Discussion Notes Federal Reserve Instruments to change money supply (quantity of reserves) Influence quantity of reserves Open-market operations buying/selling bonds - - ↑ money supply Buy bonds ↓ money supply Sell bonds Lending money to banks Discount rate: the rate the Fed will charge banks ↑ money supply ↓ discount rate - banks will be more willing to ask to borrow (domino effect on other borrowers) ↓ money supply ↑ discount rate Influence the reserve ratio Reserve requirement - ↑ money supply ↓ reserve requirement ↓ money supply ↑ reserve requirement Reserve ratio = reserves / deposits Paying interest on interest ↑ money supply ↑ money multiplier ↓ reserve ratio ↓ interest rate on reserves ↓ money supply ↓ money multiplier ↑ reserve ratio ↑ interest rate on reserves - Money multiplier = 1/R R = reserve ratio Monetary neutrality Any change in money supply will not affect real variables Nominal variables are usually measured in monetary units Real variables are usually measured in physical units Ex. real GDP, real interest rate, savings, investment, unemployment) Quantity Equation: V x M = P x Y → dv + dm = dp + dy V = velocity M = quantity of money P = Prices Y = GDP (V x M) = nominal value of money (P x Y) = nominal value of GDP Measures of Money Stock M1: currency, checks, deposits M2: M1 + savings, mutual funds Ex. You take money from saving and make it cash M1 will increase M2 will stay constant Examples 1. Assume that the reserve requirement is 20%. Also assume that banks do not hold excess reserves and there is no cash held by the public. The Fed decides that it wants to expand the money supply by $40 million. a. If the Fed is using open-market operations, will it buy or sell bonds? buy b. What quantity of bonds does the Fed need to buy or sell to accomplish the goal? Explain your reasoning. Change in money supply = (x) (1/R) X = money inserted into the economy R = reserve ratio 1/R = multiplier (x) (1/0.2) = 40 x=8 2. The economy of Elmendyn contains 2,000 $1 bills. a. If people hold all money as currency, what is the quantity of money? $2,000 b. If people hold all money as demand deposits and banks maintain 100% reserves, what is the quantity of money? $2,000 c. If people hold equal amounts of currency and demand deposits and banks maintain 100% reserves, what is the quantity of money? $1,000 (demand deposits) → not lending $1,000 (currency) → $2,000 d. If people hold all money as demand deposits and banks maintain a reserve ratio of 10%, what is the quantity of money? $2,000 (demand deposits) 2000 x (1/R) = x 2000 x (1/0.1) = $20,000 e. If people hold equal amounts of currency and demand deposits and banks maintain a reserve ratio of 10%, what is the quantity of money? $1,000 (demand deposits) → 1000 x (1/0.1) = $10,000 $1,000 (currency) → $1,000 $10k + $1k = $11,000 3. If Aubrey Huff takes $1,000 from his savings account and moves it to his checking account a. M1 goes up b. M2 goes up c. Both A and B are true d. Neither A nor B are true 4. If Matt Cain deposits $5,000 cash into his savings account, then a. M1 goes up b. M2 goes up c. Both A and B are true d. Neither A nor B are true For Questions 5-7 First Bank of Prosperity Assets 5. 6. 7. Liabilities Reserves $500 Loans $1,500 If the reserve requirement is 10%, this bank a. Is holding total excess reserves of $200 b. Is in a position to make a new loan of $300 $2,000 (deposits) → 10 % = 200 → $500 - $200 = $300 c. Has total reserves of $2,000 d. Has less reserves required If the reserve requirement is 25%, this bank a. Has fewer reserves than required b. Can make no further loans $500/$2000 = 25% Cannot take money from reserves to loan out c. Can make further loans d. Both A and B are correct Which of the following is true? a. This bank never lends money to anyone Deposits $2,000 b. c. d. This bank lends out 100% of what it receives This bank has zero net worth (or owner’s equity) Zero net worth = assets - liabilities This bank holds a large amount of bonds