Transcript Principles of Economics

Principles of Economics
Session 12
Topics To Be Covered
Definition of Money
Categories of Money
The Federal Reserve System
Money Multiplier
Supply and Demand for Money
Equilibrium of the Money Market
Monetary Policy
Definition of Money
Money is the set of assets in the economy
that people regularly use to buy goods and
services from other people.
It serves three functions:
 Medium
of exchange
 Unit of account
 Store of value
Three Functions of Money
 A medium
of exchange is anything that is
readily acceptable as payment.
 A unit of account is the yardstick people use
to post prices and record debts.
 A store of value is an item that people can
use to transfer purchasing power from the
present to the future.
Barter
Barter is the direct exchange of goods
and services for other goods and services.
A barter system requires a double
coincidence of wants for trade to take
place. Money eliminates this problem.
Money as a means of payment, or
medium of exchange, is more efficient
than barter.
Categories of Money
 Commodity
Money
Commodity money takes the form of a
commodity with intrinsic value. For example:
Gold, silver, cigarettes.
 Fiat Money
Fiat money is used as money because of
government decree. It does not have intrinsic
value. For example: Coins, currency, check
deposits.
Money in the U.S. Economy
Measure Amount in 2000 What’s Included
M1
$1,103 billion
Currency
Traveler’s checks
Demand deposits
Other checkable deposits
M2
$4,778 billion
Everything in M1
Saving deposits
Small time deposits
Money market mutual funds
M3
$5,505 billion
Everything in M2
Large time deposits
The Central Bank
 Generally,
the central bank of a country
serves the following functions:
 It
oversees the banking system.
 It acts as a banker’s bank, making loans to
banks and as a lender of last resort.
 It conducts monetary policy by controlling the
money supply.
The Chinese central bank is the People’s
Bank of China and the American one is the
Federal Reserve System.
The Fed’s Organization
 The
Federal Reserve System (Fed)
consists of :

The Board of Governors

The Regional Federal Reserve Banks

The Federal Open Market Committee
The Fed’s Organization
 The Fed is run by a Board of Governors,
which has seven members appointed by the
President and confirmed by the Senate.
 Among the seven members, the most
important is the chairman. The chairman
directs the Fed staff, presides over board
meetings, and testifies about Fed policy in
front of Congressional Committees.
The Fed’s Organization
The Fed also includes 12 regional reserve
banks.
Each regional reserve bank consists of nine
directors—three appointed by the Board of
Governors and six elected by the commercial
banks in the district.
The directors appoint the district president
which is approved by the Board of Governors.
The Fed’s Organization
 The
Federal Open Market Committee
(FOMC) is made up of the following voting
members:
 The
chairman and the other six members of the
Board of Governors.
 The president of the Federal Reserve Bank of New
York.
 The presidents of the other regional Federal
Reserve banks (four votes on a yearly rotating
basis).
The Fed’s Organization
 FOMC
serves as the main policy-making
organ of the Federal Reserve System.
 FOMC
meets approximately every six
weeks to review the economy.
 FOMC
conducts the monetary policy
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
Open-Market Operations
The Fed conducts open-market operations
when it buys government bonds from or sells
government bonds to the public:
 When
the Fed buys government bonds, the
money supply increases.
 The
money supply decreases when the Fed sells
government bonds.
Changing the
Reserve Requirement
The reserve requirement is the amount (%)
of a bank’s total reserves that may not be
loaned out.
 Increasing
the reserve requirement decreases
the money supply.
 Decreasing the reserve requirement increases
the money supply.
Changing the Discount Rate
The discount rate is the interest rate the
Fed charges banks for loans.
 Increasing
the discount rate decreases the
money supply.
 Decreasing the discount rate increases the
money supply.
Money Creation
Banks can influence the quantity of demand
deposits in the economy and the money
supply.
 In a fractional reserve banking system,
banks hold a fraction of the money
deposited as reserves and lend out the rest.
 When a bank makes a loan from its
reserves, the money supply increases.

Money Creation
 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 (R).
 Loans become an asset to the bank.
Money Creation
First Bank
Assets
Liabilities
This T-Account
shows a bank that:
 accepts
Reserves
$10.00
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
deposits
 keeps a portion as
reserves
 lends out the rest.
It assumes a reserve
Total Liabilities ratio of 10%.
$100.00
Money Creation
 When
one bank loans money, that
money is generally spent. And the
recipient deposits it 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.
Money Creation
First Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
Second Bank
Assets
Reserves
$9.00
Liabilities
Deposits
$90.00
Loans
$90.00
$81.00
Total Assets
Total Liabilities
$100.00
$100.00
Total Assets
$90.00
Total Liabilities
$90.00
Money Supply = $190.00
Money Creation
Original deposit
First lending
Second lending
Third lending
=$
=$
=$
=$
100.00
90.00 [=0.9 x $100.00]
81.00 [=0.9 x $90.00]
72.90 [=0.9 x $81.00]
……………………………………………………….
$100
Ms 
 $1,000
1  0.9
The Money Multiplier
The money multiplier is the amount of
money the banking system generates
with each dollar of reserves.
1
Ms 
R
Supply and Demand for Money
 In the money market, interest rates are
determined by the supply and demand
for money.
 The central bank can change the
interest rate level because it controls
the supply of money.
Supply and Demand for Money
Interest
Rate
Ms
Equilibrium
Interest rate
Md
Money
The Demand for Money
(The Liquid Preference)
 Portfolio of holding financial wealth:
stocks, bonds or money.
 Holding wealth in currency or checking
deposits means loss of potential income
from interest on bonds and dividends on
stocks.
The Demand for Money
The market rate of interest is the opportunity
cost of holding money.
As interest rates rise, the opportunity cost of
holding money rises, and the public demands
less money. So the demand curve is downward
sloping.
Macroeconomic variables that change the
demand for money are price level and real
GDP.
Demand for Money and
the Price Level
Interest
Rate
Ms
When the price level
rises, the demand for
money increases.
r2
r1
Md2
Md1
Money
Demand for Money and
the Real GDP
Interest
Rate
Ms
When real GDP rises,
the demand for money
increases.
r2
r1
Md2
Md1
Money
The Demand for Money
Generally, the motives of people holding
money can be roughly classified into two
categories.
 Transaction
demand for money
 Speculative
demand for money
The Demand for Money
Transaction demand for money
The needs or desires of individuals or firms
to make purchases on short notice without
incurring excessive costs.
Speculative demand for money
An attitude that holding money over short
periods is less risky than holding stocks or
bonds.
The Transaction Demand
for Money
The transactions demand for money (L1) is
based on the desire to facilitate transactions.
It mainly depends on the income (Y), so its
function is:
L1  L1 (Y )
The Speculative Demand
for Money
The speculative demand for money (L2) is
based on the desire to make wise decisions
to invest in securities such as bonds.
It mainly depends on the interest, so its
function is:
L2  L2 (r )
Bond Prices and Interest Rates
Bonds are promises to pay
money in the future. The price
of a bond one year from now is
the promised payment divided
by 1 plus the interest rate.
Bond Prices and Interest Rates
For example, a bond that promises to pay
$106 a year, with an interest rate is 6%
per year, would cost today:
$106
Pr ice of bond 
 $100
1  0.06
In other words, if you can invest at 6% per
year, you would be willing to pay $100 today
for a $106 promised payment next year.
Interest Rates and Bond Prices
Bond prices change in the opposite
direction from changes in interest rates:
Promised
Payment
Interest
Rate
Promised
Payment
Interest
Rate
$106
6%
$106
4%
price of bond 
$106
1  $100
(1  0.06)
price of bond 
$106
1  $101.92
(1  0.04)
If the interest rate rose to 8%, how much
would you like to pay?
$98.15.
Interest Rates and Bond Prices
When interest rates rise, investors need
less money to obtain the same promised
payments in the future, so the price of
bonds falls.
Therefore, bonds’ prices are inversely
related to interest rates.
The Speculative Demand
for Money
When the interest is high, the bond price is
low. Usually people will guess that the bond
price is to rise, so they purchase bonds, thus
having less money in hand.
high
interest
rates
Low
bond
prices
Purchasing
bonds
Less
money
in hand
The Speculative Demand
for Money
When the interest is low, the bond price is high.
Usually people will expect that the bond price is to
fall, so they sell the bonds they own. Consequently
they have more money in hand.
Low
interest
rates
High
bond
prices
Selling
bonds
More
money
in hand
Demand for Money
L  L1  L2  L1 (Y )  L2 (r)  kY  hr
r
L1=L1(Y)
r
L=L1+ L2
L2=L2(r)
m
m
Equilibrium of
the Money Market
When the money market is at equilibrium,
the demand for money (L) should be equal to
the supply of money (m).
mL
The money supply is controlled by the
central bank.
Equilibrium of
the Money Market
m1
r
L
E
r1
m1
When money demand
and supply equal, the
money market is at
equilibrium
m
Central Bank and Interest Rates
The central bank can influence the interest
rate through changing the money supply.
An increase in the money supply leads to a
lower interest rate.
A decrease in the money supply leads to a
higher interest rate.
Central Bank and Interest Rates
m3 m 1 m2
r
L
r3
r1
E
r2
m3 m 1 m2
m
Monetary Policy
Monetary policy is the range of
actions taken by the Federal
Reserve to influence the level of
GDP or the rate of inflation.
Monetary Policy
The central bank can influence the output
by changing the money supply.
When the central bank increase the money
supply, the interest rate goes down.
With the decrease of interest rate, the
investment increases.
Since increase is part of GDP, the total
output increases.
Monetary Policy
Investment
Money
r1
r1
r2
r2
Md
Ms1 Ms2
Open
market
purchase
Money
supply
increases
Output
AE2
AE1
I1
I2
Interest
rates
fall
Y1
Investment
spending
rises
Y2
GDP
increases
Limitations of Monetary Policy
If the economy has reached the level of
potential output, namely, the full-employment
output, the expansionary monetary policy
won’t work effectively.
Initially, monetary expansion leads to output
above full employment. The demand for money
increases, leading to a higher interest rate.
The increase of interest rate will decrease the
investment, which will return the GDP back to
the full-employment level.
Limitations of Monetary Policy
Potential
GDP
r1
Md2
r2
Md1
Ms1 Ms2
Money
AE2
r1
AE1
r2
I1
I2
Investment
Y1
Y2
Output
Assignment
Review Chapter 25 and 26.
Answer questions on P491 and 513.
Search for information on China’s
monetary policies in the recent years.
Preview Chapter 29 and 30.
Thanks