on (Not second Midterm) Ch. 9 Money, the Price Level and Inflation
I. What is Money? Examples of items used as money: seashells, cigarettes, gold, salt A. Definition: Money is any commodity that is generally accepted as a means of payment.
In economic terminology, money is not income or wealth as in everyday usage. R.A. Radford The Economic Organization of a POW camp
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B. 3 functions of money
Medium of Exchange
A medium of exchange is an object that is generally accepted in exchange for goods and services. In the absence of money, people would need to exchange goods and services directly, which is called barter. Barter requires a double coincidence of wants, which is rare, so barter is costly. Money allows for greater specialization Unit of Account A unit of account is an agreed measure for stating the prices of goods and services. Prices in US are quoted in $. In Israel during the high inflation, they quoted their prices in dollars
Store of Value As a store of value, money can be held for a time and later exchanged for goods and services. Disadvntg doesn't pay inerest, inflation and decrease in value of money, risk of being stollen Adv anonymous and difficult to trace
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C. Measuring Money
There is no clear distinction a continuum of ease of converting for use in exchange. The two main official measures of money in the United States are M1 and M2. Liquidity M1 consists of currency and traveler's checks and checking deposits owned by individuals and businesses. Doesn't count currency held in banks or the gov't M2 consists of M1 plus time, saving deposits, money market mutual funds, and other deposits.
As of Dec. 2007:
Currency + traveler's checks:$770 billion Checkable deposits:$613 billion
M1 - $1384 M2 - $7485.3
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II. Depository Institutions A. A depository institution is a firm that takes deposits from households and firms and makes loans to other households and firms. Financial intermidiary B. The institutions in the banking system divide into Commercial banks Thrift institutions Money market mutual funds
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1. Commercial Banks A commercial bank is a private firm that receives deposits and makes loans.
Trade-off between profit and prudence - Loans generate profit, but depositors must be able to obtain their funds when they want them.
To achieve security for its depositors, a bank divides its funds into two parts: reserves and loans.
A bank's reserves are the cash in its vault and its deposit at the Federal Reserve.
A bank keeps only a small percentage of deposits as reserves and lends the rest.
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2. Thrift Institutions Saving and loan associations Saving banks Credit unions A savings and loan association (S&L) is a depository institution that accepts checking and savings deposits and that make personal, commercial, and home-purchase loans. A savings bank is a depository institution owned by its depositors that accepts savings deposits and makes mainly mortgage loans. A credit union is a depository institution owned by its depositors that accepts savings deposits and makes consumer loans 3. Money Market Mutual Fund A money market fund is a fund operated by a financial institution that sells shares in the fund and uses the proceeds to buy liquid assets such as U.S. Treasury bills.
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2. Thrift Institutions Saving and loan associations Saving banks Credit unions A savings and loan association (S&L) is a depository institution that accepts checking and savings deposits and that make personal, commercial, and home-purchase loans. A savings bank is a depository institution owned by its depositors that accepts savings deposits and makes mainly mortgage loans. A credit union is a depository institution owned by its depositors that accepts savings deposits and makes consumer loans 3. Money Market Mutual Fund A money market fund is a fund operated by a financial institution that sells shares in the fund and uses the proceeds to buy liquid assets such as U.S. Treasury bills.
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C. Economic Functions of Depository Institutions 1. Creating liquidity Borrow short and lend long
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Minimizing the cost of obtaining funds Finding someone to borrow from is difficult. Depository Institutions lower the cost of this search.
1. Minimizing the cost of monitoring borrowers Dep. Inst. Screen and monitor loans so you don't have to.
1. Pooling risk Your deposit is split over many loans. Diversification.
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III. The Federal Reserve System A. Overview The Federal Reserve System (the Fed) is the central bank of the United States. A central bank is the public authority that regulates a nation's depository institutions and control the quantity of money. The Fed's goals is to keep inflation in check, maintain full employment, moderate the business cycle, and contribute toward achieving long-term growth. In pursuit of its goals, the Fed pays close attention to the federal funds rate--the interest rate that banks charge each other on overnight loans of reserves.
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B. and
History Structure Created by the Federal Reserve Act of 1913 There are 12 regional Federal Reserve Banks
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B.
History and Structure (continued) The Board of Governors in Washington, D.C.
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B.
History and Structure (continued) The Federal Open Market Committee (FOMC)
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C. Policy Tools The Fed uses three main policy tools: Required reserve ratios
Discount rate
Open market operations
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D. The Fed's Balance Sheet
Assets Liabilities
Gold & Foreign Exchange $13 b
U.S. Gov't Securities
Federal Reserve Notes
$754
$ 21
$762 b Bank Deposits
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IV. How Banks Create Money A. Creating Deposits by Making Loans
Because checking deposits are part of M1, banks are key to the creation of money.
A key aspect is the reserve ratio: The reserve requirement is the fraction of deposits that a bank must keep on reserve (either at the Fed or as cash in the vault). The desired reserve ratio is the ratio of reserves to deposits that a bank wants to hold. This ratio exceeds the required reserve ratio by an amount that banks determine to be prudent. Let rr = desired reserve ratio A bank's excess reserves are its actual reserves minus its desired reserves. 15
Suppose I sell $1,000 of bonds to the Fed and they credit my 1st National Bank account with $1,000.
1st National Bank Assets Liabilities
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1st National Bank can make a $900 loan to someone. He spends it at the store, which then deposits it in 2nd National Bank
1st National Bank Assets Liabilities
2nd National Bank Assets Liabilities
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But now 2nd National Bank can lend its excess reserves. It will lend $810 which someone will then spend and deposit in another bank. With rr = 10%, an extra $1 added to bank reserves turns into:
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B.
The Money Multiplier
The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base.
The money multiplier depends on (1) the desired reserve ratio (rr) and (2) the desired currency to deposit ratio (c)
Monetary Base = MB = Currency + Reserves M = Deposits + Currency
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B.
The Money Multiplier (continued)
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B.
The Money Multiplier (continued)
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V. A.
The Market for Money The Influences on Money Holding
The quantity of money that people plan to hold depends on four main factors:
The price level The nominal interest rate Real GDP
Financial innovation
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1.
The Price Level A rise in the price level increases the quantity of nominal money but doesn't change the quantity of real money that people plan to hold.
Nominal money is the amount of money measured in dollars. M
Real money equals nominal money
price level. M/P
The quantity of nominal money demanded is proportional to the price level--a 10 percent rise in the price level increases the quantity of nominal money demanded by 10 percent.
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1.
The Price Level A rise in the price level increases the quantity of nominal money but doesn't change the quantity of real money that people plan to hold.
Nominal money is the amount of money measured in dollars. M
Real money equals nominal money
price level. M/P
The quantity of nominal money demanded is proportional to the price level--a 10 percent rise in the price level increases the quantity of nominal money demanded by 10 percent. Nominal Interest Rate The nominal interest rate is the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset. A rise in the nominal interest rate on other assets decreases the quantity of real money that people plan to hold.
2.
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3.
Real GDP
An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold.
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Financial Innovation Financial innovation that lowers the cost of switching between money and interest-bearing assets decreases the quantity of real money that people plan to hold.
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B. The Demand for Money The demand for money is the relationship between the quantity of real money demanded and the nominal interest rates
Nominal interest rate i
Real money M/P
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Shifts in the demand for money
Nominal interest rate i
Real money M/P
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C. Money Market Equilibrium Money market equilibrium occurs when the quantity of money demanded equals the quantity of money supplied.
Nominal interest rate i
Real money M/P
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VI. The Quantity Theory of Money A. Concept
In the long run, the price level adjusts to make the quantity of real money demanded equal the quantity supplied.
The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.
The velocity of money is the average number of times a dollar is used annual to buy the goods and services of GDP.
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Using our relationship on growth rates, we can also see:
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Evidence from the US
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International Evidence
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Milton Friedman: Inflation is always and everywhere a monetary phenomenon.
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