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Money, Prices, and the Federal ReserveMoney, Prices, and the Federal Reserve
Principles of Macroeconomics
Dr. Gabriel X. Martinez
Ave Maria University
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
22
IntroductionIntroduction
Is Economics about Money?Is Economics about Money?
What is Money?What is Money?
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
33
IntroductionIntroduction
MoneyMoney– Any asset that is generally accepted in making Any asset that is generally accepted in making
purchasespurchases– ExamplesExamples
Paper Currency, (worthless) Coins, and Checking Paper Currency, (worthless) Coins, and Checking AccountsAccounts
But alsoBut also– Bronze, Silver, and GoldBronze, Silver, and Gold– Cows, Clams, and Cocoa BeansCows, Clams, and Cocoa Beans– At different times and in different places, foreign currency, At different times and in different places, foreign currency,
boulders, even tulip bulbs have been accepted as money.boulders, even tulip bulbs have been accepted as money.
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Money and Its UsesMoney and Its Uses
An asset is money if it is …An asset is money if it is … ……A Medium of ExchangeA Medium of Exchange
– If it is used in purchasing goods and services.If it is used in purchasing goods and services.
……A Unit of AccountA Unit of Account– If it is a basic measure of economic value.If it is a basic measure of economic value.
……A Store of ValueA Store of Value– If is serves as a means of holding wealth.If is serves as a means of holding wealth.
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Money and Its UsesMoney and Its Uses
Why is barter inconvenient?Why is barter inconvenient?– Double coincidence of wants.Double coincidence of wants.
Would a bartender accept an economics lecture?Would a bartender accept an economics lecture?
– Less specializationLess specialization People try to do everything by themselves.People try to do everything by themselves.
How does money solve this problem?How does money solve this problem?– Why is everyone willing to accept money?Why is everyone willing to accept money?– What if people refuse to accept your “money”?What if people refuse to accept your “money”?
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Money and Its UsesMoney and Its Uses
Is cash money?Is cash money? Are checking accounts money?Are checking accounts money? Are savings accounts money?Are savings accounts money? Are 3-month certificates of deposit money?Are 3-month certificates of deposit money? Are 1-year, negotiable, CDs money?Are 1-year, negotiable, CDs money? Is a gold mine money?Is a gold mine money? Is a house money?Is a house money?
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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How do non-cash assets that are also How do non-cash assets that are also money (e.g., checking accounts) come into money (e.g., checking accounts) come into existence?existence?
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
Palazzo Ducale di Venetia
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Republic of VeniceRepublic of Venice– Central Bank issues 1 million guilders.Central Bank issues 1 million guilders.
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
Colonna di San Todaro
Basilica di San Marco
Colonna di San Marco
Source of pictures:
www.VeNETia.it
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
People want to place their 1 million guilders People want to place their 1 million guilders in a bankin a bank
Why? Why do banks exist?Why? Why do banks exist?– They are safer than your pocket or couch.They are safer than your pocket or couch.– They are convenient (fund transfers, check-They are convenient (fund transfers, check-
writing).writing).– They may pay interest on your deposited funds.They may pay interest on your deposited funds.– They channel your savings to productive uses.They channel your savings to productive uses.
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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AssetsCurrency 1,000,000 guilders
LiabilitiesDeposits 1,000,000 guilders
Central Bank issues 1 million guilders.Citizens open accounts and deposit
1 million guilders• Deposits are liabilities for the bank• The guilders are an asset for the bank
Consolidated Balance Sheet of Consolidated Balance Sheet of Venetian Commercial Banks (Initial)Venetian Commercial Banks (Initial)
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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If a bank receives deposits If a bank receives deposits and keeps themand keeps them, , those guilders are the bank’s those guilders are the bank’s reservesreserves..
Bank ReservesBank Reserves– Cash or similar assets held by commercial Cash or similar assets held by commercial
banks for the purpose of meeting depositor banks for the purpose of meeting depositor withdrawals and paymentswithdrawals and payments
Suppose Suppose Reserves = deposits. Then we Reserves = deposits. Then we have 100% reserve banking.have 100% reserve banking.
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Why keep Reserves?Why keep Reserves?– Because if depositors want to withdraw some of Because if depositors want to withdraw some of
their funds, the bank their funds, the bank mustmust have cash available. have cash available. Why not keep 100% Reserves?Why not keep 100% Reserves?
– Because a bank’s business is to lend out funds Because a bank’s business is to lend out funds (i.e., its depositors’ savings).(i.e., its depositors’ savings).
How much should banks keep in Reserves?How much should banks keep in Reserves?– The Central Bank’s requirement,The Central Bank’s requirement,– plus plus predicted withdrawals.predicted withdrawals.
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Commercial Banks and the Creation of MoneyCommercial Banks and the Creation of Money
ReservesReserves DepositsDeposits Reserve/Deposit RatioReserve/Deposit Ratio
2020 200200
4040 200200
6060 200200
8080 200200
100100 200200
120120 200200
140140 200200
160160 200200
180180 200200
200200 200200
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Reserves are not part of the money supply Reserves are not part of the money supply (they cannot be used for exchange with (they cannot be used for exchange with goods/services).goods/services).
Deposits are part of the money supply (you Deposits are part of the money supply (you can write checks on your checking can write checks on your checking deposits).deposits).
Remember Remember checks checks are NOT money!are NOT money!
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
The Process of Deposit CreationThe Process of Deposit Creation
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
1818
AssetsCurrency 1,000,000 guilders
LiabilitiesDeposits 1,000,000 guilders
Central Bank issues 1 million guilders.Citizens open accounts and deposit
1 million guilders• Deposits are liabilities for the bank• The guilders are an asset for the bank
Consolidated Balance Sheet of Consolidated Balance Sheet of Venetian Commercial Banks (Initial)Venetian Commercial Banks (Initial)
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
1919
AssetsCurrency (= reserves) 100,000 guilders
Loans to farmers 900,000 guilders
LiabilitiesDeposits 1,000,000 guilders
Fractional Reserve Banking System• Bankers agree they only need a reserve to deposit ratio of 10%• R = r D = 0.1 D• Required reserves = 100,000 guilders, 10% of deposits
• Lend the excess reserves of 900,000 guilders
The Process of Deposit CreationThe Process of Deposit Creation
Consolidated Balance Sheet of Venetian Commercial BanksConsolidated Balance Sheet of Venetian Commercial BanksAfter One Round of LoansAfter One Round of Loans
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
2020
$Bank 1
Palazzo Ducale di Venetia
Sourcehttp://www.dtsonline.com/media/img_investors.jpg
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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$Bank 1
$Bank 2
Palazzo Ducale di Venetia
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
2222
$Bank 1
$Bank 2
$Bank 3
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
2323
$Bank 1
$Bank 2
$Bank 3
$Bank 4
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
2424
$Bank 1
$Bank 2
$Bank 3
$Bank 4
1000
900
810
729
810
729
900
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
2525
900
+
Deposits
3439
810
+
729
Notice how the original deposit of 1000 has gotten multiplied.
Because Deposits are part of money, the money supply has grown by $3439
1000+
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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AssetsCurrency (= reserves) 100,000 guilders
Loans to farmers 900,000 guilders
LiabilitiesDeposits 1,000,000 guilders
Fractional Reserve Banking System• Bankers agree they only need a reserve to deposit ratio of 10%• R = r D = 0.1 D• Required reserves = 100,000 guilders, 10% of deposits
• Lend the excess reserves of 900,000 guilders
The Process of Deposit CreationThe Process of Deposit Creation
Consolidated Balance Sheet of Venetian Commercial BanksConsolidated Balance Sheet of Venetian Commercial BanksAfter One Round of LoansAfter One Round of Loans
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
2727
AssetsCurrency (= reserves)
1,000,000 guilders
Loans to farmers
900,000 guilders
LiabilitiesDeposits 1,900,000 guilders
Loan proceeds are redeposited• Reserves = 100,000 + 900,000 = 1,000,000 guilders• Deposits = 1,900,000 guilders• Money supply = Deposits = 1,900,000 guilders• Excess reserves = Reserves – 0.1 * Deposits• Excess reserves = 1,000,000 – 0.1 * 1,900,000• Excess reserves = 1,000,000 – 190,000 = 810,000
• Banks can lend the excess 810,000 guilders
The Process of Deposit CreationThe Process of Deposit CreationConsolidated Balance Sheet of Venetian Commercial Banks Consolidated Balance Sheet of Venetian Commercial Banks
After One Round of LoansAfter One Round of Loans
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
2828
AssetsCurrency (= reserves)
190,000 guilders
Loans to farmers
900,000 guilders
Loans to merchants
810,000 guilders
LiabilitiesDeposits 1,900,000 guilders
Lend excess reserves• Reserves = 190,000 guilders• Deposits = 1,900,000 guilders• Money supply = Deposits = 190,000 guilders• Loans = 900,000 + 810,000 = 1,710,000
The Process of Deposit CreationThe Process of Deposit Creation
Consolidated Balance Sheet of Venetian Commercial BanksConsolidated Balance Sheet of Venetian Commercial BanksAfter Two Rounds of Loans and RedepositsAfter Two Rounds of Loans and Redeposits
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
2929
AssetsCurrency (= reserves)
1,000,000 guilders
Loans to farmers
900,000 guilders
Loans to merchants
810,000 guilders
LiabilitiesDeposits 2,710,000 guilders
Loan proceeds are redeposited• Reserves = 190,000 + 810,000 = 1,000,000 guilders• Deposits = 1,900,000 + 810,000 = 2,710,000 guilders• Money supply = Deposits = 2,710,000 guilders• Excess reserves = Reserves – 0.1 * Deposits• Excess reserves = 1,000,000 – 271,000 = 729,000• Excess reserves = 729,000 guilders
The Process of Deposit CreationThe Process of Deposit Creation
Consolidated Balance Sheet of Venetian Commercial BanksConsolidated Balance Sheet of Venetian Commercial BanksAfter Two Rounds of Loans and RedepositsAfter Two Rounds of Loans and Redeposits
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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The Process of Deposit CreationThe Process of Deposit CreationDeposits Reserves Loans
1,000,000 100,000 900,000
900,000 90,000 810,000
810,000 81,000 729,000
729,000 72,900 656,100
656,100 65,610 590,490
590,490 59,049 531,441
531,441 53,144 478,297
478,296 47,830 430,467
10,000,000 1,000,000 9,000,000… … …
Notice Reserves = 10% of D
Also Reserves = original injection of Reserves by Central Bank =
1 millionD=10*R
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The Process of Deposit CreationThe Process of Deposit CreationDeposits Reserves Loans
1,000 100 900
900 900 810
810 81 729
729 72.9 656.1
656 65.61 590.49
590.49 59.05 531.44
531.44 53.14 478.30
478.30 47.83 430.47
10,000 1,000 9,000… … …
Notice Reserves = 10% of D
Also Reserves = original injection of Reserves by Central Bank =
1000D=10*R
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
3232
AssetsCurrency (= reserves)
1,000,000 guilders
Loans to farmers
9,000,000 guilders
LiabilitiesDeposits 10,000,000 guilders
Observations• Lending will continue to keep the reserve to deposit ratio = 10%• When loans = 9,000,000 guilders
•Deposits = 10,000,000 guilders•Reserves = 1,000,000 guilders•Reserve to deposit ratio = 10%•No excess reserves
• The money supply = 10,000,000 guilders
The Process of Deposit CreationThe Process of Deposit CreationFinal Consolidated Balance Sheet of Venetian Commercial BanksFinal Consolidated Balance Sheet of Venetian Commercial Banks
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
3333
The use of a fractional-reserve banking system The use of a fractional-reserve banking system allows the money supply to grow as a multiple of allows the money supply to grow as a multiple of the reserves.the reserves.
In Venice, with a 10% reserve-deposit ratio,In Venice, with a 10% reserve-deposit ratio,1 guilder in reserve can support 10 guilders in 1 guilder in reserve can support 10 guilders in deposit.deposit.– The CB creates currency, which is kept by banks as The CB creates currency, which is kept by banks as
reserves. As long as banks have reserves, they can reserves. As long as banks have reserves, they can make loans, which are redeposited and become money.make loans, which are redeposited and become money.
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
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SummarySummary– R = r DR = r D– Bank reserves/bank deposits = desired reserve-Bank reserves/bank deposits = desired reserve-
deposit ratiodeposit ratio– R / D = rR / D = r– Bank deposits = bank reserves/desired reserve-Bank deposits = bank reserves/desired reserve-
deposit ratiodeposit ratio– D = R / rD = R / r
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
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3535
The Central Bank can control the amount of The Central Bank can control the amount of money in an economy bymoney in an economy by– Printing more (or fewer) dollar bills.Printing more (or fewer) dollar bills.
It gives them out by exchanging them for government It gives them out by exchanging them for government bonds or by lending them to banks.bonds or by lending them to banks.
– Changing the reserve requirement ( Changing the reserve requirement ( rr ). ).
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
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Exercise 23.2Exercise 23.2
Suppose banks’ desired reserve/deposit ratio is Suppose banks’ desired reserve/deposit ratio is 10%, and the CB prints 1m guilders.10%, and the CB prints 1m guilders.
How does the money supply change?How does the money supply change?• Since we are still assuming people don’t hold currency, Since we are still assuming people don’t hold currency,
the 1m guilders the 1m guilders mustmust be held as reserves by the be held as reserves by the banking system.banking system.
• Without currency, money supply = deposits.Without currency, money supply = deposits.• Deposits = (1/r)*ReservesDeposits = (1/r)*Reserves• Deposits = (1/r)*Deposits = (1/r)*ReservesReserves• 10m = 10*1m = (1/0.10)*1m10m = 10*1m = (1/0.10)*1m
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
3737
Exercise 23.2Exercise 23.2
Suppose banks’ desired reserve/deposit Suppose banks’ desired reserve/deposit ratio is 10%, and the CB prints 2m guilders.ratio is 10%, and the CB prints 2m guilders.
How does the money supply change?How does the money supply change?• Without currency, money supply = deposits.Without currency, money supply = deposits.• Deposits = (1/r)*ReservesDeposits = (1/r)*Reserves• Deposits = (1/r)*Deposits = (1/r)*ReservesReserves• 20m = 10*2m = (1/0.10)*2m20m = 10*2m = (1/0.10)*2m
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Exercise 23.2Exercise 23.2
Suppose banks’ desired reserve/deposit Suppose banks’ desired reserve/deposit ratio is 5%, and the CB prints 1m guilders.ratio is 5%, and the CB prints 1m guilders.
How does the money supply change?How does the money supply change?• Deposits = (1/r)*ReservesDeposits = (1/r)*Reserves• Deposits = (1/r)*Deposits = (1/r)*ReservesReserves• 20m = 20*1m = (1/0.05)*1m20m = 20*1m = (1/0.05)*1m
Money Supply with Both Money Supply with Both Currency and DepositsCurrency and Deposits
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Money Supply = Currency + DepositsMoney Supply = Currency + Deposits
Money Supply = Currency + R / rMoney Supply = Currency + R / r
Currency + Reserves = Central Bank MoneyCurrency + Reserves = Central Bank Money
– If the Central Bank prints $1000, If the Central Bank prints $1000, all of it must be all of it must be heldheld either in Currency or in Reserves. either in Currency or in Reserves.
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
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The Money Supply with Both Currency and The Money Supply with Both Currency and DepositsDeposits– Suppose residents choose to hold 500,000 Suppose residents choose to hold 500,000
guilders as currencyguilders as currency– If the CB issues 1 million guilders, people If the CB issues 1 million guilders, people
deposit 500,000 in the banksdeposit 500,000 in the banks– Reserve-deposit ratio = 10%Reserve-deposit ratio = 10%– Bank deposits = 500,000/0.10 = 5,000,000Bank deposits = 500,000/0.10 = 5,000,000
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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The Money Supply with Both Currency and The Money Supply with Both Currency and DepositsDeposits– Money supply = currency + bank deposits Money supply = currency + bank deposits
5,500,000 = 500,000 + 5,000,000 5,500,000 = 500,000 + 5,000,000 But before we found that currency = 0,But before we found that currency = 0,
10,000,000 = 0 + 10,000,00010,000,000 = 0 + 10,000,000
– The money supply is reduced by 4,500,000 The money supply is reduced by 4,500,000 guilders when the residents hold 500,000 guilders when the residents hold 500,000 guilders in currencyguilders in currency
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
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The Money Supply at ChristmasThe Money Supply at Christmas– Currency = 500Currency = 500– Bank reserves = 500Bank reserves = 500– Reserve-deposit ratio = 0.20Reserve-deposit ratio = 0.20– Money supplyMoney supply
= 500 + 500/.20= 500 + 500/.20= 500 + 2,500= 500 + 2,500= 3,000= 3,000
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
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The Money Supply at ChristmasThe Money Supply at Christmas– If Xmas shoppers withdraw 100If Xmas shoppers withdraw 100– Money supplyMoney supply
= (500+100) + (500 – 100)/0.20= (500+100) + (500 – 100)/0.20= 600 + 400/0.20= 600 + 400/0.20= 600 + 2,000= 600 + 2,000= 2,600= 2,600
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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The Money Supply at ChristmasThe Money Supply at Christmas– ObservationObservation
When the reserve-deposit ratio = 0.20, every $1 When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money supply reduction in reserves may reduce the money supply by $5.by $5.
In general, when people make withdrawals, the In general, when people make withdrawals, the money supply contracts by a multiple of the money supply contracts by a multiple of the withdrawal.withdrawal.
Fall in Money SupplyFall in Money Supply= (1/r) x Withdrawal – increase in cash held by public= (1/r) x Withdrawal – increase in cash held by public
Commercial Banks and the Creation Commercial Banks and the Creation of Moneyof Money
Central BanksCentral Banks
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Central BanksCentral Banks
Two Main ResponsibilitiesTwo Main Responsibilities– Monetary policyMonetary policy– Oversight and regulation of financial marketsOversight and regulation of financial markets
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
4848
Central BanksCentral Banks
Their primary mission is to promote low Their primary mission is to promote low inflation, economic growth, and stable inflation, economic growth, and stable financial markets.financial markets.
The Bank of England was founded in 1694.The Bank of England was founded in 1694. The US Federal Reserve System, 1913.The US Federal Reserve System, 1913. Many Latin American countries founded Many Latin American countries founded
central banks in the 1920s.central banks in the 1920s.
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Central BanksCentral Banks
Controlling the Money Supply: Open-Market Controlling the Money Supply: Open-Market OperationsOperations– The primary function of Central Banks is The primary function of Central Banks is
monetary policy.monetary policy.– CBs control the money supply by changing the CBs control the money supply by changing the
supply of bank reserves.supply of bank reserves.
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Central BanksCentral Banks
Controlling the Money Supply: Open-Market Controlling the Money Supply: Open-Market Operations (OMOs)Operations (OMOs)– Open-market operations are the most important Open-market operations are the most important
method of changing the supply of bank method of changing the supply of bank reserves.reserves.
The “Market” in OMOs is the Market for The “Market” in OMOs is the Market for Government or Central Bank Bonds.Government or Central Bank Bonds.– The CB exchanges bonds for currency.The CB exchanges bonds for currency.
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
5353
BondBond– A legal promise to repay a debt, usually A legal promise to repay a debt, usually
including both the principal amount and regular including both the principal amount and regular interest payments.interest payments.
Central BanksCentral Banks
Source: www.rainfall.com/ posters/WWI/catalog11.htm
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Open Market OperationsOpen Market Operations
Increasing The Money SupplyIncreasing The Money Supply– The Fed purchases US government bonds from The Fed purchases US government bonds from
the public.the public.– The people deposit the funds they get from their The people deposit the funds they get from their
sale of bonds to the Fed.sale of bonds to the Fed.– The increase in deposits increase bank The increase in deposits increase bank
reserves.reserves.
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Open Market OperationsOpen Market Operations
Increasing The Money SupplyIncreasing The Money Supply– The increase in reserves will lead to an The increase in reserves will lead to an
expansion of the money supply as banks make expansion of the money supply as banks make more loans.more loans.
– RecallRecall The change in the money supply is a multiple of the The change in the money supply is a multiple of the
change in reserves.change in reserves.
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Open Market OperationsOpen Market Operations
Reducing The Money SupplyReducing The Money Supply– The CB sells government bonds to the public.The CB sells government bonds to the public.– The CB presents the checks from the sale of The CB presents the checks from the sale of
the bonds to the banks for payment.the bonds to the banks for payment.– The bank’s reserves will fall when they clear the The bank’s reserves will fall when they clear the
checks.checks.– The money supply will fall by a multiple of the The money supply will fall by a multiple of the
decrease in reserves.decrease in reserves.
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
5757
Open Market PurchaseOpen Market Purchase
Open-Market PurchaseOpen-Market Purchase– The purchase of government bonds from the The purchase of government bonds from the
public by the CB for the purpose of increasing public by the CB for the purpose of increasing the supply of bank reserves and the money the supply of bank reserves and the money supply.supply.
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5858
Open Market PurchaseOpen Market Purchase
Fed pays for BOND purchase with a check, which is depositedin a commercial bank
New money becomes a part of the bank’s reserves
Reserves are the basis for additional lending
Additional lending increases the money supply
D → L → D → L → D → L → …
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
5959
Open Market SaleOpen Market Sale
Open-Market SaleOpen-Market Sale– The sale by the CB of government bonds to the The sale by the CB of government bonds to the
public for the purpose of reducing bank public for the purpose of reducing bank reserves and the money supplyreserves and the money supply
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Open Market SaleOpen Market SaleFed receive a check (drawn on a commercial bank deposit) in exchange for the Bond.
Open market sale reduces the supply of bank reserves
Fewer reserves are available to back new loans
Reduction in lending means that fewer dollars will be created.
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
6161
Open Market OperationsOpen Market Operations
Suppose the CB wants to increase the Suppose the CB wants to increase the money supply using open-market operations.money supply using open-market operations.
Currency = 1,000 shekels; Reserves = 200Currency = 1,000 shekels; Reserves = 200 Reserve-deposit ratio = 0.2Reserve-deposit ratio = 0.2 Money supply = 1,000 + 200/0.2 = 2,000 shekelsMoney supply = 1,000 + 200/0.2 = 2,000 shekels
What should the CB do?What should the CB do?
Chapter 23: Money, Prices, and thChapter 23: Money, Prices, and the Federal Reservee Federal Reserve
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Open Market OperationsOpen Market Operations
An Open Market Purchase increases An Open Market Purchase increases Reserves and the Money SupplyReserves and the Money Supply
Open market purchase = 100Open market purchase = 100 Reserves increase to 300Reserves increase to 300 Money supply = 1,000 + 300/0.2 = 2,500 shekelsMoney supply = 1,000 + 300/0.2 = 2,500 shekels
Money and PricesMoney and Prices
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Money and PricesMoney and Prices
““Inflation is always and everywhere a Inflation is always and everywhere a monetary phenomenon”monetary phenomenon”
-- Milton Friedman-- Milton Friedman
This is true in the This is true in the long runlong run and if inflation and if inflation is is very highvery high..
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Money and PricesMoney and Prices
Price of 1 radio = 4 oranges
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Money and PricesMoney and Prices
Price of 1 radio = 6 oranges
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Money and PricesMoney and Prices
Price of 1 radio = 3 oranges
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Money and PricesMoney and Prices Assume an economy where dollar bills are Assume an economy where dollar bills are
used only once a year (“velocity” = 1); and used only once a year (“velocity” = 1); and where annual real GDP = 10 million houses.where annual real GDP = 10 million houses.
Suppose MSuppose Mss=$10bn. What will P be?=$10bn. What will P be?
MV = PYMV = PY $10bn x 1 = P x 10 million houses$10bn x 1 = P x 10 million houses P = $1 thousand / houseP = $1 thousand / house
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Money and PricesMoney and Prices Now suppose MNow suppose Mss=$20bn. What will P be?=$20bn. What will P be? MV = PYMV = PY $20bn x 1 = P x 10 million houses$20bn x 1 = P x 10 million houses P = $2 thousand / houseP = $2 thousand / house If M doubles, P doubles. M/P doesn’t If M doubles, P doubles. M/P doesn’t
change.change. Why doesn’t this happen in the short Why doesn’t this happen in the short
run?run? Because M affects P through the goods, money, and labor Because M affects P through the goods, money, and labor
market, market, over timeover time..
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Money and PricesMoney and Prices
VelocityVelocity– The speed at which money circulates.The speed at which money circulates.
The number of times a dollar bill is used in one year.The number of times a dollar bill is used in one year.
kMoney stoc
GDP Nominal
kMoney stoc
nstransactio of Value Velocity
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Money and PricesMoney and Prices
VelocityVelocity– The speed at which money circulatesThe speed at which money circulates
The number of times a dollar bill is used in one year.The number of times a dollar bill is used in one year.
M
x YP
supply)(money M
GDP) (real x Y level) (price P (V)Velocity
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Money and PricesMoney and Prices
Money and Inflation in the Long RunMoney and Inflation in the Long Run
– Quantity equationQuantity equation
M x V = P x YM x V = P x Y
It’s a definition, so it’s always true.
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Money and PricesMoney and Prices
Money and Inflation in the Long RunMoney and Inflation in the Long Run– Assume Assume V & YV & Y are constant over the time period are constant over the time period
Y x P V x M
PYMV
This is a definition, so it’s always true.
This is a theory, so it may or may not be true.
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Money and PricesMoney and Prices
Money and Inflation in the Long RunMoney and Inflation in the Long Run– Why should we assume Why should we assume V & YV & Y are constant? are constant?– Y is determined by human capital, technology, etc.. Y is determined by human capital, technology, etc..
This theory says economic growth is This theory says economic growth is unrelated to the unrelated to the quantity of moneyquantity of money..
– V is determined by institutions, etc.. V is determined by institutions, etc.. This theoryThis theory says says that the that the needneed for transactions (which use money) is also for transactions (which use money) is also unrelated to the quantity of moneyunrelated to the quantity of money..
– So if we change M, we assume V or Y won’t change. So if we change M, we assume V or Y won’t change. Then assume they are constant.Then assume they are constant.
Y x P V x M
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Money and Inflation in the Long RunMoney and Inflation in the Long Run– If the Fed increases If the Fed increases MM by 10%, then prices by 10%, then prices
must increase by 10%.must increase by 10%.– High rates of money growth are associated with High rates of money growth are associated with
high rates of inflation.high rates of inflation.– Too much money is chasing too few goods.Too much money is chasing too few goods.
Y x P V x M
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Inflation and Money Growth in Latin Inflation and Money Growth in Latin America, 1995-2001America, 1995-2001
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If high rates of money growth lead to If high rates of money growth lead to inflation, why do countries allow their money inflation, why do countries allow their money supplies to rise so quickly?supplies to rise so quickly?– In the case of Ecuador, In the case of Ecuador, because of the need for because of the need for
a lender of last resorta lender of last resort!!– The Central Bank had to print billions of sucres The Central Bank had to print billions of sucres
to try to save the banks from failing … which to try to save the banks from failing … which caused the economy, and the banks, to caused the economy, and the banks, to collapse.collapse.