Download Class 8 PPT

© 2007 Thomson South-Western
This lecture….
• Money Growth
• Inflation
• Functions and Types of Money
• Federal Reserve System Basics
© 2007 Thomson South-Western
Money Growth and Inflation
• The Meaning of Money
– Money is the set of assets in an economy that
people regularly use to buy goods and services
from other people.
•Inflation is an increase in the overall level of prices.
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The Level of Prices and the Value of
Money
• The quantity theory of money is used to explain
the long-run determinants of the price level and
the inflation rate.
• Inflation is an economy-wide phenomenon that
concerns the value of the economy’s medium of
exchange.
• When the overall price level rises, the value of
money falls.
© 2007 Thomson South-Western
Money Supply, Money Demand, and
Monetary Equilibrium
• The money supply is a policy variable that is
controlled by the federal govt.
• Through instruments such as open-market
operations (what?), the govt. directly controls
the quantity of money supplied.
• Money demand has several determinants,
including interest rates and the average level of
prices in the economy.
© 2007 Thomson South-Western
Money Supply, Money Demand, and
Monetary Equilibrium
• People hold money because it is the medium of
exchange.
• The amount of money people choose to hold
depends on the prices of goods and services.
• In the long run, the overall level of prices
adjusts to the level at which the demand for
money equals the supply.
© 2007 Thomson South-Western
Figure 2 An Increase in the Money Supply
Value of
Money, 1/P
(High)
MS1
MS2
1
1
1. An increase
in the money
supply . . .
3
2. . . . decreases
the value of
money . . .
Price
Level, P
/4
12
/
A
/
1.33
2
B
14
(Low)
3. . . . and
increases
the price
level.
4
Money
demand
(High)
(Low)
0
M1
M2
Quantity of
Money
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The Effects of a Monetary Injection
• The Quantity Theory of Money
• How the price level is determined and why it might
change over time is called the quantity theory of
money.
• The quantity of money available in the economy
determines the value of money.
• The primary cause of inflation is the growth in the
quantity of money.
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The Classical Dichotomy and Monetary
Neutrality
• Nominal variables are variables measured in
monetary units.
• Real variables are variables measured in
physical units.
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The Classical Dichotomy and Monetary
Neutrality
• According to Hume and others, real economic
variables do not change with changes in the
money supply.
• According to the classical dichotomy, different
forces influence real and nominal variables.
• Changes in the money supply affect nominal
variables but not real variables.
• The irrelevance of monetary changes for real
variables is called monetary neutrality.
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Velocity and the Quantity Equation
• The velocity of money refers to the speed at
which the typical dollar bill travels around the
economy from wallet to wallet.
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Velocity and the Quantity Equation
• The quantity equation shows that an increase in
the quantity of money in an economy must be
reflected in one of three other variables:
• The price level must rise,
• the quantity of output must rise, or
• the velocity of money must fall.
© 2007 Thomson South-Western
CASE STUDY: Money and Prices during
Four Hyperinflations
• Hyperinflation is inflation that exceeds 50
percent per month.
• Hyperinflation occurs in some countries
because the government prints too much money
to pay for its spending.
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Figure 4 Money and Prices During Four Hyperinflations
(a) Austria
(b) Hungary
Index
(Jan. 1921 = 100)
Index
(July 1921 = 100)
100,000
100,000
Price level
Price level
10,000
10,000
Money supply
1,000
100
Money supply
1,000
1921
1922
1923
1924
1925
100
1921
1922
(c) Germany
1924
1925
(d) Poland
Index
(Jan. 1921 = 100)
100,000,000,000,000
1,000,000,000,000
10,000,000,000
100,000,000
1,000,000
10,000
100
1
1923
Index
(Jan. 1921 = 100)
10,000,000
Price level
Money
supply
Price level
1,000,000
Money
supply
100,000
10,000
1,000
1921
1922
1923
1924
1925
100
1921
1922
1923
1924
1925
© 2007 Thomson
South-Western
The Inflation Tax
• When the government raises revenue by
printing money, it is said to levy an inflation
tax.
• An inflation tax is like a tax on everyone who
holds money.
• The inflation ends when the government
institutes fiscal reforms such as cuts in
government spending.
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THE COSTS OF INFLATION
• A Fall in Purchasing
Power?
• Inflation does not in
itself reduce people’s
real purchasing
power….
• Or does it?
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THE COSTS OF INFLATION
•
•
•
•
•
•
Shoeleather costs
Menu costs
Relative price variability
Tax distortions
Confusion and inconvenience
Arbitrary redistribution of
wealth
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What Money Is and Why It’s Important
• Without money, trade would require barter,
the exchange of one good or service for another.
• Every transaction would require a double coincidence of
wants – the unlikely occurrence that two people each
have a good the other wants.
• Most people would have to spend time searching for
others to trade with – a huge waste of resources.
• This searching is unnecessary with money,
the set of assets that people regularly use to buy g&s
from other people.
THE MONETARY SYSTEM
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© 2007 Thomson South-Western
The Functions of Money
• Money has three functions in the economy:
– Medium of exchange
– Unit of account
– Store of value
• Medium of Exchange
• A medium of exchange is an item that buyers give
to sellers when they want to purchase goods and
services.
• A medium of exchange is anything that is readily
acceptable as payment.
© 2007 Thomson South-Western
The Functions of Money
• Unit of Account
– A unit of account is the yardstick people use to
post prices and record debts.
• Store of Value
– A store of value is an item that people can use to
transfer purchasing power from the present to the
future.
© 2007 Thomson South-Western
The 2 Kinds of Money
Commodity money:
takes the form of a commodity
with intrinsic value
Examples: gold coins, cigarettes
in POW camps
Fiat money:
money without intrinsic value,
used as money because of
govt decree
Example: the U.S. dollar
THE MONETARY SYSTEM
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© 2007 Thomson South-Western
THE FEDERAL RESERVE SYSTEM
• The Federal Reserve (Fed) serves as the
nation’s central bank.
– Three Primary Functions of the Fed
• Regulates banks to ensure they follow federal laws
intended to promote safe and sound banking practices.
• Acts as a banker’s bank, making loans to banks and as a
lender of last resort.
• Conducts monetary policy by controlling the money
supply.
© 2007 Thomson South-Western
The Federal Open Market Committee
(FOMC)
• Monetary policy is conducted by the Federal
Open Market Committee.
– The money supply refers to the quantity of money
available in the economy.
– Monetary policy is the setting of the money supply
by policymakers in the central bank.
© 2007 Thomson South-Western
The Federal Open Market Committee
• Open-Market Operations
– The money supply is the quantity of money
available in the economy.
– The primary way in which the Fed changes the
money supply is through open-market operations.
• The Fed purchases and sells U.S. government bonds.
• To increase the money supply, the Fed buys government
bonds from the public.
• To decrease the money supply, the Fed sells
government bonds to the public.
© 2007 Thomson South-Western
BANKS AND THE MONEY SUPPLY
• Banks can influence
the quantity of
demand deposits in
the economy and the
money supply.
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BANKS AND THE MONEY SUPPLY
• Reserves are deposits that banks have received
but have not loaned out.
• In a fractional-reserve banking system, banks
hold a fraction of the money deposited as
reserves and lend out the rest.
• The reserve ratio is the fraction of deposits
that banks hold as reserves.
© 2007 Thomson South-Western
Money Creation with FractionalReserve Banking
• When a bank makes a loan from its reserves,
the money supply increases.
• The money supply is affected by the amount
deposited in banks and the amount that banks
loan.
– Deposits into a bank are recorded as both assets
and liabilities.
– The fraction of total deposits that a bank has to
keep as reserves is called the reserve ratio.
– Loans become an asset to the bank.
© 2007 Thomson South-Western
Banking Money Creation with
•Fractional-Reserve
This T-Account
First National Bank
shows a bank that…
– accepts deposits,
– keeps a portion
as reserves,
– and lends out
the rest.
• It assumes a
reserve ratio
of 10%.
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
Total Liabilities
$100.00
© 2007 Thomson South-Western
Money Creation with FractionalReserve Banking
• When one bank loans money, that money is
generally deposited into another bank.
• This creates more deposits and more reserves
to be lent out.
• When a bank makes a loan from its reserves,
the money supply increases.
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The Money Multiplier
• How much money is eventually created by the
new deposit in this economy?
• The money multiplier is the amount of money
the banking system generates with each dollar
of reserves.
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The Money Multiplier
Increase
in theBank
MoneySecond
Supply National
= $190.00!
First
National
Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
Assets
Reserves
$9.00
Liabilities
Deposits
$90.00
Loans
$90.00
Total Assets
Total Liabilities
$100.00
$100.00
$81.00
Total Assets
$90.00
Total Liabilities
$90.00
© 2007 Thomson South-Western
The Money Multiplier
Original deposit = $100.00
• 1st Natl. Lending = 90.00 (=.9 x $100.00)
• 2nd Natl. Lending = 81.00 (=.9 x $ 90.00)
• 3rd Natl. Lending = 72.90 (=.9 x $ 81.00)
• … and on until there are just pennies left to
lend!
• Total money created by this $100.00 deposit is
$1000.00. (= 1/.1 x $100.00)
© 2007 Thomson South-Western
The Money Multiplier
• The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R
• Example:
– With a reserve requirement, R = 20% or .2:
– The money multiplier is 1/.2 = 5.
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The Fed’s Tools of Monetary Control
• The Fed has three tools in its monetary
toolbox:
– Open-market operations
– Changing the reserve requirement
– Changing the discount rate
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The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase and
sale of U.S. government bonds by the Fed.
 To increase money supply, Fed buys govt bonds,
paying with new dollars.
…which are deposited in banks, increasing reserves
…which banks use to make loans, causing the
money supply to expand.
 To reduce money supply, Fed sells govt bonds,
taking dollars out of circulation, and the process
works in reverse.
 OMOs are easy to conduct, and are the Fed’s
monetary policy tool of choice.
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© 2007 Thomson South-Western
The Fed’s 3 Tools of Monetary Control
2. Reserve Requirements (RR):
affect how much money banks can create by making
loans.
 To increase money supply, Fed reduces RR.
Banks make more loans from each dollar of reserves,
which increases money multiplier and money supply.
 To reduce money supply, Fed raises RR,
and the process works in reverse.
 Fed rarely uses reserve requirements to control
money supply: Frequent changes would disrupt
banking.
THE MONETARY SYSTEM
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© 2007 Thomson South-Western
The Fed’s 3 Tools of Monetary Control
3. The Discount Rate:
the interest rate on loans the Fed makes to banks
 When banks are running low on reserves,
they may borrow reserves from the Fed.
 To increase money supply,
Fed can lower discount rate, which encourages
banks to borrow more reserves from Fed.
 Banks can then make more loans, which increases
the money supply.
 To reduce money supply, Fed can raise discount rate.
THE MONETARY SYSTEM
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© 2007 Thomson South-Western
The Fed’s 3 Tools of Monetary Control
3. The Discount Rate:
the interest rate on loans the Fed makes to banks
 The Fed uses discount lending to provide extra
liquidity when financial institutions are in trouble,
e.g. after the Oct. 1987 stock market crash.
 If no crisis, Fed rarely uses discount lending –
Fed is a “lender of last resort.”
THE MONETARY SYSTEM
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© 2007 Thomson South-Western
Monetary Policy and the Fed Funds Rate
To raise fed funds
rf
rate, Fed sells Federal
funds rate
govt bonds (OMO).
This removes
3.75%
reserves from the
banking system,
3.50%
reduces supply of
federal funds,
causes rf to rise.
The Federal
Funds market
S2
S1
D1
F2 F1
Quantity of
federal funds
THE MONETARY SYSTEM
F
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© 2007 Thomson South-Western
Problems Controlling the Money Supply
• If households hold more of their money as
currency, banks have fewer reserves,
make fewer loans, and money supply falls.
• If banks hold more reserves than required,
they make fewer loans, and money supply
falls.
• Yet, Fed can compensate for household
and bank behavior to retain fairly precise
control over the money supply.
THE MONETARY SYSTEM
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© 2007 Thomson South-Western