V
MONEY AND PRICES IN THE LONG RUN
1
The Monetary
System
11
THE MEANING OF MONEY
• Money is the set of assets that people
commonly use to buy things.
THE MONETARY SYSTEM
3
The Functions of Money
• Money has three functions in the economy:
• Medium of exchange
• Unit of account
• Store of value
THE MONETARY SYSTEM
4
Money Consists Of …
• Currency: the paper bills and coins
in the hands of the public
• Demand deposits: balances in bank
accounts that depositors can use as
payment by writing a check.
• And a few other less important things,
such as travelers’ checks
THE MONETARY SYSTEM
8
M1 and M2 in September 2012
$ Billions
Currency
1068.5
+ Traveler’s Checks
3.9
+ Demand Deposits
878.7
+ Other Checkable Deposits
431.5
= M1
2,382.6
+ Savings Deposits
6,454.6
+ Small-denomination Time Deposits
667.7
+ Retail Money Market Mutual Funds
621.9
= M2
10,126.8
Source: http://www.federalreserve.gov/releases/h6/current/h6.htm
THE MONETARY SYSTEM
10
THE FEDERAL RESERVE SYSTEM
• The Federal Reserve (The Fed) serves as the central bank of
the US.
• It is designed to oversee the banking system.
• It regulates the quantity of money in the economy.
• This activity is called monetary policy.
11
The Fed: Helicopter and Vacuum Cleaner
• You can think of the Fed as
printing money and dropping it
from helicopters, thereby adding
to the quantity of money in the
economy
• Conversely, you can think of the
Fed as a giant vacuum cleaner
that sucks money out of people’s
wallets, thereby reducing the
quantity of money
15
The Fed: Helicopter and Vacuum Cleaner
• The helicopter-and-vacuum view
of the Fed is a bit too simple,
however
• The Fed really can increase or
decrease the quantity of money
• But it uses a process called open
market operations to do so
16
The Fed: Helicopter and Vacuum Cleaner
• When the Fed wishes to increase
the quantity of money in the
economy, it prints money and
buys financial assets—such as
government bonds—on the
open market
• That’s the Fed acting as a moneydropping helicopter
17
The Fed: Helicopter and Vacuum Cleaner
• When the Fed wishes to
decrease the quantity of money
in the economy, it sells financial
assets—such as the government
bonds it may have bought in the
past—on the open market, and
burns the money it gets from the
sale
• That’s the Fed acting as a moneysucking vacuum
18
BANKS AND THE MONEY SUPPLY
• Banks can also increase or
decrease the economy’s quantity
of money
• That is, banks can also act like a
money-dropping helicopter or a
money-sucking vacuum
19
BANKS AND THE MONEY SUPPLY
• Remember that the quantity of
money consists of:
• Currency: the paper bills and coins in
the hands of the public
• Demand deposits: balances in bank
accounts that depositors can use as
payment by writing a check.
• Banks can control the quantity of
money by controlling the quantity
of money in demand deposits
THE MONETARY SYSTEM
20
BANKS AND THE MONEY SUPPLY
• When banks make new loans
faster than borrowers are
repaying old loans, the quantity
of money in demand deposits
increases and, therefore, the
economy’s quantity of money
increases
• That is, banks can act like a
money-dropping helicopter
THE MONETARY SYSTEM
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BANKS AND THE MONEY SUPPLY
• When banks make new loans
slower than borrowers are
repaying old loans, the quantity
of money in demand deposits
decreases and, therefore, the
economy’s quantity of money
decreases
• That is, banks can act like a
money-sucking vacuum
THE MONETARY SYSTEM
22
BANKS AND THE MONEY SUPPLY
• Banks take deposits from people (depositors)
and pay interest to the depositors
• Some of the deposits may be given as loans to
borrowers, who must repay the loans with
interest
• Reserves are deposits that banks have received
but have not loaned out.
• Deposits = Reserves + Loans
THE MONETARY SYSTEM
23
100-Percent-Reserve Banking
• Deposits = Reserves + Loans
• In 100-percent-reserve banking, banks make no
loans; they simply keep the deposits safe until the
depositors turn up to withdraw their deposits
• Therefore, Loans = 0 and Deposits = Reserves
• In this system, banks have no effect on M1
• When someone makes (withdraws) a $100 deposit,
currency decreases (increases) by $100 and demand
deposits increase (decrease) by $100, leaving M1
unchanged
THE MONETARY SYSTEM
24
Fractional-Reserve Banking
• In a fractional-reserve banking system, banks
hold a fraction of their deposits as reserves and
lend out the rest.
THE MONETARY SYSTEM
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Money Creation with Fractional-Reserve Banking
• When a bank makes a loan from its reserves,
the money supply increases right away.
• But further increases in the money supply
follow.
THE MONETARY SYSTEM
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Money Creation with Fractional-Reserve Banking
• When one bank loans money, that money
generally ends up as a deposit in a second
bank.
• This creates more deposits and more reserves
to be lent out by the second bank.
• When the second bank makes a loan from its
reserves, the money supply increases again.
• And the process continues …
THE MONETARY SYSTEM
27
The Money Multiplier
• How much money is eventually created in this
economy?
THE MONETARY SYSTEM
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The Money Multiplier
• The money multiplier is the amount of money
the banking system generates with each dollar
of reserves.
THE MONETARY SYSTEM
29
BANKS AND THE MONEY SUPPLY
• Reserve Ratio
• The reserve ratio is the fraction of total deposits
that banks hold as reserves.
• The fraction of its total deposits that a bank is
required by the Fed to keep as reserves is called
the required reserve ratio.
• When banks hold reserves in excess of the required
reserves, those reserves are called excess reserves.
• Reserves = Required Reserves + Excess Reserves
THE MONETARY SYSTEM
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The Money Multiplier
• The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R
• With a reserve ratio of R = 20% or 1/5,
• The multiplier is 5.
• Example: In this case, if the Fed prints a fresh dollar
bill and buys a government bond with it, the
money supply may increase by as much as $5.00!
THE MONETARY SYSTEM
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1.
The Fed prints $100 of new cash and uses it
to buy a government bond from Astoria
Bank. M1 +0
2.
Astoria Bank lends $100 to Betty. Betty buys
a shirt from Chris with the money. Chris
deposits $100 in his account in Delaware
Bank. M1 +100
3.
4.
5.
As the required reserve ratio is 10%,
Delaware Bank adds $10 to its reserves and
lends $90 to Eddie. Eddie buys a pair of
shoes with the money from Frank. Frank
deposits $90 in his account in Georgia Bank.
M1 +90
Georgia Bank adds $9 to its reserves and
lends $81 to Harry. Harry buys a winter coat
with the money from Inez. Inez deposits $81
in her account in Japan Bank. M1 +81
Japan Bank adds $8.10 to its reserves and
lends $72.90 to Kelly. M1 +72.90 …
2. Therefore, loans, deposits, and M1, the
money supply, must all increase by $1000.
Loans
Deposits
M1
Required
Reserves
Excess
Reserves
+100
Event 2
+100
+100
+10
+90
Event 2
Event 2
Event 3
Event 3
+90
+90
+90
+9
+81
Event 3
Event 3
Event 3
Event 4
Event 4
+81
+81
+81
+8.10
+72.90
Event 4
Event 4
Event 4
Event 5
Event 5
⋮
⋮
⋮
⋮
⋮
⋮
⋮
⋮
⋮
⋮
+1000
+1000
+1000
+100
+900
3. This should not be a surprise because the
money multiplier is m = 1/R = 1 / 0.10 = 10.
1. Ultimately all of the newly printed cash
must end up as required reserves.
32
Financial Crisis of 2008–2009
• Bank capital
• Resources a bank’s owners have put into the
institution
• It is used to generate profit
33
Financial Crisis of 2008–2009
• Leverage
• Use of borrowed money to supplement existing
funds for purposes of investment
• Leverage ratio
• Ratio of assets to bank capital
• Capital requirement
• Government regulation specifying a minimum
amount of bank capital
34
Financial Crisis of 2008–2009
• If bank’s assets – rise in value by 5%
• Because some of the securities the bank was
holding rose in price
• $1,000 of assets would now be worth $1,050
• Bank capital rises from $50 to $100
• So, for a leverage rate of 20
• A 5% increase in the value of assets
• Increases the owners’ equity by 100%
35
Financial Crisis of 2008–2009
• If bank’s assets – fall in value by 5%
• Because some people who borrowed from the
bank default on their loans
• $1,000 of assets would be worth $950
• Value of the owners’ equity falls to zero
• So, for a leverage ratio of 20
• A 5% fall in the value of the bank assets
• Leads to a 100% fall in bank capital
36
Financial Crisis of 2008–2009
• Banks in 2008 and 2009
• Shortage of capital
• After they had incurred losses on some of their assets
• Mortgage loans
• Securities backed by mortgage loans
• Reduce lending (credit crunch)
• Contributed to a severe downturn in economic activity
37
Financial Crisis of 2008–2009
• U.S. Treasury and the Fed
• Put many billions of dollars of public funds into the
banking system
• To increase the amount of bank capital
• It temporarily made the U.S. taxpayer a part owner
of many banks
• Goal: to recapitalize the banking system
• Bank lending could return to a more normal level
• Occurred by late 2009
38
Fed’s Tools of Monetary Control
• Influences the quantity of reserves
• Open-market operations
• Fed lending to banks
• Influences the reserve ratio
• Reserve requirements
• Paying interest on reserves
39
Fed’s Tools of Monetary Control
• Open-market operations
• Purchase and sale of U.S. government bonds by the
Fed
• To increase the money supply
• The Fed buys U.S. government bonds
• To reduce the money supply
• The Fed sells U.S. government bonds
• Used more often
40
Fed’s Tools of Monetary Control
• Fed lending to banks
• To increase the money supply
• Discount window
• At the discount rate
• Term Auction Facility
• To the highest bidder
41
Fed’s Tools of Monetary Control
• The discount rate
• Interest rate on the loans that the Fed makes to
banks
• Higher discount rate
• Reduce the money supply
• Smaller discount rate
• Increase the money supply
42
Fed’s Tools of Monetary Control
• Term Auction Facility
• The Fed sets a quantity of funds it wants to lend to
banks
• Eligible banks bid to borrow those funds
• Loans go to the highest eligible bidders
• Acceptable collateral
• Pay the highest interest rate
43
Fed’s Tools of Monetary Control
• Reserve requirements
• Regulations on minimum amount of reserves
• That banks must hold against deposits
• An increase in reserve requirement
• Decrease the money supply
• A decrease in reserve requirement
• Increase the money supply
• Used rarely – disrupt business of banking
44
Fed’s Tools of Monetary Control
• Paying interest on reserves
• Since October 2008
• The higher the interest rate on reserves
• The more reserves banks will choose to hold
• An increase in the interest rate on reserves
• Increase the reserve ratio
• Lower the money multiplier
• Lower the money supply
45
Problems in Controlling the Money Supply
• The Fed’s control of the money supply is not
precise.
• The Fed must wrestle with two problems that
arise due to fractional-reserve banking.
• The Fed does not control the amount of money
that households choose to hold as deposits in
banks.
• The Fed does not control the amount of money
that bankers choose to lend.
THE MONETARY SYSTEM
46
The Federal Funds Rate
• The Federal Funds Rate is the interest rate that
banks charge for overnight loans to one
another
• When the federal funds rate rises or falls, other
interest rates often move in the same direction
• When interest rates change they affect the
behavior of consumers and businesses.
• This, in turn, has short-run effects on the
economy
THE MONETARY SYSTEM
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The Federal Funds Rate
• In recent years, the Fed has used its policy
tools to control the Federal Funds Rate
• From time to time the Fed announces a target level
for the federal funds rate
• The Fed then uses its monetary policy tools to push
the federal funds rate to the target rate
• The theory of how the Fed can control interest
rates and why it does so will be discussed
further when we discuss the short run
THE MONETARY SYSTEM
48
The Federal Funds Rate
The Federal Funds Rate
Summary
• The term money refers to assets that people
regularly use to buy goods and services.
• Money serves three functions in an economy:
as a medium of exchange, a unit of account,
and a store of value.
• Commodity money is money that has intrinsic
value.
• Fiat money is money without intrinsic value.
THE MONETARY SYSTEM
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Summary
• The Federal Reserve, the central bank of the
United States, regulates the U.S. monetary
system.
• It controls the money supply through openmarket operations or by changing reserve
requirements or the discount rate.
THE MONETARY SYSTEM
52
Summary
• When banks loan out their deposits, they
increase the quantity of money in the
economy.
• Because the Fed cannot control the amount
bankers choose to lend or the amount
households choose to deposit in banks, the
Fed’s control of the money supply is imperfect.
THE MONETARY SYSTEM
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