$$$$ Money!!! $$$
Who is on the…
1. $100 Bill
2. $50 Bill
3. $20 Bill
4. $10 Bill
5. $5 Bill
6. $2 Bill
7. Half Dollar
8. Dime
9. $1,000 Bill
10.$100,000 Bill
1. Franklin
2. Grant
3. Jackson
4. Hamilton
5. Lincoln
6. Jefferson
7. JFK
8. FDR
9. Cleveland
10. Wilson
Bonus:
“E Pluribus Unum”
means….
“Out of Many, One”
1
2
What Would We Do Without Money?
• If there were no money, we would have to exchange
goods and services directly for each other in a barter
system
• Imagine taking a pig into a shoe store and
trying to exchange it for a pair of tennis
shoes
• What if the owner of the tennis shoes doesn’t happen
to want a pig or any portion of a pig?
• What if he does, but the pig is worth
5 pairs of tennis shoes and you only
want one pair?
What Would We Do Without Money?
• Money is much more convenient than
barter, because everyone is willing to
accept money as a medium of exchange
for whatever it is that one might want to
buy or sell
• It is also very easily
divisible to the scale of
what is being exchanged
What is Money?
Money is anything that is generally
accepted in payment for goods and
services
Commodity Money - Something that performs the
function of money and has alternative uses.
– Examples: Gold, silver, cigarettes, etc.
Fiat Money- Something that serves as money but
has no other important uses.
– Examples: Paper Money, Copper coins
5
3 Functions of Money
1. A Medium of Exchange
• Money can easily be used to buy goods and services
without problems of barter
2. A Unit of Account
• Money acts as a measurement of value of goods and
services
• 1 goat = $50 = 5 chickens OR 1 chicken = $10
3. A Store of Value
• Money allows you to store purchasing power for the
future. It doesn’t spoil!
6
How Much Money Is There?
• Depends on how you define money!
• Different measures of money vary by liquidity
Liquidity - ease with
which an asset can be
accessed and
converted into cash
(liquidated)
7
Measuring the Money Supply
M1 (High Liquidity) - Coins, Currency, and checking
accounts
This is the most common definition of the money
supply
M2 (Medium Liquidity) - M1 plus savings deposits
(money market accounts), time deposits (CDs =
certificates of deposit), and Mutual Funds below $100K.
Current U.S. M1 Money Supply:
$3.1 Trillion
9
Bonus!
Money Velocity:
5.9
10
What is our money backed by?
Nothing. Until 1973, dollars could be redeemed for gold. Not
anymore, thanks to Richard Nixon.
Then what makes money effective?
1. Generally Accepted - Buyers and sellers have confidence
that it others will accept it.
2. Scarce – Can’t be easily reproduced.
3. Portable and Dividable – Must be easily transported and
divided.
The Purchasing Power of money is the quantity of real goods
and services a unit of money can buy
11
Why I studied
economics:
12
The Money Market
(Supply and Demand for Money)
13
The Demand for Money
• People must choose how to allocate their wealth between
different kinds of assets: e.g. a house, stocks, bonds,
bank accounts, and physical cash
• A person’s demand for money refers to how much of her
wealth she wishes to hold as money at any moment in
time
• There are two types of money demand: transactions
demand and asset demand
• Transactions demand refers to the desire to hold money
in order to use it to make transactions (a.k.a. to buy stuff)
• Asset demand refers to the desire to hold cash as a store
of value
14
The Demand for Money
• Holding wealth in the form of money is advantageous because
it is very liquid, meaning it can be easily traded
• Holding money as cash comes at a cost, however – the
opportunity cost of interest that could have been earned by
holding other types of assets like stocks and bonds instead
• Therefore – there is a tradeoff between liquidity and interest
• The average interest rate in the economy and the quantity of
money demanded are inversely related
• When interest rates are high, the opportunity cost of holding
money is high – meaning people will tend to hold less
money, other things equal
• When interest rates are low, people will tend to hold more of
their wealth as money
15
The Demand for Money
Inverse relationship between interest rates
and the quantity of money demanded
Nominal
Interest Rate
(ir)
20%
5%
2%
0
DMoney
Quantity of Money
(billions of dollars)
16
Shifts in the Money Demand Curve
• A change in the nominal interest rate causes a movement
along the curve
• A change in money demand caused by something else will
cause the entire curve to shift
• Money demand curve shifters include:
1. Changes in the Price Level
• A higher price level means that more money is
needed to pay for goods and services
2. Changes in Real Income (Real GDP)
• An increase in income increases the demand for
money because more money is needed to facilitate
transactions
17
Shifts in the Money Demand Curve
3. Changes in Payments Technologies
• The advent of credit cards has
significantly reduced the demand for
money
4. Changes in the (Perceived) Riskiness of
Non-Money Assets
• After a financial crisis, people tend to
hold a lot more physical cash
Why?
18
The Demand for Money
What happens if the price level increases?
Nominal
Interest Rate
(ir)
20%
5%
2%
0
DMoney2
DMoney
Quantity of Money
(billions of dollars)
19
The Demand for Money
What happens if real income decreases?
Nominal
Interest Rate
(ir)
20%
5%
2%
0
DMoney
Quantity of Money
(billions of dollars)
20
The Money
Supply
21
The Supply of Money
The U.S. money supply is controlled by the Board of
Governors of the Federal Reserve System (The Fed)
Interest
Rate (ir)
SMoney
20%
The Fed is a nonpartisan
quasi-governmental body that
adjusts the money supply to
manipulate the economy
This is called
Monetary Policy
5%
2%
DMoney
200
Quantity of Money
(billions of dollars)
22
Monetary Policy
When the “Fed” adjusts the money
supply to achieve macroeconomic goals
23
Increasing the Money Supply
Interest
Rate (ir)
SM SM1
If the Fed increases the
money supply, interest
rates will fall
10%
How does this
affect the
economy?
5%
2%
DM
200
250 Quantity of Money
(billions of dollars)
Increase in the
money supply
Decreases
interest rate
Increases
Investment (I)
Increases
AD 24
Decreasing the Money Supply
Interest
Rate (ir)
SM1 SM
10%
If the Fed decreases the
money supply, interest rates
will rise
How does this
affect the
economy?
5%
2%
DM
150
Decrease in the
money supply
200
Quantity of Money
(billions of dollars)
Increases
interest rate
Decreases
Investment (I)
Decreases
AD
25
Monetary Policy…
On the Graph!!!!
Three Related Graphs:
• Money Market
• Investment Demand
• AD/AS
26
Interest
Rate (i)
S&D of Money
SM SM1
Interest
Rate (i)
10%
10%
5%
5%
2%
2%
DM
200
PL
250
QuantityM
AD/AS
PL1
PLe
Qe
Q1
DInvestment
Quantity of Investment Spending
The Fed increases the
money supply to
stimulate the economy…
AS
AD
Investment Demand
AD1
GDPR
1. Interest Rate Decreases
2. Investment Increases
3. AD, GDP and PL
Increase
27
Interest
Rate (i)
S&D of Money
SM1 SM
Interest
Rate (i)
10%
10%
5%
5%
2%
2%
DM
175
PL
200
QuantityM
AD/AS
PLe
AD
AD1
Q1
Qe
DInvestment
Quantity of Investment
The Fed decreases the
money supply to slow
down the economy…
AS
PL1
Investment Demand
GDPR
1. Interest rates increase
2. Investment decreases
3. AD, GDP and PL
decrease
28
How the Government Manipulates the Economy
29
How the Fed Stabilizes the Economy
These are the three Shifters of
Money Supply
30
3 Shifters of the Money Supply
1. Reserve Requirement
2. Discount Rate
3. Open Market Operations
The Fed is now chaired by Janet Yellen.
31
I love this
job.
I swear.
32
#1. The Reserve Requirement
If you have a bank account,
where is your money?
Only a small percent of your money is in the
safe. The rest of it has been lent out.
This is called “Fractional Reserve Banking”
The Fed sets the minimum amount that banks
must keep in their safes – this is called the
reserve requirement (or reserve ratio)
33
The Money Multiplier
Example: Assume the reserve ratio in the US is 10%
Harris deposits $1,000 into his checking account at the bank
The bank must hold $100 (required reserves)
The bank lends $900 out to Hari
Hari deposits the $900 in his bank
Hari’s bank must hold $90. It loans out $810 to Clark, who then
deposits $810 into his bank
SO FAR, Harris’s initial deposit of $1000 caused the CREATION
of another $1710 (Hari’s $900 + Clark’s $810)
Money
Multiplier
=
1
Reserve ratio
34
Money
Multiplier
=
1
Reserve ratio
Example:
•The reserve ratio is .20. Tony discovers $3,000 cash in his
backpack and decides to deposit it into the bank. What is
the maximum amount by which the money supply could
increase?
Answer:
Assuming consumers hold no cash, $12,000
(initial amount first lent out after Tony’s
deposit ($2,400), times the multiplier (5))
35
The Money Multiplier
In reality, people do not keep all of their money in the
bank; they hold some of their money as physical currency
Therefore, a deposit will not increase the money supply
by the full amount of the money multiplier
The money multiplier describes
the maximum amount by which
a deposit could increase the
money supply, not necessarily
the actual amount
36
Using Reserve Requirement
1. In a recession, what can the Fed do?
Decrease the Reserve Ratio
1. Banks hold less money and have more excess reserves
2. Banks create more money by loaning out excess
3. Money supply increases, interest rates fall, AD goes up
2. If there’s inflation, what can the Fed do?
Increase the Reserve Ratio
1. Banks hold more money and have less excess reserves
2. Banks create less money
3. Money supply decreases, interest rates up, AD down
37
#2. The Discount Rate
The Discount Rate is the interest rate that the
Fed charges commercial banks.
Example:
• If Bank of America needs $10 million, they might borrow
directly from the Fed at 3% interest.
To increase the Money supply, the Fed should
DECREASE the Discount Rate
_________
(To decrease the Money supply, the Fed should
INCREASE the Discount Rate
_________
38
Where does the Fed get the
money it lends out?
From customer deposits?
From the government?
From foreigners?
From people who accidentally left their
wallets on bus stop benches?
None of the above…
39
40
#3. Open Market Operations
• The Fed buys or sells government bonds
• This is the most important and widely used
monetary policy
To increase the Money supply, the Fed should
_________
government securities.
BUY
To decrease the Money supply, the Fed should
SELL
_________
government securities.
How to remember this:
Buy-BIG- Buying bonds increases money
supply
Sell-SMALL- Selling bonds decreases money
supply
41
Where does the Fed get the
money to buy government
bonds?
From the lemonade stand it operates in
its spare time?
From panhandling outside of subway
stations?
From selling Janet Yellen’s kidneys on
the black market?
Wrong on all counts!
42
43
Practice
1. If the reserve requirement is .5 and the Fed sells
$10 million of bonds, what is the maximum
change in money supply? $20 million decrease
2. If the reserve requirement is .1 and the Fed buys
$10 million bonds, what is the maximum change
in money supply? $100 million increase
3. If the Fed decreases the reserve requirement
from .50 to .20 what will happen to the money
multiplier? Increase from 2 to 5
44
Federal Funds Rate
The interest rate banks charge each other
for one-day loans of reserves.
• Fed uses open market operation to hit a
so-called “target rate”
• The rate fluctuates due to market
conditions but it is heavily influenced by
monetary policy
45
Federal Funds Rate
46
Banking
47
The Balance Sheet
• A balance sheet is a financial statement that records a
firm’s assets (what it owns), and liabilities (what it
owes)
• Total assets will always be equal to total liabilities on a
balance sheet
• Types of assets on a bank’s balance sheet:
1. Cash reserves
• Required reserves – the percentage of demand
deposits that a bank must keep in its vaults
• Excess reserves – any extra reserves a bank
holds beyond the required reserves
2. Loans
48
The Balance Sheet
• Types of liabilities on a bank’s balance sheet:
1. Demand Deposits
• Customer deposits into checking
accounts – must be withdrawable “on
demand”
2. Owner’s equity
• What is left over for the bank’s owners
(shareholders) after all assets are sold
and all liabilities are paid
49
*Assume a required reserve ratio of .10
Assets
Required
Reserves
Loans
Total
$9
Liabilities
Demand
Deposits
$90
$91
Owner’s Equity
$10
$100
Total
$100
50
*Assume a required reserve ratio of .10
Assets
Required
Reserves
$50
Liabilities
Demand
Deposits
$500
Loans
$450
Owner’s Equity
$0
Total
$500
Total
$500
51
*Assume a required reserve ratio of .10
Assets
Required
Reserves
$20
Excess Reserves $30
Loans
$150
Total
$200
Liabilities
Demand
Deposits
$200
Owner’s Equity
$0
Total
$200
52
What is the reserve requirement?
0.10
53
Assume that Luis withdraws $5,000 cash from his checking
account at Mi Tierra Bank. By how much will Mi Tierra’s total
reserves change based on Luis’s withdrawal?
Reserves will decrease by $5,000
54
As a result of the withdrawal, what is the new value of excess
reserves on the balance sheet of Mi Tierra Bank based on the
reserve requirement of 0.10?
Excess reserves are now $500
55
What is the initial effect of the withdrawal on the M1
measure of money supply? Explain.
One point is earned for stating that the $5,000 withdrawal has no
effect on the M1 measure of the money supply because it only
changes the composition of M1 between cash and demand
deposits.
56
Based on this bank’s balance sheet, what is the
required reserve ratio?
0.20
57
Suppose the Fed purchases $5,000 worth of bonds
from this bank. What will be the change in the dollar
value of each of the following immediately after the
purchase? i. Excess Reserves. ii. Demand Deposits
Excess Reserves: $5,000
Demand Deposits: $0
58
Calculate the maximum amount that the money supply
can change as a result of the $5,000 purchase of
bonds by the Federal Reserve.
$25,000
59
When the Federal Reserve purchases bonds, what will
happen to the price of bonds in the open market?
Explain. The price of bonds will increase. The purchase of
bonds increases the money supply, which decreases
the interest rate, which increases the price of existing
bonds.
60
Suppose that instead of the purchase of bonds by the Federal
Reserve, an individual deposits $5,000 in cash into her
checking (demand deposit) account. What is the immediate
effect of the cash deposit on the M1 measure of the money
supply?
The cash deposit will not immediately change the
money supply. (It will only change the composition of
M1 between cash and demand deposits)
61
Assume that the reserve requirement is 20 percent and
banks hold no excess reserves.
(a)Assume that Kim deposits $100 of cash from her
pocket into her checking account. Calculate each of the
following.
i.
The maximum dollar amount the commercial bank
can initially lend
$80
62
Assume that the reserve requirement is 20 percent and
banks hold no excess reserves.
(a)Assume that Kim deposits $100 of cash from her
pocket into her checking account. Calculate each of the
following.
i.
The maximum possible change in the money supply
due to Kim’s deposit.
$400
63
Assume that the reserve requirement is 20 percent and
banks hold no excess reserves.
(a)Assume that Kim deposits $100 of cash from her
pocket into her checking account. Calculate each of the
following.
i.
The maximum total change in demand deposits in the
banking system
$500
64