BANKINGPART I

Chicago's "End the Fed" Protest 11/22/09

BANKING, MONEY AND THE FED

WHAT IS MONEY? WHY DO WE NEED IT? HOW CAN WE GET IT?

IS THERE EVER ENOUGH? IS THERE EVER TOO MUCH????

WHAT BACKS OUR MONEY?

What Gives Money Its Value?

Our money today has value because of its general acceptability.

Three Kinds of Economic Goods

Consumer goods (end product)Capital goods (human, tools,machinery)Money (medium of exchange-store of

value- a liquid asset- deferred payment- basis for quoting prices)

Money is the most important part of market economy-it is at least one part of a barter transaction and whatever affects money affects everything else.

The larger the money supply >our demand for G & S.

***More money available the more willing to spend

Money Differs From Other Economic Goods

It’s supply must remain scarce for it to be valuable By itself it is nothing….. Must be circulated in

the economy by consuming or saving. If quantities of dollars increase in economy,

benefits go to those who get it first rather than who gets it last, because the first with the $$ can spend it with lower prices…

It is only useful for what it gets you in exchange for what you want.

Last to get the $$$ run the risk of inflation having set in.

Money vs. Barter

Money - Any good that is widely accepted for purposes of exchange and in the repayment of debt.

Barter - Exchanging goods and services for other goods and services without the use of money.

HISTORY OF MONEYBarter was symbol of primitive

cultureHomer wrote about cattle being

used as barter in the IlliadWhat are some of the things used as

money? rats, pigs, whales, teeth, tobacco, beads, women, cattle Why was gold and silver best used

as money?durable, convenient to handle, portable,difficult for supply to be increased, gold= glistened

Barter is inefficient and expensive

Deteriorates after few tradesRequires a double co-incidence of wants.Too costly to travel long distances

(trading a cow for a fuzzy fleece from L.L. Bean)

Coins were adopted

Money concept was born… Silver- Gold Then currency – 1863…. “In God We Trust.”

COMPONENTS OF MONEY

M1= Currency coins, demand deposits, travelers checks

M2=M1+Savings deposits, small time deposits (under $100,000), money market mutual funds.

M3=M1+M2+large denomination time deposits (over $100,000)

LM3 + liquid assets (T-bills,

U.S.Savings bonds, commercial paper)

Near Monies:Credit cardsStocks and BondsIRA’s401 K

Four functions of money

Medium of exchangeBasis for quoting pricesStore of value (can accumulate wealth by

saving)Standard of deferred payment (buy now, pay

later… no payments until 2020) Money will be good to pay in 2020 as is today.

Are Credit and Debit Cards Money?Yes!

Credit card use represents loans which must be repaid. They represent the use of someone else's money.

Debit cards give access to checkable deposits which are already part of the money supply.

Value of Money

How much money do you have:in your pocketin your checking accountin your savings account

Money has value- too much in circulation, decreases its value……. inflation is BAD

What backs our currency? Our money is called what? What will a dollar buy today?

FEDERAL RESERVE STRUCTURE

Board of Governors7 Members

12 District Banks

Member Banks

One of 7 is Chairman

FED Can Issue Federal Reserve Notes……………….

Have you ever seen a Federal Reserve Note?Do any of you have any Federal Reserve Notes?A=BostonB= New YorkC= PhiladelphiaD= ClevelandE= Richmond, VAF= AtlantaG= ChicagoH= St. LouisI= MinneapolisJ= Kansas CityK= DallasL= San Francisco

12 District Banks.Dallas is the 11th District… Khttp://www.dallasfed.org/

25 Regional Banks.Dallas has region banks in El Paso, San Antonio, Houston.

1. A. Boston

2. B. NY

3.C. Philadelphia

4.D. Cleveland

5.E. Richmond, VA

6.F. Atlanta

7. G. Chicago

8.H. St. Louis

9. I. Minneapolis

10. J. Kansas City11. K. Dallas*12.L. San Francisco

12 Regional Banks

BOARD OF GOVERNORS DUTIES

Appointed by Pres/confirmed by Senate-Serve 14 year terms-2 years rotationalOne appointed ChairmanSupervises the issuance and

distribution of federal reserve notes. *

Regulates all money and credit policies in U.S.

Supervises all 12 District Banks

Duties Continued

Sets Reserve Requirements- all banks required today.

Sets Discount RateServes as Majority of FOMCSets Margin Rates for purchasing stocksMaintain stability of financial systemProvide certain financial services for U.S.

govtRegulates state banks that join.

FOMC sets the Federal Funds Rate and then each District Bank sets their Discount Rate.

(they tend to be aligned.)

What is the Federal Funds Rate Today? 11/19/14 .25

7/1 /10 .254/22/10 .254/20/09 .2511/17/08 1.00%4/15/08 2.25 %4/16/07 5.25% 6/29/06 5.18% 4/17/06, 5.00% 11/21/05, 4.15%Was 2.875%(spring, 2005) (was 2% 12/2004) (2003, FFR was 1.0%)

Federal Funds Rate

http://research.stlouisfed.org/fred2/series/FEDFUNDS/

Is the Fed effective???---------

What is the Discount Rate today? 11/19/14 .75% 7/1/10 .75%4/22/2010 .75 4/20/09 .5011/17/08 1.25% 4/15/08 2.504/16/07 6.25% 6/29/06 6.00%4/17/06 5.75% 11/21/05 5.00% Spring, 2005 3.75% Dec. 2004, 3.00%

Discount Rate

http://www.ny.frb.org/banking/discountwindow.html

Prime Rate? – Today 11/19/14 3.257/1/10 3.25

4/22/10 3.25 4/20/09 3.25%11/17/08 4.00%5/15/08 5.25% 4/16/07 8.25%6/29/06, 8.00%4/17/06, 7.75%, 11/21, 7.00% (was 5.75% in spring 2005) (was 5.00 12/2004)?

Where does fiscal policy enter in here?

WHO BELONGS TO THE FED?All National BanksState Banks may opt to joinMonetary Control Act 1980 brought about

big changes in banking – very little difference exists now between member/non-member

ALL Depository institutions in U.S. are now under the jurisdiction of the Fed-which applies regulations on each and offers services to each ( check-clearing service used to be a money-maker-) Big banks have always exchanged checks among themselves. Others send to District for clearing. What has the Debit Card done to this service?

12 DISTRICT BANK STRUCTURE/DUTIES

Each bank has 9 on Board of Directors 6 members chosen by member banks, 3 chosen by BOG *only 3 may be bankers- why? Oversees operations of member banks Set interest-rate bank may charge for short-term

collateral loans- Approve member banks Pres and VP Clearing house for check from all regions Researches the economic health of the region-beige

book.

AUTONOMY OF FEDERAL RESERVE

Fed operates independently of Congress or Executive Branch- autonomous

Congress does not fund the Fed. Earnings made on financial assets, mostly government bonds- provides more funding than needed- rest returned to Treasury.

Each District Bank receives a % of assets from member banks and other services DB provides (check clearing/not much anymore why? Revenue lost by Fed????)

Fed does not undergo GAO Audits (Government Accountability Office)

Was set-up to be apolitical.

3 Monetary Tools for the FED1. Reserve Requirement

2. Discount Rate

3. FOMC

One Tool to Control Money SupplyReserve Requirement

The Fed requires banking institutions, including S&Ls, Credit Unions, Loan Assns, to maintain reserves against the demand deposits of their customers. Required and excess are important concepts

Required Reserves are: vault cash and deposits held for them at the Fed.

This RR can alter the loans that members can make by:

a) Lowering RR = creating more money to loan

b) Raising the RR= decreasing money creation.

RR’s do not change very often.Changes in RR can be disruptive of banking operations. RR change could force banks to sell securities quickly or call in loans to meet the Fed requirement.

Current: 3% 0- $79.5 Mil 10% $79.5+

Amount to be held on reserve

All banks as of 2014

Current: 3% 0- $79.5 Mil 10% $79.5+

Big Banks (8 largest banks)

Current (2014) 5% - $68 billion.

Will affect Goldman Sachs and Morgan Stanley most who do not have retail banking operations to accept cash deposits.

How Fractional Banking WorksFed RR is 20%(bank required to hold a percentage of

its deposits on RR

Deposit made = $100,000

-20,000 (bank holds in reserve

$ 80,000 (bank can loan this amount)

This $80,000 is considered new money

Whoever receives the $80,000 as a loan then deposits it into an account and can write checks immediately, but the bank views it as “never seen before.”

CONTINUED RR/FRACTIONAL BANKING EXAMPLE

$80,000

-16,000 (20% reserve required)

$64,000 (potential new loan which can be created and loaned out to another customer

$64,000 new deposit in mind of bank

- 12,800 (20 % must be kept in reserve)

$51,200 considered new money available for loan

CONTINUED RR/FRACTIONAL EXAMPLE

This cycle keeps going on and on-

The multiplier factor for 20% RR is 5 to 1

Using the above example- banks could create 5 times the $100,000 at 20% reserve required or in other words, it can create $500,00 “NEW MONEY”

At 25% required as opposed to say 10%- higher requirement would lower the multiplier effect from 10 to 4 which in turn would not allow banks to have as much money to loan- or would be taking money out of circulation.

Summary/RR/Fractional Banking/Multiplier

The higher the required reserve- the lower the multiplier.

The potential deposit expansion multiplier is merely the reciprocal of the required reserve ratio (r ) In case of 20% example or l/5 of total deposits to be held- deposit expansion multiplier is 5

If 10% was to be held- deposit expansion multiplier is 10.

DOES MULTIPLIER ALWAYS WORK? no

Creating New Money with the deposit expansion multiplier effect will not work if:

All excess reserves are tied up. (purchase securities, loans, etc.)

If person receiving the loan decides to hold currency rather than deposit it into the bank

If banks decide not to extend loans even though they have excess reserves available (referred in the early 90’s as “credit crunch.” And… happened after TARP and QE – to some extent still in place today!

WAMU Syndrome

Confidence! Do you have confidence in your bank? If no… take your money and runSelf-fulfilling prophecy.

SECOND TOOL TO CONTROL MONEY SUPPLY- DISCOUNT RATE

There are two types of interest: Simple and discount. Simple- paid each time a payment is made on the

loan. Discount- entire amount of interest owed is

deducted from loan before it is issued

Discount Rate Continued

The Discount Rate is the interest rate charged to member banks that borrow from the Fed District Banks.

Why would a member bank need to borrow from the “mother fed?”

Firms would go to their bank and request a loan… If bank had used its excess reserves, the commercial bank would then go to the District Bank to borrow the money.

The Commercial Bank would write an IOU to the District bank with asset collateral tied usually to government securities held at the District Bank.

The District bank would deduct whatever the Discount Rate of interest was from the requested amount and credit the commercial bank’s account.

Continued Discount Rate

These loans are generally overnight or short-term.

When money is transferred back to District to pay off IOU – the entire amount of the loan is due.

Say you borrowed $1,000 and the interest rate was 8 percent, the interest is deducted = $80 and the commercial bank account is credited $920…

All the bank gets is $920, but pays back $1,000

Setting up Prime Rate

District Bank is not a charity bank… charges interest on money loaned to member banks. If Member Bank borrows $100,000 at 10%

The interest is discounted up-front- Member has $90,000 to take back to loan.

Member bank is not going to loan at 10%

Adds 2 to 3 points to constitute prime rate. In this example is 13%

Discount Rate continued

If ordinary citizen wants to borrow, points added to prime depending on type of loan, collateral, history, etc.

Say 13% is Prime…. Points added 3 or 4 for ordinary person(remember, they build in inflation premium too.)

Prime rate is always higher than discount- each bank sets own prime, but large banks tend to all have the same.

Prime is rate given to best corporate customers.

DISCOUNT RATE CONTINUED

If Fed wants to cut down on bank loans, they can raise the discount rate.

Recently the Fed lowered the discount rate to encourage loans

**Banks will borrow from Federal Funds Rate before going to the Fed to borrow. Too many trips to the Fed to borrow signals poor fiscal management of the bank

What is the Federal Funds Rate? The rate banks can charge (as set by the BOG) for short-term loans between each other – often overnight.

Federal Funds rate will be lower than discount rate. Why?

The FF Target is the target for interest set by the FOMC.

This triggers either the buying or selling of government bonds on the open market.

Done by dealers through the securities desk at NY FED.

Primary Credit

.75%

Secondary Credit

1.25%

Seasonal Credit

.20%

Fed Funds Target

.25%

Discount Window Primary and Secondary Lending Rate

THIRD TOOL TO CONTROL OPEN MARKET COMMITTEE (FOMC)

This is the most common tool used by Fed to alter the money supply.

Buying and Selling of U.S. Securities on the open market

FOMC meets about every six weeks.FOMC = all 7 BOG, 12 District PresidentsN.Y. President permanent member, other 11

Presidents rotate on the voting 12 on yearly basis.

FOMC constitutes 12 persons who vote. Can directly influence the money supply in a

non-disruptive way.

FOMC Continued

FED can write a check without funds in an account so to speak.

FED holds large portfolio of U.S. government securities

FED engages in open market trading with approximately 3 dozen major securities dealers.

A SELL OPERATION When Fed wishes to restrain money supply

growth, the Fed sells U.S. government securities on the open market.

FOMC Continued

Securities dealers then pay the Fed from deposits held at their banks, and the Fed simply deducts an equivalent amount from the banks’ reserve account.

As result- banks have less credit in reserve-(taken from excess reserves) and cannot make as many loans

Banks might even have to sell some of their investments… reduced supply of credit throughout the banking system.

FED controls this operation by enticing banks to buy government securities by offering “good deals.”

Example: Treasury Bond issued to FED. $10,000. FED offers this Bond interest to pay a fixed rate of 10% yearly until bond expires.- Fed goes to bank and says (sell this $10,000 bond for $8,000 – still pay the 10%- (this is selling below par)

This pulls lump sum out of circulation (actual rate bank will make over bond life is 12l/2 % . Money supply has shrunk. If the banks elect to buy- less money to loan.

Banks can only buy government securities..Cannot buy corporate bonds.

FOMC CONTINUED

BUY OPERATION: When FED wants to increase the money

supply, it reverses the procedure and purchases U.S. government securities on the open market. It then credits the reserve accounts of the banks in which securities dealers keep their deposits. End result is that banks have more funds to lend.

Example: Fed offers to buy the $10,000 bond sold on open market for $12,000. Bank sells- this puts money in circulation or creates potential for banks to loan more to member banks.

FOMC CONTINUED

Open Market is not in the business to make money- they actually lose money on most transactions

Main function is to control loans the banks can make.

Securities desk in N.Y. puts the bonds for buy or sell out to Security dealers for best bid.

Every security purchased lowers the money supply.

FED can use this tool as major way to offset cyclical economic swings. Can also supply money for seasonal adjustment demands made by business and consumers. Or, as we saw, provide money when disaster strikes.

FOMC assesses growth operations directed to 4 objectives:

full employment, economic growth, stable prices and balance of payments.

No bank will ever loan out ALL of its excess reserves-

This would leave them with no flexibility in buying Govt Securities.

Banks are in business to make a profit!

Voting FOMC membersChairman Janet Yellen7 Federal Board of

Governors5 regional Reserve Bank

presidentsGuess who is boss?Her term as Chairman

is till 2018. Term on BOG over January, 2024.

Prior to the FED, Dr. Yellen was an economic professor at Berkley.

History of Why American Banks were created

The war left us in debt. Some states were bankrupt. We needed one unified currency ... Hamilton

suggested a central bank. The First Bank's charter was drafted in 1791 by the Congress and signed by

George Washington. In 1811, Congress voted to

abandon

EARLY PROBLEMS OF U.S. BANKING SYSTEM.

Before the Fed was established 1913- U.S. could not adjust supplies of money to business activity

Banks were often short of cash- if people deposited their money- wanted it on the spot, had legal right to withdraw it.

Banks often kept some $ in their reserve accts, and deposited money in other banks.

Sometimes demand for currency was >than the amount of money on hand.

Banks would draw on deposits from other banks and sell other assets such as government securities.

https://www.youtube.com/watch?v=EOzMdEwYmDU

U.S. Banking- 1970 to Present

Technology has changed bankingNo cancelled checks, electronic

transfers, Online banking, etc.See a lot of banks mergingServices of banking changed today

from 1970Many new regulations, Monetary

Deregulation Act (80’s) other regs later after massive bank and S&L failures in late 80’s early 90’s.

Government in Banking-Help or Hindrance?

S&L Debacle! (late 80’s)Worst financial disaster since Great Depression *until

nowInflation was eating away at profits for S&LsBegan to make very risky mortgage loans. Could not recoup from all loans that were made at

such low rates- Went bankrupt.Then Congress deregulated the S&L to allow them to

act like banks. *Beginning of our current debacle.Monetary Deregulation Act of 1980… This created a

tumble in the market then the Fed had to bail out at taxpayers expense.

FDIC actually took over Continental Illinois Bank (too big to fail.)

The collapse of Continental Illinois National Bank and Trust was a watershed event inmodern banking history that holds lessons for both bank risk managers and regulators. Itshowed how quickly the revelation of credit problems at a well-regarded bank could turninto a liquidity problem that jeopardized not only the survival of the bank itself, but also,in the view of the US regulators, the financial system.

Today…. It’s TARP

Troubled Assets Relief Program (TARP): In October 2008, Congress enacted the Emergency Economic Stabilization Act (EESA) to respond to instability in U.S. financial institutions, caused particularly by these institutions' being saddled by delinquent mortgages. That legislation created the Troubled Asset Relief Program (TARP).

So… what’s the bottom line?Beginning government – attempt at

national banking… that failedStates wanted to control banking and

that failed.Chaos evident with no confidence and

market crashes/ depression- banks failed… attempt to re-build national stability

For a period of years, banking stability seemed assured.

In 2010 banking took a turn back to instability.

Banks Today!

Community Reinvestment Act (Carter Administration)- required banks to provide loans to low-income families.

Continued with no-income families. Banks bundled the risky loans- sold paper- good

investment for other banks, financials, global players entered here also.

Continued for about 10 years, with banks continuing the risky loans.

Hedge fund investors played their cards, and entered the scene.

Off to the races!

Bailout Begins!@ U.S. Government.gov

Federal Reserve/Treasury Department have orchestrated the biggest bailout of banks, financials, Fannie and Freddie, AIG, etc. etc. The automobile industry is also in on the act.

Fed has pumped billions into system (QE1, QE2, QE3)

Treasury has trillions extra and200 billion for Fannie and Freddie

What is a billion?

A billion seconds ago it was 1959 A billion hours ago our ancestors were living in the Stone Age. Approximately $250 billion was requested to re-build New Orleans. Here is how many million it takes to equal $1 Billion:

$1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00 +1,000,000.00

EARLY BANKING

Under what authority can the U.S. Treasury print dollars?

(Article I, Section 8, clause 5)

In early days:most banks were state banks – issued their own currency backed by their own supply of either gold or silver

Bank of the U.S. – only national bank- acted much like the U.S. Treasury by collecting and paying debts owed to the federal government

No regulation of state banks-no limit on amount of currency they could print.

Early years- many banks went bankrupt.

Additional info on Banking….legalities

Has Congress the power to incorporate a bank? (Yes, “necessary and proper clause”

“to make all laws which shall be necessary and proper for carrying into execution” the expressed powers in the Constitution.”

May a state tax a U.S. Bank? (No, the power to tax involves the power to

destroy. Such a tax could be used to destroy an institution vitally necessary to carry out the operations of the federal government, and therefore is unconstitutional and void. McCulloch vs. Maryland (1819)

Early Banking Revisited

In beginning Civil War- 1861- Congress authorized printing of demand notes- later called Greenbacks (ink was green)

People skeptical- so National Banking System was created and national bank notes were printed.

1863- Gold certificates were issued- This was paper currency backed by gold on deposit with U.S. Treasury

1866- federal government issued Silver Certificates- modeled after gold certificates and backed by silver coins. (remember the parable of Wizard of OZ?)

Early Banking

GOLD STANDARD- 1900 Congress passed the Gold Standard Act- tied to the basic unit of currency and equal to it. Currency could be traded in for gold- people felt secure. Advantage: confidence of people- prevented

government from printing too much currency.

Disadvantage- economic growth is tied to the money supply – no flexibility for productive growth.

Most countries between 1871 and 1914 were on Gold Standard. U.S was last to get on.

Early Banking Continued1933- U.S. government went off the gold standardBritain went of two years earlier. 1934 Gold Reserve Act passed- required citizens

to turn in their gold and gold certificates- people were given Federal Reserve Notes in exchange- those who refused to turn in gold had their gold confiscated

1971- President Nixon declared no gold backing whatever for dollar- placed the exchange equivalent with other currencies (dollar v pound v yen v mark) (now in 2008… dollar v pound v Euro) Gold window was closed!

And as we know, the dollar will fluctuate with currency market. .Referred to as

Exchange rate.

Supply and Demand for Credit

• Banks and other lending institutions lend money- expect to be paid for its use.

•Amount they lend (subject to some legal restrictions) is determined by how much they have to lend and how much the borrower is willing to pay.

•This charge or price for use of money = interest

The Supply of Money

The supply curve of money is a vertical line at the quantity of money, which is largely, but not exclusively, determined by the Fed.

Equilibrium in the Money Market

At an interest rate of i1, the money market is in equilibrium: There is neither an excess supply of money nor an excess demand for money

Interest rates fluctuate with changes in demand for money in relationship to changes in supply of money available.

Money becomes valuable just like other value created for other commodities (demand relative to supply)

So when the FED began lowering the FF Rate, and money was almost “free,” did this help or hinder the financial crisis ????

PART III

FED AS THE NATION’S CENTRAL BANK

MONETARY POLICY AS REQUIRED BY Congress Provide a flow of credit and money that will foster

economic stability and growth Establish a high level of employment Provide stability in purchasing power of the dollar. Reminder- Fed is autonomousThree principal tools to implement monetary policy:1. Reserve requirements2. Discount rate3. Open market operations

What Indicators does the Fed check?

Real Gross Domestic Product (GDP)

Consumer Price Index (CPI)

Nonfarm Payroll Employment

Housing Starts Industrial

Production/Capacity Utilization

Retail Sales

Business Sales and Inventories

Advance Report on Durable Goods Shipments

Light-Weight Vehicle Sales

Yield on 10-year Treasury Bond

S&P 500 Stock Index M2 Money Supply

Money and ProductionMoney is the means of helping to

facilitate our economic purposes of production, distribution, and consumption of goods and services

Relationship between money supply, price levels and business is important aspect of macro theory.

Equation of Exchange: MV=PT or MV=PQ

Money x Velocity = Prices x Business Transactions (real levels of output)

MV= total spending for the year (velocity is # times $ turns over in a year )

PQ= total business for that year.If any of these get out of balance- economy

out of sync.

Equation of Exchange

M x V ≡ P x Q

where:M represents Money SupplyV represents Velocity*≡ means must be equal to P represents PriceQ represents Real GDP*The average number of times a dollar is spent to buy final goods and services in a year

We want the economy to grow, butwhile growing maintain stable price levels.

Necessary to balance an increase in actual production (T) with an increase in spending or (MV)

BIG PICTURE FOR FED

To forestall depressions in period of prosperity

To stimulate the economy in period of declining economic activity.

I.E. To smooth out the swings of the business cycle… uses counter-cyclical moves

Remember!

Inflation is Bad!!!Inflation is Bad!!!Inflation is Bad!!!

MONETIZING THE DEBT

S1 S2

Interestrate

Quantity of money

D1

Supply ofMoneyBeforeexpansion

10

12

Supply of MoneyAfter Expansion

DemandBeforeGovernmentborrowing

D

Demand AfterGovernmentBorrowing

1. When the government borrows toCover a deficit in the federal budget,Interest rates tend to rise because of the Increased demand for credit (raising thePossibility of “crowding out.”

2. If the Fed expands the money supply just enough

To offset the borrowing, interest rates may remain

Unchanged.

What are the long-run effects of monetizing the debt?

So, are you better off?

Or is the federal government the Grinch?