Download What is Money?

Ch. 9: Money, the Price Level, 9
and Inflation
• Definition of money and its functions
• Economic functions of banks and other depository
institutions
• 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.
• 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
GRESHAM’S LAW
 "bad money drives out good"
 Prior to 1834, 24.75 grains of gold was worth more than
371.25 grains of silver. Only silver coins circulated (a
"silver standard" by default).
 After 1834, the reverse was true (a "gold standard" by
default).
 If gold coin has 10 grains and silver has 30 grains, what
happens if gold price is 5 times silver price? 2 times silver
price?
 What happens to coin circulation if price of its metal
rises relative to other metals?
 Wizard of Oz and bimetallic standard
Functions of Money
Medium of Exchange
•Generally accepted in exchange for goods and services.
•Without money, trade is barter system.
•Barter requires a double coincidence of wants makes it
costly.
Unit of Account
An agreed measure for stating the value of goods and
services.
3 Functions of Money
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:
•
•
•
•
Create liquidity
Minimize the cost of obtaining funds
Minimize the cost of monitoring borrowers
Pool risks
HISTORY OF BANKING IN U.S.
 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)
• Total
100
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.
The Home State experience in Ohio.
Bank Objectives.
Profit vs. Prudence: A Balancing Act
Goal of any bank is to maximize wealth of its owners.
To accomplish this, must consider:
1. Attracting deposits to make loans possible.
2. Choosing loan portfolio and balance risk versus
return.
3. Liquidity.
4. 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 macroneconomy.
The Federal Reserve System
The Structure of the Fed
The key elements in the structure of the Fed are
 The Board of Governors
 The regional Federal Reserve banks
 The 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 nine-person 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.
•Consists of the members of the Board of Governors, the president of
the Federal Reserve Bank of New York, and the 11 presidents of other
regional Federal Reserve banks 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
M1
DDmax
= nonbank cash + bank reserves
= nonbank cash + demand dep.
= (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.
• 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
COB=$10m; rr=25%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
270 m
Owner’s equity
5 m.
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
sytem, 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” discussed in text.
Focus only on “deposit multiplier”]
Changes in the money supply
The balance sheet
COB=$10m; rr=25%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
270 m
Owner’s equity
5 m.
Plant & equipment
5 m.
Total assets
365 m.
Total Liabilities
365 m.
Suppose the Fed reduces 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.
Changes in the money supply
The balance sheet
COB=$10m; rr=25%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
270 m
Owner’s equity
5 m.
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
The Market for Money
The Demand for Money Holding
The quantity of money that people plan to hold depends
on four main factors:
 The price level
 The nominal interest rate
 Real GDP
 Financial innovation
The Market 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 that people
plan to hold.
•Real money equals nominal money ÷ price level.
•10 percent increase in P increases the quantity of
nominal money demanded by 10 percent.
The Market 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.
Real GDP
An increase in real GDP increases the volume of
expenditure, which increases the quantity of real money
that people plan to hold.
The Market 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.
The Demand for Money
is the 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 Market for Money
Short-Run Equilibrium
Suppose that the Fed’s
interest rate target is 5
percent a year.
The Fed adjusts the
quantity of money each
day to hit its interest rate
target.
The Market for Money
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.
Real GDP equals potential GDP, so the only variable left to
adjust in the long run is the price level.
The Quantity Theory of Money
The quantity theory of money is the proposition that, in
the long run, an increase in the quantity of money brings
an equal percentage increase in the price level.
The quantity theory of money is based on the velocity of
circulation and the equation of exchange.
The velocity of circulation is the average number of
times in a year a dollar is used to purchase goods and
services in GDP.
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.
The equation of exchange becomes the quantity theory of
money if M does not influence V or Y.
% change in P = % change in M
The Quantity Theory of Money
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
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 marked tendency
for high money growth rates
to be associated with high
inflation rates.
evidence for 134 countries
from 1990 to 2005.