Page 521 - Introduction to Business

CHAPTER 14 Understanding the Financial System, Money, and Banking 495

• M1. Money that can be readily spent by the public, including cash (coins and
paper currency) and checking accounts (third-party drafts on funds held in
banks). Demand deposits are checking accounts that pay no interest to cus-
tomers, whereas NOW (negotiable order of withdrawal) accounts are interest-
bearing checking accounts.
• M2. M1 plus all small savings and time deposits in banks worth less than
$100,000. Short-term assets held by small investors in money market mutual
funds (to be discussed later) are also included in M2.
• M3. M2 plus large-time deposits in banks worth more than $100,000, which
are normally deposited by business firms.
•L. M3 plus short-term money securities with maturities less than one year.
Of these monetary aggregates, M1 and M2 are most closely watched by central
banks. The reason for this is that M1 and M2 represent money held by consumers that
can be spent on goods and services in the economy. Since consumer spending drives
production by firms, M2 is a good measure of money to use in monetary policy.
The “moneyness” of a particular type of money is dependent on how fast it can
be spent by consumers. Money held in M1 is immediately spendable, while L is
made up of short-term money market securities that must first be sold and con-
verted to cash before they can be spent. However, since money market securities
are highly liquid, we can think of L as near-money.

Monetary Policy Framework

Exhibit 14.4 shows a picture of the monetary policy framework, including policy monetary policy A central bank
tools, operating targets, intermediate targets, and economic goals. The Fed can use framework for using policy tools to
affect operating targets, intermediate
policy tools, such as open market operations, the discount rate, and reserve targets, and economic goals
requirements, to directly control day-to-day operating targets, namely, the federal policy tools The tools that the central
funds rate and bank reserves. Open market operations are the most powerful and bank uses to implement monetary
frequently used policy tool. If these operations are not successful in achieving policy, such as open market operations,
the discount rate, and reserve
requirements
operating targets The everyday targets
EXHIBIT 14.4 that the central bank seeks to achieve
using its policy tools, namely, the
How Monetary Policy Works federal funds rate and bank reserves
The Fed can use open market operations to buy securities from banks, lower discount rates, or lower
reserve requirements to decrease the Fed funds rate and increase bank reserves. Over time these
changes would tend to lower long-term interest rates, increase bank credit, and increase the money
supply. These monetary changes would stimulate productivity and increase employment.

Fed policy Operating Monetary Economic
tools targets goals goals

• Open market • Fed funds rate • Long-term • Productivity
operations (buy • Bank reserves interest rates (GDP)
or sell securities) • Bank credit • Full employment
• Discount rate • Money supply • Stable prices
(bank (M1, M2, and (low inflation)
borrowing rate) M3) • International
• Reserve trade and
requirements finance

Day-to-day activity Long and variable lags
under direct control between Fed actions and
of the central bank monetary and economic goals

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