Money and Monetary Policy

00:01 Hello and welcome back to your online presentation of macroeconomics.

00:04 My name is James DeNicco.

00:06 Today, we're going to be switching gears a little bit.

00:08 We're going to be talking about money and monetary policy in this presentation.

00:12 What exactly are we going to be talking about? We're going to find out what money is.

00:17 We're going to find out about the roles of money.

00:19 We're going to see who controls money, supply, and how they control it.

00:23 We're going to see why the demand curve for money is downward sloping, why the supply curve is vertical.

00:28 We're going to take a look at how we move along those curves and how we see shifts in those curves. Any time you talk about money, it's a natural place to talk about exchange rates. So we're going to talk about exchange rates and see about the relationship with net exports and net capital outflows.

00:43 And we're going to see how monetary policy affects exchange rates and therefore affects trade and affects net capital outflows.

00:50 So let's get started.

00:52 First, what is money? Money is any asset that can be used conducting transactions.

00:58 So a credit card is not money.

00:59 That's a promise to pay.

01:01 But cash, gold, silver, stocks, bonds, any asset that can be traded in a transaction for goods and services, that's money. So what are the roles of money? Well, first, one of the main roles is the medium of exchange.

01:17 So back in the day, if the baker wanted a piece of meat from the butcher, he had to hope that the butcher wanted some bread.

01:23 If the butcher wanted a pair of shoes, well, then the baker had to go to the shoemaker and hope the shoemaker wanted bread for shoes so he could trade the bread for shoes and then take the shoes, and he could trade it to the butcher for a slab of meat.

01:35 Well, money makes life a lot easier if the butcher wants a pair of shoes.

01:39 Well, now the baker can go, and he can pay money for his meat.

01:42 And then the butcher can go, and he can use that money to buy his own pair of shoes.

01:46 So it makes a life lot easier having this medium of exchange instead of having to barter or trade for everything.

01:53 It's also a unit of account.

01:55 So say you want to see how many cups of coffee and iPhones worth.

01:58 If I ask you to do that without thinking about money, it's very difficult.

02:02 You have to think, well, what's the value of a cup of coffee to me? How how happy does it make? How happy does an iPhone make me? You have to try to compare the two automatically.

02:11 You're mind just wants to go to how much does a cup of coffee a cup of coffee cost, how much does an iPhone cost? And then you compare them.

02:18 That's natural and that's what money allows us to do.

02:21 It's a unit of account.

02:23 It can tell us how many cups of coffee are worth one iPhone, so it makes life easier to compare the value of two goods.

02:31 It's also a store of value, however, it's a bad store of value.

02:35 So the nominal interest rate of money holdings is zero.

02:38 So when I hold this dollar bill right here, I earn zero nominal interest rate on it. The bank pays me nothing for holding on to my money.

02:47 So it's a store of value, but it's a bad one because the real interest rate of money it equals the nominal interest rate adjusted for inflation or the nominal interest rate of money minus inflation.

02:59 With the nominal interest rate of money is zero.

03:02 So the real interest rate of money is negative inflation, whereas inflation goes up, the purchasing power of my currency here, my dollar goes down. So those are our three main roles of money, medium of exchange, unit of count and store value, even though it's a bad store of value.

03:22 So now let's look at a picture to try to make this all make sense.

03:24 Let's put our supply and demand graph together.

03:27 So here on our graph we'll see on our vertical axis is our nominal interest rate on a horizontal axis is our money or the amount of money in the economy.

03:35 We'll see. Again, we're going to have a downward sloping demand curve curve here.

03:40 It's our money demand.

03:41 So why is it downward sloping? Well, because the nominal interest rate represents our opportunity cost of holding money. As the nominal interest rate goes down, the opportunity cost of money holding money goes down.

03:53 So we demand more money.

03:55 It's not as big of a deal when we're holding on to money, we miss out on that nominal interest rate that we could be earning if the money were in the bank.

04:03 So if that opportunity cost is lower, we're more willing to hold on to that money.

04:07 We demand more money.

04:09 Now, the supply curve is going to be a little different than what we've seen in the past. The supply curve is vertical here.

04:14 The reason it's vertical is it's independent of the nominal interest rate.

04:19 It doesn't depend on the nominal interest rate.

04:21 It depends on the central bank.

04:23 The central bank is going to control the money supply here in the United States. That's the Federal Reserve.

04:30 They have a few different ways they can control this money, supply a few different tools to increase or decrease the money supply and change the nominal interest rate. If they increase the nominal interest rate that's called contractionary monetary policy.

04:45 People are less willing to hold money and less willing to spend money, so it'll slow down GDP growth or contract the economy.

04:53 If they decrease the nominal interest rate.

04:55 That's expansionary monetary policy.

04:58 It lowers the opportunity cost of holding money.

05:01 People are more willing to hold that money and spend that money and grow GDP.

05:05 That's expansionary monetary policy.

05:08 So let's take a look at some of these tools of monetary policy.

05:12 So first, we have what are called open market operations.

05:15 That's the most often used tool of monetary policy.

05:18 You have open market purchases and open market sales, open market purchases or expansionary monetary policy.

05:25 Open market sales are contractionary monetary policy.

05:28 So when the Federal Reserve goes out and they purchase bonds, they're going to pull bonds out of the economy.

05:34 They buy bonds from you, me, from the bank.

05:36 They pull these bonds out of the economy and they push cash into the economy.

05:41 So there's more money out there that will lower the nominal interest rate as the nominal interest rate comes down.

05:48 People demand more money.

05:49 They want to spend more money.

05:50 That's expansionary monetary policy.

05:53 The opportunity cost of holding on to money goes down.

05:58 Open market sales, that's when they sell bonds.

06:01 So they push bonds out into the economy and pull money out of the economy.

06:06 So bonds go out and money comes in.

06:08 There's less money that drives up.

06:11 The nominal interest rate.

06:13 As the nominal interest rate goes up, there's less demand for money.

06:16 That's contractionary monetary policy because it'll slow GDP growth. So again, our open market purchases, that's expansionary monetary policy. They buy bonds and push cash out into the economy.

06:30 Then you have your open market sales that's contractionary monetary policy.

06:33 They're going to sell bonds, so they're going to push bonds out into the economy and pull money out of the economy.

06:39 Their second tool is the reserve requirement ratio.

06:42 So the reserve requirement is the minimum level of the ratio of reserves to deposits that commercial banks must hold.

06:49 So if there's a 10% reserve requirement, that means if the bank has $1,000,000 in deposits, they need to hold 10% or 100,000 in reserves. So the lower that reserve requirement, the more loans banks can make out, the more loans they can make, the more money there is circulating circulating throughout the economy.

07:10 That's expansionary monetary policy.

07:12 When you lower that reserve requirement ratio, the third tool they have is changing the discount rate.

07:19 So we have this discount window lending here.

07:22 That's when the central banks can lend reserves to the commercial banks and charge them an interest rate, what we call the discount rate.

07:28 Lowering that discount rate is expansionary monetary policy as well, because banks are more willing to borrow from the central bank and we're willing to make these loans as they make more loans, there's more money circulating around there, lowers the interest rates. People are willing to spend money and hold on to money.

07:46 That's expansionary monetary policy.

07:49 It's meant to grow GDP.

07:52 So now that we know the three tools that affect money supply, let's take a look at money demand. What affects money demand? Well, you can have changes in the nominal interest rate effect, money demand.

08:03 So say we have open market purchases of bonds.

08:06 Again, the central bank is going to buy bonds.

08:09 So they pull bonds out of the economy and push money out into the economy.

08:12 So that increases the supply of money as that nominal interest rate comes down, it lowers the opportunity cost of holding money.

08:21 So we demand more money.

08:23 We move along the demand curve.

08:25 Things can also shift the demand curve for money, changes in price or changes in income. Both increases in prices and increases in income will shift the demand curve for money to the right.

08:37 It increases our demand for money if the prices go up, we need more money to buy goods.

08:43 If buying bread costs $5 this week but $10 next week, we need to hold more money in order to buy that bread.

08:50 Also, if our income goes up, we want to buy more stuff, right? More watches, more bling bling, more cars.

08:55 The more income we have, the more money we're going to demand, the more we're going to want to hold on ourselves so that we can buy stuff.

09:02 So increases in prices and increases in income will increase the demand for money. It'll shift the demand curve to the right.

09:10 That'll drive up the nominal interest rate.

09:13 So now let's switch gears and talk about the exchange rate.

09:15 Let's open the economy here.

09:17 All right. So it's natural place when you talk about money to talk about exchange rates. So exchange rates are very applicable to all our lives.

09:24 If you ever want to import or export or you want to go ahead and take a vacation somewhere, these things apply.

09:31 So nominal exchange rates, that's the rate at which a person can trade the currency of one country for the currency of another country.

09:38 So an example here, the US exchange rate with the euro, how many euros can I buy with $1? So you can have an appreciation or depreciation in the exchange rate on appreciation of the dollar.

09:51 That would be if US currency exchange rate with euro went from 0.6 to 0.7. So if I can buy €0.6 with a dollar and now I can buy €0.7 with the dollar, the dollar has appreciated against the euro a depreciation.

10:07 That's when your currency gets weaker against other currencies.

10:10 So if the US exchange rate with the euro goes from 0.7 to 0.6, that means I can go from buying €0.7 with a dollar to being able to buy 0.60 with the dollar.

10:21 The dollar depreciates against the euro.

10:24 Those are nominal exchange rates.

10:26 We can adjust those so that we have real exchange rates going from dollar figures to quantities.

10:32 Whenever we go from nominal.

10:34 That's in dollar figures to real that's in quantities.

10:37 Now real exchange rates are important because they're the key determinant and net exports. So here the real exchange rate takes the nominal exchange rate and it adjusts it by the ratio of domestic prices to foreign prices. Since we're a macroeconomics, we're not looking at specific goods and services, we're looking over all.

10:58 So we're looking at price indices like the Consumer Price Index.

11:02 So here we have a real exchange rate equals the nominal exchange rate e times the price domestic over the price for an r p star.

11:11 That gives us a real exchange rate.

11:13 So let's see now how real exchange rates play into this net.

11:17 These net exports and trade.

11:20 So again, we'll draw a picture.

11:21 We'll put our supply and demand together.

11:23 So here we're going to talk about the appreciation of an exchange rate.

11:27 So on our vertical axis here, what we have is the real exchange rate.

11:31 On our horizontal axis, we're going to have the quantity of dollar's exchange into the foreign currency from the US.

11:36 So it's normal for me to talk from the US's point of view.

11:40 So that's what we're going to do here.

11:41 So what we're going to see is we have our downward sloping demand for dollars in the foreign exchange market.

11:47 So why is it downward sloping? Well, if you take a look at the vertical axis as the real exchange rate goes down, that's a depreciation of the dollar.

11:56 As the dollar depreciates, US goods become cheaper relative to foreign goods. So foreigners want more dollars to buy US goods. That increases the demand for dollars as the dollar appreciates in real terms.

12:12 Now we take a look at our vertical axis, or we take a look at our supply of dollars from net capital outflows.

12:19 The reason it's vertical here, like in our money supply and money demand graph, is because it's independent of real exchange rates.

12:25 What it depends on is the real interest rate.

12:29 It depends on interest rates because that's what net capital outflows depend on.

12:33 Now there's a decrease in the supply of dollars that's going to raise the real exchange rate. It's going to raise the price of the dollar.

12:42 So if there's a decrease in the supply of dollars that raises the real exchange rate, you're going to see an appreciation of the dollar against foreign currency.

12:51 So if the dollar appreciates, there's going to be less demand for the dollar because goods in the US become relatively more expensive to foreign goods, less people want dollars to buy US goods.

13:05 So now let's take this a step further.

13:08 Let's see how monetary policy affects the real exchange rate and henceforth affects trade.

13:13 Let's take a look here.

13:15 Let's have some contractionary monetary policy.

13:18 Say the Fed goes ahead and does some open market sales.

13:21 They sell bonds to pool the money supply out of the economy.

13:25 That's going to move the money supply to the left.

13:28 It's going to drive up the nominal interest rate.

13:32 Also, as they pull money out of the economy, that's going to decrease savings.

13:36 It's going to increase the real interest rate in the United States as the real interest rate in the United States goes up.

13:42 That's going to increase foreign ownership of domestic assets and drive down net capital outflows.

13:49 If you remember net capital outflows, that's the net change in domestic ownership of foreign assets, minus the net change in foreign ownership of domestic assets. So foreigners are going to want more of our domestic assets if the real interest rate goes up.

14:06 So that's going to pull the supply of dollars out of the foreign economy and back into the United States so they can take advantage of those higher real interest rates.

14:15 So as we see a decrease in the supply of dollars in the foreign market, the price of the dollar is going to go up.

14:21 The real exchange rate is going to go up, making us goods more expensive relative to foreign goods.

14:29 So what's that going to do that's going to appreciate the dollar and that's going to decrease net exports.

14:34 There's going to be less exports from the United States to the rest of the world.

14:39 So that's how monetary policy affects real exchange rates, affects net capital outflows, and affects trade.

14:45 Now, if there's expansionary monetary policy, it would be just the opposite and all those mechanics.

14:52 So now we've gone through money and we've gone through monetary policy.

14:55 What do we know? What are we more knowledgeable about? Well, we know we know what money is and we know what it's used for.

15:02 We know how central banks control the supply of money.

15:05 We know the difference between real nominal exchange rates.

15:08 Again, it's just adjusting for prices going from dollar figures to quantities.

15:13 We know the real exchange rates affect trade and we know how net capital outflows are affected by that.

15:19 And we also know how monetary policy plays into effecting trade and net capital outflows. That's what we've learned in this presentation.

15:26 Thank you.