Download Ch. 8: Money, the Price Level and Inflation.

Ch. 8: Money, the Price Level, and Inflation
• Definition of money and its functions
• Economic functions of banks
• Structure and function of the Federal Reserve
System
• Creation of money by the banking system
• Demand for money, the supply of money, and the
nominal interest rate
• Link between quantity of money, the price level
and inflation
What is Money?
Anything that is generally acceptable as a means of payment.
 Commodity Money
• gold dust, tobacco, cigarettes in POW camp
• Problems
•transactions cost; perishable; value fluctuates.
 Coins with precious metal
• Gold & silver coins
•Problems
•Coin shaving
• value of metal fluctuates.
• Greshams Law: Bad money drives out good (more
later).
 Fiat money
MONEY IN U.S. HISTORY
• U.S. constitution gave Congress sole right to
"coin money and regulate value thereof".
• Illegal for states to coin money.
 Bi-metallic standard initially.
 In the 1792 coin act, a $1 coin was quoted in
terms of both silver and gold
 24.75 grains of gold =$1
 371.25 grains of silver = $1
 i.e. a grain of gold was worth 15 times a grain of silver.
GRESHAM’S LAW
“Bad money drives out good"
Prior to 1834
1 grains of gold was worth more than 15 grains of silver.
Only silver coins circulated ("silver standard").
After 1834,
reverse was true (a "gold standard")
 The Crime of 1873: demonetization of silver
After 1873, price of gold began to rise and deflation
occurred in U.S.
3 Functions of Money
Medium of Exchange
•Generally accepted in exchange for goods and services.
•Without money, trade is barter.
•Barter requires a double coincidence of wants makes it
costly.
Unit of Account
An agreed measure for stating the value of goods and
services.
Store of Value
•Money can be held for a time and later exchanged for
goods and services.
•Can be poor store of value
•Inflation
•No interest
HISTORY OF BANKING
• Initially banks formed as “safekeeping”
institutions.
• Gradually evolved to serve several functions:
•
•
•
•
•
Minimize the cost of borrowing funds
Minimize the cost of monitoring borrowers
Link lenders with borrowers
Pool risks for lenders
Create liquidity
HISTORY OF BANKING
 States could not print or mint money, but privately
owned banks could if licensed by the state
government.
 Banks printed notes that were backed by gold or
silver
• easier to trade
• avoided problems with weighing
• banks found it profitable to print more notes than they
had "reserves“ (gold/silver) for and loaned out the extra
notes.
• Fractional reserve banking was started.
 Fractional reserve banking poses problems if there
is a bank run.
Assets
Reserves (gold) 100
Total
100
Liabilities
Notes
100
100
Banks would print notes beyond reserves and
extend loans.
Reserves
Loans
Total
100
900
1000
Notes
1000
____
1000
• With “fractional reserve banking”, the banking
system
“creates money” and lends it out.
 has only a fraction of liabilities on reserve.
 cannot satisfy customer’s demands if all want to
withdraw deposits at once.
• Source of “bank panics”.
News that loans are not likely to be paid back,
customers will make a “run” on the bank.
• Droughts.
• Stock market crash.
• Effect of bank panic on economy?
Bank Panics and Deposit Insurance
• 7 major bank panics in the U.S. in the 1800s
 2 in the early 1900s.
 Onset of the great depression in the 1930s, another
bank panic occurred.
 In 1934, the federal government established FDIC to
help reduce spread of bank panics.
• Deposit insurance has reduced bank panics in the
U.S.
• Problems with deposit insurance
Incentives created for risk taking (moral hazard).
The 1985 Home State experience in Ohio.
The most recent financial crisis.
Bank Objectives.
Goal of any bank is to maximize wealth of its owners.
To accomplish this, must consider:
1.
2.
3.
4.
Attracting deposits to make loans possible.
Choosing loan portfolio and balance risk versus return.
Liquidity
Service quality, fees, etc.
Bank Objectives.
Risk, Return, and Liquidity.
1. Liquid assets (low risk, low return)
•
U.S. government Treasury bills and commercial bills
2. Investment securities
• longer–term U.S. government bonds and other bonds
3. Loans (higher risk, higher return)
• commitments of fixed amounts of money for agreedupon periods of time
Federal Reserve System
•
•
•
•
•
Established in 1913 by the Federal Reserve Act.
First central bank of the United States
Conducts monetary policy and regulates banks.
Aims to stabilize the macroeconomy.
Structure
– The Board of Governors
– The 12 regional Federal Reserve banks
– Federal Open Market Committee
The Federal Reserve System
Board of Governors
• 7 members appointed by the president and confirmed by
Senate.
•Terms are for 14 years
•The president appoints one member to a four-year term as
chairman.
Regional Banks
•Each of the 12 Federal Reserve Regional Banks has a nineperson board of directors and a president.
•Monitors economic conditions within district and regulates
banks
•Clearinghouse for checks and replacement of currency
The Federal Reserve System
Federal Open Market Committee
•FOMC is the main policy-making group in the
Federal Reserve System.
–7 members of the Board of Governors
–President of FRB of NY
–11 presidents of the other regional FRB of whom,
on a rotating basis, 4 are voting members.
•The FOMC meets every six weeks to formulate
monetary policy.
Components of the Money Supply
Bank reserves
bank deposits at the Federal Reserve + cash
Monetary base
currency held by the nonbank public + bank
reserves.
M1
currency outside banks, traveler’s checks, and
checking deposits owned by individuals and
businesses.
M2
M1 plus time deposits, savings deposits, and money
market mutual funds and other deposits.
How do banks create money?
 Suppose that there is $100 million of cash and no
bank system.
 A bank now begins and $90 million of cash is
deposited in the bank in exchange for checking
account (demand deposit) balances.
 The bank’s owners invest $5 million in plant and
equipment and thus have $5 million of owner’s
equity. The bank’s balance sheet is now:
How do banks create money?
The balance sheet
Assets
Liabilities
Cash
90 m.
Demand deposits
90 m.
Plant & equipment
5 m.
Owner’s equity
5 m.
Total assets
95 m.
Total Liabilities
95 m.
Note: The balance sheet requires that total assets
equal total liabilities.
How do banks create money?
 Fed sets a reserve ratio (let’s suppose it’s 25%).
Implying bank must have 25% of it’s demand
deposits on reserve.
 Reserves = cash in bank + deposits at Fed.
 Bank can increase demand deposits by creating new
loans to customers until it no longer has any excess
reserves.
 required reserves = rr * demand deposits
 Maximum demand deposits = (1/rr) * reserves
How do banks create money?
The balance sheet
Assets
Liabilities
Cash
90 m.
Demand deposits
90m360
m.
Loans
0270 m
Owner’s equity
5 m.
Plant & equipment
5 m.
Total assets
95m365
m.
Total Liabilities
95m365
m.
Note: The bank system created $270 million of additional money
by creating new demand deposits for borrowers (loans). This
assumes that none of the new loans/demand deposits are
withdrawn as cash.
How Banks Create Money
• Deposits lead to a multiplier effect on M1 as banks
convert a $1 deposit into several dollars of demand
deposits.
• To illustrate, assume rr=25%
A new deposit of $100,000 is made.
The bank keeps $25,000 in reserve and lends $75,000.
This loan is credited to someone’s bank deposit.
The person spends the deposit and another bank now
has $75,000 of extra deposits.
This bank keeps $18,750 on reserve and lends $56,250.
How Banks Create Money
• The process
continues and
keeps
repeating with
smaller and
smaller loans at
each “round.”
How do banks create money?
Summary of money creation process.
monetary base
= nonbank cash + bank reserves
M1
= nonbank cash + demand dep.
Maximum DD = (1/rr) * bank reserves
The Fed controls the money supply through its
control over the monetary base and the deposit
multiplier (1/rr).
Fed Tools
Open market operations.
The Fed buys (sells) government securities in the
open market to increase (decrease) the money
supply.
Discount window lending.
The Fed loans reserves to member banks and
charges the discount rate.
Reserve requirements.
The Fed sets the required reserve ratio.
Rarely used.
OPEN MARKET OPERATIONS.
• If the Fed wants to increase the amount of bank
reserves
buy government securities from member banks
banks give up government bonds and receive deposit
at the Fed or cash.
More recently, Fed has purchased commercial paper
from banks – new policy!
• By buying government securities
Fed created new reserves that multiply into new
loans and demand deposits (remember the deposit
multiplier).
• If the Fed sold government securities, reserves and
M1 would decrease.
Changes in the money supply
The balance sheet
NBC=$10m; rr=25%
Assets
Liabilities
Reserves
90 m.
Demand deposits
360 m.
Loans
200m
Owner’s equity
5 m.
Govt bonds
70m
Plant & equipment
5 m.
Total assets
365 m.
Total Liabilities
365 m.
Suppose the Fed purchases $10 m. of government securities.
What is the effect on:
Loans
Demand deposits
M1
DISCOUNT WINDOW LENDING.
 The Fed lends banks reserves at the “discount rate”.
• The higher the discount rate, the less likely
banks are to borrow reserves to increase the
money supply.
 The federal funds rate is the interest rate that
banks charge each other for a loan of reserves.
• The federal funds rate tracks the discount rate
fairly closely.
 If the Fed wants to increase reserves in the system,
it would lower the discount rate.
THE RESERVE REQUIREMENT.
If the Fed increases the reserve requirement
• the deposit multiplier (1/rr) falls
• the amount of demand deposits that banks can create
for a given amount of reserves is reduced.
• [Note: you may ignore the “money multiplier” and the
“currency drain ratio” discussed in text. Focus only on
“deposit multiplier”]
Changes in the money supply
The balance sheet
NBC=$10m; rr=25%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
200 m
Owner’s equity
5 m.
Government bonds
70m
Plant & equipment
5 m.
Total assets
365 m.
Total Liabilities
365 m.
Suppose the Fed cuts the rr to 20% What is the effect on:
Loans
Demand deposits
M1
OTHER FACTORS INFLUENCING THE MONEY SUPPLY
The amount of cash people choose to hold
• Cash in bank multiplies
• Cash outside bank does not.
The type of deposits people make.
• the reserve requirement is higher on demand
deposits (about 3%) than on certificates of deposit.
• If people switch between different types of
accounts, the “average” reserve requirement and
money multiplier will change.
Bank holdings of excess reserves
Changes in the money supply: Cash held by public
The balance sheet
NBC=$10m; rr=25%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
200 m
Owner’s equity
5 m.
Government bonds
70m
Plant & equipment
5 m.
Total assets
365 m.
Total Liabilities
365 m.
Suppose the public withdraws $10m. Of DD as cash. What is
the effect on:
Loans
Demand deposits
M1
Components of the monetary base: 1983-2013
M1: 1975-2013
Reserves vs. Excess Reserves: 1994-2013
The Market for Money
The Demand for Money
relationship between the quantity of real money demanded
and the nominal interest rate when all other influences on the
amount of money that people wish to hold remain the same
The Demand for Money Holding
The quantity of money that people plan to hold depends on
four main factors:
 The nominal interest rate
The price level
 Real GDP
 Financial innovation
The demand for money
The Nominal Interest Rate
–the opportunity cost of holding wealth in the
form of money rather than an interest-bearing
asset.
–Increase in the nominal interest rate on other
assets decreases the quantity of real money that
people plan to hold.
The demand for money
The Price Level
An increase in the price level
• increases the quantity of nominal money people wish
to hold, doesn’t change the quantity of real money
demanded.
•Real money equals nominal money ÷ price level.
•10 percent increase in P increases the quantity of
nominal money demanded by 10 percent.
Real GDP
•Increase in real GDP increases increases the quantity of
real money that people plan to hold.
The demand for money
Financial Innovation
–that lowers the cost of switching between money
and interest-bearing assets decreases the quantity
of real money that people plan to hold.
Summary of money demand factors
• Nominal interest rate
• Price level
• Real GDP (income)
• Financial innovation
Equilibrium interest rate
The Market for Money
Long-Run Equilibrium
–In the long run, the loanable funds market
determines the interest rate.
–Nominal interest rate equals the equilibrium real
interest rate plus the expected inflation rate.
–nominal interest rates on government (“risk-free”)
bonds differ for different terms due to
• inflation expectations over different periods
• longer term bonds are subject to more inflation risk.
The Quantity Theory of Money
V=velocity
P=price level
Y=real GDP
M=quantity of money
The equation of exchange states that
MV = PY
Expressing the equation of exchange in growth
rates:
 % ch in M + % ch in V = % ch in P + % ch in Y
 % ch in P = % ch in M + % ch in V - % ch in Y
The Quantity Theory of Money
Quantity theory of money
In the long run, velocity does not change, so
Inflation rate = Money growth rate  Real GDP
growth
The Quantity Theory of Money
International evidence shows
a tendency for high money
growth rates to be
associated with high inflation
rates.
Evidence for 134 countries
from 1990 to 2005.
According to the equation of exchange, which of
the following will lead to greater inflation?
1. Decreased velocity
of money
2. Faster growth of the
money supply
3. Faster growth of
real GDP
4. All of the above
0%
1.
0%
0%
2.
3.
0%
4.
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