Embed Size (px)
Citation preview
Ch. 8: Money, the Price Level, and Inflation9
• Definition of money and its functions• Economic functions of banks• Structure and function of the Federal Reserve
System• Creation of money by the banking system• Demand for money, the supply of money, and the
nominal interest rate• Link between quantity of money, the price level
and inflation
What is Money?Anything that is generally acceptable as a means of payment.
Commodity Money• gold dust, tobacco, cigarettes in POW camp• Problems
•transactions cost; perishable; value fluctuates. Coins with precious metal
• Gold & silver coins•Problems
•Coin shaving• value of metal fluctuates.• Greshams Law: Bad money drives out good (more later).
Fiat money
MONEY IN U.S. HISTORY
• U.S. constitution gave Congress sole right to "coin money and regulate value thereof".
• Illegal for states to coin money. Bi-metallic standard initially. In the 1792 coin act, a $1 coin was quoted in
terms of both silver and gold. 24.75 grains of gold =$1371.25 grains of silver = $1
GRESHAM’S LAW “Bad money drives out good" Prior to 1834, 24.75 grains of gold was worth more
than 371.25 grains of silver. Only silver coins circulated (a "silver standard" by default).
After 1834, the reverse was true (a "gold standard" by default).
Wizard of Oz and bimetallic standard (see web page link)
Suppose a gold coin has 10 grains of metal and a silver coin has 30 grains. If the price of a grain of metal is 5 times higher for gold than silver,
which coins will circulate?
Only
gold co
in...
Only
silve
r co...
Neith
er both
0% 0%0%0%
1. Only gold coins2. Only silver coins3. Neither4. both
10
Suppose that both gold and silver coins are currently circulating. If the price of gold rises and the price of silver does not, which coins will stop circulating?
Gold coins
Silve
r coins
0%0%
1. Gold coins2. Silver coins
10
3 Functions of MoneyMedium of Exchange
•Generally accepted in exchange for goods and services.•Without money, trade is barter system.•Barter requires a double coincidence of wants makes it costly.
Unit of AccountAn agreed measure for stating the value of goods and services.
Store of Value•Money can be held for a time and later exchanged for goods and services.•Can be poor store of value
•Inflation•No interest
HISTORY OF BANKING
• Initially banks formed as “safekeeping” institutions.
• Gradually evolved to serve several functions:• Minimize the cost of borrowing funds• Minimize the cost of monitoring borrowers• Link lenders with borrowers• Pool risks for lenders• Create liquidity
HISTORY OF BANKINGStates could not print or mint money, but privately
owned banks could if licensed by the state government.
Banks printed notes that were backed by gold or silver
• easier to trade• avoided problems with weighing • banks found it profitable to print more notes than they
had "reserves“ (gold/silver) for and loaned out the extra notes.
• Fractional reserve banking was started.
Fractional reserve banking poses problems if there is a bank run.
Assets LiabilitiesReserves (gold) 100 Notes 100Total 100 100
Banks would print notes beyond reserves and extend loans.
Reserves 100 Notes 1000Loans 900 ____Total 1000 1000
• With “fractional reserve banking”, the banking system
“creates money” and lends it out. has only a fraction of liabilities on reserve. cannot satisfy customer’s demands if all want to
withdraw deposits at once.
• Source of “bank panics”.News that loans are not likely to be paid back,
customers will make a “run” on the bank. • Droughts.• Stock market crash.
• Effect of bank panic on economy?
Bank Panics and Deposit Insurance• 7 major bank panics in the U.S. in the 1800s
2 in the early 1900s. Onset of the great depression in the 1930s, another
bank panic occurred. In 1934, the federal government established FDIC to
help reduce spread of bank panics.
• Deposit insurance has reduced bank panics in the U.S.
• Problems with deposit insuranceIncentives created for risk taking (moral hazard).The 1985 Home State experience in Ohio.The most recent financial crisis.
Bank Objectives.Goal of any bank is to maximize wealth of its owners.To accomplish this, must consider:
1. Attracting deposits to make loans possible.2. Choosing loan portfolio and balance risk versus return.3. Liquidity 4. Service quality, fees, etc.
Bank Objectives.
Risk, Return, and Liquidity.1. Liquid assets (low risk, low return)
• U.S. government Treasury bills and commercial bills
2. Investment securities • longer–term U.S. government bonds and
other bonds
3. Loans (higher risk, higher return)• commitments of fixed amounts of money
for agreed-upon periods of time
Federal Reserve System• Established in 1913 by the Federal Reserve Act.• First central bank of the United States• Conducts monetary policy and regulates banks.• Aims to stabilize the macroeconomy.• Structure
– The Board of Governors– The 12 regional Federal Reserve banks– Federal Open Market Committee
The Federal Reserve SystemBoard of Governors
• 7 members appointed by the president and confirmed by Senate.•Terms are for 14 years•The president appoints one member to a four-year term as chairman.
Regional Banks•Each of the 12 Federal Reserve Regional Banks has a nine-person board of directors and a president.•Monitors economic conditions within district and regulates banks•Clearinghouse for checks and replacement of currency
The Federal Reserve SystemFederal Open Market Committee•FOMC is the main policy-making group in the Federal Reserve System.•Consists of the members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the 11 presidents of other regional Federal Reserve banks of whom, on a rotating basis, 4 are voting members.•The FOMC meets every six weeks to formulate monetary policy.
Components of the Money SupplyBank reserves
bank deposits at the Federal Reserve + cash
Monetary base currency held by the nonbank public + bank reserves.
M1 currency outside banks, traveler’s checks, and checking deposits owned by individuals and businesses.
M2 M1 plus time deposits, savings deposits, and money market mutual funds and other deposits.
Components of Money Supply
How do banks create money?
Suppose that there is $100 million of cash and no bank system.
A bank now begins and $90 million of cash is deposited in the bank in exchange for checking account (demand deposit) balances.
The bank’s owners invest $5 million in plant and equipment and thus have $5 million of owner’s equity. The bank’s balance sheet is now:
How do banks create money?
The balance sheet
Assets LiabilitiesCash 90 m. Demand deposits 90 m.
Plant & equipment 5 m. Owner’s equity 5 m.
Total assets 95 m. Total Liabilities 95 m.
Note: The balance sheet requires that total assets equal total liabilities.
How do banks create money?
Fed sets a reserve ratio (let’s suppose it’s 25%). Implying bank must have 25% of it’s demand deposits on reserve.
Reserves = cash in bank + deposits at Fed.
Bank can increase demand deposits by creating new loans to customers until it no longer has any excess reserves.
required reserves = rr * demand deposits Maximum demand deposits = (1/rr) * reserves
How do banks create money?
The balance sheet
Assets LiabilitiesCash 90 m. Demand deposits 90m360
m.
Loans 0270 m Owner’s equity 5 m.
Plant & equipment 5 m.
Total assets 95m365 m.
Total Liabilities 95m365 m.
Note: The bank system created $270 million of additional money by creating new demand deposits for borrowers (loans). This assumes that none of the new loans/demand deposits are withdrawn as cash.
How Banks Create Money
• Deposits lead to a multiplier effect on M1 as banks convert a $1 deposit into several dollars of demand deposits.
• To illustrate, assume rr=25%A new deposit of $100,000 is made.The bank keeps $25,000 in reserve and lends $75,000.This loan is credited to someone’s bank deposit.The person spends the deposit and another bank now
has $75,000 of extra deposits.This bank keeps $18,750 on reserve and lends $56,250.
How Banks Create Money
• The process continues and keeps repeating with smaller and smaller loans at each “round.”
How do banks create money?
Summary of money creation process.
monetary base = nonbank cash + bank reserves
M1 = nonbank cash + demand dep. Maximum DD = (1/rr) * bank reserves
The Fed controls the money supply through its control over the monetary base and the deposit multiplier (1/rr).
Fed Tools Open market operations.
The Fed buys (sells) government securities in the open market to increase (decrease) the money supply.
Discount window lending.The Fed loans reserves to member banks and
charges the discount rate.Reserve requirements.
The Fed sets the required reserve ratio.Rarely used.
OPEN MARKET OPERATIONS.• If the Fed wants to increase the amount of bank
reservesbuy government securities from member banksbanks give up government bonds and receive deposit at
the Fed or cash. More recently, Fed has purchased commercial paper
from banks – new policy!
• By buying government securitiesFed created new reserves that multiply into new loans
and demand deposits (remember the deposit multiplier).
• If the Fed sold government securities, reserves and M1 would decrease.
Changes in the money supplyThe balance sheet
NBC=$10m; rr=25%
Assets LiabilitiesReserves 90 m. Demand deposits 360 m.
Loans 200m Owner’s equity 5 m.
Govt bonds 70m
Plant & equipment 5 m.
Total assets 365 m. Total Liabilities 365 m.
Suppose the Fed purchases $10 m. of government securities. What is the effect on:
Loans Demand deposits M1
Assuming banks loan out all excess reserves, if the Fed purchases $10 million of government securities, total loans will
increase by$10 million.
increase by$40 million
decrease by$10 million.
None of theabove.
0% 0%0%0%
1. increase by $10 million.2. increase by $40 million3. decrease by $10
million.4. None of the above.
10
Assuming banks loan out all excess reserves, if the Fed purchases $10 million of government securities, M1 will
increase by$10 million.
increase by$40 million
Increase by$30 million.
None of theabove.
0% 0%0%0%
1. increase by $10 million.2. increase by $40 million3. Increase by $30 million.4. None of the above.
10
DISCOUNT WINDOW LENDING.
The Fed lends banks reserves at the “discount rate”. • The higher the discount rate, the less likely
banks are to borrow reserves to increase the money supply.
The federal funds rate is the interest rate that banks charge each other for a loan of reserves. • The federal funds rate tracks the discount rate
fairly closely. If the Fed wants to increase reserves in the system,
it would lower the discount rate.
Note: DPCREDIT is the new measure of the discount rate.
THE RESERVE REQUIREMENT.
If the Fed increases the reserve requirement• the deposit multiplier (1/rr) falls • the amount of demand deposits that banks can create
for a given amount of reserves is reduced. • [Note: you may ignore the “money multiplier” and the
“currency drain ratio” discussed in text. Focus only on “deposit multiplier”]
Changes in the money supplyThe balance sheet
NBC=$10m; rr=25%
Assets LiabilitiesCash 90 m. Demand deposits 360 m.
Loans 200 m Owner’s equity 5 m.
Government bonds 70m
Plant & equipment 5 m.
Total assets 365 m. Total Liabilities 365 m.
Suppose the Fed cuts the rr to 20% What is the effect on:
Loans Demand deposits M1
If the reserve ratio is cut from 25 to 20%, M1 will
Not change Increase by$1...
Increase by$9...
None of theab...
0% 0%0%0%
1. Not change2. Increase by $18
million3. Increase by $90
million4. None of the above.
10
OTHER FACTORS INFLUENCING THE MONEY SUPPLY The amount of cash people choose to hold
• Cash in bank multiplies• Cash outside bank does not.
The type of deposits people make.• the reserve requirement is higher on demand
deposits (about 3%) than on certificates of deposit. • If people switch between different types of
accounts, the “average” reserve requirement and money multiplier will change.
Bank holdings of excess reserves
Changes in the money supply: Cash held by public
Suppose the public withdraws $10m. Of DD as cash. What is the effect on:
Loans Demand deposits M1
The balance sheet
NBC=$10m; rr=25%
Assets LiabilitiesCash 90 m. Demand deposits 360 m.
Loans 200 m Owner’s equity 5 m.
Government bonds 70m
Plant & equipment 5 m.
Total assets 365 m. Total Liabilities 365 m.
Based on prior example, loans would
Not change Decrease $10m...
Decrease $40m...
None of theab...
25% 25%25%25%1. Not change2. Decrease $10 m.3. Decrease $40 m.4. None of the above.
10
Based on prior example, M1 would
Not change Decrease $10m...
Decrease $40m...
None of theab...
25% 25%25%25%1. Not change2. Decrease $10 m.3. Decrease $40 m.4. None of the above.
10
M1 would increase if
The Fe
d incre
ases t
he re...
The Fe
d purchase
s gov..
.
The public
decides t
o hol...
All of t
he above
0% 0%0%0%
1. The Fed increases the required reserve ratio
2. The Fed purchases government securities
3. The public decides to hold less money as demand deposits and more as cash
4. All of the above
20
If banks decide to hold more money as excess reserves, M1 will ____ and bank loans will ____
Incre
ase; in
cr...
Incre
ase; d
ecr...
Decrease
; decr.
..
Decrease
; incr.
..
0% 0%0%0%
1. Increase; increase2. Increase; decrease3. Decrease; decrease4. Decrease; increase
10
Total Bank Reserves: 1980-2011
MONETARY BASE:1983-2011
Components of the monetary base: 1983-2011
M1: 1980-2011
Reserves vs. Excess Reserves: 1984-2011
The Market for MoneyThe Demand for Money
relationship between the quantity of real money demanded and the nominal interest rate when all other influences on the amount of money that people wish to hold remain the same
The Demand for Money HoldingThe quantity of money that people plan to hold depends on four main factors:
The nominal interest rateThe price level Real GDP Financial innovation
The demand for moneyThe Nominal Interest Rate
–the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset.–Increase in the nominal interest rate on other assets decreases the quantity of real money that people plan to hold.
The demand for moneyThe Price Level
An increase in the price level• increases the quantity of nominal money people wish to hold, doesn’t change the quantity of real money demanded. •Real money equals nominal money ÷ price level.•10 percent increase in P increases the quantity of nominal money demanded by 10 percent.
Real GDP•Increase in real GDP increases increases the quantity of real money that people plan to hold.
The demand for moneyFinancial Innovation
–that lowers the cost of switching between money and interest-bearing assets decreases the quantity of real money that people plan to hold.
Summary of money demand factors• Nominal interest rate•Price level • Real GDP (income)• Financial innovation
Equilibrium interest rate
If the Fed purchases government bonds from the banking system, interest rates will ____
Fall b
ecause
m...
Rise beca
use m
...
Fall b
ecause
m...
None of th
e ab...
0% 0%0%0%
1. Fall because money supply increases
2. Rise because money demand increases
3. Fall because money demand decrease
4. None of the above
20
If the economy enters a recession and real GDP falls, interest rates will:
Fall a
s money ...
Fall a
s money ...
Rise as m
oney ...
None of th
e ab...
0% 0%0%0%
1. Fall as money demand decreases
2. Fall as money supply increases
3. Rise as money supply decreases
4. None of the above
20
If the Fed wants to stimulate spending by cutting interest rates, it could:
Purchase
gove
r...
Cut the re
quir...
Lower t
he disc...
All of t
he abo...
0% 0%0%0%
1. Purchase government bonds
2. Cut the required reserve ratio
3. Lower the discount rate
4. All of the above
20
The Market for Money
Long-Run Equilibrium–In the long run, the loanable funds market determines the interest rate.–Nominal interest rate equals the equilibrium real interest rate plus the expected inflation rate.–nominal interest rates on government (“risk-free”) bonds differ for different terms due to
• inflation expectations over different periods• longer term bonds are subject to more inflation risk.
The Quantity Theory of Money
V=velocityP=price levelY=real GDPM=quantity of moneyThe equation of exchange states that
MV = PYExpressing the equation of exchange in growth rates: % ch in M + % ch in V = % ch in P + % ch in Y % ch in P = % ch in M + % ch in V - % ch in Y
The Quantity Theory of Money
Quantity theory of moneyIn the long run, velocity does not change, soInflation rate = Money growth rate Real GDP growth
The Quantity Theory of Money
International evidence shows a tendency for high money growth rates to be associated with high inflation rates.
Evidence for 134 countries from 1990 to 2005.
According to the equation of exchange, which of the following will lead to greater inflation?
Decrease
d velo...
Faste
r gro
wth ...
Faste
r gro
wth ...
All of t
he abo...
0% 0%0%0%
1. Decreased velocity of money
2. Faster growth of the money supply
3. Faster growth of real GDP
4. All of the above
10
