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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