22 Prepared by: Fernando Quijano and Yvonn Quijano © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair CHAPTER 25 The Money Supply and the Central Bank

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 2 of 42 An Overview of Money Money is anything that is generally accepted as a medium of exchange. Money is not income, and money is not wealth. Money is: a means of payment, a store of value, and a unit of account.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 3 of 42 What is Money? 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. As a medium of exchange, or means of payment, money is generally accepted by buyers and sellers as payment for goods and services.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 4 of 42 What is Money? As a store of value, money serves as an asset that can be used to transport purchasing power from one time period to another.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 5 of 42 What is Money? As a unit of account, money is a standard that provides a consistent way of quoting prices.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 6 of 42 What is Money? Money is easily portable, and easily exchanged for goods at all times. The liquidity property of money makes money a good medium of exchange as well as a store of value.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 7 of 42 Commodity and Fiat Monies Commodity monies are items used as money that also have intrinsic value in some other use. Gold is one form of commodity money. Fiat, or token, money is money that is intrinsically worthless.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 8 of 42 Commodity and Fiat Monies Legal tender is money that a government has required to be accepted in settlement of debts. Currency debasement is the decrease in the value of money that occurs when its supply is increased rapidly.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 9 of 42 Measuring the Supply of Money in the United States M1, or transactions money is money that can be directly used for transactions. M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits M1 is a stock measure—it is measured at a point in time— on a specific day.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 10 of 42 Measuring the Supply of Money in the United States M2, or broad money, includes near monies, or close substitutes for transactions money. M2 ≡ M1 + savings accounts + money market accounts + other near monies The main advantage of looking at M2 instead of M1 is that M2 is sometimes more stable.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 11 of 42 The Private Banking System Financial intermediaries are banks and other financial institutions that act as a link between those who have money to lend and those who want to borrow money.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 12 of 42 How Banks Create Money A Historical Perspective: Goldsmiths Goldsmiths functioned as warehouses where people stored gold for safekeeping. Upon receiving the gold, a goldsmith would issue a receipt to the depositor. After a time, these receipts themselves began to be traded for goods, and were backed 100 percent by gold. Then, Goldsmiths realized that they could lend out some of this gold without any fear of running out. Now there were more claims than there were ounces of gold.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 13 of 42 How Banks Create Money A run on a goldsmith (or a modern-day bank) occurs when many people present their claims at the same time.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 14 of 42 The Modern Banking System A brief review of accounting: Assets – liabilities ≡ Net Worth, or Assets ≡ Liabilities + Net Worth A bank’s most important assets are its loans. Other assets include cash on hand (or vault cash) and deposits with the CB. A bank’s liabilities are its debts—what it owes. Deposits are debts owed to the bank’s depositors.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 15 of 42 The Modern Banking System Reserves are the deposits that a bank has at the Central Bank plus its cash on hand. The required reserve ratio is the percentage of its total deposits that a bank must keep as reserves at the Central Bank.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 16 of 42 T-Account for a Typical Bank 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). T-Account for a Typical Bank (millions of dollars) ASSETSLIABILITIES Reserves20100Deposits Loans9010Net worth Total110 Total

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 17 of 42 The Creation of Money Banks usually make loans up to the point where they can no longer do so because of the reserve requirement restriction (or up to the point where their excess reserves are zero).

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 18 of 42 The Creation of Money When someone deposits $100 in a bank, and the bank deposits the $100 with the central bank, the bank has $100 in total reserves. Balance Sheets of a Bank in a Single-Bank Economy In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400. Panel 1Panel 2Panel 3 ASSETSLIABILITIESASSETSLIABILITIESASSETSLIABILITIES Reserves 00 DepositsReserves DepositsReserves Deposits Loans 400

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 19 of 42 The Creation of Money If the required reserve ratio is 20%, the bank has excess reserves of $80. With $80 of excess reserves, the bank can have up to $400 of additional deposits. The $100 in reserves plus $400 in loans equal $500 in deposits. Balance Sheets of a Bank in a Single-Bank Economy In Panel 2, there is an initial deposit of $100. In Panel 3, the bank has made loans of $400. Panel 1Panel 2Panel 3 ASSETSLIABILITIESASSETSLIABILITIESASSETSLIABILITIES Reserves 00 DepositsReserves DepositsReserves Deposits Loans 400

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 20 of 42 The Creation of Money The Creation of Money When There Are Many Banks Panel 1Panel 2Panel 3 ASSETSLIABILITIESASSETSLIABILITIESASSETSLIABILITIES Reserves DepositsReserves 100 Loans DepositsReserves 20 Loans Deposits Reserves 8080 DepositsReserves 80 Loans DepositsReserves 16 Loans Deposits Reserves 6464 DepositsReserves DepositsReserves Deposits.00500Total Bank 4 64Bank 3 80Bank 2 100Bank 1 DepositsSummary:

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 21 of 42 The Money Multiplier The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves. In the example above, the required reserve ratio is 20%. Each dollar increase in reserves could cause an increase in deposits of $5 when there is no leakage out of the system. An additional $100 of reserves result in additional deposits of $ Total Bank 4 64Bank 3 80Bank 2 100Bank 1 DepositsSummary:

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 22 of 42 Functions of the Central Bank Clearing interbank payments. Managing exchange rates and the nation’s foreign exchange reserves. Lender of last resort: The CB provides funds to troubled banks that cannot find any other sources of funds. The CB performs important functions for banks including:

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 23 of 42 Functions of the Central Bank To monitor the financial markets, Setting of reserve requirements for all financial institutions. To determine the terms and types of deposits in banks The Central Bank performs important functions for banks including:

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 24 of 42 The Central Bank Balance Sheet Assets and Liabilities of the Federal Reserve System, June 30, 2003 (millions of dollars) ASSETSLIABILITIES Gold$11,045$593,031Federal Reserve notes (outstanding) Loans to banks36,538Deposits: U.S. Treasury securities 550,31420,359Bank reserves (from depository institutions) 6,219U.S. Treasury All other assets46,26824,556All other liabilities and net worth Total$644,165$644,165Total Source: Federal Reserve Bulletin, August 2003, Table 1.18.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 25 of 42 How the Central Bank Controls the Money Supply Three tools are available to the Fed for changing the money supply: 1. changing the required reserve ratio; 2. changing the discount rate; and 3. engaging in open market operations.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 26 of 42 The Required Reserve Ratio The required reserve ratio establishes a link between the reserves of the commercial banks and the deposits (money) that commercial banks are allowed to create. If the CB wants to increase the money supply, the CB can decrease the required reserve ratio, which allows the bank to create more deposits by making loans.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 27 of 42 The Required Reserve Ratio 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% Central BankCommercial Banks AssetsLiabilitiesAssetsLiabilities Government$200$100Reserves $100$500Deposits securities$100CurrencyLoans$400 Note: Money supply (M1) = Currency + Deposits = $600. PANEL 2: REQUIRED RESERVE RATIO = 12.5% Central BankCommercial Banks AssetsLiabilitiesAssetsLiabilities Government$200$100Reserves $100$800Deposits securities$100CurrencyLoans (+ $300) $700 (+ $300) Note: Money supply (M1) = Currency + Deposits = $900.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 28 of 42 The Discount Rate The discount rate is the interest rate that banks pay to the CB to borrow from it. Bank borrowing from the CB leads to an increase in the money supply. The higher the discount rate, the higher the cost of borrowing, and the less borrowing banks will want to do.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 29 of 42 The Discount Rate The Effect On the Money Supply of Commercial Bank Borrowing from the CB (All Figures in Billions of Dollars) PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE CB Central BankCommercial Banks AssetsLiabilitiesAssetsLiabilities Securities$160$80Reserves $80$400Deposits $80CurrencyLoans$320 Note: Money supply (M1) = Currency + Deposits = $480. PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE CB Central BankCommercial Banks AssetsLiabilitiesAssetsLiabilities Securities$160$100Reserves (+ $20) $100$500Deposits (+ $100) Loans$20$80CurrencyLoans (+ $100) $420$20Amount owed to Fed (+ $20) Note: Money supply (M1) = Currency + Deposits = $580.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 30 of 42 Open Market Operations Open market operations is the purchase and sale by the CB 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. Open market operations is by far the most significant tool of the CB for controlling the supply of money.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 31 of 42 Open Market Operations An open market purchase of securities by the CB 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.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 32 of 42 Open Market Operations An open market sale of securities by the CB 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.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 33 of 42 Open Market Operations Open market operations are the CB’s preferred means of controlling the money supply because: they can be used with some precision, are extremely flexible, and are fairly predictable.

C H A P T E R 22: The Money Supply and the Federal Reserve System © 2004 Prentice Hall Business PublishingPrinciples of Economics, 7/eKarl Case, Ray Fair 34 of 42 The Supply Curve for Money Through open market operations, the CB can have the money supply be whatever value it wants.