Money, Prices, and the Federal Reserve

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Money, Prices, and the Federal Reserve

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Money, Prices, and the Federal Reserve Principles of Macroeconomics Dr. Gabriel X. Martinez Ave Maria University Introduction Is Economics about Money? – PowerPoint PPT presentation

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Title: Money, Prices, and the Federal Reserve


1
Money, Prices, and the Federal Reserve
Principles of Macroeconomics Dr. Gabriel X.
Martinez Ave Maria University
2
Introduction
  • Is Economics about Money?
  • What is Money?

3
Introduction
  • Money
  • Any asset that is generally accepted in making
    purchases
  • Examples
  • Paper Currency, (worthless) Coins, and Checking
    Accounts
  • But also
  • Bronze, Silver, and Gold
  • Cows, Clams, and Cocoa Beans
  • At different times and in different places,
    foreign currency, boulders, even tulip bulbs have
    been accepted as money.

4
Money and Its Uses
  • An asset is money if it is
  • A Medium of Exchange
  • If it is used in purchasing goods and services.
  • A Unit of Account
  • If it is a basic measure of economic value.
  • A Store of Value
  • If is serves as a means of holding wealth.

5
Money and Its Uses
  • Why is barter inconvenient?
  • Double coincidence of wants.
  • Would a bartender accept an economics lecture?
  • Less specialization
  • People try to do everything by themselves.
  • How does money solve this problem?
  • Why is everyone willing to accept money?
  • What if people refuse to accept your money?

6
Money and Its Uses
  • Is cash money?
  • Are checking accounts money?
  • Are savings accounts money?
  • Are 3-month certificates of deposit money?
  • Are 1-year, negotiable, CDs money?
  • Is a gold mine money?
  • Is a house money?

7
Components of M1 and M2,July 2002 (billions of
dollars)
M1 Currency held by the public plus Demand
deposits plus Other checkable deposits plus
Travelers checks M2 M1 plus Savings
deposits plus Small-denomination time
deposits plus Money market mutual funds
1,197.8 615.1 303.8 270.3 8.6 5,641.2
1,197.8 2,552.8 920.8 969.8
8
Money and Its Uses
  • M1 --- very liquid
  • Sum of currency outstanding and balances held in
    checking accounts
  • M2 --- less liquid, but
  • All the assets in M1 plus some additional assets
    that are usable in making payments but at greater
    cost or inconvenience than currency or checks

9
Commercial Banks and the Creation of Money
  • How do non-cash assets that are also money (e.g.,
    checking accounts) come into existence?

Palazzo Ducale di Venetia
10
Commercial Banks and the Creation of Money
  • Republic of Venice
  • Central Bank issues 1 million guilders.

Colonna di San Todaro
Colonna di San Marco
Source of pictures www.VeNETia.it
Basilica di San Marco
11
Commercial Banks and the Creation of Money
  • People want to place their 1 million guilders in
    a bank
  • Why? Why do banks exist?
  • They are safer than your pocket or couch.
  • They are convenient (fund transfers,
    check-writing).
  • They may pay interest on your deposited funds.
  • They channel your savings to productive uses.

12
Consolidated Balance Sheet of Venetian
Commercial Banks (Initial)
Assets Currency 1,000,000 guilders
Liabilities Deposits 1,000,000 guilders
  • Central Bank issues 1 million guilders.
  • Citizens open accounts and deposit1 million
    guilders
  • Deposits are liabilities for the bank
  • The guilders are an asset for the bank

13
Commercial Banks and the Creation of Money
  • If a bank receives deposits and keeps them, those
    guilders are the banks reserves.
  • Bank Reserves
  • Cash or similar assets held by commercial banks
    for the purpose of meeting depositor withdrawals
    and payments
  • Suppose Reserves deposits. Then we have 100
    reserve banking.

14
Commercial Banks and the Creation of Money
  • Why keep Reserves?
  • Because if depositors want to withdraw some of
    their funds, the bank must have cash available.
  • Why not keep 100 Reserves?
  • Because a banks business is to lend out funds
    (i.e., its depositors savings).
  • How much should banks keep in Reserves?
  • The Central Banks requirement,
  • plus predicted withdrawals.

15
Commercial Banks and the Creation of Money
Reserves Deposits Reserve/Deposit Ratio
20 200
40 200
60 200
80 200
100 200
120 200
140 200
160 200
180 200
200 200
16
Commercial Banks and the Creation of Money
  • Reserves are not part of the money supply (they
    cannot be used for exchange with goods/services).
  • Deposits are part of the money supply (you can
    write checks on your checking deposits).
  • Remember checks are NOT money!

17
The Process of Deposit Creation
18
Consolidated Balance Sheet of Venetian
Commercial Banks (Initial)
Assets Currency 1,000,000 guilders
Liabilities Deposits 1,000,000 guilders
  • Central Bank issues 1 million guilders.
  • Citizens open accounts and deposit1 million
    guilders
  • Deposits are liabilities for the bank
  • The guilders are an asset for the bank

19
The Process of Deposit Creation
Consolidated Balance Sheet of Venetian Commercial
Banks After One Round of Loans
Assets Currency ( reserves) 100,000
guilders Loans to farmers 900,000 guilders
Liabilities Deposits 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

20
Bank 1
Source http//www.dtsonline.com/media/img_investor
s.jpg
21
Bank 1
Bank 2
22
Bank 1
Bank 2
Bank 3
23
Bank 1
Bank 2
Bank 3
Bank 4
24
1000
Bank 1
900
Bank 2
900
810
Bank 3
810
729
Bank 4
729
25
Deposits
1000
900
Notice how the original deposit of 1000 has
gotten multiplied. Because Deposits are part of
money, the money supply has grown by 3439
810
729
3439
26
The Process of Deposit Creation
Consolidated Balance Sheet of Venetian Commercial
Banks After One Round of Loans
Assets Currency ( reserves) 100,000
guilders Loans to farmers 900,000 guilders
Liabilities Deposits 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

27
The Process of Deposit Creation
Consolidated Balance Sheet of Venetian Commercial
Banks After One Round of Loans
Assets Currency ( reserves) 1,000,000
guilders Loans to farmers 900,000 guilders
Liabilities Deposits 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

28
The Process of Deposit Creation
Consolidated Balance Sheet of Venetian Commercial
Banks After Two Rounds of Loans and Redeposits
Assets Currency ( reserves) 190,000
guilders Loans to farmers 900,000 guilders Loans
to merchants 810,000 guilders
Liabilities Deposits 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

29
The Process of Deposit Creation
Consolidated Balance Sheet of Venetian Commercial
Banks After Two Rounds of Loans and Redeposits
Assets Currency ( reserves) 1,000,000
guilders Loans to farmers 900,000 guilders Loans
to merchants 810,000 guilders
Liabilities Deposits 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

30
The Process of Deposit Creation
Deposits 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
Also Reserves original injection of Reserves by
Central Bank 1 million
Notice Reserves 10 of D



DD10DR
31
The Process of Deposit Creation
Deposits 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
Also Reserves original injection of Reserves by
Central Bank 1000
Notice Reserves 10 of D



DD10DR
32
The Process of Deposit Creation
Final Consolidated Balance Sheet of Venetian
Commercial Banks
Assets Currency ( reserves) 1,000,000
guilders Loans to farmers 9,000,000 guilders
Liabilities Deposits 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

33
Commercial Banks and the Creation of Money
  • The use of a fractional-reserve banking system
    allows the money supply to grow as a multiple of
    the reserves.
  • In Venice, with a 10 reserve-deposit ratio,1
    guilder in reserve can support 10 guilders in
    deposit.
  • The CB creates currency, which is kept by banks
    as reserves. As long as banks have reserves,
    they can make loans, which are redeposited and
    become money.

34
Commercial Banks and the Creation of Money
  • Summary
  • R r D
  • Bank reserves/bank deposits desired
    reserve-deposit ratio
  • R / D r
  • Bank deposits bank reserves/desired
    reserve-deposit ratio
  • D R / r

35
Commercial Banks and the Creation of Money
  • The Central Bank can control the amount of money
    in an economy by
  • Printing more (or fewer) dollar bills.
  • It gives them out by exchanging them for
    government bonds or by lending them to banks.
  • Changing the reserve requirement ( r ).

36
Exercise 23.2
  • Suppose banks desired reserve/deposit ratio is
    10, and the CB prints 1m guilders.
  • How does the money supply change?
  • Since we are still assuming people dont hold
    currency, the 1m guilders must be held as
    reserves by the banking system.
  • Without currency, money supply deposits.
  • Deposits (1/r)Reserves
  • DDeposits (1/r)DReserves
  • 10m 101m (1/0.10)1m

37
Exercise 23.2
  • Suppose banks desired reserve/deposit ratio is
    10, and the CB prints 2m guilders.
  • How does the money supply change?
  • Without currency, money supply deposits.
  • Deposits (1/r)Reserves
  • DDeposits (1/r)DReserves
  • 20m 102m (1/0.10)2m

38
Exercise 23.2
  • Suppose banks desired reserve/deposit ratio is
    5, and the CB prints 1m guilders.
  • How does the money supply change?
  • Deposits (1/r)Reserves
  • DDeposits (1/r)DReserves
  • 20m 201m (1/0.05)1m

39
Money Supply with Both Currency and Deposits
40
Commercial Banks and the Creation of Money
  • Money Supply Currency Deposits
  • Money Supply Currency R / r
  • Currency Reserves Central Bank Money
  • If the Central Bank prints 1000, all of it must
    be held either in Currency or in Reserves.

41
Commercial Banks and the Creation of Money
  • The Money Supply with Both Currency and Deposits
  • Suppose residents choose to hold 500,000 guilders
    as currency
  • If the CB issues 1 million guilders, people
    deposit 500,000 in the banks
  • Reserve-deposit ratio 10
  • Bank deposits 500,000/0.10 5,000,000

42
Commercial Banks and the Creation of Money
  • The Money Supply with Both Currency and Deposits
  • Money supply currency bank deposits
    5,500,000 500,000
    5,000,000
  • But before we found that currency 0,
  • 10,000,000 0 10,000,000
  • The money supply is reduced by 4,500,000 guilders
    when the residents hold 500,000 guilders in
    currency

43
Commercial Banks and the Creation of Money
  • The Money Supply at Christmas
  • Currency 500
  • Bank reserves 500
  • Reserve-deposit ratio 0.20
  • Money supply 500 500/.20 500 2,500 3,000

44
Commercial Banks and the Creation of Money
  • The Money Supply at Christmas
  • If Xmas shoppers withdraw 100
  • Money supply (500100) (500 100)/0.20 600
    400/0.20 600 2,000 2,600

45
Commercial Banks and the Creation of Money
  • The Money Supply at Christmas
  • Observation
  • When the reserve-deposit ratio 0.20, every 1
    reduction in reserves may reduce the money supply
    by 5.
  • In general, when people make withdrawals, the
    money supply contracts by a multiple of the
    withdrawal.
  • Fall in Money Supply (1/r) x Withdrawal
    increase in cash held by public

46
Central Banks
47
Central Banks
  • Two Main Responsibilities
  • Monetary policy
  • Oversight and regulation of financial markets

48
Central Banks
  • Their primary mission is to promote low
    inflation, economic growth, and stable financial
    markets.
  • The Bank of England was founded in 1694.
  • The US Federal Reserve System, 1913.
  • Many Latin American countries founded central
    banks in the 1920s.

49
The Federal Reserve System
  • The Feds Structure
  • 12 regional Federal Reserve banks
  • Assess economic conditions in their regions to
    assist in national policymaking
  • Provide service to the commercial banks in their
    districts

50
The Federal Reserve System
  • The Feds Structure
  • Board of Governors
  • Seven governors, Appointed by the president to 14
    year staggered terms. The Chairman is selected
    by the president from the governors, and serves a
    four year term.
  • Federal Open Market Committee (FOMC)
  • Members include
  • The seven Fed governors, President of the New
    York Fed, four presidents, chosen on a rotating
    basis, from the remaining Federal Reserve Banks
  • Determines monetary policy

51
Central Banks
  • Controlling the Money Supply Open-Market
    Operations
  • The primary function of Central Banks is monetary
    policy.
  • CBs control the money supply by changing the
    supply of bank reserves.

52
Central Banks
  • Controlling the Money Supply Open-Market
    Operations (OMOs)
  • Open-market operations are the most important
    method of changing the supply of bank reserves.
  • The Market in OMOs is the Market for Government
    or Central Bank Bonds.
  • The CB exchanges bonds for currency.

53
Central Banks
  • Bond
  • A legal promise to repay a debt, usually
    including both the principal amount and regular
    interest payments.

Source www.rainfall.com/ posters/WWI/catalog11.ht
m
54
Open Market Operations
  • Increasing The Money Supply
  • The Fed purchases US government bonds from the
    public.
  • The people deposit the funds they get from their
    sale of bonds to the Fed.
  • The increase in deposits increase bank reserves.

55
Open Market Operations
  • Increasing The Money Supply
  • The increase in reserves will lead to an
    expansion of the money supply as banks make more
    loans.
  • Recall
  • The change in the money supply is a multiple of
    the change in reserves.

56
Open Market Operations
  • Reducing The Money Supply
  • The CB sells government bonds to the public.
  • The CB presents the checks from the sale of the
    bonds to the banks for payment.
  • The banks reserves will fall when they clear the
    checks.
  • The money supply will fall by a multiple of the
    decrease in reserves.

57
Open Market Purchase
  • Open-Market Purchase
  • The purchase of government bonds from the public
    by the CB for the purpose of increasing the
    supply of bank reserves and the money supply.

58
Open Market Purchase
New money becomes a part of the banks reserves
Fed pays for BOND purchase with a check, which is
depositedin a commercial bank
Additional lending increases the money supply
Reserves are the basis for additional lending
D ? L ? D ? L ? D ? L ?
59
Open Market Sale
  • Open-Market Sale
  • The sale by the CB of government bonds to the
    public for the purpose of reducing bank reserves
    and the money supply

60
Open Market Sale
Fed 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.
61
Open Market Operations
  • Suppose the CB wants to increase the money supply
    using open-market operations.
  • Currency 1,000 shekels Reserves 200
  • Reserve-deposit ratio 0.2
  • Money supply 1,000 200/0.2 2,000 shekels
  • What should the CB do?

62
Open Market Operations
  • An Open Market Purchase increases Reserves and
    the Money Supply
  • Open market purchase 100
  • Reserves increase to 300
  • Money supply 1,000 300/0.2 2,500 shekels

63
Discount Lending
  • Controlling the Money Supply Discount Window
    Lending
  • Banks can borrow reserves from the Fed.
  • Discount window lending
  • The lending of reserves to commercial banks.
  • The discount rate
  • The interest rate charged on these loans.

64
The Reserve Requirement
  • Controlling the Money Supply Changing Reserve
    Requirements
  • The Fed sets a minimum reserve-deposit ratio, the
    reserve requirement.
  • A reduction in the reserve requirement would
    allow the money supply to increase.
  • An increase in the reserve requirement may reduce
    the money supply.

65
The Lender of Last Resort
  • The CBs Role in Stabilizing Financial Markets
    Banking Panics
  • Suppose
  • Depositors lose confidence in their bank.
  • They attempt to withdraw their funds.
  • Bank may not have enough reserves (fractional) to
    meet the depositors demand.
  • The bank fails and further erodes depositor
    confidence which triggers additional failures.

66
The Lender of Last Resort
  • The CBs Role in Stabilizing Financial Markets
    Banking Panics
  • The CB to the rescue
  • Instill confidence
  • Discount lending
  • Open Market Operations

Bank Panic (1930)  People lined up outside a New
York City bank, trying to get in to get their
money out. Source Library of Congress.  
Depositors attempt to claim their funds during
the 1907 Bank Panic. Source Altanta Fed
67
Key U.S. MonetaryStatistics, 1929-1933
Currency Reserve-deposit Bank Money held by
public ratio reserves supply
December 1929 3.85 0.075 3.15 45.9 December
1930 3.79 0.082 3.31 44.1 December
1931 4.59 0.095 3.11 37.3 December
1932 4.82 0.109 3.18 34.0 December
1933 4.85 0.133 3.45 30.8
Currency, reserves, and money supply are in
billions of dollars. Note that as C, r, and R
rise, MS falls. The process of Deposit Creation
is choked.
68
Money and Prices
69
Money and Prices
  • Inflation is always and everywhere a monetary
    phenomenon
  • -- Milton Friedman
  • This is true in the long run and if inflation is
    very high.

70
Money and Prices
Price of 1 radio 4 oranges
71
Money and Prices
Price of 1 radio 6 oranges
72
Money and Prices
Price of 1 radio 3 oranges
73
Money and Prices
  • Assume an economy where dollar bills are used
    only once a year (velocity 1) and where
    annual real GDP 10 million houses.
  • Suppose Ms10bn. What will P be?
  • MV PY
  • 10bn x 1 P x 10 million houses
  • P 1 thousand / house

74
Money and Prices
  • Now suppose Ms20bn. What will P be?
  • MV PY
  • 20bn x 1 P x 10 million houses
  • P 2 thousand / house
  • If M doubles, P doubles. M/P doesnt change.
  • Why doesnt this happen in the short run?
  • Because M affects P through the goods, money, and
    labor market, over time.

75
Money and Prices
  • Velocity
  • The speed at which money circulates.
  • The number of times a dollar bill is used in one
    year.

76
Money and Prices
  • Velocity
  • The speed at which money circulates
  • The number of times a dollar bill is used in one
    year.

77
Money and Prices
  • Velocity in 2001
  • M1 1,177.9 billion
  • Nominal GDP 10,082.2 billion

78
Money and Prices
  • Money and Inflation in the Long Run
  • Quantity equation
  • M x V P x Y

Its a definition, so its always true.
79
Money and Prices
  • Money and Inflation in the Long Run
  • Assume V Y are constant over the time period

This is a definition, so its always true. This
is a theory, so it may or may not be true.
80
Money and Prices
  • Money and Inflation in the Long Run
  • Why should we assume V Y are constant?
  • Y is determined by human capital, technology,
    etc.. This theory says economic growth is
    unrelated to the quantity of money.
  • V is determined by institutions, etc.. This
    theory says that the need for transactions (which
    use money) is also unrelated to the quantity of
    money.
  • So if we change M, we assume V or Y wont change.
    Then assume they are constant.

81
Money and Prices
  • Money and Inflation in the Long Run
  • If the Fed increases M by 10, then prices must
    increase by 10.
  • High rates of money growth are associated with
    high rates of inflation.
  • Too much money is chasing too few goods.

82
Inflation and Money Growth in Latin America,
1995-2001
83
Money and Prices
  • If high rates of money growth lead to inflation,
    why do countries allow their money supplies to
    rise so quickly?
  • In the case of Ecuador, because of the need for a
    lender of last resort!
  • The Central Bank had to print billions of sucres
    to try to save the banks from failing which
    caused the economy, and the banks, to collapse.