© 2007 Thomson South-Western. This lecture…. Money Growth Inflation Functions and Types of Money Federal Reserve System Basics

© 2007 Thomson South-Western


This lecture….

• Money Growth

• Inflation

• Functions and Types of Money

• Federal Reserve System Basics


Money Growth and Inflation• The Meaning of Money

– Money is the set of assets in an economy that people regularly use to buy goods and services from other people.

•Inflation is an increase in the overall level of prices.


The Level of Prices and the Value of Money

• The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate.

• Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange.

• When the overall price level rises, the value of money falls.


Money Supply, Money Demand, and Monetary Equilibrium

• The money supply is a policy variable that is controlled by the federal govt.

• Through instruments such as open-market operations (what?), the govt. directly controls the quantity of money supplied.

• Money demand has several determinants, including interest rates and the average level of prices in the economy.


Money Supply, Money Demand, and Monetary Equilibrium

• People hold money because it is the medium of exchange.• The amount of money people choose to hold

depends on the prices of goods and services.

• In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.


Figure 2 An Increase in the Money Supply

Quantity ofMoney

Value ofMoney, 1/P

Price Level, P

Moneydemand

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4

M1

MS1

M2

MS2

2. . . . decreasesthe value ofmoney . . .

3. . . . andincreasesthe pricelevel.

1. An increasein the moneysupply . . .

A

B


The Effects of a Monetary Injection

• The Quantity Theory of Money• How the price level is determined and why it might

change over time is called the quantity theory of money.

• The quantity of money available in the economy determines the value of money.

• The primary cause of inflation is the growth in the quantity of money.


The Classical Dichotomy and Monetary Neutrality

• Nominal variables are variables measured in monetary units.

• Real variables are variables measured in physical units.


The Classical Dichotomy and Monetary Neutrality

• According to Hume and others, real economic variables do not change with changes in the money supply.• According to the classical dichotomy, different

forces influence real and nominal variables.

• Changes in the money supply affect nominal variables but not real variables.

• The irrelevance of monetary changes for real variables is called monetary neutrality.


Velocity and the Quantity Equation

• The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.


Velocity and the Quantity Equation

• The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables:• The price level must rise,• the quantity of output must rise, or• the velocity of money must fall.


CASE STUDY: Money and Prices during Four Hyperinflations

• Hyperinflation is inflation that exceeds 50 percent per month.

• Hyperinflation occurs in some countries because the government prints too much money to pay for its spending.


Figure 4 Money and Prices During Four Hyperinflations(a) Austria (b) Hungary

Money supply

Price level

Index(Jan. 1921 = 100)

Index(July 1921 = 100)

Price level

100,000

10,000

1,000

10019251924192319221921

Money supply

100,000

10,000

1,000

10019251924192319221921

(c) Germany

1

Index(Jan. 1921 = 100)

(d) Poland

100,000,000,000,000

1,000,000

10,000,000,0001,000,000,000,000

100,000,000

10,000100

Moneysupply

Price level

19251924192319221921

Price levelMoneysupply

Index(Jan. 1921 = 100)

100

10,000,000

100,000

1,000,000

10,000

1,000

19251924192319221921


The Inflation Tax

• When the government raises revenue by printing money, it is said to levy an inflation tax.

• An inflation tax is like a tax on everyone who holds money.

• The inflation ends when the government institutes fiscal reforms such as cuts in government spending.


THE COSTS OF INFLATION

• A Fall in Purchasing Power?

• Inflation does not in itself reduce people’s real purchasing power….

• Or does it?


THE COSTS OF INFLATION

• Shoeleather costs

• Menu costs

• Relative price variability

• Tax distortions

• Confusion and inconvenience

• Arbitrary redistribution of wealth


THE MONETARY SYSTEM 18

What Money Is and Why It’s Important

• Without money, trade would require barter, the exchange of one good or service for another.

• Every transaction would require a double coincidence of wants – the unlikely occurrence that two people each have a good the other wants.

• Most people would have to spend time searching for others to trade with – a huge waste of resources.

• This searching is unnecessary with money, the set of assets that people regularly use to buy g&s from other people.


The Functions of Money• Money has three functions in the economy:

– Medium of exchange– Unit of account– Store of value

• Medium of Exchange• A medium of exchange is an item that buyers give

to sellers when they want to purchase goods and services.

• A medium of exchange is anything that is readily acceptable as payment.


The Functions of Money

• Unit of Account– A unit of account is the yardstick people use to

post prices and record debts.

• Store of Value– A store of value is an item that people can use to

transfer purchasing power from the present to the future.



The 2 Kinds of Money

Commodity money: takes the form of a commodity with intrinsic value

Examples: gold coins, cigarettes in POW camps

Fiat money: money without intrinsic value, used as money because of govt decree

Example: the U.S. dollar


THE FEDERAL RESERVE SYSTEM

• The Federal Reserve (Fed) serves as the nation’s central bank.– Three Primary Functions of the Fed

• Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices.

• Acts as a banker’s bank, making loans to banks and as a lender of last resort.

• Conducts monetary policy by controlling the money supply.


The Federal Open Market Committee (FOMC)• Monetary policy is conducted by the Federal

Open Market Committee.– The money supply refers to the quantity of money

available in the economy.– Monetary policy is the setting of the money supply

by policymakers in the central bank.


The Federal Open Market Committee

• Open-Market Operations– The money supply is the quantity of money

available in the economy.– The primary way in which the Fed changes the

money supply is through open-market operations.• The Fed purchases and sells U.S. government bonds.

• To increase the money supply, the Fed buys government bonds from the public.

• To decrease the money supply, the Fed sells government bonds to the public.


BANKS AND THE MONEY SUPPLY• Banks can influence

the quantity of demand deposits in the economy and the money supply.


BANKS AND THE MONEY SUPPLY

• Reserves are deposits that banks have received but have not loaned out.

• In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.

• The reserve ratio is the fraction of deposits that banks hold as reserves.


Money Creation with Fractional-Reserve Banking• When a bank makes a loan from its reserves,

the money supply increases.• The money supply is affected by the amount

deposited in banks and the amount that banks loan.– Deposits into a bank are recorded as both assets

and liabilities.– The fraction of total deposits that a bank has to

keep as reserves is called the reserve ratio.– Loans become an asset to the bank.


Banking Money Creation with Fractional-Reserve • This T-Account

shows a bank that…– accepts deposits,– keeps a portion

as reserves, – and lends out

the rest.

• It assumes a reserve ratio of 10%.

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00


Money Creation with Fractional-Reserve Banking• When one bank loans money, that money is

generally deposited into another bank.

• This creates more deposits and more reserves to be lent out.

• When a bank makes a loan from its reserves, the money supply increases.


The Money Multiplier

• How much money is eventually created by the new deposit in this economy?

• The money multiplier is the amount of money the banking system generates with each dollar of reserves.



Increase in the Money Supply = $190.00!

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00


Assets Liabilities

Second National Bank

Reserves$9.00

Loans$81.00

Deposits$90.00

Total Assets$90.00




Original deposit = $100.00

• 1st Natl. Lending = 90.00 (=.9 x $100.00)

• 2nd Natl. Lending = 81.00 (=.9 x $ 90.00)

• 3rd Natl. Lending = 72.90 (=.9 x $ 81.00)

• … and on until there are just pennies left to lend!

• Total money created by this $100.00 deposit is $1000.00. (= 1/.1 x $100.00)



• The money multiplier is the reciprocal of the reserve ratio:

M = 1/R

• Example:– With a reserve requirement, R = 20% or .2:– The money multiplier is 1/.2 = 5.


The Fed’s Tools of Monetary Control

• The Fed has three tools in its monetary toolbox:– Open-market operations– Changing the reserve requirement– Changing the discount rate


35

The Fed’s 3 Tools of Monetary Control1. Open-Market Operations (OMOs): the purchase and

sale of U.S. government bonds by the Fed.

To increase money supply, Fed buys govt bonds, paying with new dollars. …which are deposited in banks, increasing reserves…which banks use to make loans, causing the money supply to expand.

To reduce money supply, Fed sells govt bonds, taking dollars out of circulation, and the process works in reverse.

OMOs are easy to conduct, and are the Fed’s monetary policy tool of choice.



The Fed’s 3 Tools of Monetary Control2. Reserve Requirements (RR):

affect how much money banks can create by making loans.

To increase money supply, Fed reduces RR.

Banks make more loans from each dollar of reserves, which increases money multiplier and money supply.

To reduce money supply, Fed raises RR, and the process works in reverse.

Fed rarely uses reserve requirements to control money supply: Frequent changes would disrupt banking.



The Fed’s 3 Tools of Monetary Control3. The Discount Rate:

the interest rate on loans the Fed makes to banks

When banks are running low on reserves, they may borrow reserves from the Fed.

To increase money supply, Fed can lower discount rate, which encourages banks to borrow more reserves from Fed.

Banks can then make more loans, which increases the money supply.

To reduce money supply, Fed can raise discount rate.



The Fed’s 3 Tools of Monetary Control3. The Discount Rate:

the interest rate on loans the Fed makes to banks

The Fed uses discount lending to provide extra liquidity when financial institutions are in trouble, e.g. after the Oct. 1987 stock market crash.

If no crisis, Fed rarely uses discount lending – Fed is a “lender of last resort.”



Monetary Policy and the Fed Funds Rate

To raise fed funds rate, Fed sells govt bonds (OMO).

This removes reserves from the banking system, reduces supply of federal funds,

causes rf to rise.

rf

FD1

S2

3.75%

F2

S1

F1

3.50%

The Federal Funds marketFederal

funds rate

Quantity of federal funds



Problems Controlling the Money Supply

• If households hold more of their money as currency, banks have fewer reserves, make fewer loans, and money supply falls.

• If banks hold more reserves than required, they make fewer loans, and money supply falls.

• Yet, Fed can compensate for household and bank behavior to retain fairly precise control over the money supply.

Documents

© 2007 Thomson South-Western. This lecture…. Money Growth Inflation Functions and Types of Money Federal Reserve System Basics