Chapter 10

Money, Prices, and the Federal Reserve

Learning Objectives

1. Discuss the three functions of money and how the money supply is measured.
2. Analyze how the lending behavior of commercial banks affects the money supply.
3. Describe the structure and responsibilities of the Federal Reserve System.
4. Explain why control of the money supply is important and how the money supply is related to inflation in the long run.

2

Money in Economics

• The term "money" in economics has a specific meaning different from every day use
• To an economist:
• Your paycheck is income
• The income you don't spend is saving
• The increase in the value of your stock is a capital gain
• When your house appreciates, your wealth increases

9-3

Money

• Money is any asset that can be used in making purchases
• Examples include coins and currency, checking account balances, and traveler's checks
• Shares of stock are not money
• Money has three principal uses
1. Medium of exchange
2. Unit of account
3. Store of value
• Money makes barter unnecessary
• Barter is trading goods directly

4

Roles of Money

• A medium of exchange is an asset that individuals acquire for the purpose of trading rather than for their own consumption.�
• A store of value is a means of holding purchasing power over time.�
• A unit of account is a measure used to set prices and make economic calculations. (Comparisons)

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What does money mean to you

• Income
• Security
• Cars
• Homes
• Lunch
• Vacations

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It is what you use to get what makes you happy. It is not what makes you happy.

Private Money

• Money is usually issued and controlled by the government
• Private money can develop in certain circumstances
• An Ithaca Hour is worth $10, the average hourly wage of workers
• 1,600 individuals have earned and spent this currency
• Encourages local shopping
• LETS (Local Electronic Trading System) is electronic money from buying and selling goods and services
• Used in UK, Australia, and New Zealand
• Bitcoin virtual currency
• Obtained through “mining,” or in exchange for other currencies, products, and services
• The price of Bitcoins is significantly volatile

8

M1 & M2 Categorization of Money

Before May 2020, M2 consists of M1 plus (1) savings deposits (including money market deposit accounts); (2) small-denomination time deposits (time deposits in amounts of less than $100,000) less individual retirement account (IRA) and Keogh balances at depository institutions; and (3) balances in retail money market funds (MMFs) less IRA and Keogh balances at MMFs.

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Beginning May 2020, M2 consists of M1 plus (1) small-denomination time deposits (time deposits in amounts of less than $100,000) less IRA and Keogh balances at depository institutions; and (2) balances in retail MMFs less IRA and Keogh balances at MMFs. Seasonally adjusted M2 is constructed by summing savings deposits (before May 2020), small-denomination time deposits, and retail MMFs, each seasonally adjusted separately, and adding this result to seasonally adjusted M1.

20-10

20-11

Global money comparison

CURRENCY IN CIRCULATION

Monetary Aggregates, August 2008

Banking System

• Financial intermediaries are firms that extend credit to borrowers using funds raised from savers
• Thousands of commercial banks accept deposits from individuals and businesses and make loans
• Banks and other intermediaries specialize in evaluating the quality of borrowers
• Principle of Comparative Advantage
• Banks have a lower cost of evaluating opportunities than an individual would
• Banks pool the saving of many individuals to make large loans

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9-16

Banking System

• Banks gather information about potential investments
• Evaluate the options
• Direct saving
• Service provided to depositors
• Banks provide access to credit for small businesses and homeowners
• May be the only source of credit for some investments
• When banks make loans, they earn interest which, in turn, is paid to the bank's depositors

9-17

The Banking System

• Having bank deposits makes payments easier
• Checks
• ATMs
• Debit card
• Checks and debit cards are safer than cash
• Banks provide a record of your transactions

9-18

The Allocation of Saving

• A successful economy allocates its saving to the most productive investments
• The interest on deposits is one important reason people put their saving in banks
• The banking system improves the allocation of saving:
• Provides information to savers about the possible uses of their funds
• Help savers share the risks of individual investment projects
• Risk sharing makes funding possible for projects that are risky but potentially very productive

9-19

Commercial Banks Create Money

• Republic of Gorgonzola begins with no banking system
• Government issues 1 million guilders
• Banks are created to store cash
• Payments are made by withdrawing cash or writing checks
• Checks tell bankers of change in ownership of the specified number of guilders
• Without interest, banks earn profits by charging depositors fees

20

Consolidated Bank Balance Sheet – Part 1

• All guilders (g) are deposited

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• Bank reserves are cash or similar assets held by banks
• Used to meet depositors' withdrawals and payments
• Gorgonzola's banks have 100% reserves
• 100% reserve banking is when banks' reserves equal 100% of their deposits

21

Bank Reserves

• Cash in a bank's vault is not part of the money supply
• Unavailable for payments
• Bank deposits available for use in transactions are part of the money supply
• Depositing a $100 bill in your checking account does not change the money supply
• Bankers realize that inflows and outflows from vaults leave some guilders unused
• Only 10% of deposits are needed for transactions
• 90% can be lent to borrowers for a fee -- interest

9-22

Consolidated Bank Balance Sheet – Part 2

• Currency held in the vault is the bank reserves

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• The reserve – deposit ratio is bank reserves divided by total deposits
• Fractional reserve banking system holds less bank reserves than deposits
• The reserve – deposit ratio is less than 100%

23

Consolidated Bank Balance Sheet – Part 3

• Farmers borrow 900,000 guilders to buy supplies
• Farmers spend the 900,000 guilders which are then deposited in the banks

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• Bank deposits are the entire money supply
• Loan of 900,000 guilders increased the money supply by 900,000 guilders
• Banks are again holding excess reserves on deposits of 1,900,000 guilders

24

Consolidated Bank Balance Sheet – Part 4

• With deposits of 1,900,000 guilders and a reserve – deposit ratio of 10%, banks want only 190,000 guilders in reserves
• Currently holding 1,000,000 guilders
• Loan 810,000 guilders

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• Loan are spent and re-deposited
• Excess reserves are created and re-loaned

25

Bank Reserves

• Bankers realize that inflows and outflows from vaults leave some guilders unused
• Only 10% of deposits are needed for transactions
• 90% can be lent to borrowers for a fee -- interest
• By making loans, they put more money into the economy, increasing the money supply

26

Consolidated Bank Balance Sheet – The End

• Expansion of loans and deposits stops when reserves are 10% of deposits
• 1,000,000 guilders available as reserves
• Deposits stabilize at 10,000,000 guilders

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• Beginning with 1,000,000 guilders in cash, the money supply is now 10,000,000 guilders

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27

Money Creation

• With 10% reserves, each guilder supports 10 guilders in deposits
• Deposits in the banking system satisfy this relationship

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• Solving for bank deposits we get

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28

Money Supply with Currency and Deposits

• Gorgonzola residents hold 500,000 guilders as currency
• Deposit 500,000 guilders in the banks
• Reserve-deposit ratio = 10%
• Bank deposits = 500,000 / 0.10 = 5,000,000 guilders
• Money supply = 500,000 cash + 5,000,000 deposits� = 5,500,000 guilders

29

Money supply = Currency held by public +

Money Supply at Christmas

• Suppose banks hold $500 billion in reserves and the public holds $500 billion in cash
• Reserve-deposit ratio = 0.20
• Money supply = $500 + (500 / 0.20) = $3,000
• As Christmas approaches, consumers reduce bank deposits by $100 billion
• Banks have $400 billion in reserves; public holds $600 billion cash
• Money supply = $600 + ($400 / 0.20) = $2,600
• Reducing bank deposits reduces the money supply

30

Bank Deposits

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=

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initial deposits/reserve ratio

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Money Supply

=

currency + bank deposits

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bank deposits = (initial deposits/rr)

rr = reserve ratio

Money Multiplier

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=

1/reserve ratio

Money Supply

=

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currency +

(initial deposits*money multiplier)

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The Federal Reserve

• Central bank of the United States
• Responsibilities of the Federal Reserve:
• Conduct monetary policy
• Oversee and regulate financial markets
• Central to solving financial crises
• The Federal Reserve System began operations in 1914
• Does not attempt to maximize profit
• Promotes public goals such as economic growth, low inflation, and smoothly functioning financial markets
• www.federalreserve.gov

35

The Federal Reserve Organization

• 12 Federal Reserve Bank districts
• Assess economic conditions in their region
• Provide services to commercial banks in their region
• Leadership is provided by the Board of Governors
• Seven governors are appointed by the President to 14-year terms
• President selects one of the seven as chairman for a four-year term
• The Federal Open Market Committee (FOMC) reviews economic conditions and sets monetary policy
• 12 members who meet eight times a year

36

The Federal Reserve System

• The Fed is the central bank of the US
• Responsible for monetary policy and the oversight and regulation of financial markets
• Monetary policy is deciding and managing the size of the nation's money supply
• Money supply is controlled indirectly
• Open-market purchase of government bonds from the pubic by the Fed increases bank reserves and the money supply
• Open-market sale of government bonds by the Fed to the public decreases reserves and money supply

37

The Federal Reserve System

Four Tools of the Fed

• Reserve Requirements
• Discount Rates
• Open Market Operations
• Interest on excess reserves

Reserve Requirements and the Discount Rate

• The federal funds market allows banks that fall short of the reserve requirement to borrow funds from banks with excess reserves.�
• The federal funds rate is the interest rate determined in the federal funds market.�
• The discount rate is the rate of interest the Fed charges on loans to banks. (Normally 1% above federal funds rate) (Lender of last resort)

Fed actions (Rarely used)

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↑ Reserve Requirements = ↓ Money Supply

↓ Reserve Requirements = ↑ Money Supply

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↑ Discount Rates = ↓ Money Supply

↓ Discount Rates = ↑ Money Supply

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Open Market Operations

• When the Fed purchases a bond from the public
• Fed pays bond holder with new money
• The new money enters the economy
• The bond, which wasn’t money, leaves the economy
• Receipts are deposited and this leads to a multiple expansion of the money supply

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42

Open Market Operations

• When the Fed sells a bond to the public
• Bondholder pays with checking funds
• The checking funds, which were money, leave the economy
• The bond, which is not money, enters the economy
• Bank reserves decrease and this leads to a multiple contraction of the money supply

43

Open market operations

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Buys Bond = ↑ Money Supply

Sells Bond = ↓ Money Supply

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Open-Market Operations

Open-market operations by the Fed are the principal tool of monetary policy: the Fed can increase or reduce the monetary base by buying government debt from banks or selling government debt to banks.

The Federal Reserve’s Assets and Liabilities:

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Open-Market Operations by the Federal Reserve

An Open-Market Purchase of $100 Million – Increase Reserves to Lend

Open-Market Operations by the Federal Reserve

An Open-Market Sale of $100 Million – Decreases Reserves

Increasing the Money Supply

• An economy has 1,000 shekels in currency and bank reserves of 200 shekels
• Reserve-deposit ratio = 0.2
• Money supply = 1,000 + (200 / 0.2) = 2,000 shekels
• Central bank pays 100 shekels for a bond held by the public
• Assume that all 100 shekels are deposited
• Money supply = 1,000 + (300/ 0.2) = 2,500 shekels
• 100 shekel increase in reserves leads to a 500 shekel increase in the money supply

48

MONEY SUPPLY VS MONETARY BASE

• The monetary base is the sum of currency in circulation and bank reserves.
• The money multiplier is the ratio of the money supply to the monetary base.

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Monetary base

Monetary Base = Reserves + Currency in Circulation

Money and Prices

• In the long run, the amount of money circulating and the level of prices are closely linked
• Sustained high inflation rates occur with a comparably high growth rate of the money supply

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20-52

Money and Inflation in the Long Run

• The quantity equation states that money times velocity equals nominal GDP, M x V = P x Y
• Restatement of the velocity definition
• Shows a relationship between money and price level
• Suppose velocity and real GDP are constant

• The quantity equation becomes

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• An increase in the money supply by a given percentage would increase the price level by the same percentage

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M*V = P*Y

M = Money Supply

V = Velocity of Money

P = Price Level

Y = Real GDP

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PxY = Nominal GDP

M*V = Nominal GDP

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V = Nominal GDP/M

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Velocity of Money (V)

• Velocity is a measure of the speed money changes hands in transactions for final goods and services

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• Nominal GDP is the price level (P) times real GDP (Y)
• M is the money stock

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Velocity in the U.S., 2016

• M1 = $3,247.9 billion
• M2 = $12,829.2 billion
• Nominal GDP = $18,624.5 billion
• Using M1, velocity is 5.73

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• Using M2, velocity is 1.45

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56

Velocity

• Velocity is determined by a number of factors including technology such as ATMs and debit cards
• These technologies allow people to conduct business while carrying less cash
• Less cash is needed + plenty of money changing hands → higher velocity

58

Stabilizing Financial Markets

• Motivation for creating the Fed was to stabilize the financial markets and the economy
• Banking panics occurred when customers believe one or more banks might be bankrupt
• Depositors rush to withdraw funds
• Everyone tries to withdraw before the bank runs out of money
• Banks have inadequate reserves to meet demand
• Banks close

59

Stabilizing Financial Markets

• Fed prevents bank panics by
• Supervising and regulating banks
• Loaning banks funds if needed
• Fed did not prevent the bank panics of 1930 – 1933
• The Fed was more effective at preventing later panics

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60

Crisis in American Banking

• In response to the Panic of 1907, the Fed was created to centralize holding of reserves, inspect banks’ books, and make the money supply sufficiently responsive to varying economic conditions.

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• The Great Depression sparked widespread bank runs in the early 1930s, which greatly worsened and lengthened the depth of the Depression. �
• Federal deposit insurance was created, and the government recapitalized banks by lending to them and by buying shares of banks. �
• By 1933, banks had been separated into two categories: commercial (covered by deposit insurance) and investment (not covered). �
• Public acceptance of deposit insurance finally stopped the bank runs of the Great Depression.

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Bank Panics, 1930 - 1933

• One-third of the banks closed
• Increased the severity of the Great Depression
• Difficult for small businesses and consumers to get credit
• Money supply decreased
• With no federal deposit insurance, people held cash
• Feared banks would close and they would lose their deposits
• Holding cash reduced banks' reserves
• Lower reserves decreased the money supply by a multiple of the change in reserves

23-62

Bank Panics, 1930 - 1933

• Banks increased their reserve – deposit ratio
• Further decreased the money supply

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23-63

Deposit Insurance

• Congress created deposit insurance in 1934
• Deposits of less than $100,000 will be repaid even if the bank is bankrupt
• Decreases incentive to withdraw funds on rumors
• No significant bank panics since 1934
• With less risk, depositors pay less attention to whether banks are making prudent investments
• In the 1980s, many savings and loan associations went bankrupt
• Cost the taxpayers hundreds of billions of dollars

23-64

Indy Mac bank run

The Savings and Loan Crisis of the 1980s

• The savings and loan (thrift) crisis of the 1980s arose because insufficiently regulated S&Ls engaged in overly risky speculation and incurred huge losses.
• Depositors in failed S&Ls were compensated with taxpayer funds because they were covered by deposit insurance.
• The crisis caused steep losses in the financial and real estate sectors, resulting in a recession in the early 1990s.

Japanese Banking Crisis, 1990s

• Japanese banks fell into severe trouble
• Property values decreased and some loans on real estate went into default
• Banks held stocks and the stock values decreased
• Japan had relied on banks to allocate its saving
• Thin financial markets
• Borrowers had difficulty obtaining credit
• Small- and medium-sized businesses suffered
• Credit shortages prolonged the recession as businesses struggled to fund new projects

9-67

The Fed and the Economy

23-68

Money and Inflation in the Long Run

Why do countries allow their money supplies to rise quickly?

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• Governments can issue new money to make up for deficits
• If taxes and loans cannot make up the deficit, they must issue new currency
• If they issue enough new currency, inflation will result

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During the Great Recession, �the Fed printed over �$3,000,000,000,000 �to save the economy.

Monetary base

Monetary Base = Reserves + Currency in Circulation

Open Market Operations

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Fed bought Bad Housing Bonds

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Banks got cold hard cash!

Fed’s balance sheet, normal and abnormal

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WHERE’S THE MONEY?

If our monetary based increased from $800B to $3,000B, then shouldn’t our money supply be higher causing inflation?

It Depends…

What happened in Oct. 2008?

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• Fed started paying interest on reserves

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• (Newest tool to help adjust rates)

The Fed created more money��The banks never lent it out to the public��So velocity of money went down, thus there was very little inflation

Monetary Base VS Money Supply

• While the central bank can create the monetary base….

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• It is up to commercial banks to determine the money supply

Money, Prices, and the Federal Reserve

82

Money

Federal Reserve

Open-Market Sales and Purchases

M1

Velocity

Inflation

Definitions of Money

Fractional Reserves

Banks

M2