SV151, Principles of Economics K. Christ 6 9 February 2012
SV151, Principles of Economics K. Christ 9 February 2012 Key terms / chapter 21: Medium of exchange Unit of account Store of value Liquidity Commodity money Fiat money Demand deposits Excess reserves Fractional reserve banking Required reserve ratio Money multiplier Federal Reserve Open market operation Discount rate Federal funds rate The Banking System
Fractional Reserve Banking A bank s balance sheet is key to understanding the process of money creation in a fractional reserve banking system: : Required* Excess $100 0 Deposits $1,000 900 Securities * Reserve Ratio in this case = 0.10. The money multiplier is simply the reciprocal of the reserve ratio.
Fractional Reserve Banking A simplified fractional reserve banking system Assuming banks lend out all excess reserves Bank Balance Sheet 1 $100 900 Deposits $1,000 Bank Balance Sheet 2 $90 810 Deposits $900 Bank Balance Sheet 3 $81 729 Deposits $810 Summary: Initial deposit $1,000 Required reserve ratio 0.10 Initial excess reserves $900 New loans by these three banks $2,439 Money multiplier 10 New loans possible by all banks $9,000
Let s make the bank s balance sheets a bit more complicated Now Suppose these three banks hold some of their reserves as securities (instead of lending out all excess reserves) Bank Balance Sheet 1 Securities $100 800 100 Deposits $1,000 Bank Balance Sheet 2 Securities $80 620 100 Deposits $800 Bank Balance Sheet 3 Securities $62 458 100 Deposits $620 Summary: Initial deposit $1,000 Required reserve ratio 0.10 Initial excess reserves $900 New loans by these three banks $1,878 Money multiplier 10 New loans possible by all banks $9,000
Let s introduce a central bank Now Suppose the Central Bank buys $150 of securities from these three banks (an open market operation) Bank Balance Sheet 1 Securities $100 850 50 Deposits $1,000 Bank Balance Sheet 2 Securities $85 715 50 Deposits $850 Bank Balance Sheet 3 Securities $71.50 593.50 50 Deposits $715 Summary: New excess reserves $150 New loans by these three banks $280.50 Money multiplier 10 New loans possible by all banks $1,500
Example
SV151, Principles of Economics K. Christ 13 February 2012 Key terms / chapters 21 and 22: Federal Reserve Open market operation Discount rate Federal funds rate Classical theory of inflation Quantity theory of money Quantity equation Velocity of money Classical dichotomy Monetary neutrality Fisher effect The Banking System (continued) and Money Growth & Inflation
U.S. Federal Reserve System Established by Congress with the passage of the Federal Reserve Act, December 23, 1913. Organization: 12 District Banks and a separate 7- member Board of Governors. Responsibilities include facilitation of payments systems, bank supervision and regulation, conduct of monetary policy. Monetary policy implemented by the Federal Open Market Committee (FOMC).
Central bank policy tools 1. 2. Open market operations The buying and selling of government bonds, through which a central bank can quickly influence the money supply and availability of credit. Reserve requirements Regulations concerning the minimum amount of reserves that banks must hold against deposits in a fractional reserve banking system. 3. Discount rate The short-term interest rate on loans that a central bank makes to commercial banks.
Central bank policy tools 1. Open market operations To Increase The Money Supply Purchase Bonds To Decrease The Money Supply Sell Bonds 2. Reserve requirements Lower the Requirements Raise the Requirements 3. Discount rate Lower the Rate Raise the Rate
Central bank open market operations Expansionary (Loose) Monetary Policy Contractionary (Tight) Monetary Policy Nominal short-term interest rates fall Nominal short-term interest rates rise Increased Spending? Decreased Spending
Recent Federal Reserve Monetary Policy 1/1/1990 1/1/1991 1/1/1992 1/1/1993 1/1/1994 1/1/1995 1/1/1996 1/1/1997 1/1/1998 1/1/1999 1/1/2000 1/1/2001 1/1/2002 1/1/2003 1/1/2004 1/1/2005 1/1/2006 1/1/2007 1/1/2008 1/1/2009 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% U.S. Federal Reserve Monetary Polcy: Target for Federal Funds Rate, 1900 to present 0.00%
Interest Rates, Real and Nominal Short-Term U.S. Interest Rates and Inflation 12.00 10.00 8.00 6.00 4.00 2.00 0.00 Jan-85-2.00 Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 U.S. Govt. Short Term Federal Funds 3-Month CD Consumer Inflation Rate Estimated Real S-T Interest Rate
Monetary Policy and the Money Market INTEREST RATES INTEREST RATES Expansionary Monetary Policy 0 M s M 1 s Contractionary Monetary Policy M 1 s 0 M s i 0 i 1 i 1 i 0 M d Y, i M d Y, i MONEY DEMAND & SUPPLY MONEY DEMAND & SUPPLY
Can monetary policy makers control inflation? What causes inflation? The Quantity Theory of Money F F MV = PQ ( equation of exchange ) Inflation is purely a monetary phenomenon Growth in the money supply, if greater than the growth rate of real output, leads to rising prices How can we control the money supply? Federal Open Market Operations: F Buying securities Increases the money supply Selling securities Decreases the money supply
The quantity theory of money: the quantity equation Money Supply May be measured in various ways Price Level May be measured in various ways MV PY Velocity The rate at which money changes hands Real Output Real GDP is a typical approximation
The quantity theory of money % M % V % P % Y F If velocity is stable, to maintain price stability, the growth rate of the money supply should equal the growth rate of real output. F If velocity is stable, a money supply growth rate in excess of the growth rate of real output will lead to rising prices.
The classical dichotomy (and monetary neutrality) 1. The classical dichotomy The theoretical separation of nominal and real variables. 2. Variables measured in monetary units: Nominal GDP Money supply Prices and price levels Nominal interest rates Variables measured in physical units: Real GDP Quantities of specific goods Relative prices Real interest rates Monetary neutrality The proposition that changes in the money supply do not affect real variables. Long-run Neutrality vs. Short-run Neutrality