Download Introduction to Macroeconomics

Introduction to Macroeconomics
Chapter 26
Money, Banking and
the Federal Reserve
Money, Banking, & the Federal Reserve
1.
2.
3.
4.
5.
6.
Barter Economy
Characteristics of Money
Definition of Money
Fractional Reserve Banking
How Banks Create Money
Federal Reserve Policy Tools
1. Barter Economy
Transaction Costs
Barter - direct trade of one good for another
Transaction Costs:
– double coincidence of wants
– problem of divisibility
– negotiating relative values
2. Characteristic of Money
General Characteristics
• Medium of Exchange - item generally
acceptable as payment for goods and services.
Avoids double coincidence of wants.
• Store of Value - money can be accumulated
without deterioration or loss. No problem with
divisibility.
• Unit of Account - money is a standard unit
for quoting prices and establishing relative values.
Reduces negotiation costs.
2. Characteristics of Money
Commodity Money
• Characteristics:
– scarce relative to other commodities
– stable in supply
– portable
– divisible
– durable
• Problems:
– opportunity cost
– debasing (Gresham’s Law)
– can’t directly control supply
2. Characteristics of Money
Representative Money
Paper money that can be exchanged for a
specific commodity, like silver or gold.
Advantages:
• Lower opportunity cost
• Eliminates debasing
Problems:
• Depends on value of underlying commodity
• Counterfeiting
2. Characteristics of Money
Fiat Money
Paper money that is solely money because
the government says it is
Generally not backed by a valuable commodity such
as god but is backed by the “full faith and credit of
the government”
Advantages:
• No opportunity cost
• Not dependent on value of a commodity
Disadvantages
• No restraint in printing money
3. Definitions of Money
Categorized by Liquidity
Liquidity - how easily money can be used to make
purchases
• Monetary Base - currency held by public +
currency held in bank vaults (reserves)
• M1 = currency held by public plus checking
deposits
• M2 = M1 + savings deposits + small (less than
$100,000) time deposits (CDs)
• M3 = M2 + large (more than $100,000) time
deposits
3. Definitions of Money
M1
Currency
$567.8
Demand
Deposits
$618.4
Traveler's
Checks
$8.4
Source: Federal Reserve, H-6 Statistical Release, Table 4, September 2001.
3. Definitions of Money
M2
Retail Money
Funds
$1,012.0
M1
$1,194.6
Small Time
Deposits
$1,006.0
Savings Deposits
$2,185.5
Source: Federal Reserve, H-6 Statistical Release, Table 5, September 2001.
4. Fractional Reserve Banking
• Banks hold reserves (cash in their
vault) that are only a fraction of their
demand deposits (e.g., checking and
savings accounts)
• Banks make a profit by charging a
higher interest rate for loans than is
paid for deposits.
4. Fractional Reserve Banking
Risks
Risks:
• Bank runs
• Bank failures because of bad loans
Institutions to reduce risks:
• FDIC deposit insurance
• Federal Reserve System bank
regulations
4. Fractional Reserve Banking
Key Measurements
Demand Deposits (D) - total of checking and
savings account
Required Reserve Ratio (r) - fraction of D
established by Federal Reserve
Required Reserves, RR = r * D
Total Reserves = cash in bank vaults
Excess Reserves = Total Reserves - RR
5. How Banks Create Money
Money Multiplier
• Money Multiplier = 1 / r
• Maximum Possible Increase in
Money Supply
= Initial change in monetary base
x money multiplier
5. How Banks Create Money
Money Multiplier at Work
Cash Held
by
individuals
(C)
Cash in
Bank
Vault
(R)
Total
Demand
Deposits
(D)
Required
Reserves
(RR = r * D)
Excess
Reserves
(R – RR)
M1
Money
Supply
(C + D)
0
0
0
0
0
0
100
0
0
0
0
100
0
100
100
20
80
100
Bank loans excess
reserves to person B
80
20
100
20
0
180
B deposits cash in
checking account
0
100
180
36
64
180
Bank loans excess
reserves to person C
64
36
180
36
0
244
Federal Reserve
Holds $100 Cash
Fed buys $100 T-Bill
from individual A
Individual A deposits
$100 in checking
account
6. Federal Reserve Policy Tools
The Federal Reserve System
Created by act of Congress in 1913
Federal Reserve
Board of Governors
7 members appointed
by the President
12 Federal Reserve Banks
25 Federal Reserve
Branch Banks
Commercial banks
and other depository
institutions
Open Market Committee
Federal Advisory Council
Board of Governors plus 5 Federal
Reserve Bank presidents, alternating
terms, New York always represented
12 commercial bankers
for 12 districts
6. Federal Reserve Policy Tools
Policy Options
• Open Market Operations - buy and sell T-Bills
• Discount Rate - interest rate charged by Fed
for overnight loans to banks
• Required Reserve Ratio
• Stock Market Margin Requirements
• Moral Persuasion
6. Federal Reserve Policy Tools
Open Market Operations
Open Market Operation - purchase or sale
of government securities (T-bills) on the
open market
• T-Bill Par Value: cash-in value when TBill matures
• Interest Rate - difference between par
value of T-Bill and and purchase price
6. Federal Reserve Policy Tools
Expansionary Policy
• Objective: Lower Interest Rate
• Fed buys T-Bills (increase in money
supply)
• Market price of T-Bills increase
• Difference between market price and
par value declines.
• Result: Lower interest rate
6. Federal Reserve Policy Tools
Open Market Operations
Purchase T-Bills Sell T-Bills
Change in Monetary Base
From
Bank
+
From From From
Public Bank Public
+
-
Initial Change in Money Supply
n/c
+
n/c
-
Max Change in Money Supply
1/r
1/r
Bond Prices
+
+
-
-
Interest Rate
-
-
+
+
Investment / Aggregate Demand
+
+
-
-
-1/r -1/r
+ represents increase, - represents decrease
6. Federal Reserve Policy Tools
Summary of Policy Options
Expansionary
Policy
Contractionary
Policy
Interest rate
Lower
Higher
Money Supply
Higher
Lower
Buy T-Bills
Sell T-Bills
Discount rate
Reduce
Increase
Required reserves
Reduce
Increase
Objectives:
Policies:
Open market operation
6. Federal Reserve Policy Tools
Money and the Unemployment Rate
250
30
25
200
20
150
15
100
10
50
Monetary Base
Unemployment Rate
0
Jan18
5
0
Jan23
Jan28
Jan33
Jan38
Jan43
Jan48
Jan53
Unemployment rate, percent
Ratio: Reserves-to-Required Reserves