1. Ch. 9: Money, the Price Level, and Inflation
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? Commodity Money Coins with precious metal Fiat 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
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
grains of silver = $1

4. GRESHAM’S LAW “Bad money drives out good"
Prior to 1834, grains of gold was worth more than 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 Unit of Account
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. Banks would print notes beyond reserves and extend loans.
Assets Liabilities
Reserves (gold) Notes 100
Total
Banks would print notes beyond reserves and extend loans.
Reserves Notes 1000
Loans ____
Total

10. With “fractional reserve banking”, the banking system
“creates money” and lends it out.
has only a fraction of liabilities on reserve.
cannot satisfy customer’s 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
longer–term 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

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, traveler’s checks, and checking deposits owned by individuals and businesses. M2 M1 plus time deposits, savings deposits, and money market mutual funds and other deposits.

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 bank’s owners invest $5 million in plant and equipment and thus have $5 million of owner’s equity. The bank’s balance sheet is now:

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

22. How do banks create money?
Fed sets a reserve ratio (let’s suppose it’s 25%). Implying bank must have 25% of it’s 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
Assets
Liabilities
Cash
90 m.
Demand deposits
90m360 m.
Loans
0270 m
Owner’s equity
5 m.
Plant & equipment
Total assets
95m365 m.
Total Liabilities
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 rr=25%
A new deposit of $100,000 is made.
The bank keeps $25,000 in reserve and lends $75,000.
This loan is credited to someone’s 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
M = 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
COB=$10m; rr=25%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
270 m
Owner’s equity
5 m.
Plant & equipment
Total assets
365 m.
Total Liabilities
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
increase by $10 million.
increase by $40 million
decrease by $10 million.
None of the above. 20

31. Assuming banks loan out all excess reserves, if the Fed purchases $10 million of government securities, M1 will
increase by $10 million.
increase by $40 million
Increase by $30 million.
None of the above. 20

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.

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
COB=$10m; rr=25%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
270 m
Owner’s equity
5 m.
Plant & equipment
Total assets
365 m.
Total Liabilities
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
Not change
Increase by $18 million
Increase by $90 million
None of the above. 20

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
COB=$10m; rr=25%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
270 m
Owner’s equity
5 m.
Plant & equipment
Total assets
365 m.
Total Liabilities
Suppose the public withdraws $10m. Of DD as cash. What is the effect on:
Loans Demand deposits M1

39. M1 would increase if The Fed increases the required reserve ratio
The Fed purchases government securities
The public decides to hold less money as demand deposits and more as cash
All of the above 20

40. Increase; increase Increase; decrease Decrease; decrease
If banks decide to hold more money as excess reserves, M1 will ____ and bank loans will ____
Increase; increase
Increase; decrease
Decrease; decrease
Decrease; increase 20

41. Total Bank Reserves:

42. MONETARY BASE:

43. M1:

44. EXCESS RESERVES:

45. The Market for Money The Demand for Money The Demand for Money Holding
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.

48. The demand for money The Price Level Real GDP
An increase in the price level
increases the quantity of nominal money people wish to hold, doesn’t 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 Fed’s interest rate target is 5 percent a year. The Fed adjusts the quantity of money each day to hit its interest rate target.

52. Fall because money supply increases
If the Fed purchases government bonds from the banking system, interest rates will ____
Fall because money supply increases
Rise because money demand increases
Fall because money demand decrease
None of the above 20

53. Fall as money demand decreases Fall as money supply increases
If the economy enters a recession and real GDP falls, interest rates will:
Fall as money demand decreases
Fall as money supply increases
Rise as money supply decreases
None of the above 20

54. Purchase government bonds Cut the required reserve ratio
If the Fed wants to stimulate spending by cutting interest rates, it could:
Purchase government bonds
Cut the required reserve ratio
Lower the discount rate
All of the above 20

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
V=velocity P=price level Y=real GDP M=quantity 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

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. Decreased velocity of money Faster growth of the money supply
According to the equation of exchange, which of the following will lead to greater inflation?
Decreased velocity of money
Faster growth of the money supply
Faster growth of real GDP
All of the above 20