Money Pres

7/23/2019 Money Pres

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© 2011 South-Western, a part of Cengage Learning, all rights reserved

C H A P T ER

2011update

The Monetary System

EconomicsP R I N C I P L E S O F

N. Gregory

Mankiw

Premium PowerPoint Slidesby Ron Cronovich

29



In this chapter,

look for the answers to these

questions: What assets are considered “money”? What are

the functions of money? The types of money?

What is the Federal Reserve?

What role do bans play in the monetary system?!ow do bans “create money”?

!ow does the Federal Reserve control the moneysupply?

2



THE MONETARY SYSTEM "

What Money Is and Why It’sImportant Without money# trade would re$uire barter #

the e%chan&e of one &ood or service for another'

(very transaction would re$uire a double

coincidence of wants ) the unliely occurrence

that two people each have a &ood the other wants' *ost people would have to spend time searchin& for

others to trade with ) a hu&e waste of resources'

This searchin& is unnecessary with money#the set of assets that people re&ularly use to buy&+s from other people'



THE MONETARY SYSTEM ,

The 3 Functions of Money

Medium of exchange- an item buyers &ive to

sellers when they want to purchase &+s

Unit of account- the yardstic people use topost prices and record debts

Store of value- an item people can use totransfer purchasin& power from the present tothe future



THE MONETARY SYSTEM .

The !inds of Money

Commodity money-

taes the form of a commoditywith intrinsic value

(%amples- &old coins#ci&arettes in P/W camps

Fiat money-

money without intrinsic value#

used as money because of&ovt decree

(%ample- the 0'S' dollar



THE MONETARY SYSTEM 1

The Money Supply

The money supply 2or money stock3-

the $uantity of money available in the economy

What assets should be considered part of themoney supply? Two candidates-

Currency- the paper bills and coins in thehands of the 2non4ban3 public

Demand deposits- balances in ban accounts

that depositors can access on demand by

writin& a chec


http://slidepdf.com/reader/full/money-pres 7/36THE MONETARY SYSTEM 5

Measures of the "#S# MoneySupply M1- currency# demand deposits#

traveler6s checs# and other checable deposits'*7 8 97': trillion 2February ;<773

M- everythin& in *7 plus savin&s deposits#

small time deposits# money maret mutual funds#and a few minor cate&ories'

*; 8 9=': trillion 2February ;<773

The distinction between M1 and M2will usually not matter when we talk about

“the money supply” in this course.



THE MONETARY SYSTEM =

$entral %anks & Monetary'olicy Central bank- an institution that oversees the

banin& system and re&ulates the money supply

Monetary policy- the settin& of the moneysupply by policymaers in the central ban

Federal !eserve "Fed#- the central ban of the0'S'



THE MONETARY SYSTEM :

The Structure of the Fed

The Federal Reserve System

consists of- $oard of %overnors

25 members3#located in Washin&ton# >C

1 regional Fed banks#located around the 0'S'

Federal &pen Market

Committee "F&MC##includes the d of @ovs andpresidents of some of the re&ional Fed bansThe F/*C decides monetary policy'

Ben S. BernankeChair of FOMC,

Feb 2006 – pree!t



THE MONETARY SYSTEM 7<

%ank (eser)es An a fractional reserve banking system#

bans eep a fraction of deposits as reserves and use the rest to mae loans'

The Fed establishes reserve re'uirements#re&ulations on the minimum amount of reserves

that bans must hold a&ainst deposits'

ans may hold more than this minimum amountif they choose'

The reserve ratio# R 8 fraction of deposits that bans hold as reserves

8 total reserves as a percenta&e of total deposits




%ank T*account ()account- a simplified accountin& statement

that shows a ban6s assets + liabilities' (%ample-

F*!S( +,(*&+,- $,+.

,ssets -iabilities

Reserves 9 7<

Boans 9 :<

>eposits 97<<

ans6 liabilities include deposits#assets include loans + reserves'

An this e%ample# notice that R 8 97<97<< 8 7<D'



THE MONETARY SYSTEM 7;

%anks and the Money Supply: +n-ample

Suppose 97<< of currency is in circulation'

To determine bans6 impact on money supply#we calculate the money supply in " different cases-

1' Eo banin& system

' 7<<D reserve banin& system-

bans hold 7<<D of deposits as reserves#

mae no loans

/' Fractional reserve banin& system



THE MONETARY SYSTEM 7"


C,S0 1- Eo banin& system

Public holds the 97<< as currency'

*oney supply 8 97<<'



THE MONETARY SYSTEM 7,


C,S0 - 7<<D reserve banin& system

Public deposits the 97<< at First Eational an 2FE3'

F*!S( +,(*&+,- $,+.

,ssets -iabilities

Reserves 97<<

Boans 9 <

>eposits 97<<

FE holds

7<<D of

depositas reserves-

*oney supply8 currency deposits 8 9< 97<< 8 97<<

In a 1! reser"e bankin# system$banks do not a%%ect si&e o% money supply.



THE MONETARY SYSTEM 7.


C,S0 /- Fractional reserve banin& system

*oney supply 8 97:< 2GGG3

>epositors have 97<< in deposits#

orrowers have 9:< in currency'

F*!S( +,(*&+,- $,+.

,ssets -iabilities

Reserves 97<<

Boans 9 <

>eposits 97<<

Suppose R 8 7<D' FE loans all but 7<D

of the deposit-

7<

:<





!ow did the money supply suddenly &row?

When bans mae loans# they create money'

The borrower &ets

9:< in currency 2an asset counted in themoney supply3

9:< in new debt 2a liability3


' %ractional reser"e bankin# system

creates money$ but not wealth.






Af R 8 7<D for SE# it will loan all but 7<D of the

deposit'

S0C&+D +,(*&+,- $,+.

,ssets -iabilities

Reserves 9 :<

Boans 9 <

>eposits 9 :<

Suppose borrower deposits the 9:< at SecondEational an 2SE3'

Anitially# SE6s

T4account

loos lie this-:

=7

k d h l



THE MONETARY SYSTEM 7=



Af R 8 7<D for TE# it will loan all but 7<D of the

deposit'

(*!D +,(*&+,- $,+.

,ssets -iabilities

Reserves 9 =7

Boans 9 <

>eposits 9 =7

The borrower deposits the 9=7 at Third Eationalan 2TE3'

Anitially# TE6s

T4account

loos lie this-9 ='7<

95;':<

k d h S l



THE MONETARY SYSTEM 7:



The process continues# and money is created witheach new loan'

/ri&inal deposit 8

FE lendin& 8

SE lendin& 8

TE lendin& 8'''

9

7<<'<<9

:<'<<

9=7'<<

95;':<''

'

In this

e(ample$)1 o%

reser"es

#enerates

)1 o%

money.



THE MONETARY SYSTEM ;<

The Money Multiplier

Money multiplier - the amount of money the

banin& system &enerates with each dollar ofreserves

The money multiplier e$uals 7R '

An our e%ample#R 8 7<D

money multiplier 8 7R 8 7<

97<< of reserves creates 97<<< of money



A C T I E L E A R N I N G 1

%anks and the money supply

2!

While cleanin& your apartment# you loo under thesofa cushion find a 9.< bill 2and a half4eaten taco3'

Hou deposit the bill in your checin& account'

The Fed6s reserve re$uirement is ;<D of deposits',2 What is the ma%imum amount that the

money supply could increase?

$2 What is the minimum amount that themoney supply could increase?




+nswers

22

Af bans hold no e%cess reserves# thenmoney multiplier 8 7R 8 7<'; 8 .

The ma%imum possible increase in deposits is

. % 9.< 8 9;.<

ut money supply also includes currency#

which falls by 9.<'

!ence# ma% increase in money supply 8 9;<<'

Hou deposit 9.< in your checin& account',2 What is the ma%imum amount that the





+nswers

2"

Inswer- 9<

Af your ban maes no loans from your deposit#

currency falls by 9.<# deposits increase by 9.<#

money supply does not chan&e'

Hou deposit 9.< in your checin& account',2 What is the ma%imum amount that the


Inswer- 9;<<$2 What is the minimum amount that the


Th F d’ 3 T l f M t



THE MONETARY SYSTEM ;,

The Fed’s 3 Tools of Monetary$ontrol

1' &pen)Market &perations "&M&s#- the purchase

and sale of 0'S' &overnment bonds by the Fed' To increase money supply# Fed buys &ovt bonds#

payin& with new dollars'

Jwhich are deposited in bans# increasin& reservesJwhich bans use to mae loans# causin& the

money supply to e%pand'

To reduce money supply# Fed sells &ovt bonds#

tain& dollars out of circulation# and the processwors in reverse'




THE MONETARY SYSTEM ;.


1' &pen)Market &perations "&M&s#- the purchase

and sale of 0'S' &overnment bonds by the Fed' /*/s are easy to conduct# and are the Fed6s

monetary policy tool of choice'




THE MONETARY SYSTEM ;1


' Reserve Re$uirements 2RR3-

affect how much money bans can create bymain& loans'

To increase money supply# Fed reduces RR'

ans mae more loans from each dollar of reserves#

which increases money multiplier and money supply'

To reduce money supply# Fed raises RR#

and the process wors in reverse'

Fed rarely uses reserve re$uirements to control

money supply- Fre$uent chan&es would disrupt

banin&'

The Fed’s 3 Tools of Monetar



THE MONETARY SYSTEM ;5


/' (he Discount !ate-

the interest rate on loans the Fed maes to bans When bans are runnin& low on reserves#

they may borrow reserves from the Fed'

To increase money supply#Fed can lower discount rate# which encoura&es

bans to borrow more reserves from Fed'

ans can then mae more loans# which increases

the money supply'

To reduce money supply# Fed can raise discount rate'

The Fed’s 3 Tools of Monetary



THE MONETARY SYSTEM ;=


/' (he Discount !ate-

the interest rate on loans the Fed maes to bans The Fed uses discount lendin& to provide e%tra

li$uidity when financial institutions are in trouble#

e"#" after the /ct' 7:=5 stoc maret crash'

Af no crisis# Fed rarely uses discount lendin& )

Fed is a “lender of last resort'”



THE MONETARY SYSTEM ;:

The Federal Funds (ate

/n any &iven day# bans with insufficient reserves

can borrow from bans with e%cess reserves' The interest rate on these loans is the federal

funds rate'

The F/*C uses /*/s to tar&et the fed fundsrate'

*any interest rates are hi&hly correlated#so chan&es in the fed funds rate cause chan&es in

other rates and have a bi& impact in the economy'

Th F d F d ( t d .th ( t



The Fed Funds (ate and .ther (ates,/012*2//

7:5<

7:5.

7:=<

7:=.

7::<

7::.

;<<<

;<<.

;<7<

<

.

7<

7.

;< Fed Funds

Prime

" *onth T4ill

*ort&a&e

"3#

Monetary 'olicy and the Fed Funds



THE MONETARY SYSTEM "7

Monetary 'olicy and the Fed Funds(ate

To raise fed funds

rate# Fed sells&ovt bonds 2/*/3'

This removesreserves from thebanin& system#reduces supply offederal funds#

causes r f to rise'

r f

* >7

S;

"'5.D

*

S7

* 1

"'.<D

The Federal

Funds maretFederal

fundsrate

Kuantity offederal funds

'rolems $ontrollin4 the Money



THE MONETARY SYSTEM ";

'rolems $ontrollin4 the MoneySupply

Af households hold more of their money as

currency# bans have fewer reserves#mae fewer loans# and money supply falls'

Af bans hold more reserves than re$uired#

they mae fewer loans# and money supply falls' Het# Fed can compensate for household

and ban behavior to retain fairly precise controlover the money supply'

%ank (uns and the Money



THE MONETARY SYSTEM ""

%ank (uns and the MoneySupply I run on banks-

When people suspect their bans are in trouble#they may “run” to the ban to withdraw their funds#holdin& more currency and less deposits'

0nder fractional4reserve banin&# bans don6t

have enou&h reserves to pay off IBB depositors#hence bans may have to close'

Ilso# bans may mae fewer loans and hold more

reserves to satisfy depositors' These events increase R # reverse the process of

money creation# cause money supply to fall'

%ank (uns and the Money



THE MONETARY SYSTEM ",

%ank (uns and the MoneySupply >urin& 7:;:47:""# a wave of ban runs and

ban closin&s caused money supply to fall ;=D'

*any economists believe this contributed to theseverity of the @reat >epression'

Since then# federal deposit insurance has helpedprevent ban runs in the 0'S'

An the 0'L'# thou&h# Eorthern Roc ban

e%perienced a classic ban run in ;<<5 and waseventually taen over by the ritish &overnment'



$5+'T( S"MM+(6

*oney includes currency and various types ofban deposits'

The Federal Reserve is the central ban of the0'S'# is responsible for re&ulatin& the monetarysystem'

The Fed controls the money supply mainly

throu&h open4maret operations' Purchasin&&ovt bonds increases the money supply# sellin&&ovt bonds decreases it'

"#



$5+'T( S"MM+(6

An a fractional reserve banin& system# banscreate money when they mae loans' anreserves have a multiplier effect on the moneysupply'

"$

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