Money, Banking and the Federal Reserve

What Is Money?Money is any asset that can easily be used to purchase goods and services.

• Fiat money : Money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money.

• Commodity money: A good used as money that also has value independent of its use as money.

Currency in circulation: Cash held by the public.

Checkable bank deposits: Bank accounts on which people can write checks.

Money Supply: The total value of financial assets in the economy that are considered money.

Roles of Money1. A medium of exchange is an asset that individuals

acquire for the purpose of trading rather than for their own consumption.

2. A store of value is a means of holding purchasing power over time.

3. A unit of account is a measure used to set prices and make economic calculations.

4. Money is useful because it can serve as a standard of deferred payment in borrowing and lending.

Measuring the Money SupplyMonetary aggregate:An overall measure of the money supply.

The Fed uses three measures of the money supply known as M1, M2, and M3.

Near-moneys:Financial assets that can’t be directly used as a medium of exchange but can readily be converted into cash or checkable bank deposits.

M1

•M1 is the narrowest definition of the money supply and is also the most liquid.1 Currency, which is all the paper money and coins that are in circulation,

where “in circulation” means not held by banks or the government

2 The value of all checking account deposits at banks

3 The value of traveler’s checks (although this last category is so small—less than $7 billion in May 2007—we will ignore it in our discussion of the money supply)

M1 = $1,368.4 (billions of dollars), June 2005

M1 is equally split between currency in circulation and checkable bank deposits.

Measuring the Money Supply, July 2009

M2

•M2 is a broader definition. Includes M1 + other assets that are “almost” checkable.–M1 +–Near Moneys•Savings Account Deposits•Money Market Funds•Time Deposits

Many people buy goods and services with credit cards, yet credit cards are not included in definitions of the money supply.

What about Credit Cards and Debit Cards?

M2 = $6,510.0 (billions of dollars), June 2005

M2 has a much broader definition: it includes M1, plus a range of other deposits and deposit-like assets, making it about three times as large.

Because balances in checking account deposits are included in the money supply, banks play an important role in the process by which the money supply increases and decreases.

Monetary Role of Banks

Financial intermediary:Uses liquid assets in the form of bank deposits to finance the illiquid investments of borrowers.

Bank reserves: Currency banks hold in their vaults plus their deposits at the Federal Reserve. These don’t count as “currency in circulation.”

Reserve ratio: Fraction of bank deposits that a bank holds as reserves.

Banks

Balance Sheet for Wachovia Bank, December 31, 2006

Reserves: Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve.

Required reserves: Reserves that a bank is legally required to hold, based on its checking account deposits.

Required reserve ratio: The minimum fraction of deposits banks are required by law to keep as reserves.

Excess reserves: Reserves that banks hold over and above the legal requirement.Fractional reserve banking system: A banking system in which banks keep less

than 100 percent of deposits as reserves.

T-Account

•T-account summarizes a bank’s financial position.

How Banks Create Money

1. If banks did not exist, the money supply would simply be equal to the amount of currency in circulation.

2. Remember that “Checkable Deposits” ARE INCLUDED in the money supply measure M1.

3. Because banks lend out the majority of their deposits the total checkable deposits can exceed the amount of currency in circulation.

4. Thus, banks “create money”

Bank Regulations

Capital Requirements - regulators require that the owners of banks hold substantially more assets than the value of bank deposits. In practice, banks’ capital is equal to 7% or more of their assets.

Additional capital can come from investors in the bank.

Bank Regulations

Reserve Requirements - rules set by the Federal Reserve that determine the minimum reserve ratio for a bank.

For example, in the United States, the minimum reserve ratio for checkable bank deposits is 10%.

Excess Reserves and Deposits

Excess Reserves: Bank reserves over and above its required reserves. i.e. Money available for lending.

Example:$10 Million in Deposits / 10% Reserve Requirement (rr)

1. What is the Minimum $$ Reserve Requirement?

2. Before making any loans, how much is available to lend as “Excess Reserves”?

Bank Runs

A bank run is a phenomenon in which many of a bank’s depositors try to withdraw their funds due to fears of a bank failure.

Bank panic: A situation in which many banks experience runs at the same time.

Historically, they have often proved contagious, with a run on one bank leading to a loss of faith in other banks, causing additional bank runs.

Bank Regulations

Deposit Insurance - guarantees that a bank’s depositors will be paid even if the bank can’t come up with the funds.

The FDIC currently guarantees the first $100,000 of each account.

What negative consequences might there be from providing deposit insurance?

How Do Banks Create Money?Learning Objective 13.3

Using T-Accounts to Show How a Bank Can Create Money

How Do Banks Create Money?Learning Objective 13.3

Using T-Accounts to Show How a Bank Can Create Money

How Do Banks Create Money?Learning Objective 13.3

Using T-Accounts to Show How a Bank Can Create Money

How Do Banks Create Money?Learning Objective 13.3

Using T-Accounts to Show How a Bank Can Create Money

The Money Multiplier

Recall “The Multiplier” from our discussion of MPC and GDP.

“Fractional Reserve Banking” has a similar multiplying effect from lending out deposits in multiple rounds.

The Money Multiplier

Assume a “Checkable Deposits Only” economy. i.e. All money is put in the bank, no currency is held in circulation.

Increase in Bank Deposits from an initial $1,000 in excess reserves.

RR1 multiplierdeposit Simple

1Change in checking account deposits Change in bank reserves x RR

The Money Multiplier

Total Increase in Deposits = $1,000/rr

So, if the Reserve Requirement (rr) = 10% what is the total increase in deposits?

Answer: $10,000

This means that each $1 of reserves supports $10 in checkable deposits in the system.

Money Multiplier: In RealityThe monetary base is the sum of currency in circulation and bank reserves.The money multiplier is the ratio of the money supply to the monetary base.

Money Multiplier =

Money Supply÷

Monetary Base

The Federal Reserve System

The Federal Reserve System

The Federal Reserve is a central bank—an institution that oversees and regulates the banking system, and controls the monetary base.

“Independent” means it is not really part of the U.S. government, but it is not really private either.

The Federal Reserve System

1. Board of Governors in Washington, D.C.a. 7 Members Appointed by the President and

Confirmed by the Senate for 14 Year Termsb. The Chairman is appointed every 4 years but

usually serves for long periods.

2. Twelve Federal Reserve Banks serving their respective 12 geographic regions in the U.S.

Federal Reserve Districts

To which Federal Reserve District does Wyoming belong?

Monetary policy The actions the Federal Reserve takes to manage the money supply

Open Market Operations

Federal Open Market Committee (FOMC) The Federal Reserve committee responsible for open market operations and managing the money supply in the United States.

Open market operations The buying and selling of Treasury securities by the Federal Reserve in order to control the money supply.

Discount PolicyDiscount loans Loans the Federal Reserve makes to banks.

Discount rate The interest rate the Federal Reserve charges on discount loans.

Reserve RequirementsWhen the Fed reduces the required reserve ratio, it converts required reserves into excess reserves.

The Quantity Theory Explanation of Inflation

Quantity theory of money: A theory of the connection between money and prices that assumes that the velocity of money is constant.

In the early twentieth century, Irving Fisher, an economist at Yale, formalized the connection between money and prices using the quantity equation:

We can rewrite the above equation by taking logs as:

M+V=P+YGrowth rate of the money supply + Growth rate of velocity = Growth rate of the price level (or inflation rate) + Growth rate of real output

Y x P V x M

The Quantity Theory of Money

Velocity of money: The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.The velocity of money is nominal GDP divided by the nominal quantity of money.

According to the velocity of money approach to money demand, the real quantity of money demanded is proportional to real aggregate spending.

Velocity Approach to Money Demand

Nominal GDP

Nominal GDP

The Quantity Theory Explanation of Inflation

The growth rate of the price level is just the inflation rate, so we can rewrite the quantity equation to help us understand the factors that determine inflation:

If Irving Fisher was correct that velocity is constant, then the growth rate of velocity will be zero. This allows us to rewrite the equation one last time:

Inflation rate = Growth rate of the money supply + Growth rate of velocity − Growth rate of real output

The Quantity Theory of Money

Inflation rate = Growth rate of the money supply − Growth rate of real output

M and P will generally move in the same direction!

Printing money causes inflation !!!

Quantity Theory of Money

ΔM + ΔV = ΔP + ΔYΔM = ΔP

If V and Y are fixed then both = zero

Calculate Change in Y (real GDP):Real GDP Q3 2006: 11,336.7 billionReal GDP Q3 2007: 11,630.7 billion

2.59 %Calculate Change in P (CPI):

CPI October 2006: 201.8CPI October 2007: 208.936

3.52%

U.S. Example to Prove It

ΔM = ΔP + ΔY

So, using the Quantity Theory and real data on the U.S. economy we would predict that the U.S. Money Supply increased by 6.11%

What really happened? Let’s look up M2 which is our best measure of the Money Supply.

U.S. Example to Prove Relationship

ΔM = ΔP + ΔY

Predicted ΔM = 3.52% + 2.59%

Predicted ΔM 6.11%

The Quantity Theory Explanation of Inflation

This equation leads to the following predictions:

1 If the money supply grows at a faster rate than real GDP, there will be inflation.

2 If the money supply grows at a slower rate than real GDP, there will be deflation. (Recall that deflation is a decline in the price level.)

3 If the money supply grows at the same rate as real GDP, the price level will be stable, and there will be neither inflation nor deflation.

The Quantity Theory of Money

High Rates of Inflation

Very high rates of inflation—in excess of hundreds or thousands of percentage points per year—are known as hyperinflation.

Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession.

The Quantity Theory of Money

•The German Hyperinflation of the Early 1920s

Makingthe

Connection

During the hyperinflation of the 1920s, people in Germany used paper currency to light their stoves.