3/08/2011
Upcoming Events:
 SECOND MIDTERM: Tuesday, March 15 (Next Tuesday). Comprehensive.
Emphasis on Chaps 8, 9, 11, 12, and readings.
 Online Discussion: Jessica L. vs Jonathan: Was the TARP Good Policy?
Kate vs. Matt Continues: Should You Put Your Savings in the Stock Market?
Assignment:

Read Chapter 12.
 Read James Hamilton on Money vs Monetary Base.
Key Points from Last Class:
 M1 = (Checking Deposits) + (Currency in Circulation) + (Travelers' Checks).
 Checking deposits and currency in circulation each compose about half of M1.
 M2, another measure of the money supply, includes (M1) plus (savings deposits) plus
(some other less liquid items). M2 is nearly 5 times as big as M1.
 Currency is not the same thing as money. In fact, currency in banks is NOT money.
 When you deposit cash in your checking account, the money supply does not change.
 When you put $100 cash in your savings account M1 drops by $100, but M2 is unchanged.
 The Federal Reserve (“The Fed”) is the Central Bank of the U.S., quasi-independent of
government. It regulates banks and the money supply. It's "the banks' bank."
 The Fed Board of Governors is composed of up to 7 people nominated by the President
and confirmed by the Senate to 14-year terms. The Chairman of the Fed is Ben Bernanke,
a PhD economist and expert on the Great Depression.
 Fed profits are returned to the Treasury.
 The Fed has 12 Regional banks; each has its own President
 The Federal Open Market Committee (FOMC) of the Fed regulates the money supply
through purchases (+) and sales (-) of government bonds on the open market.
 The FOMC consists of the Board of Governors, plus the President of the NY Fed, plus four
other regional Fed Presidents, on a rotating basis.
 Monetary Base = (Currency in Circulation) + (Currency in Bank Vaults) + (Banks' Balances
at the Fed).
 RESERVES = (Cash in Bank Vaults) + (Bank Balances at Fed)
 RESERVE RATIO = R = Reserves/Deposits.
 REQUIRED RESERVES = (Required Reserve Ratio) x (Checking Deposits).
 EXCESS RESERVES = Reserves  (Required Reserves).
 Banks create money by making loans from their excess reserves.
 The “Money Multiplier” gives the maximum amount of new money that can be created from
an additional dollar of excess reserves. It equals 1/R, so
Change in the Money Supply (1/R) x (Change in Excess Reserves).
 The amount of new money created from an additional dollar of excess reserves will be less
than the money multiplier if (1) the public does not deposit all the loan proceeds back into
the banking system, or (2) if banks decide to hold excess reserves rather than loaning
them out.
 In normal times, banks do not hold much in excess reserves. These are not normal times.
Current Class Outline:
XI. The Monetary System
A. The Meaning of Money
B. The Federal Reserve System
C. Banks and the Money Supply
Interest on Reserves: A New Fed Tool
James Hamilton on Velocity of Reserves
XII. Money Growth and Inflation
A. Money Supply and Demand
B. The Classical Theory of Inflation
C. The Costs of Inflation
Zimbabwe (Wikipedia)
More on Zimbabwe
Weimar Republic of Germany`
Hyperinflation Episodes in History
Hyperinflation (Cato Institute)
Wizard of OZ
“Inflation is always and everywhere a monetary phenomenon.”
- Milton Friedman
Monetary Components (Numbers are rounded)
Demand Deposits:
Currency in Circ:
Travelers’ Checks:
M1:
Savings Deposits:
Small Time Deposits:
Money Market Funds:
M2:
$ 922B
$ 923B
$ 5B
$1850B
$5440B
$ 900B
$ 690B
$8880B
Monetary Base = Currency in Circulation + Currency in Banks + Banks' Deposits at Fed
= Total Currency + Banks' Deposits at the Fed
= $2050 B
Since January 2008:
M1 has grown 33%
(9.5% per year)
M2 has grown 18%.
(5.5% per year)
The monetary base has grown 146%.
Excess reserves have grown to $1 trillion
from about $2 Billion (59,000%).
The Fed’s Assets, 2/10/10. Graphic copied from James Hamilton, source: http://www.federalreserve.gov/releases/h41/
The Fed’s Liabilities, 2/10/10. Graphic copied from James Hamilton. Source: http://www.federalreserve.gov/releases/h41/
1) “Total Currency” = “Currency in Circulation” + “Currency Held by Banks.”
Consider also the following definitions:
Monetary Base = “Total Currency” + “Account balances at the Fed” and
Reserves = “Currency Held by Banks” + “Account balances at the Fed”
It is true therefore, by definition, that the Monetary Base equals
a) M1 + Reserves.
b) M2 + Reserves.
c) Currency in Circulation + Excess Reserves.
d) Currency in Circulation + Reserves.
Recall that M1 is defined as follows:
M1 = Currency in Circulation + Demand Deposits + Travellers Checks.
Monetary Base = “Total Currency” + “Account balances at the Fed” and
Reserves = “Currency Held by Banks” + “Account balances at the Fed”
Total Currency = “Currency in Circulation” + “Currency Held by Banks.”
2) Given the above definitions, what is the relationship between the money supply, (as measured by M1)
and the monetary base?
a) the money supply (M1) and the monetary base are the same thing.
b) the money supply (M1) is part of the monetary base
c) the monetary base and the money supply have a common element, but are not the same thing.
d) the monetary base is part of M1.
M1 = Currency in Circulation + Demand Deposits + Travellers Checks.
Monetary Base = “Total Currency” + “Account balances at the Fed” and
Reserves = “Currency Held by Banks” + “Account balances at the Fed”
Total Currency = “Currency in Circulation” + “Currency Held by Banks.”
3) Suppose the Fed buys $1 billion in bonds from a bank, which it pays the bank for by increasing the
balance in the bank’s account at the Fed by $1 billion.
This action by itself increases
a) the money supply (M1) and the monetary base.
b) the monetary base, but not the money supply (M1).
c) the money supply (M1), but not the monetary base.
d) neither the money supply (M1) nor the monetary base.
M1 = Currency in Circulation + Demand Deposits + Travellers Checks.
Monetary Base = “Total Currency” + “Account balances at the Fed” and
Reserves = “Currency Held by Banks” + “Account balances at the Fed”
Total Currency = “Currency in Circulation” + “Currency Held by Banks.”
4) Thus the Fed, through its open market operations, has direct control over
a) both the money supply (M1) and the monetary base.
b) the monetary base, but not the money supply (M1).
c) the money supply (M1), but not the monetary base.
d) neither the money supply (M1) nor the monetary base.
5) If the Fed directly controls the monetary base, but not M1 or M2, why do economists often say that the
Fed controls the money supply (M)?
a) The monetary base and the money supply are nearly the same thing.
b) The monetary base is a better measure of M than either M1 or M2 are.
c) The Fed controls the monetary base, from which banks make loans, and banks’ loans create money,
so the Fed has considerable control over M.
d) Economists generally have no clue what they are talking about.
6) Suppose that after trick-or-treating Annie, Bob, and Charlie each has a different candy bar worth $1.
None of them likes the candy bar that s/he has. Annie has Bob’s favorite candy bar, Charlie has
Annie’s, and Bob has Charlie’s. Rather than do a two-stage barter exchange (their parents have
forbidden them to trade candy with each other), they decide to buy their favorites from each other on the
spot (which will result in $3 in total transactions, which we’ll refer to as nominal GDP). They have
access only to the money in their pockets. In which case is the velocity of money greatest?
a) The three children each have a dollar, which each exchanges at once for his favorite candy bar.
b) The three children each have $2, and each exchanges one of them for his favorite candy bar.
c) Charlie has $1. Neither of the others has any money.
d) Answer c would be correct, except that the children won’t be able to perform the $3 in transactions
with only $1.
7) Same situation. Annie, Bob, and Charlie each has a different candy bar worth $1. Annie has Bob’s
favorite candy bar, Charlie has Annie’s, and Bob has Charlie’s. They decide to buy their favorites from
each other on the spot (which will result in $3 in “nominal GDP”). They have access only to the money
in their pockets. In which case is the velocity of money lowest?
a) The three children each have a dollar, which each exchanges at once for his favorite candy bar.
b) The three children each have $2, and each exchanges one of them for his favorite candy bar.
c) Charlie has $1. Neither of the others has any money.
d) Charlie has $3. Neither of the others has any money.