What Is Money and Why Do We Need It?
Money Assets that people are generally willing to accept in
exchange for goods and services or for payment of debts.
Asset Anything of value owned by a person or a firm.
The Functions of Money
• Medium of exchange: buy stuff with money
No need to barter
• Unit of account: post prices/keep books in money terms
• Standard of deferred payment: need money to pay debts
• Store of value
Hold money on chance prices of other assets fall
What Can Serve as Money?
Criteria for an asset to be a medium of exchange:
1 It must be acceptable to most people.
2 It should be of standardized quality.
3 It should be durable.
4 It should be valuable relative to its weight.
5 It should be divisible.
Currency is fine… “fiat money”
Checking account balances are just as good.
Electronic “money” is even better.
Precious metals serve when confidence falters.
Commodity money.
How Is Money Measured in the United States Today?
M1: The Narrowest Definition of the Money Supply
M1 includes means of payment:
1 Currency: paper money and coins in circulation.
•
“in circulation” means not held by banks or the
government
2 The value of all checking account deposits at banks
3 The value of traveler’s checks
1 Because balances in checking accounts are in the money supply, banks play
an important role in the way money supply increases and decreases.
What about Credit Cards and Debit Cards?
You haven’t paid until you write a check to your bank.
How Is Money Measured
in the United States Today?
M1: The Narrowest Definition of the Money Supply
Figure 25-1
Measuring the Money Supply, July 2009
The Federal Reserve uses two different measures of the money supply: M1 and M2.M2 includes all the assets in
M1, as well as the additional assets shown in panel (b).
Money is an asset, like stocks and bonds and real estate.
Unlike these other assets, however, money pays no interest
and promises no yield. Why, then, do people hold money as a
store of value?
A) You need money to buy stuff
B) You need money to pay off your debts
C) It’s good to hold some of your wealth in money,
particularly if you think the prices of other asset will fall.
D) All of the above
How Banks Create Money in a Fractional Reserve
Banking System
Legal Reserves Funds a bank keeps as cash in its “vault” or on
deposit with the Federal Reserve.
Required reserves Reserves that a bank is legally required to
hold, based on its checking account deposits.
Required reserve ratio The minimum fraction of deposits banks
are required by law to keep as reserves.
Excess reserves Reserves that banks hold over and above the
legal requirement.
Banks buy interest yielding assets with deposits they don’t
keep in reserves:
•Gov’t securities, loans to households and firms
Balance Sheet for a Large Bank, December 31, 2010
How Banks Create Money
If the required reserve ratio is 10%,
Wachovia now has $900 in excess reserves
PNC now has excess reserves
of $810. It can extend a loan
and create a deposit of $810.
How Banks Create Money
BANK
Wachovia
INCREASE IN
CHECKING
DEPOSITS
$1,000
PNC
+ 900
(= 0.9 x $1,000)
Third Bank
+ 810
(= 0.9 x $900)
Fourth Bank
+ 729
(= 0.9 x $810)
.
+•
.
+•
.
+
Total Change in Checking
Account Deposits
=$10,000
d. What is the maximum possible increase in deposits in the banking
system if all banks lend to the limit and no currency is held by the
Simple deposit multiplier The ratio of the amount of
deposits created by banks to the amount of new reserves.
1
Simple deposit multiplier 
RR
Change in required reserves
for a bank and for the
banking system
=
RR x Change in deposits
1
Change in checking account deposits  Change in bank reserves x
RR
The Simple Deposit Multiplier versus the Real-World Deposit Multiplier:
•Not everything that one bank lends gets deposited in other banks.
– Much leaks out as currency holdings rather than deposits.
•And banks may not lend to full extent the can…they hold excess reserves.
Real world deposit multiplier is less than the simple multiplier.
The deposit multiplier we just developed and the
expenditure multiplier we studied before are the same thing.
A) True
B) False
The deposit multiplier we just developed and the
expenditure multiplier we studied before are the same thing.
A) True
B) False
False: The deposit multiplier multiplies an injection of
additional reserves into the banking system into a larger
increase in bank loans, bank deposits and Money Supply
(Currency + Deposits).
The expenditure multiplier multiples an increase in
autonomous spending into a larger increase in total output,
total income, and total spending.
The Functions of a Modern Central Bank
The Banker’s Bank:
Lender of last resort in crises
• Bank run: When many depositors rush to withdraw money at
the same time...They “run” to get to the cashier.
• Silent run: Major creditors don’t turn over their loans to a
bank.
• Bank panic: Many banks experience runs at the same time.
Operates clearing system for interbank payments.
Oversees financial intermediaries
- ensure their soundness.
- ensure public confidence
The Government's Bank:
– Manages government transactions.
– Controls availability of money and credit.
The Federal Reserve System
The Organization of the Federal Reserve System
Federal Reserve Districts
Board of Governors:
Seven Governors
nominated by President and confirmed
by Senate for 14 year
terms. The Chair has a
renewable 4 year
term.
Federal Open Market Committee: Board of Governors + District Bank
Presidents meet 8 times a year to set policy. All presidents attend the
FOMC meetings but they take turns voting (FRBNY guy always votes).
Which of the following people vote on monetary policy at the
Federal Open Market Committee (FOMC) meetings?
a. The seven members of the Federal Reserve’s Board of
Governors.
b. The president of the Federal Reserve Bank of New York.
c. Four presidents from Federal Reserve banks other than the
president of the Federal Reserve Bank of New York
(rotating basis).
d. All of the above.
How the Federal Reserve Manages the Money Supply
Monetary policy The actions the Federal Reserve takes to manage the money
supply and interest rates in pursuit of economic objectives.
To manage the money supply, the Fed uses three monetary policy tools:
1 Open market operations: Fed buys and sells gov’t securities
• Federal Open Market Committee (FOMC) sets target federal funds rate.
• “Federal funds” are reserves that banks borrow and lend to each other.
• Fed buys bonds to increase the supply of reserves and lower the fed funds
rate: BEST – BUY EASE SELL TIGHTEN.
2 Discount policy: Fed lends to banks @ discount rate
 injects reserves into banking system directly
3 Reserve requirements: lowering reserve requirement converts
required reserves to excess reserves that banks can lend
Two other actors—the nonbank public and banks—also influence the money
supply.
Multiple Creation of Money and Credit
The Fed’s Balance Sheet
Owns
Gold, Forex
Owes
.
Federal Reserve Notes
•Currency in Circulation
Vault Cash
Reserves
Bank IOUs
(Discount loans)
Securities
Bank Deposits @ Fed
Bank A
Bank B
:
Gov’t Deposits
Gov’t Bonds
MBSs
Miscellaneous
Fed buys something … MB up
A bond
A bank IOU
Seller deposits proceeds in Bank A
Money supply increases
Bank A’s deposits @ Fed increase
Bank A now has more reserves
Bank A holds reserves against its
new deposit (required + excess)
Bank A makes loan to customer
Borrower now has more deposits
... Money has just been created
Borrower buys something
Monetary Base
High Powered
= MB
Money = H = MB
Note: MB = Currency + Bank Reserves = Cu + R
Ms = Currency + Demand Deposits = Cu + D
Seller holds onto currency and
deposits the rest in its Bank B
Bank B’s deposits @ Fed increase
:
The Fed uses three monetary policy tools. Which
of the following is not one of those tools?
a. Open market operations.
b. Discount policy.
c. Reserve requirements.
d. Federal funds rate setting.
The “Shadow Banking System” and the Financial Crisis
The banks we have been discussing are commercial banks, who accept
funds from depositors and lend those funds to borrowers.
In the past 20 years, important developments have occurred in the
financial system:
• Banks have begun to resell many of their loans rather than keep them
until they are paid off.
• Financial firms other than commercial banks, e.g., less-regulated
investment banks, MMMFs, hedge funds, have become sources of
credit to businesses. Banks have faced increased competitive pressure.
• Banks and these non-bank financial firms increasingly rely on very
short-term liabilities, e.g., overnight repurchase agreements, to finance
their long-term, income-earning assets, e.g., loans.
• Loans (mortgage loans, student loans, credit card loans,...) have been
bundled together with shares in these bundles sold off as securities
(securitization).
Securitization The process of transforming loans or other financial
assets into securities.
The Process of Securitization
(a) Securitizing a loan
(b) The flow of payments on a securitized loan
As the trigger of the crisis, problems in the U.S. housing market led to a
myriad of troubles in the financial system:
• Mortgage-backed securities lost value; their investors suffered heavy
losses.
• Many investment banks and other financial firms without deposit
insurance that had borrowed short term and invested long term had to
sell their holdings of securities  fire sale.
• In 2008, the failure of the investment bank Lehman Brothers set off a
panic  securitization and interbank lending nearly ground to a halt.
• A wave of withdrawals from money market mutual funds disabled their
role as buyers of corporate commercial paper.
• As banks and other financial firms sold assets and cut back on lending
to shore up their financial positions – deleveraging – the flow of funds
from savers to borrowers was disrupted and the resulting credit crunch
significantly worsened the recession.
A “Global Saving Glut”
The best
of times
Capital Inflows
Escalating
House Prices
Easy Money
Policy
Eager Home Buyers
Ambitious
Mortgage Brokers
Developer Clout
Innovative
Banks
Bank Regulators
Gov’t Sponsored
Enterprises
Securitization
MBSs
Rating
Agencies
The best
of times
Capital Inflows
Escalating
House Prices
Easy Money
Policy
Eager Home Buyers
Ambitious
Mortgage Brokers
Developer Clout
Innovative
Banks
Bank Regulators
Gov’t Sponsored
Enterprises
Securitization
MBSs
Rating
Agencies
Vicious Spirals Unleashed
House Price –
Foreclosure
Spiral
Deleveraging – Debt Deflation
Spiral
Global Repercussion
Spiral
Demand –
Jobs –
Wages –
Income –
Spiral
Government
Revenue –
Cutback
Spiral
Macroeconomic Linkages
and
Feedbacks
Responses: No Bank Left Behind
Lender of Last Resort / Spender of Last Resort
Tax Rebate $124 bil.
Fed Fund Rate Cuts
Fannie/Freddie $200 bil.
Bear-Stearns $29 bil.
AIG $174 bil.
Fed “Facilities”
Primary Dealer Credit Facility (PDCF) $58 bil.
Treasury Security Loan Facility (TSLF) $133 bil.
Term Auction Facility (TAF) $416 bil.
Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil.
Money Market Investor Funding Facility (MMIFF) $540 bil.
More Fed Fund Rate Cuts … Hold At ~0%
Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil.
Term Asset-Backed Securities Loan Facility (TALF) $200 bil.
Emergency Economic Stabilization Act/TARP $700 bil.
Government Loans
Government Equity
Stimulus Package $787 bil.
aka The American Recovery and Reinvestment Act
TARP II
Stress Tests
The Quantity Theory of Money
Connecting Money and Prices: The Quantity Equation
M×V=P×Y
Velocity of money The average number of times each dollar in the
money supply is used to purchase goods and services included in GDP.
P xY
V
M
The Quantity Theory Explanation of Inflation
We can transform the quantity equation from:
M xV  P x Y
to:
Growth rate of the money supply + Growth rate of velocity
= Growth rate of the price level (or inflation rate)
+ Growth rate of real output
If velocity is constant, then the growth rate of velocity is
zero. This allows us to rewrite the equation one last time:
Inflation rate = Growth rate of the money supply
− Growth rate of real output
a. 3%
b. 6%
c. 9%
d. 18%
Making
the
Connection
The German Hyperinflation
of the Early 1920s
During the hyperinflation of the
1920s, people in Germany used
paper currency to light their stoves.
Key Terms
Asset
Bank panic
Bank run
Commodity money
Discount loans
Discount rate
Excess reserves
Federal Open Market
Committee (FOMC)
Federal Reserve System
Fiat money
Fractional reserve banking system
M1
M2
Monetary policy
Money
Open market operations
Quantity theory of money
Required reserve ratio
Required reserves
Reserves
Simple deposit multiplier
Velocity of money