Class 11 - Money

Function of Money

I. Medium of Exchange
II. Store of Value
III. Unit of Account

1. Commodity Money
2. Fiat Money

Change to the syllabus:
Just adding chapter 21 tonight
The final will only cover chapters 15, 16 and 21

Chapter 21 - introduces us to ben bernanke pg 470
FOMC meets tomorrow.
On Wednesday, they issue their report. Policy conclusion as to what they will do to the federal funds rate and the money supply. (One of the essay questions on the final will probably be on monetary policy.)

Before we cover the mechanics of central banking, we need to cover the theory of money.
In order for something to be "good" money, it needs to do 3 things:
medium of exchange
store of value
unit of account

Best seminar on the nature of money - 4 months in Russia in mid 1990s

medium of exchange - ppl commonly use it to buy goods and services
store of value - you can hold on to it for months and spend it later. makes saving possible.
unit of account - it's what prices are expressed in

Up until the 20th century, money was mostly commodity money - something with intrinsic value. Metal, stone, tobacco and even salt. "worth his salt" "salting it away". However, salt can literally dissolve. So gold and silver are better. But they tend to be relatively random in when they appear. Hard to run a stable economy based on them because the money supply can vary.

Fiat - declaration - money. Can be increased without limit. This is an advantage, but it can be misused. But if the govt just prints more money, it increases inflation. When there's inflation, the money isn't a store of value. Ppl use other things. Ppl also start using some other currency as the unit of account.

Basis for fiat money - currency and demand deposits. See the book.

The Structure of the Federal Reserve System

Set up in 1913 in response to financial crises
Modified as a result of the Great Depression

Board of Governors - 7 members appointed by the president and confirmed by the senate. 14 year terms. Independent of political considerations. may be reappointed. staggered terms - only one expires every 2 years. president sometimes appoints more when govs retire or die. chairman is appointed by the president (and confirmed by the senate) for a 4 year term. it must be someone who also has a 14 year term.

12 Federal Reserve Banks - each "district" bank with 9 directors who appoint the president of the banks. banks are concentrated on the east coast due to the population distribution in 1913. 2 banks in Missouri (st. louis and kansas city). The 6,000 member commercial banks elect 6 directors of the federal reserve banks.

Federal Open Market Committee (FOMC) - Board of Governors plus 5 federal reserve bank presidents. 4 presidents are on a rotating system. NY fed president is always on the committee because they are the adminitrators of monetary policy - they actually do the buying and selling.

Functions of the Federal Reserve

I. Routing Functions

1. Bank for banks - where banks go when they don't have enough money to cover depositors' demand. it's a "lender of last resort".
2. Bank for federal government - it's where the money that is paid to the govt goes and where govt funds are paid out of
3. Payments system - maintains a system of electronic money transfer and for processing checks

II. Policy Functions - counter-cyclical activities. while everyone else is holdling on to money, there must be something that provides an elastic currency and stimulates demand. and vice versa. "take the punch bowl away just when the party is getting started." fed can take away money, but they can't expand the money supply by itself. people have to want to borrow on their own. banks need to want to lend on their own. according to keynes, the only institution that can expand spending is the federal government. not even local govts can do it.

1. Money supply
2. Interest rates

What instruments does the Fed have to influence the money supply and interest rates?

Fed's Tools of Monetary Policy (most used to least used)

1. Open market operations - buying and selling of federal govt securities: t-bills (30-360 days), t-notes (2-10 years), t-bonds (10-30 years); adding liquidity into the system means buying securities (typically t-bills); bank reserves go up and the fed funds rate goes down. this is the rate that banks charge each other when lending to each other. when the fed is worried about inflation, they drain liquidity from the system, the fed sells securities. bank reserves go down and the federal funds rate goes up.
2. Discount rate - the interest rate that the fed charges banks when it lends them money. currently 0.5%. the fed doesn't directly control the prime rate, but it's important to consumers. it's what bankers charge their best customers. currently 3.25%. it's usually about 3% above the federal funds rate.
3. Required reserve ratio - the amount of cash in the vault or deposits at the fed that banks are required to keep. to cut the money supply, they raise the reserve ratio. see san francisco fed web site - alice rivlin - speech in october to the sf society of certified financial analysts.

these tools are relatively easy to implement - no legislation is required.

Problems with controlling the money supply: it only happens if ppl go to banks.

One final exam essay question will have to do with this: how, when, why does the fed change the money supply.

The other essay question will be on the GDP formula. components of GDP. bottom of 328. Y=C+I+G+NX. No graphs. No calculator required.

There will be 30 multiple choice questions - 10 from each chapter.

8-9:50 on wednesday the 16th

Class 10 - GDP and CPI

Real and Nominal GDP

See Table 2 on pg 332. "Real" means adjusted for inflation. Nominal is not adjusted.

See example of Babe Ruth making $80k in 1931 and A-Rod making $28m in 2007. You have to adjust for inflation. Still, Babe Ruth's $80k in 1931 is only worth about $1m in today's dollars.

The example in table 2 shows the number of hot dogs and hamburgers fluctuating and some inflation happening at the same time.

To calculate the Real GDP, you have to use a consistent price for the hot dogs and hamburgers and ignore the inflation. Pick an arbitrary base year and use that for the fixed price.

To calculate the GDP Deflator, divide Nominal GDP by Real GDP. This is an index value. For the base year, it'll always be 100.

See Figure 2, page 335 - Real GDP in the US vs. time. 2000 is the base year.

Recession is when real GDP declines for 2 successive quarters. NBER.org is an independent, non-governmental research organization that defines when a recession begins and ends.

There is no pattern of recurrence of recessions, no consistency, no periodicity. This makes macroeconomic forecasting is very difficult.

However, you can predict the results of presidential elections based on these economic data. Only the 2000 election doesn't follow the pattern.

See Table 3 - GDP and the Quality of Life, pg 339.

Consumer Price Index - CPI

Data comes from the BLS - Bureau of Labor Statistics

CPI is set up to measure changes in the cost of living for the average US urban household.

It used to be for the avg urban "worker". Now, since it is used for COLA for social security, it includes retirees also.

They conduct surveys, focus groups, spending logs and estimate the typical budget for an urban household and where they spend their money. They construct a theoretical "basket of goods and services". They "buy" those goods and services every month and calculates how much much they cost.

The basket changes over time, slowly, as technology changes, ex: 8 track tape, cassette tapes, lps, CDs, etc. But in general, the basket is fixed.

See table 1, pg 347. Calculate the CPI as (current year cost/base year cost) x 100.

Inflation rate = [(CPI₂ - CPI₁)/CPI₁] x 100
(They don't use a midpoint formula.)

See figure 2 pg 353. CPI and GDP Deflator go together, but the CPI is more sensitive to oil prices.

European central bank considers 2% inflation to be stable prices.