PRINCIPLES OF MACROECONOMICS
Ranjit Dighe
WEEK 14 (LECTURE 34)
Mon., Nov. 29, 1999

[There was only one lecture this week.  Wednesday's lecture was canceled; the makeup notes will appear with the notes for Week 15.  Friday was our third exam.  Monday's notes correspond to parts of Chapter 13 ("Money and Banking") of McConnell's textbook.]

WEEK 14, LECTURE 34
Mon., Nov. 29, 1999

* Today: Money and monetary policy (begin)

Last week we learned about fiscal policy, which is one of the two main approaches that economic policymakers can use to influence the level of real GDP, unemployment, and inflation. The other approach is monetary policy, which is what we'll be covering for these entire last two weeks of class. Monetary policy refers to the steps that the Federal Reserve takes to influence the economy through changes in the supply of money and credit (which usually take the form of changes in interest rates).
-- Before we go any further, let us recall that the macroeconomist's usage of the term "money" refers not to wealth or income (as in "I have a lot of money" or "I make a lot of money") but to the following definition:
-- MONEY - the medium of exchange; anything that is generally accepted as payment.
-- The money supply is not the same thing as GDP. Students sometimes confuse the two, but they are two very different things. GDP is the economy's total output of final goods and services in a given year; the money supply is, roughly speaking, the total amount of cash plus bank accounts in the economy at a given point in time. GDP is a "flow" measure, in that it measures the output of something over a particular interval; the money supply is a "stock" measure, in that it measures the quantity of money at a particular point in time.

Ever since the mid-1980s, fiscal policy has been DEAD, because Congress no longer deliberately uses changes in the size of the government deficit in order to stimulate or slow down the economy. Monetary policy, on the other hand, is more important than ever. In the 1990s, the Federal Reserve, more than anybody else, runs the economy.

In most countries, including the U.S., monetary policy is carried out by a central bank, which has the power to change the supply of money and credit through its actions. In the U.S., that central bank is not one single bank but a whole network called the FEDERAL RESERVE SYSTEM (a.k.a. the Federal Reserve, or the Fed). At the head of the Federal Reserve is Alan Greenspan, who has been its Chairman since 1987.

Despite the confusion between the word "Fed" (nickname for Federal Reserve) and "Feds" (the federal government), the Fed is not part of the government. It is what we'd call a "quango" -- a quasi-non-governmental organization.
-- Although the Fed is technically an independent, private agency, its most powerful members are appointed by the President and confirmed by the Senate (much like Supreme Court Justices).
-- The chairperson of the Fed serves a four-year term, which means that each President gets the chance to appoint a Fed chair of his choosing.
---- Alan Greenspan was originally appointed by Ronald Reagan in 1987 and was reappointed by George Bush and Bill Clinton.
-- Also, the Fed, unlike a truly private organization, must return 100% of any excess profits it makes to the government (although it does not get its funding from the government).

The Federal Reserve System consists of:

* 12 regional Federal Reserve Banks (FRB's, or Fed banks).
-- The New York Fed, located in the Wall Street financial district, is by far the most powerful. Most major U.S. financial centers have a Fed bank -- these include Chicago, San Francisco, Boston, Atlanta, Dallas, and St. Louis.

* about 4000 commercial banks (about 40% of all banks in the U.S.). As members of the Federal Reserve System, these banks can borrow money from the Fed at cheap rates (the "discount rate") and, more importantly, can use their status as a member of the Fed system to signal to customers that their bank is a safe and soundly managed bank. Banks that belong to the Fed system are required to set a certain fraction of their deposits aside as reserves, to be held as cash at the bank or at the nearest regional Fed bank.
-- FRACTIONAL RESERVE BANKING refers to the modern system of banking, in which banks do not keep all of their deposits as cash reserves but instead loan or invest most of them so as to earn interest. Adhering to the Fed's reserve requirements, which are set considerably higher than the amount most banks actually net to meet the normal demand for withdrawals, is costly to banks, because they earn no interest on their reserves, whereas they could earn interest by loaning those reserves out. So it is no mystery why thousands of banks choose not to belong to the Federal Reserve System.

* the Federal Open Market Committee (FOMC) -- the group that really controls monetary policy.
-- The FOMC has 12 members. They are:
---- the president of the New York Fed (who serves as Vice-Chairman)
---- four presidents from the other 11 regional Fed Banks, who serve on the FOMC on a rotating basis;
---- the seven members of the Federal Reserve Board of Governors.
------ The seven Fed Governors are economists who serve 14-year terms and are headquartered in Washington, DC. Since they are the most permanent and prestigious members of the FOMC, they are also the most powerful.
-- The FOMC meets every six weeks to plot the course of monetary policy. It usually does this by adjusting two interest rates:
----   DISCOUNT RATE: the interest rate at which the regional Fed banks loan money to commercial banks
          (currently 5%);
----   FEDERAL FUNDS RATE: the interest rate at which banks loan reserves to each other, on an overnight basis (currently about 5.5%).
------ The Fed does not set the federal funds rate directly, but rather takes steps to manipulate the supply of bank reserves so as to affect the federal funds rate by affecting supply and demand in that market.

The money supply is controlled by the Federal Reserve. There are three official measures of the money supply:

-- The narrowest, sometimes called "transactions money," is:
M1 = currency + checking account deposits + travelers' checks = $1.1 trillion (~13% of GDP)

-- A much larger and broader measure is:
M2 = currency + checking account deposits + travelers' checks + Savings deposits + Small CD's (time deposits) + money-market mutual funds (MMF's) = ~$4 trillion

-- Broader still is:
M3 = currency + checking account deposits + travelers' checks + Savings deposits + Small CD's (time deposits) + money-market mutual funds (MMF's)+ Large CD's = ~$5 trillion

Note that all three are considerably smaller than GDP, which is about $8 trillion. That is because GDP is measured over the course of a year, whereas the money stock is measured a single point in time. Nearly every item bought and sold in GDP is financed by an exchange of money, but money "turns over" several times in the course of a year. (Just imagine, for example, how many times the $1 bill in your pocket will get used, by different people and in different transactions, in the course of the next year.)