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Parkin-Bade Chapter 25

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Title: Parkin-Bade Chapter 25


1
Ch. 9 Money, the Price Level, and Inflation
9
  • 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

2
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

3
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

4
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

5
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.

6
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

7
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

8
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.

9
  • 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

10
  • 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?

11
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.

12
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.

13
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

14
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

15
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

16
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17
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.

18
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.

19
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20
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

21
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.
22
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

23
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.
24
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.

25
How Banks Create Money
  • The process continues and keeps repeating with
    smaller and smaller loans at each round.

26
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).

27
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.

28
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.

29
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
30
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.

31
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.

32
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.

33
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34
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

35
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
36
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.

37
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

38
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
39
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

40
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

41
Total Bank Reserves 1980-2009
42
MONETARY BASE1983-2009
43
M1 1980-2009
44
EXCESS RESERVES 1980-2009
45
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

46
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.

47
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48
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.

49
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

50
Equilibrium interest rate
51
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.

52
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

53
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

54
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

55
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.

56
The Quantity Theory of Money
  • Vvelocity Pprice level Yreal GDP Mquantity 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

57
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

58
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59
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.

60
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
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