1. Principles of Economics
Session 12

2. Topics To Be Covered Definition of Money Categories of Money
The Federal Reserve System
Money Multiplier
Supply and Demand for Money
Equilibrium of the Money Market
Monetary Policy

3. Definition of Money
Money 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 exchange
Unit of account
Store 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. Barter
Barter 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 Money
Commodity 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 billion
Currency
Traveler’s checks
Demand deposits
Other checkable deposits M2
$4,778 billion
Everything in M1
Saving deposits
Small time deposits
Money market mutual funds M3
$5,505 billion
Everything in M2
Large time deposits

8. The Central Bank
Generally, 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 Governors
The Regional Federal Reserve Banks
The 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 operations
Changing the reserve requirement
Changing 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 Creation
Banks 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 Creation
The 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 deposits
keeps a portion as reserves
lends out the rest.
It assumes a reserve ratio of 10%.
Assets
Liabilities
Reserves
$10.00
Loans
$90.00
Deposits
$100.00
Total Assets
$100.00
Total Liabilities

21. Money Creation
When 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
Liabilities
Assets
Liabilities
Reserves
$10.00
Loans
$90.00
Deposits
$90.00
Deposits
$100.00
Reserves
$9.00
Loans
$81.00
Total Assets
$100.00
Total Liabilities
$100.00
Total Assets
$90.00
Total Liabilities
Money 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 Multiplier
The 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 Rate Ms Md
Equilibrium Interest rate
Money

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 Money
The 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 Rate
Md2 Ms
When the price level rises, the demand for money increases.
Md1 r2 r1
Money

30. Demand for Money and the Real GDP
Interest Rate
Md2 Ms
When real GDP rises, the demand for money increases.
Md1 r2 r1
Money

31. The Demand for Money
Generally, the motives of people holding money can be roughly classified into two categories.
Transaction demand for money
Speculative demand for money

32. The Demand for Money
Transaction 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 Rate
Promised Payment
Interest Rate
Promised Payment
$106 6%
$106 4%
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 rates
Low bond prices
Purchasing bonds
Less 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 rates
High bond prices
Selling bonds
More money in hand

41. Demand for Money
L1=L1(Y) m r m r
L2=L2(r)
L=L1+ L2

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 equilibrium r1 E m

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 Ratesm3 m1 m2 L r3 E r1 r2 m

46. Monetary Policy
Monetary policy is the range of actions taken by the Federal Reserve to influence the level of GDP or the rate of inflation.

47. Monetary Policy
The 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.

48. Money supply increases Investment spending rises
Monetary Policy
Money
Investment
Output
Ms2
AE2 Y2 r1 r1 r2 r2
AE1 Md I2
Ms1 I1 Y1
Open market purchase
Money supply increases
Interest rates fall
Investment spending rises
GDP 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 GDP
Md2
Ms2
AE2 Y2 r1 r1 r2 r2
AE1
Md1 I2
Ms1 I1
Money
Investment
Output

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.

52. Thanks