12S_Topic 5_Money
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12S_Topic 5_Money

Course Number: ECON 452, Spring 2013

College/University: Salisbury

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Topic 5 The Monetary System Chapters 16 & 17 Learning objective Consider the nature of money and its functions in the economy Learn about the Federal Reserve System Examine how the banking system helps determine the supply of money Examine the tools used by the Federal Reserve to alter the supply of money Introduce the quantity theory of money The Meaning of Money Money is the set of assets in the...

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5 Topic The Monetary System Chapters 16 & 17 Learning objective Consider the nature of money and its functions in the economy Learn about the Federal Reserve System Examine how the banking system helps determine the supply of money Examine the tools used by the Federal Reserve to alter the supply of money Introduce the quantity theory of money The Meaning of Money Money is the set of assets in the economy that people regularly use to buy goods and services from other people. Three Functions of Money Money has three functions in the economy: x Medium of exchange x Unit of account x Store of value Medium of Exchange A medium of exchange is anything that is readily acceptable as payment. 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. Liquidity Liquidity is the ease with which an asset can be converted into the economy's medium of exchange. The Kinds of Money Commodity x money takes the form of a commodity with intrinsic value. Examples: Gold, silver, cigarettes. Fiat x money is used as money because of government decree. It does not have intrinsic value. x Examples: Coins, currency, check deposits. Money in the U.S. Economy Currency is the paper bills and coins in the hands of the public. Demand deposits are balances in bank accounts that depositors can access on demand by writing a check. Figure 1 Money in the U.S. Economy Billions of Dollars $5,455 M2 Savings deposits Small time deposits Money market mutual funds A few minor categories ($4,276 billion) M1 Demand deposits Traveler's checks Other checkable deposits ($599 billion) Currency ($580 billion) Everything in M1 ($1,179 billion) $1,179 0 Copyright2003 Southwestern/Thomson Learning The Federal Reserve The x Federal Reserve (Fed) serves as the nation's central bank. It is designed to oversee the banking system. x It regulates the quantity of money in the economy. The Federal Reserve The Fed was created in 1914 after a series of bank failures convinced Congress that the U.S. needed a central bank to ensure the health of the nation's banking system. The Federal Reserve System The x Structure of the Federal Reserve System: The primary elements in the Federal Reserve System are: 1) The Board of Governors 2) The Regional Federal Reserve Banks 3) The Federal Open Market Committee The Fed's Organization The Fed is run by a Board of Governors, which has seven members appointed by the President and confirmed by the Senate. Among the seven members, the most important is the chairman. The chairman directs the Fed staff, presides over board meetings, and testifies about Fed policy in front of Congressional Committees. The Fed's Organization The x Board of Governors Seven members x Appointed by the President x Confirmed by the Senate x Serve staggered 14-year terms so that one comes vacant every two years. x President appoints a member as chairman to serve a four-year term. The Fed's Organization The Federal Reserve Banks x 12 District banks x Nine directors x Three appointed by the Board of Governors. x Six are elected by the commercial banks in the district. x The directors appoint the district president which is approved by the Board of Governors. The Federal Reserve System The Federal Reserve System The Federal Reserve Banks xThe New York Fed implements some of the Fed's most important policy decisions. The Fed's Organization The Federal Open Market Committee (FOMC) x Serves as the main monetary policymaking organ of the Federal Reserve System. x Meets approximately every six weeks to review the economy. The Fed's Organization The Federal Open Market Committee (FOMC) is made up of the following voting members: x The chairman and the other six members of the Board of Governors. x The president of the Federal Reserve Bank of New York. x The presidents of the other regional Federal Reserve banks (four vote on a yearly rotating basis). 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. 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. x The Fed purchases and sells U.S. government bonds. Open-Market Operations 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. Three concepts of reserves Required reserves are the minimum amount of reserves that meets the standard set by the Fed. Excess reserves are the amount of reserves that exceeds the required reserves for a given amount of deposits. Actual reserves =Required reserves+Excess reserves Money Creation When a bank makes a loan from its reserves, the money supply increases. Money Creation 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. x The fraction of total deposits that a bank has to keep as reserves is called the required reserve ratio. x Loans become an asset to the bank. x Money Creation xThis T-Account shows a bank that... ...accepts deposits, ...keeps a portion as reserves, ...and lends out the rest. xIt assumes a required reserve ratio of 10%. First National Bank Assets Reserves $10.00 Loans $90.00 Total Assets $100.00 Total Liabilities $100.00 Liabilities Deposits $100.00 Money Creation When one bank loans money, that money is generally deposited into another bank. This creates more deposits and more reserves to be lent out. ... In this process, the money supply increases. Money Creation First National Bank Assets Reserves $10.00 Loans $90.00 Total Assets Total Liabilities $100.00 $100.00 Second National Bank Assets Reserves $9.00 Loans $81.00 Total Assets $90.00 Total Liabilities $90.00 Liabilities Deposits $100.00 Liabilities Deposits $90.00 Money Supply = $190.00! The Money Multiplier How much money is eventually created in this economy? ? The Money Multiplier The money multiplier is the amount of money the banking system generates with each dollar of reserves. The Money Multiplier How much money is eventually created in this economy? Original deposit First National lending Second National lending Third National lending Total money supply =$ =$ =$ =$ 100.00 90.00 [=0.9 x $100.00] 81.00 [=0.9 x $90.00] 72.90 [=0.9 x $81.00] $1,000 = The Money Multiplier The money multiplier (m) is the reciprocal of the reserve ratio (R): m= 1/R the earlier example, R = 10% or 1/10, so, the multiplier is 10. xIn Financial Crisis of 20082009 Bank capital Resources a bank's owners have put into the institution Used to generate profit 37 Financial Crisis of 20082009 Leverage Use of borrowed money to supplement existing funds for purposes of investment Leverage ratio Ratio of assets to bank capital Capital requirement Government regulation specifying a minimum amount of bank capital 38 Financial Crisis of 20082009 If bank's assets rise in value by 5% Because some of the securities the bank was holding rose in price $1,000 of assets would now be worth $1,050 Bank capital rises from $50 to $100 So, for a leverage rate of 20 A 5% increase in the value of assets increases the owners' equity by 100% 39 Financial Crisis of 20082009 If bank's assets reduced in value by 5% Because some people who borrowed from the bank default on their loans $1,000 of assets would be worth $950 Value of the owners' equity falls to zero So, for a leverage ratio of 20 A 5% fall in the value of the bank assets leads to a 100% fall in bank capital 40 Financial Crisis of 20082009 Banks in 2008 and 2009 Shortage of capital After they had incurred losses on some of their assets Mortgage loans Securities backed by mortgage loans Reduce lending (credit crunch) Contributed to a severe downturn in economic activity 41 Financial Crisis of 20082009 U.S. Treasury and the Fed Put many billions of dollars of public funds into the banking system To increase the amount of bank capital It temporarily made the U.S. taxpayer a part owner of many banks Goal: to recapitalize the banking system Bank lending could return to a more normal level Occurred by late 2009 42 Fed's Tools of Monetary Control The Fed has four tools in its monetary toolbox: Open-market Changing operations Fed lending to banks discount rate Term Auction Facility Changing the reserve requirement Paying interest on reserves Open-Market Operations The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public: When the Fed buys government bonds, the money supply increases. x The money supply decreases when the Fed sells government bonds. x Changing the Discount Rate The x discount rate is the interest rate the Fed charges banks for loans. Increasing the discount rate decreases the money supply. x Decreasing the discount rate increases the money supply. Term Auction Facility Term Auction Facility The Fed sets a quantity of funds it wants to lend to banks Eligible banks bid to borrow those funds Loans go to the highest eligible bidders Acceptable collateral Pay the highest interest rate 46 Changing the Required Reserve Ratio The reserve requirement is the amount (%) of a bank's total reserves that may not be loaned out. Increasing the reserve requirement decreases the money supply. x Decreasing the reserve requirement increases the money supply. x Paying Interest on Reserves Paying interest on reserves Since October 2008 The higher the interest rate on reserves The more reserves banks will to choose hold An increase in the interest rate on reserves Increase the reserve ratio Lower the money multiplier Lower the money supply 48 Five Tools of Monetary Policy Open market operations Buy bonds to increase money supply Sell bonds to reduce money supply Change in the required reserve ratio Lower the ratio to increase money supply Raise the ratio to reduce money supply Change in the discount rate Decrease the rate to increase money supply Increase the rate to reduce money supply Term Auction Facility Raise the auctioned quantity of loans Lower the auctioned quantity of loans Paying interest on reserves Lower the interest rate on reserves Raise the interest rate on reserves Problems in Controlling the Money Supply The Fed's control of the money supply is not precise. The Fed must wrestle with two problems that arise due to fractional-reserve banking. The Fed does not control the amount of money that households choose to hold as deposits in banks. x The Fed does not control the amount of money that bankers choose to lend. x The Federal Funds Rate The federal funds rate Interest rate at which banks make overnight loans to one another Lender has excess reserves Borrower needs reserves A change in federal funds rate Changes other interest rates 51 The Federal Funds Rate Fed: target the federal funds rate Open-market operations The Fed buys Decrease in the federal funds rate Increase in money supply The Fed sells Increase in the federal funds rate Decrease in money supply 52 Exercise: Deposit vs. Currency You take $100 you had kept under your pillow and deposit it in your bank account. If this $100 stays in the banking system as reserves and if banks hold reserves equal to 10 percent of deposits, by how much does the total amount of deposits in the banking system increase? By how much does the money supply increase? Exercise: More on Deposit and Currency The economy of Elmendyn contains 2,000 $1 bills. If people hold all money as currency, what is the quantity of money? If people hold all money as demand deposits and banks maintain 100 percent reserves, what is the quantity of money? If people hold equal amounts of currency and demand deposits and banks maintain 100 percent reserves, what is the quantity of money? If people hold all money as demand deposits and banks maintain a reserve ratio of 10 percent, what is the quantity of money? If people hold equal amounts of currency and demand deposits and banks maintain a reserve ratio of 10 percent, what is the quantity of money? Exercise: Factors that Determine Money Supply The Federal Reserve conducts a $10 million open-market purchase of government bonds. Suppose that the required reserve ratio is 10 percent. What is the largest possible increase in the money supply that could result? What is the smallest possible increase? Explain. Exercise: Money Multiplier and Money Supply Suppose that the T-account for First National Bank shows reserves of $100,000, loans of 400,000, and deposits of 500,000. If the Fed requires banks to hold 5 percent of deposits as reserves, how much in excess reserves does First National now hold? Assume that all other banks hold only the required amount of reserves. If First National decides to reduce its reserves to only the required amount, by how much would the economy's money supply increase. Exercise: Leverage and Capital Happy Bank starts with $200 in bank capital. It then takes in $800 in deposits. It keeps 12.5 percent (1/8th) of deposits in reserve. It uses the rest of its assets to make bank loans. Show the balance sheet of Happy Bank. What is Happy Bank's leverage ratio? Suppose that some borrowers from Happy Bank default and 10 percent of loans become worthless. Show the bank's new balance sheet. By what percentage do the bank's total assets decline? By what percentage does the bank's capital decline? Which change is larger? Why? Inflation Inflation is a percentage increase in the overall level of prices. Inflation: Historical Aspects Over the past sixty years, prices have risen on average about 5 percent per year. Deflation, meaning decreasing average prices, occurred in the U.S. in the nineteenth century. Hyperinflation refers to high rates of inflation such as Germany experienced in the 1920s. U.S. Inflation in the 2000s The Classical Theory of Inflation 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. Value of goods vs. value of money Example 1: If P=$2 per ice-cream cone, then, 1/P=1/2 ice-cream cone per dollar. Example 2: If P is the relative price change of a market basket from 1982-84 to 1998, 164.2, then, 1/P =(1/164.2)100=0.61, suggesting that the value of a dollar in 1998 is worth only 61% of a dollar in 1982-84. Money Supply, Money Demand, and Monetary Equilibrium The x money supply is a policy variable that is controlled by the Fed. Through instruments such as open-market operations, the Fed directly controls the quantity of money supplied. Money Supply, Money Demand, and Monetary Equilibrium 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 x 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. Money Supply, Money Demand, and Monetary Equilibrium In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply. Money Supply, Money Demand, and the Equilibrium Price Level Value of Money (1/P) (High) 1 3/4 Equilibrium value of money 1/2 1/4 Quantity fixed by the Fed A Money supply Price Level (P) 1 (Low) 1.33 Equilibriu m price level 2 4 (Low) 0 Money demand Quantity of Money (High) The Effects of Monetary Injection Value of Money (1/P) (High) 1 2. ...decreases the value of money ... 3/4 1/2 1/4 M1 A B Money demand M2 Quantity of Money MS1 MS2 1. An increase in the money supply... Price Level (P) 1 (Low) 1.33 2 4 3. ...and increases the price level (Low) 0 (High) 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. x The primary cause of inflation is the growth in the quantity of money. x 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. x 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 Classical Dichotomy and Monetary Neutrality 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 V = (P x Y)/M Where: V = velocity P = the price level Y = the quantity of output M = the quantity of money Velocity and the Quantity Equation Rewriting the equation gives the quantity equation: M x V = P x Y Velocity and the Quantity Equation The quantity equation relates the quantity of money (M) to the nominal value of output (P x Y). M1 Velocity vs. M2 Velocity 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, x the quantity of output must rise, or x the velocity of money must fall. x Nominal GDP, the Quantity of Money, and the Velocity of Money 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a passwordprotected website for classroom use. 80 Episodes of Hyperinflations (a) Austria Index (Jan. 1921 = 100) 100,000 10,000 1,000 100 Price level Money supply Index (July 1921 = 100) 100,000 (b) Hungary Price level 10,000 1,000 100 Money supply 1921 1922 1923 1924 1925 1921 1922 1923 1924 1925 Copyright 2004 South-Western The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money The velocity of money is relatively stable over time. When the Fed changes the quantity of money, it causes proportionate changes in the nominal value of output (P x Y). Because money is neutral, money does not affect output. The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money When the Fed alters the money supply and induces parallel changes in the nominal value of output, these changes are also reflected in changes in the price level. When the Fed increases the money supply rapidly, the result is a high rate of inflation. Exercise: Quantity Equation of Money Suppose that this year's money supply is $500 billion, nominal GDP is $10 trillion, and real GDP is $5 trillion. What is the price level? What is the velocity of money? Suppose that velocity is constant and the economy's output of goods and services rises by 5 percent each year. What will happen to nominal GDP and the price level next year if the Fed keeps the money supply constant. What money supply should the Fed set next year if it wants to keep the price level stable? What money supply should the Fed set next year if it wants inflation of 10 percent? Exercise: Money Market Stability Suppose that changes in the bank regulations expand the availability of credit cards so that people need to hold less cash. How does this event affect the demand for money? If the Fed does not respond to this event, what will happen to the price level? If the Fed wants to keep the price level stable, what should it do?
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