Chapter 13
Money and the Banking System
OUTLINE
I. What is Money?
A. Medium of Exchange
B. Store of Value
C. Unit of Account
II. How the Supply of Money Affects Its Value
A. The main thing that makes money valuable is the same thing that generates
value for other commodities: Demand relative to supply.
B. People demand money because it reduces the cost of exchange. When the
supply of money is limited relative to the demand, money will be valuable.
III. How is the Money Supply Measured?
A. Components of M1 Money Supply
1. Currency
2. Checking Deposits (including demand deposits and interest-earning
checking deposits)
3. Traveler’s checks
B. M2 money supply: broader measure that includes savings and time deposits
and money market mutual funds
C. Credit Cards versus Money
1. Money is an asset; credit card balances are a liability. Thus, credit card
purchases are not money.
IV. The Business of Banking
A. The banking industry includes savings and loans and credit unions as well as
commercial banks.
B. Banks accept deposits and use part of them to extend loans and make
investments.
C. Banks are profit-seeking institutions
D. Banks play a central role in the capital (loanable funds) market. They help to
bring together people who want to save for the future with those who want to
borrow in order to undertake investment projects.
E. The banking system is a fractional reserve system: Banks maintain only a
fraction of their assets in reserves to meet the requirements of depositors
F. Compared to other businesses, banks are more vulnerable to failure (and
abuse) and the consequences of failure exert a larger impact on the economy.
G. The bank failures of the 1920s and 1930s led to the establishment of the
Federal Deposit Insurance Corporation (FDIC) in 1934.
1. The FDIC restored confidence in the banking system and reduced bank
failures.
V. How Banks Create Money by Extending Loans
A. Under a fractional reserve system, an increase in reserves will permit banks to
extend additional loans and thereby expand the money supply (create
additional checking deposits)
B. The lower the percentage of the reserve requirement, the greater is the
potential expansion in the money supply resulting from the creation of new
reserves.
C. The fractional reserve requirement places a ceiling on potential money
creation from new reserves.
D. The actual deposit multiplier will be less than the potential because:
1. Some persons will hold currency rather than bank deposits.
2. Some banks may not use all their excess reserves to extend loans.
VI. The Federal Reserve System
A. The Fed is a central bank responsible for the conduct of monetary
policy
B. Bankers’ Bank
C. Structure of the Fed
D. Independence of the Fed
1. Stems from the lengthy terms—14 years—of members of the Board of
Governors and the fact that its revenues are derived from interest on the
bonds it holds rather than allocations from Congress.
E. How the Fed Controls the Money Supply
1. Reserve requirements.
a. When the Fed lowers the required reserve ratio, it creates excess
reserves and allows banks to extend additional loans, expanding the
money supply. Raising the reserve requirements has the opposite
effect.
2. Open Market operations.
a. The buying and selling of bonds in the open market.
b. Primary tool used by Fed.
c. When the Fed buys bonds, the money supply will expand because the
bond buyers will acquire money and bank reserves will increase
(placing banks in a position to expand the money through the
extension of additional loans).
d. When the Fed sells bonds, the money supply will contract because
bond buyers are giving up money in exchange for securities and the
reserves available to banks will decline (causing them to extend fewer
loans).
3. The Discount rate and Federal Funds rate.
a. The discount rate is the rate that the Fed charges banking institutions
for borrowing funds.
b. In federal funds market, banks with excess reserves extend short-term
loans to other banks seeking additional reserves.
c. The Fed charges banks a discount rate that is greater than the federal
funds rate.
(1) The precise rate the Fed charges is determined by the financial
conditions of the bank borrowing the funds
d. An increase in the discount rate is restrictive because it discourages
banks from borrowing from the Fed to extend new loans.
e. A reduction in the discount rate is expansionary because it makes
borrowing from the Fed less costly.
f. In recent years, the announcements of the Fed regarding monetary
policy have focused on its target for the federal funds rate.
F. The Difference Between the Fed and the Treasury
1. U.S. Treasury.
a. Concerned with the finance of the Federal Government
b. Issues bonds to the general public to finance the budget deficits of the
federal government.
c. Does not determine the money supply.
2. Federal Reserve.
a. Concerned with the monetary climate for the economy.
b. Does not issue bonds.
c. Determines the money supply—primarily through its buying and
selling of bonds issued by the U.S. Treasury.
VII. Ambiguities in the Meaning and Measurement of the Money Supply
A. Interest Earning Checking Deposits
1. Less costly to hold than currency and demand deposits.
2. Their introduction changed the nature of the M1 money supply in the
1980s.
B. Widespread Use of the U.S. Dollar Outside of the United States
1. More than one-half and perhaps as much as two-thirds of this currency is
held overseas.
2. This reduces the reliability of the M1 money supply measure.
C. Sweeping of various interest-earning checking accounts into Money Market
Deposit Accounts.
D. The increasing availability of low-fee stock and bond mutual funds.
E. Debit Cards and Electronic Money
F. Summary:
1. Historically, the rate of change of the money supply has been used to
judge the direction and intensity of monetary policy. However, recent
financial innovations and other structural changes (for example, the
widespread use of U.S. currency in other countries) have blurred the
meaning of money and reduced the reliability of the various money supply
measures.
Chapter 13: OBJECTIVES
This chapter focuses on the supply of money—how it is defined and what determines its
value. The heart of this chapter is an outline of the monetary institutional arrangements
for the United States that explains how monetary planners control the money supply. This
material lays the foundation for Chapter 14, which analyzes how changes in the money
supply affect economic activity.
It is important that the student gain an understanding of a fractional reserve
banking system and how the actions of the central bank (the Federal Reserve System in
the United States) can alter the deposit levels of member banks (and the money supply).
However, this is not a text on money and banking. Historical information about banking
institutions and endless detail about the banking industry add little to the student’s
understanding of monetary policy and how it works. Therefore, material of this sort, often
included in introductory texts, was kept to a minimum.
Chapter 14
Modern Macroeconomics and Monetary Policy
OUTLINE
I. Impact of Monetary Policy on Output and Inflation
A. Evolution of Modern View
1. Keynesian View: Dominated during the 1950s and 1960s, Keynesians
argued that money supply does not matter much.
2. Monetarists challenged Keynesian view during 1960s and 1970s.
According to monetarist, changes in the money supply are the cause of
both inflation and economic instability.
3. Modern view emerged from this debate: While minor disagreements
remain, both modern Keynesians and monetarists agree that monetary
policy exerts an important impact on the economy.
B. Demand and Supply of Money
1. The quantity of money people want to hold is inversely related to the
money rate of interest, because higher interest rates make it more costly to
hold money instead of interest-earnings assets like bonds.
2. The supply of money is vertical because it is determined by the Fed.
3. Equilibrium: The money interest rate will gravitate toward the rate where
the quantity of money people want to hold is just equal to the stock of
money the Fed has supplied.
C. How Does Monetary Policy Affect the Economy?
1. The impact of a shift in monetary policy is generally transmitted through
interest rates, exchange rates, and asset prices.
2. Shift to a more expansionary monetary policy—Fed generally buys bonds,
which will both increase bond prices and create additional bank reserves,
placing downward pressure on real interest rates. As a result, an
unanticipated shift to a more expansionary policy will stimulate aggregate
demand and thereby increase output and employment.
3. Shift to a more restrictive monetary policy—Fed sells bonds, which will
depress bond prices and drain reserves from the banking system. An
unanticipated shift to a more restrictive monetary policy will increase real
interest rates and reduce aggregate demand, output, and employment in the
short run.
D. Why is Timing Important?
1. Proper timing of monetary policy is not an easy task.
2. While the Fed can institute policy changes rapidly, there may be a
substantial time lag before the change will exert a significant impact on
AD.
II. Monetary Policy in the Long Run
A. The Quantity Theory of Money: MV=PY
1. If V (velocity) and Y (output) are constant, an increase in M (money
supply) would lead to a proportional increase in P (price level).
B. Long-Run Impact of Monetary Policy: The Modern View
1. In the long run, the primary impact will be on prices rather than on real
output.
2. When expansionary monetary policy leads to rising prices, decision
makers eventually anticipate the higher inflation rate and build it into their
choices. As this happens, money interest rates, wages, and incomes will
reflect the expectation of inflation, so real interest rates, wages, and output
will return to their long-run normal levels.
III. Monetary Policy When the Effects Are Anticipated
A. When the effects are anticipated prior to their occurrence, the short-run impact
of an increase in the money supply is similar to its impact in the long run.
B. Nominal prices and interest rates rise, but real output remains unchanged.
IV. Interest Rates and Monetary Policy
A. While the Fed can strongly influence short-term interest rates, its impact on
long-term rates is much more limited.
B. Interest rates can be a misleading indicator of monetary policy. In the long
run, expansionary monetary policy leads to inflation and high interest rates,
rather than low interest rates. Similarly, restrictive monetary policy when
pursued over a lengthy time period leads to low inflation and low interest
rates.
V. Effects of Monetary Policy: Summary
A. An unanticipated shift to a more expansionary (restrictive) monetary policy
will temporarily stimulate (retard) output and employment.
B. The stabilizing effects of a change in monetary policy are dependent upon the
state of the economy when the effects of the policy change are observed.
C. Persistent growth of the money supply at a rapid rate will cause inflation.
D. Money interest rates and the inflation rate will be directly related.
E. There will be only a loose year-to-year relationship between shifts in monetary
policy and changes in output and prices.
VI. Testing the Major Implications of Monetary Policy
A. In the short run, changes in monetary policy tend to cause real GDP to
change in the same direction, typically with a time lag of 12 to 18
months.
B. In the long run, however, rapid growth of the money supply leads to inflation.
(1) Countries with persistently low rates of growth in their money supply tend
to experience low rates of inflation.
(2) In contrast, countries with persistently high rates of growth in the money
supply tend to experience high rates of inflation.
Chapter 14: OBJECTIVES
This chapter integrates money into our basic aggregate demand/aggregate supply model.
The evolution of the modern view of monetary policy—including the quantity theory of
money and the early Keynesian view—is presented. The modern view of money indicates
that monetary policy may be transmitted to the goods and services market by changing
consumption and investment spending, exchange rates, asset prices, and credit rationing.
These mechanisms are illustrated.
The modern view of monetary policy also stresses the importance of whether a
change in monetary policy is anticipated or unanticipated. Only the latter will exert an
impact on real interest rates, output, and employment. Similarly, the impact of monetary
policy in the long run may differ from its impact in the short run. This chapter focuses on
each of these issues and analyzes the empirical evidence with respect to alternative
theories.
Chapter 16
Economic Growth and the Wealth of Nations
OUTLINE
I. The Importance of Economic Growth
A. Economic growth expands the productive capacity of an economy.
B. Differences in sustained growth rates over two or three decades will
substantially alter the relative incomes of countries.
C. The rule of 70: dividing 70 by a country’s average growth rate gives about the
number of years required for an income level to double
II. The Best and Worst Growth Records
A. The fastest growing countries in the world are LDCs although other LDCs are
doing very poorly.
B. The growth picture of LDCs is clearly one of diversity.
III. What Determines Whether A Country Will Grow or Stagnate?
A. Investment in Physical and Human Capital
B. Technological Progress
C. Institutional Environment
IV. What Institutions and Policies Will Promote Growth
A. Secure Property Rights and Political Stability
B. Competitive Markets
C. Free International Trade
D. An Open Capital Market
E. Stable Money and Prices
F. Relatively Low Marginal Tax Rates
V. The Role of Government and Economic Progress
A. Government activities that focus on protective and productive activities in
which it has a comparative advantage, can enhance growth.
B. Continued growth of government will eventually exert a negative impact on
the economy, for four major reasons.
1. Higher taxes and/or additional borrowing will impose increasing
deadweight losses on the economy as government expands.
2. Diminishing returns will cause the rate of return derived from government
activities to fall.
3. The political process is much less dynamic than the market process.
4. A larger government becomes more heavily involved in the redistribution
of income and regulatory activism.
VI. Economic Freedom and Growth
A. Economists since the time of Adam Smith have generally argued that freer
economies are likely to be more productive.
B. Economic freedom is complex and very difficult to measure.
C. Measure of economic freedom developed by Fraser Institute indicates
consistency of the legal structure and policies with secure property, monetary
stability, free trade, and reliance on markets.
1. Rating developed by more than 100 countries.
2. Country ratings vary substantially.
D. Countries with more economic freedom, as measured by the Freedom Index in
1980-2002 also had both a higher average per capita GDP in 2002 and more
rapid average growth rates during 1980-2002.
Chapter 16: OBJECTIVES
In this chapter, we analyze the economic development of nations in an attempt to place
the economic growth of the past 250 years into historical perspective. We discuss the size
of the current economic gap among nations. Alternative methods of measuring income
differences among countries are presented. We do not have a general theory of economic
growth. However, over time, growth rates are crucial to economic well-being, and we do
know a few things about conditions that promote growth and factors that are obstacles to
growth. Investment in human and physical capital, technological progress, and efficient
economic organization are important determinants of growth. Institutional arrangements
that encourage investment, technological innovation, and efficient use of resources will
simultaneously encourage growth. These include (1) private ownership, (2) competitive
markets, (3) stable prices, (4) an open economy, (5) an open capital market, and (6)
avoidance of high marginal tax rates. On the other hand, nations that save and invest only
a small proportion of their current income, impose high marginal tax rates, and follow
polices that undermine property rights and cause inflation experience slower rates of
economic growth.
The chapter next analyzes the role of size of government and economic freedom in
determining economic growth. When governments focus on productive activities they
promote economic growth. However, when governments expand into activities for which
they are ill-suited, they deter growth. The empirical evidence indicates that the
governments of most, if not all, industrial countries are larger than the growthmaximizing size. More economic freedom is present when people are permitted to choose
for themselves, trade freely with others in both domestic and international markets, and
live in an environment where property rights are secure and money has a stable value.
Countries with more economic freedom tend to grow more rapidly.