Transcript Parkin-Bade Chapter 25

Ch. 9: Money, the Price Level, and Inflation
9
• 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 =$1
 371.25 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
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 Account
An 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 BANKING
 States 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
Reserves (gold) 100
Total
100
Liabilities
Notes
100
100
Banks would print notes beyond reserves and
extend loans.
Reserves
Loans
Total
100
900
1000
Notes
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 insurance
Incentives 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.
2.
3.
4.
Attracting deposits to make loans possible.
Choosing loan portfolio and balance risk versus return.
Liquidity
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 System
Board 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 nineperson 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 Supply
Bank 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:
How do banks create money?
The balance sheet
Assets
Liabilities
Cash
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.
How do banks create money?
 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
How do banks create money?
The balance sheet
Assets
Liabilities
Cash
90 m.
Demand deposits
90m360
m.
Loans
0270 m
Owner’s equity
5 m.
Plant & equipment
5 m.
Total assets
95m365
m.
Total Liabilities
95m365
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.”
How do banks create money?
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
reserves
buy government securities from member banks
banks 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 securities
Fed 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%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
270 m
Owner’s equity
5 m.
Plant & equipment
5 m.
Total assets
365 m.
Total Liabilities
365 m.
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
25%
25%
25%
25%
1. increase by $10 million.
2. increase by $40 million
3. decrease by $10
million.
4. None of the above.
increase by
$10 million.
increase by
$40 million
decrease by
$10 million.
20
None of the
above.
Assuming banks loan out all excess reserves, if the Fed
purchases $10 million of government securities, M1
will
25%
1.
2.
3.
4.
25%
25%
25%
increase by $10 million.
increase by $40 million
Increase by $30 million.
None of the above.
increase by
$10 million.
increase by
$40 million
Increase by
$30 million.
20
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%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
270 m
Owner’s equity
5 m.
Plant & equipment
5 m.
Total assets
365 m.
Total Liabilities
365 m.
Suppose the Fed reduces the rr to 20% What is the effect on:
Loans
Demand deposits
M1
If the reserve ratio is cut from 25 to
20%, M1 will
1. Not change
2. Increase by $18
million
3. Increase by $90
million
4. None of the above.
25%
Not change
25%
Increase by
$1...
25%
Increase by
$9...
25%
20
None of the
ab...
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 public
The balance sheet
COB=$10m; rr=25%
Assets
Liabilities
Cash
90 m.
Demand deposits
360 m.
Loans
270 m
Owner’s equity
5 m.
Plant & equipment
5 m.
Total assets
365 m.
Total Liabilities
365 m.
Suppose the public withdraws $10m. Of DD as cash. What
is the effect on:
Loans
Demand deposits
M1
M1 would increase if
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
ab
o.
..
de
c..
he
of
t
Al
l
Th
e
pu
b
lic
rc
ha
.
Th
e
Fe
d
pu
in
Fe
d
Th
e
.
..
cr
ea
.. .
25% 25% 25% 25%
20
If banks decide to hold more money as excess reserves,
M1 will ____ and bank loans will ____
in
cr
. ..
25%
De
cr
ea
se
;
...
de
cr
ec
r. .
.
25% 25%
ea
se
;d
In
cr
ea
se
;i
nc
r..
.
25%
De
cr
ea
se
;
Increase; increase
Increase; decrease
Decrease; decrease
Decrease; increase
In
cr
1.
2.
3.
4.
20
Total Bank Reserves: 1980-2009
MONETARY BASE:1983-2009
M1: 1980-2009
EXCESS RESERVES: 1980-2009
The Market for Money
The Demand for Money
relationship 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 Holding
The quantity of money that people plan to hold
depends on four main factors:
 The nominal interest rate
The price level
 Real GDP
 Financial innovation
The demand for money
The 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 money
The 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 money
Financial 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
The Market for Money
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 ____
1. Fall because money
supply increases
2. Rise because money
demand increases
3. Fall because money
demand decrease
4. None of the above
b.
..
.. .
ea
m
No
ne
of
th
us
e
ec
a
lb
Fa
l
be
ca
se
Ri
Fa
l
lb
ec
a
us
e
us
e
m
m
. ..
.. .
25% 25% 25% 25%
20
If the economy enters a recession and real GDP
falls, interest rates will:
1. Fall as money
demand decreases
2. Fall as money supply
increases
3. Rise as money
supply decreases
4. None of the above
ea
th
of
No
ne
m
as
se
Ri
b.
..
on
ey
...
...
on
ey
sm
la
Fa
l
Fa
l
la
sm
on
ey
...
25% 25% 25% 25%
20
If the Fed wants to stimulate spending by cutting
interest rates, it could:
1. Purchase
government bonds
2. Cut the required
reserve ratio
3. Lower the discount
rate
4. All of the above
he
of
t
Al
l
Lo
w
er
t
he
di
ab
o.
..
sc
...
ir.
.
re
qu
th
e
Cu
t
Pu
rc
h
as
e
go
ve
r..
.
.
25% 25% 25% 25%
20
The Market for Money
Long-Run Equilibrium
In 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=velocity
P=price level
Y=real GDP
M=quantity of money
The equation of exchange states that
MV = PY
Expressing 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
The Quantity Theory of Money
Quantity theory of money
In the long run, velocity does not change, so
Inflation rate = Money growth rate  Real GDP
growth
The Quantity Theory of Money
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?
1. Decreased velocity
of money
2. Faster growth of the
money supply
3. Faster growth of
real GDP
4. All of the above
ab
o.
..
...
he
of
t
Al
l
Fa
st
er
g
ro
w
th
...
th
ro
w
Fa
st
er
g
De
cr
ea
se
d
ve
lo
...
25% 25% 25% 25%
20