1. © 2007 Thomson South-Western

2. This lecture…. Money Growth Inflation Functions and Types of Money Federal Reserve System Basics

3. © 2007 Thomson South-Western Money Growth and Inflation The Meaning of Money –Money is the set of assets in an economy that people regularly use to buy goods and services from other people. Inflation is an increase in the overall level of prices.

4. © 2007 Thomson South-Western The Level of Prices and the Value of Money The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate. Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange. When the overall price level rises, the value of money falls.

5. © 2007 Thomson South-Western Money Supply, Money Demand, and Monetary Equilibrium The money supply is a policy variable that is controlled by the federal govt. Through instruments such as open-market operations (what?), the govt. directly controls the quantity of money supplied. Money demand has several determinants, including interest rates and the average level of prices in the economy.

6. © 2007 Thomson South-Western Money Supply, Money Demand, and Monetary Equilibrium People hold money because it is the medium of exchange. The amount of money people choose to hold depends on the prices of goods and services. In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

7. © 2007 Thomson South-Western Figure 2 An Increase in the Money Supply Quantity of Money Value of Money, 1/ P Price Level, P Money demand 0 1 (Low) (High) (Low) 1 / 2 1 / 4 3 / 4 1 1.33 2 4 M1M1 MS 1 M2M2 MS 2 2.... decreases the value of money... 3.... and increases the price level. 1. An increase in the money supply... A B

8. © 2007 Thomson South-Western The Effects of a Monetary Injection The Quantity Theory of Money How the price level is determined and why it might change over time is called the quantity theory of money. The quantity of money available in the economy determines the value of money. The primary cause of inflation is the growth in the quantity of money.

9. © 2007 Thomson South-Western The Classical Dichotomy and Monetary Neutrality Nominal variables are variables measured in monetary units. Real variables are variables measured in physical units.

10. © 2007 Thomson South-Western The Classical Dichotomy and Monetary Neutrality According to Hume and others, real economic variables do not change with changes in the money supply. According to the classical dichotomy, different forces influence real and nominal variables. Changes in the money supply affect nominal variables but not real variables. The irrelevance of monetary changes for real variables is called monetary neutrality.

11. © 2007 Thomson South-Western Velocity and the Quantity Equation The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

12. © 2007 Thomson South-Western Velocity and the Quantity Equation The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: The price level must rise, the quantity of output must rise, or the velocity of money must fall.

13. © 2007 Thomson South-Western CASE STUDY: Money and Prices during Four Hyperinflations Hyperinflation is inflation that exceeds 50 percent per month. Hyperinflation occurs in some countries because the government prints too much money to pay for its spending.

14. © 2007 Thomson South-Western Figure 4 Money and Prices During Four Hyperinflations (a) Austria(b) Hungary Money supply Price level Index (Jan. 1921 = 100) Index (July 1921 = 100) Price level 100,000 10,000 1,000 100 19251924192319221921 Money supply 100,000 10,000 1,000 100 19251924192319221921 (c) Germany 1 Index (Jan. 1921 = 100) (d) Poland 100,000,000,000,000 1,000,000 10,000,000,000 1,000,000,000,000 100,000,000 10,000 100 Money supply Price level 19251924192319221921 Price level Money supply Index (Jan. 1921 = 100) 100 10,000,000 100,000 1,000,000 10,000 1,000 19251924192319221921

15. © 2007 Thomson South-Western The Inflation Tax When the government raises revenue by printing money, it is said to levy an inflation tax. An inflation tax is like a tax on everyone who holds money. The inflation ends when the government institutes fiscal reforms such as cuts in government spending.

16. © 2007 Thomson South-Western THE COSTS OF INFLATION A Fall in Purchasing Power? Inflation does not in itself reduce people’s real purchasing power…. Or does it?

17. © 2007 Thomson South-Western THE COSTS OF INFLATION Shoeleather costs Menu costs Relative price variability Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth

18. © 2007 Thomson South-Western THE MONETARY SYSTEM 17 What Money Is and Why It’s Important Without money, trade would require barter, the exchange of one good or service for another. Every transaction would require a double coincidence of wants – the unlikely occurrence that two people each have a good the other wants. Most people would have to spend time searching for others to trade with – a huge waste of resources. This searching is unnecessary with money, the set of assets that people regularly use to buy g&s from other people.

19. © 2007 Thomson South-Western The Functions of Money Money has three functions in the economy: –Medium of exchange –Unit of account –Store of value Medium of Exchange A medium of exchange is an item that buyers give to sellers when they want to purchase goods and services. A medium of exchange is anything that is readily acceptable as payment.

20. © 2007 Thomson South-Western The Functions of Money Unit of Account –A unit of account is the yardstick people use to post prices and record debts. Store of Value –A store of value is an item that people can use to transfer purchasing power from the present to the future.

21. © 2007 Thomson South-Western THE MONETARY SYSTEM 20 The 2 Kinds of Money Commodity money: takes the form of a commodity with intrinsic value Examples: gold coins, cigarettes in POW camps Fiat money: money without intrinsic value, used as money because of govt decree Example: the U.S. dollar

22. © 2007 Thomson South-Western THE FEDERAL RESERVE SYSTEM The Federal Reserve (Fed) serves as the nation ’ s central bank. –Three Primary Functions of the Fed Regulates banks to ensure they follow federal laws intended to promote safe and sound banking practices. Acts as a banker ’ s bank, making loans to banks and as a lender of last resort. Conducts monetary policy by controlling the money supply.

23. © 2007 Thomson South-Western The Federal Open Market Committee (FOMC) Monetary policy is conducted by the Federal Open Market Committee. –The money supply refers to the quantity of money available in the economy. –Monetary policy is the setting of the money supply by policymakers in the central bank.

24. © 2007 Thomson South-Western The Federal Open Market Committee Open-Market Operations –The money supply is the quantity of money available in the economy. –The primary way in which the Fed changes the money supply is through open-market operations. The Fed purchases and sells U.S. government bonds. To increase the money supply, the Fed buys government bonds from the public. To decrease the money supply, the Fed sells government bonds to the public.

25. © 2007 Thomson South-Western BANKS AND THE MONEY SUPPLY Banks can influence the quantity of demand deposits in the economy and the money supply.

26. © 2007 Thomson South-Western BANKS AND THE MONEY SUPPLY Reserves are deposits that banks have received but have not loaned out. In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest. The reserve ratio is the fraction of deposits that banks hold as reserves.

27. © 2007 Thomson South-Western Money Creation with Fractional- Reserve Banking When a bank makes a loan from its reserves, the money supply increases. The money supply is affected by the amount deposited in banks and the amount that banks loan. –Deposits into a bank are recorded as both assets and liabilities. –The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio. –Loans become an asset to the bank.

28. © 2007 Thomson South-Western Banking Money Creation with Fractional-Reserve This T-Account shows a bank that … –accepts deposits, –keeps a portion as reserves, –and lends out the rest. It assumes a reserve ratio of 10%. AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00

29. © 2007 Thomson South-Western Money Creation with Fractional- Reserve Banking When one bank loans money, that money is generally deposited into another bank. This creates more deposits and more reserves to be lent out. When a bank makes a loan from its reserves, the money supply increases.

30. © 2007 Thomson South-Western The Money Multiplier How much money is eventually created by the new deposit in this economy? The money multiplier is the amount of money the banking system generates with each dollar of reserves.

31. © 2007 Thomson South-Western The Money Multiplier Increase in the Money Supply = $190.00! AssetsLiabilities First National Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00 AssetsLiabilities Second National Bank Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00

32. © 2007 Thomson South-Western The Money Multiplier Original deposit = $100.00 1st Natl. Lending = 90.00 (=.9 x $100.00) 2nd Natl. Lending = 81.00 (=.9 x $ 90.00) 3rd Natl. Lending = 72.90 (=.9 x $ 81.00) … and on until there are just pennies left to lend! Total money created by this $100.00 deposit is $1000.00. (= 1/.1 x $100.00)

33. © 2007 Thomson South-Western The Money Multiplier The money multiplier is the reciprocal of the reserve ratio: M = 1/R Example: –With a reserve requirement, R = 20% or.2: –The money multiplier is 1/.2 = 5.

34. © 2007 Thomson South-Western The Fed ’ s Tools of Monetary Control The Fed has three tools in its monetary toolbox: –Open-market operations –Changing the reserve requirement –Changing the discount rate

35. © 2007 Thomson South-Western 34 The Fed’s 3 Tools of Monetary Control 1. Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.  To increase money supply, Fed buys govt bonds, paying with new dollars. …which are deposited in banks, increasing reserves …which banks use to make loans, causing the money supply to expand.  To reduce money supply, Fed sells govt bonds, taking dollars out of circulation, and the process works in reverse.  OMOs are easy to conduct, and are the Fed’s monetary policy tool of choice.

36. © 2007 Thomson South-Western THE MONETARY SYSTEM 35 The Fed’s 3 Tools of Monetary Control 2. Reserve Requirements (RR): affect how much money banks can create by making loans.  To increase money supply, Fed reduces RR. Banks make more loans from each dollar of reserves, which increases money multiplier and money supply.  To reduce money supply, Fed raises RR, and the process works in reverse.  Fed rarely uses reserve requirements to control money supply: Frequent changes would disrupt banking.

37. © 2007 Thomson South-Western THE MONETARY SYSTEM 36 The Fed’s 3 Tools of Monetary Control 3. The Discount Rate: the interest rate on loans the Fed makes to banks  When banks are running low on reserves, they may borrow reserves from the Fed.  To increase money supply, Fed can lower discount rate, which encourages banks to borrow more reserves from Fed.  Banks can then make more loans, which increases the money supply.  To reduce money supply, Fed can raise discount rate.

38. © 2007 Thomson South-Western THE MONETARY SYSTEM 37 The Fed’s 3 Tools of Monetary Control 3. The Discount Rate: the interest rate on loans the Fed makes to banks  The Fed uses discount lending to provide extra liquidity when financial institutions are in trouble, e.g. after the Oct. 1987 stock market crash.  If no crisis, Fed rarely uses discount lending – Fed is a “lender of last resort.”

39. © 2007 Thomson South-Western THE MONETARY SYSTEM 38 Monetary Policy and the Fed Funds Rate To raise fed funds rate, Fed sells govt bonds (OMO). This removes reserves from the banking system, reduces supply of federal funds, causes r f to rise. rfrf F D1D1 S2S2 3.75% F2F2 S1S1 F1F1 3.50% The Federal Funds market Federal funds rate Quantity of federal funds

40. © 2007 Thomson South-Western THE MONETARY SYSTEM 39 Problems Controlling the Money Supply If households hold more of their money as currency, banks have fewer reserves, make fewer loans, and money supply falls. If banks hold more reserves than required, they make fewer loans, and money supply falls. Yet, Fed can compensate for household and bank behavior to retain fairly precise control over the money supply.