Title: Parkin-Bade%20Chapter%2025
1Ch. 8 Money, the Price Level, and Inflation
9
- Definition of money and its functions
- Economic functions of banks
- 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
2What 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
3MONEY 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
4GRESHAMS 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 (see web
page link)
53 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. - 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
6HISTORY OF BANKING
- Initially banks formed as safekeeping
institutions. - Gradually evolved to serve several functions
- Minimize the cost of borrowing funds
- Minimize the cost of monitoring borrowers
- Link lenders with borrowers
- Pool risks for lenders
- Create liquidity
7HISTORY 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.
8- 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
9- 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?
10Bank 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 (moral
hazard). - The 1985 Home State experience in Ohio.
- The most recent financial crisis.
11Bank 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.
12Bank 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
13Federal 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
14The 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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16The 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.
17Components 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.
18Components of Money Supply
19How 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
20How 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.
21How 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
22How 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.
23How 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.
24How Banks Create Money
- The process continues and keeps repeating with
smaller and smaller loans at each round.
25How 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).
26Fed 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.
27OPEN 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.
28Changes 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
29DISCOUNT 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.
30Note DPCREDIT is the new measure of the
discount rate.
31THE 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 and
the currency drain ratio discussed in text.
Focus only on deposit multiplier
32Changes 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 cuts the rr to 10 What is the
effect on Loans Demand deposits M1
33OTHER 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
34Changes 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
35Total Bank Reserves 1980-2011
36MONETARY BASE1983-2011
37Components of the monetary base 1983-2011
38M1 1980-2011
39Reserves vs. Excess Reserves 1984-2011
40The 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
41The 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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43The 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.
44The 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
45Equilibrium interest rate
46The 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. - nominal interest rates on government
(risk-free) bonds differ for different terms
due to - inflation expectations over different periods
- longer term bonds are subject to more inflation
risk.
47The 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
48The 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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50The Quantity Theory of Money
- International evidence shows a tendency for high
money growth rates to be associated with high
inflation rates. - Evidence for 134 countries from 1990 to 2005.