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Economics for Managersby Paul Farnhamy
Chapter 13:The Role of Money in theThe Role of Money in the
Macro Economy
13.1© 2005 Prentice Hall, Inc.
Money and the U. S. Fi i l S tFinancial System
Money: financial assets that can easily be used to make market ytransactions and that serve as a medium of exchange and a store
f lof valueBarter system: when goods and y gservices are exchanged directly without a common unit of account
13.2© 2005 Prentice Hall, Inc.
Measures of theM S lMoney Supply
Liquidity: ability to immediately make market transactionsM1 is the money supply (includes most liquid components)most liquid components)Demand deposits: checkable deposits and a component of thedeposits and a component of the M1 measure of the money supply
13.3© 2005 Prentice Hall, Inc.
Commercial Banks Commercial Banks
Depository institution backed by the FDIC, which protects deposits up to $100 000$100,000Fractional reserve system (rr): banks need only keep a fraction of their eed o y eep a act o o t ereservesReserve requirement: required
di id d b d d d itreserves divided by demand depositsMoney supply: currency plus demand deposits
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deposits
Monetary Base andM S lMoney Supply
M S l
Currency Demand Deposits
Money Supply
Currency Demand Deposits
M M lti liMoney Multiplier
Currency Reserves
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Monetary Base
The Federal ReserveThe Federal Reserve
Acts as central bank of U.S. that implements monetary policy and p y p yregulates U.S. financial system12 district banks and 25 branches12 district banks and 25 branchesIndependent within the government
13.6© 2005 Prentice Hall, Inc.
Open Market OperationsOpen Market Operations
Buying and selling of government securities in open marketInfluences amount of reserves held by commercial banks, which i t i fl f d l f din turn influences federal funds rateF d l f d k t i tFederal funds market: private market where banks borrow to meet reserve requirements
13.7© 2005 Prentice Hall, Inc.
meet reserve requirements
Open Market OperationsOpen Market Operations
Expansionary monetary policy: increases rate of Real GDP by increasing amount of bank reserves inincreasing amount of bank reserves in system and lowering federal funds and other interest ratesOther interest rates tend to fall along with federal funds rate
13.8© 2005 Prentice Hall, Inc.
ContractionaryM t P liMonetary Policy
Fed decreases rate of growth of real GDP by increasing bank reserves and
i i f d l f d d th i t traising federal funds and other interest ratesFOMC l i iti d ilFOMC also engages in securities daily after analyzing economic conditions
13.9© 2005 Prentice Hall, Inc.
Discount RateDiscount Rate
Interest rate Fed charges banks that borrow reserves at Fed’s discount windowIndicates contractionary monetaryIndicates contractionary monetary policyCommercial banks have beenCommercial banks have been reluctant to borrow at the discount window
13.10© 2005 Prentice Hall, Inc.
discount window
Reserve RequirementsReserve Requirements
Monetary Control Act of 1980: made all depository institutions p ysubject to reserve requirements established by the FedRaising reserve requirements has contractionary effect on economyy yEven small changes have major impact on reserve requirements
13.11© 2005 Prentice Hall, Inc.
impact on reserve requirements
Managerial Rule of Thumb: d l liFederal Reserve Policy
Managers must• Watch Fed policy statements and• Watch Fed policy statements and
actionsDecide how monetary policy will• Decide how monetary policy will influence economic activityB id d b th ti f th• Be guided by the actions of the Federal Open Market Committee regarding federal funds rates
13.12© 2005 Prentice Hall, Inc.
regarding federal funds rates
Supply of MoneySupply of Money
N i l l (M )Nominal money supply (MS): money supply (M1) controlled by the Federal Reservethe Federal ReserveReal money supply: (M / P) nominal money supply divided by the pricemoney supply divided by the price level (influences individuals’ behavior)An increase in the nominal money supply results in an increase in the real money supply all else
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real money supply, all else constant
Real MoneyS l F tiSupply Function
Figure 13.3
RLMS1 Increase in MS by Fed or decrease in price level (P)
RLMS2
in price level (P) will cause real money supplymoney supply function to shift from RLMS1 to RLMS2
0
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M / P0 (MS / P)1 (MS / P)2
Real Money S l F tiSupply Function
R MS / PRLMS = MS / P
whereRLMS = MS / P = f (r MS P) where
RLMS = real money supply
RLMS = MS / P = f (r, MS, P)
y pp y
MS = nominal money supply
P = the price level
l i t t t13.15© 2005 Prentice Hall, Inc.
r = real interest rate
Demand for MoneyDemand for MoneyFigure 13.4
AAr1
Br2 C
RLMD1
0RLMD2
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(M / P)0 (M / P)3(M / P)2(M / P)1
Demand for MoneyDemand for Money
whereRLMD = MD / P = f (r, Y)
RLMD = real money demandMD = nominal money supplyP = the price levelpr = real interest rateY l l f l i
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Y = level of real income
Demand for MoneyDemand for Money
Demand for money focuses on decisions individuals make regarding their assetsregarding their assetsIndividuals hold money because it is liquid and enables them to conductliquid and enables them to conduct transactionsHigher interest rates cause gindividuals to hold fewer assetsReal demand depends on level of
13.18© 2005 Prentice Hall, Inc.
preal income (Y) in economy
Change in the R l M S lReal Money Supply
Figure 13.5
A A’
RLMS1 RLMS2
Ar1
A’
Br2
RLMD
013.19© 2005 Prentice Hall, Inc.
(M / P)0 (M / P)2(M / P)1
Change in the D d f MDemand for Money
Figure 13.6
RLMS
r1
B
r2
r1
A A’
RLMD1 (Y1)RLMD2 (Y2)
13.20© 2005 Prentice Hall, Inc.
(M / P)0
Summary of Key TermsSummary of Key Terms
Barter systemBarter systemCommercial banksContractionary monetary policyDemand depositsDiscount rate and prime rateExpansionary monetary policyExpansionary monetary policyFDIC
13.21© 2005 Prentice Hall, Inc.
Summary of Key TermsSummary of Key Terms
F d l f d k t d f d lFederal funds market and federal funds rate FOMCFOMCThe Fed/ Czech National Bank, etc.Fractional reserve systemLiquidityLiquidityMoney
13.22© 2005 Prentice Hall, Inc.