In review, money serves three functions:
When most people think of money, they think of bills or coins. However, if it is anything that allows us to get what we want, wouldn't checks and debit cards also be considered money? What else could it potentially be?
Depending on how easy or difficult it is to go out and spend a certain type of money immediately, we classify it accordingly. Some forms of money, like cash, are the easiest form of money to go out and spend right now, while other forms of money, like money in a savings account, involve a few more steps in order to be able to spend it.
This concept is known as liquidity. Cash is extremely liquid; it is the most liquid form of money because it can be spent right now. Money in a savings account is less liquid.
Forms of money can be classified into the following categories according to their liquidity:
|M0||Narrowest definition of money; includes only the stock of physical currency||Most liquid, immediately available|
|M1||Includes demand deposits (checking account balances) + M0 (stock of physical currency)||Still liquid, accessible via checks and debit cards|
|M2||Broadest definition of money; includes time deposits such as savings accounts, money market mutual funds, etc. + M1 (demand deposits + M0, stock of physical currency)||Least liquid, accessibility requires a couple steps|
The FOMC, or the Federal Open Market Committee, is part of the Fed. They meet eight times a year to manage our nation's money supply.
The FOMC has various tools that they use to control these various parts of our money supply, M0, M1, and M2:
This tutorial will focus on the second bullet, open market operations.
Now, open market operations are defined as one of the mechanisms available to the Fed to regulate interest rates and the money supply. These open market operations refer to the purchase and sale of U.S. Treasury securities.
However, how does the money end up in our hands? This is a complicated process that many people do not fully understand.
The process of actually getting that money that has been printed into and out of circulation happens through these open market operations, the buying and selling of U.S. Treasuries, which are bonds, bills, and notes.
When the Fed wants to get the money that they have printed into M0, meaning into that actual physical stock of cash in circulation, they buy treasuries.
Now, if the Fed wants to actually take money out of circulation, they simply do the opposite. They sell securities. Again, when someone sells something to you, you have to give up cash. Similarly, buyers--these bondholders--give up cash in exchange for the securities. This takes money out of circulation. The Fed, then, shreds this cash, taking it out of M0.
So, if the Fed wants to increase the amount of loanable funds and the amount of money in M0 in circulation, they buy bonds, because this puts money into people's hands. When they buy from us, basically, they are giving us cash.
If the Fed wants to take money out of circulation and decrease or contract the money supply, they sell bonds.
Let's look at the impact this has on the money market. Here is a demand and supply graph for money.
We assume that the Fed controls the supply of money right now, so it is fixed, which is why it is represented by a straight vertical line.
However, the demand for money does, in fact, vary with interest rates.
This is why the demand for money varies with interest rates.
Now, with expansionary monetary policy, when the Fed is buying bonds and putting money into circulation, they are increasing the money supply, illustrated by a shift to the right in our demand and supply graph for money.
So, when they buy treasuries, they are putting money into bondholders' hands, increasing the amount of money in circulation.
Notice the overall impact on the economy. It lowers interest rates in the economy. At lower rates, people and firms will tend to take money out of the banks and take advantage of lower rates by taking out loans, thereby getting more money into circulation.
The opposite occurs when the Fed is selling bonds. This is known as a contractionary, or tight money policy. If the Fed is contracting the money supply, they will engage in selling U.S. Treasury securities, because they are taking money from bondholders and decreasing the amount of money in circulation.
That represents a shift of the money supply to the left, and it raises interest rates in the economy.
You may recall that at higher rates, people and firms tend to keep money in the banks, and they take out fewer loans for homes and cars. They tend to wait until rates fall again, which has a contractionary effect. The more money that is tied up in the banks, the less spending and circulating of money is going on outside of the banks.
Source: Adapted from Sophia instructor Kate Eskra.