2 Topics To Be Covered Definition of Money Categories of Money The Federal Reserve SystemMoney MultiplierSupply and Demand for MoneyEquilibrium of the Money MarketMonetary Policy
3 Definition of MoneyMoney is the set of assets in the economy that people regularly use to buy goods and services from other people.It serves three functions:Medium of exchangeUnit of accountStore of value
4 Three Functions of Money A medium of exchange is anything that is readily acceptable as payment.A unit of account is the yardstick people use to post prices and record debts.A store of value is an item that people can use to transfer purchasing power from the present to the future.
5 BarterBarter is the direct exchange of goods and services for other goods and services.A barter system requires a double coincidence of wants for trade to take place. Money eliminates this problem.Money as a means of payment, or medium of exchange, is more efficient than barter.
6 Categories of MoneyCommodity Money Commodity money takes the form of a commodity with intrinsic value. For example: Gold, silver, cigarettes.Fiat Money Fiat money is used as money because of government decree. It does not have intrinsic value. For example: Coins, currency, check deposits.
7 Money in the U.S. Economy Measure Amount in 2000 What’s Included M1 $1,103 billionCurrencyTraveler’s checksDemand depositsOther checkable depositsM2$4,778 billionEverything in M1Saving depositsSmall time depositsMoney market mutual fundsM3$5,505 billionEverything in M2Large time deposits
8 The Central BankGenerally, the central bank of a country serves the following functions:It oversees the banking system.It acts as a banker’s bank, making loans to banks and as a lender of last resort.It conducts monetary policy by controlling the money supply.The Chinese central bank is the People’s Bank of China and the American one is the Federal Reserve System.
9 The Fed’s Organization The Federal Reserve System (Fed) consists of :The Board of GovernorsThe Regional Federal Reserve BanksThe Federal Open Market Committee
10 The Fed’s Organization The Fed is run by a Board of Governors, which has seven members appointed by the President and confirmed by the Senate.Among the seven members, the most important is the chairman. The chairman directs the Fed staff, presides over board meetings, and testifies about Fed policy in front of Congressional Committees.
11 The Fed’s Organization The Fed also includes 12 regional reserve banks.Each regional reserve bank consists of nine directors—three appointed by the Board of Governors and six elected by the commercial banks in the district.The directors appoint the district president which is approved by the Board of Governors.
12 The Fed’s Organization The Federal Open Market Committee (FOMC) is made up of the following voting members:The chairman and the other six members of the Board of Governors.The president of the Federal Reserve Bank of New York.The presidents of the other regional Federal Reserve banks (four votes on a yearly rotating basis).
13 The Fed’s Organization FOMC serves as the main policy-making organ of the Federal Reserve System.FOMC meets approximately every six weeks to review the economy.FOMC conducts the monetary policy
14 Fed’s Tools of Monetary Control The Fed has three tools in its monetary toolbox:Open-market operationsChanging the reserve requirementChanging the discount rate
15 Open-Market Operations The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public:When the Fed buys government bonds, the money supply increases.The money supply decreases when the Fed sells government bonds.
16 Changing the Reserve Requirement The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out.Increasing the reserve requirement decreases the money supply.Decreasing the reserve requirement increases the money supply.
17 Changing the Discount Rate The discount rate is the interest rate the Fed charges banks for loans.Increasing the discount rate decreases the money supply.Decreasing the discount rate increases the money supply.
18 Money CreationBanks can influence the quantity of demand deposits in the economy and the money supply.In a fractional reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.When a bank makes a loan from its reserves, the money supply increases.
19 Money CreationThe money supply is affected by the amount deposited in banks and the amount that banks loan.Deposits into a bank are recorded as both assets and liabilities.The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio (R).Loans become an asset to the bank.
20 Money Creation First Bank This T-Account shows a bank that: accepts depositskeeps a portion as reserveslends out the rest.It assumes a reserve ratio of 10%.AssetsLiabilitiesReserves$10.00Loans$90.00Deposits$100.00Total Assets$100.00Total Liabilities
21 Money CreationWhen one bank loans money, that money is generally spent. And the recipient deposits it into another bank.This creates more deposits and more reserves to be lent out.When a bank makes a loan from its reserves, the money supply increases.
22 Money Creation Money Supply = $190.00 First Bank Second Bank Assets LiabilitiesAssetsLiabilitiesReserves$10.00Loans$90.00Deposits$90.00Deposits$100.00Reserves$9.00Loans$81.00Total Assets$100.00Total Liabilities$100.00Total Assets$90.00Total LiabilitiesMoney Supply = $190.00
23 Money Creation Original deposit = $ 100.00 First lending = $First lending= $ [=0.9 x $100.00]Second lending= $ [=0.9 x $90.00]Third lending= $ [=0.9 x $81.00]……………………………………………………….
24 The Money MultiplierThe money multiplier is the amount of money the banking system generates with each dollar of reserves.
25 Supply and Demand for Money In the money market, interest rates are determined by the supply and demand for money.The central bank can change the interest rate level because it controls the supply of money.
26 Supply and Demand for Money Interest RateMsMdEquilibrium Interest rateMoney
27 The Demand for Money (The Liquid Preference) Portfolio of holding financial wealth: stocks, bonds or money.Holding wealth in currency or checking deposits means loss of potential income from interest on bonds and dividends on stocks.
28 The Demand for MoneyThe market rate of interest is the opportunity cost of holding money.As interest rates rise, the opportunity cost of holding money rises, and the public demands less money. So the demand curve is downward sloping.Macroeconomic variables that change the demand for money are price level and real GDP.
29 Demand for Money and the Price Level Interest RateMd2MsWhen the price level rises, the demand for money increases.Md1r2r1Money
30 Demand for Money and the Real GDP Interest RateMd2MsWhen real GDP rises, the demand for money increases.Md1r2r1Money
31 The Demand for MoneyGenerally, the motives of people holding money can be roughly classified into two categories.Transaction demand for moneySpeculative demand for money
32 The Demand for MoneyTransaction demand for money The needs or desires of individuals or firms to make purchases on short notice without incurring excessive costs.Speculative demand for money An attitude that holding money over short periods is less risky than holding stocks or bonds.
33 The Transaction Demand for Money The transactions demand for money (L1) is based on the desire to facilitate transactions.It mainly depends on the income (Y), so its function is:
34 The Speculative Demand for Money The speculative demand for money (L2) is based on the desire to make wise decisions to invest in securities such as bonds.It mainly depends on the interest, so its function is:
35 Bond Prices and Interest Rates Bonds are promises to pay money in the future. The price of a bond one year from now is the promised payment divided by 1 plus the interest rate.
36 Bond Prices and Interest Rates For example, a bond that promises to pay $106 a year, with an interest rate is 6% per year, would cost today:In other words, if you can invest at 6% per year, you would be willing to pay $100 today for a $106 promised payment next year.
37 Interest Rates and Bond Prices Bond prices change in the opposite direction from changes in interest rates:Interest RatePromised PaymentInterest RatePromised Payment$1066%$1064%If the interest rate rose to 8%, how much would you like to pay?$98.15.
38 Interest Rates and Bond Prices When interest rates rise, investors need less money to obtain the same promised payments in the future, so the price of bonds falls.Therefore, bonds’ prices are inversely related to interest rates.
39 The Speculative Demand for Money When the interest is high, the bond price is low. Usually people will guess that the bond price is to rise, so they purchase bonds, thus having less money in hand.high interest ratesLow bond pricesPurchasing bondsLess money in hand
40 The Speculative Demand for Money When the interest is low, the bond price is high. Usually people will expect that the bond price is to fall, so they sell the bonds they own. Consequently they have more money in hand.Low interest ratesHigh bond pricesSelling bondsMore money in hand
42 Equilibrium of the Money Market When the money market is at equilibrium, the demand for money (L) should be equal to the supply of money (m).The money supply is controlled by the central bank.
43 Equilibrium of the Money Market When money demand and supply equal, the money market is at equilibriumr1Em
44 Central Bank and Interest Rates The central bank can influence the interest rate through changing the money supply.An increase in the money supply leads to a lower interest rate.A decrease in the money supply leads to a higher interest rate.
45 Central Bank and Interest Rates m3m1m2Lr3Er1r2m
46 Monetary PolicyMonetary policy is the range of actions taken by the Federal Reserve to influence the level of GDP or the rate of inflation.
47 Monetary PolicyThe central bank can influence the output by changing the money supply.When the central bank increase the money supply, the interest rate goes down.With the decrease of interest rate, the investment increases.Since increase is part of GDP, the total output increases.
49 Limitations of Monetary Policy If the economy has reached the level of potential output, namely, the full-employment output, the expansionary monetary policy won’t work effectively.Initially, monetary expansion leads to output above full employment. The demand for money increases, leading to a higher interest rate.The increase of interest rate will decrease the investment, which will return the GDP back to the full-employment level.
50 Limitations of Monetary Policy Potential GDPMd2Ms2AE2Y2r1r1r2r2AE1Md1I2Ms1I1MoneyInvestmentOutput
51 Assignment Review Chapter 25 and 26. Answer questions on P491 and 513. Search for information on China’s monetary policies in the recent years.Preview Chapter 29 and 30.