Three Functions of Money
- Medium of Exchange
- Store Value
- Unit of Account
Definition of M1
paper currency, coins, traveler’s checks, and checking account balances
Appox. size of M1 and M2 today
M1: $2.5 trillion
M2: $11.5 trillion
Definition of M2
all of M1, plus long-term savings, mutual funds, money market funds
Taylor Rule
what the Fed uses to calculate the optimal FFR should be
=inflation rate+avg. LT FFR+half inflation gap+half RGDP gap
Federal Funds Rate
interbank lending rate (>$1 million), usually overnight
0-.25% today
Prime Rate
rate banks charge preferred customer
3.25% today
Discount Rate
rate Fed lends to member banks (lender of last resort)
.75% today
Five interest rates:
- Federal Funds Rate
- Prime Rate
- Discount Rate
- Mortgage Rate
- T-bill rate
Three reasons to hold money
- Transaction Demand
- Speculation Demand
- Precautionary Demand
Six Methods for Fed to manipulate money supply
- Open-market operations
- Change reserve requirements
- Discount Rate
- Term Auction Facility
- Interest Payments on reserves
- Quantitative Easing
Seven Functions of the Fed:
- Issuing currency
- Setting reserve requirements
- Lending to Financial institutions and serving as an emergency lender
- Providing for check collection
- Acting as a fiscal agent; provides financial services for the federal government
- Supervising banks
- Controlling the money supply
What two feature of our banking system allow banks to create money?
- Fractional Reserve System
2. Checking deposits are included in the money supply
Money Multiplier
how much of every dollar deposited can be made into “new” money
=1/RR
Why is the supply of money so important?
the amount of money in an economy determines the interest rates for investment and some consumer spending, which in turn affects RGDP and whether the economy is in recession or inflation
Pros of Monetary Policy (4)
- quicker to implement
- isolated from politics
- doesn’t increase debt
- more subtle (better for inflation)
Cons of Monetary Policy (4)
- Long operational lag
- not as effective in a recession
- liquidity trap
- doesn’t help unemployed