Transcript Economics R. Glenn Hubbard, Anthony Patrick O`Brien, 2e.

Chapter 13: Money, Banks, and the Federal Reserve System
Today (Tuesday, April 7):
1. Money
1. Nature of money: (fiat vs. commodity money, double coincidence of
wants)
2. Functions of money
3. Measurement of money
2. Banks
1. How banks make money
2. Reserve requirement and money multiplier
3. The Federal Reserve System
1. Monetary policy
2. The quantity theory of money
Money
What Is Money and Why Do We
Need It?
Money Assets that people are generally willing to accept in exchange
for goods and services or for payment of debts.
Asset Anything of value owned by a person or a firm.
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.
The Functions of Money
Medium of Exchange
Money serves as a medium of exchange when sellers are
willing to accept it in exchange for goods or services.
Unit of Account
In a barter system, each good has many prices.
Store of Value
Money allows value to be stored easily: If you do not use all
your accumulated Dinnars to buy goods and services today,
you can hold the rest to use in the future.
Standard of Deferred Payment
Money is useful because it can serve as a standard of
deferred payment in borrowing and lending.
Learning Objective 13.1
What Is Money and Why Do We Need It?
What Can Serve as Money?
Five criteria make a good suitable to use as a medium of exchange:
1 The good must be acceptable to (that is, usable by)
most people.
2 It should be of standardized quality so that any two
units are identical.
3 It should be durable so that value is not lost by
spoilage.
4 It should be valuable relative to its weight so that
amounts large enough to be useful in trade can be
easily transported.
5 The medium of exchange should be divisible because
different goods are valued differently.
Learning Objective 13.1
Making
the
Connection
Money without a Government? The
Strange Case of the Iraqi Dinar
Many Iraqis continued to use currency with Saddam’s picture
on it, even after he was forced from power.
How Is Money Measured Today?
M1: The Narrowest Definition of the Money Supply
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
M2: A Broader Definition of Money
M1 plus savings account balances, small-denomination time
deposits, balances in money market deposit accounts in banks,
and noninstitutional money market fund shares.
What about Credit Cards and Debit Cards?
Many people buy goods and services with credit
cards, yet credit cards are not included in definitions
of the money supply.
2008
M1 = 4856.3 Million KD
M2 = 20393 Million KD
Banks
Reserves Deposits that a bank keeps as cash in its vault or on deposit
with the Central Bank.
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.
FIGURE 13.2
Balance Sheet
for Wachovia
Bank,
December 31,
2006
Learning Objective 13.3
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
Learning Objective 13.3
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
Learning Objective 13.3
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
Learning Objective 13.3
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
Learning Objective 13.3
How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create Money
BANK
Wachovia
INCREASE IN CHECKING ACCOUNT DEPOSITS
$1,000
PNC
+ 900
(= 0.9 x $1,000)
Third Bank
+ 810
(= 0.9 x $900)
Fourth Bank
+ 729
(= 0.9 x $810)
.
+•
.
+•
.
+
Total Change in Checking Account
Deposits
=$10,000
Simple deposit multiplier The ratio of the
amount of deposits created by banks to the
amount of new reserves.
1
Simple deposit multiplier 
RR
Change in checking account deposits  Change in bank reserves x
1
RR
1 Whenever banks gain reserves, they make new loans,
and the money supply expands.
2 Whenever banks lose reserves, they reduce their
loans, and the money supply contracts.
Making
the
The 2001 Bank Panic in Argentina
Connection
Bank run A situation in which many
depositors simultaneously decide to
withdraw money from a bank.
Bank panic A situation in which
many banks experience runs at the
same time.
The Argentine central bank was
unable to stop the bank panic of
2001.
The Federal Reserve
System
Monetary policy The actions the Central Bank takes to
manage the money supply
Open Market Operations
Open Market Committee (OMC) The CB committee responsible for
open market operations and managing the money supply in the
country.
Open market operations The buying and selling of Treasury
securities by the CB in order to control the money supply.
Discount Policy
Discount loans Loans the CB makes to banks.
Discount rate The interest rate the CB charges on discount
loans.
Reserve Requirements
When the CB reduces the required reserve ratio, it converts
required reserves into excess reserves.
Learning Objective 13.5
The Quantity Theory of Money
Connecting Money and Prices: The Quantity Equation
In the early twentieth century, Irving Fisher, an
economist at Yale, formalized the connection
between money and prices using the quantity
equation:
M×V=P×Y
Learning Objective 13.5
The Quantity Theory of Money
Connecting Money and Prices: The Quantity Equation
Velocity of money The average number of times each
dollar in the money supply is used to purchase goods and
services included in GDP.
P xY
V
M
Quantity theory of money A theory of the connection
between money and prices that assumes that the velocity
of money is constant.
Learning Objective 13.5
The Quantity Theory of Money
The Quantity Theory Explanation of Inflation
We can transform the quantity equation from:
M xV  P x Y
to
Growth rate of the money supply + Growth rate of velocity
= Growth rate of the price level (or inflation rate) + Growth
rate of real output
Learning Objective 13.5
The Quantity Theory of Money
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:
Inflation rate = Growth rate of the money supply +
Growth rate of velocity − Growth rate of real output
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 real output
Learning Objective 13.5
The Quantity Theory of Money
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.
Learning Objective 13.5
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.
Making
the
Connection
The German Hyperinflation
of the Early 1920s
During the hyperinflation of the
1920s, people in Germany used
paper currency to light their stoves.
Recall, there are many policies that can applied to change
a GDP gap or to generally change the real GDP and the
price level. One of these policies is the Fiscal Policy. The
other policy is monetary policy.
Monetary policy: policy by the central Bank to adjust and
control the quantity of money in circulation (money
supply) through different tools to influence GDP growth,
the general price level and other macroeconomics
variables.
To understand the operation of the monetary policy, we need
to understand the definition and function of money,
commercial banks, and the central bank.
To understand the operation of the monetary policy, we need
to understand the definition and function of money,
commercial banks, and the central bank.
First: Money
FEDERAL RESERVE NOTE
THE
THE UNITED
UNITED STATES
STATES OF
OF AMERICA
AMERICA
THIS NOTE IS LEGAL TENDER
L70744629F
FOR ALL DEBTS, PUBLIC AND PRIVATE
12
WASHINGTON, D.C.
12
A
Q: What is money ?
H 293
L70744629F
12
SERIES
1985
ONE DOLLAR
Money: anything that is generally accepted as a means of
payment (in the exchange of goods & services)
12
Functions of Money:
1- Medium of exchange
2- Unit of account
3- Store of value
4- Standard of deferred payment
Q: What is meant by quantity of money (money supply)?
And how to measure it ?
(1) Narrow definition: financial assets that are the most
liquid :
M1 = currency in circulation (coins & papers in the hands
of the public ) +
Demand deposits (+ traveler's checks)
(2) Broad definition:
M2 = M1 + Saving and time deposits (in commercial
banks
(3) Broad definition:
M3 = M2 + time deposits in other financial institutions
Note: part of the quantity of money is held by commercial
banks as demand and time deposits.
In Kuwait (2000):
M1: KD
M2: KD
M3: KD
1467.7 m
6695.5 m
8175.2 m
Second: Commercial Banks
Functions of Commercial Banks
1- Accepting deposits
2- Lending money
3- Other banking services
4- Money creation
Required reserve ratio
Required reserve ratio (RRR): percentage of deposits that is
required by the central bank to keep as reserves.
Example: if RRR=10% , of an initial deposit = KD100
Required reserves = 100 * 10% =10 ( ‫) االحتياطى القانوني‬
Excess reserves = 100 -10 = 90 ( ‫) االحتياطى الفائض‬
Note: If the bank was able to lend KD 60 of its excess
reserves, what is the total reserve this bank has ?
Total Reserve = Required reserves + Excess reserves
= 10 + 30 = 40
Money Creation
Money creation is based on the process of deposits &
loans and the RRR. To explain this process we assume:
1- All Commercial Banks will apply the RRR
2- All banks will lend their excess reserves
3- No currency leakage out of the banking system
Example: RRR= 10% , an initial deposit = KD 100
Bank
Deposits
Required
Reserves
Excess Reserve
A
100
10
90
B
90
9
81
C
81
8.1
72.9
D
72.9
7.29
65.61
E
65.61
6.56
59.05
1000
100
900
The multiplier: maximum possible change in total deposits
out of any new deposit created by a multi-bank system.
Money Multiplier (Deposit expansion multiplier):
Mm
=
1
RRR
Potential money creation = initial deposit
x
Mm
Q: What will happen to the effect Mm
when :
A: there is a leakage (money drain) from the
banking system?
B: Banks were not able to lend all their excess
reserves?
C: Banks fail to apply the RRR?
Example1:
IF RRR= 20%, and an initial deposit = KD 7000
was deposited at Alnoor Bank. What is the maximum
Value of loans can this bank lend ? What is the
maximum value of loans can the banking system create
out of this deposit ?
Answer :
Alnoor
Deposits
Required
Reserves
Excess Reserve
7000
1400
5600
Since Mm = 1/20% = 5
Total loans (by the banking system) = 5600 x 5 = 28000
Example2:
IF RRR= 10%, and a commercial bank has deposits =
KD 50,000 and total reserves = KD 7000
What is the value of excess reserves this bank has ?
Answer :
Required reserves = deposit x RRR
= 50,000 x (10/100) = 5000
Excess reserves = Total reserves - Required reserves
= 7000 – 5000 = 2000
Third: Central Bank
Functions of the Central Bank
1- Issuing the national currency
2- Banker’s Bank (maintain cash deposits ,
reserves, transferring funds and checks between
banks, imposes regulations on banks, lender of
last resort).
3- Government bank (handling payroll
accounts, financial consultant & representative)
4- Implementing monetary policy (through
monitoring and controlling money supply)
Tools of Monetary Policy
1- Discount rate: the interest rate
that the central bank charges the commercial
banks.
2- Required reserve ratio.
3- Open market operation: the purchase and sale
of government securities (bonds) by the central
bank
Note: To understand how these tools can affect macro economic
activities, we first view the impact of changes in money
supply.
Factors affecting demand for money:
Factors affecting investment and consumption expenditure
such as: income, interest rate, expectation ..etc.
Factors affecting supply of money:
Factors affecting saving decisions and central bank policy
such as: income, interest rate, macroeconomic conditions
Now assuming all factors constant except interest rate,
then money demand is inversely related to interest rate,
while money supply is positively related to interest rate
i
Ms
i
Md
q
Qm
i
Ms
Ms2
i
i2
Md
q
q2
Qm
If the central bank increases the money supply
lower
interest rate
stimulate consumption and investment
expenditure , i.e increases AE (other things equal)
Note: This is an expansionary monetary policy that can be
applied to increase AE (e.g in case of a deflationary gap)
Ms2
Ms
i
i2
i
Md
q2 q
Qm
If the central bank reduces the money supply
raise
interest rate
reduced consumption and
investment expenditure , i.e reduce AE (other things equal)
Note: This is a contractionary monetary policy that can be
applied to reduce AE (e.g in case of an inflationary gap)
First: If an economy is facing a deflationary gap, the
central bank can increase money supply, i.e applying
an expansionary monetary policy
An expansionary monetary policy tools:
1- Reducing discount rate :
reduce interest
rate
stimulate consumption & investment
expenditure
increase AE
An expansionary monetary policy tools:
2- Reducing RRR :
increase money
supply
lower interest rate
stimulate
consumption & investment expenditure
increase AE
3- Buying government securities :
increase
money supply
lower interest rate
stimulate consumption & investment
expenditure
increase AE
Second: If an economy is facing an inflationary gap, the
central bank can reduce money supply, i.e applying a
contractionary monetary policy
a contractionary monetary policy tools:
1- increasing the discount rate :
increase
interest rate
lower consumption &
investment expenditure
lower AE
A contractionary monetary policy tools:
2- Raising RRR :
reduce money supply
raise interest rate
reduce consumption &
investment expenditure
reduce AE
3- Selling government securities :
lower
money supply
raise interest rate
reduce consumption & investment expenditure
reduce AE
Possible obstacles to effective fiscal & monetary policies:
1- Possible time lags in policy implementation
(more for fiscal policy)
2- Possible crowding out effect (as the
government borrows to finance the deficit,
interest rates increases and crowds out
investment expenditure
3- Possible fiscal & monetary coordination
problems
4- Lack of full control over some domestic and
international economic variables. (e.g lack of
control over international money movement,
investors & consumers expectations, social &
political changes)
5- Limitations of accurate economic
forecasting of dynamic economic variables.
Q: What policies should be applied in case of stagflation?