Principles of MacroEconomics: Econ101 Chapter 13 & 14: Money & Banking & The Federal Reserve & Monetary Policy Principles of MacroEconomics: Econ101

In this Lecture……………….. Money Defined Measurements of the Money Supply The Money Creation Process The Federal Reserve Monetary Policy

Money vs. Barter Money: Any good that is widely accepted for purposes of exchange and in the repayment of debt. Barter: Exchanging goods and services for other goods and services without the use of money.

Functions of Money Money as a Medium of Exchange: Anything that is generally acceptable in exchange for goods and services. durable Store of value High in value in relation to weight…..no cotton Scarce Money as a Unit of Account: A common measure in which relative values are expressed. Money as a Store of Value: The ability of an item to hold value over time.

Why Do We Need Money? ….……….because by making exchange easier, money allows for specialization and higher productivity. In a barter economy, before a trade can be made, a trader must find another trader who is willing to trade what the first trader wants (Double Coincidence of Wants) and at the same time wants what the first trader has.

Our money today has value because of its general acceptability. What Gives Money Its Value? Our money today has value because of its general acceptability.

Measuring the Money Supply: M1 M1: The narrowest definition of the money supply: the sum of currency in circulation, checking account balances in banks, and holdings of traveler’s checks. It includes: 1. All the paper money and coins that are in circulation – meaning what is not held by banks or the government. 2. The value of all checking account balances at banks. 3. The value of traveler’s checks.

Measuring the Money Supply M2 M2: A broader definition of the money supply: M1 plus savings account balances, small-denomination time deposits, balances in money market deposit accounts in banks, and non-institutional money market fund shares. Two key points about the money supply to keep in mind are: 1. The money supply consists of both currency and balances in checking accounts and traveler’s checks. 2. Because balances in checking accounts are included in the money supply, banks play an important role in the process by which the money supply increases and decreases.

Self-Test 1. Why (not how) did money evolve out of a barter economy? Money evolved because individuals wanted to make trading easier (i.e., less time-consuming). In a barter economy, this need motivated people to accept the good with relatively greater acceptability than all other goods. In time, the effect snowballed, and finally the good with initially relatively greater acceptability emerged into a good that was widely accepted for purposes of exchange. At this point, the good became money. 2. If individuals remove funds from their checkable deposits and transfer them to their money market accounts, will M1 fall and M2 rise? Explain your answer. No. M1 will fall, but M2 will not rise; it will remain constant. To illustrate, suppose M1 is $400 and M2 is $600. If people remove $100 from checkable deposits, M1 will decline to $300. For purposes of illustration, think of M2 as equal to M1 money market accounts. The M1 component of M2 falls by $100, but the money market accounts component rises by $100; so there is no net effect on M2. Thus M1 falls and M2 remains constant. 3. How does money reduce the transaction costs of making trades? In a barter (moneyless) economy, a double coincidence of wants will not occur for every transaction. When it does not occur, the cost of the transaction increases because more time must be spent to complete the trade. In a money economy, money is acceptable for every transaction; so a double coincidence of wants is not necessary. All buyers offer money for what they want to buy, and all sellers accept money for what they want to sell.

The Money Creation Process Reserves: The sum of bank deposits at the Fed and vault cash. Required Reserve Ratio (r): A percentage of each dollar deposited that must be held on reserve (at the Fed or in the bank’s vault). Required Reserves: The minimum amount of reserves a bank must hold against its checkable deposits as mandated by the Fed. Excess Reserves: Any reserves held beyond the required amount. The difference between (total) reserves and required reserves.

Using T-Accounts to Show How a Bank Can Create Money How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money

Using T-Accounts to Show How a Bank Can Create Money How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money

Using T-Accounts to Show How a Bank Can Create Money How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money

Using T-Accounts to Show How a Bank Can Create Money How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money

The Simple Deposit / Money Multiplier BANK INCREASE IN CHECKING ACCOUNT DEPOSITS Wachovia $1,000 PNC $900 (= 0.9 x $1,000) Third Bank $810 (= 0.9 x $900) Fourth Bank $729 (= 0.9 x $810) . Total Change in Checking Account Deposits $10,000 Simple Deposit/Money Multiplier: the ratio of the amount of deposits created by banks to the amount of new reserves. Change in checking account deposits = Change in bank reserves x (1/RR)

Self-Test 1. If a bank’s deposits equal $579 million and the required reserve ratio is 9.5 percent, what dollar amount must the bank hold in reserve form? .095 X $579 = $55 million 2. If the Fed creates $600 million in new reserves, what is the maximum change in checkable deposits that can occur if the required reserve ratio is 10 percent? 1/10 X .6 billion = $6 billion

The Federal Reserve System The central bank of the United States, established in 1913 as lender of last resort to avoid bank panics and manage the money supply. 17

Structure of the Federal Reserve System Board of Governors - The 7-member governing body of the Federal Reserve System. Federal Open Market Committee (FOMC) -The 12-member policymaking group within the Fed. The committee has the authority to conduct open market operations. To view a presentation on the Fed click the picture of Fed Headquarters – select “Structure Tour” 18

Federal Open Market Committee (FOMC) The Federal Open Market Committee (FOMC) is the major policymaking group within the Fed. Authority to conduct open market operations—the buying and selling of government securities—rests with the FOMC. The FOMC has 12 members: the 7-member Board of Governors and 5 Federal Reserve District Bank presidents. 19

Self-Test 1. What is the most important responsibility of the Fed? The Fed controls the money supply. 2. What does it mean to say the Fed acts as “lender of last resort”? Acting as the lender of last resort means the Fed stands ready to lend funds to banks that are suffering cash management, or liquidity, problems. 20

Tools for Controlling the Money Supply Open Market Operations Required Reserve Ratio Discount Policy 21

Open Market Operations The buying and selling of government securities by the Fed…….”printing more money”. Open Market Purchase: The buying of U.S. government securities by the Fed Open Market Sale: The selling of U.S. government securities by the Fed 22

Open Market Operations 23

Required Reserve Ratio The Fed rule that specifies the amount of reserves a bank must hold to back up deposits. Maximum change in checkable deposits = (1/rr) x ΔR (rr=required reserve ratio; R = reserves) ↑ rr → ↓ in checkable deposits & excess reserves ↓ rr→ ↑ in checkable deposits & excess reserves 24

Discount Policy Discount loans: Loans the Federal Reserve makes to banks. Discount rate: The interest rate the Federal Reserve charges on discount loans. Lower interest rate encourages banks to take on loans. Raising interest rate has reverse effect 25

The Fed Responds to the Terrorist Attacks of September 11, 2001 16 - 2 The Fed Responds to the Terrorist Attacks of September 11, 2001 The day after the terrorist attacks of September 11, 2001, the Fed made massive discount loans to banks and succeeded in preventing a financial panic. Alan Greenspan, pictured here, was the chairman of the Fed at the time of the attacks.

Borrowing Reserves Federal Funds Market: A market where banks lend reserves to one another, usually for short periods. Why? To increase loan making ability To meet required reserve requirements Federal Funds Rate: The interest rate in the federal funds market; the interest rate banks charge one another to borrow reserves. Affects short term treasury bills Affects interest rates on long term financial assets, such as corporate bonds and mortgages. 27

Fed Monetary Tools and Their Effects on the Money Supply 28

Self-Test 1. How does the money supply change as a result of (a) an increase in the discount rate, (b) an open market purchase, (c) an increase in the required reserve ratio? a. The money supply falls. b. The money supply rises. c. The money supply falls. 2. What is the difference between the federal funds rate and the discount rate? The federal funds rate is the interest rate that one bank charges another bank for a loan. The discount rate is the interest rate that the Fed charges a bank for a loan. 3. If bank A borrows $10 million from bank B, what happens to the reserves in bank A? in the banking system? Reserves in bank A rise; reserves in the banking system remain the same (bank B lost the reserves that bank A borrowed). 4. If bank A borrows $10 million from the Fed, what happens to the reserves in bank A? in the banking system? Reserves in bank A rise; reserves in the banking system rise because there is no offset in reserves for any other bank. 29