Transcript money supply

CHAPTER 4
The Monetary System: What It Is and How It Works
A PowerPointTutorial
To Accompany
MACROECONOMICS, 8th Edition
N. Gregory Mankiw
Tutorial written by:
Mannig J. Simidian
B.A. in Economics with Distinction, Duke University
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M.P.A., Harvard University Kennedy School of Government
M.B.A., Massachusetts Institute of Technology (MIT) Sloan School of Management
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Money
Stock of assets
Used for transactions
A type of wealth
As a medium of exchange, money is used to buy goods and
services. The ease at which an asset can be converted into a
medium of exchange and used to buy other things is sometimes
called an asset’s liquidity. Money is the economy’s most liquid
asset.
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Inflation is an increase in the average level of prices, and a price
is the rate at which money is exchanged for a good or service.
Here is a great illustration of the power of inflation:
In 1970, the New York Times cost 15 cents, the median price of a
single-family home was $23,400, and the average wage in
manufacturing was $3.36 per hour. In 2008, the Times cost
$1.50, the price of a home was $183,300, and the average wage
was $19.85 per hour.
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It serves as a store of value, unit of account, and a medium of
exchange. The ease with which money is converted into other things
such as goods and services--is sometimes called money’s liquidity.
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Money is the yardstick with which we measure
economic transactions. Without it, we would be
forced to barter. However, barter requires the
double coincidence of wants—the unlikely
situation of two people, each having a good that
the other wants at the right time and place to make
an exchange.
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Fiat money is money by declaration.
It has no intrinsic value.
Commodity money is money that
has intrinsic value.
When people use gold as money, the
economy is said to be on a gold standard.
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The government may get involved in
the monetary system to help people
reduce transaction costs. Using gold as
a currency is costly because the purity
and weight has to be verified. Also,
coins are more widely recognized than
gold bullion.
The government then accepts gold from the public
in exchange for gold-certificates— pieces of paper
that can be redeemed for actual gold. If people trust
that the government will give them the gold upon
request, then the currency will be just as valuable as
the gold itself—plus, it is easier to carry around the
paper than the gold. The end result is that because
no one redeems the gold anymore and everyone
accepts the paper, they will have value and serve as
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money.
The money supply is the quantity of money available in an economy.
The control over the money supply is called monetary policy.
In the United States, monetary policy is conducted in a partially
independent institution called the central bank. The central bank in the
U.S. is called the Federal Reserve, or the Fed.
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To expand the money supply:
The Federal Reserve buys U.S. Treasury Bonds
and pays for them with new money.
To reduce the money supply:
The Federal Reserve sells U.S. Treasury Bonds
and receives the existing dollars and then destroys
them.
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The Federal Reserve controls
the money supply in 3 ways:
Conducting Open Market Operations
(buying and selling U.S. Treasury bonds).
Changing the Reserve requirements
(never really used).
Changing the Discount rate which
member banks (not meeting the reserve
requirements) pay to borrow from the
Fed.
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How the Quantity of Money is Measured ?
Currency
(C)
Cash
Demand
Deposits
(M1)
M1 + plus money
market mutual
fund balances,
savings deposits,
and small time
deposits
(M2)
Checking accounts
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M=C+D
Money Supply
Currency
Demand Deposits
In this chapter, we’ll see that the money supply is determined not onl
by the Federal Reserve, but also by the behavior of households
(which hold money) and banks (where money is held).
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The deposits that banks have received but have not lent out are
called reserves. Consider the case where all deposits are held as
reserves: banks accept deposits, place the money in reserve, and
leave the money there until the depositor makes a withdrawal or
writes a check against the balance.
In a 100-percent-reserve banking system, all deposits are held in reserve; thus
the banking system does not affect the supply of money.
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A Sample 100-Percent-Reserve Bank Balance Sheet
Assets
Liabilities
Reserves
Deposits
$1,000
$1,000
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Assume each bank maintains a reserve-deposit ratio (rr) of 20 percent and that the initial deposit
is $1,000.
Firstbank
Balance Sheet
Assets
Liabilities
Secondbank
Balance Sheet
Assets
Liabilities
Reserves $200 Deposits $1,000 Reserves $160 Deposits $800
Loans $800
Loans $640
Thirdbank
Balance Sheet
Assets
Liabilities
Reserves $128 Deposits $640
Loans $512
Mathematically, the amount of money the original $1000 deposit creates is:
Original Deposit
=$1,000
process of transferring funds
Firstbank Lending
= (1- rr) The
$1,000
Secondbank Lending
= (1- rr)2  $1,000 from savers to borrowers is called
Thirdbank Lending
= (1- rr)3 
$1,000
financial
intermediation.
Fourthbank Lending
=. (1- rr)4  $1,000
..
Total Money Supply
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= [1 + (1-rr) + (1-rr)2 + (1-rr)3 + …]  $,1000
= (1/rr)  $1,000
Money and Liquidity Creation
= (1/.2)  $1,000
(but not wealth creation)
= $5,000
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Money
Store of value
Unit of account
Medium of exchange
Fiat money
Commodity money
Gold Standard
Money supply
Monetary policy
Central bank
Federal Reserve
Open-market
operations
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Currency
Demand deposits
Reserves
100-percent-reserve
banking
Balance sheet
Fractional-reserve
banking
Financial intermediation
Bank capital
Leverage
Capital requirement
Monetary base
Reserve-deposit ratio
Currency-deposit
ratio
Money multiplier
High-powered
money
Discount rate
Reserve requirements
Excess reserves
Interest on reserves
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