Ch8. Money, Banking & Monetary Policy — The Fed and Interest Rates

Functions of Money

Three Functions of Money:
  ① Medium of Exchange: eliminates the
    double-coincidence-of-wants problem
  ② Store of Value: preserves purchasing power
    over time
  ③ 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:
  ① Open market purchase (Fed buys Treasuries)
  ② Fed discount window lending (repos, advances)
  ③ 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.