Money, Banks and the Federal Reserve By The Great Gamecock 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 1 of 43
2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 2 of 43 McDonald s Money Problems in Argentina LEARNING Objectives 15.1 Define money and discuss its four functions. 15.2 Discuss the definitions of the money supply used in the United States today. 15.3 Explain how banks create money. 15.4 Discuss the three policy tools the Federal Reserve uses to manage the money supply. Confidence and trust cannot be taken for granted. households and firms losing faith in an official money can harm trade and economic activity in an economy. 15.5 Explain the quantity theory of money and use it to explain how high rates of inflation occur.
Learning Objective 15.1 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 3 of 43 What Is Money and Why Do We Need It? Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts. Asset Anything of value owned by a person or a firm.
Learning Objective 15.1 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 4 of 43 What Is Money and Why Do We Need It? Barter and the Invention of Money Commodity money A good used as money that also has value independent of its use as money. The Functions of Money Anything used as money whether a deerskin, a cowrie seashell, cigarettes, or a dollar bill should fulfill the following four functions: Medium of exchange Unit of account Store of value Standard of deferred payment
Learning Objective 15.1 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 5 of 43 What Is Money and Why Do We Need It? The Functions of Money Medium of Exchange Money serves as a medium of exchange when sellers are willing to accept it in exchange for goods or services. Unit of Account In a barter system, each good has many prices. Store of Value Money allows value to be stored easily: If you do not use all your accumulated dollars to buy goods and services today, you can hold the rest to use in the future. Standard of Deferred Payment Money is useful because it can serve as a standard of deferred payment in borrowing and lending.
Learning Objective 15.1 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 6 of 43 What Is Money and Why Do We Need It? What Can Serve as Money? 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 different goods are valued differently.
Learning Objective 15.1 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 7 of 43 What Is Money and Why Do We Need It? What Can Serve as Money? Commodity Money Fiat Money Commodity money meets the criteria for a medium of exchange. It can be inefficient for an economy to rely on only gold or other precious metals for its money supply.
Learning Objective 15.1 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 8 of 43 What Is Money and Why Do We Need It? What Can Serve as Money? Commodity Money Federal Reserve System The central bank of the United States. Fiat money Money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money.
2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 9 of 43 Making the Connection Money without a Government? The Strange Case of the Iraqi Dinar Learning Objective 15.1 Many Iraqis continued to use currency with Saddam s picture on it, even after he was forced from power.
Learning Objective 15.2 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 10 of 43 How Is Money Measured in the United States Today? M1: The Narrowest Definition of the Money Supply M1 The narrowest definition of the money supply: The sum of currency in circulation, checking account deposits in banks, and holdings of traveler s checks.
Learning Objective 15.2 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 11 of 43 How Is Money Measured in the United States Today? M1: The Narrowest Definition of the Money Supply M1 includes: 1 Currency, which is all the paper money and coins that are in circulation, where in circulation means not held by banks or the government 2 The value of all checking account deposits at banks 3 The value of traveler s checks (although this last category is so small less than $7 billion in April 2008 we will ignore it in our discussion of the money supply)
Learning Objective 15.2 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 12 of 43 How Is Money Measured in the United States Today? M1: The Narrowest Definition of the Money Supply Figure 15-1 Measuring the Money Supply, April 2008
2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 13 of 43 Making the Connection Do We Still Need the Penny? Learning Objective 15.2 Unfortunately, these cost the government more than a penny to produce.
Learning Objective 15.2 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 14 of 43 How Is Money Measured in the United States Today? M2: A Broader Definition of Money M2 A broader definition of the money supply: M1 plus savings account balances, smalldenomination time deposits, balances in money market deposit accounts in banks, and noninstitutional money market fund shares. Don t Let This Happen to YOU! Don t Confuse Money with Income or Wealth
Learning Objective 15.2 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 15 of 43 How Is Money Measured in the United States Today? M2: A Broader Definition of Money There are two key points about the money supply 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 money supply, banks play an important role in the process by which the money supply increases and decreases. We will discuss this second point further in the next section. What about Credit Cards and Debit Cards? Many people buy goods and services with credit cards, yet credit cards are not included in definitions of the money supply.
Learning Objective 15.2 Solved Problem 15-2 The Definitions of M1 and M2 Suppose you decide to withdraw $2,000 from your checking account and use the money to buy a bank certificate of deposit (CD). Briefly explain how this will affect M1 and M2. 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 16 of 43
Learning Objective 15.3 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 17 of 43 How Do Banks Create Money? Bank Balance Sheets Figure 15-2 Balance Sheet for Wachovia Bank, December 31, 2007 Don t Let This Happen to YOU! Know When a Checking Account Is an Asset and When It Is a Liability
Learning Objective 15.3 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 18 of 43 How Do Banks Create Money? Bank Balance Sheets Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve. Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits. Required reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves. Excess reserves Reserves that banks hold over and above the legal requirement.
Learning Objective 15.3 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 19 of 43 How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money
Learning Objective 15.3 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 20 of 43 How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money
Learning Objective 15.3 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 21 of 43 How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money
Learning Objective 15.3 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 22 of 43 How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money
Learning Objective 15.3 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 23 of 43 How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money BANK Wachovia $1,000 INCREASE IN CHECKING ACCOUNT DEPOSITS PNC + 900 (= 0.9 x $1,000) Third Bank + 810 (= 0.9 x $900) Fourth Bank + 729 (= 0.9 x $810). +. +. + Total Change in Checking Account Deposits =$10,000
Learning Objective 15.3 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 24 of 43 How Do Banks Create Money? The Simple Deposit Multiplier Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves. Simple deposit multiplier 1 RR Change in checking account deposits 1 Change in bank reserves x RR
Learning Objective 15.3 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 25 of 43 Solved Problem 15-3 Showing How Banks Create Money PNC Bank Assets Liabilities Reserves +$5,000 Deposits +$5,000 PNC Bank Assets Liabilities Reserves +$5,000 Deposits +$5,000 Loans +$4,500 Deposits +$4,500 PNC Bank Assets Liabilities Reserves +$500 Deposits +$5,000 Loans +$4,500 Wachovia Bank Assets Liabilities Reserves +$4,500 Deposits +$4,500
Learning Objective 15.3 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 26 of 43 How Do Banks Create Money? The Simple Deposit Multiplier versus the Real-World Deposit Multiplier We can summarize these important conclusions: 1 Whenever banks gain reserves, they make new loans, and the money supply expands. 2 Whenever banks lose reserves, they reduce their loans, and the money supply contracts.
Learning Objective 15.4 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 27 of 43 The Federal Reserve System Bank Balance Sheets Fractional reserve banking system A banking system in which banks keep less than 100 percent of deposits as reserves. Bank run A situation in which many depositors simultaneously decide to withdraw money from a bank. Bank panic A situation in which many banks experience runs at the same time.
2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 28 of 43 Making the Connection The 2001 Bank Panic in Argentina Learning Objective 15.4 The Argentine central bank was unable to stop the bank panic of 2001.
Learning Objective 15.4 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 29 of 43 The Federal Reserve System The Organization of the Federal Reserve System Figure 15-3 Federal Reserve Districts
Learning Objective 15.4 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 30 of 43 The Federal Reserve System How the Federal Reserve Manages the Money Supply Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives. To manage the money supply, the Fed uses three monetary policy tools: 1 Open market operations 2 Discount policy 3 Reserve requirements
Learning Objective 15.4 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 31 of 43 The Federal Reserve System How the Federal Reserve Manages the Money Supply Open Market Operations Federal Open Market Committee (FOMC) The Federal Reserve committee responsible for open market operations and managing the money supply in the United States. Open market operations The buying and selling of Treasury securities by the Federal Reserve in order to control the money supply.
Learning Objective 15.4 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 32 of 43 The Federal Reserve System How the Federal Reserve Manages the Money Supply Discount Policy Discount loans Loans the Federal Reserve makes to banks. Discount rate The interest rate the Federal Reserve charges on discount loans. Reserve Requirements When the Fed reduces the required reserve ratio, it converts required reserves into excess reserves.
Learning Objective 15.4 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 33 of 43 The Federal Reserve System Putting It All Together: Decisions of the Nonbank Public, Banks, and the Fed Using its three tools open market operations, the discount rate, and reserve requirements the Fed has substantial influence over the money supply, but that influence is not absolute. Two other actors the nonbank public and banks also influence the money supply.
Learning Objective 15.5 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 34 of 43 The Quantity Theory of Money Connecting Money and Prices: The Quantity Equation In the early twentieth century, Irving Fisher, an economist at Yale, formalized the connection between money and prices using the quantity equation: M V = P Y
Learning Objective 15.5 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 35 of 43 The Quantity Theory of Money Connecting Money and Prices: The Quantity Equation Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services included in GDP. V P x Y M Quantity theory of money A theory of the connection between money and prices that assumes that the velocity of money is constant.
Learning Objective 15.5 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 36 of 43 The Quantity Theory of Money The Quantity Theory Explanation of Inflation We can transform the quantity equation from: M xv P xy to: Growth rate of the money supply + Growth rate of velocity = Growth rate of the price level (or inflation rate) + Growth rate of real output
Learning Objective 15.5 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 37 of 43 The Quantity Theory of Money The Quantity Theory Explanation of Inflation The growth rate of the price level is just the inflation rate, so we can rewrite the quantity equation to help us understand the factors that determine inflation: Inflation rate = Growth rate of the money supply + Growth rate of velocity Growth rate of real output If Irving Fisher was correct that velocity is constant, then the growth rate of velocity will be zero. This allows us to rewrite the equation one last time: Inflation rate = Growth rate of the money supply Growth rate of real output
Learning Objective 15.5 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 38 of 43 The Quantity Theory of Money The Quantity Theory Explanation of Inflation This equation leads to the following predictions: 1 If the money supply grows at a faster rate than real GDP, there will be inflation. 2 If the money supply grows at a slower rate than real GDP, there will be deflation. (Recall that deflation is a decline in the price level.) 3 If the money supply grows at the same rate as real GDP, the price level will be stable, and there will be neither inflation nor deflation.
Learning Objective 15.5 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 39 of 43 The Quantity Theory of Money High Rates of Inflation Very high rates of inflation in excess of hundreds or thousands of percentage points per year are known as hyperinflation. Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession.
Learning Objective 15.5 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 40 of 43 The Quantity Theory of Money High Inflation in Argentina Figure 15-4 Money Growth and Inflation in Argentina
2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 41 of 43 Making the Connection The German Hyperinflation of the Early 1920s Learning Objective 15.4 During the hyperinflation of the 1920s, people in Germany used paper currency to light their stoves.
2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 42 of 43 An Inside LOOK at Policy Using Reserve Requirements to Slow Bank Lending in China China Lifts Bank Reserves in Bid to Cool Growth Fixing the value of the yuan against the U.S. dollar has effectively fueled the growth in China s bank reserves.
K e y T e r m s Asset Bank panic Bank run Commodity money Discount loans Discount rate Excess reserves Federal Open Market Committee (FOMC) Federal Reserve System Fiat money Fractional reserve banking system M1 M2 Monetary policy Money Open market operations Quantity theory of money Required reserve ratio Required reserves Reserves Simple deposit multiplier Velocity of money 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O Brien, 2e. 43 of 43