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Frank & Bernanke 3rd edition, 2007 Ch. 10: Money, Prices, and the Federal Reserve 1 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. 2 Functions of Money 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 Money had to be invented. 3 Functions of Money Medium of exchange Barter requires double coincidence of wants. Exchange makes both parties better-off. Money had to be invented. 4 Functions of Money 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.” 5 Financial Assets Savers Can Hold Currency Checking account Savings account Certificate of Deposit Foreign currency Bonds Stocks Options on stocks, bonds, foreign currency Futures on commodities, foreign currency 6 Assets According to Liquidity Currency Checking Account Savings Account Money Market Mutual Fund Bonds 7 Measuring Money In billions of dollars http://research.stlouisfed.org/publications/mt/page16.pdf 8 Measuring Money 9 Components of M1 and M2, July 2002 (billions of dollars) M1 1,197.8 Currency 615.1 Demand deposits 303.8 Other checkable deposits 270.3 Travelers’ checks 8.6 M2 5,641.2 M1 1,197.8 Savings deposits 2,552.8 Small-denomination time deposits 920.8 Money market mutual funds 969.8 10 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. 11 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. 12 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? 13 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] 14 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? 15 Narrow Money, M1 M1 is defined as currency outside of the banks plus bank deposits. Monetary Base is defined as Currency + Reserves. 16 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? 17 •What was the amount of currency in January 2006, December 2006? •What was the amount of bank deposits in January 2005, December 2006? •What was the reserve ratio in January 2005, December 2006? 18 Banks and the Creation of Money Summary Bank reserves/bank deposits = desired reserve-deposit ratio Bank deposits = bank reserves/desired reserve-deposit ratio 19 Banks and the Creation of Money The Money Supply with Both Currency and Deposits CB provides 1 million in cash to residents Residents choose to hold 500,000 as currency Deposit 500,000 in the banks Reserve-deposit ratio = 10% Bank deposits = 500,000/.10 = 5,000,000 20 Banks and the Creation of Money The Money Supply with Both Currency and Deposits Money supply = currency + bank deposits 5,500,000 = 500,000 + 5,000,000 Money is increased by 4,500,000 when the residents hold 500,000 in bank deposits 21 Banks and the Creation of Money The Money Supply at Christmas Currency = 500 Bank reserves = 500 Reserve-deposit ratio = 0.20 Money supply = 500 + 500/.20 = 500 + 2,500 = 3,000 22 Banks and the Creation of Money The Money Supply at Christmas If Xmas shoppers withdraw 100 Money supply = 600 + 400/.20 = 600 + 2,000 = 2,600 23 Banks and the Creation of Money The Money Supply at Christmas Observation When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money supply by $5. In general, when people make withdraws, the money supply contracts by a multiple of the withdrawal. 24 The Federal Reserve System The Central Bank of the United States. The Fed is responsible for monetary policy. Amount of money supplied to the system. Affects interest rates, inflation, unemployment and exchange rates. The Fed oversees and regulates the financial markets. 25 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. 26 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. 27 Controlling the Money Supply Open-Market Operations: buying and selling of financial assets. Buying government bonds from the public increases bank reserves, hence money supply. Selling bonds decreases money supply. Discount window lending: Lending to banks increases bank reserves. Changing reserve requirements: Raising reserve-deposit ratio decreases money supply. New Tools: http://stlouisfed.org/publications/re/2009/a/pages/presidents-message.html 28 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? 29 The Federal Reserve System Example Increasing the money supply by openmarket operations Currency = 1,000 Reserves = 200 Reserve-deposit ratio = 0.2 30 The Federal Reserve System Example Increasing the money supply by openmarket operations Money supply = 1,000 + 200/0.2 = 2,000 Open market purchase = 100 Reserves increase to 300 Money supply = 1,000 + 300/0.2 = 2,500 31 The Federal Reserve System Controlling the Money Supply: Discount Window Lending Banks can borrow reserves from the Fed. Discount window lending The lending of reserves to commercial banks 32 The Federal Reserve System Controlling the Money Supply: Discount Window Lending The discount rate The interest rate charged on these loans Discount lending will increase reserves and the money supply. 33 Primary Credit Rate http://research.stlouisfed.org/publications/mt/page9.pdf 34 The Federal Reserve System Controlling the Money Supply: Changing Reserve Requirements The Fed sets the reserve-deposit ratio Called the reserve requirement A reduction in the reserve requirement would allow the money supply to increase. An increase in the reserve requirement may reduce the money supply. 35 http://www.federalreserve.gov/monetarypolicy/default.htm 36 The Federal Reserve System The Fed’s Role in Stabilizing Financial Markets: Banking Panics Suppose: Depositors lose confidence in their bank. They attempt to withdraw their funds. Bank may not have enough reserves (fractional) to meet the depositors demand. The bank fails and further erodes depositor confidence which triggers additional failures. 37 The Federal Reserve System The Fed’s Role in Stabilizing Financial Markets: Banking Panics The Fed to the rescue: Instill confidence Discount lending Open Market Operations 38 The Great Depression The Fed did not prevent the Great Depression. Both currency held by the public and reservedeposit ratio rose, reducing money supply. The Fed increased the reserves but not enough. Lack of enough reserves forced bank bankruptcies. One-third of U.S. banks closed 39 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. 40 The Federal Reserve System In response to the panics of 1929-1933, deposit insurance was established in 1934. Deposit insurance gives depositors an incentive to keep their money in the banks. Deposit insurance reduces the incentive for depositors to pay attention to the financial strength of their bank. 41 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. MV = PY 42 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. 43 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. 44 Money and Prices Velocity The speed at which money circulates Value of transactio ns Nominal GDP Velocity Money stock Money stock 45 Money and Prices Velocity The speed at which money circulates P (price level) x Y (real GDP) P x Y Velocity (V) M (money supply) M 46 Money and Prices Velocity in 2001 M1 = $1,177.9 billion M2 = $5,449.1 billion Nominal GDP = $10,082.2 billion $10,082.2 billion M1, V 8.56 $1,117.9 billion $10,082.2 billion M2, V 1.85 $5,499.1 billion 47 Money and Prices Money and Inflation in the Long Run Recall P xY V M 48 Money and Prices Money and Inflation in the Long Run Quantity equation M xV=PxY Assume V & Y are constant over the time period M xV P x Y 49 Money and Prices Money and Inflation in the Long Run If the Fed increases M by 10%, then prices must increase by 10%. High rates of money growth are associated with high rates of inflation (too much money chasing too few goods). M xV P x Y 50 Inflation and Money Growth in Latin America, 1995-2001 51