1. Money $ Money $ Money What is money? Anything that performs these functions: –A medium of exchange –A unit of account –A store of value

2. Medium of Exchange Anything used to determine value during the exchange of goods and services Money makes these transactions easier The alternative is barter

3. Unit of Account Allows us to compare the values of goods and services

4. Store of Value Keeps its value over a period of time What threatens this? –Inflation

5. Types of Money Commodity Money –Something that is used as a medium of exchange that has value in its own right (gold, silver, cigarettes) Representative Money –Commodity backed money –A bank note redeemable for a commodity (gold or silver) Fiat Money –Something that has value because government says that it has value

6. Types of Money What type of money is today’s U.S. dollar? Fiat Money

7. Measuring the Money Supply M1 Money Supply (most liquid) Includes currency in circulation, coins, travelers checks, and checkable/demand deposits (checking accts) **About 50/50 Currency and coins to Deposits

8. Measuring the Money Supply M2 Money Supply Includes M1 and “near moneys” -- savings deposits (savings accounts) and other interest bearing accounts like CD’s M1 is about 20% of M2

9. The Goldsmiths and the Origins of Paper Money Goldsmiths provided a place of storage for an individual’s gold and silver They would charge a fee for this service They would issue a receipt to the owner of the specie (gold and silver)

10. The Goldsmiths and the Origins of Paper Money Receipts then began to be exchanged for goods and services Why? The receipts were accepted as a medium of exchange Voila! The first paper money!

11. The Goldsmiths and the Origins of Paper Money Then some shrewd Goldsmith realized he could issue receipts in excess of the amount of gold he had. Why? They rarely had to exchange receipts for gold! Voila! The first bank loan!

12. The Monetary Role of Banks About half of M1 is bank deposits What Banks Do –Uses its assets to finance the investments of borrowers –Not all assets are lent out –Some assets must be kept on hand to satisfy the demands of depositors that want to withdraw their funds (Reserves)

13. Fractional Reserve Banking System The assets that a bank must keep in reserve is established by the Fed This is known as the RESERVE RATIO or the RESERVE REQUIREMENT

14. It’s a Wonderful Banking System! What would happen, if for some reason, all a bank’s depositors wanted their deposits at the same time? See – The Bank Run on You Tube

15. It’s a Wonderful Banking System! Is this a problem today? Not likely. Why not? The Federal Deposit Insurance Corporation (FDIC) Insures bank deposits (of member banks) up to $250,000 (result of a new law President Obama signed in 2010)

16. It’s a Wonderful Banking System! The insurance also eliminates the cause of bank runs Bank Regulation –Deposit Insurance –The fact that insurance exists can promote reckless behavior on the part of financial institutions – “don’t worry, if we fail the taxpayers will bail us out” –Reserve Requirements – usually a minimum of 10%)

17. How Banks Create New Money Let’s look at an initial $1000 cash deposit into a checking acct. (demand deposit) First key point –This does NOT add anything NEW to the money supply –There is $1000 less currency and $1000 more in demand deposits – No net increase

18. How Banks Create New Money Now let’s assume the bank has a 10% reserve requirement (rr) The bank must keep $100 in reserve in its vaults (required reserves) It can then lend out the $900 in excess reserves This begins the process of money creation

19. How Banks Create New Money How much NEW money will be created? The first step is to determine the money multiplier 1/rr OR 1/reserve requirement Multiplier of 10 In this instance, the $900 excess reserves is multiplied 10 times throughout the economy - $9000 in NEW money

20. How Banks Create New Money If a bank initially lent out $1000 in excess reserves, $10,000 in NEW money would be created What if you were asked the change in demand deposits as a result of this? The initial $1000 demand deposit would result in how much of a total change in demand deposits? $10000

21. From the 2009 AP Test 3. Assume that the reserve requirement is 20 percent and banks hold no excess reserves. –(a) Assume that Kim deposits $100 of cash from her pocket into her checking account. Calculate each of the following. (i) The maximum dollar amount the commercial bank can initially lend (ii) The maximum total change in demand deposits in the banking system (iii) The maximum change in the money supply

22. Bank A Bank B Bank C Bank D Bank E Bank F Bank G Bank H Bank I Bank J Bank K Bank L Bank M Bank N Other Banks Bank (1) Acquired Reserves and Deposits (2) Required Reserves (Reserve Ratio =.2) (3) Excess Reserves (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) $100.00 80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 21.99 $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $400.00 The Banking S ystem 32-22

23. The Monetary Multiplier Monetary multiplier = 1 required reserve ratio New Reserves $100 $20 Required Reserves $80 Excess Reserves $100 Initial Deposit $400 Bank System Lending Money Created Graphic Example = 1 rr 32-23

24. The Federal Reserve System Historical Background Prior to 1913, the U.S. had a decentralized and unregulated banking system This led to much economic instability, (fraud, different currencies, bank failures)

26. The Federal Reserve System A financial crisis in 1907 led to the desire to create a centralized banking system with control over the money supply In 1913 Congress passed and President Wilson signed, The Federal Reserve Act

27. The Federal Reserve System The Federal Reserve Act (1913) The Board of Governors –7 members –Appointed by the President, Confirmed by the Senate –14 year terms; staggered so one member is replaced every two years (above political pressure)

28. The Federal Reserve System President chooses a board member to be the Chairman of the Fed (4 year term) Janet Yellen

29. The Fed - Basics

31. Main Functions of The Fed –A bank to banks and to the Federal government –Regulate the banks in their district –Provide a safe and stable financial system –****Monetary Policy

32. The Fed - Basics Monetary Policy –Manipulation of the money supply in order to bring about the desired macroeconomic goals (expanding Real GDP, low inflation, low unemployment)

33. The Tools of the Fed Manipulate the Discount Rate –The interest rate the Fed charges to banks that want to borrow money Manipulate the Reserve Ratio The percentage of reserves a bank is required to keep on hand as cash Target a higher or lower FEDERAL FUNDS RATE

34. The Federal Funds Rate Banks keep some of their reserves in accounts at a Federal Reserve bank Sometimes bank required reserves go lower than a bank wants or needs Banks with excess reserves willingly lend deficient banks funds from their Federal Reserve accounts ($1 Million minimum)

35. The Federal Funds Rate The interest rate that banks charge each other for these short-term, often overnight loans, is known as the FEDERAL FUNDS RATE The Federal Reserve does NOT set the Fed Funds Rate but it does target a rate that they would like (0 to 0.25) (0.09) They influence the rate through their Open Market Operations

36. The Federal Funds Rate The lower the Federal Funds Rate, the more it encourages banks to borrow from each other The higher the Federal Funds Rate, the more it discourages banks to borrow from each other The current Fed Funds target rate is really a range, from 0 to 0.25%

37. The Tools of the Fed Carry out Open Market Operations (OMO) –Buying and selling of government securities (bonds) –Executed by the Federal Open Market Committee (FOMC) –7 member Board of Governors, President of the New York Fed, 4 other bank presidents on a rotating basis

38. Tools of Monetary Policy Monetary PolicyExpansionary Policy (Easy Money) Contractionary Policy (Tight Money) Open Market Operations Discount Rate Reserve Requirements Federal Funds RateTarget a

39. The Tools of the Fed Expansionary Monetary Policy –Aka – Easy Money Policy –Increasing the money supply (increasing excess reserves) –Lowers interest rates –To fight against recession –Stimulate AD (through Ig)

40. The Tools of the Fed Contractionary Monetary Policy –Aka – Tight Money Policy or Restrictive Policy –Decreasing the money supply (decreasing excess reserves) –Increases interest rates –To fight against inflation –To reduce AD (through Ig)

41. The Demand and Supply of Money m m

42. The Money Market Graph Shows the relationship between the supply of money (Sm or Ms) and the demand for money (Dm or Md) The Money Demand Curve –Impacted by Fiscal Policy –Changes in the Price Level can shift the Dm curve – Higher PL the higher the demand for money – Lower PL the lower the demand for money

43. Changes in Real GDP shift the Dm curve –Increases in Real GDP shift the Dm curve to the right –Decreases shift the curve to the left Changes in Technology have shifted the Dm curve –The easier it is to buy stuff without cash (Credit cards for example) the less demand there is for money – Shift to the left The Money Market Graph

44. The Money Supply curve –Impacted by Monetary Policy –Fed actions shift the curve depending on whether the money supply has been increased or decreased

45. The Demand and Supply of Money m m

46. What would happen to the money supply AND interest rates if the Fed Targeted a reduction of the Federal Funds Rate Raised the Discount Rate Lowered the Reserve Requirement Bought government securities on the open market Targeted an increase the Federal Funds Rate Sold government securities on the open market

47. Money Supply or Money Demand? The rate of inflation declines (disinflation) The Fed buys bonds The reserve requirement is raised There is economic growth (a rise in Real GDP) The Fed targets an increase in the federal funds rate

48. Interest Rates and Bond Prices Bonds are bought and sold in the open market based on supply and demand They sell for a certain price and pay fixed interest rates Suppose a $1000 bond pays an annual $50 in interest That’s a 5% yield annually (5% interest rate)

49. Interest Rates and Bond Prices Now, what happens interest rates rise to 7.5% Would you want to purchase the old bond at 5% when you could get a new one at 7.5%? What would make you be willing to purchase the $1000 old bond? If it was sold for less than $1000

50. Interest Rates and Bond Prices In fact, if you could buy the old bond for $667 and receive the fixed $50 interest you would be receiving 7.5% annually on your investment THUS, WHEN INTEREST RATES RISE BOND PRICES DECLINE WHEN INTEREST RATES DECLINE, BOND PRICES RISE

51. One Final Point If the Fed buys $10,000 in government bonds, does the money supply initially increase by $10,000? Yes it does!!! Why? Because the money in the vaults of Fed banks is not considered to be a demand deposit and is therefore not part of M1

52. One Final Point So, there is a difference between you taking $1,000 cash and putting it into your checking account and the Fed making a $1,000 purchase of government bonds. What is that difference? The Fed purchase initially increases the M1 money supply by $1,000, the cash deposit does not

53. –Practice Monetary Policy problems 2014 #2 2012 #1

54. Limitations of Monetary Policy Hard to determine how much money growth is optimal Can’t always predict the exact results of a monetary action Lag time before the actions of the Fed kick in World events make things more complex Congress may do things (Fiscal Policy) that conflict with the Fed

55. Practice Complete Connections: Countercyclical Monetary Policies (On the back of Countercyclical Fiscal Policies) Examine the 2012 exam question on T- Accounts

56. The Monetarists When Keynesian fiscal policy failed to deal with the stagflation of the 1970’s, some economists put forth the concept of MONETARISM They believed that a steady growth of the money supply would assure economic growth and macroeconomic stability

57. The Monetarists Monetarists call for a steady increase of the money supply (say at 3% a year) regardless of the status of the economy They rejected an active monetary policy (an important distinction). In other words, they didn’t feel that the supply of money should be expanded and contracted (Monetary Policy) to meet certain conditions because of its limitations They are basically conservative, laissez-faire economists

58. The Monetarists Milton Friedman was its leading advocate and he has become a conservative icon over the last 30+ years

60. The Equation of Exchange The fundamental equation for monetarists is MV=PQ M is the supply of money V is the velocity of money (the average number of times a dollar is spent during a year – this is relatively stable they believe) P is the price level Q is the quantity of all goods and services produced

61. The Equation of Exchange MV is the money supply multiplied by the number of times the money is spent throughout the year PQ is basically nominal GDP MV (Spending) equals the value of PQ (Output)

62. The Equation of Exchange If V is relatively stable and predictable, INCREASING THE MONEY SUPPLY WILL INCREASE NOMINAL GDP

63. Decrease in Invest Demand r

65. The Monetary Role of Banks The T-account summarizes a banks financial position

66. AssetsLiabilities and Net Worth Creating a Bank Transaction #1 Vault cash: cash held by the bank Creating a Bank Balance Sheet 1: Wahoo Bank Cash$250,000Stock Shares$250,000 32-66

67. AssetsLiabilities and Net Worth Creating a Bank Transaction #2 Acquiring property and equipment Acquiring Property and Equipment Balance Sheet 2: Wahoo Bank Cash$10,000Stock Shares$250,000 Property240,000 32-67

68. Assets Liabilities and Net Worth Creating a Bank Transaction #3 Commercial bank functions –Accepting deposits –Making loans Accepting Deposits Balance Sheet 3: Wahoo Bank Cash $110,000 Checkable Deposits $100,000 Property 240,000 Stock Shares 250,000 32-68

69. AssetsLiabilities and Net Worth Creating a Bank Depositing Reserves at the Fed Balance Sheet 4: Wahoo Bank Cash$0Checkable Deposits $100,000 Property240,000Stock Shares250,000 Reserves110,000 Transaction #4 Assume the bank deposits all cash on reserve at the Fed 32-69

70. AssetsLiabilities and Net Worth Creating a Bank Transaction #5 Clearing a check –$50,000 check reduces reserves and checkable deposits Clearing a Check Balance Sheet 5: Wahoo Bank Checkable Deposits $50,000 Property 240,000 Stock Shares250,000 Reserves $60,000 32-70

71. Financial Institutions Institutions offering checkable deposits –Commercial banks JP Morgan Chase Bank of America Wells Fargo –Credit unions 31-71

72. Crowding Out - Revisited Initiated by Government deficit spending to pay for an _______________ fiscal policy.

73. The Loanable Funds Market A market that brings together borrowers and lenders There is a supply of loanable funds and a demand for those loanable funds

75. Shifts in the Demand for LF Business and Consumer expectations –Optimistism leads to increased demand of LF –Pessimism leads to declining demand of LF Government borrowing to finance an expansionary fiscal policy increases the demand for LF (Which leads to crowding out)

77. Shifts in the Supply of LF Changes in private savings behavior –More savings increases the supply of LF –Less savings decrease the supply of LF Changes in the flow of foreign investment in the U.S. (We will understand this when we study the international economy)