TM 13-1 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Define money and describe its functions Explain the economic functions of banks and other financial institutions Describe the financial innovations of the 1980s and 1990s

TM 13-2 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain how banks create money Explain why the quantity of money is an important economic magnitude Explain the quantity theory of money

TM 13-3 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Define money and describe its functions Explain the economic functions of banks and other financial institutions Describe the financial innovations of the 1980s and 1990s

TM 13-4 Copyright © 1998 Addison Wesley Longman, Inc. Fiscal Policy Multipliers and the Price Level Fiscal Policy and Aggregate Demand Expansionary fiscal policy is an increase in government purchases or a decrease in taxes. However, the distance of the AD curve shifts is smaller for a tax cut than for a government purchases increase of the same size.

TM 13-5 Copyright © 1998 Addison Wesley Longman, Inc. Fiscal Policy Multipliers and the Price Level Fiscal Policy and Aggregate Demand Contractionary fiscal policy is a decrease in government purchases or an increase in taxes.

CHAPTER 13 Money Chapter 30 in Economics

TM 13-7 Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Money is any commodity or token that is generally acceptable as the means of payment. A means of payment is a method of settling a debt.

TM 13-8 Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Other functions of Money 1) Medium of exchange 2) Unit of account 3) Store of value

TM 13-9 Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Medium of Exchange A medium of exchange is an object that is generally accepted in exchange for goods and services. Without money, people would have to exchange goods for goods, or barter.

TM Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Unit of Account A unit of account is an agreed measure for stating the prices of goods and services. This simplifies value comparisons and purchase decision making if all prices are expressed using a uniform measure.

TM Copyright © 1998 Addison Wesley Longman, Inc. The Unit of Account Functions of Money Simplifies Price Comparisons Movie$6.00 each2 six-packs of soda Soda$3.00 per six-pack2 ice-cream cones Ice cream$1.50 per cone3 packs of jelly beans Jelly beans$0.50 per pack2 cups of coffee Coffee$0.25 per cup1 local phone call Price inPrice in units Goodmoney unitsof another good

TM Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Store of Value A store of value is any commodity or token that can be held and exchanged later for goods and services.

TM Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Money in the United States Today Money in the U.S. consists of: Currency Deposits at banks and other financial institutions

TM Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Money in the United States Today Currency is the bills and coins that we use. Deposits are also money because they can be converted into currency and are used to settle debts.

TM Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Official Measures of Money 1) M1 consists of currency and traveler’s checks plus checking deposits. Includes accounts held by individuals and businesses, but does not include currency held by banks, or currency and checking deposits owned by the U.S. government

TM Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Official Measures of Money 2) M2 consists of M1 plus saving deposits, money market mutual funds and time deposits

TM Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Official Measures of Money 3) M3 consists of M2 plus large-scale time deposits and term deposits

TM Copyright © 1998 Addison Wesley Longman, Inc. Two Measures of Money

TM Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Are M1 and M2 Really Money? The test of whether an asset is money is whether it serves as a means of payment. Currency does so Checking deposits are money because they can be transferred by writing a check. M1 is money

TM Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Are M1 and M2 Really Money Some savings deposits are readily accessible and can be used as a means of payment. Other deposits are less liquid. Liquidity is the property of being instantly convertible into a means of payment with little loss in value Liquidity is the property of being instantly convertible into a means of payment with little loss in value. M2 is money

TM Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Other Points Regarding Money 1) Deposits are money but checks are not. 2) Credit cards are not money.

TM Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Define money and describe its functions Explain the economic functions of banks and other financial institutions Describe the financial innovations of the 1980s and 1990s

TM Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries Financial intermediaries are firms that take deposits from households and firms and makes loans to other households and firms.

TM Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries Four Types of Financial Intermediaries 1) Commercial banks 2) Savings and loan associations 3) Savings banks 4) Credit unions

TM Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries Commercial Banks A commercial bank is a firm, licensed by the Comptroller of the Currency or by a state agency to receive deposits and make loans.

TM Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries Reserves and Loans Banks divide their funds into two parts: Reserves are cash in a bank’s vault plus its deposits at Federal Reserve banks Loans

TM Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries Savings and Loan Associations A savings and loan association is a financial intermediary that receives checking deposits and savings deposits and that makes personal, commercial, and home-purchase loans.

TM Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries Savings Banks A savings bank (mutual savings bank) is a financial intermediary owned by its depositors that accepts deposits and makes mostly home- purchase loans.

TM Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries Credit Unions A credit union is a financial intermediary owned by its depositors that accepts savings deposits and makes mostly consumer loans. The key difference between savings banks and credit unions is that credit unions are owned by a social or economic group such as a firm’s employees.

TM Copyright © 1998 Addison Wesley Longman, Inc. Financial Regulation, Deregulation, and Innovation Deposit Insurance The deposits of most financial intermediaries are insured by the Federal Deposit Insurance Corporation. Receives its income from compulsory premiums paid by financial intermediaries Protects depositors

TM Copyright © 1998 Addison Wesley Longman, Inc. Financial Regulation, Deregulation, and Innovation Deregulation in the 1980s The Depository Institutions’ Deregulation and Monetary Control Act (DIDMCA), passed in 1980, removed many of the distinctions between commercial banks and other financial intermediaries.

TM Copyright © 1998 Addison Wesley Longman, Inc. How Banks Create Money Reserves: Actual and Required The reserve ratio is the fraction of a bank’s total deposits that are held in reserves. The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold. Excess reserves are actual reserves minus required reserves.

TM Copyright © 1998 Addison Wesley Longman, Inc. How Banks Create Money Creating Deposits by Making loans in a One-Bank Economy Let’s see an example of how banks create money.

TM Copyright © 1998 Addison Wesley Longman, Inc. How Banks Create Money The Deposit Multiplier Money Multiplier = 1 Required Reserve Ratio

TM Copyright © 1998 Addison Wesley Longman, Inc. How Banks Create Money The Deposit Multiplier in the United States The actual deposit multiplier in the U.S. works the same as the one presented. However, it does differ in some aspects.

TM Copyright © 1998 Addison Wesley Longman, Inc. How Banks Create Money The deposit multiplier in the United States differs from our model economy’s for three main reasons: 1)The actual required reserve ratio is smaller than the 25 percent used here. 2) Banks sometimes choose to hold excess reserves.

TM Copyright © 1998 Addison Wesley Longman, Inc. How Banks Create Money The deposit multiplier in the United States differs from our model economy’s for three main reasons: 3)Not all loans made by banks return to them in the form of reserves.

CHAPTER 14 Monetary Policy Chapter 31 in Economics

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System The Federal Reserve System serves as the central bank for the United States. A central bank is a bank’s bank and a public authority that regulates a nation’s financial institutions and markets.

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System Monetary policy is conducted by the Fed. Monetary policy is the adjustment of the quantity of money in circulation to achieve specific economic goals.

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System These goals include: 1) Keeping inflation in check 2) Maintaining full employment 3) Moderating the business cycle 4) Contributing toward achieving long-term growth

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System The Structure of the Federal Reserve System The primary elements in the Federal Reserve System are: 1) The Board of Governors 2) The Regional Federal Reserve Banks 3) The Federal Open Market Committee

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System The Board of Governors Seven members Appointed by the President Confirmed by the Senate Serve 14-year term

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System The Board of Governors Terms are staggered so that one comes vacant every two years President appoints a member as Chairman to serve a four-year term

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System The Federal Reserve Banks 12 District banks Nine directors Three appointed by the Board of Governors Six are elected by the commercial banks in the district The directors appoint the district president which is approved by the Board of Governors

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System The Federal Reserve Banks The New York Fed implements some of the Fed’s most important policy decisions

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System The Federal Open Market Committee (FOMC) Serves as the main policy-making organ of the Federal Reserve System Meets approximately every six weeks to review the economy

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System The Federal Open Market Committee (FOMC) 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 vote on a yearly rotating basis)

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System The Fed’s Power Center The chairman of the Board of Governors has the largest influence on the Fed’s monetary policy actions. Paul Volcker Alan Greenspan

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System The Fed’s Policy Tools The Fed controls the money supply by adjusting the reserves of the banking system. The Fed has three main tools it uses to achieve this objective.

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System The Fed’s Policy Tools The three main policy tools are: 1) Required reserve ratios 2) Discount rate 3) Open market operations

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System Required Reserve Ratios The Fed determines a required reserve ratio for each type of deposit. In 1997, banks were required to keep 3 percent of checking deposits up to $49 million and 10 percent of deposits in excess of $49 million. Other deposits had no reserve requirement.

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System Discount Rate The discount rate is the interest rate at which the Fed stands ready to lend reserves to commercial banks.

TM Copyright © 1998 Addison Wesley Longman, Inc. The Federal Reserve System Open Market Operations Open market operations are the purchase or sale of government securities by the Federal Reserve System on the open market.

TM Copyright © 1998 Addison Wesley Longman, Inc. Money Market Equilibrium Real money (trillions of 1992 dollars) Interest rate (percent per year) MD

TM Copyright © 1998 Addison Wesley Longman, Inc. Money Market Equilibrium Real money (trillions of 1992 dollars) Interest rate (percent per year) MD MS

TM Copyright © 1998 Addison Wesley Longman, Inc. Money Market Equilibrium Real money (trillions of 1992 dollars) Interest rate (percent per year) MD MS Excess supply of money. People buy bonds and interest rate falls

TM Copyright © 1998 Addison Wesley Longman, Inc. Interest Rate Changes Real money (trillions of 1992 dollars) Interest rate (percent per year) MD MS MS 1

TM Copyright © 1998 Addison Wesley Longman, Inc. Interest Rate Changes Real money (trillions of 1992 dollars) Interest rate (percent per year) MD MS

TM Copyright © 1998 Addison Wesley Longman, Inc. The Ripple Effects of Monetary Policy