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Hello.

my name is Jennifer Clark with the University of Florida and welcome to week 8 section 2 of Economic Issues, Food, and You.todays lesson is Monetary Policy. Today we will be talking about monetary policy to better understand how actual money flows through the economy and the implications that it has on an economy when there is too much of it. In order to understand this we will learn

Today we will be talking about monetary policy to better understand how actual money flows through the economy and the implications that it has on an economy when there is too much of it. In order to understand this we will learn

How the Federal Reserve System, the Central Bank in the United States, is structured and why its existence is essential to the US economy

We will also look at the methods used by the federal reserve system to influence monetary policy. We will refer to these methods as tools.

We will learn what inflation is, how it affects the economy and how the actions of the federal reserve system can influence the level of inflation within the economy and the implications for a hyperinflation situation.

We will also understand what the quantity theory of money is and the concept of monetary neutrality

As well as be able to define the velocity of money, calculate its value, and understand the benefits it has to society

Monetary policy is generally defined to be the policies that affect the supply and demand of money within an economic system including equilibrium within the money market. In the United States, and many other counties around the world, a central bank exists to provide the function of money management/ or monetary policy regarding the overall supply of monetary resources used as the medium of exchange to facilitate trade.

So lets start by understanding why we need a Federal Reserve System to control money in the economy. There are two different kinds of money commodity money and fiat money. Commodity money is money in the form of a commodity with intrinsic value, for example gold or cigarettes (in prison). Fiat money is money without intrinsic value that is used as money because of government decree, such as paper money, or in the United States, the dollar bill. When economies use a system of fiat money, like the US, some agency must be responsible for regulating the system and in the United States, its the Federal Reserve ( the Fed). The Fed is an example of a central bank, an institution designed to oversee the banking system and regulate the quantity of money in the economy. The Federal Reserve system was started in 1913 when Congress decided the United Stated needed a central bank to avoid bank failures. Its run by a board of governors appointed by the president and confirmed by the senate. They are given long terms in order to avoid political pressures when they are working on monetary policy. The federal reserve system is made up of the board in Washington, D.C., and twelve regional Federal Reserve Banks located in major cities around the country. The Fed has two jobs: To regulate banks and ensure the health of the banking system by maintaining the value of the systems currency; this is accomplished by regional Federal Reserve Banks and it also acts as the local banks bank. Well talk about this function shortly. Most importantly, it controls the quantity of money available in the economy, the money supply. Decisions made by policymakers concerning the money supply is called monetary policy, which again, is the topic of this section. Monetary policy in the US is made by the Federal Open Market Committee which meets every six

weeks in DC to discuss the conditions of the economy and consider changes in monetary policy. The FOMC buys and sells government bonds (IOUs) that directly affect the quantity supplied (and therefore equilibrium prices) within an economy.

Lets take a look at how the Fed carries out the job of managing the money supply through their monetary policy. The Fed can control the money supply indirectly or directly due to the way because banks create money in a system of fractional reserve-banking. Fractional-reserve banking is a banking system in which banks hold only a fraction of deposits as reserves, this fraction is called the reserve ratio. When the Fed decides to change the money supply, it must consider how its action will work through the banking system. We say the fed uses different tools from its monetary tool box to influence the quantity of required reserves that banks must hold in their accounts as well as excess reserves that the bank may choose to hold. The reserve ratio is the amount of money (and liquid assets) that the Federal Reserve Member Banks must hold in cash or on deposit with the Federal Reserve System. The Federal Reserve also may engage in the direct purchase and sale government securities (government bonds) through open-market operations at the trading desk at the Federal Reserve Bank of New York. Lets explore these tools a little further

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Open market operation, the Feds primary tool, is the purchase and sale of US government bonds. To increase money supply, the Feds tell the bond trader at the NY Fed to buy bonds from the public in the bond market. The dollars the Fed pays for the bonds increases the number of dollars in the economy. Some money is kept as currency and the other is sent to the bank. The money that is kept as currency, increases the money supply by exactly $1, each dollar that is deposited in a bank increases the money supply by more than a dollar because it increases reserves and therefore the amount of money the banking system can create. To reduce the money supply, the Fed does the opposite and sells government bonds to the public, the public pays for these bonds with its currency and bank deposits which reduces the amount of money in circulation. Since people withdraw money to pay for theses bonds, it reduces the amount of reserves and with lower reserves banks reduce the amount of lending. Now we can understand why this is the Feds primary tool, it allows for a large or small change in money supply with out major changes in laws or bank regulations. The second method by which the Fed can influence the supply of money within an economy is the Feds role to lend money to banks. Why would a bank need to borrow money from the Fed, you might ask? Recall that in our lesson about money and financial intermediaries that banks are required to keep a required level of money in their vault to satisfy bank customer withdrawalsthis required level of money

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is called required reserves. The Fed is the entity that determines the quantity of required reserves that banks are required to have on hand at the close of business every day. The Fed can make policy to increase the quantity of required reserves and they provide the service of lending reserves to banks if needed. Banks pay an interest rate on these loans which then increases the amount of reserves and this allows the banking system to create more money. The third way the Fed can alter the money supply by altering the interest rate, a higher interest rate on reserve requirement loans discourages banks from borrowing from the Fed and reduces the quantity of loans that they are willing to make to their consumers in the economy, preferring to keep their reserves on hand. This reduces the available supply of loanable funds which can slow the economy (meaning that it slows the transactions being made in the circular flow model). Or, the Fed can pay interest to banks on their excess reserves. This occurs when a bank holds reserves on deposits at the Federal bank and the Fed pays an interest on that banks deposit. This provides an incentive for banks to hold their money in reserve if the interest rate is high. If the bank holds more reserves, this increases the overall reserve ratio (or required and excess reserves) and thus lowers the money supply. The Fed can use these three tools to influence the overall supply and demand for loanable funds by increasing or decreasing the money supply through their monetary policy.

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Now lets understand why the amount of money circulating through the economy at any given time is so important, and why there is the need for the Fed to control the supply of money. Inflation is an increase in the overall level of prices, lets note that inflation is more about the value of money than the value of the good. However, we can see the price level as a measure of the value of money, if the price rises we now need more money to pay for an item, so the value of money goes down. Now, you may be wondering what determines this fluctuation in the value of money? Supply and demand. Just like supply and demand determine the price of oranges, supply and demand determines the value of money. Lets first recall that the supply of money is controlled by the Federal Reserve and the banking system and monetary policy determines how these entities act. But how about money demand? Demand is influenced by many things, but the most important factor is the average level of prices in the economy. Since money is a medium of exchange, people hold money in their wallet or checking account in order to buy goods and services. The higher the prices, the less the value of money, the more of it you need and the more of it you will keep available in cash and debit accounts to buy these goods and services. At the equilibrium price level, the quantity of money that people want to hold exactly balances the quantity of money supplied by the Fed.

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So what happens when a surplus of money is injected into the economy? It creates an extremely high rate of inflation which we refer to as hyperinflation. Hyperinflation occurs when there is a large increase in the money supply not

supported by gross domestic product growth. Hyperinflation results in an imbalance in the supply and demand of money and causes prices to increase and currency to lose its value. This can often lead to panic as consumers see prices rising daily and prefer to hoard goods rather than hold money (and watch their purchasing power erode). Hyperinflation can occur during wartime when there is economic instability and a loss of confidence in a currency's ability to maintain its value in the aftermath. Suppliers will want to demand a risk premium in order to accept the currency, and they do this by raising their prices.

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If we consider the general economy in terms of supply and demand for money assets, then the price of money (the interest rate) is illustrated on the vertical axis and the quantity supplied and the quantity demanded of money can be illustrated on the horizontal axis. Demand is downward sloping due to the law of demand, however, the supply of money is vertical since its level is set by the Federal Reserve System and not influenced by the law of supply. The Fed seeks to maintain an equlibrium quantity of money needed by the economy to pursue targeted growth of the economy and to avoid inflation (which we know erodes the purchasing power money). Now with our familiar model of supply and demand changes in the supply of money will influence the interest rate which has a direct effect on 1) the amount of money that society prefers to have available since they may decide at higher interest rates to invest or save their money and 2) the interest rate also influences the quantity demanded of loanable funds that individuals and firms may seek to invest in capital assets like home or automobile purchases or new capital equipment for production. As you can imagine, controlling the supply of money is very important in order to maintain equilibrium, to keep prices low, and to keep the value of money high. This is what we call the Quantity Theory of Money. The Quantity Theory of Money states that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate, therefore, we conclude that the growth in the quantity of money is the primary cause of inflation.

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This increase in the quantity of money increases the quantity demanded for goods and services because people have more money to purchase the goods and services that they desire (in economic terms, there are now more people in the market who are willing and able to purchase those goods and services a movement along the demand curve). Now in the market for goods and services, just because there is more money available does not logically mean that the immediate availability of physical goods and services has increased as well. So now we can see that just because the demand of goods and services has increased the supply of goods and services usually needs some time to adjust due to production decisions and will tend to lag in the short-run

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especially in agricultural markets, in the short-run, agricultural producers arent able to always immediately adjust production levels immediately since their ability to bring their products to market are typically influenced by a biological lag. For example, while a corn farmer may easily be able to switch their market outlets from the feed markets to the ethanol market, that same farmer cannot as easily switch from corn production to wheat production or consider the fish farmer with fingerlingsize fish not ready for market..that farmer is constrained by the biological lag of waiting for those fish to grow to market size since the capital investment in the fish stock has already been committed. If we assume that the supply of money has increased leading to an increase in the number of demanders (a demand determinant) then it follows that the demand curve for aggregate market goods increases (and is illustrated by a shift to the right). When more consumers (with more money) are now seeking to buy the same supply of market goods and services, according to the fundamental relationship in a supply and demand model for any good, if demand increases, ceteris paribus, this dynamic will naturally lead to a price increase. We call this concept, inflation, which is a general increase in the price of a particular good or service in the market.

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Now that weve seen how changes in the money supply causes changes in the average level of prices, lets look at how this concept of inflation affects other factors of the economy such as production, employment, real wages and real interest rates. These factors, or variables, are divided into two groups: nominal variables and real variables. Nominal variables are variables that are measured in monetary units and real variables are variables that are measured in physical units. For example, the income of orange grove workers is a nominal value, but the quantity of oranges produced in the grove is a real variable because it is measured in boxes or bushels. It is important to understand that we make this distinction between nominal and real because there are different forces that influence each type of variable. Nominal variables (specifically prices) are influenced by developments in the economys monetary system where as money does not influence real variables (specifically the quantity of goods and services). The level of real output is driven by the production function and the quantity of capital, labor, natural resources, and technology. Therefore, inflation only affects nominal variables, not real variables. This concept is called monetary neutrality; changes in the money supply do not affect the quantity of real variables. A good way of thinking about this would be to compare the quantity of money (a nominal variable measured in prices) it to the length of a meter (a measurable unit). If, hypothetically, by government decree, the length of a meter was reduced from 100 centimeters to 50 centimeters this means that everything you measure with a meter will now be double the length. So what use to be 1 meter is now measured to be 2 meters. However, the actual physical distance has not changed, only the units with which you measure it. This actual distance is real and

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just by changing the measure with which you quantify the length, when we give the same consideration to the unit of measurement of money (for example, a dollar) you can see how money supply does not affect a real variable..this comparison exemplifies what we call money neutrality. Increases or decreases in the money supply affect nominal prices like prices for goods and services or interest rates, however, these changes do not affect the overall level of real variables measured in physical units.

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So, weve looked at how the supply of money affects the economy, but now lets turn to think about a single dollar bill and the concept of the velocity of money. The velocity of money is defined to be how many times the average dollar is used to purchase goods or services as it passes from person to person (buyer to seller to buyer to seller as weve modeled in the circular-flow diagram) , in a given period of time (typically a year). This is what we call, the velocity of money. The velocity of money is the rate at which money changes hands and is a consideration for government policy created to influence the level of growth of the economy. To calculate the velocity of money, we take into account the nominal GDP which is equal to the real GDP times the price level and divide it by the quantity of money. So lets look at the equation used to calculate the velocity of money. V = (P x Y)/M. where V is the velocity of money, P is the price level, Y is the quantity of output and M is the quantity of money in the economy.

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Lets look at an example. In this example, we set price equal to two dollars, output is 750,000, and the money supply is $950,000 dollars. To calculate how many times the average dollar circulates in this economy in this example, we assume the price level for some basket of goods to be equal to $2.00, the quantity of real output (real GDP) to be equal to 750,000 units and the quantity of money in this economy to be equal to $950,000. Then we calculate the velocity of money to be equal to 2 dollars times 750,000 divided by 950,000. V is equal to 1.58. So, money exchanges hands, or flows through our economy, 1.58 times. The higher the velocity of money, the healthier that our economy is understood be since it relates to the overall level of economic activity of the participants in the society.

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Policy makers can use the velocity of money calculation to help determine how to set the tax rate in a country. For instance, if the velocity of money is low, perhaps a tax cut could be beneficial in terms of stimulating the economy to influence exchanges between buyers and sellers of goods and services in all types of markets. This type of policy can also stimulate hiring and reduce unemployment within an economy. Some economists believe that the velocity of money is stable over time and not sensitive to interest rate changesand some economists believe that the velocity of money is unstable and hard to predict, given some level of monetary increase into an economic system. So, depending on which type of economist you are will influence the type of normative economic advice you may give to policy makers. In a very simplified explanation, if we assume that velocity is inherently stable, the change in the money supply (multiplying the left side of the equation by a factor of 2) will lead to a change in either the price level or quantity of real output and most economists believe that increases in the money supply increase nominal prices (inflation) and not real output. Reducing the money supply by half would have the opposite effect of reducing the overall price level (in other words, decreasing inflation). If you are an economist offering advice to fight inflation, you might fall into one of two categories; there are economists called monetarists whose endorsement policy to fight inflation is that by decreasing the supply of money in the economy it will cause the inflation rate to fall (through reduced demand) and effectively reduce nominal interest rates. These economists advocate steady, predictable money growth to keep inflation and nominal interest rates low.

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Another type of economists, called the Keynesians, advocate a decrease in the money supply that would first increase interest rates, then decrease spending and eventually lead to lower prices. So both Keynesian and Monetarists both advocate a decrease in the money supply to reduce inflation although they expect it to work for different reasons however, both of these policies are intended to fight the inflation that erodes the purchasing power of the money supply. To fight unemployment, Keynesians advise that the money supply should be increased (this is called expansionary monetary policy) that would decrease interest rates, increase spending and increase prices and output which would lead to lower unemployment. The monetarists believe that an increase in the money supply will affect mostly prices and not increase output (that would lead to hiring and lower the level of unemployment) unless the economy is very far below full employment. Monetarists tend towards a fixed money supply (which can be painful for society as inflation and unemployment are wrung out of the system) while Keynesians believe in more flexibility to adjust the money supply to respond to economic conditions.

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Monetary policy is generally defined to be the policies that affect the supply and demand of money within an economic system including equilibrium within the money market. The money supply is controlled by the central bank, which in the United States is called the Federal Reserve System. he federal reserve system is made up of the board in Washington, D.C., and twelve regional Federal Reserve Banks located in major cities around the country. The Fed has two jobs: To regulate banks and ensure the health of the banking system by maintaining the value of the systems currency. Decisions made by policymakers concerning the money supply is called monetary policy. Monetary policy in the US is made by the Federal Open Market Committee which meets every six weeks in DC to discuss the conditions of the economy and consider changes in monetary policy. The Fed has three main tools in its toolbox that can be used as monetary policy, buying a selling bonds in

open market operations, changing member banks reserve ratio, changing the interest rate it charges other banks for reserve loans. The Fed controls the money supply primarily to control inflation. Inflation is an increase in the
overall level of prices, lets note that inflation is more about the value of money than the value of the good. Hyperinflation occurs when there is a large increase in

the money supply not supported by gross domestic product growth. Hyperinflation results in an imbalance in the supply and demand of money and causes prices to increase and currency to lose its value. The Fed seeks to
maintain an equlibrium quantity of money needed by the economy to pursue targeted growth of the economy and to avoid inflation (which we know erodes the

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purchasing power money). The Quantity Theory of Money states that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate. This can be a concern for agricultural producers who need time to adjust their production capacity in response to changing market conditions. The quantity theory of money states that increases or decreases in the money supply affect nominal variable (like prices) but do not directly affect the quantity of real variables. Money velocity is the rate at which money flows through an economy through market transactions and can be helpful to policymakers who seek to curb inflation and reduce unemployment which is desirable for a healthy economy. Weve only just brushed the surface of monetary policy in this lesson and I encourage you to continue to read and learn about your own economy as well as to educate yourself about the global economy in which we all participate. The economic theory that youve learned in this course can explain many of the news events you hear about and learning about the dynamics of an economic system will permit you to be a much more well-informed citizen who is able to educate others about newsworthy current events. So, good-bye for now and I hope you remain in contact with me via Facebook and Twitter feeds!

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