Money $ Money $ Money
• What is money?
• Anything that performs these
functions:
–A medium of exchange
–A unit of account
–A store of value
Medium of Exchange
• Anything used to determine
value during the exchange of
goods and services
• Money makes these
transactions easier
• The alternative is barter
Unit of Account
• Allows us to compare the
values of goods and
services
Store of Value
• Keeps its value over a
period of time
• What threatens this?
–Inflation
Types of Money
• Commodity Money
– Something that is used as a medium of exchange that
has value in its own right (gold, silver, cigarettes)
• Representative Money
– Commodity backed money
– A bank note redeemable for a commodity (gold or
silver)
• Fiat Money
– Something that has value because government says
that it has value
Types of Money
• What type of money is
today’s U.S. dollar?
• Fiat Money
Measuring the Money Supply
M1 Money Supply (most liquid)
• Includes currency in
circulation, coins, travelers
checks, and
checkable/demand deposits
(checking accts) **About
50/50 Currency and coins to
Deposits
Measuring the Money Supply
M2 Money Supply
• Includes M1 and “near moneys” -savings deposits (savings
accounts) and other interest
bearing accounts like CD’s
• M1 is about 20% of M2
The Goldsmiths and the Origins
of Paper Money
• Goldsmiths provided a place of
storage for an individual’s gold
and silver
• They would charge a fee for this
service
• They would issue a receipt to the
owner of the specie (gold and
silver)
The Goldsmiths and the Origins
of Paper Money
• Receipts then began to be
exchanged for goods and
services
• Why? The receipts were
accepted as a medium of
exchange
• Voila! The first paper
money!
The Goldsmiths and the Origins
of Paper Money
• Then some shrewd Goldsmith
realized he could issue receipts in
excess of the amount of gold he
had. Why?
• They rarely had to exchange
receipts for gold!
• Voila! The first bank loan!
The Monetary Role of Banks
• About half of M1 money supply is bank
deposits
• What Banks Do
– Uses its assets to finance the investments
of borrowers
– Not all assets are lent out
– Some assets must be kept on hand to
satisfy the demands of depositors that
want to withdraw their funds (Reserves)
Fractional Reserve Banking
System
• The assets that a bank must keep in
reserve is established by the Fed
• This is known as the RESERVE RATIO
or the RESERVE REQUIREMENT
It’s a Wonderful Banking System!
• What would happen, if for some reason,
all a bank’s depositors wanted their
deposits at the same time?
It’s a Wonderful Banking System!
• Is this a problem today?
• Not likely. Why not?
• The Federal Deposit Insurance
Corporation (FDIC)
• Insures bank deposits (of member
banks) up to $250,000 (result of a
new law President Obama signed
in 2010)
It’s a Wonderful Banking
System!
• The insurance also eliminates the
cause of bank runs
How Banks Create New Money
• Let’s look at an initial $1000 cash
deposit into a checking acct. (demand
deposit)
• First key point
– This does NOT add anything NEW to the
money supply
– There is $1000 less currency and $1000
more in demand deposits – No net
increase
How Banks Create New Money
• Now let’s assume the bank has a 10%
reserve requirement (rr)
• The bank must keep $100 in reserve in
its vaults (required reserves)
• It can then lend out the $900 in excess
reserves
• This begins the process of money
creation
How Banks Create New Money
• How much NEW money will be created
initially?
• How much NEW money will be created in
the end (total)?
• The first step is to determine the money
multiplier
• ***1/rr OR 1/reserve requirement***
• Multiplier of 10
How Banks Create New Money
• How much new money will be created
initially?
• $900
• How much total new money will be created?
• The initial new money times the multiplier
• $900 X 10
• In this instance, the $900 excess reserves is
multiplied 10 times throughout the economy
- $9000 in total NEW money
How Banks Create New Money
• If a bank initially lent out $1000 in excess
reserves, $10,000 in NEW money would be
created
• What if you were asked the change in
demand deposits as a result of this?
• The initial $1000 demand deposit would
result in how much of a total change in
demand deposits?
• $10000
From the 2009 AP Test
• 3. 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
• (ii) The maximum total change in demand
deposits in the banking system
• (iii) The maximum change in the money supply
The Banking System
Bank
(1)
Acquired
Reserves
and Deposits
Bank A
$100.00
Bank B
80.00
Bank C
64.00
Bank D
51.20
Bank E
40.96
Bank F
32.77
Bank G
26.21
Bank H
20.97
Bank I
16.78
Bank J
13.42
Bank K
10.74
Bank L
8.59
Bank M
6.87
Bank N
5.50
Other Banks 21.99
(2)
Required
Reserves
(Reserve
Ratio = .2)
(3)
Excess
Reserves
(1)-(2)
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
(4)
Amount Bank Can
Lend; New Money
Created = (3)
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
$400.00
32-23
The Monetary Multiplier
Monetary
multiplier
=
Graphic
Example
1
required reserve ratio
=
1
rr
New Reserves
$100
$80
Excess
Reserves
$400
Bank System Lending
Money Created
$20
Required
Reserves
$100
Initial
Deposit
32-24
The Federal Reserve System
• Historical Background
• Prior to 1913, the U.S. had a
decentralized and unregulated banking
system
• This led to much economic instability,
(fraud, different currencies, bank
failures)
The Federal Reserve System
• A financial crisis in 1907 led to the
desire to create a centralized banking
system with control over the money
supply
• In 1913 Congress passed and President
Wilson signed, The Federal Reserve
Act
The Federal Reserve System
• The Federal Reserve Act (1913)
• The Board of Governors
– 7 members
– Appointed by the President, Confirmed by
the Senate
– 14 year terms; staggered so one member
is replaced every two years (above
political pressure)
The Federal Reserve System
• President
chooses a
board member
to be the
Chairman of
the Fed (4
year term)
• Janet Yellen
The Fed - Basics
The Fed - Basics
The Fed - Basics
• Main Functions of The Fed
– A bank to banks and to the Federal
government
– Regulate the banks in their district
– Provide a safe and stable financial
system
– ****Monetary Policy
The Fed - Basics
• Monetary Policy
–Manipulation of the money
supply in order to bring about the
desired macroeconomic goals
(expanding Real GDP, low inflation,
low unemployment)
The Tools of the Fed
• Manipulate the Discount Rate
– The interest rate the Fed charges to banks
that want to borrow money
• Manipulate the Reserve Ratio
• The percentage of reserves a bank is required to
keep on hand as cash
• Target a higher or lower FEDERAL
FUNDS RATE --> by selling or buying
government bonds (Open Market
Operations)
The Federal Funds Rate
• Banks keep some of their reserves in
accounts at a Federal Reserve bank
• Sometimes bank required reserves go
lower than a bank wants or needs
• Banks with excess reserves willingly
lend deficient banks funds from their
Federal Reserve accounts ($1 Million
minimum)
The Federal Funds Rate
• The interest rate that banks charge
each other for these short-term, often
overnight loans, is known as the
FEDERAL FUNDS RATE
• The Federal Reserve does NOT set the
Fed Funds Rate but it does target a rate
that they would like (0 to 0.25) (0.09)
• They influence the rate through their
Open Market Operations
The Federal Funds Rate
• The lower the Federal Funds Rate,
the more it encourages banks to
borrow from each other
• The higher the Federal Funds Rate,
the more it discourages banks to
borrow from each other
• The current Fed Funds target rate
is really a range, from 0 to 0.25%
The Tools of the Fed
• Carry out Open Market Operations
(OMO)
– Buying and selling of government
securities (bonds)
– Executed by the Federal Open Market
Committee (FOMC)
– 7 member Board of Governors, President
of the New York Fed, 4 other bank
presidents on a rotating basis
The Tools of the Fed
• Expansionary Monetary Policy
–Aka – Easy Money Policy
–Increasing the money supply
(increasing excess reserves)
–Lowers interest rates
–To fight against recession
–Stimulate AD (through Ig)
The Tools of the Fed
• Contractionary Monetary Policy
– Aka – Tight Money Policy or
Restrictive Policy
– Decreasing the money supply
(decreasing excess reserves)
– Increases interest rates
– To fight against inflation
– To reduce AD (through Ig)
Tools of Monetary Policy
Monetary Policy
Expansionary Policy
(Easy Money)
Contractionary
Policy (Tight Money)
Target a
Target a
Open Market
Operations
Discount Rate
Reserve
Requirements
Federal Funds Rate
The Demand and Supply of Money
m
m
The Money Market Graph
• Shows the relationship between the
supply of money (Sm or Ms) and the
demand for money (Dm or Md)
• The Money Demand Curve
– Impacted by Fiscal Policy
– Changes in the Price Level can shift the
Dm curve
• – Higher PL the higher the demand for money
• – Lower PL the lower the demand for money
The Money Market Graph
• Changes in Real GDP shift the Dm
curve
– Increases in Real GDP shift the Dm curve
to the right
– Decreases shift the curve to the left
• Changes in Technology have shifted
the Dm curve
– The easier it is to buy stuff without cash
(Credit cards for example) the less demand
there is for money – Shift to the left
The Money Market Graph
• The Money Supply curve
– Impacted by Monetary Policy
– Fed actions shift the curve depending on
whether the money supply has been
increased or decreased
The Demand and Supply of Money
m
m
What would happen to the money supply
AND interest rates if the Fed
• Targeted a reduction of the Federal Funds
Rate
• Raised the Discount Rate
• Lowered the Reserve Requirement
• Bought government securities on the open
market
• Targeted an increase the Federal Funds Rate
• Sold government securities on the open
market
Money Supply or
Money Demand?
• The rate of inflation declines
(disinflation)
• The Fed buys bonds
• The reserve requirement is raised
• There is economic growth (a rise in
Real GDP)
• The Fed targets an increase in the
federal funds rate
Interest Rates and Bond Prices
• Bonds are bought and sold in the open
market based on supply and demand
• They sell for a certain price and pay
fixed interest rates
• Suppose a $1000 bond pays an annual
$50 in interest
• That’s a 5% yield annually (5% interest
rate)
Interest Rates and Bond Prices
• Now, what happens interest rates rise
to 7.5%
• Would you want to purchase the old
bond at 5% when you could get a new
one at 7.5%?
• What would make you be willing to
purchase the $1000 old bond?
• If it was sold for less than $1000
Interest Rates and Bond Prices
• In fact, if you could buy the old bond
for $667 and receive the fixed $50
interest you would be receiving 7.5%
annually on your investment
• THUS, WHEN INTEREST RATES RISE
BOND PRICES DECLINE
• WHEN INTEREST RATES DECLINE,
BOND PRICES RISE
One Final Point
• If the Fed buys $10,000 in government
bonds, does the money supply initially
increase by $10,000?
• Yes it does!!!
• Why?
• Because the money in the vaults of Fed
banks is not considered to be a
demand deposit and is therefore not
part of M1
One Final Point
• So, there is a difference between you
taking $1,000 cash and putting it into
your checking account and the Fed
making a $1,000 purchase of
government bonds.
• What is that difference?
• The Fed purchase initially increases the
M1 money supply by $1,000, the cash
deposit does not
– Practice Monetary Policy problems
• 2014 #2
• 2012 #1
Limitations of Monetary Policy
• Hard to determine how much money
growth is optimal
• Can’t always predict the exact results
of a monetary action
• Lag time before the actions of the Fed
kick in
• World events make things more
complex
• Congress may do things (Fiscal Policy)
that conflict with the Fed
Practice
• Complete
• Connections: Countercyclical
Monetary Policies (On the back of
Countercyclical Fiscal Policies)
• Examine the 2012 exam question on TAccounts
The Monetarists
• When Keynesian fiscal policy failed to
deal with the stagflation of the 1970’s,
some economists put forth the concept
of MONETARISM
• They believed that a steady growth of
the money supply would assure
economic growth and macroeconomic
stability
The Monetarists
• Monetarists call for a steady increase of the
money supply (say at 3% a year) regardless
of the status of the economy
• They rejected an active monetary policy (an
important distinction).
• In other words, they didn’t feel that the
supply of money should be expanded and
contracted (Monetary Policy) to meet certain
conditions because of its limitations
• They are basically conservative, laissez-faire
economists
The Monetarists
• Milton
Friedman was
its leading
advocate and
he has become
a conservative
icon over the
last 30+ years
The Equation of Exchange
• The fundamental equation for
monetarists is MV=PQ
• M is the supply of money
• V is the velocity of money (the average
number of times a dollar is spent
during a year – this is relatively stable
they believe)
• P is the price level
• Q is the quantity of all goods and
services produced
The Equation of Exchange
• MV is the money supply
multiplied by the number of
times the money is spent
throughout the year
• PQ is basically nominal GDP
• MV (Spending) equals the value
of PQ (Output)
The Equation of Exchange
• If V is relatively stable and
predictable, INCREASING THE
MONEY SUPPLY WILL
INCREASE NOMINAL GDP
Decrease in Invest Demand
r
The Monetary Role of Banks
• The T-account summarizes a banks
financial position
Creating a Bank
• Transaction #1
• Vault cash: cash held by the
bank
Creating a Bank
Balance Sheet 1: Wahoo Bank
Assets
Cash
Liabilities and Net Worth
$250,000 Stock Shares
$250,000
32-67
Creating a Bank
• Transaction #2
• Acquiring property and equipment
Acquiring Property and Equipment
Balance Sheet 2: Wahoo Bank
Assets
Cash
Property
Liabilities and Net Worth
$10,000 Stock Shares
240,000
$250,000
32-68
Creating a Bank
• Transaction #3
• Commercial bank functions
–Accepting deposits
–Making loans
Accepting Deposits
Assets
Cash
Property
Balance Sheet 3: Wahoo Bank
Liabilities and Net Worth
$110,000
240,000
Checkable
Deposits
Stock Shares
$100,000
250,000
32-69
Creating a Bank
• Transaction #4
• Assume the bank deposits all
cash on reserve at the Fed
Depositing Reserves at the Fed
Balance Sheet 4: Wahoo Bank
Assets
Liabilities and Net Worth
Cash
Reserves
$0 Checkable
110,000
Deposits
Property
240,000 Stock Shares
$100,000
250,000
32-70
Creating a Bank
• Transaction #5
• Clearing a check
–$50,000 check reduces reserves
and checkable deposits
Clearing a Check
Balance Sheet 5: Wahoo Bank
Assets
Reserves
Property
Liabilities and Net Worth
Checkable
$60,000
Deposits
240,000 Stock Shares
$50,000
250,000
32-71
Financial Institutions
• Institutions offering checkable
deposits
–Commercial banks
• JP Morgan Chase
• Bank of America
• Wells Fargo
–Credit unions
31-72
Crowding Out - Revisited
• Initiated by Government deficit spending to
pay for an _______________ fiscal policy.
The Loanable Funds Market
• A market that brings together
borrowers and lenders
• There is a supply of loanable
funds and a demand for those
loanable funds
Shifts in the Demand for LF
• Business and Consumer expectations
– Optimistism leads to increased demand of
LF
– Pessimism leads to declining demand of
LF
• Government borrowing to finance an
expansionary fiscal policy increases
the demand for LF (Which leads to
crowding out)
Shifts in the Supply of LF
• Changes in private savings behavior
– More savings increases the supply of LF
– Less savings decrease the supply of LF
• Changes in the flow of foreign
investment in the U.S. (We will
understand this when we study the
international economy)