needs to buy the bonds out of thin air or simply adds the additional assets it buys to its balance sheet). This is graphically illustrated in the money market as a shift of the money supply curve to the right and a decrease in the equilibrium interest rate. See panel c.

Lower interest rates encourage households and businesses to spend money (especially spending on credit). The consumption and investment components of aggregate demand increase, causing a shift of the aggregate demand curve to the right in the goods and services market. The price level rises in equilibrium. See panel a.

Finally, the higher price level makes domestic goods and services appear more expensive to foreigners, which discourages U.S. exports. At the same time, foreign goods appear relatively cheaper, which encourages Americans to increase imports. These effects put pressure on the value of the dollar as follows: demand for dollars decreases, and the supply of dollars increases, leading to a cheaper dollar in the foreign exchange market. See panel (b) to see what happens to price levels and demand when the Fed responds to a recession by buying bonds.

 

To review, see Monetary Policy and the Federal Reserve and Bond Prices and Interest Rates.

4h. Explain how the foreign exchange market works and how changes in the interest rate affect the exchange rate for a country's currency

• How does the foreign exchange market work?
• How do changes in the interest rate affect the exchange rate for a country's currency?
• Why can a stronger U.S. dollar be both a blessing and a curse, depending on the party's role in a transaction?

The information below will guide you in the highlights of the material. The readings indicated for review below are strongly recommended to provide more insight into these topics.

Most of the international economy occurs in multiple national currencies, where individuals and firms convert one currency to another when they sell, buy, hire, borrow, travel, or invest in foreign countries. People and businesses purchase foreign currencies in the foreign exchange market.

Businesses that buy and sell on international markets learn that they must pay the costs to their workers, suppliers, and investors in the currency where the production occurs. Still, their revenues from sales are measured in the currency of the nation where their sales occurred. For example, a Chinese firm exporting abroad will earn another currency from the sale – perhaps U.S. dollars – but it will need Chinese yuan to pay its workers, suppliers, and investors who live in China. In the foreign exchange market, the Chinese business is a supplier of U.S. dollars and a demander of Chinese yuan.

The foreign exchange market works through financial institutions and operates on several levels. Most people and firms who exchange a substantial quantity of currency go to a bank. Most banks provide foreign exchange to their customers. Banks and other firms, known as dealers, then trade the foreign exchange. This is called the interbank market.

A currency appreciates or strengthens when the exchange rate for a currency rises (we can buy a lot more Euros with a set amount of dollars). A currency depreciates or weakens when the exchange rate for it falls, so it trades for less than other currencies (we can only buy a few Euros with a set amount of dollars).

Movements in the exchange rate affect exporters, tourists, and international investors differently. A stronger dollar hurts U.S. businesses that sell products abroad. A strong U.S. dollar means foreign currencies are correspondingly weak. When the U.S. exporter is paid or earns foreign currencies from its export sales and converts them into U.S. dollars to pay its workers, suppliers, and investors who live in the United States, the foreign currency buys fewer U.S. dollars (because the U.S. dollar is stronger).

Consequently, the firm's profits (measured in U.S. dollars) fall. The U.S. company may decide to reduce its exports (waiting for the U.S. dollar to fall), or it may raise its selling price, which also tends to reduce its exports. Because of this, stronger currencies reduce countries' exports.

A stronger dollar is a blessing for foreign firms that sell products to the United States. Each dollar they earn from export sales in the United States will buy more home currency than they had anticipated before the dollar strengthened. Consequently, a stronger dollar means foreign exporters will earn more profits than they had expected. The company will seek to expand sales in the U.S. economy, or it may reduce prices, which will also lead to expanded sales. A stronger U.S. dollar means consumers buy more foreign products, expanding the country's level of imports.

Try to turn this scenario around to see what happens when the U.S. dollar weakens.

To review, see:

• Exchange Rates and International Capital Flows
• Demand and Supply Shifts in Foreign Exchange Markets
• Macroeconomic Effects of Exchange Rates
• Exchange Rate Policies
• More on Exchange Rates

4i. Graphically represent the money demand and the money supply functions and determine the equilibrium interest rate and quantity of money in the money market

• What is the shape of the money supply curve?
• What factors can shift the money supply curve?
• How does a shift of the money demand curve due to changes in factors of money demand affect the equilibrium interest rate?
• What about shifts in the money supply curve?
• How does a change in the interest rate influence the demand for money or the motivation people have to hold onto money or cash?
• How does money demand change with fluctuations in real GDP, the price level (inflation or deflation), expectations, transfer costs, and preferences?

The money supply describes the total quantity of money in the economy. The figure below is a graph of the money demand curve. Note the relationship between the variables: the quantity of money on the horizontal axis and the interest rate on the vertical axis.

Money demand represents the relationship between the quantity of money people demand or want to hold onto as ready cash or in a readily available, non-interest-bearing account (for transactional, precautionary, or speculative reasons) and the opportunity cost of money or interest rate (what you would earn if you invested your money into an interest-bearing account).

The Demand Curve for Money

The demand curve for money shows the quantity of money demanded at each interest rate. Its downward slope shows a negative relationship between the quantity of money demanded and the interest rate.

Money Market Equilibrium

In the figure below, we put money demand and money supply together on the same graph to analyze the relationship between the money market and the equilibrium interest rate. The supply curve for the money supply is a vertical line because it represents the fixed, total amount of money that exists in various bank deposits or reserves, as determined by the U.S. Federal Reserve. The market for money is in equilibrium when the quantity of money demanded equals the total quantity of money supplied. In this figure, equilibrium occurs at interest rate r.

Money Market Equilibrium

To review, see:

• Monetary Policy
• Monetary Policy and Economic Outcomes
• Pitfalls for Monetary Policy
• Exchange Rates and International Capital Flows
• Demand and Supply Shifts in Foreign Exchange Markets

4j. Use graphs to analyze the effect of changes in the bonds and money markets on the equilibrium real GDP and the price level

• What is the difference between the interest rate and the coupon rate of bonds?
• How does an increase in government borrowing (reflected as a new issue of bonds) affect the economy's interest rate?
• How do bonds compare with stocks?

The bond market is a financial market that allows firms and governments to borrow money directly from the public without going through financial intermediaries, such as banks. When an institution issues and sells a bond, it is essentially borrowing an amount of money (the bond's face value) at a predetermined interest rate (the bond's coupon rate) for a specific period of time (the bond's maturity date).

Once bonds are issued, investors can resell them on the secondary market. The demand and supply of bonds in the bond market determine the equilibrium price of bonds.

The bond price is negatively related to the interest rate. This means that when the price of a bond increases, the bond yield will decrease. This occurs because bonds have a fixed face value and a fixed coupon rate (if they have a coupon rate at all). Paying more for an existing bond will reduce its rate of return.

The Bond Market

To review, see Interest as Rent for Money and Money Supply, Money Demand, and Interest Rates.

 

Unit 4 Vocabulary

• bond
• bond market
• commodity money
• coupon rate
• discount rate
• face value
• fiat money
• financial intermediary
• foreign exchange market
• money supply
• open market operations
• secondary market