SV151, Principles of Economics
K. Christ
6 – 9 February 2012
SV151, Principles of Economics
K. Christ
9 February 2012
Key terms / chapter 21:
Medium of exchange
Unit of account
Store of value
Liquidity
Commodity money
Fiat money
Demand deposits
Reserves
Excess reserves
Fractional reserve banking
Required reserve ratio
Money multiplier
Federal Reserve
Open market operation
Discount rate
Federal funds rate
The Banking
System
Fractional Reserve Banking
 A bank’s balance sheet is key to understanding the
process of money creation in a fractional reserve
banking system:
Assets
Reserves:
Required*
Excess
Loans
Liabilities
$100
0
Deposits
$1,000
900
Securities
* Reserve Ratio in this case = 0.10.
 The money multiplier is simply the reciprocal of the
reserve ratio.
Fractional Reserve Banking
A simplified fractional reserve banking system
Assuming banks lend out all “excess” reserves …
Bank Balance Sheet 1
Liabilities
Assets
Reserves
Loans
$100
900
Deposits
$1,000
Bank Balance Sheet 2
Liabilities
Assets
Reserves
Loans
$90
810
Deposits
$900
Bank Balance Sheet 3
Liabilities
Assets
Reserves
Loans
$81
729
Deposits
$810
Summary:
Initial deposit
Required reserve ratio
Initial “excess” reserves
New loans by these three banks
Money multiplier
New loans possible by all banks
$1,000
0.10
$900
$2,439
10
$9,000
Let’s make the bank’s balance sheets a bit more complicated …
Now Suppose these three banks hold some of their reserves as securities (instead
of lending out all “excess”reserves) …
Bank Balance Sheet 1
Liabilities
Assets
Reserves
Loans
Securities
$100
800
100
Deposits
$1,000
Bank Balance Sheet 2
Liabilities
Assets
Reserves
Loans
Securities
$80
620
100
Deposits
$800
Bank Balance Sheet 3
Liabilities
Assets
Reserves
Loans
Securities
$62
458
100
Deposits
$620
Summary:
Initial deposit
Required reserve ratio
Initial “excess” reserves
New loans by these three banks
Money multiplier
New loans possible by all banks
$1,000
0.10
$900
$1,878
10
$9,000
Let’s introduce a central bank …
Now Suppose the Central Bank buys $150 of securities from these three banks (an
“open market” operation) …
Bank Balance Sheet 1
Liabilities
Assets
Reserves
Loans
Securities
$100
850
50
Deposits
$1,000
Bank Balance Sheet 2
Liabilities
Assets
Reserves
Loans
Securities
$85
715
50
Deposits
$850
Bank Balance Sheet 3
Liabilities
Assets
Reserves
Loans
Securities
$71.50
593.50
50
Deposits
$715
Summary:
New “excess” reserves
New loans by these three banks
Money multiplier
New loans possible by all banks
$150
$280.50
10
$1,500
Example
SV151, Principles of Economics
K. Christ
13 February 2012
Key terms / chapters 21 and 22:
Federal Reserve
Open market operation
Discount rate
Federal funds rate
Classical theory of inflation
Quantity theory of money
Quantity equation
Velocity of money
Classical dichotomy
Monetary neutrality
Fisher effect
The Banking
System (continued)
and
Money Growth
& Inflation
U.S. Federal Reserve System

Established by Congress with the passage of the Federal
Reserve Act, December 23, 1913.

Organization: 12 District Banks and a separate 7member Board of Governors.

Responsibilities include facilitation of payments
systems, bank supervision and regulation, conduct of
monetary policy.

Monetary policy implemented
by the Federal Open Market
Committee (FOMC).
Central bank policy tools
1. Open market operations
The buying and selling of government bonds,
through which a central bank can quickly
influence the money supply and availability of credit.
2. Reserve requirements
Regulations concerning the minimum amount
of reserves that banks must hold against deposits in a
fractional reserve banking system.
3. Discount rate
The short-term interest rate on loans that a central bank
makes to commercial banks.
Central bank policy tools
To Increase The
Money Supply…
1. Open market operations Purchase
Bonds
To Decrease The
Money Supply…
Sell
Bonds
2. Reserve requirements Lower the
Raise the
Requirements Requirements
3. Discount rate
Lower the
Rate
Raise the
Rate
Central bank open market operations
Expansionary (Loose)
Monetary Policy
Contractionary (Tight)
Monetary Policy
Nominal short-term
interest rates fall
Nominal short-term
interest rates rise
Increased Spending
?
Decreased Spending
Recent Federal Reserve Monetary Policy
U.S. Federal Reserve Monetary Polcy:
Target for Federal Funds Rate, 1900 to present
9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1/1/2009
1/1/2008
1/1/2007
1/1/2006
1/1/2005
1/1/2004
1/1/2003
1/1/2002
1/1/2001
1/1/2000
1/1/1999
1/1/1998
1/1/1997
1/1/1996
1/1/1995
1/1/1994
1/1/1993
1/1/1992
1/1/1991
0.00%
1/1/1990
1.00%
Interest Rates, Real and Nominal
Short-Term U.S. Interest Rates and Inflation
12.00
10.00
8.00
6.00
4.00
2.00
0.00
Jan-85
-2.00
Jan-87
Jan-89
Jan-91
U.S. Govt. Short Term
3-Month CD
Estimated Real S-T Interest Rate
Jan-93
Jan-95
Jan-97
Jan-99
Federal Funds
Consumer Inflation Rate
Jan-01
Monetary Policy and the Money Market
Expansionary Monetary Policy
M 1s
M 1s
INTEREST RATES
INTEREST RATES
M s0
Contractionary Monetary Policy
i0
i1
M d Y , i 
MONEY DEMAND & SUPPLY
M s0
i1
i0
M d Y , i 
MONEY DEMAND & SUPPLY
Can monetary policy makers control inflation?
What causes inflation?
F The Quantity Theory of Money
MV = PQ (“equation of exchange”)
F “Inflation is purely a monetary phenomenon”
Growth in the money supply, if greater than the growth
rate of real output, leads to rising prices
How can we control the money supply?
F Federal Open Market Operations:
Buying securities
Increases the money supply
Selling securities
Decreases the money supply
The quantity theory of money: the quantity equation
Money Supply
Price Level
May be measured
in various ways
May be measured
in various ways
MV  PY
Velocity
Real Output
The rate at which
money changes hands
Real GDP is a
typical approximation
The quantity theory of money
%M  %V  %P  %Y
F
F
If velocity is stable, to maintain price stability,
the growth rate of the money supply should equal
the growth rate of real output.
If velocity is stable, a money supply growth rate
in excess of the growth rate of real output will lead
to rising prices.
The “classical dichotomy” (and monetary neutrality)
1. The “classical dichotomy”
The theoretical separation of nominal and real variables.
Variables measured in monetary units: Variables measured in physical units:
Nominal GDP
Real GDP
Money supply
Quantities of specific goods
Prices and price levels
Relative prices
Nominal interest rates
Real interest rates
2. Monetary neutrality
The proposition that changes in the money supply do not
affect real variables.
Long-run
Neutrality
vs.
Short-run
Neutrality