Ch. 9: Money, the Price Level, and Inflation 9 Definition of money and its functions Economic...

Ch. 9: Money, the Price Level, and Inflation9

• 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 (more later).

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 =$1371.25 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

http://www.micheloud.com/FXM/MH/Crime/wwizoz.htm#fgfd

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 AccountAn 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 BANKINGStates 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 LiabilitiesReserves (gold) 100 Notes 100Total 100 100

Banks would print notes beyond reserves and extend loans.

Reserves 100 Notes 1000Loans 900 ____Total 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 insuranceIncentives created for risk taking.The 1985 Home State experience in Ohio.

Bank Objectives.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 agreed-upon 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 macroeconomy.• Structure

– The Board of Governors– The 12 regional Federal Reserve banks– Federal Open Market Committee

The Federal Reserve SystemBoard 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 SupplyBank 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:


The balance sheet

Assets LiabilitiesCash 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.


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


The balance sheet

Assets LiabilitiesCash 90 m. Demand deposits 90m360

m.

Loans 0270 m Owner’s equity 5 m.

Plant & equipment 5 m.

Total assets 95m365 m.

Total Liabilities 95m365 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.”


Summary of money creation process.

monetary base = nonbank cash + bank reserves

M1 = nonbank cash + demand dep. Maximum DD = (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

reservesbuy government securities from member banksbanks give up government bonds and receive deposit at

the Fed or cash. More recently, Fed has purchased commercial paper

from banks – new policy!

• By buying government securitiesFed 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%





Suppose the Fed purchases $10 m. of government securities. What is the effect on:

Loans Demand deposits M1

Assuming banks loan out all excess reserves, if the Fed purchases $10 million of government securities, total loans will

increase by$10 million.

increase by$40 million

decrease by$10 million.

None of theabove.

25% 25%25%25%

20

1. increase by $10 million.2. increase by $40 million3. decrease by $10

million.4. None of the above.

Assuming banks loan out all excess reserves, if the Fed purchases $10 million of government securities, M1 will

increase by$10 million.

increase by$40 million

Increase by$30 million.

None of theabove.

25% 25%25%25%

20

1. increase by $10 million.2. increase by $40 million3. Increase by $30 million.4. None of the above.

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 system,

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%





Suppose the Fed reduces the rr to 20% What is the effect on:


If the reserve ratio is cut from 25 to 20%, M1 will

Not change Increase by$1...

Increase by$9...

None of theab...

25% 25%25%25%

20

1. Not change2. Increase by $18

million3. Increase by $90

million4. None of the above.

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.

Bank holdings of excess reserves

Changes in the money supply: Cash held by publicThe balance sheet

COB=$10m; rr=25%





Suppose the public withdraws $10m. Of DD as cash. What is the effect on:


M1 would increase if

The Fed in

crea...

The Fed purch

a...

The public dec..

.

All of t

he abo...

25% 25%25%25%

20

1. The Fed increases the required reserve ratio

2. The Fed purchases government securities

3. The public decides to hold less money as demand deposits and more as cash

4. All of the above

If banks decide to hold more money as excess reserves, M1 will ____ and bank loans will ____

Incre

ase; in

cr...

Incre

ase; d

ecr...

Decre

ase; d

ecr...

Decre

ase; in

cr...

25% 25%25%25%

20

1. Increase; increase2. Increase; decrease3. Decrease; decrease4. Decrease; increase

Total Bank Reserves: 1980-2009

MONETARY BASE:1983-2009

M1: 1980-2009

EXCESS RESERVES: 1980-2009

The Market for Money

The Demand for Moneyrelationship 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 Demand for Money HoldingThe quantity of money that people plan to hold depends on four main factors:

The nominal interest rateThe price level Real GDP Financial innovation

The demand for moneyThe 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.

The demand for moneyThe 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 demanded. •Real money equals nominal money ÷ price level.•10 percent increase in P increases the quantity of nominal money demanded by 10 percent.

Real GDP•Increase in real GDP increases increases the quantity of real money that people plan to hold.

The demand for moneyFinancial Innovation

–that lowers the cost of switching between money and interest-bearing assets decreases the quantity of real money that people plan to hold.

Summary of money demand factors• Nominal interest rate•Price level • Real GDP (income)• Financial innovation

Equilibrium interest rate


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.

If the Fed purchases government bonds from the banking system, interest rates will ____

Fall b

ecause

m...

Rise beca

use m

...

Fall b

ecause

m...

None of t

he ab...

25% 25%25%25%

20

1. Fall because money supply increases

2. Rise because money demand increases

3. Fall because money demand decrease

4. None of the above

If the economy enters a recession and real GDP falls, interest rates will:

Fall a

s money ...

Fall a

s money ...

Rise as m

oney ...

None of t

he ab...

25% 25%25%25%

20

1. Fall as money demand decreases

2. Fall as money supply increases

3. Rise as money supply decreases

4. None of the above

If the Fed wants to stimulate spending by cutting interest rates, it could:

Purchase

gove

r...

Cut the re

quir...

Lower t

he disc...

All of t

he abo...

25% 25%25%25%

20

1. Purchase government bonds

2. Cut the required reserve ratio

3. Lower the discount rate

4. All of the above


Long-Run EquilibriumIn 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.

The Quantity Theory of Money

V=velocityP=price levelY=real GDPM=quantity of moneyThe equation of exchange states that

MV = PYExpressing 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


Quantity theory of moneyIn the long run, velocity does not change, soInflation rate = Money growth rate Real GDP growth


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.

According to the equation of exchange, which of the following will lead to greater inflation?

Decre

ased ve

lo...

Faste

r gro

wth ...

Faste

r gro

wth ...

All of t

he abo...

25% 25%25%25%

20

1. Decreased velocity of money

2. Faster growth of the money supply

3. Faster growth of real GDP

4. All of the above

Ch. 9: Money, the Price Level, and Inflation 9 Definition of money and its functions Economic...

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