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Economics 102
Spring 2001
Lecture Notes for April 16 through April 25, 2001
Chapter 11 and 12
Money
Definition: standard object used in exchanging goods and services
Money as a medium of exchange:
Money as a unit of account:
Money as a store of value:
Measuring the Money Supply
 M1: is the summation of all coins and currency in circulation (held outside banks) + Demand
Deposits + Travelers Checks + Other Checkable Deposits
o Other checkable deposits include NOW accounts, ATS
o Credit cards?
 M2 is M1 plus savings accounts + money market accounts + other near monies
o Other near monies: are liquid assets that are close substitutes for money: e.g., time
deposits (CDs < $100,000), overnight Eurodollars, overnight repurchase agreements
 Size of M1 versus M2
M1 and M2 do not include
 All available means of payment: e.g., credit cards
 Some technological methods of payment: electronic cash
Money supply is then the cash in the hands of the public + Demand Deposits
Liquidity refers to the ease with which as asset can be converted into cash
Examples:
Importance of Financial Intermediation
Savers, Lenders >>>>>Financial Intermediaries>>>>>Borrowers, Spenders
E.g., Financial Intermediaries: commercial banks, S and Ls, Credit Unions, Mutual Savings
Banks, Life Insurance, and Pension Funds
Rise of Banking motivated by
o People want to borrow
o People want a safe place to hold wealth
o People want convenience
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Fractional Reserve Banking system: a system in which bankers keep as reserves only a fraction of their
funds they hold on deposit
 Banks are in business to earn a profit

Bank decisions affect the money supply

Banks are concerned about runs: banks should keep prudent level of reserves and lend out money
carefully
Conflict for banks between profit and safety/soundness led to bank regulation
 Deposit insurance: system guaranteeing depositors will not lose money even if bank goes
bankrupt
 Bank examinations
 Required reserves
Brief review of accounting before we can explore fractional reserve banking system
 Assets: things that a firm owns that are worth something
 Liabilities: things that a firm owes or its debt
Examples: mortgages, deposits, bank buildings, furniture
Assets – Liabilities = Net Worth or Capital
Net Worth = what is owed to owners
Assets = Liabilities + Net Worth
Bank’s balance sheet: T-account: a bank’s balance sheet must always balance
Reserves = Vault Cash + balances held at the Fed
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Required Reserves = minimum amount of reserves bank must hold. This depends on the amount of its
demand deposits and on the required reserve ratio that is set by the Fed.
Required Reserve Ratio = minimum fraction of checking account balances that bank must hold as
reserves.
Example:
Numerical Example:
Banks legally required to hold reserves equal to
Required reserves = (RR ratio)(Deposits)
Excess reserves = actual reserves – required reserves
Consider a change in a T-account:
Someone drops $200 out of the sky: $200 deposited in Bank A. Bank a is the only bank and the
required reserve ratio is 20%. There are no currency drains and no excess reserves.
Initial Position:
With deposit of $200
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But, there are excess reserves
But, process doesn’t end there
This process continues until
Money supply increases by $1000 when $200 drops out of the sky.
AN INCREASE IN BANK RESERVES LEADS TO A GREATER THAN ONE-FOR-ONE INCREASE
IN THE MONEY SUPPLY
 Money Multiplier: is the multiple by which deposits can increase for every dollar increase in new
reserves
 Money Multiplier = 1/(required reserve ratio)
So, if the required reserve ratio is .2, then the money multiplier is _____________
So, if the required reserve ratio is .1, then the money multiplier is ______________
Intuition?
ABILITY OF BANKS TO CREATE MONEY IS CONTROLLED BY THE VOLUME OF RESERVES
IN THE SYSTEM: THIS IS CONTROLLED BY THE FEDERAL RESERVE.
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Another example:
Suppose there are three banks, the RR ratio is 10%, and there is an initial deposit of $200 in Bank
1. Assume there are no currency drains, and no excess reserves.
Summary:
Bank 1 deposits equal
Bank 2 deposits equal
Bank 3 deposits equal
…
TOTAL
$200
$180
$162
….
$2000
Now, we have a sense of the Fractional Reserve Banking System: let’s add in the Federal Reserve System
to complete the picture.
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FEDERAL RESERVE SYSTEM:
Established in 1913
Independent agency: does not take orders from Congress or the President
Financially independent: earns interest from T-bills
Organizational Structure:
CHAIRMAN OF THE FEDERAL RESERVE:
 Appointed by the President
 Approved by the Senate
 4 year term
BOARD OF GOVERNORS
 7 members, including the Chairman
 Appointed by the President
 Approved by the Senate
 14 year term
 Supervises, regulates member banks
 Supervises 12 Federal Reserve Banks
 Sets reserve requirements and approves discount rate
FEDERAL OPEN MARKET COMMITTEE
 7 governors and 12 Federal Reserve Presidents
 Board of Governors, President of NY Fed, and 4 other Presidents have vote
 Conduct open market operations
12 FEDERAL RESERVE BANKS
 Lend reserves
 Provide currency
 Clear checks
Role of the Fed
 Macro Role: control the money supply, promote a strong economy, high employment, stable price
level
 Other roles: clear interbank payments, regulate banking system, assist banks in difficult financial
position (lender of last resort), manage exchange rate and nation’s foreign exchange reserves
How can Fed affect the money supply?
By controlling the supply of reserves in the banking system:
Fed can do this through their three monetary policy tools:
1.
2.
3.
a
Comments on these tools
#1:
#2:
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#3 Open market operations = purchase and sale by Fed of government securities in open market:
tool used to expand or contract amount of reserves in the banking system and thus the money
supply.
Role of the Treasury: Treasury Department is responsible for collecting taxes and paying
government’s bills. If G – T> 0, then the Treasury is required by law to borrow the difference.
THE TREASURY CANNOT PRINT MONEY TO FINANCE THE DEFICIT.
The Treasury borrows money by issuing bills, bonds and notes that pay interest. The total amount
of outstanding government securities is the Federal debt.
THE FED IS NOT THE U.S. TREASURY.
The Fed is authorized to buy and sell outstanding (pre-existing) U.S. government securities on the
open market.
OPEN MARKET OPERATIONS:
A. Open Market Purchase
RR ratio = 20% of Demand Deposits (DD)
Fed buys $10 in T-bills: this will lead to an increase in the money supply
Intuition:
T-Account:
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Money multiplier = 1/RR
So, money multiplier in this example = 1/.2= 5
Change in the money supply = (money multiplier)(change in reserves)
Change in the money supply = 5($10) = $50
B. Open Market Sale
Open market sale will lead to a decrease in the money supply
Intuition:
Assume: 20% RR ratio
Fed sells $10 in T-bills
Money multiplier = 1/RR = 1/.2 = 5
Change in the money supply = (Money multiplier)(change in reserves)
Change in the money supply = 5(-$10) = -$50
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Or, if the public buys the T-bill from the Fed:
What happens if someone writes a check on one bank and it is deposited at another bank? Does this
expand the money supply?
New reserves are not created when this happens. Merely, shifting funds from one bank to another:
individual actions CANNOT lead to an increase or a decrease in the money supply.
Conclude: the Fed can control the money supply by controlling the amount of reserves in the economy.
Simplifying assumption: the money supply is vertical and hence, independent of the interest rate.
Effect of an open market purchase on the money supply:
Effect of an open market sale on the money supply:
We have an understanding of the money supply and the Fed’s role with regard to the money supply. Let’s
turn our attention to money demand.
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MONEY DEMAND
Money Demand: how much money people would like to hold, given the constraints they face
Money demand is a function of



Price level (+)
Real income (+)
Interest rate (-)
Graph:
Movement along the money demand curve:
Shift of the money demand curve: due to changes in
 Income

Prices

Spending shock (AE increase or decrease)

New technology for payments

Expectations about future interest rate
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Now, we can talk about the determination of interest rates:
In LR, interest rates are determined in the loanable funds market
In SR, interest rates are determined in the money market
Equilibrium is where the demand for money = supply of money
Example:
Money supply = 2000
Money demand = 2500 – 10,000 r
Money supply = money demand in equilibrium
2000 = 2500 – 10,000r
r = 500/10,000 = .05 = 5%
What if the interest rate does not equal the equilibrium interest rate?
If r > the equilibrium interest rate, then money supply > money demand
If r < the equilibrium interest rate, then money supply < money demand
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Let’s consider these two possibilities:
1. When money supply > money demand
People want to get rid of some of their money: they buy bonds
This bids up the price of bonds and lowers the interest rate
Example:
2. When money supply < money demand
People want money so they sell their bonds
This leads to a decrease in the price of bonds and an increase in interest rates
Example:
WHEN THE PRICE OF BONDS RISES, THE INTEREST RATE FALLS AND WHEN THE PRICE OF
BONDS FALLS, THE INTEREST RATE RISES.
What happens in the money market if the Fed engages in open market operations?

Open Market Purchase: this leads to an increase in the money supply
Price of bonds increases, the interest rate falls in order to equilibrate the new money supply to the
money demand
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
Open Market Sale: this leads to a decrease in the money supply
Price of bonds decreases, the interest rate rises in order to equilibrate the new money supply to the
money demand
How do interest rates affect the economy? Decrease in interest rates affect spending:
1. Stimulates business spending on plant and equipment
2. Stimulates spending on new houses and apartments
3. Stimulates spending on consumer durables
Now, things get complicated!
How, could we model the above ideas?
Consider investment: before it was always autonomously given in our model. Now, can we model a more
realistic demand for investment?
Graph:
Now, investment is affected by the interest rate: it is no longer autonomous.
If interest rates increase, then investment decreases
If interest rates decrease, then investment increases
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So, if the money supply is increased through an open market purchase, this will:
Equilibrium in the money market depends on equilibrium in the goods market, BUT equilibrium
in the goods market depends on equilibrium in the money market.
So, if the money supply is decreased through an open market sale, this will:
Equilibrium in the money market depends on equilibrium in the goods market, BUT equilibrium
in the goods market depends on equilibrium in the money market.
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