N. G R E G O R Y M A N K I W Premium PowerPoint ® Slides by Ron Cronovich 2008 update © 2008 South-Western, a part of Cengage Learning, all rights reserved 29 P R I N C I P L E S O F F O U R T H E D I T I O N The Monetary System

1 CHAPTER 29 THE MONETARY SYSTEM In this chapter, look for the answers to these questions:  What assets are considered “money”? What are the functions of money? The types of money?  What is the Federal Reserve?  What is the People’s Bank of China?  What role do banks play in the monetary system? How do banks “create money”?  How does the Federal Reserve / People’s Bank control the money supply?

2 CHAPTER 29 THE MONETARY SYSTEM What Money Is, and Why It’s Important  Without money, trade would require barter, the exchange of one good or service for another.  Every transaction would require a double coincidence of wants – the unlikely occurrence that two people each have a good the other wants.  Most people would have to spend time searching for others to trade with – a huge waste of resources.  This searching is unnecessary with money, the set of assets that people regularly use to buy g&s from other people.

3 CHAPTER 29 THE MONETARY SYSTEM The 3 Functions of Money  Medium of exchange: an item buyers give to sellers when they want to purchase g&s  Unit of account: the yardstick people use to post prices and record debts  Store of value: an item people can use to transfer purchasing power from the present to the future

4 CHAPTER 29 THE MONETARY SYSTEM The 2 Kinds of Money Commodity money: takes the form of a commodity with intrinsic value Examples: gold coins, cigarettes in POW camps Fiat money: money without intrinsic value, used as money because of govt decree Example: the U.S. dollar

5 CHAPTER 29 THE MONETARY SYSTEM The Money Supply  The money supply (or money stock): the quantity of money available in the economy  What assets should be considered part of the money supply? Two candidates: Currency: the paper bills and coins in the hands of the (non-bank) public Demand deposits: balances in bank accounts that depositors can access on demand by writing a check

6 CHAPTER 29 THE MONETARY SYSTEM Measures of the U.S. Money Supply  M1: currency, demand deposits, traveler’s checks, and other checkable deposits. M1 = $1.4 trillion (February 2008)  M2: everything in M1 plus savings deposits, small time deposits, money market mutual funds, and a few minor categories. M2 = $7.6 trillion (February 2008) The distinction between M1 and M2 will usually not matter when we talk about “the money supply” in this course.

7 CHAPTER 29 THE MONETARY SYSTEM Central Banks & Monetary Policy  Central bank: an institution that oversees the banking system and regulates the money supply  Monetary policy: the setting of the money supply by policymakers in the central bank  Federal Reserve (Fed): the central bank of the U.S.  People’s Bank of China: the central bank of the PRC

8 CHAPTER 29 THE MONETARY SYSTEM The Structure of the Fed The Federal Reserve System consists of: Board of Governors (7 members), located in Washington, DC 12 regional Fed banks, located around the U.S. Federal Open Market Committee (FOMC), includes the Bd of Govs and presidents of some of the regional Fed banks The FOMC decides monetary policy. Alan Greenspan Chair of FOMC, Aug – Jan 2006

9 CHAPTER 29 THE MONETARY SYSTEM The Structure of the People’s Bank  A governor and a certain number of deputy governors.  The governor of the PBC is appointed into or removed from office by the President of the People's Republic of China.  The deputy governors of the PBC are appointed into or removed from office by the Premier of the State Council.  The PBC adopts a governor responsibility system under which the governor supervises the overall work of the PBC while the deputy governors provide assistance to the governor to fulfill his or her responsibility.

10 CHAPTER 29 THE MONETARY SYSTEM Role of the People’s Bank  The objective of the monetary policy is to maintain the stability of the value of the currency and thereby promote economic growth.  The monetary policy instruments applied by the PBC include reserve requirement ratio, central bank base interest rate, rediscounting, central bank lending, open market operation and other policy instruments specified by the State Council.

11 CHAPTER 29 THE MONETARY SYSTEM Bank Reserves  In a fractional reserve banking system, banks keep a fraction of deposits as reserves, and use the rest to make loans.  The Fed / People’s Bank establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits.  Banks may hold more than this minimum amount if they choose.  The reserve ratio, R =fraction of deposits that banks hold as reserves =total reserves as a percentage of total deposits

12 CHAPTER 29 THE MONETARY SYSTEM Bank T-account  T-account: a simplified accounting statement that shows a bank’s assets & liabilities.  Example: FIRST NATIONAL BANK AssetsLiabilities Reserves$ 10 Loans $ 90 Deposits$100  Banks’ liabilities include deposits, assets include loans & reserves.  In this example, notice that R = $10/$100 = 10%.

13 CHAPTER 29 THE MONETARY SYSTEM Banks and the Money Supply: An Example Suppose $100 of currency is in circulation. To determine banks’ impact on money supply, we calculate the money supply in 3 different cases: 1.No banking system 2.100% reserve banking system: banks hold 100% of deposits as reserves, make no loans 3.Fractional reserve banking system

14 CHAPTER 29 THE MONETARY SYSTEM Banks and the Money Supply: An Example CASE 1: no banking system Public holds the $100 as currency. Money supply = $100.

15 CHAPTER 29 THE MONETARY SYSTEM Banks and the Money Supply: An Example CASE 2: 100% reserve banking system Public deposits the $100 at First National Bank (FNB). FIRST NATIONAL BANK AssetsLiabilities Reserves$100 Loans $ 0 Deposits$100 FNB holds 100% of deposit as reserves: Money supply = currency + deposits = $0 + $100 = $100 In a 100% reserve banking system, banks do not affect size of money supply.

16 CHAPTER 29 THE MONETARY SYSTEM Banks and the Money Supply: An Example CASE 3: fractional reserve banking system Money supply = $190 (!!!) depositors have $100 in deposits, borrowers have $90 in currency. FIRST NATIONAL BANK AssetsLiabilities Reserves$100 Loans $ 0 Deposits$100 Suppose R = 10%. FNB loans all but 10% of the deposit: 10 90

17 CHAPTER 29 THE MONETARY SYSTEM Banks and the Money Supply: An Example How did the money supply suddenly grow? When banks make loans, they create money. The borrower gets $90 in currency (an asset counted in the money supply) $90 in new debt (a liability) CASE 3: fractional reserve banking system A fractional reserve banking system creates money, but not wealth.

18 CHAPTER 29 THE MONETARY SYSTEM Banks and the Money Supply: An Example CASE 3: fractional reserve banking system If R = 10% for SNB, it will loan all but 10% of the deposit. SECOND NATIONAL BANK AssetsLiabilities Reserves$ 90 Loans $ 0 Deposits$ 90 Suppose borrower deposits the $90 at Second National Bank (SNB). Initially, SNB’s T-account looks like this: 9 81

19 CHAPTER 29 THE MONETARY SYSTEM Banks and the Money Supply: An Example CASE 3: fractional reserve banking system If R = 10% for TNB, it will loan all but 10% of the deposit. THIRD NATIONAL BANK AssetsLiabilities Reserves$ 81 Loans $ 0 Deposits$ 81 The borrower deposits the $81 at Third National Bank (TNB). Initially, TNB’s T-account looks like this: $ 8.10 $72.90

20 CHAPTER 29 THE MONETARY SYSTEM Banks and the Money Supply: An Example CASE 3: fractional reserve banking system The process continues, and money is created with each new loan. Original deposit = FNB lending = SNB lending = TNB lending =... $ $90.00 $81.00 $ Total money supply =$ In this example, $100 of reserves generate $1000 of money.

21 CHAPTER 29 THE MONETARY SYSTEM The Money Multiplier  Money multiplier: the amount of money the banking system generates with each dollar of reserves  The money multiplier equals 1/R.  In our example, R = 10% money multiplier = 1/R = 10 $100 of reserves creates $1000 of money

A C T I V E L E A R N I N G 1 : Exercise While cleaning your apartment, you look under the sofa cushion find a CNY 50 bill. You deposit the bill in your checking account. The People’s Bank reserve requirement is 20% of deposits. 22 A. What is the maximum amount that the money supply could increase? B. What is the minimum amount that the money supply could increase?

A C T I V E L E A R N I N G 1 : Answers If banks hold no excess reserves, then money multiplier = 1/R = 1/0.2 = 5 The maximum possible increase in deposits is 5 x $50 = $250 But money supply also includes currency, which falls by $50. Hence, max increase in money supply = $ You deposit $50 in your checking account. A. What is the maximum amount that the money supply could increase?

A C T I V E L E A R N I N G 1 : Answers Answer: $0 If your bank makes no loans from your deposit, currency falls by $50, deposits increase by $50, money supply remains unchanged. 24 You deposit $50 in your checking account. A. What is the maximum amount that the money supply could increase? Answer: $200 B. What is the minimum amount that the money supply could increase?

25 CHAPTER 29 THE MONETARY SYSTEM The Fed’s 3 Tools of Monetary Control 1.Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.  To increase money supply, Fed buys govt bonds, paying with new dollars. …which are deposited in banks, increasing reserves …which banks use to make loans, causing the money supply to expand.  To reduce money supply, Fed sells govt bonds, taking dollars out of circulation, and the process works in reverse.

26 CHAPTER 29 THE MONETARY SYSTEM The Fed’s 3 Tools of Monetary Control 1.Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.  OMOs are easy to conduct, and are the Fed’s monetary policy tool of choice.

27 CHAPTER 29 THE MONETARY SYSTEM The Fed’s 3 Tools of Monetary Control 2.Reserve Requirements (RR). Affect how much money banks can create by making loans.  To increase money supply, Fed reduces RR. Banks make more loans from each dollar of reserves, which increases money multiplier and money supply.  To reduce money supply, Fed raises RR, and the process works in reverse.  Fed rarely uses reserve requirements to control money supply: Frequent changes would disrupt banking.

28 CHAPTER 29 THE MONETARY SYSTEM The Fed’s 3 Tools of Monetary Control 3.The Discount Rate: the interest rate on loans the Fed makes to banks  When banks are running low on reserves, they may borrow reserves from the Fed.  To increase money supply, Fed can lower discount rate, which encourages banks to borrow more reserves from Fed.  Banks can then make more loans, which increases the money supply.  To reduce money supply, Fed can raise discount rate.

29 CHAPTER 29 THE MONETARY SYSTEM The Fed’s 3 Tools of Monetary Control 3.The Discount Rate: the interest rate on loans the Fed makes to banks  The Fed uses discount lending to provide extra liquidity when financial institutions are in trouble, e.g. after the Oct stock market crash.  If no crisis, Fed rarely uses discount lending – Fed is a “lender of last resort.”

30 CHAPTER 29 THE MONETARY SYSTEM The Federal Funds Rate  On any given day, banks with insufficient reserves can borrow from banks with excess reserves.  The interest rate on these loans is the federal funds rate.  The FOMC uses OMOs to target the fed funds rate.  Many interest rates are highly correlated, so changes in the fed funds rate cause changes in other rates and have a big impact in the economy.

The Fed Funds Rate and Other Rates, (%) Fed funds prime 3-month Tbill mortgage

32 CHAPTER 29 THE MONETARY SYSTEM Monetary Policy and the Fed Funds Rate To raise fed funds rate, Fed sells govt bonds (OMO). This removes reserves from the banking system, reduces supply of federal funds, causes r ff to rise. r ff F D1D1 S2S2 3.75% F2F2 S1S1 F1F1 3.50% The Federal Funds market federal funds rate quantity of federal funds

33 CHAPTER 29 THE MONETARY SYSTEM Problems Controlling the Money Supply  If households hold more of their money as currency, banks have fewer reserves, make fewer loans, & money supply falls.  If banks hold more reserves than required, they make fewer loans, & money supply falls.  Yet, Fed can compensate for household & bank behavior to retain fairly precise control over the money supply.

34 CHAPTER 29 THE MONETARY SYSTEM Bank Runs and the Money Supply  A run on banks: When people suspect their banks are in trouble, they may “run” to the bank to withdraw their funds, holding more currency and less deposits.  Under fractional-reserve banking, banks don’t have enough reserves to pay off ALL depositors, hence banks may have to close.  Also, banks may make fewer loans & hold more reserves to satisfy depositors.  These events increase R, reverse the process of money creation, cause money supply to fall.

35 CHAPTER 29 THE MONETARY SYSTEM Bank Runs and the Money Supply  During , a wave of bank runs and bank closings caused money supply to fall 28%.  Many economists believe this contributed to the severity of the Great Depression.  Bank runs not a problem today due to federal deposit insurance.

36 CHAPTER 29 THE MONETARY SYSTEM Recent Chinese Monetary Policy Moves  China Hacks At Rates  , 11:50 AM EST Beijing sharply cut interest rates to aid the country's faltering economy.  China is scrambling to prop up its economy. The People's Bank of China made a 108-basis-point cut to interest rates on Wednesday after the markets closed, accelerating its recent policy of monetary loosening in the face of slowing exports and industrial production.  Though a rate cut was expected by the central bank, its magnitude-- the largest since the Asian financial crisis in October was surprising. "Bottom line is the Chinese authorities think the economy is slowing down fast," said Nigel Rendell, a senior emerging market strategist at RBC Capital Markets. "It would not be unusual to cut by around 25 basis points--to do more than four times that highlights the downside risks."

37 CHAPTER 29 THE MONETARY SYSTEM Recent Chinese Monetary Policy Moves  Analysts split on impact of China interest rate, reserve ratio cuts Special Report: Global Financial Crisis BEIJING, Nov. 27 (Xinhua) -- Analysts on Thursday offered widely diverging views of the impact of an unusually large interest rate cut and a reduction in banks' reserve ratio, which were announced by the People's Bank of China (PBOC, central bank) after the markets closed on Wednesday. Financial Crisis  Some said banks would benefit from the reductions, while others took a negative view.  The PBOC cut the benchmark one-year lending rate to 5.58 percent from 6.66 percent and the one-year deposit rate to 2.52 percent from 3.60 percent. These cuts, of 108 basis points each, were the largest since the Asia crisis of the late 90s and took effect on Thursday.  The PBOC also said as of Dec. 5, it would lower the reserve requirement ratio by 1 percentage point at large banks and 2 percentage points at other banks.

38 CHAPTER 29 THE MONETARY SYSTEM Recent Chinese Monetary Policy Moves  Chinese regulators ask banks to increase capital adequacy ratios  By Jamil Anderlini in Beijing  Published: November :00 | Last updated: November :00  Chinese regulators have asked the country's banks to increase the amount of capital they have on hand in anticipation of deteriorating growth and expectations that the state-owned banks will be made to underwrite the bulk of Beijing's economic stimulus package.  The China Banking Regulatory Commission has told banks, particularly small and medium-sized lenders, to raise their capital adequacy ratios from the official requirement of 8 per cent to 10 per cent by the end of the year, a senior CBRC official said.  "We haven't changed the law but we are encouraging the banks to increase their provisioning and have more liquidity on hand because China cannot be immune to the global crisis and we expect next year to be much more severe," the official said.  Chinese banks are currently required to conform to a domestic standard based on the Basle I framework for global bank regulation, which recommends that banks maintain capital adequacy ratios of 8 per cent.  At least three medium-sized lenders have already sold shares or bonds, lifting their capital adequacy ratios above 10 per cent.

39 CHAPTER 29 THE MONETARY SYSTEM Recent Chinese Monetary Policy Moves  Capital adequacy ratios are a measure of the amount of a bank's capital expressed as a percentage of its risk weighted credit exposures.  An international standard which recommends minimum capital adequacy ratios has been developed to ensure banks can absorb a reasonable level of losses before becoming insolvent.  Applying minimum capital adequacy ratios serves to protect depositors and promote the stability and efficiency of the financial system.

40 CHAPTER 29 THE MONETARY SYSTEM CHAPTER SUMMARY  Money includes currency and various types of bank deposits.  The Federal Reserve is the central bank of the U.S., is responsible for regulating the monetary system.  The Fed controls the money supply mainly through open-market operations. Purchasing govt bonds increases the money supply, selling govt bonds decreases it.  In a fractional reserve banking system, banks create money when they make loans. Bank reserves have a multiplier effect on the money supply.