Download Chapter 31 - McGraw Hill Higher Education - McGraw

Chapter 31
Money and the Monetary System
© 2014 by McGraw-Hill Education
1
What will you learn in this chapter?
• What the main functions of money are and
what makes something a good choice for
money.
• How to explain the concept of fractionalreserve banking and the money multiplier.
• What role the central bank plays and what the
Federal Reserve’s (Fed) dual mandate is.
• How the Fed conducts monetary policy.
• How monetary policy affects interest rates, the
money supply, and the broader economy.
© 2014 by McGraw-Hill Education
2
What is money? Functions of money
• Money is the set of all assets that are regularly
used to directly purchase goods and services.
• Money serves three main functions:
1. Store of value: Money represents a certain amount of
purchasing power.
2. Medium of exchange: Money can be used to
purchase goods and services.
–
A barter system is where people directly offer a
good or service for another good or service.
3. Unit of account: Money provides a standard unit of
comparison.
© 2014 by McGraw-Hill Education
3
1
What makes for good money?
• There are two basic considerations that make
certain money better than others.
• Stability of value:
– Early versions of money generally took the form of a
physical material that was durable and had intrinsic
value.
– Money does not need intrinsic value to maintain
stability.
• Convenience:
– Technology has allowed for the development of more
convenient forms of money.
• For example, paper money is more convenient than gold
coins.
© 2014 by McGraw-Hill Education
4
Commodity-backed money versus fiat money
• Any form of money that can be legally
exchanged into a fixed amount of an
underlying commodity is commodity-backed
money.
– The most common underlying commodity is gold.
• Money created by rule, without any
commodity backing it, is fiat money.
– U.S. currency is backed only by the trust that the
government will keep the value of money relatively
constant.
© 2014 by McGraw-Hill Education
5
Banks and the money-creation process
• Paper money made it possible for banks to
create money through a process called
fractional-reserve banking.
• The primary way that banks earn money is
through lending a fraction of deposited funds
and collecting interest on those loans.
– Demand deposits are funds held in bank accounts
that can be withdrawn by depositors at any time,
without advance notice.
© 2014 by McGraw-Hill Education
6
2
Banks and the money-creation process
• Reserves refers to the money that banks keep
on hand.
• The reserve ratio is the ratio of the total
amount of demand deposits at the bank to the
amount kept as cash reserves.
– Required reserves is the amount that a bank is
legally required to keep on hand.
– Excess reserves is any additional amount that a
bank chooses to keep beyond the required
reserves.
© 2014 by McGraw-Hill Education
7
Banks and the money-creation process
The money creation process occurs through banks repeatedly
accepting deposits and lending out a fraction of the deposits.
Original deposit of
1,000 gold coins
100 gold coins
held on reserve
(10% of original deposit)
900 gold coins
loaned out
(90% of original deposit)
One
gold
coin
Deposit of
900 more gold coins
Total deposits = 1,000 gold coins + 900 gold coins = 1,900 gold coins
© 2014 by McGraw-Hill Education
8
Banks and the money-creation process
A simple way to account for a bank’s transactions is by using
T-account formatting to record changes in banks assets and
liabilities.
Original deposit
Assets
Cash:
Liabilities
$1,000 Deposit: $1,000
Bank makes its first loan
Assets
Loan:
Required
reserves:
$900
Liabilities
Deposit: $1,000
$100
The loan is deposited in
the bank
The bank loans out 90%
of its new deposits
Assets
Assets
Loan:
$900
New cash
deposit:
$900
Required
reserves: $100
Liabilities
Deposit: $1,900
Liabilities
Loans:
$1,710 Deposit: $1,900
Required
reserves: $190
The above process increases money by $900.
© 2014 by McGraw-Hill Education
9
3
Active Learning: Money creation
A bank accepts a $1,000 deposit. If the bank has
a reserve ratio of 20% and loans out the rest,
find the change in assets and liabilities.
Assets
Loans:
Required
reserves
$2,000
Liabilities
Deposit:
$2,500
$500
© 2014 by McGraw-Hill Education
10
Banks and the money-creation process
• The money creation process continues with
repeated cycles of lending and depositing of
funds.
• The money multiplier is the ratio of money
created by the lending activities of the banking
system to the money created by the central bank:
Money multiplier =
• In a fractional-reserve banking system, banks keep
less than 100% of their deposits on reserves.
© 2014 by McGraw-Hill Education
11
Active Learning: The money multiplier
Use the money multiplier equation to fill in the
blanks in the following table.
Situation
Reserve ratio
A
10%
B
5%
C
© 2014 by McGraw-Hill Education
Money Multiplier
5
12
4
Measuring money
• The money supply is the amount of money
available in the economy.
– The money supply is managed by the Fed.
• The Fed classifies different types of money by
their liquidity.
– The monetary base includes cash and bank
reserves, sometime referred to as hard money.
– M1 includes cash plus checking account balances.
– M2 includes M1 plus savings accounts and other
financial instruments.
© 2014 by McGraw-Hill Education
13
Measuring money
Each measure provides a distinct understanding
of the financial system.
Hard money, M1, and M2 over time
• M1 indicates liquidity.
• M2 indicates savings.
• M2 is a measure of the
money multiplier when
compared to the
monetary base.
Hard money
Trillions of U.S. dollars
10
M2
9
8
7
6
5
4
3
M1
2
1
0
1984
1989
1994
1999
2004
2009
© 2014 by McGraw-Hill Education
14
Managing the money supply
• The central bank is the institution responsible
for managing the nation’s money supply and
coordinating the banking system.
• In the U.S., the central bank is the Federal
Reserve, which has been mandated by Congress
to conduct monetary policy to perform two
essential functions:
1. Manage the money supply.
2. Act as a lender of last resort.
• Monetary policy refers to the actions made by
the central bank to manage the money supply.
© 2014 by McGraw-Hill Education
15
5
Managing the money supply
The Federal Reserve System has a seven-member Board of Governors
and twelve regional banks that collectively act as the central bank of
the U.S.
Minneapolis
Boston
Chicago
San
Francisco
Cleveland
Philadelphia
Kansas
St.
City Louis
Dallas
NewYork
Board of Governors,
Richmond Washington D.C.
Atlanta
© 2014 by McGraw-Hill Education
16
Managing the money supply
• In addition, five of the twelve regional bank
presidents serve on the Federal Open Market
Committee, or FOMC.
– Carries full responsibility for setting the overall
direction of monetary policy and guiding the money
supply.
• The Fed has a twin or dual mandate:
– Ensuring price stability: Enacting monetary policy that
meets the needs of the economy while keeping prices
constant over time.
– Maintaining full employment: Enacting monetary
policy that keeps the economy strong and stable.
© 2014 by McGraw-Hill Education
17
Tools of monetary policy
• The Fed achieves these mandates by managing
the money supply through three main tools.
1. The reserve requirement is the amount of money
banks must hold in reserve.
2. The discount window is the lending facility that
allows banks to borrow reserves from the Fed.
• The discount rate is the interest rate charged by the Fed
for loans through the discount window.
3. Open-market operations are sales or purchases of
government bonds by the Fed to or from banks
on the open market.
© 2014 by McGraw-Hill Education
18
6
Tools of monetary policy
• These transactions directly impact the money supply.
– Contractionary monetary policy is when money supply is
decreased to lower aggregate demand.
– Expansionary monetary policy is when money supply is
increased to raise aggregate demand.
• Open market operations also affect the inter-bank
lending market, the federal funds market.
– The federal funds rate is the interest rate at which banks
lend reserves to one another.
• The Fed affects the federal funds rate through
changes in the supply of reserves by conducting
contractionary and expansionary monetary policy.
© 2014 by McGraw-Hill Education
19
The economic effects of monetary policy
• Monetary policy primarily influences the economy through changes
in the interest rate.
• Changes in the interest rate, in turn, affect the appeal of borrowing
and lending, which can have significant impacts on the economy.
The liquidity-preference model
• The liquidity-preference model
refers to the idea that the
quantity of money people
want to hold is a function of
the interest rate.
Interest rate, r
Monetary supply
r*
Monetary
demand
Q*
Quantity of money
© 2014 by McGraw-Hill Education
– This means the money demand
curve slopes downward.
– The Fed sets the money supply,
which means the money supply
curve is set by monetary policy.
20
The economic effects of monetary policy
The liquidity-preference model explains how the
Fed’s actions can change interest rates.
Shifts in the money supply curve
Interest rate, r
MSc
MS*
MSe
rc
r*
re
MD
Qe
Q*
Quantity of money
© 2014 by McGraw-Hill Education
Qc
• Expansionary monetary
policy results in a higher
quantity of money and
lower interest rates.
• Contractionary monetary
policy results in a lower
quantity of money and
higher interest rates.
21
7
Active Learning: The money supply
For each of the following situations, indicate the
effect (increase or decrease) on the money
supply and interest rate.
Change in money
supply
Situation
Change in interest rate
The Federal Reserve
conducts open-market
bond purchases.
The Federal Reserve sells
government bonds on the
open market.
© 2014 by McGraw-Hill Education
22
Expansionary monetary policy
Expansionary monetary policy
Expansionary monetary policy and the AD/AS model
Price level
Interest rate, r
LRAS
MS1
MS2
SRAS
P2
P1
r1
AD2
r2
Money
demand
AD1
Q1
Q2
Quantity of money
Y1 Y2
Real GDP
• During a recession, expansionary
monetary policy decreases the interest
rate.
• Cheaper to borrow and less rewarding
to save money.
• The aggregate demand curve shifts out.
• Price and output increase.
© 2014 by McGraw-Hill Education
23
Contractionary monetary policy
Contractionary monetary policy
Contractionary monetary policy and the AD/AS model
Interest rate, r
Price level
LRAS
MS
2
SRAS
MS
1
P1
P2
r2
AD1
r1
AD2
MD
Q2
Q1
Quantity of money
• During overheating, contractionary
monetary policy increases the interest
rate.
• More expensive to borrow and
encourages saving.
© 2014 by McGraw-Hill Education
Y2 Y1
Real GDP
• The aggregate demand curve shifts in.
• Prices and output decrease.
24
8
The economic effects of monetary policy
Analyzing the use of monetary policy shows how
policy can work in ideal cases, but it is rare for the
world to work so cleanly.
Challenges
Advantages
• The Fed faces time lags
and imperfect
information.
• The Fed does not have to
wait for politicians to come
to a policy consensus.
• The Fed is made up of
prominent economic
policy-makers.
– A few months can pass
before the Fed’s actions
make their impact.
– Mistiming of monetary
policy could make
economic conditions
worse.
– It is their job to make sure
they fully understand the
nuances of the overall
economy.
© 2014 by McGraw-Hill Education
25
Two interconnected markets
• One concern is how the lending market is affected
during times of expansionary monetary policy.
• That is, it may be that extra borrowing causes a
shortage of loanable funds, as the demand from
borrowers increases and the supply from savers
decreases.
• This leads to two very different models of the way
the world works:
1. The Federal Reserve determines the interest rate by
managing the supply and demand for money.
2. The market as a whole determines the interest rate
by the interaction of savers and borrowers.
© 2014 by McGraw-Hill Education
26
Two interconnected markets
These two models are connected by the dynamics of the economy.
Market for loanable funds
Liquidity-preference model
Interest rate
Interest rate
MS 1 MS 2
Savings 1
Savings 2
r1
r1
r2
r2
MD
Q1
Q2
Quantity of dollars
• When the Fed acts to lower interest
rates, it spurs borrowing and increases
output in the economy.
© 2014 by McGraw-Hill Education
Investment
Q1
Q2
Quantity of dollars
• Some of this increase in output is saved.
• Shifts the supply of loanable funds outward
to equalize interest rates between models.
27
9
Summary
• The three main functions of money are a store
of value, a medium of exchange, and a unit of
account.
• Money needs to have stability of value to be
convenient.
• Banks create money by lending through the
fractional reserve banking.
• The money multiplier is the ratio of money
created by the lending activities to the money
created by the central bank.
© 2014 by McGraw-Hill Education
28
Summary
• The Fed classifies different types of money by
their liquidity.
– M1 includes hard money plus checkable deposits.
– M2 includes M1 plus money in savings accounts
and CDs.
• The central bank maintains the money supply
and coordinates the banking system.
• The Federal Reserve has a dual mandate:
– Ensure price stability.
– Maintain full employment.
© 2014 by McGraw-Hill Education
29
Summary
• Monetary policy includes changing the reserve
requirement, lending through the discount
window, and engaging in open-market
operations.
• The liquidity-preference model explains that
the demand for money is a function of the
interest rate.
• The Fed may want to engage in expansionary
or contractionary monetary policy depending
on the economic circumstances.
© 2014 by McGraw-Hill Education
30
10