1 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Prepared by: Fernando Quijano & Shelly Tefft CASE FAIR OSTER P R I N C I P L E S O F MACROECONOMICS T E N T H E D I T I O N

2 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall

3 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER OUTLINE 10 The Money Supply and the Federal Reserve System An Overview of Money What Is Money? Commodity and Fiat Monies Measuring the Supply of Money in the United States The Private Banking System How Banks Create Money A Historical Perspective: Goldsmiths The Modern Banking System The Creation of Money The Money Multiplier The Federal Reserve System Functions of the Federal Reserve Expanded Fed Activities Beginning in 2008 The Federal Reserve Balance Sheet How the Federal Reserve Controls the Money Supply The Required Reserve Ratio The Discount Rate Open Market Operations Excess Reserves and the Supply Curve for Money Looking Ahead

4 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Money is a means of payment, a store of value, and a unit of account. barter The direct exchange of goods and services for other goods and services. medium of exchange, or means of payment What sellers generally accept and buyers generally use to pay for goods and services. An Overview of Money What Is Money? A Means of Payment, or Medium of Exchange

5 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Which field of economic theory does not require that we know anything about money? a.Microeconomics. b.Macroeconomics. c.Neither microeconomic nor macroeconomic theory requires that we know anything about money. d.None of the above. Both microeconomic and macroeconomic theory require that we know quite a bit about money.

6 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Which field of economic theory does not require that we know anything about money? a.Microeconomics. b.Macroeconomics. c.Neither microeconomic nor macroeconomic theory requires that we know anything about money. d.None of the above. Both microeconomic and macroeconomic theory require that we know quite a bit about money.

7 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall store of value An asset that can be used to transport purchasing power from one time period to another. liquidity property of money The property of money that makes it a good medium of exchange as well as a store of value: It is portable and readily accepted and thus easily exchanged for goods. unit of account A standard unit that provides a consistent way of quoting prices. An Overview of Money What Is Money? A Store of Value A Unit of Account

8 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Which of the following refers to the liquidity property of money? a.The fact that money makes a good medium of exchange. b.The fact that money is portable and comes in convenient denominations. c.The fact that money is readily accepted and thus easily exchanged for goods. d.All of the above.

9 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Which of the following refers to the liquidity property of money? a.The fact that money makes a good medium of exchange. b.The fact that money is portable and comes in convenient denominations. c.The fact that money is readily accepted and thus easily exchanged for goods. d.All of the above.

10 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall commodity monies Items used as money that also have intrinsic value in some other use. fiat, or token, money Items designated as money that are intrinsically worthless. legal tender Money that a government has required to be accepted in settlement of debts. currency debasement The decrease in the value of money that occurs when its supply is increased rapidly. An Overview of Money Commodity and Fiat Monies

11 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall In most countries commodity monies are not used anymore, but the world is a big place and there are exceptions. In the Solomon Islands, dolphin teeth are being used as a means of payment and a store of value. Note that even with a currency like dolphin teeth there is a concern about counterfeit currency, namely fruit-bat teeth, but also tooth decay. Dolphin Teeth as Currency E C O N O M I C S I N P R A C T I C E Shrinking Dollar Meets Its Match in Dolphin Teeth Wall Street Journal

12 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall M1, or transactions money Money that can be directly used for transactions. M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits An Overview of Money Measuring the Supply of Money in the United States M1: Transactions Money

13 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall near monies Close substitutes for transactions money, such as savings accounts and money market accounts. M2, or broad money M1 plus savings accounts, money market accounts, and other near monies. M2 ≡ M1 + savings accounts + money market accounts + other near monies An Overview of Money Measuring the Supply of Money in the United States M2: Broad Money

14 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall When you transfer $1,000 from your checking account to your savings account, this transaction will: a.Decrease both M1 and M2. b.Decrease M1 and increase M2. c.M1 will remain the same and M2 will increase. d.M2 will remain the same and M1 will decrease.

15 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall When you transfer $1,000 from your checking account to your savings account, this transaction will: a.Decrease both M1 and M2. b.Decrease M1 and increase M2. c.M1 will remain the same and M2 will increase. d.M2 will remain the same and M1 will decrease.

16 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall There are no rules for deciding what is and is not money. This poses problems for economists and those in charge of economic policy. An Overview of Money Measuring the Supply of Money in the United States Beyond M2

17 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall financial intermediaries Banks and other institutions that act as a link between those who have money to lend and those who want to borrow money. An Overview of Money The Private Banking System The main types of financial intermediaries are commercial banks, followed by savings and loan associations, life insurance companies, and pension funds.

18 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall run on a bank Occurs when many of those who have claims on a bank (deposits) present them at the same time. How Banks Create Money A Historical Perspective: Goldsmiths Today’s bankers differ from goldsmiths—today’s banks are subject to a “required reserve ratio.” Goldsmiths had no legal reserve requirements, although the amount they loaned out was subject to the restriction imposed on them by their fear of running out of gold.

19 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Assets − Liabilities ≡ Net Worth or Assets ≡ Liabilities + Net Worth Federal Reserve Bank (the Fed) The central bank of the United States. How Banks Create Money The Modern Banking System A Brief Review of Accounting reserves The deposits that a bank has at the Federal Reserve bank plus its cash on hand. required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Federal Reserve.

20 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth).  FIGURE 10.1 T-Account for a Typical Bank (millions of dollars) How Banks Create Money The Modern Banking System A Brief Review of Accounting

21 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall On the T-account of a bank: a.Reserves are on the liability side. b.Deposits are an important liability. c.Assets plus net worth equal liabilities. d.Assets are usually greater than liabilities plus net worth.

22 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall On the T-account of a bank: a.Reserves are on the liability side. b.Deposits are an important liability. c.Assets plus net worth equal liabilities. d.Assets are usually greater than liabilities plus net worth.

23 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall excess reserves The difference between a bank’s actual reserves and its required reserves. excess reserves ≡ actual reserves − required reserves In panel 2, there is an initial deposit of $100. In panel 3, the bank has made loans of $400.  FIGURE 10.2 Balance Sheets of a Bank in a Single-Bank Economy How Banks Create Money The Creation of Money

24 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall In panel 1, there is an initial deposit of $100 in bank 1. In panel 2, bank 1 makes a loan of $80 by creating a deposit of $80. A check for $80 by the borrower is then written on bank 1 (panel 3) and deposited in bank 2 (panel 1). The process continues with bank 2 making loans and so on. In the end, loans of $400 have been made and the total level of deposits is $500.  FIGURE 10.3 The Creation of Money When There Are Many Banks How Banks Create Money The Creation of Money

25 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall An increase in bank reserves leads to a greater than one-for-one increase in the money supply. Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multiplier. money multiplier The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio. How Banks Create Money The Money Multiplier

26 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Assuming there are no leakages out of the banking system, a money multiplier equal to 10 means that: a.The reserve ratio equals 10. b.An additional $10 of reserves create one dollar of deposits. c.Each additional dollar of deposits creates $10 of reserves. d.Each additional dollar of reserves creates $10 of additional deposits.

27 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Assuming there are no leakages out of the banking system, a money multiplier equal to 10 means that: a.The reserve ratio equals 10. b.An additional $10 of reserves create one dollar of deposits. c.Each additional dollar of deposits creates $10 of reserves. d.Each additional dollar of reserves creates $10 of additional deposits.

28 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall  FIGURE 10.4 The Structure of the Federal Reserve System The Federal Reserve System

29 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Federal Open Market Committee (FOMC) A group composed of the seven members of the Fed’s Board of Governors, the president of the New York Federal Reserve Bank, and four of the other 11 district bank presidents on a rotating basis; it sets goals concerning the money supply and interest rates and directs the operation of the Open Market Desk in New York. Open Market Desk The office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed. The Federal Reserve System

30 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall From a macroeconomic point of view, the Fed’s crucial role is to control the money supply. The Fed also performs several important functions for banks, such as clearing interbank payments, regulating the banking system, and assisting banks in a difficult financial position. The Fed is also responsible for managing exchange rates and the nation’s foreign exchange reserves. It is often involved in intercountry negotiations on international economic issues. lender of last resort One of the functions of the Fed: It provides funds to troubled banks that cannot find any other sources of funds. The Federal Reserve System Functions of the Federal Reserve

31 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The Federal Reserve System Expanded Fed Activities Beginning in 2008 When housing prices began to fall in late 2005, the stage was set for a worldwide financial crisis, which essentially began in There has been much political discussion of whether the Fed should have regulated more in 2003–2005 and whether it should be intervening in the private sector as much as it has been doing. It is certainly the case that the Fed has taken a much more active role in financial markets since 2008.

32 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall TABLE 10.1 Assets and Liabilities of the Federal Reserve System, June 30, 2010 (Billions of Dollars) AssetsLiabilities Gold$ 11$ 945Currency in circulation U.S. Treasury securities777970Reserve balances Federal agency debt securities165288U.S. Treasury deposits Mortgage-backed securities1, All other liabilities and net worth All other assets 302$2,373Total $2,373 The Federal Reserve System The Federal Reserve Balance Sheet

33 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall If the Fed wants to increase the supply of money, it creates more reserves, thereby freeing banks to create additional deposits by making more loans. If it wants to decrease the money supply, it reduces reserves. Three tools are available to the Fed for changing the money supply: (1) Changing the required reserve ratio. (2) Changing the discount rate. (3) Engaging in open market operations. How the Federal Reserve Controls the Money Supply

34 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The preferred tool of the Federal Reserve for conducting monetary policy involves: a.Changes in the reserve requirement. b.Changes in the discount rate. c.Open market operations. d.Government spending and taxation.

35 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall The preferred tool of the Federal Reserve for conducting monetary policy involves: a.Changes in the reserve requirement. b.Changes in the discount rate. c.Open market operations. d.Government spending and taxation.

36 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall TABLE 10.2 A Decrease in the Required Reserve Ratio from 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars) Panel 1: Required Reserve Ratio = 20% Federal ReserveCommercial Banks AssetsLiabilitiesAssetsLiabilities Government$200$100Reserves $100$500Deposits securities $100CurrencyLoans$400 Note: Money supply (M1) = Currency + Deposits = $600. Panel 2: Required Reserve Ratio = 12.5% Federal ReserveCommercial Banks AssetsLiabilitiesAssetsLiabilities Government$200$100Reserves $100$800Deposits securities $100CurrencyLoans (+ $300) $700(+ $300) Note: Money supply (M1) = currency + deposits = $900. How the Federal Reserve Controls the Money Supply The Required Reserve Ratio

37 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Decreases in the required reserve ratio allow banks to have more deposits with the existing volume of reserves. As banks create more deposits by making loans, the supply of money (currency + deposits) increases. The reverse is also true: If the Fed wants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce their deposits by “calling in” some of their loans. The result is a decrease in the money supply. How the Federal Reserve Controls the Money Supply The Required Reserve Ratio

38 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall discount rate The interest rate that banks pay to the Fed to borrow from it. How the Federal Reserve Controls the Money Supply The Discount Rate moral suasion The pressure that in the past the Fed exerted on member banks to discourage them from borrowing heavily from the Fed.

39 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall TABLE 10.3 The Effect on the Money Supply of Commercial Bank Borrowing from the Fed (All Figures in Billions of Dollars) Panel 1: No Commercial Bank Borrowing from the Fed Federal ReserveCommercial Banks AssetsLiabilitiesAssetsLiabilities Securities$160$80Reserves $80$400Deposits $80CurrencyLoans$320 Note: Money supply (M1) = currency + deposits = $480. Panel 2: Commercial Bank Borrowing $20 from the Fed Federal ReserveCommercial Banks AssetsLiabilitiesAssetsLiabilities Securities$160$100Reserves (+ $20) $100$500Deposits (+ $300) Loans$20$80CurrencyLoans (+ $100) $420$20Amount owed to Fed (+ $20) Note: Money supply (M1) = currency + deposits = $580. How the Federal Reserve Controls the Money Supply The Discount Rate

40 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall open market operations The purchase and sale by the Fed of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply. How the Federal Reserve Controls the Money Supply Open Market Operations The Treasury Department is responsible for collecting taxes and paying the federal government’s bills. The Fed is not the Treasury. It is a quasi-independent agency authorized by Congress to buy and sell outstanding (preexisting) U.S. government securities on the open market. Two Branches of Government Deal in Government Securities

41 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall If the Fed wants to increase the money supply, it will: a.Increase the discount rate. b.Increase the reserve requirement. c.Buy government securities in the open market. d.Print money. e.Sell gold.

42 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall If the Fed wants to increase the money supply, it will: a.Increase the discount rate. b.Increase the reserve requirement. c.Buy government securities in the open market. d.Print money. e.Sell gold.

43 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall TABLE 10.4 Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences between Those Panels and Panel 1. All Figures in Billions of Dollars) Panel 1 Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities$100$20Reserves $20$100Deposits $5$0Debts $80CurrencyLoans$80$5Net Worth Note: Money supply (M1) = Currency + Deposits = $180. Panel 2 Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities (  $5) $95$15Reserves (  $5) $15$95Deposits (  $5) $0 Debts $80CurrencyLoans$80Securities (+ $5) $5 Net Worth Note: Money supply (M1) = Currency + Deposits = $175. Panel 3 Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities (  $5) $95$15Reserves (  $5) $15$75Deposits (  $25) Deposits (  $5) $0 Debts $80CurrencyLoans (  $20) $60Securities (+ $5) $5 Net Worth Note: Money supply (M1) = Currency + Deposits = $155. How the Federal Reserve Controls the Money Supply Open Market Operations The Mechanics of Open Market Operations

44 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall ■An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves. ■An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves. We can sum up the effect of these open market operations this way: How the Federal Reserve Controls the Money Supply Open Market Operations The Mechanics of Open Market Operations

45 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall If the Fed’s money supply behavior is not influenced by the interest rate, the money supply curve is a vertical line. Through its three tools, the Fed is assumed to have the money supply be whatever value it wants.  FIGURE 10.5 The Supply of Money How the Federal Reserve Controls the Money Supply Excess Reserves and the Supply Curve for Money

46 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall Looking Ahead This chapter has discussed only the supply side of the money market. In the next chapter, we turn to the demand side of the money market. We will examine the demand for money and see how the supply of and demand for money determine the equilibrium interest rate.

47 of 47 PART III The Core of Macroeconomic Theory © 2012 Pearson Education, Inc. Publishing as Prentice Hall barter commodity monies currency debasement discount rate excess reserves Federal Open Market Committee (FOMC) Federal Reserve Bank (the Fed) fiat, or token, money financial intermediaries legal tender lender of last resort liquidity property of money M1, or transactions money M2, or broad money medium of exchange, or means of payment money multiplier moral suasion near monies Open Market Desk open market operations required reserve ratio reserves run on a bank store of value unit of account 1. M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits 2. M2 ≡ M1 + savings accounts + money market accounts + other near monies 3. Assets ≡ Liabilities + Net Worth 4. Excess reserves ≡ actual reserves − required reserves 5. Money multiplier ≡ R E V I E W T E R M S A N D C O N C E P T S