Money $ Money $ Money

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Money Money Money

• What is money?
• Anything that performs these functions
• A medium of exchange
• A unit of account
• A store of value

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Medium of Exchange

• Anything used to determine value during the
  exchange of goods and services
• Money makes these transactions easier
• The alternative is barter

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Unit of Account

• Allows us to compare the values of goods and
  services

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Store of Value

• Keeps its value over a period of time
• What threatens this?
• Inflation

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Types of Money

• Commodity Money
• Something that is used as a medium of exchange
  that has value in its own right (gold, silver,
  cigarettes)
• Representative Money
• Commodity backed money
• A bank note redeemable for a commodity (gold or
  silver)
• Fiat Money
• Something that has value because government says
  that it has value

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Types of Money

• What type of money is todays U.S. dollar?
• Fiat Money

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Measuring the Money Supply

• M1 Money Supply (most liquid)
• Includes currency in circulation, coins,
  travelers checks, and checkable/demand deposits
  (checking accts) About 50/50 Currency and
  coins to Deposits

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Measuring the Money Supply

• M2 Money Supply
• Includes M1 and near moneys -- savings deposits
  (savings accounts) and other interest bearing
  accounts like CDs
• M1 is about 20 of M2

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The Goldsmiths and the Origins of Paper Money

• Goldsmiths provided a place of storage for an
  individuals gold and silver
• They would charge a fee for this service
• They would issue a receipt to the owner of the
  specie (gold and silver)

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The Goldsmiths and the Origins of Paper Money

• Receipts then began to be exchanged for goods and
  services
• Why? The receipts were accepted as a medium of
  exchange
• Voila! The first paper money!

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The Goldsmiths and the Origins of Paper Money

• Then some shrewd Goldsmith realized he could
  issue receipts in excess of the amount of gold he
  had. Why?
• They rarely had to exchange receipts for gold!
• Voila! The first bank loan!

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The Monetary Role of Banks

• About half of M1 is bank deposits
• What Banks Do
• Uses its assets to finance the investments of
  borrowers
• Not all assets are lent out
• Some assets must be kept on hand to satisfy the
  demands of depositors that want to withdraw their
  funds (Reserves)

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Fractional Reserve Banking System

• The assets that a bank must keep in reserve is
  established by the Fed
• This is known as the RESERVE RATIO or the RESERVE
  REQUIREMENT

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Its a Wonderful Banking System!

• What would happen, if for some reason, all a
  banks depositors wanted their deposits at the
  same time?
• See The Bank Run on You Tube

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Its a Wonderful Banking System!

• Is this a problem today?
• Not likely. Why not?
• The Federal Deposit Insurance Corporation (FDIC)
• Insures bank deposits (of member banks) up to
  250,000 (result of a new law President Obama
  signed in 2010)

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Its a Wonderful Banking System!

• The insurance also eliminates the cause of bank
  runs
• Bank Regulation
• Deposit Insurance
• The fact that insurance exists can promote
  reckless behavior on the part of financial
  institutions dont worry, if we fail the
  taxpayers will bail us out
• Reserve Requirements usually a minimum of 10)

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How Banks Create New Money

• Lets look at an initial 1000 cash deposit into
  a checking acct. (demand deposit)
• First key point
• This does NOT add anything NEW to the money
  supply
• There is 1000 less currency and 1000 more in
  demand deposits No net increase

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How Banks Create New Money

• Now lets assume the bank has a 10 reserve
  requirement (rr)
• The bank must keep 100 in reserve in its vaults
  (required reserves)
• It can then lend out the 900 in excess reserves
• This begins the process of money creation

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How Banks Create New Money

• How much NEW money will be created?
• The first step is to determine the money
  multiplier
• 1/rr OR 1/reserve requirement
• Multiplier of 10
• In this instance, the 900 excess reserves is
  multiplied 10 times throughout the economy -
  9000 in NEW money

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How Banks Create New Money

• If a bank initially lent out 1000 in excess
  reserves, 10,000 in NEW money would be created
• What if you were asked the change in demand
  deposits as a result of this?
• The initial 1000 demand deposit would result in
  how much of a total change in demand deposits?
• 10000

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From the 2009 AP Test

• 3. Assume that the reserve requirement is 20
  percent and banks hold no excess reserves.
• (a) Assume that Kim deposits 100 of cash from
  her pocket into her checking account. Calculate
  each of the following.
• (i) The maximum dollar amount the commercial bank
  can initially lend
• (ii) The maximum total change in demand deposits
  in the banking system
• (iii) The maximum change in the money supply

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The Banking System
Bank A Bank B Bank C Bank D Bank E Bank F Bank
G Bank H Bank I Bank J Bank K Bank L Bank M Bank
N Other Banks
100.00 80.00 64.00 51.20 40.96 32.77 26.21 20.97
16.78 13.42 10.74 8.59 6.87 5.50 21.99
20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36
2.68 2.15 1.72 1.37 1.10 4.40
80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 1
3.42 10.74 8.59 6.87 5.50 4.40 17.59
80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 1
3.42 10.74 8.59 6.87 5.50 4.40 17.59
400.00
32-22
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The Monetary Multiplier
1

rr
New Reserves
Graphic Example
100
20 Required Reserves
80 Excess Reserves
100 Initial Deposit
400 Bank System Lending
Money Created
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The Federal Reserve System

• Historical Background
• Prior to 1913, the U.S. had a decentralized and
  unregulated banking system
• This led to much economic instability, (fraud,
  different currencies, bank failures)

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The Federal Reserve System

• A financial crisis in 1907 led to the desire to
  create a centralized banking system with control
  over the money supply
• In 1913 Congress passed and President Wilson
  signed, The Federal Reserve Act

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The Federal Reserve System

• The Federal Reserve Act (1913)
• The Board of Governors
• 7 members
• Appointed by the President, Confirmed by the
  Senate
• 14 year terms staggered so one member is
  replaced every two years (above political
  pressure)

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The Federal Reserve System

• President chooses a board member to be the
  Chairman of the Fed (4 year term)
• Janet Yellen

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The Fed - Basics
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The Fed - Basics
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The Fed - Basics

• Main Functions of The Fed
• A bank to banks and to the Federal government
• Regulate the banks in their district
• Provide a safe and stable financial system
• Monetary Policy

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The Fed - Basics

• Monetary Policy
• Manipulation of the money supply in order to
  bring about the desired macroeconomic goals
  (expanding Real GDP, low inflation, low
  unemployment)

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The Tools of the Fed

• Manipulate the Discount Rate
• The interest rate the Fed charges to banks that
  want to borrow money
• Manipulate the Reserve Ratio
• The percentage of reserves a bank is required to
  keep on hand as cash
• Target a higher or lower FEDERAL FUNDS RATE

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The Federal Funds Rate

• Banks keep some of their reserves in accounts at
  a Federal Reserve bank
• Sometimes bank required reserves go lower than a
  bank wants or needs
• Banks with excess reserves willingly lend
  deficient banks funds from their Federal Reserve
  accounts (1 Million minimum)

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The Federal Funds Rate

• The interest rate that banks charge each other
  for these short-term, often overnight loans, is
  known as the FEDERAL FUNDS RATE
• The Federal Reserve does NOT set the Fed Funds
  Rate but it does target a rate that they would
  like (0 to 0.25) (0.09)
• They influence the rate through their Open Market
  Operations

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The Federal Funds Rate

• The lower the Federal Funds Rate, the more it
  encourages banks to borrow from each other
• The higher the Federal Funds Rate, the more it
  discourages banks to borrow from each other
• The current Fed Funds target rate is really a
  range, from 0 to 0.25

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The Tools of the Fed

• Carry out Open Market Operations (OMO)
• Buying and selling of government securities
  (bonds)
• Executed by the Federal Open Market Committee
  (FOMC)
• 7 member Board of Governors, President of the New
  York Fed, 4 other bank presidents on a rotating
  basis

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Tools of Monetary Policy
Monetary Policy Expansionary Policy (Easy Money) Contractionary Policy (Tight Money)
Open Market Operations
Discount Rate
Reserve Requirements
Federal Funds Rate Target a Target a
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The Tools of the Fed

• Expansionary Monetary Policy
• Aka Easy Money Policy
• Increasing the money supply (increasing excess
  reserves)
• Lowers interest rates
• To fight against recession
• Stimulate AD (through Ig)

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The Tools of the Fed

• Contractionary Monetary Policy
• Aka Tight Money Policy or Restrictive Policy
• Decreasing the money supply (decreasing excess
  reserves)
• Increases interest rates
• To fight against inflation
• To reduce AD (through Ig)

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The Demand and Supply of Money
m
m
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The Money Market Graph

• Shows the relationship between the supply of
  money (Sm or Ms) and the demand for money (Dm or
  Md)
• The Money Demand Curve
• Impacted by Fiscal Policy
• Changes in the Price Level can shift the Dm curve
  
• Higher PL the higher the demand for money
• Lower PL the lower the demand for money

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The Money Market Graph

• Changes in Real GDP shift the Dm curve
• Increases in Real GDP shift the Dm curve to the
  right
• Decreases shift the curve to the left
• Changes in Technology have shifted the Dm curve
• The easier it is to buy stuff without cash
  (Credit cards for example) the less demand there
  is for money Shift to the left

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The Money Market Graph

• The Money Supply curve
• Impacted by Monetary Policy
• Fed actions shift the curve depending on whether
  the money supply has been increased or decreased

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The Demand and Supply of Money
m
m
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What would happen to the money supply AND
interest rates if the Fed

• Targeted a reduction of the Federal Funds Rate
• Raised the Discount Rate
• Lowered the Reserve Requirement
• Bought government securities on the open market
• Targeted an increase the Federal Funds Rate
• Sold government securities on the open market

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Money Supply or Money Demand?

• The rate of inflation declines (disinflation)
• The Fed buys bonds
• The reserve requirement is raised
• There is economic growth (a rise in Real GDP)
• The Fed targets an increase in the federal funds
  rate

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Interest Rates and Bond Prices

• Bonds are bought and sold in the open market
  based on supply and demand
• They sell for a certain price and pay fixed
  interest rates
• Suppose a 1000 bond pays an annual 50 in
  interest
• Thats a 5 yield annually (5 interest rate)

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Interest Rates and Bond Prices

• Now, what happens interest rates rise to 7.5
• Would you want to purchase the old bond at 5
  when you could get a new one at 7.5?
• What would make you be willing to purchase the
  1000 old bond?
• If it was sold for less than 1000

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Interest Rates and Bond Prices

• In fact, if you could buy the old bond for 667
  and receive the fixed 50 interest you would be
  receiving 7.5 annually on your investment
• THUS, WHEN INTEREST RATES RISE BOND PRICES
  DECLINE
• WHEN INTEREST RATES DECLINE, BOND PRICES RISE

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One Final Point

• If the Fed buys 10,000 in government bonds, does
  the money supply initially increase by 10,000?
• Yes it does!!!
• Why?
• Because the money in the vaults of Fed banks is
  not considered to be a demand deposit and is
  therefore not part of M1

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One Final Point

• So, there is a difference between you taking
  1,000 cash and putting it into your checking
  account and the Fed making a 1,000 purchase of
  government bonds.
• What is that difference?
• The Fed purchase initially increases the M1 money
  supply by 1,000, the cash deposit does not

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• Practice Monetary Policy problems
• 2014 2
• 2012 1

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Limitations of Monetary Policy

• Hard to determine how much money growth is
  optimal
• Cant always predict the exact results of a
  monetary action
• Lag time before the actions of the Fed kick in
• World events make things more complex
• Congress may do things (Fiscal Policy) that
  conflict with the Fed

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Practice

• Complete
• Connections Countercyclical Monetary Policies
  (On the back of Countercyclical Fiscal Policies)
• Examine the 2012 exam question on T-Accounts

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The Monetarists

• When Keynesian fiscal policy failed to deal with
  the stagflation of the 1970s, some economists
  put forth the concept of MONETARISM
• They believed that a steady growth of the money
  supply would assure economic growth and
  macroeconomic stability

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The Monetarists

• Monetarists call for a steady increase of the
  money supply (say at 3 a year) regardless of the
  status of the economy
• They rejected an active monetary policy (an
  important distinction).
• In other words, they didnt feel that the supply
  of money should be expanded and contracted
  (Monetary Policy) to meet certain conditions
  because of its limitations
• They are basically conservative, laissez-faire
  economists

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The Monetarists

• Milton Friedman was its leading advocate and he
  has become a conservative icon over the last 30
  years

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The Equation of Exchange

• The fundamental equation for monetarists is MVPQ
• M is the supply of money
• V is the velocity of money (the average number of
  times a dollar is spent during a year this is
  relatively stable they believe)
• P is the price level
• Q is the quantity of all goods and services
  produced

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The Equation of Exchange

• MV is the money supply multiplied by the number
  of times the money is spent throughout the year
• PQ is basically nominal GDP
• MV (Spending) equals the value of PQ (Output)

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The Equation of Exchange

• If V is relatively stable and predictable,
  INCREASING THE MONEY SUPPLY WILL INCREASE NOMINAL
  GDP

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Decrease in Invest Demand
r
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The Monetary Role of Banks

• The T-account summarizes a banks financial
  position

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Creating a Bank

• Transaction 1
• Vault cash cash held by the bank

Creating a Bank
Balance Sheet 1 Wahoo Bank
Cash
250,000
Stock Shares
250,000
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Creating a Bank

• Transaction 2
• Acquiring property and equipment

Acquiring Property and Equipment
Balance Sheet 2 Wahoo Bank
Cash
10,000
Stock Shares
250,000
Property
240,000
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Creating a Bank

• Transaction 3
• Commercial bank functions
• Accepting deposits
• Making loans

Accepting Deposits
Balance Sheet 3 Wahoo Bank
Checkable Deposits
Cash
110,000
100,000
Property
240,000
Stock Shares
250,000
32-68
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Creating a Bank

• Transaction 4
• Assume the bank deposits all cash on reserve at
  the Fed

Depositing Reserves at the Fed
Balance Sheet 4 Wahoo Bank
Cash
0
Checkable Deposits
Reserves
110,000
100,000
Property
240,000
Stock Shares
250,000
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Creating a Bank

• Transaction 5
• Clearing a check
• 50,000 check reduces reserves and checkable
  deposits

Clearing a Check
Balance Sheet 5 Wahoo Bank
Checkable Deposits
Reserves
60,000
50,000
Property
240,000
Stock Shares
250,000
32-70
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Financial Institutions

• Institutions offering checkable deposits
• Commercial banks
• JP Morgan Chase
• Bank of America
• Wells Fargo
• Credit unions

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Crowding Out - Revisited

• Initiated by Government deficit spending to pay
  for an _______________ fiscal policy.

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The Loanable Funds Market

• A market that brings together borrowers and
  lenders
• There is a supply of loanable funds and a demand
  for those loanable funds

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Shifts in the Demand for LF

• Business and Consumer expectations
• Optimistism leads to increased demand of LF
• Pessimism leads to declining demand of LF
• Government borrowing to finance an expansionary
  fiscal policy increases the demand for LF (Which
  leads to crowding out)

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Shifts in the Supply of LF

• Changes in private savings behavior
• More savings increases the supply of LF
• Less savings decrease the supply of LF
• Changes in the flow of foreign investment in the
  U.S. (We will understand this when we study the
  international economy)