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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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-2 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-3 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) Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-4 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-5 FIGURE 16.7 Components of the Monetary Aggregates, July 2009 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-6 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” Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-7 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) Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-8 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-9 TABLE 16.1 Reserve Requirements of Depository Institutions Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-10 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-11 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-12 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-13 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. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-14 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-15 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. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-16 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-17 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. M1 16-18 The Money Market Ms r An increase in the money supply causes a decrease in interest rates. Ms2 5% 4% Md M1 M12 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. M1 16-19 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) Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-20 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-21 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-22 FIGURE 16.16 Federal Open Market Committee (FOMC) Intended Federal Funds Rate, and Discount Rate, and Primary Credit Rate Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-23 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. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-24 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-25 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. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-26 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. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-27 Money Demand increases as the economy grows, increasing M1 and interest rates Ms r 6% 5% Md’ Md Q0 Q1 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. M1 16-28 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. M1 Q2 16-29 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. M1 16-30 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-31 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. • Can the Fed use Monetary Policy to Prevent another Financial Crisis? • Raise Interest Rates to reduce speculation • Increased Regulation 1-32 FIGURE 16.BP.4 Financial Crisis 101 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-33 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. Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-34 FIGURE 16.1 Precautionary and Transactions Demand for Money Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-35 FIGURE 16.2 Speculative Demand for Money Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-36 FIGURE 16.3 Total Demand for Money Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-37 FIGURE 16.4 The Effect of Income Changes on the Demand for Money Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-38 FIGURE 16.5 Federal Reserve System Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-39 FIGURE 16.6 Boundaries of Federal Reserve Districts and Their Branch Territories Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-40 FIGURE 16.8 The Money Supply Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-41 FIGURE 16.9 Equilibrium in the Money Market Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-42 FIGURE 16.10 Changes in the Money Supply Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-43 TABLE 16.2 Money Creation: Example Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-44 FIGURE 16.BP.1 Money Market Equilibrium Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-45 FIGURE 16.BP.2 Investment Demand Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-46 FIGURE 16.BP.3 Money, Interest Rates, Investment, and the Keynesian Multiplier Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-47 FIGURE 16.11 The Interest-Investment Relationship Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-48 FIGURE 16.12 Income Response to a Change in Investment Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-49 FIGURE 16.13 Money Supply Increase in the Liquidity Trap Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-50 TABLE 16.3 Present Value of $100.00 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-51 FIGURE 16.14 Increased Demand for Bonds Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-52 FIGURE 16.15 Demand and Supply of Dollars in the International Market Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-53 FIGURE 16.17 Stock Market Bubbles Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-54 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 Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 16-56