1. Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001) Ch. 10: The Monetary System

2. Econ 202 Dr. Ugur Aker 2 Money Had To Be Invented As the number of products to be exchanged increases, the relative prices of these goods become impossible to remember and compare: Unit of account. Barter required double coincidence of wants. Something had to be invented to make exchange easier: Medium of exchange. Some people wanted to postpone their consumption to the future. Money allowed this: Store of value.

3. Econ 202 Dr. Ugur Aker 3 Unit of Account We use money to measure the value of goods and services. Suppose we had 4 goods and no money. How do we measure the price of each good? –A in terms of B –B in terms of C –C in terms of D –A in terms of C –A in terms of D –B in terms of D Money allows to quote prices in terms of currency only.

4. Econ 202 Dr. Ugur Aker 4 Medium of Exchange By eliminating barter, this function of money increases efficiency in a society. As human societies started to engage in exchange, money had to be invented. Any technological change that reduces transaction costs increases the wealth of the society. Any technological change that allows people to specialize also increases wealth.

5. Econ 202 Dr. Ugur Aker 5 Storing Value: Assets Cash Checking Accounts Saving Accounts Mutual funds Stocks Bonds Real estate Paintings

6. Econ 202 Dr. Ugur Aker 6 Store of Value All assets are stored value. Money, although without any return, is still desirable to hold because it allows purchases immediately. Other assets take time (transaction costs) to use as a payment for purchases. The more liquid an asset is, the less transaction cost it carries. Inflation erodes the value of money.

7. Econ 202 Dr. Ugur Aker 7 What Makes An Asset Money The willingness of other people to accept it in return for debts and goods and services. The ease an asset can be transferred into cash: liquidity. –The higher the transaction cost, the farther is the asset from money. The expectation that the asset will have a relatively stable value. –High inflation: no one wants to hold cash. –High return: no one wants to part with it.

8. Econ 202 Dr. Ugur Aker 8 Meaning of Money Money (=money supply) any vehicle used as a means of exchange to pay for goods, services or debts. In today’s society, any asset that can quickly be transferred into cash is considered money. The more liquid an asset is, the closer it is to money. In economics,money does not mean wealth nor does it mean income.

9. Econ 202 Dr. Ugur Aker 9 Kinds of Money Metals, like gold, silver or copper, have served as money because they were durable, recognizable and transportable. In Micronesia, heavy stones serve as money. Exchanging ownership of stones allows people to transact sales of large items, like houses or fields. In order to diffuse confidence on the intrinsic weight of the precious metal, the state put stamps on coins. Eventually, the state put stamps on worthless paper and declared it fiat money.

10. Econ 202 Dr. Ugur Aker 10 What Is Included in the Money Supply The medium of exchange function of money in the US is satisfied by currency, checking deposits, traveler’s checks and sometimes money market mutual funds. Banks make it quite easy for their customers to move funds from savings to checking accounts. Sometimes banks allow their customers to overdraw their checking accounts by extending a personal loan. Credit cards extend a short term loan to consumers. These loans have to be paid from the checking deposits.

11. Econ 202 Dr. Ugur Aker 11 Measuring Money M1: Currency, demand deposits, travelers checks. M2: M1, saving deposits, small time deposits, retail MMMF. M3: M2, large time deposits, repos, Eurodollar deposits, institutional MMMF. MZM: M2, institutional MMMF minus small time deposits. Growth rates of these aggregates do not always go hand in hand, making monetary policy difficult since signals are conflicting.

12. Econ 202 Dr. Ugur Aker 12 Why Is There So Much Currency? The January 2001 average for currency is $535 billion. M1 was $1102 billion. –Source: http://www.stls.frb.org/fred/data/monetary.htmlhttp://www.stls.frb.org/fred/data/monetary.html The population of the US is 283 million. It would imply that each person (man, woman and child) would be carrying $1890 on average! –A substantial portion of US currency is overseas. –Underground economy operates strictly on cash.

13. Econ 202 Dr. Ugur Aker 13 Who Controls the Money Supply The primary institution that controls the money supply is the Central Bank. In the US, the Central Bank is called Federal Reserve System (the Fed). The banking system diffuses the money the Fed desires to provide. Their choices affect the amount of money in the system. The way people want to hold their liquid funds, in cash or in checking deposits, also affects the money supply.

14. Econ 202 Dr. Ugur Aker 14 The Fed Woodrow Wilson signed the law establishing the Fed on Dec. 23, 1913 to establish stability to the financial system. In 1907, run on the 19th Ward Bank of New York City created a financial panic that led to bankruptcies, unemployment, recession. To have more local control, there are 12 Federal Reserve Banks.

15. Econ 202 Dr. Ugur Aker 15 The Fed The Federal Reserve Board consists of 7 governors nominated by the President and confirmed by the Senate for 14-year terms. The chair of the Board is appointed for a 4-year term by the President. Monetary Policy is formed by the FOMC (Federal Open Market Committee). Voting FOMC members are the 7 governors, Presidents of New York Fed, and 4 other Fed Presidents on a rotating basis.

16. Econ 202 Dr. Ugur Aker 16 Responsibilities of the Fed Monetary Policy –FOMC determines how much money and credit should be available. Supervision and Regulation –Supervise banks, bank holding companies, foreign bank offices in the US. Government Services –It is the bank for the Federal Government. Depository Institution Services –Distributes currency. –Processes checks. –Federal Reserve Communications System allows wire transfers of funds and securities among 7800 depository institutions. –Automated Clearinghouses allow electronic exchange of payments among depository institutions.

17. Econ 202 Dr. Ugur Aker 17 Tools of Monetary Policy Open-market operations –Buying US securities increases the money supply. –Selling US securities decreases the money supply. Reserve Ratio –Raising the reserve ratio decreases the money supply. Discount rate –Lowering the discount rate allows banks to borrow more from the Fed and increase the money supply.

18. Econ 202 Dr. Ugur Aker 18 The Role of Banks in Money Supply 1.The Fed buys $100 million worth of US securities from Anthony. 2.Anthony deposits the check he got from the Fed in his bank, First Bank. 3.First Bank now has excess reserves because it only has to keep 10% as required reserves. 4.First Bank gives a loan of $90 million to Beatrice. 5.Beatrice purchases Courtney’s services. 6.Courtney deposits $90 million in Second Bank.

19. Econ 202 Dr. Ugur Aker 19 The Role of Banks in Money Supply Finish the sequence. Develop a formula for calculating the increase (decrease) in money supply. Calculate how much money is created. Figure out what would happen if the banks did not loan out all of the excess reserves. Figure out what would happen if the reserve ratio were larger. Figure out what would happen if the banks took larger loans from the Fed.

20. Econ 202 Dr. Ugur Aker 20 Money Creation

21. Econ 202 Dr. Ugur Aker 21 Not All the Excess Reserves Are Loaned Out

22. Econ 202 Dr. Ugur Aker 22 Larger Reserve Ratio

23. Econ 202 Dr. Ugur Aker 23 Banks Borrowing More From the Fed

24. Econ 202 Dr. Ugur Aker 24 Households Affect Money Supply, Too What happens if households decide to hold less demand deposits and more cash? As households withdraw some of their deposits, the banks will have to reduce their outstanding loans. This will affect other banks and they will all reduce their loan portfolio. Money supply shrinks.