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Chapter 16
Financial
Markets, Money,
and Monetary
Policy
Copyright © 2011 Pearson Addison-Wesley. All rights reserved.
People have used many different things as
money
•  Commodity money
–  Gold, silver, copper, cigarettes, shells, beaver pelts, vodka, coca paste
•  Problem with commodity money:
–  Subject to fluctuations in S & D
–  Inflation, depression can happen simply due to amount of commodity
money that is available
•  Can be very bad for the economy
•  M*V = P*Q
–  Fixed M implies no growth in Real GDP (Q)
–  Large increase in M leads to large increases in P
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Fiat (Paper) Money
•  Has value because the government backs it AND
•  People believe it has value
•  If the government keeps printing money, then
eventually it will become worthless and people won’t
accept it as payment.
–  Zimbabwe’s government printed trillions of Z$ to pay debts
in 2007
–  Resulting in a 30,000% inflation rate
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Functions of Money
1. Medium of Exchange: eliminates the need for barter,
dramatically increases the efficiency of the economy
2. Unit of Account: express the value of items in dollars
3. Store of value: money itself is an asset
4. Standard of deferred payment: can expresses a future
value (implies a stable currency)
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Definitions of Money
1. M1 = Money Stock or Money Supply
– 
– 
M1 = currency + checkable deposits
M1 consists of the most LIQUID assets (most easily
converted into cash)
2. M2 = M1 + small savings accts., money mkt. mutual
funds, bonds, small CDs
– 
Near money, less liquid than cash, but can be converted
fairly easily
3. M3 = M2 + large CDs & savings accts., business
savings
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FIGURE 16.7 Components of the Monetary
Aggregates, July 2009
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Banks and the creation of money (deposits)
•  Banks make money by loaning out the money of their
depositors
–  More loans result in more profits
•  Banks only keep enough money on hand to cover what
depositors need
–  Can have a RUN on the bank if a large number of depositors
all try to withdraw a lot of money
–  Runs occur when people lose faith in the bank
•  Depression: banks failed one after another as people
lost confidence in banks;
–  Even healthy banks experienced “runs”
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The Government created FDIC, FSLIC
•  Insures deposits up to $100,000
–  In order to qualify for insurance, banks must keep a certain
percentage of deposits as RESERVES
•  The required reserve ratio
–  Banks must submit to regular inspections, maintain a
“conservative” portfolio
•  Deregulation of the banking system in 1980 removed this constraint, led
to massive bank and S & L failures, huge taxpayer bail out
•  REQUIRED RESERVE RATIO (rrr) = % of deposits that
banks must hold as reserves
•  rrr is often 10% for checking accts., less for less liquid
assets (M2)
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Reserves
•  RESERVES = CASH + DEPOSITS AT FED
•  Required reserves = minimum amount of deposits that
must be kept.
•  EXCESS RESERVES may be loaned out.
–  Banks sometimes hold excess reserves, especially if they are
fearful that the default rate will be high
–  E.g., in recessions
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TABLE 16.1
Reserve Requirements of Depository
Institutions
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Banks actually have the power to
CREATE MONEY
•  DEPOSIT CREATION OCCURS AS BANKS
TAKE IN AND LOAN OUT MONEY
–  Money (or deposit) Multiplier works much like the
spending multiplier
•  Money creation gives banks tremendous power
to affect the economy, which must be regulated
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How banks create money
•  Initial $100,000 deposit, rrr=10%
–  Bank will loan out $90,000, keep $10,000 in reserves
•  $90,000 loaned to a home buyer, who writes a check to
the homeowner, who then deposits the check at her bank
–  Her bank will keep $9,000 in reserves and loan out $81,000.
•  $81,000 gets spent on something else, deposited in
another bank
–  Resulting in $8100 in reserves, $72,900 in new loans
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Total change in M1
• 
• 
• 
• 
• 
$100,000+90,000+81,000+72,900+….
$100,000(1+.9+.92+.93+…)
$100,000*(1/1-.9)=$100,000*(1/.1)
=$100,000*10=$1,000,000
Money Multiplier = 1/(rrr) = 10
–  Money multiplier will be smaller if banks hold
excess reserves or if people hold cash instead of
depositing money
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T- Account
Assets
Reserves
Securities
Loans
Property
Liabilities
Checkable Deposits
Savings & Time Deposits
Owner Equity
Assets must always balance liabilities. If a
bank loses deposits, it must cash in assets.
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The Fed and Monetary Policy
•  3 Fed Policy Tools:
1. Open Market Operations
2. Interest rates the Fed controls/affects
a. Discount Rate
b. Federal Funds Rate (manipulated via Open Market
Operations)
3. Setting the required reserve ratio
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Open Market Operations: Purchase or Sale of
government securities
•  Govt. buys or sells govt. bonds on the open market
•  Example: open market PURCHASE: Fed buys $100
million of govt. bonds from the public
–  Public now has $100 M more dollars, $100 M less in
securities
–  This money is paid directly into peoples’ accounts in banks
–  Deposits increase by $100 M.
–  With a reserve requirement of 10%, required reserves
increase by $10 Million, Excess reserves increase by $90
Million, which can be loaned out.
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The effect of an open market purchase
Assets
Liabilities
Reserves +10
Deposits +100
Loans +90
•  So an Open Market purchase increases excess reserves
and increases deposits, which increases M1, the
money stock or money supply by an amount equal to
the Fed’s purchase times the money multiplier.
•  Increase in M1 will Decrease interest rates
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The Money Market
•  Md = demand for
r
money = how much
money people need for
purchases
•  Ms = supply of money
= how much money is
available (set by Fed) 5%
•  r = interest rate = price
of money (opportunity
cost of holding money)
•  If the Fed increases Ms,
interest rates fall.
Ms
Md
M1
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M1
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The Money Market
Ms
r
An increase in
the money
supply causes
a decrease in
interest rates.
Ms2
5%
4%
Md
M1 M12
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M1
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Open Market SALE: Fed sells govt.
securities to the public.
•  Public has more securities, less $ in their accounts
•  Example: If Fed sells $200 Million in securities to the public,
with a rrr of .05, the money supply (M1) will fall by $4000
Million ($4 Billion)=($200M*20).
•  Initially, people take $200 million out of their accounts to pay the
Fed
Assets
Liabilities
Reserves -10
Deposits -200
Securities -190
•  Banks must come up with $190 million to cover the loss in
deposits (some was simply paid directly out of reserves)
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When banks are short of reserves
•  They sell securities, borrow money from other
banks (at the Federal Funds rate), or borrow
from the Fed (at the Discount rate)
•  Or they can sell assets such as bonds, property,
or even loans
–  Banks frequently sell loans to other banks
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Interest rates the Fed controls:
Discount Rate & Federal Funds rate
•  Discount Rate = rate of interest Fed charges banks to
borrow reserves
•  Federal Funds rate = rate of interest banks charge each
other to borrow reserves
•  Increase in either rate will decrease amount of
borrowing of reserves (too expensive to borrow)
–  Banks will sell securities or loan out less in order to get
reserves in some other fashion
–  Causing a decrease in M1, increase in r
•  A decrease in either rate would do the opposite
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FIGURE 16.16
Federal Open Market Committee (FOMC) Intended
Federal Funds Rate, and Discount Rate, and
Primary Credit Rate
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The Money Market in more detail
•  Supply of Money: determined by the Fed &
Banks
–  Tends to be very steep
–  If banks hold excess reserves, they might Supply
less $ at lower interest rates because it is not as
profitable to loan money out.
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Demand for money comes from consumers,
businesses, the government
1. TRANSACTIONS DEMAND: need money to pay
bills, buy things
–  Any time C, I, G, X increase, Md increases because there are
more transactions
–  This increases interest rates (less money in banks)
2. ASSET DEMAND: hold money as a safe asset
3. SPECULATIVE DEMAND: hold $ if you expect
stocks to fall, or the exchange rate to appreciate
•  Md is downward-sloping: lower r leads people to hold
more money, put less in the bank
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Setting the Required Reserve Ratio
•  Increasing the rrr from 5% to 10% would
increase the amount of required reserves, forcing
banks to sell securities, loan out less.
–  Causing M1 to fall.
•  Lowering the rrr would do the opposite.
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The Fed & Monetary Policy
•  The Fed can manipulate M1 through 1) open
market operations, 2) changing the discount rate
or federal funds rate, or 3) changing reserve
requirements.
•  As the economy grows and Md increases, the
Fed can either let Ms increase (to keep interest
rates low), or if worried about inflation, can
keep Ms fixed or reduce Ms.
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Money Demand increases as the economy grows,
increasing M1 and interest rates
Ms
r
6%
5%
Md’
Md
Q0 Q1
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M1
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Fed Option 1: Promote Growth by Increasing
M1, keeping interest rates at original level
Ms
r
While this will
promote
growth, the
increase in M1
could cause
inflation.
Ms’
6%
5%
Md’
Md
Q0 Q1
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M1
Q2
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Fed Option 2: Reduce M1 to prevent inflation
•  But by
reducing
M1 and
raising r,
this could
stifle
growth
r
Ms’
Ms
6.3%
6%
5%
Md’
Md
Q0 Q1
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M1
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Fed can also choose something in between
– allow r to increase slightly
•  Fed critics from the left:
–  Fed targets inflation too strictly
–  Should do more to stimulate growth since
inflation seems under control
•  Fed critics from the right:
–  Fed is too activist, should not keep increasing
M1 to stimulate the economy
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The Fed’s Bailout of Financial Markets
•  Used Monetary Policy to
Combat Financial Crisis
•  Increased Money Supply
•  Lowered Interest Rates
•  Lowered Federal Funds Rate
•  Increased and Injected
Liquidity into security markets
•  Got federal money to help
buy toxic assets from
banks to stabilize their
balance sheets
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•  Can the Fed use Monetary
Policy to Prevent another
Financial Crisis?
•  Raise Interest Rates to reduce
speculation
•  Increased Regulation
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FIGURE 16.BP.4
Financial Crisis 101
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FIGURE 16.18
Bailout Costs vs Big Historical Events
The financial market
bailout has cost more
than the New Deal, the
Vietnam, Korean and
Iraq wars, the race to the
moon, the Marshall Plan,
and the Louisiana
Purchase combined.
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FIGURE 16.1
Precautionary and Transactions Demand for
Money
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FIGURE 16.2
Speculative Demand for Money
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FIGURE 16.3
Total Demand for Money
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FIGURE 16.4
The Effect of Income Changes on the
Demand for Money
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FIGURE 16.5
Federal Reserve System
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FIGURE 16.6
Boundaries of Federal Reserve Districts and
Their Branch Territories
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FIGURE 16.8
The Money Supply
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FIGURE 16.9
Equilibrium in the Money Market
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FIGURE 16.10
Changes in the Money Supply
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TABLE 16.2
Money Creation: Example
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FIGURE 16.BP.1
Money Market Equilibrium
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FIGURE 16.BP.2
Investment Demand
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FIGURE 16.BP.3
Money, Interest Rates, Investment, and the
Keynesian Multiplier
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FIGURE 16.11
The Interest-Investment Relationship
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FIGURE 16.12
Income Response to a Change in Investment
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FIGURE 16.13
Money Supply Increase in the Liquidity Trap
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TABLE 16.3
Present Value of $100.00
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FIGURE 16.14
Increased Demand for Bonds
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FIGURE 16.15
Demand and Supply of Dollars in the
International Market
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FIGURE 16.17
Stock Market Bubbles
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The Financial Crisis
•  Financial Bubble formed
around asset backed
securities
–  Mortgage companies bundled
risky mortgages into securities
•  Sold these securities to other
investors along with insurance
(credit default swaps)
–  Collapse of housing market and
defaults
•  Causes a collapse in the value of
securities
•  Which means the banks issuing
insurance (credit default swaps)
are now liable for billions of $ in
losses
•  Financial System
insatiability
–  Banks were so intertwined
that when one failed, the
other banks who invested
in the failing bank also
were are risk of failure
•  Required Government
intervention through
Monetary Policy
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