Download the money supply?

12-14
Money and
Banking
12-1
Copyright 2008 The McGraw-Hill Companies
Learning objectives
In this chapter students will learn:
A.
About the functions of money and the components of the money supply.
B.
What “backs” the money supply, making us willing to accept it as payment.
C.
The makeup of the Central bank and the banking system.
D.
The functions and responsibilities of the Central Bank.
E.
Why the banking system is called a “fractional reserve” system.
F.
The distinction between a bank’s actual reserves and its required reserves.
G. How a bank can create money through granting loans.
H. About the multiple expansion of loans and money by the entire banking
system.
I.
What the monetary multiplier is and how to calculate it.
J.
How the equilibrium interest rate is determined in the market for money.
K. The goals and tools of monetary policy.
L.
About the Federal funds rate and how the Fed controls it.
M. The mechanisms by which monetary policy affects GDP and the price level.
N.
The effectiveness of monetary policy and its shortcomings.
12-2
Copyright 2008 The McGraw-Hill Companies
Functions of Money
1.
Medium of exchange: Money can be used for buying and
selling goods and services. This way it:
–
–
2.
Allows the economy to escape the complications of barter
Allows the society to gain the advantages of geographic and human
specialization
Unit of account: Prices are quoted in KDs and filses.
–
–
–
Measure of the relative worth of a wide variety of goods, services
and resources. Just as distance is measured by meters, value is
measured by money.
Price of a commodity needs only to be stated in terms of money, not
in terms of other commodities
It also permits to define debt obligations, taxes owed and calculate
GDP
12-3
Copyright 2008 The McGraw-Hill Companies
Functions of Money
3.
•
•
Store of value: Money allows us to transfer purchasing
power from present to future.
Money is preferred as a convenient way to store value
because it is the most liquid asset.
There is a negative relationship between the purchasing
power of money and price level.
12-4
Copyright 2008 The McGraw-Hill Companies
Components of the Money Supply
• M1 (Narrow definition)
1. Currency (coins and paper money) in the hands of the public
(this is a debt on government)
• Coins: the “small change” of money supply, they constitute a
small percentage of M1. All coins are “token money”, i.e., the
intrinsic or the value of metal contained in the coin is less
than its face value, otherwise the public will melt it down
• Paper money: banknotes issued by the central bank with the
authorization of the law (legal money).
2. All checkable deposits in banks or thrift institutions (this is a
debt on commercial banks and saving institutions).
Checkable deposits are the largest component of M1.
12-5
Copyright 2008 The McGraw-Hill Companies
Components of the Money Supply
Advantages of checkable deposits:
• Safety
• Convenience
• Institutions that offer checkable deposits:
- Commercial banks
- Saving and loan associations, mutual saving banks, and credit unions.
These are called thrift institutions.
12-6
Copyright 2008 The McGraw-Hill Companies
Components of the Money Supply
• Money Supply M2
Includes M1 plus near monies (Quasi money).
Near or Quasi money includes:
- Saving deposits
- Time deposits
• Money Supply M3
Includes M2 plus deposits with other non-bank financial
institutions. There is a minor difference between M2 and M3
in Kuwait.
12-7
Copyright 2008 The McGraw-Hill Companies
What “backs” the money supply?
• Money is essentially backed by the government’s ability to
keep its value stable provides the backing. The government
manages money to provide the amount needed to:
- Achieve full employment
- Price level stability
- Economic growth
• Money is debt; paper money is a debt of the Central Banks and checkable
deposits are liabilities of banks and thrifts because depositors own them.
The value of money
• Value of money arises not from its intrinsic value. The central
bank will not redeem currency for any tangible assets (e.g.,
gold), but its value arises from its use in exchanging for goods
and services.
• What gives money its value:
1. acceptability: It is acceptable as a medium of exchange.
12-8
Copyright 2008 The McGraw-Hill Companies
What “backs” the money supply?
2. Legal tender: Currency is legal tender or fiat money. In
general, it must be accepted in repayment of debt, but that
doesn’t mean that private firms and government are
mandated to accept cash; alternative means of payment may
be required. (Note that checks are not legal tender but, in fact,
are generally acceptable in exchange for goods, services, and
resources. Legal cases have essentially determined that
pennies are not legal tender.)
3. The relative scarcity of money: Compared to goods and
services will allow money to retain its purchasing power.
12-9
Copyright 2008 The McGraw-Hill Companies
What “backs” the money supply?
• Money’s purchasing power determines its value. Higher prices
mean less purchasing power.
- The purchasing power of money: is the amount a KD will buy.
It varies inversely with the price level. Hence
KDvalue = 1/P
If price increased from 100 to 120, the value of KD will be
83.33 (1/120), a 20% increase in price level lowers the value of
the dollars by 16.67%.
• Inflation and acceptability:
• Excessive inflation may make money worthless and
unacceptable. An extreme example of this was German
hyperinflation after World War I, which made the mark worth
less than 1 billionth of its former value within a four-year
period.
12-10
Copyright 2008 The McGraw-Hill Companies
What “backs” the money supply?
• Worthless money leads to use of other currencies that are more
stable.
• Worthless money may lead to barter exchange system.
Maintaining the value of money
• The government tries to keep supply stable with appropriate
fiscal policy.
• Monetary policy tries to keep money relatively scarce to
maintain its purchasing power, while expanding enough to
allow the economy to grow.
12-11
Copyright 2008 The McGraw-Hill Companies
12-12
Copyright 2008 The McGraw-Hill Companies
CHAPTER THIRTEEN
MONEY CREATION
12-13
Copyright 2008 The McGraw-Hill Companies
The Banking System: Multiple-Deposit Expansion (all
banks combined)
• The entire banking system can create an amount of
money which is a multiple of the system’s excess
reserves, even though each bank in the system can
only lend dollar for dollar with its excess reserves.
• Three simplifying assumptions:
1. Required reserve ratio assumed to be 20 percent.
2. Initially banks have no excess reserves; they are
“loaned up.”
3. When banks have excess reserves, they loan it all to
one borrower, who writes check for entire amount to
give to someone else, who deposits it at another
bank. The check clears against original lender.
12-14
Copyright 2008 The McGraw-Hill Companies
The Banking System
Bank
(1)
Acquired
Reserves
and Deposits
Bank A
$100.00
Bank B
80.00
Bank C
64.00
Bank D
51.20
Bank E
40.96
Bank F
32.77
Bank G
26.21
Bank H
20.97
Bank I
16.78
Bank J
13.42
Bank K
10.74
Bank L
8.59
Bank M
6.87
Bank N
5.50
Other Banks 21.99
12-15
Copyright 2008 The McGraw-Hill Companies
(2)
Required
Reserves
(Reserve
Ratio = .2)
(3)
Excess
Reserves
(1)-(2)
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
(4)
Amount Bank Can
Lend; New Money
Created = (3)
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
$400.00
The Monetary Multiplier
Monetary Multiplier or Checkable-Deposit
Multiplier
Monetary
Multiplier
=
or in Symbols…
Graphic
Example
1
Required Reserve Ratio
1
m =
New Reserves
$100
$80
Excess
Reserves
$400
Bank System Lending
Money Created
12-16
Copyright 2008 The McGraw-Hill Companies
R
$20
Required
Reserves
$100
Initial
Deposit
The Banking System: Multiple-Deposit Expansion (all
banks combined)
•
System’s lending potential: Suppose a junkyard owner finds
a $100 bill and deposits it in Bank A. The system’s lending
begins with Bank A having $80 in excess reserves, lending
this amount, and having the borrower write an $80 check
which is deposited in Bank B. See further lending effects on
Bank C. The possible further transactions are summarized
in Table 13.2.
Monetary multiplier is illustrated in Table 13.2.
1. Formula for monetary or checkable deposit multiplier is:
Monetary multiplier = 1/required reserve ratio or m = 1/R or
1/.20 in our example.
2. Maximum deposit expansion possible is equal to: excess
reserves × monetary multiplier, or
12-17
Copyright 2008 The McGraw-Hill Companies
The Banking System: Multiple-Deposit Expansion (all
banks combined)
• Figure 13.1 illustrates this process.
• Higher reserve ratios generate lower money multipliers.
• a. Changing the money multiplier changes the money creation
potential.
• b. Changing the reserve ratio changes the money multiplier
but be careful! It also changes the amount of excess reserves
that are acted on by the multiplier. Cutting the reserve ratio
in half will more than double the deposit creation potential of
the system.
• The process is reversible. Loan repayment destroys money,
and the money multiplier increases that destruction.
12-18
Copyright 2008 The McGraw-Hill Companies
CHAPTER FOURTEEN:
MONETARY POLICY
12-19
Copyright 2008 The McGraw-Hill Companies
The Demand for Money: Two Components
1. Transactions demand, Dt, is money kept for
purchases and will vary directly with GDP (Figure
14.1a).
2. Asset demand, Da, is money kept as a store of value
for later use. Asset demand varies inversely with the
interest rate, since that is the price of holding idle
money (Figure 14.1b).
3. Total demand, equal quantities of money demanded
for assets plus that for transactions (Figure 14.1c).
12-20
Copyright 2008 The McGraw-Hill Companies
Interest Rates
Demand for Money and the Money Market
Rate of Interest, I percent
(a)
Transactions
Demand for
Money, Dt
(b)
Asset
Demand for
Money, Da
(c)
Total
Demand for
Money, Dm
And Supply
10
Sm
7.5
=5
+
5
2.5
Dt
Da
Dm
0
50
100
150
200
Amount of Money
Demanded
(Billions of Dollars)
12-21
Copyright 2008 The McGraw-Hill Companies
50
100
150
200
Amount of Money
Demanded
(Billions of Dollars)
50
100
150
200
250
300
Amount of Money
Demanded and Supplied
(Billions of Dollars)
Interest Rates
Demand for Money and the Money Market
Sm
Dm
Buy assets
5
Sell assets
50
100
150
200
250
300
Amount of Money
Demanded and Supplied
(Billions of Dollars)
12-22
Copyright 2008 The McGraw-Hill Companies
The Market for Money: Interaction of Money Supply
and Demand
• Key Graph 14.1c illustrates the money market. It
combines demand with supply of money.
• If the quantity demanded exceeds the quantity
supplied, people sell assets like bonds to get money.
This causes bond supply to rise, bond prices to fall,
and a higher market rate of interest.
• If the quantity supplied exceeds the quantity
demanded, people reduce money holdings by buying
other assets like bonds. Bond prices rise, and lower
market rates of interest result (see example in text).
12-23
Copyright 2008 The McGraw-Hill Companies
Rate of interest, i (percent)
THE MONEY MARKET
Changes in Money Supply
Sm
10
7.5
ie
5
Dm
2.5
0
Suppose the money
supply is decreased
from $200 billion, Sm,
to $150 billion Sm1.
0
50
100
150
200 250 300
Amount of money demanded
(billions of dollars)
12-24
Copyright 2008 The McGraw-Hill Companies
Rate of interest, i (percent)
THE MONEY MARKET
Sm1
Sm
10
7.5
ie
5
Dm
2.5
0
A temporary shortage
of money will require
the sale of some assets
to meet the need.
0
50
100
150
200 250 300
Amount of money demanded
(billions of dollars)
12-25
Copyright 2008 The McGraw-Hill Companies
Rate of interest, i (percent)
THE MONEY MARKET
Sm
10
7.5
ie
5
Dm
2.5
0
Suppose the money
supply is increased
from $200 billion, Sm,
to $250 billion Sm2.
0
50
100
150
200 250 300
Amount of money demanded
(billions of dollars)
12-26
Copyright 2008 The McGraw-Hill Companies
Rate of interest, i (percent)
THE MONEY MARKET
Sm Sm2
10
7.5
ie
5
Dm
2.5
0
A temporary surplus
of money will require
the purchase of some
assets to meet the desired level of liquidity.
0
50
100
150
200 250 300
Amount of money demanded
(billions of dollars)
12-27
Copyright 2008 The McGraw-Hill Companies
The Central Bank has Three Major “Tools” of
Monetary Policy
1. Open-market operations refer to the central bank buying and selling of
government bonds.
• Buying securities will increase bank reserves and the money supply (see
Figure 14.2).
a. If the central bank buys directly from banks, then bank reserves go up
by the value of the securities sold to the central bank, Banks’ lending
ability rises with new excess reserves. Money supply rises directly with
increased deposits by the public.
b. b. If the central bank buys from the general public, people receive checks
from the central bank and then deposit the checks at their bank. Bank
customer deposits rise and therefore bank reserves rise by the same
amount.
•
Conclusion: When the central bank buys securities, bank reserves will
increase and the money supply potentially can rise by a multiple of these
reserves.
12-28
Copyright 2008 The McGraw-Hill Companies
Tools of Monetary Policy
Fed Buys $1,000 Bond from a Commercial Bank.
RRR = 20%.
New Reserves
$1000
$1000
Excess
Reserves
$5000
Bank System Lending
Total Increase in the Money Supply, ($5,000)
12-29
Copyright 2008 The McGraw-Hill Companies
Tools of Monetary Policy
Fed Buys $1,000 Bond from the Public. RRR = 20%.
Check is Deposited
New Reserves
$1000
$800
Excess
Reserves
$4000
Bank System Lending
$200
Required
Reserves
$1000
Initial
Checkable
Deposit
Total Increase in the Money Supply, ($5000)
12-30
Copyright 2008 The McGraw-Hill Companies
2. The reserve ratio is another “tool” of monetary policy. It is
the fraction of reserves required relative to their customer
deposits.
• Raising the reserve ratio increases required reserves and
shrinks excess reserves. Loss of excess reserves shrinks banks’
lending ability and the potential money supply by a multiple
amount of the change in excess reserves.
• Lowering the reserve ratio decreases the required reserves and
expands excess reserves. Gain in excess reserves increases
banks’ lending ability and the potential money supply by a
multiple amount of the change in excess reserves.
• Changing the reserve ratio has two effects.
a. It affects the size of excess reserves.
b. It changes the size of the monetary multiplier. For example, if
ratio is raised from 10 percent to 20 percent, the multiplier
falls from 10 to 5.
12-31
Copyright 2008 The McGraw-Hill Companies
3. The third “tool” is the discount rate, which is the interest rate
that the central bank charges to commercial banks that borrow
from the central bank.
• An increase in the discount rate signals that borrowing reserves
is more difficult and will tend to shrink excess reserves.
• A decrease in the discount rate signals that borrowing reserves
will be easier and will tend to expand excess reserves.
12-32
Copyright 2008 The McGraw-Hill Companies
Monetary Policy
Monetary Policy and Equilibrium GDP
Sm1
Sm2
(c)
Equilibrium Real
GDP and the
Price Level
Sm3
AS
10
P3
8
AD3
I=$25
AD2
I=$20
AD1
I=$15
P2
Dm
6
ID
0
$125
$150
$175
Amount of Money
Demanded and Supplied
(Billions of Dollars)
12-33
(b)
Investment
Demand
Price Level
Rate of Interest, i (Percent)
(a)
The Market
For Money
Copyright 2008 The McGraw-Hill Companies
$15
$20
$25
Amount of Investment, I
(Billions of Dollars)
Q1
Qf Q3
Real Domestic Product, GDP
(Billions of Dollars)
Monetary Policy
Expansionary Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Unemployment and Recession
Fed Buys Bonds, Lowers Reserve
Ratio, or Lowers the Discount Rate
Excess Reserves Increase
Money Supply Rises
Interest Rate Falls
Investment Spending Increases
Aggregate Demand Increases
Real GDP Rises
12-34
Copyright 2008 The McGraw-Hill Companies
Monetary Policy
Restrictive Monetary Policy
CAUSE-EFFECT CHAIN
Problem: Inflation
Fed Sells Bonds, Increases Reserve
Ratio, or Increases the Discount Rate
Excess Reserves Decrease
Money Supply Falls
Interest Rate Rises
Investment Spending Decreases
Aggregate Demand Decreases
Inflation Declines
12-35
Copyright 2008 The McGraw-Hill Companies