Money, Banking & Monetary Policy — The Fed and Interest Rates

Functions of Money

Three Functions of Money

Medium of Exchange: eliminates the double-coincidence-of-wants problem
Store of Value: preserves purchasing power over time
Unit of Account: common measure for comparing prices

US Money Supply Measures

M0 (Monetary Base): currency in circulation + bank reserves held at the Fed
M1: M0 + demand deposits + other checkable deposits + traveler’s checks
M2: M1 + savings deposits + small time deposits + retail money-market funds (Published monthly by the Federal Reserve)

Credit Creation and the Money Multiplier

Deposit Creation Mechanism — Initial deposit → bank lends out (1 − reserve ratio) → borrower deposits elsewhere → repeat

Money Multiplier = 1 / Reserve Requirement Ratio

Example: RRR = 10% → multiplier = 10 $100 in base money → up to $1,000 in deposits

Expansion of the Monetary Base

Open market purchase (Fed buys Treasuries)
Fed discount window lending (repos, advances)
Quantitative easing (large-scale asset purchases)

Federal Reserve Monetary Policy Tools

The Federal Reserve (central bank of the US)

① Federal Funds Rate Target (primary tool)

Rate ↑ → borrowing costs rise → spending falls → money supply contracts → inflation falls
Rate ↓ → borrowing costs fall → spending rises → money supply expands → economy stimulated
FOMC sets the target at 8 scheduled meetings/year

② Open Market Operations (OMO)

Buy Treasuries → inject reserves → money supply ↑
Sell Treasuries → drain reserves → money supply ↓
Primary mechanism for hitting the fed funds target

③ Reserve Requirements

Rate ↑ → multiplier ↓ → money supply ↓ (Fed set RRR to 0% in March 2020)

④ Discount Rate (rate on Fed loans to banks)

Discount rate ↑ → banks borrow less from Fed → tighter credit conditions

Interest Rates and Bond Prices

Interest Rates and Bond Prices move INVERSELY

Rates ↑ → bond prices ↓
Rates ↓ → bond prices ↑

Why

Bond coupon is fixed → when market rates rise, existing bonds (paying a lower fixed coupon) become less attractive → price falls

Yield to Maturity (YTM)

YTM ≈ Annual coupon / Bond price
Price falls → YTM rises (and vice versa)

Duration

Weighted-average time to receive cash flows
Measures a bond’s sensitivity to rate changes
Longer duration → greater price volatility when rates move

Quantity Theory of Money and Inflation

Quantity Theory (Irving Fisher)

MV = PQ
M = Money supply, V = Velocity (assumed stable)
P = Price level, Q = Real output

Money supply ↑ → P ↑ (inflation)

Effects of Inflation

Creditors (lenders): lose (real value erodes)
Debtors (borrowers): gain (real debt shrinks)
Real-asset holders: gain
Cash/bond holders: lose

Phillips Curve

Short run: inflation ↑ ↔ unemployment ↓ (trade-off between price stability and jobs)
Long run: vertical at the natural rate of unemployment (no lasting trade-off)
Stagflation (1970s): shifted the curve outward — high inflation and high unemployment simultaneously

Key Concept Cards

Money Multiplier = 1 / Reserve Ratio ★★★★★ : RRR = 10% → multiplier = 10. $1 of base money supports up to $10 of deposits. Memory hook: multiplier = 1 ÷ reserve ratio

Interest Rates and Bond Prices: Always Inverse ★★★★★ : Rates up → bond prices down. Rates down → bond prices up. Never the same direction. Memory hook: rates and bonds = opposite directions

MV = PQ ★★★★☆ : Money supply × velocity = price level × real output. More money → higher prices (inflation). Memory hook: more M → more P (inflation)

Practice Questions

Q. Name three expansionary monetary policy tools the Fed uses during a recession.

① Cut the federal funds rate target ② Buy US Treasury securities (open market purchase) ③ Lower the discount rate. Together these expand reserves, lower borrowing costs, and stimulate lending and spending.

Q. If the Fed raises the federal funds rate from 3% to 5%, what happens to the price of existing long-term bonds?

Bond prices fall. Interest rates and bond prices are inversely related. With market rates now higher, existing bonds paying a lower fixed coupon are less valuable to investors — buyers will only purchase them at a discounted price. The longer the duration of the bond, the greater the price decline.