Parkin-Bade Chapter 25

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Ch. 9 Money, the Price Level, and Inflation
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• Definition of money and its functions
• Economic functions of banks and other depository
  institutions
• Structure and function of the Federal Reserve
  System
• Creation of money by the banking system
• Demand for money, the supply of money, and the
  nominal interest rate
• Link between quantity of money, the price level
  and inflation

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What is Money?

• Anything that is generally acceptable as a means
  of payment.
• Commodity Money
• gold dust, tobacco, cigarettes in POW camp
• Problems
• transactions cost perishable value fluctuates.
• Coins with precious metal
• Gold silver coins
• Problems
• Coin shaving value of metal fluctuates.
• Greshams Law Bad money drives out good (more
  later).
• Fiat money

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MONEY IN U.S. HISTORY

• U.S. constitution gave Congress sole right to
  "coin money and regulate value thereof".
• Illegal for states to coin money.
• Bi-metallic standard initially.
• In the 1792 coin act, a 1 coin was quoted in
  terms of both silver and gold.
• 24.75 grains of gold 1
• 371.25 grains of silver 1

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GRESHAMS LAW

• Bad money drives out good"
• Prior to 1834, 24.75 grains of gold was worth
  more than 371.25 grains of silver. Only silver
  coins circulated (a "silver standard" by
  default).
• After 1834, the reverse was true (a "gold
  standard" by default).
• If gold coin has 10 grains and silver has 30
  grains, what happens if gold price is 5 times
  silver price? 2 times silver price?
• What happens to coin circulation if price of its
  metal rises relative to other metals?
• Wizard of Oz and bimetallic standard

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Functions of Money

• Medium of Exchange
• Generally accepted in exchange for goods and
  services.
• Without money, trade is barter system.
• Barter requires a double coincidence of wants
  makes it costly.
• Unit of Account
• An agreed measure for stating the value of goods
  and services.

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3 Functions of Money

• Store of Value
• Money can be held for a time and later exchanged
  for goods and services.
• Can be poor store of value
• Inflation
• No interest

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HISTORY OF BANKING

• Initially banks formed as safekeeping
  institutions.
• Gradually evolved to serve several functions
• Create liquidity
• Minimize the cost of obtaining funds
• Minimize the cost of monitoring borrowers
• Pool risks

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HISTORY OF BANKING

• States could not print or mint money, but
  privately owned banks could if licensed by the
  state government.
• Banks printed notes that were backed by gold or
  silver
• easier to trade
• avoided problems with weighing
• banks found it profitable to print more notes
  than they had "reserves (gold/silver) for and
  loaned out the extra notes.
• Fractional reserve banking was started.
• Fractional reserve banking poses problems if
  there is a bank run.

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• Assets Liabilities
• Reserves (gold) 100 Notes 100
• Total 100 100
• Banks would print notes beyond reserves and
  extend loans.
• Reserves 100 Notes 1000
• Loans 900 ____
• Total 1000 1000

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• With fractional reserve banking, the banking
  system
• creates money and lends it out.
• has only a fraction of liabilities on reserve.
• cannot satisfy customers demands if all want to
  withdraw deposits at once.
• Source of bank panics.
• News that loans are not likely to be paid back,
  customers will make a run on the bank.
• Droughts.
• Stock market crash.
• Effect of bank panic on economy?

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Bank Panics and Deposit Insurance

• 7 major bank panics in the U.S. in the 1800s
• 2 in the early 1900s.
• Onset of the great depression in the 1930s,
  another bank panic occurred.
• In 1934, the federal government established FDIC
  to help reduce spread of bank panics.
• Deposit insurance has reduced bank panics in the
  U.S.
• Problems with deposit insurance
• Incentives created for risk taking.
• The 1985 Home State experience in Ohio.

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Bank Objectives.

• Goal of any bank is to maximize wealth of its
  owners.
• To accomplish this, must consider
• Attracting deposits to make loans possible.
• Choosing loan portfolio and balance risk versus
  return.
• Liquidity
• Service quality, fees, etc.

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Bank Objectives.

• Risk, Return, and Liquidity.
• Liquid assets (low risk, low return)
• U.S. government Treasury bills and commercial
  bills
• 2. Investment securities
• longerterm U.S. government bonds and other
  bonds
• 3. Loans (higher risk, higher return)
• commitments of fixed amounts of money for
  agreed-upon periods of time

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Federal Reserve System

• Established in 1913 by the Federal Reserve Act.
• First central bank of the United States
• Conducts monetary policy and regulates banks.
• Aims to stabilize the macroeconomy.
• Structure
• The Board of Governors
• The 12 regional Federal Reserve banks
• Federal Open Market Committee

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The Federal Reserve System

• Board of Governors
• 7 members appointed by the president and
  confirmed by Senate.
• Terms are for 14 years
• The president appoints one member to a four-year
  term as chairman.
• Regional Banks
• Each of the 12 Federal Reserve Regional Banks has
  a nine-person board of directors and a president.
• Monitors economic conditions within district and
  regulates banks
• Clearinghouse for checks and replacement of
  currency

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The Federal Reserve System

• Federal Open Market Committee
• FOMC is the main policy-making group in the
  Federal Reserve System.
• Consists of the members of the Board of
  Governors, the president of the Federal Reserve
  Bank of New York, and the 11 presidents of other
  regional Federal Reserve banks of whom, on a
  rotating basis, 4 are voting members.
• The FOMC meets every six weeks to formulate
  monetary policy.

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Components of the Money Supply

• Bank reserves bank deposits at the Federal
  Reserve cash
• Monetary base currency held by the nonbank
  public bank reserves.
• M1 currency outside banks, travelers checks,
  and checking deposits owned by individuals and
  businesses.
• M2 M1 plus time deposits, savings deposits, and
  money market mutual funds and other deposits.

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How do banks create money?

• Suppose that there is 100 million of cash and no
  bank system.
• A bank now begins and 90 million of cash is
  deposited in the bank in exchange for checking
  account (demand deposit) balances.
• The banks owners invest 5 million in plant and
  equipment and thus have 5 million of owners
  equity. The banks balance sheet is now

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How do banks create money?
The balance sheet The balance sheet The balance sheet The balance sheet
Assets Assets Liabilities Liabilities
Cash 90 m. Demand deposits 90 m.
Plant equipment 5 m. Owners equity 5 m.
Total assets 95 m. Total Liabilities 95 m.
Note The balance sheet requires that total
assets equal total liabilities.
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How do banks create money?

• Fed sets a reserve ratio (lets suppose its
  25). Implying bank must have 25 of its demand
  deposits on reserve.
• Reserves cash in bank deposits at Fed.
• Bank can increase demand deposits by creating new
  loans to customers until it no longer has any
  excess reserves.
• required reserves rr demand deposits
• Maximum demand deposits (1/rr) reserves

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How do banks create money?
The balance sheet The balance sheet The balance sheet The balance sheet
Assets Assets Liabilities Liabilities
Cash 90 m. Demand deposits 90m?360 m.
Loans 0?270 m Owners equity 5 m.
Plant equipment 5 m.
Total assets 95m?365 m. Total Liabilities 95m?365 m.
Note The bank system created 270 million of
additional money by creating new demand deposits
for borrowers (loans). This assumes that none of
the new loans/demand deposits are withdrawn as
cash.
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How Banks Create Money

• Deposits lead to a multiplier effect on M1 as
  banks convert a 1 deposit into several dollars
  of demand deposits.
• To illustrate, assume rr25
• A new deposit of 100,000 is made.
• The bank keeps 25,000 in reserve and lends
  75,000.
• This loan is credited to someones bank deposit.
• The person spends the deposit and another bank
  now has 75,000 of extra deposits.
• This bank keeps 18,750 on reserve and lends
  56,250.

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How Banks Create Money

• The process continues and keeps repeating with
  smaller and smaller loans at each round.

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How do banks create money?

• Summary of money creation process.
• monetary base nonbank cash bank reserves
• M1 nonbank cash demand dep.
• Maximum DD (1/rr) bank reserves
• The Fed controls the money supply through its
  control over the monetary base and the deposit
  multiplier (1/rr).

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Fed Tools

• Open market operations.
• The Fed buys (sells) government securities in the
  open market to increase (decrease) the money
  supply.
• Discount window lending.
• The Fed loans reserves to member banks and
  charges the discount rate.
• Reserve requirements.
• The Fed sets the required reserve ratio.
• Rarely used.

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OPEN MARKET OPERATIONS.

• If the Fed wants to increase the amount of bank
  reserves
• buy government securities from member banks
• banks give up government bonds and receive
  deposit at the Fed or cash.
• More recently, Fed has purchased commercial paper
  from banks new policy!
• By buying government securities
• Fed created new reserves that multiply into new
  loans and demand deposits (remember the deposit
  multiplier).
• If the Fed sold government securities, reserves
  and M1 would decrease.

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Changes in the money supply
The balance sheet COB10m rr25 The balance sheet COB10m rr25 The balance sheet COB10m rr25 The balance sheet COB10m rr25
Assets Assets Liabilities Liabilities
Cash 90 m. Demand deposits 360 m.
Loans 270 m Owners equity 5 m.
Plant equipment 5 m.
Total assets 365 m. Total Liabilities 365 m.
Suppose the Fed purchases 10 m. of government
securities. What is the effect
on Loans Demand deposits M1
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Assuming banks loan out all excess reserves, if
the Fed purchases 10 million of government
securities, total loans will

1. increase by 10 million.
2. increase by 40 million
3. decrease by 10 million.
4. None of the above.

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Assuming banks loan out all excess reserves, if
the Fed purchases 10 million of government
securities, M1 will

1. increase by 10 million.
2. increase by 40 million
3. Increase by 30 million.
4. None of the above.

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DISCOUNT WINDOW LENDING.

• The Fed lends banks reserves at the discount
  rate.
• The higher the discount rate, the less likely
  banks are to borrow reserves to increase the
  money supply.
• The federal funds rate is the interest rate that
  banks charge each other for a loan of reserves.
• The federal funds rate tracks the discount rate
  fairly closely.
• If the Fed wants to increase reserves in the
  system, it would lower the discount rate.

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THE RESERVE REQUIREMENT.

• If the Fed increases the reserve requirement
• the deposit multiplier (1/rr) falls
• the amount of demand deposits that banks can
  create for a given amount of reserves is
  reduced.
• Note you may ignore the money multiplier
  discussed in text. Focus only on deposit
  multiplier

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Changes in the money supply
The balance sheet COB10m rr25 The balance sheet COB10m rr25 The balance sheet COB10m rr25 The balance sheet COB10m rr25
Assets Assets Liabilities Liabilities
Cash 90 m. Demand deposits 360 m.
Loans 270 m Owners equity 5 m.
Plant equipment 5 m.
Total assets 365 m. Total Liabilities 365 m.
Suppose the Fed reduces the rr to 20 What is the
effect on Loans Demand deposits M1
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If the reserve ratio is cut from 25 to 20, M1
will

1. Not change
2. Increase by 18 million
3. Increase by 90 million
4. None of the above.

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OTHER FACTORS INFLUENCING THE MONEY SUPPLY

• The amount of cash people choose to hold
• Cash in bank multiplies
• Cash outside bank does not.
• The type of deposits people make.
• the reserve requirement is higher on demand
  deposits (about 3) than on certificates of
  deposit.
• If people switch between different types of
  accounts, the average reserve requirement and
  money multiplier will change.
• Bank holdings of excess reserves

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Changes in the money supply Cash held by public
The balance sheet COB10m rr25 The balance sheet COB10m rr25 The balance sheet COB10m rr25 The balance sheet COB10m rr25
Assets Assets Liabilities Liabilities
Cash 90 m. Demand deposits 360 m.
Loans 270 m Owners equity 5 m.
Plant equipment 5 m.
Total assets 365 m. Total Liabilities 365 m.
Suppose the public withdraws 10m. Of DD as cash.
What is the effect on Loans Demand
deposits M1
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M1 would increase if

1. The Fed increases the required reserve ratio
2. The Fed purchases government securities
3. The public decides to hold less money as demand
   deposits and more as cash
4. All of the above

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If banks decide to hold more money as excess
reserves, M1 will ____ and bank loans will ____

1. Increase increase
2. Increase decrease
3. Decrease decrease
4. Decrease increase

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Total Bank Reserves 1980-2009
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MONETARY BASE1983-2009
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M1 1980-2009
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EXCESS RESERVES 1980-2009
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The Market for Money

• The Demand for Money
• relationship between the quantity of real money
  demanded and the nominal interest rate when all
  other influences on the amount of money that
  people wish to hold remain the same
• The Demand for Money Holding
• The quantity of money that people plan to hold
  depends on four main factors
• The nominal interest rate
• The price level
• Real GDP
• Financial innovation

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The demand for money

• The Nominal Interest Rate
• the opportunity cost of holding wealth in the
  form of money rather than an interest-bearing
  asset.
• Increase in the nominal interest rate on other
  assets decreases the quantity of real money that
  people plan to hold.

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The demand for money

• The Price Level
• An increase in the price level
• increases the quantity of nominal money people
  wish to hold, doesnt change the quantity of
  real money demanded.
• Real money equals nominal money price level.
• 10 percent increase in P increases the quantity
  of nominal money demanded by 10 percent.
• Real GDP
• Increase in real GDP increases increases the
  quantity of real money that people plan to hold.

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The demand for money

• 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.
• Summary of money demand factors
• Nominal interest rate
• Price level
• Real GDP (income)
• Financial innovation

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Equilibrium interest rate
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The Market for Money

• Short-Run Equilibrium
• Suppose that the Feds interest rate target is 5
  percent a year.
• The Fed adjusts the quantity of money each day to
  hit its interest rate target.

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If the Fed purchases government bonds from the
banking system, interest rates will ____

1. Fall because money supply increases
2. Rise because money demand increases
3. Fall because money demand decrease
4. None of the above

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If the economy enters a recession and real GDP
falls, interest rates will

1. Fall as money demand decreases
2. Fall as money supply increases
3. Rise as money supply decreases
4. None of the above

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If the Fed wants to stimulate spending by cutting
interest rates, it could

1. Purchase government bonds
2. Cut the required reserve ratio
3. Lower the discount rate
4. All of the above

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The Market for Money

• Long-Run Equilibrium
• In the long run, the loanable funds market
  determines the interest rate.
• Nominal interest rate equals the equilibrium
  real interest rate plus the expected inflation
  rate.

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The Quantity Theory of Money

• VvelocityPprice levelYreal GDPMquantity of
  money
• The equation of exchange states that
• MV PY
• Expressing the equation of exchange in growth
  rates
• ? ch in M ch in V ch in P ch in Y?
  ch in P ch in M ch in V - ch in Y

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The Quantity Theory of Money

• Quantity theory of money
• In the long run, velocity does not change, so
• ?Inflation rate Money growth rate ? Real GDP
  growth

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The Quantity Theory of Money

• International evidence shows a marked tendency
  for high money growth rates to be associated with
  high inflation rates.
• Evidence for 134 countries from 1990 to 2005.

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According to the equation of exchange, which of
the following will lead to greater inflation?

1. Decreased velocity of money
2. Faster growth of the money supply
3. Faster growth of real GDP
4. All of the above