Chapter 14: Money, Banks, and the Federal Reserve System

Transcription

1 Chapter 14: Money, Banks, and the Federal Reserve System Yulei Luo SEF of HKU March 28, 2016

2 Learning Objectives 1. De ne money and discuss its four functions. 2. Discuss the de nitions of the money supply. 3. Explain how banks create money. 4. Discuss the three policy tools the central bank uses to manage the money supply. 5. Explain the quantity theory of money and use it to explain how high rates of in ation occur.

3 What Is Money and Why Do We Need It? I Money: Economists consider money to be any asset that people are generally willing to accept in exchange for goods and services, or for payment of debts. I Asset: Anything of value owned by a person or a rm. I Suppose you were living before the invention of money. If you wanted to trade, you would have to barter, trading goods and services directly for other goods and services. I I Shortcoming: requiring a double coincidence of wants. For a barter trade to take place bw. two people, each person must want what the other one has. Hence, the problem of BE provides an incentive to identify a product that most people will accept in exchange for what they have to trade.

4 I (Conti.) Eventually, societies started using commodity money. Commodity money: A good used as money; also has value independent of its use as money. E.g., silver, gold, and deerskin. I I Historically, once a good became widely accepted as money, people who didn t have an immediate use for it would be willing to accept it. Trading G&S is much easier once money becomes available: people only need to sell what they have for money and then use the money to buy what they want. I By making exchange easier, money allows people to specialize and become more productive while pursuing their comparative advantage.

5 The Functions of Money I Anything used as money whether a deerskin, a seashell, cigarettes, or a dollar bill should ful ll the following four functions: 1. Medium of exchange (MOE): Money serves as a MOE when sellers are willing to accept it in exchange for G&S. An economy is more e cient when a single good is recognized as a MOE. 2. Unit of account: Instead of having to quote the price of a single good in terms of many other goods, each good has a single price. This function of money gives buyers and sellers a unit of account, a way of measuring value in terms of money. E.g., in U.S., every good has a price in terms of dollars. 3. Store of value: Money allows value to be stored easily: If you do not use all your accumulated dollars to buy G&Ss today, you can hold the rest to use in the future. Note that money is not the only store of value. 4. Standard of deferred payment (SDP): Money can serve as a SDP in borrowing and lending. Money can facilitate exchange over time by providing a store of value and a standard of deferred payments.

6 What Can Serve as Money? I 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 di erent goods are valued di erently. I Dollar bills meet all these criteria.

7 Commodity Money I Commodity money (CM) meets the criteria for a medium of exchange. I But CM has a signi cant problem: its value depends on it purity. Unless traders trust each other completely, they needed to check the weight and purity of the metal at each trade. I It is ine cient to use commodity good (transportation costs and risk, etc.). To get around this problem, private institutions or governments began to store gold and issue paper certi cates that could be redeemed for gold.

8 Fiat Money I It can be ine cient for an economy to rely on only gold or other precious metals for its money supply. I Money, such as paper currency, that is authorized by a central bank or governmental body and that doesn t have to be exchanged by the central bank for gold or some other commodity money. I Federal Reserve System: The central bank of the US. A U.S. dollar bill is actually a Federal Reserve Note, issued by the FR. I Federal Reserve currency is legal tender in the US, which means the federal government requires that it be accepted in payment of debts and requires that cash or checks denominated in dollars be used in payment of taxes. I HHs and rms have con dence that if they accept paper dollars in exchange for G&Ss, the dollars will not lose much value during the time they hold them. I Hong Kong Monetary Authority: The central bank of Hong Kong.

9 How Do We Measure Money Today? I Economists have developed several di erent de nitions of the money supply (MS). Each de nition includes a di erent group of assets and is based on how liquid the assets are. I The most narrow measure of money is cash. Broader measures include other assets that can be easily converted into cash, such as checking account or saving account. I M1: The narrowest de nition of the MS. I I I Currency: All the paper money and coins that are in circulation meaning what is not held by banks or the government. The value of all checking account balances at banks. The value of traveler s checks. (ignore it in our discussion of the money supply as it is too small.) I Checking account deposits (CAD) are used much more often than currency to make payments. More than 80% of all expenditures on G&S are made with checks rather than with currency.

10 I M2: A broader de nition of the money supply: M1 plus savings account balances, small-denomination time deposits (such as CoD), balances in money market deposit accounts in banks, and non-institutional money market fund shares. I Small-denomination time deposits are similar to savings accounts, but the deposits are for a xed period of time usually from six months to several years and withdrawals before that time are subject to a penalty. I Money market mutual funds invest in very short-term bonds, such as U.S. Treasury bills. I In the following discussion, we will use the M1 de nition of the MS because it corresponds most closely to money as a medium of exchange. I There are two key points about the MS to keep in mind: 1. The money supply consists of both currency and checking account deposits. 2. Because balances in checking account deposits are included in the MS, banks play an important role in the process by which the MS increases and decreases.

11 U.S. Money Supply, July 2013 Figure 14.1 Measuring the money supply, July 2013 How much money is there in America? This is harder to answer than it first appears, because you have to decide what to count as money. M1 is the narrowest definition of the money supply: the sum of currency in circulation, checking account deposits in banks, and holdings of traveler s checks. There is a relatively large amount of U.S. currency, because people in other countries sometimes hold and use U.S. dollars instead of their own currency. 13 of 54

12 U.S. Money Supply, July 2013 continued Figure 14.1 M2 is a broader definition of the money supply: it includes M1, plus savings account balances, small-denomination time deposits, balances in money market deposit accounts, and non-institutional money market fund shares. Measuring the money supply, July of 54

13 Making the Connection Are Bitcoins Money? When we think of money, we typically think of currency issued by a government. But currency is only a small part of the money supply. Over the last decade or so, consumers have come to trust forms of e-money such as PayPal. Bitcoins are a new form of e-money, owned not by a government or firm, but a product of a decentralized system of linked computers. Bitcoins can be traded for other currencies on web sites. Some web sites accept Bitcoins as a form of payment. Should Bitcoins be included in a measure of the money supply? For now, they are not; if they grow popular, maybe they should be. 17 of 54

14 Two examples I The De nitions of M1 and M2. Suppose you decide to withdraw $2, 000 from your checking account and use the money to buy a bank certi cate of deposit (CoD). How this will a ect M1 and M2? Answers: Reduce M1 by $2000 but leaves M2 unchanged. I What About Credit Cards and Debit Cards? They are not included in the de nitions of the money supply. When you buy G&S with a credit card, you are in e ect taking out a loan from the bank issuing the card. Only when you pay your bill at the end of the moth from your checking account is the transaction complete. With a debit card, the funds to make the purchase are taken directly from your checking account. In either case, the cards themselves do not represent money.

15 Bank Balance Sheets I The key assets on a bank s balance sheet are its reserves, loans, and holdings of securities, such as U.S. treasury bills. I Reserves: Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve. I Required reserves: Reserves that a bank is legally required to hold, based on its checking account deposits. I Required reserve ratio: The minimum fraction of deposits banks are required by law to keep as reserves. I Excess reserves: Reserves that banks hold over and above the legal requirement. I Banks make consumer loans to households and commercial loans to businesses. A loan is an asset to a bank because it represents a promise by the person taking it out to make certain speci ed payments to the bank. I Deposits include checking accounts, savings accounts, and certi cates of deposit, and are liabilities to banks because they are owed to the households or rms that have deposited the funds.

16 I Fractional reserve banking system: A banking system in which banks keep less than 100% of deposits as reserves. I Bank run A situation in which many depositors simultaneously decide to withdraw money from a bank. I Bank panic A situation in which many banks experience runs at the same time. I A central bank, like the Federal Reserve in the US, can help stop a bank panic by acting as a lender of last resort. In acting as a lender of last resort, a central bank makes loans to banks that cannot borrow funds elsewhere.

17 Bank Balance Sheets Figure 14.2 Balance sheet of a typical large bank On a balance sheet, a firm s assets are listed on the left, and its liabilities (and stockholders equity, or net worth) are listed on the right. The left and right sides must add to the same amount. Banks use money deposited with them to make loans and buy securities (investments). Their largest liabilities are their deposit accounts: money they owe to their depositors. 20 of 54

18 Bank Balance Sheets Figure 14.2 Balance sheet of a typical large bank Reserves are deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve. Notice that the bank does not keep enough deposits on hand to cover all of its deposits. This is how the bank makes a profit: lending out or investing money deposited with it. 21 of 54

19 Money Creation at Bank of America A T-account is a stripped-down version of a balance sheet, showing only how a transaction changes a bank s balance sheet. When you deposit $1,000 in currency at Bank of America, its reserves increase by $1,000 and so do its deposits: The currency component of the money supply decreases by the $1,000, since that $1,000 is no longer in circulation; but the checking deposits component increases by $1,000. So there is no net change in the money supply yet. 23 of 54

20 T-Accounts But Bank of America needs to make a profit; so it keeps 10% of the deposit as reserves, and lends out the rest, creating a $900 checking account deposit. The $900 initially appears in a BoA checking account but will soon be spent; and Bank of America will transfer $900 in currency to the bank at which the $900 check is deposited. 24 of 54

21 When Will it End? Each round, the additional checking account deposits get smaller and smaller. Every round, 10% of the deposits are kept as reserves. This allows us to tell by how much the checking deposits will eventually increase: the $1,000 in currency will become the 10% required reserves for all of the checking deposits, so a total of $10,000 in checking deposits can be created. Bank Bank of America $1,000 Increase In Checking Account Deposits PNC (= 0.9 $1,000) Third Bank (= 0.9 $900) Fourth Bank (= 0.9 $810) Total change in checking account deposits = $10, of 54

22 Simple Deposit Multiplier An alternative way to find out how much money the original $1,000 in currency will create is to add up all of the checking account deposits. $1,000 + [0.9 $1,000] + [( ) $1,000] + [( ) $1,000] + = $1,000 + [0.9 $1,000] + [0.9 2 $1,000] + [0.9 3 $1,000] + = $1,000 ( ) The expression in the parentheses can be rewritten as: 1 1 = = So the total increase in deposits is $1,000(10) = $10,000. The 10 here is the simple deposit multiplier: the ratio of the amount of deposits created by banks to the amount of new reserves. 26 of 54

23 General Form for the Simple Deposit Multiplier In general, we can write the simple deposit multiplier as: Simple deposit multiplier = 1 RR So with a 10% required reserve ratio (RR), the simple deposit multiplier is 10. With a 20% required reserve ratio, the simple deposit multiplier is 5. Then: Change in checking account deposits = Change in bank reserves For example, $100,000 in new deposit, with a 10% required reserve ratio, results in: 1 Change in checking account deposits = $100, = $ 100, = 1 RR $1,000, of 54

24 Real-World Deposit Multiplier With a 10% required reserve ratio, the simple deposit multiplier tells us that a currency deposit will be multiplied 10 times. But in reality, we do not observe this: currency deposits only end up being multiplied about 2.5 times, during normal periods. Why this difference? Banks may not lend out as much as we predict, either because they want to keep excess reserves, or they cannot find creditworthy borrowers. Consumers keep some currency out of the bank; that currency cannot be used as required reserves. Note: during the recession of , research suggests that the real-world multiplier fell to close to of 54

25 How the Federal Reserve Manages the Money Supply? I Monetary policy: The actions the Federal Reserve takes to manage the money supply (MS) and interest rates to pursue economic objectives. I To manage the MS, the Fed uses three monetary policy tools: 1. Open market operations 2. Discount policy 3. Reserve requirements

26 The Federal Reserve System Figure 14.3 The Federal Reserve system In 1913, Congress divided the country into 12 Federal Reserve districts, each of which provides services to banks in the district. But the real power of the Fed lies in Washington, DC, with the Board of Governors. In 2013, the chair of the Board of Governors was Ben Bernanke. 34 of 54

27 The Federal Reserve System continued Figure 14.3 The Federal Reserve system The Fed is also responsible for managing the money supply. The Federal Open Market Committee (FOMC) conducts America s monetary policy: the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives. 35 of 54

28 Open Market Operations I Federal Open Market Committee (FOMC) The Federal Reserve committee responsible for OMOs and managing the MS in the U.S.. It meets eight times per year to discuss monetary policy. I Open market operations: The buying and selling of Treasury securities by the Federal Reserve in order to control the MS. Note that the US treasury borrows money by selling bills, note, and bonds. I To increase (decrease) MS, the FOMC directs the trading desk, located in the New York Fed, to buy (sell) US treasury securities from the public. When the sellers (buyers) deposit (withdraw) the funds in (from) their banks, the reserve of banks will rise (decline). This will start the process of increasing (decreasing) loans and checking account deposits that increases (decrease) MS.

29 I (Conti.) Three reasons why the Fed conducts MP principally through OMO: 1. The Fed initiate OMO, it completely controls their volume. 2. The Fed can make both large and small OMO. 3. The Fed can implement its OMO quickly. I The main way the Fed increases the MS is not by printing more paper money but buying Treasury securities.

30 Open Market Operations in Action The Fed has three monetary policy tools at its disposal: Open market operations (most common) Suppose the Fed engages in an open market purchase of $10 million. The banking system s T-account reflects an increase in reserves, and a corresponding decrease in assets due to its debt to the Fed. The banking system s reserves are liabilities for the Fed, but it gains assets equal to the debt owed to it by the banking system. 37 of 54

31 Discount Policy I Discount loans Loans the Federal Reserve makes to banks. I Discount rate The interest rate the Federal Reserve charges on discount loans. I When a bank receives a loan from the Fed, its reserves increase by the amount of the loan. By lowering the DR, the Fed can encourage banks to take additional loans and thereby increase their reserves. As a result, MS will increase. I Note that in practice, this policy is used to help banks that experience temporary problems with deposit withdrawals, rather than to use them to increase or decrease MS. I In response to the bank failures that were occurring at the onset of the Great Depression, Congress established the Federal Deposit Insurance Corporation (FDIC) in 1934 to insure deposits in most banks up to a limit, which is currently $250,000 per deposit.

32 Reserve Requirements I When the Fed reduces the RR ratio, it converts required reserves into excess reserves. I This policy is not conducted frequently because frequent adjustments would be disruptive and costly for banks.

33 Putting It All Together: Decisions of the Nonbank Public, Banks, and the Fed I The nonbank public and banks also a ect MS in practice. The public decide how much money to deposit in banks and banks decide how much to reserve and how to loan out. I The Fed sta monitors information on banks reserves and deposits every week, and the Fed can respond quickly to shifts in behavior by depositors or banks. It can therefore steer the MS close to the desired level.

34 The Rise and Effects of the Shadow Banking System The banks we have been discussing so far are commercial banks, whose primary role is to accept funds from depositors and make loans to borrowers. In the last 20 years, two important developments have occurred in the financial system: 1. Banks have begun to resell many of their loans rather than keep them until they are paid off. 2. Financial firms other than commercial banks have become sources of credit to businesses. 39 of 54

35 Securitization Comes to Banking A security is a financial asset such as a stock or a bond that can be bought and sold in a financial market. Traditionally, when a bank made a loan like a residential mortgage loan, it would keep the loan and collect payments until the loan was paid off. In the 1970s, secondary markets developed for securitized loans, allowing them to be traded, much like stocks and bonds. Securitization: The process of transforming loans or other financial assets into securities. (a) Securitizing a loan (b) The flow of payments on a securitized loan Figure 14.4 The process of securitization 40 of 54

36 The Shadow Banking System The 1990s and 2000s brought increasing important of non-bank financial firms, including: Investment banks: banks that do not typically accept deposits from or make loans to households; they provide investment advice, and engage also engage in creating and trading securities such as mortgage-backed securities. Money market mutual funds: funds that sell shares to investors and use the money to buy short-term Treasury bills and commercial paper (loans to corporations). Hedge funds: funds that raise money from wealthy investors and make sophisticated (often non-standard) investments. By raising funds from investors and providing them directly or indirectly to firms and households, these firms have become a shadow banking system. 41 of 54

37 How Does the Money Supply Affect Prices? Beginning in the 16 th century, Spain sent gold and silver from Mexico and Peru back to Europe. These metals were minted into coins, increasing the money supply. Prices in Europe rose steadily during those years. This helped people to make the connection between the amount of money in circulation and the price level. 45 of 54

38 Connecting Money and Prices: The Quantity Equation In the early 20 th century, Irving Fisher formalized the relationship between money and prices as the quantity equation: Money supply velocity of moneyprice level MM VV = PP YY real output Velocity of money: the average number of times each dollar in the money supply is used to purchase goods and services included in GDP. Rewriting this equation by dividing through by M, we obtain: VV = PP YY MM 46 of 54

39 Calculating the Velocity of Money Measuring: The money supply (M) with M1, The price level (P) with the GDP deflator, and The level of real output (Y) with real GDP, We obtain the following value for velocity (V): We can always calculate V. But will we always get the same answer? The quantity theory of money asserts that, subject to measurement error, we will: Quantity theory of money: A theory about the connection between money and prices that assumes that the velocity of money is constant. 47 of 54

40 The Quantity Theory Explanation of Inflation When variables are multiplied together in an equation, we can form the same equation with their growth ratesaddedtogether. So the quantity equation: generates: MM VV = PP YY Growth rate of the money supply + Growth rate of velocity = Growth rate of the price level or the inflation rate + Growth rate of real output Rearranging this to make the inflation rate the subject, and assuming that the velocity of money is constant, we obtain: Inflation rate = Growth rate of the money supply Growth rate of real output 48 of 54

41 The Inflation Rate According to the Quantity Theory Inflation rate = Growth rate of the money supply Growth rate of real output This equation provides the following predictions: 1. If the money supply grows faster than real GDP, there will be inflation. 2. If the money supply grows slower than real GDP, there will be deflation (a decline in the price level). 3. If the money supply grows at the same rate as real GDP, there will be neither inflation nor deflation: the price level will be stable. Is velocity truly constant from year to year? The answer is no. But the quantity theory of money can still provide insight: In the long run, inflation results from the money supply growing at a faster rate than real GDP. 49 of 54

42 How Accurate Are Estimates of Inflation from the QTM? Real GDP growth has been relatively consistent over time. So based on the quantity theory of money (QTM), there should be a predictable, positive relationship between the annual rates of inflation and growth rates of the money supply. There is a positive relationship, but not the consistent relationship implied by a constant velocity of money. Figure 14.5a (a) Inflation and money supply growth in the United States, 1870s-2000s The relationship between money growth and inflation over time and around the world 50 of 54

43 Accuracy of the QTM continued We see a similar story when we compare average rates of inflation and growth rates of the money supply across different countries. Although the relationship is not entirely predictable, countries with higher growth in the money supply do have higher rates of inflation. Figure 14.5b (b) Inflation and money supply growth in 56 countries, The relationship between money growth and inflation over time and around the world 51 of 54