1. PowerPoint Lectures for Principles of Macroeconomics, 9eBy
Karl E. Case, Ray C. Fair & Sharon M. Oster
; ;

3. The Money Supply and the Federal Reserve System
Prepared by:
Fernando & Yvonn Quijano

4. 10 11 The Money Supply and the Federal Reserve System
PART III THE CORE OF MACROECONOMIC THEORY 10 11
CHAPTER OUTLINE
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 The Federal Reserve Balance Sheet
How the Federal Reserve Controls the Money Supply The Required Reserve Ratio The Discount Rate Open Market Operations The Supply Curve for Money
Looking Ahead

5. An Overview of Money What Is Money?
Money is anything that is generally accepted as a medium of exchange.
A Means of Payment, or Medium of Exchange
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.

6. An Overview of Money What Is Money? A Store of Value
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.
A Unit of Account
unit of account A standard unit that provides a consistent way of quoting prices.

7. Dolphin Teeth as Currency
An Overview of Money
Commodity and Fiat Monies
Dolphin Teeth as Currency
Shrinking Dollar Meets Its Match In Dolphin Teeth
Wall Street Journal

8. An Overview of Money Commodity and Fiat Monies
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.

9. An Overview of Money
Measuring the Supply of Money in the United States
M1: Transactions Money
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

10. An Overview of Money
Measuring the Supply of Money in the United States
M2: Broad Money
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

11. An Overview of Money
Measuring the Supply of Money in the United States
Beyond M2
There are no rules for deciding what is money and what is not. This poses problems for economists and those in charge of economic policy.

12. An Overview of Money The Private Banking System
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.
A Historical Perspective: Goldsmiths
run on a bank Occurs when many of those who have claims on a bank (deposits) present them at the same time.

13. Assets − Liabilities ≡ Net Worth, or Assets ≡ Liabilities + Net Worth
How Banks Create Money
The Modern Banking System
A Brief Review of Accounting
Assets − Liabilities ≡ Net Worth, or Assets ≡ Liabilities + Net Worth
Federal Reserve Bank (the Fed) The central bank of the United States.

14. How Banks Create Money The Modern Banking System
A Brief Review of Accounting
 FIGURE T-Account for a Typical Bank (millions of dollars)
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).

15. 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.

16. excess reserves ≡ actual reserves − required reserves
How Banks Create Money
The Creation of Money
excess reserves The difference between a bank’s actual reserves and its required reserves.
excess reserves ≡ actual reserves − required reserves
 FIGURE 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.

17. How Banks Create Money The Creation of Money
 FIGURE The Creation of Money When There Are Many Banks
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.

18. How Banks Create Money The Money Multiplier
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.

19. The Federal Reserve System
 FIGURE The Structure of the Federal Reserve System

20. The Federal Reserve System
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.

21. The Federal Reserve System
Functions of the Federal Reserve
Clearing Interbank Payments
The Fed does it.
This function of clearing interbank payments allows banks to shift money around virtually instantaneously. All they need to do is wire the Fed and request a transfer, and the funds move at the speed of electricity from one computer account to another.
Other Duties of the Fed
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.

22. The Federal Reserve System
The Federal Reserve Balance Sheet
TABLE Assets and Liabilities of the Federal Reserve System, October 24, 2007 (Millions of Dollars)
Assets
Liabilities
Gold $
11,037
$776,701
Federal Reserve notes (outstanding)
Loans to banks
502
Deposits:
U.S. Treasury securities
779,574
21,107
Bank reserves (from depository institutions)
4,737
U.S. Treasury
All other assets
93,860
82,428
All other liabilities and net worth
Total
884,973
$884,973
Source: Board of Governors of the Federal Reserve System.

23. How the Federal Reserve Controls the Money Supply
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:
changing the required reserve ratio,
changing the discount rate, and
engaging in open market operations.

24. How the Federal Reserve Controls the Money Supply
The Required Reserve Ratio
TABLE 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 Reserve
Commercial Banks
Assets
Liabilities
Government
$200
$100
Reserves
$500
Deposits
securities
Currency
Loans
$400
Note: Money supply (M1) = Currency + Deposits = $600.
Panel 2: Required Reserve Ratio = 12.5%
$800
Loans (+ $300)
$700
(+ $300)
Note: Money supply (M1) = currency + deposits = $900.

25. How the Federal Reserve Controls the Money Supply
The Required Reserve Ratio
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.

26. How the Federal Reserve Controls the Money Supply
The Discount Rate
discount rate The interest rate that banks pay to the Fed to borrow from it.
moral suasion The pressure that in the past the Fed exerted on member banks to discourage them from borrowing heavily from the Fed.

27. How the Federal Reserve Controls the Money Supply
The Discount Rate
TABLE 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 Reserve
Commercial Banks
Assets
Liabilities
Securities
$160
$80
Reserves
$400
Deposits
Currency
Loans
$320
Note: Money supply (M1) = currency + deposits = $480.
Panel 2: Commercial Bank Borrowing $20 from the Fed
$100
Reserves (+ $20)
$500
Deposits (+ $300)
$20
Loans (+ $100)
$420
Amount owed to Fed (+ $20)
Note: Money supply (M1) = currency + deposits = $580.

28. How the Federal Reserve Controls the Money Supply
Open Market Operations
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.

29. How the Federal Reserve Controls the Money Supply
Open Market Operations
Two Branches of Government Deal in Government Securities
The Treasury Department is responsible for collecting taxes and paying the federal government’s bills.
The Fed is not the Treasury. Instead, it is a quasi-independent agency authorized by Congress to buy and sell outstanding (preexisting) U.S. government securities on the open market.

30. How the Federal Reserve Controls the Money Supply
Open Market Operations
The Mechanics of Open Market Operations
TABLE 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 Reserve
Commercial Banks
Jane Q. Public
Assets
Liabilities
Securities
$100
$20
Reserves
Deposits $5 $0
Debts
$80
Currency
Loans
Net Worth
Note: Money supply (M1) = Currency + Deposits = $180.
Panel 2
Securities (- $5)
$95
$15
Reserves (- $5)
Deposits (- $5)
Securities (+ $5)
Note: Money supply (M1) = Currency + Deposits = $175.
Panel 3
$75
Deposits (- $25)
Loans (- $20)
$60
Note: Money supply (M1) = Currency + Deposits = $155.

31. How the Federal Reserve Controls the Money Supply
Open Market Operations
The Mechanics of Open Market Operations
We can sum up the effect of these open market operations this way:
■ 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.

32. How the Federal Reserve Controls the Money Supply
The Supply Curve for Money
 FIGURE The Supply of Money
If the Fed’s money supply behavior is not influenced by the interest rate, the money supply curve is a vertical line. Through open market operations, the Fed can have the money supply be whatever value it wants.

33. REVIEW TERMS AND CONCEPTS
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 + capital (or net worth)
4. Excess reserves ≡ actual reserves − required reserves
5. Money multiplier ≡

34. PowerPoint Lectures for Principles of Macroeconomics, 9eBy
Karl E. Case, Ray C. Fair & Sharon M. Oster
; ;

36. Money Demand and the Equilibrium Interest Rate
Prepared by:
Fernando & Yvonn Quijano

37. 11 11 Money Demand and the Equilibrium Interest Rate
PART III THE CORE OF MACROECONOMIC THEORY 11 11
CHAPTER OUTLINE
Interest Rates and Bond Prices
The Demand for Money
The Transaction Motive
The Speculation Motive
The Total Demand for Money
The Effects of Income and the Price Level on the Demand for Money
The Equilibrium Interest Rate Supply and Demand in the Money Market
Changing the Money Supply to Affect the Interest Rate
Increases in Y and Shifts in the Money Demand Curve
Looking Ahead: The Federal Reserve and Monetary Policy
Appendix A: The Various Interest Rates in the U.S. Economy
Appendix B: The Demand for Money: A Numerical Example

38. Professor Serebryakov Makes an Economic Error
Interest Rates and Bond Prices
Interest The fee that borrowers pay to lenders for the use of their funds.
Professor Serebryakov Makes an Economic Error
Uncle Vanya
by Anton Chekhov

39. The Demand for Money
When we speak of the demand for money, we are concerned with how much of your financial assets you want to hold in the form of money, which does not earn interest, versus how much you want to hold in interest-bearing securities, such as bonds.
The Transaction Motive
transaction motive The main reason that people hold money—to buy things.

40. The Demand for Money The Transaction Motive
 FIGURE The Nonsynchronization of Income and Spending
Income arrives only once a month, but spending takes place continuously.

41. The Demand for Money The Transaction Motive
nonsynchronization of income and spending The mismatch between the timing of money inflow to the household and the timing of money outflow for household expenses.

42. The Demand for Money The Transaction Motive
 FIGURE Jim’s Monthly Checking Account Balances: Strategy 1
Jim could decide to deposit his entire paycheck ($1,200) into his checking account at the start of the month and run his balance down to zero by the end of the month. In this case, his average balance would be $600.

43. The Demand for Money The Transaction Motive
 FIGURE Jim’s Monthly Checking Account Balances: Strategy 2
Jim could also choose to put half of his paycheck into his checking account and buy a bond with the other half of his income. At midmonth, Jim would sell the bond and deposit the $600 into his checking account to pay the second half of the month’s bills. Following this strategy, Jim’s average money holdings would be $300.

44. The Demand for Money The Transaction Motive
 FIGURE The Demand Curve for Money Balances
The quantity of money demanded (the amount of money households and firms want to hold) is a function of the interest rate. Because the interest rate is the opportunity cost of holding money balances, increases in the interest rate reduce the quantity of money that firms and households want to hold and decreases in the interest rate increase the quantity of money that firms and households want to hold.

45. The Demand for Money The Speculation Motive
speculation motive One reason for holding bonds instead of money: Because the market price of interest-bearing bonds is inversely related to the interest rate, investors may want to hold bonds when interest rates are high with the hope of selling them when interest rates fall.

46. The Demand for Money The Total Demand for Money
The total quantity of money demanded in the economy is the sum of the demand for checking account balances and cash by both households and firms.
At any given moment, there is a demand for money—for cash and checking account balances. Although households and firms need to hold balances for everyday transactions, their demand has a limit. For both households and firms, the quantity of money demanded at any moment depends on the opportunity cost of holding money, a cost determined by the interest rate.

47. ATMs and the Demand for Money
The Total Demand for Money
Italy makes a great case study of the effects of the spread of ATMs on the demand for money. In Italy, virtually all checking accounts pay interest. What doesn’t pay interest is cash. In other words, in Italy there is an interest cost to carrying cash instead of depositing the cash in a checking account.
Orazio Attansio, Luigi Guiso, and Tullio Jappelli, “The Demand for Money, Financial Innovation and the Welfare Costs of Inflation: An Analysis with Household Data,” Journal of Political Economy, April 2002.

48. The Demand for Money
The Effects of Income and the Price Level on the Demand for Money
 FIGURE An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve to the Right
An increase in Y means that there is more economic activity. Firms are producing and selling more, and households are earning more income and buying more. There are more transactions, for which money is needed. As a result, both firms and households are likely to increase their holdings of money balances at a given interest rate.

49. The Demand for Money
The Effects of Income and the Price Level on the Demand for Money
The amount of money needed by firms and households to facilitate their day-to-day transactions also depends on the average dollar amount of each transaction. In turn, the average amount of each transaction depends on prices, or instead, on the price level.
TABLE Determinants of Money Demand 1.
The interest rate: r (The quantity of money demanded is a negative function of the interest rate.) 2.
The dollar volume of transactions
a. Aggregate output (income): Y (An increase in Y shifts the money demand curve to the right.)
b. The price level: P (An increase in P shifts the money demand curve to the right.)

50. The Equilibrium Interest Rate
We are now in a position to consider one of the key questions in macroeconomics: How is the interest rate determined in the economy?
The point at which the quantity of money demanded equals the quantity of money supplied determines the equilibrium interest rate in the economy.

51. The Equilibrium Interest Rate
Supply and Demand in the Money Market
 FIGURE Adjustments in the Money Market
Equilibrium exists in the money market when the supply of money is equal to the demand for money and thus when the supply of bonds is equal to the demand for bonds.
At r0 the price of bonds would be bid up (and thus the interest rate down), and at r1 the price of bonds would be bid down (and thus the interest rate up).

52. The Equilibrium Interest Rate
Changing the Money Supply to Affect the Interest Rate
 FIGURE The Effect of an Increase in the Supply of Money on the Interest Rate
An increase in the supply of money from to lowers the rate of interest from 7 percent to 4 percent.

53. The Equilibrium Interest Rate
Increases in Y and Shifts in the Money Demand Curve
 FIGURE The Effect of an Increase in Income on the Interest Rate
An increase in aggregate output (income) shifts the money demand curve from to , which raises the equilibrium interest rate from 4 percent to 7 percent.

54. Looking Ahead: The Federal Reserve and Monetary Policy
tight monetary policy Fed policies that contract the money supply and thus raise interest rates in an effort to restrain the economy.
easy monetary policy Fed policies that expand the money supply and thus lower interest rates in an effort to stimulate the economy.

55. REVIEW TERMS AND CONCEPTS
easy monetary policy
interest
nonsynchronization of income and spending
speculation motive
tight monetary policy
transaction motive

56. A P P E N D I X A THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY
THE TERM STRUCTURE OF INTEREST RATES
The term structure of interest rates is the relationship among the interest rates offered on securities of different maturities.
According to a theory called the expectations theory of the term structure of interest rates, the 2-year rate is equal to the average of the current 1-year rate and the 1-year rate expected a year from now.
People’s expectations of higher future short-term interest rates are likely to increase. These expectations will then be reflected in current long- term interest rates.

57. A P P E N D I X A THE VARIOUS INTEREST RATES IN THE U.S. ECONOMY
TYPES OF INTEREST RATES
Three-Month Treasury Bill Rate
Government Bond Rate
Federal Funds Rate
Commercial Paper Rate
Prime Rate
AAA Corporate Bond Rate

58. 2 Average Money Holdingsb 3 Average Bond Holdingsc
A P P E N D I X B
THE DEMAND FOR MONEY: A NUMERICAL EXAMPLE
TABLE 11B.1 Optimum Money Holdings
1 Number of Switchesa
2 Average Money Holdingsb
3 Average Bond Holdingsc
4 Interest Earnedd
5 Cost of Switchinge
6 Net Profitf
r = 5 percent
$600.00 $
$ 0.00
$0.00 1
300.00
15.00
2.00
13.00 2
200.00
400.00
20.00
4.00
16.00 3
150.00*
450.00
22.50
6.00
16.50 4
120.00
480.00
24.00
8.00
Assumptions: Interest rate r = Cost of switching from bonds to money equals $2 per transaction.
r = 3 percent
9.00
7.00
200.00*
12.00
150.00
13.50
7.50
14.40
6.40
Assumptions: Interest rate r = Cost of switching from bonds to money equals $2 per transaction.
*Optimum money holdings. aThat is, the number of times you sell a bond. bCalculated as 600/(col ). cCalculated as 600 − col. 2.
dCalculated as r × col. 3, where r is the interest rate. eCalculated as t × col. 1, where t is the cost per switch ($2). fCalculated as col. 4 − col. 5