Transcript The Monetary System

The Monetary System
EQ: What is money?
Class Auction
• Want to have this piece of candy?
• What are you willing to trade for it?
• What is required for this trade (barter) to
work?
• What is the solution for this “double
coincidence of wants?”
With a partner, answer this question What is money?
What is Money?
Money is the set of assets in an
economy that people regularly use to
buy goods and services from other
people.
Types of Money
Commodity Money
Fiat Money
What type of money does the U.S.
use?
Functions of Money
• Medium of Exchange
Functions of Money
• Standard of Value
Functions of Money
• Store of Value
Summary
• Draw the 3 functions of money – do not label
each function
• Then with a partner, switch papers and each
partner tries to identify each picture
Characteristics of
Money
It is important that money is ___________
because………………………
Portable
Durable
Divisible
Limited
Liquidity
• Liquidity is the ease with which an asset can
be converted into the economy’s medium of
exchange.
What is the most
liquid asset?
What are some less
liquid assets?
Money in the U.S. Economy
• Currency is the paper bills and coins in the
hands of the public.
• Demand deposits are balances in bank
accounts that depositors can access on
demand by writing a check.
Figure 1 Two Measures of the
Money Stock for the U.S. Economy
Billions
of Dollars
M2
$6,398
•Savings deposits
•Small time deposits
•Money market
mutual funds
•A few minor categories
($5,035 billion)
$1,363
0
M1
•Demand deposits
•Traveler ’s checks
•Other checkable deposits
($664 billion)
•Currency
($699 billion)
•Everything in M1
($1,363 billion)
CASE STUDY: Where Is All The
Currency?
• In 2004 there was $699 billion of U.S. currency
outstanding.
– That is $3,134 in currency per adult.
• Who is holding all this currency?
– Currency held abroad
– Currency held by illegal entities
Review Video
What agency has authority to print
currency in the U.S.?
The Federal Reserve System
• The Federal Reserve (Fed) serves as the
nation’s central bank – created 1913.
– It is designed to oversee the banking system.
– It regulates the quantity of money in the economy
(monetary policy).
– It is the lender of last resort.
The FED
• Privately Owned- banks buy stock in the Fed like a
corporation
• Board of Governors- 7 member board appointed by the
Fed. Set policies for the Fed
• Federal Reserve District Banks- Nation is divided into 12
districts. Each district bank runs a district and has a
president and board of directors
FED Chairman
Monetary Policy Tools
1. Federal Open Market Operations Committee
(FOMC)
2. Reserve Requirement
3. Discount Rate/Federal Funds Rate
*******FOMC******
• To increase the money supply, the Fed buys
government bonds from the public.
• To decrease the money supply, the Fed sells
government bonds to the public.
• The Fed uses OMO to control the Fed Funds
rate (the rate banks charge each other for over
night lending)
What does an increase in the money
supply do to the nominal interest rate
and price levels? Decrease?
Reserve Requirement
• Reserves are deposits that banks have
received but have not loaned out.
• In a fractional-reserve banking system, banks
hold a fraction of the money deposited as
reserves and lend out the rest.
• The reserve ratio is the fraction of deposits
that banks hold as reserves.
What is the risk with this type of
banking?
Banking Money Creation with
Fractional-Reserve
This T-Account shows
a bank that…
– accepts deposits,
– keeps a portion
as reserves,
– and lends out
the rest.
It assumes a
reserve ratio
of 10%.
First National Bank
Assets
Liabilities
Owes
Owns
Reserves
$10.00
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
Total Liabilities
$100.00
T Accounts – assume 1/5 rr
1.
2.
3.
4.
5.
$1000 deposit into
checking
Bank issues $5000 in
loans
FED buys $1000 worth
of govt securities
FED sells $1000 worth
of govt securities
What is the money
multiplier?
Assets
$2000 Required
Reserves
$6000 Excess
Reserves
$2000 Securities
Liabilities
$10000 Deposits
Money Creation… out of thin air…
Increase in the Money Supply = $190.00!
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
Second National Bank
Assets
Reserves
$9.00
Liabilities
Deposits
$90.00
Loans
$90.00
Total Assets
$100.00
$81.00
Total Liabilities
$100.00
Total Assets
$90.00
Total Liabilities
$90.00
The Money Multiplier
Original deposit = $100.00
• 1st Natl. Lending = 90.00 (=.9 x $100.00)
• 2nd Natl. Lending = 81.00 (=.9 x $ 90.00)
• 3rd Natl. Lending = 72.90 (=.9 x $ 81.00)
• … and on until there are just pennies left to
lend!
• Total money created by this $100.00 deposit is
$1000.00. (= 1/.1 x $100.00)
The Money Multiplier
• The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R
• Example:
– With a reserve requirement, R = 20% or .2:
– The money multiplier is 1/.2 = 5.
1 – 5 on L4/A38 wksht
The Fed and the Reserve
Requirement
• What does changing the reserve requirement
from 10% to 20% do the money supply?
Nominal interest rates? Show me the new
multiplier.
• What does decreasing the reserve
requirement do to the money supply?
Nominal interest rates? Show me the new
multiplier.
The Discount Rate (no longer used)
• 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.
Discount rate now set higher than FFR… why does
this make the discount rate obsolete?
FED REVIEW
• http://www.youtube.com/watch?v=HdZnOQp
4SmU
6-12 on L4/A38 wksht
finish remainder for HW
11/10 Warm up
• A-F on worksheet
Warm-up
• Scenario – high unemployment and low
growth (show this on ASAD graph)
1.
2.
3.
4.
Action by FED – loose or tight?
OMO – Buy or sell bonds? Why?
What happens to money supply (graph)? Why?
What happens to nominal interest (same
graph)? Why?
5. What happens to investment? Why?
6. What happens to aggregate demand? Why?
EQ: How do interest rates affect
the macroeconomy?
Watch the video to complete the
chart
Demand
Deposit
RR
$20000
5%
$20000
10%
$20000
15%
Money
Multiplier
Excess
Reserves
available for
loans
What is the
max money
created(not
including
original
deposit)?
Review Video – Creating Money
Watch the video to complete the
chart
Demand
Deposit
RR
$20000
5%
$20000
10%
$20000
15%
Money
Multiplier
Excess
Reserves
available for
loans
What is the
max money
created(not
including
original
deposit)?
What are some potential problems
with controlling the money supply?
• The Fed’s control of the money supply is not
precise.
• The Fed must wrestle with two problems that
arise due to fractional-reserve banking.
– The Fed does not control the amount of money
that households choose to hold as deposits in
banks.
– The Fed does not control the amount of money
that bankers choose to lend.
Monetary policy in action
Easy/Expansionary
Policy
RR _____
DR _____
OMO – Buy or Sell
FF Target _____
MS _____
Excess Reserves _____
Nom interest rate _____
I_____
AD ______
Tight/Contractionary
Policy
RR _____
DR _____
OMO – Buy or Sell
FF Target _____
MS _____
Excess Reserves _____
Nominal interest rate_____
I_____
AD ______
Monetary policy in action
Easy Money
↓ RR= Banks can loan
more $
Fed Buys OMO’s = bank
have more $ fewer bonds
↓Discount Rate= Fed
lowers cost of borrowing*
↓Federal Funds Rate
Target = Fed lowers cost of
bank borrowing and
lending – done by OMO
Tight Money
↑RR = Banks have less $ to
loan out.
Fed Sells OMO’s = banks
have less $ and more
Bonds
↑Discount Rate = Fed
lowers cost of borrowing*
↑Federal Funds Rate
Target = Fed increases the
cost of bank borrowing and
lending – done by OMO
So…. How do monetary policies
affect macroeconomic goals?
Whiteboards
MONETARY POLICY
SOLUTION GRAPH A
Three L’s and Win:
Draw and AD/AS
graph starting
with a
Draw a money market What happens to recessionary gap.
graph showing
investment given What curve will
expansionary
OMO buy monetary
,
r  I in ,
I
 MS  r the
 ADWhat
PL (P -P
)
shift?
will
change
rGDP (Y -Y )
(the decrease in r leads to an
policy.
A
UE to
(Y -FE)
happen
increase
in the quantity
of interest
interest
rates?
E (Y -FE)
sensitive investment demanded)
discount rate  MS  r
,
r  I
,
I employment,
 AD PL (P -P )
rGDP (Y -Y )
(the decrease in r leads to an
1 B
output,
UEand
(Y -FE)
increase in the quantity of interest
sensitive investment demanded)
E (Y -FE)
prices?
RR  MS  r
,
r  I
,
I  AD PL (P -P )
1
2
1
*
1
1
1
2
1
*
1
1
1
C
(the decrease in r leads to an
increase in the quantity of interest
sensitive investment demanded)
2
rGDP (Y1-Y*)
UE (Y1-FE)
E (Y1-FE)
MONETARY POLICY
SOLUTION GRAPH C
2
A
Draw a money
market graph
showing
OMO
sale  MS 
contractionary
monetary policy.
r
discount rate  MS  r
Draw and AD/AS
graph starting
with a inflationary
What happens to
gap. What curve
investment given
shift?
,
r  I
,
Iwill
 AD
PL What
(P -P )
the
change
in
rGDP (Yto
-Y )
(the increase in r leads to a
will
happen
UE (Y -FE)
decrease
in the quantity
of interest
interest
rates?
sensitive investment demanded)
E (Y -FE)
employment,
,
r  I
,
I  AD PL (P -P )
output,
and
rGDP
(Y -Y )
(the increase in r leads to a
UE (Y -FE)
decrease in the quantity of interest
prices?
sensitive investment demanded)
E (Y -FE)
1
2
1
1
1
1
2
1
B
*
*
1
RR  MS  r
C
,
r  I
1
,
(the increase in r leads to a
decrease in the quantity of interest
sensitive investment demanded)
I  AD PL (P1-P2)
rGDP (Y1-Y*)
UE (Y1-FE)
E (Y1-FE)
Review Video
• http://www.frbsf.org/education/activities/chai
rman/
So…. How do monetary policies
affect macroeconomic goals?