Macroeconomics CHAPTER 13. Money, Banking, and the Federal Reserve System

Transcription

1 Macroeconomics CHAPTER 13 Money, Banking, and the Federal Reserve System

2 What you will learn in this chapter: The various roles money plays and the many forms it takes in the economy. How the actions of private banks and the Federal Reserve determine the money supply. How the Federal Reserve uses open-market operations to change the monetary base. 2

3 The Meaning of Money Money is any asset that can easily be used to purchase goods and services. Currency in circulation is cash held by the public. Checkable bank deposits are bank accounts on which people can write checks. The money supply is the total value of financial assets in the economy that are considered money. 3

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. 4

5 Types of Money Commodity money is a good used as a medium of exchange that has other uses. A commodity-backed money is a medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods. Fiat money is a medium of exchange whose value derives entirely from its official status as a means of payment. 5

6 Money and Banking Money 1. Why do we have money? There are three basic functions that money serves a) Medium of exchange allows for the specialization of workers. They receive money wages to buy goods needed rather than produce their own goods. avoids the problem of the double coincidence of wants. In a society with barter you must find someone who has what you desire and wants what you have produced. b) Accounting Unit: allows valuation and pricing in a common unit c) store of value: in barter, need to store goods which could perish or lose value. e.g. light blue leisure suit with polyester floral print shirt. With money one can store value over time. Advantages of money highly liquid as compared to stocks and bonds. Disadvantages of money Loses value during inflationary periods or episodes. Different Types of Money a) Commodity Money has value as a commodity such as rice, cattle, seashells, copper, stones, cigarettes as used in the POW camps of WWII. problems when valuable resources are used as money, those resources cannot be used for consumption. Copper used to make pennies cannot be used to make electrical wire. There exists an incentive to debase the currency. Rulers would reduce the amount of the precious metal in a coin. People would tend to circulate the altered coins and save the coins which still had the greater amount of the precious metal. This is known as Gresham s law: bad money drives out good. The supply of money is determined by supply of the commodity. The money supply could fluctuate substantially. The discovery of new gold would mean that the supply of money would increase and the price level would rise. b) Fiat Money (has nothing to do with an Italian sports car) very little value as a commodity money because the public accepts it as money (not necessarily because the government declares it as money) Peopel accept it because they believe that everyone else will accept it. This is very different from a fully backed currency that is a currency that is backed by some commodity like gold or silver. For example in the early part of this century the US still had silver dollar notes. If one wanted one could take the note to the treasury and demand the silver which was held since the inception of the note as a form of its backing. 5a

7 advantages of fiat money uses relatively little of society s resources no incentive to debase this type of currency supply not tied to commodity. Therefore it potentially has less susceptibility to lead to fluctuation in the money supply. It can grow with the economy. problem government controls money supply and it may cause inflation by printing too much money Bank Money: checks backed by a bank account. in the US we have Fiat and Bank Money 5b

8 Measuring the Money Supply A monetary aggregate is an overall measure of the money supply. Near-moneys are financial assets that can t be directly used as a medium of exchange but can readily be converted into cash or checkable bank deposits. 6

9 Monetary Aggregates The Federal Reserve uses three definitions of the money supply: M1, M2, and M3. M1 = $1,368.4 (billions of dollars), June 2005 M1 is equally split between currency in circulation and checkable bank deposits. 7

10 Monetary Aggregates The Federal Reserve uses three definitions of the money supply: M1, M2, and M3. M2 = $6,510.0 (billions of dollars), June 2005 M2 has a much broader definition: it includes M1, plus a range of other deposits and deposit-like assets, making it about three times as large. 8

11 Money Supply Definitions Most liquid M1 = currency held by the public (not including the banks) + demand deposits (non-interest checking accounts) + other checkable deposits (interest bearing checking) +traveller s checks Less liquid M2 = M1 + savings deposits + money market mutual fund share, deposits + small time deposits (<$100,000) + other Least liquid M3 = M2 + large time deposits (>$100,000) We usually refer to M1 as the money supply. Credit cards are not money-they are short-term loans which must be paid off using money. 8a

12 The Monetary Role of Banks A bank is a financial intermediary that uses liquid assets in the form of bank deposits to finance the illiquid investments of borrowers. Bank reserves are the currency banks hold in their vaults plus their deposits at the Federal Reserve. The reserve ratio is the fraction of bank deposits that a bank holds as reserves. 9

13 Assets and Liabilities of First Street Bank A T-account summarizes a bank s financial position. The bank s assets, $900,000 in outstanding loans to borrowers and reserves of $100,000, are entered on the left side. Its liabilities, $1,000,000 in bank deposits held for depositors, are entered on the right side. 10

14 The Problem of Bank Runs A bank run is a phenomenon in which many of a bank s depositors try to withdraw their funds due to fears of a bank failure. Historically, they have often proved contagious, with a run on one bank leading to a loss of faith in other banks, causing additional bank runs. 11

15 Bank Regulations Deposit Insurance - guarantees that a bank s depositors will be paid even if the bank can t come up with the funds, up to a maximum amount per account. The FDIC currently guarantees the first $100,000 of each account. 12

16 Bank Regulations Capital Requirements - regulators require that the owners of banks hold substantially more assets than the value of bank deposits. In practice, banks capital is equal to 7% or more of their assets. 13

17 Bank Regulations Reserve Requirements - rules set by the Federal Reserve that determine the minimum reserve ratio for a bank. For example, in the United States, the minimum reserve ratio for checkable bank deposits is 10%. 14

18 Determining the Money Supply Effect on the Money Supply of a Deposit at First Street Bank - Initial Effect Before Bank Makes New Loans 15

19 Determining the Money Supply Effect on the Money Supply of a Deposit at First Street Bank - Effect After Bank Makes New Loans 16

20 How Banks Create Money 17

21 Reserves, Bank Deposits, and the Money Multiplier Excess reserves are bank reserves over and above its required reserves. Increase in bank deposits from $1,000 in excess reserves = $1,000 + $1,000 (1 rr) + $1,000 (1 rr)2 + $1,000 (1 rr) this can be simplified to: Increase in bank deposits from $1,000 in excess reserves = $1,000/rr 18

22 The Money Multiplier in Reality 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. 19

23 The Federal Reserve System A central bank is an institution that oversees and regulates the banking system and controls the monetary base. The Federal Reserve is a central bank an institution that oversees and regulates the banking system, and controls the monetary base. The Federal Reserve system consists of the Board of Governors in Washington, D.C., plus regional Federal Reserve Banks, each serving its district; of the 12 Federal Reserve districts: 20

24 The Federal Reserve System 21

25 What the Fed Does: 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. 22

26 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: 23

27 Open-Market Operations by the Federal Reserve An Open-Market Purchase of $100 Million 24

28 Open-Market Operations by the Federal Reserve An Open-Market Sale of $100 Million 25

29 The End of Chapter 13 coming attraction: Chapter 14: Monetary Policy 26