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Chapter 13 Notes

Chapter 13 Notes - Chapter 3.3 Money Banks and the Federal...

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Unformatted text preview: Chapter 3.3 Money, Banks, and the Federal Reserve System What is "Money and Why Be We Need tit? a. Barter and the invention of Money 0 Money is any asset that people are generally willing to accept in exchange for goods and services or for payment of debts. 0 An asset is anything of value owned by a person or firm. a The invention of money started from barter economies, which were economies where people traded goods and services directly for other goods and services. 0 For a barter trade to take place between two people, each person must want what the other one has, known as double coincidence of wants. a A good used as money that also has value independent of its use as money is called commodity money. 0 By making exchange easier, money allows for specialization and higher productivity. ii. The Functions of hioney 0 Money should fillfill four functions: 1. Money serves as a medium of exchange when sellers are willing to accept it in exchange for _ goods or services. 2. Money serves as a unit of account when each good has a price in terms of dollars. 3 Money serves as a store of value when value is stored, such as in stock, bonds, real estate, and valuable items. Sta r4 ‘gpg—H-gr hflguh 55.3.;- s a.» 4. Money serves as a standard of deferred payment in borrowing and lending. l ' f'" I \f ’. -\ "radii-hrs} a1 “pp/MA“ What {inn Serve as Money? There are five criteria that make a good suitable to use as a medium of exchange: 1. The good must be acceptable to (that is, usable by) most traders. 2. The good should be of standardized quality so that any two units are identical. 3. The good should be durable so that value is not lost by spoilage. 4. The good should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported. Pa r11 ‘-. .82“. 7" 5. The medium of exchange should be divisible because different goods are valued differently. V1» 2 - . 11;. .. .1 . . R _. . 1 ..1 ,. .. .1 1 1 . .--. 1 1 mix» 1"» \_: 1.5.”. -. -:1 .1. w- ”.1!va .1.___,,. .::= .: ~ 1 .. ;_ t 111,1.- -. ‘- 1' -- » w - ’ 3"1-= 1-.» 2 11'1.‘ 1; L .1351, 15-5; Commodity mney (e. g., gold) meets the criteria for a medium of exchange, but its value depends on Its purity. ~—> go 51 can“ .5; C freffwtiw at” Fiat money is a paper currency that IS authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money. The central bank of the United States is called the Federal Reserve System. §.—=- tr e: ‘1 : .13 _-.~..1. #11131... -rra..xcrfiu‘1:.:.—\WHMW new is Manny Measnred in the tinned grates Today '2 131. Q hill: The Narrowest fiefinitinn oi the Money Supply Economists have developed several different definitions of the money supply. M1 is the narrowest definition of the money supply and includes: 1. All the paper money (currency) and coins that are in circulation (what is not held by banks or government). 2. The value of ail checking account balances at banks. 3. The value of traveler’s checks. , hi gifting hate :0 n J ' a /-.‘.—. h“ , 'gr‘JA- ’— f; «gay-’12: - a ,—-. ”‘1 grim; g..,L , 4, .\ @WUU i d COL}? 2: iii/Ki i 1:" .-i-,- as Heist; fl 5-4 twn -. in i .J 3.. ME: A greener fieiinitien of Money M2 is a broader definition of the money supply and inciudes: 1. Everything that is in M1. 2. Savings account baiances. 3. Small denomination time deposits (e.g., certificates of deposit (CDs)). 4. Balances in money market deposit accounts in banks. 5. Noninstitutional money market fund shares. “it/féci» \idjfiinjég M3 is a broader medium of exchange and store vaiue and includes: a. Everything that is in M2. in. Large-denomination time deposits. c. Institutional money market fund shares. There are two key points about the money suppiy: 1. The money supply consists of both currency and balances in checking accounts and traveler’s checks. 2. Because balances in checking accounts are included in the money supply, hanks play an imggrtgnt role in the process by which the money supply increases and decreases. E, What nhont firedit flares and fiehii: Cards? '3 Credit cards are not included in the money supply because they are considered a loan from the bank that issued the credit card. .‘w l—leav Bo Banks meats Money? A. B. Eanls Ealance Sheets A bank balance sheet lists a firm’s assets on the left and its liabilities and stockholders’ equity on the right. The key assets on a bank’s balance sheet are its reserves, loans, and holdings of securities, such as US. Treasury bills. Reserves are deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve. Required reserves are reserves that a bank is legally required to hold, based on its checking account deposits. A required reserve ratio is the minimum traction of deposits banks are required to keep as reserves (currently 10 percent). 0 Any reserves that banks hold over and above the legal requirement are called excess reserves. Banks make consumer loans to households and commercial loans to business. A loan is an asset to a bank because it represents a promise by the person taking out the loan to make certain specified payments to the bank. 0 A bank’s reserves and its holding of securities are also assets. listng Entitlements to §how slow a Baal: fian fireate Money A T—account is a stripped-down version of a balance sheet that shows only how a transaction changes a bank’s balance sheet. When a bank accepts a deposit, it keeps only a fraction of the fluids as reserves and loans out the remainder. In making a loan, banks increase the checking account balance of the borrower. a When the borrower uses a check to buy something with the funds the bank has loaned, the seller will deposit the check in his bank. The seller’s bank will keep part of the deposit as reserves and loan out the remainder. This process will continue until no banks have excess reserves. - In this way, the process of banks making new loans increases the volume of checking account. balances and the money supply. morass/anti {in é is | ’F {2. The Simpie Beposit Maitipiier o The ratio of the amount of deposits created by banks to the amount of new reserves is called the simple deposit multiplier ”(hmwmwnm a M 5.. ww‘“ \___M z: 2:; iris-“s .. i .w 5s assessor/”yo, acce- (31.693;er “(Q32 7ny éwase" was; byyg Totes 2;?» (3% )e’“; E, The Simpie Eeposit hisfitiplier versus the Reaiu‘Woriri fleposit Mnitipiier 0 Whenever banks gain reserves, they make new loans and the money supply expands. 0 Whenever banks lose reserves, they reduce their loans and the money supply contracts. .3 is”. 51‘: 2:7; {for the aederai Reserve System The fractional reserve banking system is a banking system in which banks keep less than 100 percent of deposits as reserves. When many depositors simultaneously decide to withdraw their money from a bank, there is a bank run.- If many banks experience runs at the same time, the result is a bank panic. It is possible for one bank to handle a run by borrowing from other banks. A central bank, like the Federal Reserve in the United States, can help stop a bank panic by acting as a lender oflast resort. 0 In this case, a central bank makes ioans to banks that cannot borrow funds elsewhere. The bank can use these loans to pay off depositors. 0 When the panic ends and the depositors put their money back in their accounts, the bank can repay the loan to the central bank. ”the Organizatien ef the Federai Reserve System. With the intention of putting an end to banking panics, in 1913 Congress passed the Federal Reserve Act setting up the Federal Reserve System, which began operation in l914. The Fed acts as a lender of last resort to banks and as a bankers” bank, providing services such as check clearing to banks. The Fed also takes actions to control the money supply. To aid the Fed in carrying out its responsibilities, Congress divided the country into 12 Federal Reserve districts. ' - Each district has its own Federal Reserve bank, which provides services to banks in that district. The real power of the Fed lies in Washington, DC, with the Board of Governors. 0 There are seven members of the Board of Governors, who are appointed by the president of the United States to 14-year, nonrenewable terms. 0 One of the seven board members is appointed chairman for a four-year, renewable term. 8. flow the Federal Reserve Manages the Money Sappiy I The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives is known as the monetary policy. 0 The Federal Open Market Committee (FOMC), or the Federal Reserve committee, is responsible for open market operations and managing the money supply. 0 The buying and selling of Treasury securities is called open market operations. 0 There are three reasons the Fed conducts monetary policy principally through open market operations. 1. The Fed initiates open market operations; it completely controls their volume. 2. The Fed can make both large and small open market operations. 3. The Fed can implement its open market operations quickly, with no administrative delay or Urequired changes 1n regulations. blilg SP ‘m‘fiCTC: {\fdml. j (Hf: :&?l 16?.- IA59$~J 2:; E ‘2 it ls (W a“? MEAN fix._.:,;, 1.- 9'“- 7 \_ 9’9 it? 9 9.999 999.99%; 9.9 @999. 9-9. .9. (were 9.99:”? “993") "I [AM 0 The loans the Fed makes to banks are called discount loans, and the interest rate it charges on the loans is called the discount rate. - 2.99 (ergonom- 9999:9999 an 9’“ 9 99. 9999.99.99: 99‘ l0599-99’99E‘. .99; - ‘ . ~ - When the Fed reduces the required reserve ratio, it converts required reserves into excess reserves. 0 The Fed changes reserve requirements much more rarely than it conducts open market operations or changes the discount rate. \ij 9.9995999999992929.- 999.99....9999... “’“‘ 999‘"? "A?” 999’: w 99:99 «9.999994%. 9:9 ‘ Mtg 9’3. (I. i’utting it All Together: Decisions of the Elephant: Fairlie, Banks. and the Fed 0 Using its three tools (open market operations, the discount rate, and reserve requirements), the Fed has substantial influence over the money supply, but that influence 13 not absolute. 0 There are two other actors that also influence the money supply 1n practice: the nonbank public and banks. Extra Soived Freezer}: 13-4. Open Market Operations and Changes in the Supply of Money Suppose that the Federal Reserve would like to increase the money supply by $500,000. How can the Fed use open market operations to bring about a $500,000 money supply increase? Assume the required reserve ratio is 10 percent. got) Goals: 5! :3. f; if; Q 3; Q??? “- ' ’1 sn‘ ’ [3“ it; 322,15.) x {J (:3, w, ll: (“1/ 5; i 3%“ a :3:.._ .2 26 < 5,0 Goo ' ‘H 5“ - s E a ,, ff- ;j . 5*" efgfié 2:; dht’ifisflgfi SOLVING THE PROBLEM: Step I : Step 2: Step 3: Review the chapter material. This problem is about the Fed’s use of open market operations, so you may want to review the section “The Federal Reserve System,” which begins on page 868 in the textbook. Determine the level of deposits that can be created from the excess reserves. When the Federal Reserve uses open market operations to increase the supply of money, the Fed buys securities from the public. When the public deposits the proceeds from these security sales in their banks, the level of deposits and the level of reserves increase in the banking system. Because banks only have to keep a fraction of the deposits they receive as reserves, the level of excess reserves will be positive after this Fed security purchase. The level of deposits that can be created from these excess reserves are determined by the formula: ADZLAR RR Calculate the change in reserves. Where AD is the change in deposits, AR is the change in reserves, and R is the required reserve ratio. Using the 10 percent required reserve ratio (RR = 0.10), if the Fed would like to increase the money supply by $500,000, then the desired change in deposits is $500,000. Step 4: Using the formula: $500,000 : iAR 2 LA}? RR 0.10 Solving this equation for AR gives a value ofAR 2 $50,000. Thus, if the Fed buys $50,000 of securities from the public, then this will increase reserves by $50,000. As banks create new loans based upon these new reserves, the quantity of bank loans and deposits will increase. Determine size of the open market operation necessary to bring about the desired change in the money supply. The money supply change will be equal to the change in checking deposits, or $500,000. A $50,000 Fed open market purchase will lead to a $500,000 money supply change. If the Fed wants to increase the money supply by $500,000, it must buy $50,000 of securities from the public. The Quantity Theory of Money A. Connecting Money and i’rices: The Quantity Equation In the early twentieth century, Irving Fisher, an economist at Yale, formalized the connection between money and prices using the quantity equation. The equation states that the money supply (M) multiplied by the velocity of money (V) equals the price ievel (P) multiplied by real output (Y). Mx VxPx r I, 0? r" . " 2- . r” .r'V ."xi' Kr»? .LLi-x 5 3., Gig c~r M. r (as at f a:- w: ‘W " ”‘7 “V * i ' ' ‘ A L ._ , r“- M o f x \‘rgnhca , {3:2 Q,2 ,» big, ,3 ; ... mg W a, The velocity of money is the average number of times each dollar in the money supply is used to purchase goods and services included in GDP. The quantity theory of money is a theory of the connection between money and prices that assumes that the velocity of money is constant. Rewriting the original equation by dividing both sides by M, we have the equation for velocity: V D W Q i \. The Quantity Theery Explanation of Irritation Irving Fisher stated that when velocity is constant, the growth rate of velocity will be zero, which allowed us to rewrite the equation (Inflation rate = Growth rate of the money supply m Growth rate of real output) and led to the following predictions: 1. If the money supply grows at a faster rate than real GDP, there will be inflation. 2. If the money supply grows at a slower rate than real GDP, there will be deflation (decline in prices). 3. If the money supply grows at the same rate as real GDP, the price level will be stable, and there will be neither inflation nor deflation. In the long run, inflation results from the money supply growing at a faster rate than real GDP. {I. High Rates of inflation Very high rates of inflation are known as hyperinflation. It IS caused by central banks increasing the money supply at a rate far in excess of the growth rate of real GDP. A high rate of inflation causes money to lose its value so rapidly that households and firms avoid holding it. Economies suffering from high inflation usually also suffer from very slow growth, if not severe recessron. High Inflation in argentina The link between rapid money growth and high inflation was evident in the experience of Argentina during the 19805. This weak economic performance was frustrating to many people in Argentina because early in the twentieth century, the country had had one of the highest standards of living in the world. It was clear to policymakers in Argentina that the only way to bring inflation under control was to limit increases in the money supply. Extra Solvent fiehiem Kiwi“; Showing the Link between Growth in the Money Supply and the inflation Rate Suppose that during a particular year, the money supply grows at a rate of 20 percent, velocity grows at a rate of 5 percent, and real GDP grows at a rate of 1 percent. Caiculate the resulting inflation rate. 22 4 2— :: 2‘ we . ,2: p \:Q§;b§ (3‘? iii“ “'7" biz oi; :l e 53:22 G”? If f” x a 2‘\> __.. fa, , r2: ' ‘ .r .é W- *3 ’1 a (7 i‘ »_, - page», M .:' :5 ‘1! 4"... " 1 4,4; I I, ,9 5y: «i '3‘ is)!" La? 5: L; '1 $5:ij Q L‘i U SOLVENG THE PROBLEM: Step '|: Review the chapter material. This problem concerns the link between increases in the money supply and the inflation rate, so you may want to review the section “The Quantity Theory of Money,” which begins page 872 in the textbook. Step 2: Use the quantity equation to state the reiationship between the inflation rate and the other variables given. As the textbook shows, we can rewrite the quantity equation to give us the following relationship'between in the inflation rate and the other variables given: Inflation rate = Growth rate of the money supply + Growth rate of velocity — Growth rate of real GDP. Step 3: Calculate the inflation rate. Substituting the numbers from the problem into the equation given in Step 2, we have: Inflation rate = 20% + 5% — 1% = 24%. .J . N r“ ,. _:;,. #5:) this {@3122 C3"? fl (:Qi/E “blah” ““5 \uww" ,,,,,,, ...
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