b6e99310b5c796a5559dc6e9d732555b_EC103 Week 07 and 08 S14.ppt

8/9/2019 b6e99310b5c796a5559dc6e9d732555b_EC103 Week 07 and 08 S14.ppt

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On to: Money and

Banking

Imagine the inefficiency of barter, and youllsee that the invention of moneyranks withthe invention of the wheel, productivity-wise But changes in the amount of money in

circulation will not enhance our productivity orwealth in the long run

1


2/31

Whats Money? Define it by its 4 functions. Its what serves as

. !medium of exchange" ! good we use to make iteasier to trade othergoods.Avoids the inefficiency of barter.

#. ! unit of account" $corekeeping device used to

post prices and keep track of revenues and costs.Imagine making intelligent choices about consuming and

investing without it.

%. ! store of value" !n asset that allows people to holdonto purchasing power to use in future periods.

4. ! standard of deferred value" &acilitates borrowingand lendingImagine saving for retirement or buying on credit without it


3/31

How do we choose what to use as money?

'oday (and often historically), the good

we use as money has no intrinsicworth. *ere not on, e.g., a +gold standard, but

rather a +confidence standard. oney has value because it serves

the % aforementioned functions and

because we think it does wedemand it because others demand it,which depends partly on its supplybeing limited(or +inelastic).

If people lose confidence in thegeneral acceptability in e/change ofa particular good (e.g., +rubles),theyll use another (e.g., +dollars) asmoney.

Desirable characteristics" portable,durable, divisible, easily recogni0able


4/31

The Supply of Money

'wo basic measurements of the

money supply are M1and M2" 'he components of M11

2urrency 2hecking deposits

(including demand deposits andinterest-earning checking deposits) 'raveler3s checks (so trivial 56 ignore)

M2(a broader measure of money)= M1, plus

$avings deposits, 'ime deposits, and, oney market funds.


5/31

Updating Fig. 14.1

5

7o to"&ederal 8eserve oney $tock easures
http://www.federalreserve.gov/releases/h6/current/h6.htmhttp://www.federalreserve.gov/releases/h6/current/h6.htm


6/31

What about credit cards? 'heyre commonly used in

e/change, so arent they+money9 :ope" oney is an asset. 2redit cards are merely

convenient ways to arrange

loans. 2redit card balances are a

liability. ;ut while credit card limits

are not money, the readyavailability of such loanbalances has had an effecton money demand!"aboutwhich we will say more later.


7/31

'he banking industry includes various kinds of

+intermediaries between suppliers of loanable funds(savers) and demanders of loanable funds (borrowers).


8/31

Fractional reserve banking, 200

Assets

Vault cashReserves at the FedLoans outstandingU.S. government securitiesOther securitiesOther assets

Total

Checking depositsSavings and time depositsBorroingsOther lia!ilities"et orth

Consolidated Balance Sheet o# Commercial Banking $nstitutions

%ear&end '(()(billions of $)Lia!ilities

* 287

)+(,,-+-,

-+('/-+0,

* +/01

* 4995,811-+1

)'1,2-

* +/01

;anks held a tiny portion of their liabilities to their depositors(?.@@A,or B%@bCB%?b) as reserves(either as cash or deposits with the

%ed)to meet their daily obligations toward those depositors.


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10/31


11/31

Reserves 1 Deposits that a bank keeps as cash in its vault or on deposit withthe &ederal 8eserve.

Required reserves =8eserves that a bank is legally reJuired to hold, based onits checking account deposits.

Required reserve ratio1 'he minimum fraction of deposits banks are reJuiredby law to keep as reserves.

Excess reserves1 8eserves that banks hold over and above the legalreJuirement.

8eserves are not loaned out or invested.

Vault cashis physically kept within the bank.

;anks make consumer loansto households and commercial loanstobusinesses.! loan is an asset to a bank because it represents a promise by the persontaking it out to make certain specified payments to the bank.Deposits include checking accounts, savings accounts, and certificates ofdeposit,

and are liabilities to banks because they are owed to the households or firmsthat have deposited the funds.

*e can abbreviate the reJuired reserve ratio as .


12/31

12

Thanks to fractional reservebanking syste", banks can

#create "oney$

$uppose you go to your ;ank ! and deposit B,??? in cash. 6n !s balance sheet, liabilities to depositors (like you) rise by B,???, but

!s assetsKhere, vault cashKrise by the same amount.

If the reuired reserve ratiois, say, ?A, then ;ank ! must hold only B??of this new cash as reserves.

!ank " can loan out #$%%. !nd that loan, once spent, might be depositedin another bank, creating new reserves that can, in turn, be loaned out tosomeone else. !nd on, and on


13/31

$uppose the person who took out the BF?? loan buys a used car car for e/actlyBF?? and pays by writing a check on his account at ;ank of !merica.

'he seller of the used car then deposits the check in her account at a branch ofL:2 ;ank.

L:2 ;ank will send it to ;ank of !merica to clearthe check and collect the BF??.

*e show the result in the following '-accounts"


14/31

L:2 has an incentive to keep BF? as reserves and to loan out its e/cessreserves of BH?.

If L:2 does this, we can show the change in its balance sheet by using another

'-account"

'he initial deposit of B,??? in currency into ;ank of !merica has now resulted inthe creation of B,??? M BF?? M BH? 1 B#,G? in checking account deposits.

'he money supply has increased by B#,G? N B,??? 1 B,G?.


15/31

Bank Increase In Ceckin! "ccount #e$osits

;ank of !merica B,???

L:2 M F?? (1 ?.F O B,???)

'hird ;ank M H? (1 ?.F O BF??)

&ourth ;ank M G#F (1 ?.F O BH?)

% M %

% M%

% M %

'otal change in checking account deposits 1 B?,???

If whoever receives the BH? deposits it in another bank, that new bank will sendthe check to L:2 and will receive BH? in new reserves with an incentive to loanout F? percent of these reservesKkeeping ? percent to meet the legalreJuirementKand the process will go on.

!t each stage, the additional loans being made and the additional deposits beingcreated are shrinking by ? percent, as each bank has to withhold that amount asreJuired reserves.

*e can use a table to show the total increase in checking account deposits set offby your initial deposit of B,???"

'he dots in the table represent additional rounds in the money creation process.


16/31


17/31

1&

Money creation by banks:What you shoud be abe to do >nderstand the reuired reserve ratio &''() the fraction of

deposit liabilities banks are reJuired to hold as reserves :ote" It varies by type of deposit (e.g., higher for demand deposits than

for time deposits)

>se ''to calculate banks reuired reserves

:ote" banks actual reserves1 vault cash M &.8. deposits, though 56typically dont show these components on their '-accounts

>nderstand how to calculate banks excess reserves" actualreserves minus reJuired reserves

>nderstand how to calculate ma/imum amount by which newreserves will change the money supply, i.e., P 1 (Cr) / (initialnew reserves)

&ee, e'!', ()* $' 486, +'10 and +'11


18/31

'ho controls "oney creation("he Fed# using $ monetarypoicy toos. 6pen arket

6perations

#. Discount (rate)policy

%. 8eserve

reJuirements

1)


19/31

The Fe*+s "ost freuently use* tool &1( +pen Market +perations"

the buying and selling of >.$. securitiesQ(national debt in the form of bonds)by the &ed. ,ed buys bondsthe money supply e/pands"

bond buyers acJuire money

bank reserves increase, placing banksin a position to e/pand the money supply through thee/tension of additional loans.

,ed sells bondsthe money supply contracts" bond buyers give up money for securities bank reserves decline, causing them to e/tend fewer

loans.

Q!nd, in this recession, &ed has traded non-govt instrumentssuch as mortgage-backed securities (banks +to/ic assets)


20/31

T-o key interest rates set by the Fe* itself

&2a( -iscount 'ate" the interest rate the &edcharges member banks when it makes loans +atthe discount window !n increase in the discount ratedecreases the

money supply because it discourages banks fromborrowing from the &ed to e/tend new loans.

! reduction in the discount rateincreases themoney supply because it makes borrowing from

the &ed less costly and encourages bank lending And a new #erm Auction %acility" (#A%) now

supplements the old discount window"


21/31

...and too %b &not mentioned

by H'() 2all it the +e/cess reserves rate 'he interest rate the &ed pays banks on the

reserves those banks hold in e/cess of thosereJuired If &ed raises this rate, banks will have an incentive to

hold more e/cess reserves and make less loans, whichwill reduce monetary growth

6r if &ed cuts this rate, banks will have an incentive to

hold less e/cess reserves and make more loans, whichwill increase monetary growth

21


22/31


23/31

2.

/si*e: The #Fe* Fun*s$"arket 'o meet reserve reJs, banks often borrow from each otherK

sometimes Rust overnight S in the +&ed &unds market, at an interestrate called the +&ed &unds 8ate

&ed doesnt fi/ this rate like it does the Discount 8ate, but influencesit via 6pen arket 6perations and announces a target &&8, which isclosely watched as an indicator of the &eds overall approach tomonetary policy


24/31

/he ,ederal 'eserve" Does not issuebondsKRust trades them.

Determines the money supply K primarily throughits buying and selling of bonds issued by the 0../reasury.

ote: The S Treasury 3ept 4 the Fe*

/he 0.. /reasury" Is concerned with financing the operations of the

federal government. Issues bonds to the general public to finance the

budget deficits of the federal government. Does notdetermine the money supply.


25/31

The changing nature of "oney

8ecent innovations changed the nature of moneyand reduced the reliability of money growth figuresas an indicator of monetary policy. FH?s" Introduction of interest-earning checking

accountsreduced the opportunity cost of holding

checking deposits and changed the nature of the *+money supply.

FF?s" any depositors shifted funds from interest-earning checking accounts to money market mutualfunds. ;ecause money market mutual fundsare notincluded in *+!this also reduced the comparability of the*+figures across time periods.


26/31

The changing nature of "oney cont6 'hree additional complications"

Widespread use of the dollar abroad" !t least one-halfandperhaps as much as two-thirdsof >.$. dollar currency is heldabroad, and these holdings appear to be increasing. 'hesedollars are included in the money supply even though theyare not circulating in the >.$.

ncreasing availability of low3fee stock and bond mutualfunds" ;ecause stock and bond mutual funds are not included inanyof the money aggregates, movement of funds from various and # components into these mutual funds will distort boththe and # figures.

-ebit cards and electronic money" Increased use of debit

cards and various forms of electronic money reduces thedemand for currency. =ike other changes in the nature of money,these innovations will reduce the reliability of the money supplyfigures as an indicator of monetary policy.

"lso note ma4or changes in ,ed balance sheet during crisis


27/31

=* *M V P Y

Mone3

Velocit3 Price

Y= $ncome4Output

6n to" the 5uantity 6uation"

If Vis constant (or +stable), then an increasein Mmust lead to a proportional increase in

789, or nominal 7DL. Tey issue" how will effect be divided between

L and U9


28/31

7hanging the #8uantity 9uation$ intothe #8uantity Theoryof Money$

In =8, changes in U result only from thingsthat can shift =8!$Kwhich does not includemere monetary e/pansion. $o" In the long run, the primary impact of -.

will be onprices rather than on real output. *hen Mleads to rising prices, decision makers

eventually anticipate the higher inflation rate andbuild it into their choices.

!s this happens, money interest rates, wages, andincomes will reflect the e/pectation of inflation, andreal interest rates, wages, and output will return totheir long-run normal levels.


29/31

:ote"

#he money supply data are theactual growth rate of the moneysupply minus the growth rate ofreal ,.

8ate of money supply growth (/! log scale)

nternational

9vi*enceoncorrelatio

n of"oneygro-th toin;ation,1*+, -

%,

8ateofinflation(/!

logscale)

?? ,??? ?

?

??

???

;ra0il:icaragua

2ongo, D8

7hana

$ierra =eone

Eene0uelae/ico

:igeria2hileIndonesia

ungary

2olumbiaLaraguay

India

$wit0erland

Vapan

2entral !frica 8epublic

$outh Torea;elgium

>nited $tates

'h 7 i fl ti f th < l F#? ki


30/31

uring the hyperinflation of the+012s! people in ,ermany used

paper currency to light theirstoves.

In the peace treaty of FF, the !lliesKthe >nited $tates, 7reat ;ritain, &rance, and ItalyK

imposed payments called reparationson the new7erman government, known as the *eimar 8epublic,to compensate them for the damage 7ermany hadcaused during *orld *ar I.

7ermany financed its reparations payments and otherfundraising efforts by an inflationary monetary policy"

Its government sold bonds to the central bank, the8eichsbank, thereby increasing the money supply.

'he markKthe 7erman currencyKbecame worthlessafter its total number in circulation rose from @ millionto .% billion to 4FG billion billionin two years time,resulting in a hyperinflation Rust as predicted by theJuantity theory.

'he 7erman government took steps to end thehyperinflation, including introducing a new mark worth trillion old marks,which many 7ermans resented a decade later, itler and the :a0is sei0ed power.

'he 7erman yperinflation of the


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