Monetary Policy

Okay. Hello. This week we are continuing our discussion of how we as macro economists manipulate the aggregate demand aggregate supply curve. We have tools as an economy to move that aggregate demand curve to either combat unemployment or combat inflation. Last week we talked about fiscal policy. Fiscal policy is controlled by Congress. They deal with either taxation or government spending. This week we are moving on to monetary policy. Before we dive into monetary policy first things first, what is money? We are all familiar with money. It is how we are paid for our services. It is how we pay for our goods. For something to function as money, it needs three characteristics. Number one, it has to be a medium of exchange. For your economy to consider something money basically means it has to be accepted when we exchange goods and services. We have long moved away from the barter system where if I wanted something I had to find someone who wanted the thing that I was capable of manufacturing and offering and trading a good for a good or a service for a good service for a service. Now we kind of use money to facilitate all of those traits. We basically have decided collectively as a culture that will all just accept currency in exchange for goods. I am willing to accept currency for my services because I know someone else is willing to accept the money that I make for the goods or services that I want. It facilitates exchange. Money has to be a medium of exchange. It has to be accepted wherever we trade. Number two, it has to be a unit of account. We have to accept it in terms of trade. It also has to be something that you can count. There has to be an amount of it. We can't use smiles or laughter as money. Sometimes maybe someone might be a little bit nicer to you. If you smile to them you could get something out of a smile but it's not currency. It's not money. It can be a useful tool but it is not money. You have to be able to count it whether it is coins or dollar bills or gems that you find. There has to be some way to measure money in exchange. A third. The third thing you need for something to count as money is it has to be a store of value. It has to be accepted wherever trade takes place. You have to be able to count it and you have to be able to hang on to it and store value. It can be something that rots or goes away. You have to be able to store it. That's because trades don't always happen exactly at the same time. For instance, if I make shoe laces and I want a boat, I don't need to find someone who makes boats and wants a lot of shoe laces. I can sell shoe laces to different people over a long period of time and when they give me money, I can keep that money and I can sell lots of little things way and buy one big thing. Or if I make a boat, I don't have to buy a whole lot of things all at once. I can sell a boat for a lot of money and then I can spend it little by little because I can store it and use it as I see fit. So if something has those three characteristics, medium of exchange, unit of account, store of value, it is money. It functions as money in an economy. We have currency, the US dollar in this economy and we're talking this week about who controls the money supply and how they use it to enact economic policy. In the United States, the entity that controls our money supply is the Federal Reserve Bank, the Federal Reserve Bank or the Fed for short. The Federal Reserve Bank is made up of twelve branches spread out over the United States. The closest one to Rutgers University in Camden is Philadelphia. Philadelphia has a Fed. So they're there, spread out over the United States. Each branch is tasked with monitoring all the banking that goes on within its district. So the Federal Reserve Bank is essentially a bank for banks. You and I cannot go open checking account at the Federal Reserve Bank. We put our money in a banking system. Banks that you're familiar with, TD Bank, Wells Fargo, all of those commercial banks, credit unions, all of these different entities within our banking system. They all report to the Federal Reserve Bank. So it is a bank for banks. When banks need to borrow money, sometimes they do it from each other but they can also do it from the Federal Reserve Bank. When the government needs to borrow money, they borrow money from the Federal Reserve Bank. That is the central banking system for the United States. For our economy is the Federal Reserve Bank. So some of the things the Federal Reserve Bank does. Like I said, they supervise all the banks within their district. They are what we call a lender of last resort. They loan money to banks or to the governments. They issue our currency. If you take a dollar out of your wallet right now, it does not say the United States government on it. It says Federal Reserve notes. So they issue our currency. They act as a clearinghouse for all banks. Because all banks report to the Federal Reserve Bank, that's why if you hire your buddy to walk your dog and they have TD bank and you have Wells Fargo. If you write a Wells Fargo check and hand it to them for walking your dog, they can take it that Wells Fargo check. They can take it to a TD bank and they can cash it. Because all of the checks end up at the Fed at the end of the day. And the Fed will look at that Wells Fargo check at TD bank and they will just take some money from their Wells Fargo account. Move it over to their TD account and that money goes essentially from you to your friend through the Federal Reserve. The Federal Reserve clears all of those checks. It's how banks are able to communicate with each other. So they are a clearinghouse. They are a lender. They are a bank for banks. They supervise a banking system. Each branch has a president and then the entire Federal Reserve system is governed by a board of governors, one chairman who is the chairman of the board of governors of the Federal Reserve bank. So they control the money supply in the United States. The Federal Reserve bank is in charge of the money supply. So one of the most powerful things that the Federal Reserve bank does is enact monetary policy. When we're talking about our fundamental macro model, the aggregate supply, aggregate demand model and how we manipulate it. We talked about fiscal already and the other main way we deal with unemployment inflation. The other main way we deal with equilibrating our macro model is to monetary policy. Monetary policy is controlled by the Federal Reserve bank. It has to do with releasing money into the economy or taking money out of the economy. So when you're reading this chapter on monetary policy, what I want you to keep in the back of your mind is what are we doing to either release money into the hands of the American people or to take money away from the American people. That's how we're going to move that aggregate demand curve. That's how we're going to combat either unemployment or inflation. If you release money into the hands of the American people, there's more money in circulation. That means there's more money available to spend, which is going to push that aggregate demand curve forward, combating unemployment. If you do it too much, it's going to cause inflation. If there's too much inflation and you take money out of circulation, that's going to slow down the aggregate demand curve, reel it backward. It's going to fight inflation. If you do it too much, it's going to cause unemployment. So it's the same balancing act that they're playing only now. It's being played by the Federal Reserve Bank instead of Congress. So there are couple tools that the Federal Reserve Bank has in order to manipulate the aggregate demand curve. I want you to pay close attention to them as you're reading the chapter. The first and the most important, the most widely used tool of monetary policy is open market operations. This is the buying and selling of securities. So if the Fed wants to release more money into the public, they will buy these securities from the bank and they will buy them with money. So if the Fed is taking these securities, they are releasing the money out into circulation. That's going to increase spending because it's going to lower the interest rate for that money. Just like any other product, if there's more of it available, then the price is going to be lower. We have a name specifically for the price of money and that is the interest rate. The demand for money It's just like the demand for any other product. It is downward sloping. If the interest rate is low, we want to borrow lots of it. We want to hang on to the cash that we have instead of keeping in a bank somewhere. Money is sort of freely flowing when the interest rate is low. Because the demand for money is downward sloping. Do not confuse the demand for money with the demand for wealth. The demand for wealth is always infinite. We always want as much as we can all the time. Money is just one form that wealth can take. So we don't always want to hold on to our wealth in terms of money. If the interest rate is very, very high, we don't want to borrow money. We want to get it out of our pockets into a bank where it can earn that interest rate. It's not flowing as easily. It's sort of left a little bit untouched. So when the Fed wants to lower those interest rates and increase the money supply, they buy back those securities. They release money in exchange for securities that's going to be flowing through the economy. If they want to slow down the aggregate demand curve, they want to fight inflation. What they will do is they will sell securities to the bank. The bank will buy securities from the Fed and they will pay the Fed money for those securities. Once the Fed takes that money from the banks and is holding it, remember we as American people do not have access to funds that are at the Federal Reserve Bank. If the Fed takes that money from the bank in exchange for securities, they hold on to it. We don't have that anymore. It's not in the hands of American people anymore. That's going to slow down the spending in the economy. So every time you think about these tools, think about it as the money flowing from the Fed or as it going to the Fed where we don't have access to it anymore. Open market operations are the most widely used tool of monetary policy. When we're contrasting monetary policy and fiscal policy, members of the Federal Reserve Bank are not democratically elected. They don't have to worry about political considerations. We refer to the Federal Reserve Bank as we call it quasi-public. It is closely related to the government, but these members that are working there are not elected presidents of Federal Reserve branches are hired and fired like any other institution. The chairman is appointed by the president, for extent in terms of 14 year terms, out of the board of governors, but the board of governors is sort of hired the way that you would hire for a typical private institution. So it's closely related to the government, but they don't have to worry about if they're going to upset voters by trying to control inflation or whether they're fighting unemployment. How they're dealing with the money supply is not subject to those political considerations. So they're much faster and they're much more agile. The Fed votes on whether or not to buy or sell securities every couple of weeks that move much faster than Congress can. The committee that actually determines these open market operations is referred to as the FOMC or the Federal Open Market Committee. All the board of governors vote in the FOMC. All the board of governors on the overarching Federal Reserve System. Four of the branch presidents vote in the FOMC. They rotate on one year terms. So for a year, if you are the president of the Philadelphia branch of the Fed or the St. Louis branch of the Fed, that might be your year to vote in the FOMC. There is one branch president who never rotates out of the Federal Open Market Committee and that's the president of the New York Fed. A lot of these securities are bought and sold through Wall Street, so the president of the New York Fed never rotates out. The other presidents, they rotate on one year terms and then the full board of governors, they always vote in the Federal Open Market Committee too. They meet regularly. So this is a tool that is used aggressively. It is the most widely used tool. There are two more tools that I would like you to know. Number two is the Reserve Ratio. The Reserve Ratio is how much of your deposits have to be kept at a bank on a bank's ledger available for withdrawal at any given time. So we are going to fractional reserve system. When you deposit money into a bank, a lot of that is loaned out. If you went to a bank and tried to withdraw all of your money from the most part, unless you are extremely wealthy, it will all be there. But if everyone at the same time went to withdraw all of their money from all of the banks, a small fraction would be less than 10% would be there. Most of the money that we deposit gets loaned out. That's how banks operate. They hold your money, they loan it out, they charge interest. There is money falling to and from the bank constantly. The money that is falling to and from the bank is your money. That's the money that you deposited. So at any given time, you could withdraw your money. The bank knows that most of the money stays and they can loan it out and earn interest on it. They will pay you some of that interest in the different forms of financial assets. But a fraction of it has to be held in reserves. A fraction of it has to be held in reserves available for withdrawal at any time. Usually in between 8% and 14% has to be there. If the Fed wants to slow down the flow of money in the economy, they will raise that reserve ratio. They will go to all of the commercial banks across the country and they will say you have to keep more available for withdrawal than you did before. That's going to slow down the way money gets loaned out from banks. It's going to raise the interest rate because that money isn't flowed through the economy as freely as before. If they want to fight unemployment and they want that money flowing, they might say, hey, instead of holding 10%, you only have to hold 8% now. That money that you used to have to keep in your vault available for withdrawal, you're allowed to loan that out now. They're going to lower the reserve ratio. That's going to let the money flow out into the economy. The last tool that I want you to consider is the discount rate. That is the rate that the Fed charges banks for loans. It's basically a signal the Fed is sending to banks. If the Fed raises the discount rate, it's basically like they're saying to banks, hey, you should be really careful about who you loan money to because if for whatever reason you have a run of people that are defaulting on their loans and you're running tight on cash, it's going to cost you a lot to borrow money from us. We're going to charge you a higher discount rate. We are going to make it difficult for you to borrow money from us, so you should be pretty cautious about who you lend money to in turn. When the Fed lowers the discount rate, it's like saying loan money out from your banks. Get it into the hands of the America people. If they default on their loans, if things are a little riskier than before and it doesn't work out for you, you can always borrow money from us. We're going to make it a little bit easier for you. We're going to make it cheaper. We want to loan money to you. We want you to loan money to the American people. The discount rate is the rate that the Fed charges banks when banks need to borrow money. It's a signal they send to banks about how cautious or how freely they should, cautiously or freely, they should loan money to the American people. That's an interest rate that the Fed chooses. There is an interest rate that the Fed monitors very closely when they're enacting monetary policy. This is the last thing I'll talk about today. The interest rate that the Fed monitors very closely is something that we call the federal funds rate. The federal funds rate is the rate at which banks loan other banks money for overnight loans. For instance, like we were talking about before, there has to be a certain amount of money on your ledger, a certain percentage, when the Fed closes the books at the end of the day. If I'm a bank and I'm going to be a little bit short and you're a bank and you're going to have some excess reserves, I might borrow that from you. Just for the day, just when the Fed checks and you're going to charge me a small interest rate because I'm borrowing money for you just to clear my books by the end of the day. It's difficult to get your finger closer to the pulse of how much money is worth than when banks are charging each other for overnight loans. It's immediate and it's the institutions that are most in tune with how much money is worth, banks charging each other a rate for overnight loans. What the Fed does is when they buy yourself securities, when they raise or lower the discount rate, when they raise or lower the reserve ratio, they look at that interest rate that banks are charging each other and they see how it was affected. That is the interest rate that they monitor because the value of money basically stems from that. That's as close as you can get to how banks are valuing money in that exact moment. It's the rate the Fed looks at the closest to the federal funds rate. While you're reading this chapter, I know this is a lot. We're looking at money, banking, and the federal reserve system. Keep in mind, the primary thing I want you to think about is what's going on? Are we releasing money into the economy that are to fight unemployment? How are we doing that? Are we trying to take money away from the economy, out of the hands of the American people to fight inflation? Taking that money and we're holding it in the Fed where the American people do not have access to it? What tools are we using? That's just a monetary policy. What is the Fed doing to steer that aggregate demand curve? Are we releasing money to push it forward? Are we taking money out to hold it back? Read these next two chapters carefully. Make sure you have a handle on monetary policy. Think in the back of your mind, how does this differ from fiscal policy? How is it similar to fiscal policy? What are the expansionary tools of monetary policy? What are the contractionary tools of monetary policy? The Congress and the Fed should have the same goals, right? If we need expansionary policy, they're going to agree that we need expansionary policy. If we need contractionary policy, they should agree that we need contractionary. They should be working together. Some of the main differences, though, are that the Federal Reserve system is going to be a little more agile. They're going to be able to make decisions a little more quickly than Congress can. But overall, they should be working together to steer that aggregate demand curve. Take a look at this, as always, please do not hesitate to contact me with any questions or concerns. We're getting into the closing days of our semester. I want to make sure that everyone is on the same page in terms of material that you should know for the second midterm, as well as the final exam. So again, please don't hesitate to contact me if you have any questions or concerns. Thanks a lot.