1. © 2009 South-Western, a part of Cengage Learning, all rights reserved C H A P T E R The Monetary System E conomics P R I N C I P L E S O F N. Gregory Mankiw Premium PowerPoint Slides by Ron Cronovich 29

2. In this chapter, look for the answers to these questions:  What assets are considered “money”? What are the functions of money? The types of money?  What is the Federal Reserve?  What role do banks play in the monetary system? How do banks “create money”?  How does the Federal Reserve control the money supply? 1

3. THE MONETARY SYSTEM 2 The Money Supply  The money supply (or money stock): the quantity of money available in the economy  What assets should be considered part of the money supply? Two candidates:  Currency: the paper bills and coins in the hands of the (non-bank) public  Demand deposits: balances in bank accounts that depositors can access on demand by writing a check

4. THE MONETARY SYSTEM 3 Measures of the U.S. Money Supply  M1: currency, demand deposits, traveler’s checks, and other checkable deposits. M1 = $1.4 trillion (June 2008)  M2: everything in M1 plus savings deposits, small time deposits, money market mutual funds, and a few minor categories. M2 = $7.7 trillion (June 2008) The distinction between M1 and M2 will usually not matter when we talk about “the money supply” in this course.

5. 存款貨幣誰創造？  央行：  貨幣基數  商業銀行：  存款與放款 ( 信用創造 ) THE MONETARY SYSTEM 4

6. 5 Central Banks & Monetary Policy  Central bank: an institution that oversees the banking system and regulates the money supply  Monetary policy: the setting of the money supply by policymakers in the central bank  Federal Reserve (Fed): the central bank of the U.S.

7. Central Banks  Sveriges Riksbank (Sweden, 1668)  Bank of England (UK, 1694)  U.S. Federal Reserve System (1914)  European Central Bank  Central Bank of the Republic of China (Taiwan)  Bank of Japan  People’s Bank of China

8. The Functions of a Central Bank The Government’s Bank – Manages the finances of the government – Through interest rates, controls the availability of money and credit The Bankers’ Bank – Guarantees that sound banks can do business – Operates a payments system for interbank payments – Oversees financial institutions

9. THE MONETARY SYSTEM 8 Bank Reserves  In a fractional reserve banking system, banks keep a fraction of deposits as reserves and use the rest to make loans.  The Fed establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits.  Banks may hold more than this minimum amount if they choose. 此時有超額準備, excess reserve.  The reserve ratio, R =fraction of deposits that banks hold as reserves =total reserves as a percentage of total deposits

10.  商業銀行的存戶由於現金需求的時機各有不同， 一般來說不會同時自銀行提領全部的存款，不會 發生擠兌。所行銀行只需保留存款的一部份做為 準備，其餘可以放款。  Bank’s reserves  = Cash in vault ( 庫存現金 )  + Bank’s deposits at the central bank  ( 在央行的存款 ) THE MONETARY SYSTEM 9

11. 10 Bank T-account  T-account: a simplified accounting statement that shows a bank’s assets & liabilities.  Example: FIRST NATIONAL BANK AssetsLiabilities Reserves$ 10 Loans $ 90 Deposits$100  Banks’ liabilities include deposits, assets include loans & reserves.  In this example, notice that R = $10/$100 = 10%.

12. THE MONETARY SYSTEM 11 Banks and the Money Supply: An Example Suppose $100 of currency is in circulation. To determine banks’ impact on money supply, we calculate the money supply in 3 different cases: 1.No banking system 2.100% reserve banking system: banks hold 100% of deposits as reserves, make no loans 3.Fractional reserve banking system

13. THE MONETARY SYSTEM 12 Banks and the Money Supply: An Example CASE 1: No banking system Public holds the $100 as currency. Money supply = $100.

14. THE MONETARY SYSTEM 13 Banks and the Money Supply: An Example CASE 2: 100% reserve banking system Public deposits the $100 at First Bank (FB). FIRST BANK AssetsLiabilities Reserves$100 Loans $ 0 Deposits$100 FB holds 100% of deposit as reserves: Money supply = currency + deposits = $0 + $100 = $100 In a 100% reserve banking system, banks do not affect size of money supply.

15. THE MONETARY SYSTEM 14 Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system Money supply = $190 (!!!) Depositors have $100 in deposits, Borrowers have $90 in currency. FIRST BANK AssetsLiabilities Reserves$100 Loans $ 0 Deposits$100 Suppose R = 10%. FB loans all but 10% of the deposit: 10 90

16. THE MONETARY SYSTEM 15 Banks and the Money Supply: An Example How did the money supply suddenly grow? When banks make loans, they create money. The borrower gets  $90 in currency (an asset counted in the money supply)  $90 in new debt (a liability) CASE 3: Fractional reserve banking system A fractional reserve banking system creates money, but not wealth.

17. THE MONETARY SYSTEM 16 Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system If R = 10% for SNB, it will loan all but 10% of the deposit. SECOND BANK AssetsLiabilities Reserves$ 90 Loans $ 0 Deposits$ 90 Suppose borrower deposits the $90 at Second Bank (SB). Initially, SB’s T-account looks like this: 9 81

18. THE MONETARY SYSTEM 17 Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system If R = 10% for TNB, it will loan all but 10% of the deposit. THIRD BANK AssetsLiabilities Reserves$ 81 Loans $ 0 Deposits$ 81 The borrower deposits the $81 at Third Bank (TB). Initially, TB’s T-account looks like this: $ 8.10 $72.90

19. THE MONETARY SYSTEM 18 Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system The process continues, and money is created with each new loan. Original deposit = FB lending = SB lending = TB lending =... $100.00 $90.00 $81.00 $72.90... Total money supply =$1000.00 In this example, $100 of reserves generates $1000 of money.

20. THE MONETARY SYSTEM 19 The Money Multiplier  Money multiplier: the amount of money the banking system generates with each dollar of reserves 這是狹義的貨幣乘數，也稱為存款貨幣 乘數 (deposit expansion multiplier)  The money multiplier equals 1/R.  In our example, R = 10% money multiplier = 1/R = 10 $100 of reserves creates $1000 of money

21. A C T I V E L E A R N I N G 1 Banks and the money supply 20 While cleaning your apartment, you look under the sofa cushion find a $50 bill (and a half-eaten taco). You deposit the bill in your checking account. The Fed’s reserve requirement is 20% of deposits. A. What is the maximum amount that the money supply could increase? B. What is the minimum amount that the money supply could increase?

22. A C T I V E L E A R N I N G 1 Answers 21 If banks hold no excess reserves, then money multiplier = 1/R = 1/0.2 = 5 The maximum possible increase in deposits is 5 x $50 = $250 But money supply also includes currency, which falls by $50. Hence, max increase in money supply = $200. You deposit $50 in your checking account. A. What is the maximum amount that the money supply could increase?

23. A C T I V E L E A R N I N G 1 Answers 22 Answer: $0 If your bank makes no loans from your deposit, currency falls by $50, deposits increase by $50, money supply does not change. You deposit $50 in your checking account. A. What is the maximum amount that the money supply could increase? Answer: $200 B. What is the minimum amount that the money supply could increase?

24. Money Multiplier THE MONETARY SYSTEM 23

25. THE MONETARY SYSTEM 24

26.  The monetary base is the sum of currency in circulation and bank reserves.  The money multiplier is the ratio of the money supply to the monetary base.

27.  Money supply = money multiplier x Monetary base  The central bank controls money supply by  Affecting monetary base  Affecting the multiplier

28. THE MONETARY SYSTEM 27 The Fed’s 3 Tools of Monetary Control 1. Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.  To increase money supply, Fed buys govt bonds, paying with new dollars. …which are deposited in banks, increasing reserves …which banks use to make loans, causing the money supply to expand.  To reduce money supply, Fed sells govt bonds, taking dollars out of circulation, and the process works in reverse.

29. THE MONETARY SYSTEM 28 The Fed’s 3 Tools of Monetary Control 1. Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.  OMOs are easy to conduct, and are the Fed’s monetary policy tool of choice.

30. THE MONETARY SYSTEM 29 The Fed’s 3 Tools of Monetary Control 2. Reserve Requirements (RR): affect how much money banks can create by making loans.  To increase money supply, Fed reduces RR. Banks make more loans from each dollar of reserves, which increases money multiplier and money supply.  To reduce money supply, Fed raises RR, and the process works in reverse.  Fed rarely uses reserve requirements to control money supply: Frequent changes would disrupt banking.

31. THE MONETARY SYSTEM 30 The Fed’s 3 Tools of Monetary Control 3. The Discount Rate: the interest rate on loans the Fed makes to banks  When banks are running low on reserves, they may borrow reserves from the Fed.  To increase money supply, Fed can lower discount rate, which encourages banks to borrow more reserves from Fed.  Banks can then make more loans, which increases the money supply.  To reduce money supply, Fed can raise discount rate.

32. THE MONETARY SYSTEM 31 The Fed’s 3 Tools of Monetary Control 3. The Discount Rate: the interest rate on loans the Fed makes to banks  The Fed uses discount lending to provide extra liquidity when financial institutions are in trouble, e.g. after the Oct. 1987 stock market crash.  If no crisis, Fed rarely uses discount lending – Fed is a “lender of last resort.”

33. THE MONETARY SYSTEM 32 The Federal Funds Rate  On any given day, banks with insufficient reserves can borrow from banks with excess reserves.  The interest rate on these loans is the federal funds rate.  The FOMC uses OMOs to target the fed funds rate.  Many interest rates are highly correlated, so changes in the fed funds rate cause changes in other rates and have a big impact in the economy.

34. The Fed Funds Rate and Other Rates, 1970-2008 (%) 0 5 10 15 20 19701975198019851990199520002005 Fed funds prime 3-month Tbill mortgage

35. THE MONETARY SYSTEM 34 Monetary Policy and the Fed Funds Rate To raise fed funds rate, Fed sells govt bonds (OMO). This removes reserves from the banking system, reduces supply of federal funds, causes r f to rise. rfrf F D1D1 S2S2 3.75% F2F2 S1S1 F1F1 3.50% The Federal Funds market Federal funds rate Quantity of federal funds

36. THE MONETARY SYSTEM 35 Problems Controlling the Money Supply  If households hold more of their money as currency, banks have fewer reserves, make fewer loans, and money supply falls.  If banks hold more reserves than required, they make fewer loans, and money supply falls.  Yet, Fed can compensate for household and bank behavior to retain fairly precise control over the money supply.

37. THE MONETARY SYSTEM 36 Bank Runs and the Money Supply  A run on banks: When people suspect their banks are in trouble, they may “run” to the bank to withdraw their funds, holding more currency and less deposits.  Under fractional-reserve banking, banks don’t have enough reserves to pay off ALL depositors, hence banks may have to close.  Also, banks may make fewer loans and hold more reserves to satisfy depositors.  These events increase R, reverse the process of money creation, cause money supply to fall.

38. THE MONETARY SYSTEM 37 Bank Runs and the Money Supply  During 1929-1933, a wave of bank runs and bank closings caused money supply to fall 28%.  Many economists believe this contributed to the severity of the Great Depression.  Since then, federal deposit insurance has helped prevent bank runs in the U.S.  In the U.K., though, Northern Rock bank experienced a classic bank run in 2007 and was eventually taken over by the British government.

39. THE MONETARY SYSTEM 38 The Structure of the Fed The Federal Reserve System consists of:  Board of Governors (7 members), located in Washington, DC  12 regional Fed banks, located around the U.S.  Federal Open Market Committee (FOMC), includes the Board of Governors and presidents of some of the regional Fed banks The FOMC decides monetary policy.

40. The Federal Reserve System

41.  Board of Governors ( 聯邦準備理事會 ) ：  整個聯邦準備體系的最高決策單位  由七位理事 (governor) 組成。理事由總統提名， 經參議院同意後任命，任期 14 年，不得連任。  主要職責是決定法定存款準備率，及審核各區聯 邦準備銀行的重貼現率提議。  監督管理聯邦準備體系下的會員銀行及金融機構 等。 THE MONETARY SYSTEM 40

42.  Federal Reserve Banks ( 聯邦準備銀行 ) ：  提出調整重貼現率方案，然後上呈理事會討論。  負責監管區域內金融機構的運作，並蒐集與分析 區內的金融情勢，提供理事會決策參考。 THE MONETARY SYSTEM 41

43.  聯邦公開市場委員會 (Federal Open Market Committee, FOMC) ：  公開市場操作的決策單位，其決議經常左右市場 的資金供給與利率高低。  FOMC 有 12 位成員： 7 位理事，紐約聯邦準備銀 行總裁，及 4 位其他聯邦準備銀行總裁 ( 輪值一年 )  決定聯邦資金利率 (federal funds rate ，相當於我 國的銀行同業間隔夜拆款利率。 THE MONETARY SYSTEM 42

44. 16-43 New York Fed John McClane

45. 16- 44 FRB of NY: The Gold Vault  250 million ounces  Over $85 billion at current market prices  10% of all the gold that has ever been taken out of the ground  One bar weights about 400 ounces

46. World official gold holding (December 2010) 1USA8133.5 ( tonnes) 2Germany3401.8 6China1054.1 7Switzerland1040.1 9Japan765.2 12ECB501.4 13Taiwan423.6

47. 我國的中央銀行  我國中央銀行係 1961 年 7 月 1 日在台灣復業。 1945 年 10 月至復業前，中央銀行的部分職權由台灣銀 代理執行。  原隸屬於總統府，但自 1979 年修正中央銀行法後， 改隸行政院。

48.  總裁 / 副總裁 : 任期 5 年。  理事會 : 11-15 人，總裁為主席，其中 5-7 人為常務 理事 ( 包括財政及經濟部長 ) ，每年開會 4 次。  監事會 : 5-7 人，行政院主計長為當然監事。  以上均由行政院報請總統派任。

49.  主要職掌：  貨幣政策 --- 利率、匯率、貨幣數量  國庫之公款保管人、發行公債及國庫券 ( 政府的銀 行 )  金融穩定與監理 ( 自 2004 年起金管會成立，央行不 再負責對個別銀行進行監督。 ) THE MONETARY SYSTEM 48

50. The Objectives of a Central Bank  Low, stable inflation  High, stable growth  Financial system stability  Stable interest rate  Stable exchange rate

51. CHAPTER SUMMARY  Money includes currency and various types of bank deposits.  The Federal Reserve is the central bank of the U.S., is responsible for regulating the monetary system.  The Fed controls the money supply mainly through open-market operations. Purchasing govt bonds increases the money supply, selling govt bonds decreases it. 50

52. CHAPTER SUMMARY  In a fractional reserve banking system, banks create money when they make loans. Bank reserves have a multiplier effect on the money supply. 51