Learning Objective 13.1
Chapter 13: Money, Banks, and the Federal Reserve System
What we learned in last class:
Use basic AD-AS framework to analyze business cycles
Basic AD-AS framework:No long run growth, no inflation.
Recession: AD shifts left, Y down, P down. Y below potential Y.
Adjust back to potential Y: SRAS shifts right:
b/c wage rate down (two reasons)
Expansion: Similar to recession, led by AD.
Y and P are usually positive related.
Supply shock and stagflation: SRAS
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.1
Chapter 13: Money, Banks, and the Federal Reserve System
What we learned in last class:
Dynamic AD-AS framework
LRAS shifts to the right continually.
During most years, AD will be shifting to the right .
Except that high inflation is expected, SRAS shifts to the right.
Use Dynamic AD-AS frame work to explain inflation.
Oil shocks may not cause recession
AD decline in 2001 and slow recovery.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Money, Banks, and the
Federal Reserve System
Learning Objectives
13.1 Define money and discuss its
four functions.
13.2 Discuss the definitions of the
money supply used in the United
States today.
13.3 Explain how banks create money.
13.4 Discuss the three policy tools the
Federal Reserve uses to manage
the money supply.
Confidence and trust cannot be
taken for granted. …households
and firms losing faith in an official
money can harm trade and
economic activity in an economy.
13.5 Explain the quantity theory of
money and use it to explain how
high rates of inflation occur.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.1
Chapter 13: Money, Banks, and the Federal Reserve System
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.
Barter and the Invention of Money
Barter economies: double coincidence of wants.
Commodity money A good used as money that also has
value independent of its use as money.
By making exchange easier, money allows for
specialization and higher productivity
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.1
Chapter 13: Money, Banks, and the Federal Reserve System
What Is Money and Why Do We Need It?
The Functions of Money
Medium of Exchange
Money serves as a medium of exchange when sellers are
willing to accept it in exchange for goods or services.
Unit of Account
In a barter system, each good has many prices.
Store of Value
Money allows value to be stored easily: If you do not use all
your accumulated dollars to buy goods and services today,
you can hold the rest to use in the future.
Standard of Deferred Payment
Money is useful because it can serve as a standard of
deferred payment in borrowing and lending.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.1
Chapter 13: Money, Banks, and the Federal Reserve System
What Is Money and Why Do We Need It?
What Can Serve as Money?
Five criteria make a good suitable to use as a medium of exchange:
1 The good must be acceptable to (that is, usable by)
most people.
2 It should be of standardized quality so that any two
units are identical.
3 It should be durable so that value is not lost by
spoilage.
4 It should be valuable relative to its weight so that
amounts large enough to be useful in trade can be
easily transported.
5 The medium of exchange should be divisible because
different goods are valued differently.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.1
Chapter 13: Money, Banks, and the Federal Reserve System
What Is Money and Why Do We Need It?
What Can Serve as Money?
Commodity Money
Commodity money meets the criteria for a
medium of exchange.
Problem: Quality standard, Inconvenience for
transaction. Control for money supply.
It can be inefficient for an economy to rely on
only gold or other precious metals for its money
supply.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.1
Chapter 13: Money, Banks, and the Federal Reserve System
What Is Money and Why Do We Need It?
What Can Serve as Money?
Fiat Money
Fiat money Money, such as paper currency, that is
authorized by a central bank or governmental body and
that does not have to be exchanged by the central bank
for gold or some other commodity money.
Federal Reserve System The central bank of the
United States.
Legal tender and acceptance by households and firms:
Households and firms believe dollar will not lose much
value during the time they hold them. (Zimbabwe case
again)
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.1
Making
Chapter 13: Money, Banks, and the Federal Reserve System
the
Connection
Money without a Government? The
Strange Case of the Iraqi Dinar
Many Iraqis continued to use currency with Saddam’s picture
on it, even after he was forced from power.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.2
Chapter 13: Money, Banks, and the Federal Reserve System
How Is Money Measured in the United States Today?
M1: The Narrowest Definition of the Money Supply
M1 The narrowest definition of the
money supply: The sum of currency
in circulation, checking account
deposits in banks, and holdings of
traveler’s checks.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.2
Chapter 13: Money, Banks, and the Federal Reserve System
How Is Money Measured in the United States Today?
M1: The Narrowest Definition of the Money Supply
M1 includes:
1 Currency, which is all the paper money and coins that
are in circulation, where “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 (although this last
category is so small—less than $7 billion in May 2007—
we will ignore it in our discussion of the money supply)
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.2
Chapter 13: Money, Banks, and the Federal Reserve System
How Is Money Measured in the United States Today?
M2: A Broader Definition of Money
M2 A broader definition of the money supply:
M1 plus savings account balances, smalldenomination time deposits, balances in money
market deposit accounts in banks, and
noninstitutional money market fund shares.
Don’t Let This Happen to YOU!
Don’t Confuse Money with Income or Wealth
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.2
Chapter 13: Money, Banks, and the Federal Reserve System
How Is Money Measured in the United States Today?
M1: The Narrowest Definition of the Money Supply
FIGURE 13.1
Measuring the Money
Supply, May 2007
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.2
Making
Chapter 13: Money, Banks, and the Federal Reserve System
the
Do We Still Need the Penny?
Connection
Unfortunately, these cost
the government more than
a penny to produce.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.2
Chapter 13: Money, Banks, and the Federal Reserve System
How Is Money Measured in the United States Today?
There are two key points about the money supply to keep in mind:
1 The money supply consists of both currency and
checking account deposits.
2 Because balances in checking account deposits are
included in the money supply, banks play an important
role in the process by which the money supply increases
and decreases. We will discuss this second point further
in the next section.
What about Credit Cards and Debit Cards?
Many people buy goods and services with credit
cards, yet credit cards are not included in definitions
of the money supply.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.2
Solved Problem
13-2
Chapter 13: Money, Banks, and the Federal Reserve System
The Definitions of M1 and M2
Suppose you decide to withdraw $2,000
from your checking account and use the
money to buy a bank certificate of deposit
(CD). Briefly explain how this will affect
M1 and M2.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.3
Chapter 13: Money, Banks, and the Federal Reserve System
How Do Banks Create Money?
Bank Balance Sheets
FIGURE 13.2
Balance Sheet for Wachovia
Bank, December 31, 2006
Don’t Let This Happen to YOU!
Know When a Checking Account Is an Asset and When It Is a Liability
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.3
Chapter 13: Money, Banks, and the Federal Reserve System
How Do Banks Create Money?
Bank Balance Sheets
Reserves Deposits that 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.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.3
Chapter 13: Money, Banks, and the Federal Reserve System
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.3
Chapter 13: Money, Banks, and the Federal Reserve System
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.3
Chapter 13: Money, Banks, and the Federal Reserve System
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.3
Chapter 13: Money, Banks, and the Federal Reserve System
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.3
Chapter 13: Money, Banks, and the Federal Reserve System
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
BANK
Wachovia
INCREASE IN CHECKING ACCOUNT 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
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.3
Chapter 13: Money, Banks, and the Federal Reserve System
How Do Banks Create Money?
The Simple Deposit Multiplier
Simple deposit multiplier The ratio
of the amount of deposits created by
banks to the amount of new reserves.
1
Simple deposit multiplier 
RR
1
Change in checking account deposits  Change in bank reserves x
RR
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.3
Solved Problem
13-3
Chapter 13: Money, Banks, and the Federal Reserve System
Showing How Banks Create Money
PNC Bank
Assets
Reserves
Liabilities
+$5,000
Deposits
+$5,000
PNC Bank
Assets
Reserves
Loans
Liabilities
+$5,000
+$4,500
Deposits
Deposits
+$5,000
+$4,500
PNC Bank
Assets
Reserves
Loans
Liabilities
+$500
+$4,500
Deposits
+$5,000
Wachovia Bank
Assets
Reserves
Liabilities
+$4,500
Deposits
+$4,500
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.3
Chapter 13: Money, Banks, and the Federal Reserve System
How Do Banks Create Money?
The Simple Deposit Multiplier versus the Real-World
Deposit Multiplier
We can summarize these important conclusions:
1 Whenever banks gain reserves, they make new
loans, and the money supply expands.
2 Whenever banks lose reserves, they reduce their
loans, and the money supply contracts.
In the real world the real deposit multiplier is smaller than
the simple deposit multiplier:
Cash holding , and excess reserves.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.4
Chapter 13: Money, Banks, and the Federal Reserve System
What we learned in last class:
The definition of money (compared with assets).
Barter economies and commodity money.
Money makes specialization possible and easier.
Functions of money: Medium of exchange, unit of account, store of
value, standard of deferred payment
What can serve as money: acceptable, standardized, durable,
valuable, divisible
Commodity money vs. fiat money
problems of commodity money
fiat money is backed up by the central bank: legal tender
and acceptance by firms and household.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.4
Chapter 13: Money, Banks, and the Federal Reserve System
What we learned in last class:
M1 and M2, the narrowest vs. broader.
Don’t Confuse Money with Income or Wealth
Bank balance sheets:
assets and liabilities
reserves, required reserves and excess reserves, required
reserves ratio.
the bank system generates money
Simple Deposit multiplier: no excess reserves and cash
holding.
In the real world: Smaller deposit multiplier.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.4
Chapter 13: Money, Banks, and the Federal Reserve System
The Federal Reserve System
Bank Balance Sheets
Fractional reserve banking system A
banking system in which banks keep less
than 100 percent of deposits as reserves.
Bank run A situation in which many
depositors simultaneously decide to
withdraw money from a bank.
Bank panic A situation in which many
banks experience runs at the same time.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.4
Making
Chapter 13: Money, Banks, and the Federal Reserve System
the
The 2001 Bank Panic in Argentina
Connection
The Argentine central bank was
unable to stop the bank panic of
2001.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.4
Chapter 13: Money, Banks, and the Federal Reserve System
The Federal Reserve System
The Organization of the Federal Reserve System
FIGURE 13.3
Federal Reserve Districts
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Learning Objective 13.4
Chapter 13: Money, Banks, and the Federal Reserve System
The Federal Reserve System
How the Federal Reserve Manages the Money Supply
Monetary policy The actions the Federal
Reserve takes to manage the money supply and
interest rates to pursue economic objectives.
To manage the money supply, the Fed uses three
monetary policy tools:
1 Open market operations
2 Discount policy
3 Reserve requirements
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Learning Objective 13.4
Chapter 13: Money, Banks, and the Federal Reserve System
The Federal Reserve System
How the Federal Reserve Manages the Money Supply
Open Market Operations
Federal Open Market Committee (FOMC) The
Federal Reserve committee responsible for open
market operations and managing the money
supply in the United States.
Open market operations The buying and selling
of Treasury securities by the Federal Reserve in
order to control the money supply.
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Learning Objective 13.4
Chapter 13: Money, Banks, and the Federal Reserve System
The Federal Reserve System
How the Federal Reserve Manages the Money Supply
Discount Policy
Discount loans Loans the Federal Reserve
makes to banks.
Discount rate The interest rate the Federal
Reserve charges on discount loans.
Reserve Requirements
When the Fed reduces the required reserve
ratio, it converts required reserves into
excess reserves.
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Learning Objective 13.4
Chapter 13: Money, Banks, and the Federal Reserve System
The Federal Reserve System
Putting It All Together: Decisions of the Nonbank Public,
Banks, and the Fed
Using its three tools—open market operations,
the discount rate, and reserve requirements—the
Fed has substantial influence over the money
supply, but that influence is not absolute.
Two other actors—the nonbank public and
banks—also influence the money supply.
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Learning Objective 13.5
Chapter 13: Money, Banks, and the Federal Reserve System
The Quantity Theory of Money
Connecting Money and Prices: The Quantity Equation
In the early twentieth century, Irving Fisher, an
economist at Yale, formalized the connection
between money and prices using the quantity
equation:
M×V=P×Y
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Learning Objective 13.5
Chapter 13: Money, Banks, and the Federal Reserve System
The Quantity Theory of Money
Connecting Money and Prices: The Quantity Equation
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
Quantity theory of money A theory of the connection
between money and prices that assumes that the velocity
of money is constant.
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Learning Objective 13.5
Chapter 13: Money, Banks, and the Federal Reserve System
The Quantity Theory of Money
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
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Learning Objective 13.5
Chapter 13: Money, Banks, and the Federal Reserve System
The Quantity Theory of Money
The Quantity Theory Explanation of Inflation
The growth rate of the price level is just the inflation rate,
so we can rewrite the quantity equation to help us
understand the factors that determine inflation:
Inflation rate = Growth rate of the money supply +
Growth rate of velocity − Growth rate of real output
If Irving Fisher was correct that velocity is constant, then
the growth rate of velocity will be zero. This allows us to
rewrite the equation one last time:
Inflation rate = Growth rate of the money supply −
Growth rate of real output
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Learning Objective 13.5
Chapter 13: Money, Banks, and the Federal Reserve System
The Quantity Theory of Money
The Quantity Theory Explanation of Inflation
This equation leads to the following predictions:
1 If the money supply grows at a faster rate than
real GDP, there will be inflation.
2 If the money supply grows at a slower rate than
real GDP, there will be deflation. (Recall that
deflation is a decline in the price level.)
3 If the money supply grows at the same rate as
real GDP, the price level will be stable, and there
will be neither inflation nor deflation.
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Learning Objective 13.5
Chapter 13: Money, Banks, and the Federal Reserve System
The Quantity Theory of Money
The Quantity Theory Explanation of Inflation
The useful insight on the long run relationship
between money supply and inflation:
In the long run, inflation results from the
money supply growing at a faster rate than real
GDP.
© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.
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Learning Objective 13.5
Chapter 13: Money, Banks, and the Federal Reserve System
The Quantity Theory of Money
High Rates of Inflation
Very high rates of inflation—in excess of hundreds
or thousands of percentage points per year—are
known as hyperinflation. (Zimbabwe, Argentina,
Brazil….).
How it comes? Dynamic AD-AS framework can
not explain. It is the government’s faults !!
Financing gov’t expenditures by increasing money
supply !!
Economies suffering from high inflation usually
also suffer from very slow growth, if not severe
recession.
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Learning Objective 13.5
Chapter 13: Money, Banks, and the Federal Reserve System
The Quantity Theory of Money
High Inflation in Argentina
FIGURE 13.4
Money Growth and Inflation in Argentina
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Chapter 13: Money, Banks, and the Federal Reserve System
An Inside LOOK
Using Reserve Requirements to Slow
Bank Lending in China
China Lifts Bank Reserves in Bid to Cool Growth
Fixing the value of the yuan against the U.S. dollar has effectively fueled the growth in
China’s bank reserves.
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Learning Objective 13.4
Making
Chapter 13: Money, Banks, and the Federal Reserve System
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.
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