Download Commodity money

We just understood the equilibrium and
transmission mechanisms of the goods market.
Now we will analyze the money market…
Topic
III. MACROECOMIC EQUILIBRIUM IN A FIXED PRICE MODEL:
SORT-RUN ANALYSIS
A. The goods market
B. The money market
C. The goods and money markets together (The IS-LM model)
IV. MACROECOMIC EQUILIBRIUM IN A FLEXIBLE PRICE
MODEL: LONG-RUN ANALYSIS
A. Determination of the price level (The AS-AD model)
B. Labor Market
Textbook
chapters
8, 8A, 9, 9A
10, 11
12
13
14
• Overview of money
- What is money?
Roles of money (medium of exchange, unit of account, store of value).
- Types of money
Commodity money, fiduciary money, fiat money.
- Measuring money
M1 and M2
- Should each country has one “official” own money?
• Money supply
- Institutions involved in money creation
- Private banks
- Central Bank
Open market operations, required reserve ratio, discount rate
- Supply curve of money
Overview of money
• What is money?
- Medium of exchange (quintessential function):
-
What sellers generally accept and buyers generally use to pay for
goods and services.
A monetary economy is welfare improving compared with
barter economy because it avoids mutual coincidence of wants.
- Unit of account:
A standard unit that provides a consistent way of quoting prices
Example:
- Unit of account:
A standard unit that provides a consistent way of quoting prices
Examples:
a) 2 goods: Lunches (L) and cloth (C)
→ 1 relative price:
L in terms of unit of C
b) 3 goods: Lunches (L), cloth (C) and wood (W)
→ 3 relative prices:
L in terms of unit of C
L in terms of unit of W
C in terms of unit of W
nn  1
relative prices
2
(e.g. n=1000 → 499500 relative prices)
c) n goods: →
In a monetary economy you just need n prices in terms of money!
- Store of value:
An asset that can be used to transport purchasing power from
one time period to another.
- Liquidity of money:
The property of money that makes it a good medium of exchange
as well as a store of value.
• Types of money
- Commodity money:
Items used as money that also have intrinsic value in some
other use.
- Fiduciary money:
Paper money that is backed by precious metals or other
commodities.
- Fiat money:
Paper money that is intrinsically worthless.
• Measuring money
- Remember…
Money is an asset that is issued to:
i) buy things (medium of exchange)
ii) to hold wealth (store of value)
iii) to quote prices (unit of account)
- What is money and what is not?
Coins and currency money
Checking account
Traveler’s checks
Savings accounts
Certificate of deposit
Liquidity
- Different measures of money based on liquidity
M1 = currency held outside banks + checking accounts +
+ traveler’s checks + other checkable deposits
M2 = M1 + savings accounts + money market accounts +
+ small certificate of deposits
• Should each country has one “official” own money?
- As a general rule, each country has one “official” own money
US$, Argentinean Peso, Chinese Yuan
- Some countries share a common currency
Euro, East Caribbean dollar,
Colonies françaises d'Afrique ("French colonies of Africa")
- Some countries have not own or shared currency
Ecuador (since 2000), Panama
- Some countries have more than one “currency”
Argentina 1999-2002 has more than 15 currencies!
Money supply
• Institutions involved in money creation
- Central Bank (e.g. the Federal Reserve in the US):
Monetary institution that has the legal authority to issue bills
and coins.
Among other functions it regulates the banking system and is the
lender of last resort.
- Private banks (e.g. Bank of America):
Act as a link between those who have money to lend and those
who want to borrow money.
•
Money supply
Central bank and Private banks
•
Equilibrium in money market
Equilibrium interest rate
• Private banks
- Brief review of accounting
- Balance sheet of a typical private bank
- The creation of money
- The money multiplier
• Central Bank
- The Central Bank can determine the supply of notes
(bills and coins).
- Let us examine the balance sheet of the Central Bank
(Fed 2005, millions of US$).
Assets
Gold
Loans to banks
US treasure
securities
TOTAL
Liabilities
$11,037
3,330
724,700
$820,910
Federal reserve notes
$729,601
Deposits:
Bank reserves
26,130
US treasury
4,813
Other liabilities and net worth 60,366
TOTAL
$820,910
- How does the Central Bank controls the money supply?
• If Central Bank wants to ↑Ms  creates more reserves there by
freeing banks to create additional deposits by making more loans.
If it wants to decrease the money supply, it reduces reserves.
• The Central Bank has available 3 tools:
1) Engaging in open market operations
2) Changing the required reserve ratio
3) Changing the discount rate
1) Engaging in open market operations
The purchase and sale by the Central Bank of government
securities (bonds) in the open market.
• Example: Central Bank sells gov. securities  ↓Ms
PANEL 1
Assets
Securities
Federal Reserve
Liabilities
$100
$20 Reserves
$80 Currency
Commercial Banks
Assets
Liabilities
Reserves
Loans
$20
$80
$100 Deposits
Assets
Deposits
Jane Q. Public
Liabilities
$5
Note: Money supply (M1) = Currency + Deposits = $180.
$0
$5
Debts
Net Worth
$80 Currency
PANEL 2
Assets
Securities
( $5)
Federal Reserve
Liabilities
$95
$15 Reserves
( $5)
$80 Currency
Commercial Banks
Assets
Liabilities
Reserves
( $5)
Loans
$15
$95 Deposits
( $5)
$80
Assets
Deposits
( $5)
Securities
(+ $5)
Jane Q. Public
Liabilities
$0
$0
Debts
$5
$5
Net Worth
Note: Money supply (M1) = Currency + Deposits = $175.
PANEL 3
Assets
Securities
( $5)
Federal Reserve
Liabilities
$95
$15 Reserves
( $5)
$80 Currency
Commercial Banks
Assets
Liabilities
Reserves
( $5)
Loans
( $20)
$15
$60
$75 Deposits
( $25)
Assets
Deposits
( $5)
Securities
(+ $5)
Note: Money supply (M1) = Currency + Deposits = $155.
∆Ms = money multiplier ∆reserves = 5 * (-5) = -25
Jane Q. Public
Liabilities
$0
$0
Debts
$5
$5
Net Worth
2) Changing the required reserve ratio
Increases (decreases) in the required reserve ratio allows banks to
have less (more) deposits with the existing volume of reserves,
therefore decreasing (increasing) the supply of money.
• Example: Central Bank reduce reserve ratio from 20% to 12.5%  ↑Ms
PANEL 1: REQUIRED RESERVE RATIO = 20%
Federal Reserve
Assets
Government
securities
Commercial Banks
Liabilities
$200
Assets
$100
Reserves
Reserves
$100
$100
Currency
Loans
$400
Liabilities
$500
Deposits
Note: Money supply (M1) = Currency + Deposits = $600.
PANEL 2: REQUIRED RESERVE RATIO = 12.5%
Federal Reserve
Assets
Government
securities
$200
Commercial Banks
Liabilities
Assets
$100
Reserves
Reserves
$100
$100
Currency
Loans
(+ $300)
$700
Note: Money supply (M1) = Currency + Deposits = $900.
∆Ms = ∆money multiplier reserves = (8 - 5) * 100 = 300
Liabilities
$800
Deposits
(+ $300)
3) Changing the discount rate (interest rate that banks pay to
the Central Bank to borrow from it)
 discount rate  ↑cost of borrowing  ↓loans to banks  ↓reserves  ↓Ms
• Example: Central Bank ↓discount rate  ↑Ms
PANEL 1: NO COMMERCIAL BANK BORROWING FROM THE FED
Federal Reserve
Assets
Liabilities
Securities
$160
Commercial Banks
Assets
Liabilities
$80
Reserves
Reserves
$80
Currency
Loans
$80
$400
Deposits
$320
Note: Money supply (M1) = Currency + Deposits = $480.
PANEL 2: COMMERCIAL BANK BORROWING $20 FROM THE FED
Federal Reserve
Assets
Liabilities
Securities
Loans
Commercial Banks
Assets
Liabilities
$160
$100
Reserves
(+ $20)
Reserves
(+ $20)
$100
$500
$20
$80
Currency
Loans
(+ $100)
$420
$20
Note: Money supply (M1) = Currency + Deposits = $580.
∆Ms = money multiplier ∆reserves
money multiplier ∆loans = 5 * 20 = 100
Deposits
(+ $100)
Amount owed to
Fed (+ $20)
• Supply curve of money