Download Money, Prices, and the Federal Reserve

Frank & Bernanke 2nd
Ch. 10: Money, Prices, and the
Federal Reserve
What Is Money?
Does Bill Gates have a lot of money?
 Does LeBron James make a lot of money?
 Anything accepted by a community in
exchange of goods and services and for
settlements of debts.
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Functions of Money
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Unit of account
Increase in variety of goods requires a
common unit to quote and compare prices.
 3 goods: 2 prices
 4 goods: 6 prices
 5 goods: 24 prices
 N goods: (n-1)! Prices
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Money had to be invented.
Functions of Money
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Medium of exchange
Barter requires double coincidence of wants.
 Exchange makes both parties better-off.
 Money had to be invented.
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Functions of Money
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Store of Value
Postponing consumption by storing wealth in
an asset for future use.
 Today we have many different assets for
wealth storage.
 Depending on the ability of these assets to be
easily converted to cash (liquidity) these
assets are near or far to “money.”
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Financial Assets Savers Can Hold
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Currency
Checking account
Savings account
Certificate of Deposit
Foreign currency
Bonds
Stocks
Options on stocks, bonds, foreign currency
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Futures on commodities, foreign currency
Assets According to Liquidity
Currency
 Checking Account
 Savings Account
 Money Market Mutual Fund
 Bonds
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Measuring Money
In billions of dollars
http://research.stlouisfed.org/publications/mt/page16.pdf
Measuring Money
Banks and the Creation of Money
When depositors put money in the bank,
the bank turns around and loans part of
the money to others.
 Both the depositor and the borrower have
funds to spend.
 Money has been created.
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Banks and the Creation of Money
We will show the changes in assets and
liabilities of a bank in response to deposit
and loan activities.
 Deposits into checking accounts are
liabilities of a bank.
 Cash is an asset.
 Assets = Liabilities for a Balance Sheet to
be in balance.
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Creation of Money
Ally deposits $1000 into her checking
account with First National.
 First National holds only 10% as reserves
and loans the rest to Billy.
 Billy buys a snow blower for $900 from
Carl.
 Carl deposits $900 with Second National.
 Second National loans how much to
Deyna if it also holds 10% as reserves?
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Creation of Money
If this process goes on for thirty rounds,
how much checking deposits will be in the
banking system?
 1000 + 1000(.9) +
1000(.9)(.9)+…+1000(.9)^30
 1000 + 900 + 810 + … + 0.04
 1000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10]
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Creation of Money
The banking system used the initial
deposit of $1000 as the reserves and
multiplied it by (1/reserve ratio) to create
checking deposits for the economy.
 What would be the deposits created by the
same $1000 deposit, if the banks kept 5%
as the reserve ratio?
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Narrow Money, M1
M1 is defined as currency outside of the
banks plus bank deposits.
 Monetary Base is defined as Currency +
Reserves.
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Measuring Money
•What was the amount of currency in January
2005?
•What was the amount of bank deposits in
January 2005?
•What was the reserve ratio in January 2005?
The Federal Reserve System
The Central Bank of the United States.
 The Fed is responsible for monetary
policy.
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Amount of money supplied to the system.
 Affects interest rates, inflation, unemployment
and exchange rates.
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The Fed oversees and regulates the
financial markets.
The Fed
Fed was established in 1913 in the hopes
of eliminating banking panics of the 19th
century by providing credit to the financial
markets.
 In order to disperse power 12 regional
Federal Reserve Banks were formed.
 The seven members of the Board of
Governors are appointed by the President
for 14-year terms every other year.
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Monetary Policy
Federal Open Market Committee (FOMC)
is the group that sets the monetary policy.
 Fed Chairman (4-year term) plus
governors, plus NY Fed President, plus 4
Presidents of Fed banks comprise FOMC.
 FOMC meets eight times a year.
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Controlling the Money Supply
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Open-Market Operations: buying and selling of
financial assets.
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Buying government bonds from the public increases
bank reserves, hence money supply.
Selling bonds decreases money supply.
Discount window lending: Lending to banks that
increases bank reserves.
Changing reserve requirements: Raising
reserve-deposit ratio decreases money supply.
Primary Credit Rate
http://research.stlouisfed.org/publications/mt/page9.pdf
Open-Market Operation
Suppose an economy has $100 currency,
$100 reserves and 0.1 as reserve-deposit
ratio.
 What is the money supply?
 If the Central Bank purchased $5 worth of
bonds, what will be the money supply?
 If the CB sold $10 worth of bonds, what
will be the money supply?
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The Great Depression
The Fed did not prevent the Great
Depression.
 Both currency held by the public and
reserve-deposit ratio rose, reducing
money supply.
 The Fed increased the reserves but not
enough.
 Lack of enough reserves forced bank
bankruptcies.
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MONETARY STATISTICS DURING GREAT DEPRESSION
Currency
rr
Reserves
M1
Dec-29
3.85
0.075
3.15
45.9
Dec-30
3.79
0.082
3.31
44.1
Dec-31
4.59
0.095
3.11
37.3
Dec-32
4.82
0.109
3.18
34.0
Dec-33
4.85
0.133
3.45
30.8
Frank, R. H. and Ben S. Bernanke, Principles of Macroeconomics, 2nd
ed. (McGraw-Hill, 2004), p. 273.
Money and Price Level
In the long run, prices adjust to pressures
in the economy.
 The “quantity theory of money” captures
the long-run relationship.
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MV = PY
Quantity Theory
M is money stock, like M1 or M2.
 V is velocity, the number of times money
stock exchanges hands in creating the
nominal GDP.
 P is price level, like 1.00 or 1.26 (price
index)
 Y is real GDP.
 PY is nominal GDP.
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Long Run Inflation
In the long-run, the economy will operate
at full-employment; so Y will not change if
there is no growth. If there is growth, then
Y is predictable: Y is known.
 Velocity is also thought predictable in the
long-run.
 Therefore, any growth in money supply will
be reflected in inflation.
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