1. 1 Money, Banking, the Federal Reserve System, and Monetary Policy Chapter 13 & 14

2. 2 Functions of Money Medium of exchange. Unit of account. Store of wealth.

3. 3 Components of M2 and M1 Components of M1Components of M2 Savings deposits (48%) Checking accounts (49%) Small-denomination time deposits (15%) Currency (50%) M1 (28%) Money market mutual funds (16%) Traveler’s checks (1%) M1 (21%) McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

4. 4 The Composition of Money in the U.S. Money Supply, M1 (in billions) Currency (in circulation) Demand deposits Other checkable deposits Traveler’s checks Total M1 $664 312 309 8 $1,293 Money Supply, M2 (in billions) M1 Savings deposits a Small time deposits Money market mutual funds Total M2 $1,293 3,158 810 796 $6,057 $1,293 $6,057 a Including money market deposit accounts. Source: http://www.federalreserve.gov. The M1 and M2 Money Supply of the U.S –––––––––– (as of December 2003) ––––––––––

5. 5 The Changing Nature of M1 150 300 450 600 750 900 1,050 1,350 Billions of $ Interest-earning checkable deposits 1970197519801985199019952000 2003 $309 $312 $672 Total $1,293 1,200 Demand deposits Currency M1

6. 6 The Money Multiplier Banks lend a portion of their deposits keeping the balance as reserves. Reserves are vault cash and the bank’s deposits at the Fed.

7. 7 The reserve ratio is the ratio of reserves to deposits a bank keeps as a reserve against cash withdrawals.

8. 8 The required reserve ratio is the percentage of their deposits banks are required to hold by the Fed. If banks choose to hold an additional amount, this is called the excess reserve ratio.

9. 9 An Example of the Creation of Money The first 7 rounds of the money creation process is illustrated on the following table. Assume a deposit of $10,000 and a reserve ratio of 20 percent. Assume that all new money remains in the banking system, none is held as currency.

10. 10 An Example of the Creation of Money

11. 11 Determining How Many Demand Deposits Will Be Created To find the total amount of deposits that will eventually be created, multiply the original deposited amount by 1/r, where r is the reserve ratio.

12. 12

13. 13

14. 14 http://www.stlouisfed.org/ www.stlouisfed.org FRED for economic data

15. 15 Federal Reserve System Passed through Congress narrowly in December 1913 Regional banks to disperse power and allay fears of monopoly capitalism Lender of last resort (discount loans only) 12 - 7- 12

16. 16 Philadelphia 3 San Francisco 12 1 Boston 4 Cleveland 9 Minneapolis 11 Dallas Washington, D.C. (Board of Governors) 10 Kansas City 7 Chicago 5 Richmond 2 New York Atlanta 6 St. Louis 8 The Federal Reserve Districts

17. 17 Federal Reserve Bank of New York

18. 18 Board of Governors 7 members. 14 year non-renewable terms, one opens up every second January. Chairman has 4 year renewable term.

19. 19 Fed Chair Ben Bernanke Appointed by President Bush on October 24, 2005. Took office February 1, 2006.

20. 20 Federal Open Market Committee 12 members 7 members of Board of Governors + 5 Federal Reserve Bank Presidents http://www.federalreserve.gov/FOMC/ (always including the President of the FRBNY) Meets every 6-8 weeks in Washington to determine course of monetary policy http://www.federalreserve.gov/FOMC/

21. 21 Fed Funds Rate Rate of interest that banks charge one another for short-term loans. Determined by supply of and demand for reserves Fed adjusts the supply of reserves through open market operations.

22. 22

23. 23 Most Important Tool of Monetary Policy Open market operations: the purchase or sale of Treasury securities by the Fed Sell Treasury securities: contractionary. Buy Treasury securities: expansionary.

24. 24 Two Other Tools of Monetary Policy Changing reserve requirements. Changing the discount rate.

25. 25 Money interest rate The quantity of money people want to hold (the demand for money) is inversely related to the money rate of interest, because higher interest rates make it more costly to hold money instead of interest-earning assets like bonds. The Demand for Money Money Demand Quantity of money

26. 26 Money interest rate Money Supply The Demand and Supply of Money Money Demand i3i3 ieie i2i2 Excess supply at i 2 Excess demand at i 3 At i e, people are willing to hold the money supply set by the Fed. Quantity of money

27. 27 Quantity of money Money interest rate The supply of money is vertical because it is established by the Fed and, hence, determined independent of the interest rate. Money Supply The Supply of Money

28. D1D1 Money interest rate S1S1 D S1S1 i1i1 QsQs r1r1 Q1Q1 i2i2 QbQb r2r2 Q2Q2 S2S2 S2S2 Real interest rate Quantity of money Qty of loanable funds Transmission of Monetary Policy

29. Price Level Goods & Services (real GDP) D S1S1 r1r1 Q1Q1 r2r2 Q2Q2 S2S2 Real interest rate P1P1 Y1Y1 Y2Y2 AS 1 AD 1 P2P2 AD 2 Transmission of Monetary Policy Qty of loanable funds

30. 30 Unanticipated Expansionary Monetary Policy Fed buys bonds Transmission of Monetary Policy Real interest rates fall Increases in investment & consumption Depreciation of the dollar Increase in asset prices Increases in investment & consumption Net exports rise Increase in aggregate demand This increases money supply and bank reserves

31. 31 Monetary Policy and Real GDP Source: Federal Reserve Bank of St. Louis, http://www.stls.frb.org.http://www.stls.frb.org a Annual percent change in M2 b 4-quarter percent change in real GDP 196019651970197519801985199019952000 16 14 12 10 8 6 4 2 0 -2 % change in real GDP b 2003 % change in M2 money supply a

32. 32 Money Supply Changes & Inflation Source: Federal Reserve Bank of St. Louis, http://www.stls.frb.org. The CPI was used to measure the annual rate of inflation.http://www.stls.frb.org 14 12 10 8 6 4 2 12 10 8 6 4 2 0 a 4-quarter percent change in M2 b inflation calculated as 4-quarter moving average Δ M2 1960 1963 1965 1968 1970 1973 1975 1978 1980 1983 1985 1988 1990 1993 1995 1998 Δ P Inflation rate, % - lagged 3-years - (left axis) b % change in M2 (right axis) a 2000 2003

33. 33 Inflation & the Money Interest Rate The expectation of inflation... –reduces the supply of, and, –increases the demand for loanable funds, Note how the short-term money rate of interest has tended to increase when the inflation rate accelerates (and decline as the inflation rate falls). Source: Federal Reserve Bank of St. Louis, http://www.stls.frb.org.http://www.stls.frb.org 196019651970197519801985199019952000 16 12 8 4 0 Interest rate (3-mos. T-bill) a Inflation rate, % a a annual rate of inflation calculated using the CPI 2003

34. 34 Quantity Equation MV=PQ

35. 35 Money Growth and Inflation

36. 36