Presentation on theme: "Introduction to Macroeconomics"— Presentation transcript:
1 Introduction to Macroeconomics Chapter 26Money, Banking andthe Federal Reserve
2 Money, Banking, & the Federal Reserve 1. Barter Economy2. Characteristics of Money3. Definition of Money4. Fractional Reserve Banking5. How Banks Create Money6. Federal Reserve Policy Tools
3 1. Barter Economy Transaction Costs Barter - direct trade of one good for anotherTransaction Costs:double coincidence of wantsproblem of divisibilitynegotiating relative values
4 2. Characteristic of Money General Characteristics Medium of Exchange - item generally acceptable as payment for goods and services. Avoids double coincidence of wants.Store of Value - money can be accumulated without deterioration or loss. No problem with divisibility.Unit of Account - money is a standard unit for quoting prices and establishing relative values. Reduces negotiation costs.
5 2. Characteristics of Money Commodity Money scarce relative to other commoditiesstable in supplyportabledivisibledurableProblems:opportunity costdebasing (Gresham’s Law)can’t directly control supply
6 2. Characteristics of Money Representative Money Paper money that can be exchanged for a specific commodity, like silver or gold.Advantages:Lower opportunity costEliminates debasingProblems:Depends on value of underlying commodityCounterfeitingLower Opportuinity Cost - don’t have to hold gold reserves equivalent to all money in circulation. Can purchase/trade for commodity if needed.
7 2. Characteristics of Money Fiat Money Paper money that is solely money because the government says it isGenerally not backed by a valuable commodity such as god but is backed by the “full faith and credit of the government”Advantages:No opportunity costNot dependent on value of a commodityDisadvantagesNo restraint in printing money
8 3. Definitions of Money Categorized by Liquidity Liquidity - how easily money can be used to make purchasesMonetary Base - currency held by public + currency held in bank vaults (reserves)M1 = currency held by public plus checking depositsM2 = M1 + savings deposits + small (less than $100,000) time deposits (CDs)M3 = M2 + large (more than $100,000) time deposits
9 3. Definitions of Money M1Source: Federal Reserve, H-6 Statistical Release, Table 4, September 2001.
10 3. Definitions of Money M2Source: Federal Reserve, H-6 Statistical Release, Table 5, September 2001.
11 4. Fractional Reserve Banking Banks hold reserves (cash in their vault) that are only a fraction of their demand deposits (e.g., checking and savings accounts)Banks make a profit by charging a higher interest rate for loans than is paid for deposits.
12 4. Fractional Reserve Banking Risks Bank runsBank failures because of bad loansInstitutions to reduce risks:FDIC deposit insuranceFederal Reserve System bank regulations
13 4. Fractional Reserve Banking Key MeasurementsDemand Deposits (D) - total of checking and savings accountRequired Reserve Ratio (r) - fraction of D established by Federal ReserveRequired Reserves, RR = r * DTotal Reserves = cash in bank vaultsExcess Reserves = Total Reserves - RR
14 5. How Banks Create Money Money Multiplier Money Multiplier = 1 / rMaximum Possible Increase in Money Supply= Initial change in monetary basex money multiplier
15 5. How Banks Create Money Money Multiplier at Work
16 6. Federal Reserve Policy Tools The Federal Reserve System Created by act of Congress in 1913The Federal Reserve System (often called "the Fed") was formed in 1913 after panic of The Fed is the primary regulatory agency covering commercial banking. The responsibilities of the Fed include:- Controlling amount of money in U.S.- Lender of last resort- Acts as "bankers" bank (e.g., go through Fed on wire transfers, makes loans)- Supervises and inspects local banks- Acts as the Federal government's bank
17 6. Federal Reserve Policy Tools Policy Options Open Market Operations - buy and sell T-BillsDiscount Rate - interest rate charged by Fed for overnight loans to banksRequired Reserve RatioStock Market Margin RequirementsMoral Persuasion
18 6. Federal Reserve Policy Tools Open Market Operations Open Market Operation - purchase or sale of government securities (T-bills) on the open marketT-Bill Par Value: cash-in value when T-Bill maturesInterest Rate - difference between par value of T-Bill and and purchase price
19 6. Federal Reserve Policy Tools Expansionary Policy Objective: Lower Interest RateFed buys T-Bills (increase in money supply)Market price of T-Bills increaseDifference between market price and par value declines.Result: Lower interest rate
20 6. Federal Reserve Policy Tools Open Market Operations + represents increase, - represents decrease
21 6. Federal Reserve Policy Tools Summary of Policy Options
22 6. Federal Reserve Policy Tools Money and the Unemployment Rate Ratio: Reserves-to-Required ReservesMonetary BaseUnemployment Rate