CH 30+31 Lecture McGraw-Hill/Irwin Colander, Economics 1-1
Money 2
The Definition and Functions of Money Money is anything that is generally accepted as payment for goods or services Money is a highly liquid financial asset it is easily changeable into another asset or good 30-3
The Definition and Functions of Money Commodity money: something that performs the function of money and has alternative uses Examples: Gold, silver, cigarettes, etc. Fiat money: Something that serves as money but has no other important uses Examples: Paper money and coins McGraw-Hill/Irwin Colander, Economics 4
The 3 Functions of Money Medium of exchange Money can easily be used to buy goods and services without bartering Unit of account (measure of value) Money measures the value of all goods and services Store of wealth Money allows you to store purchasing power for the future McGraw-Hill/Irwin Colander, Economics 5
M 1 and M 2 Alternative Measures of Money M 1 : consists of coins and currency plus checking accounts (checkable deposits) and traveler s checks 30-6
Alternative Measures of Money M 2 consists of M 1 plus savings deposits (money market accounts), time deposits (CDs = certificates of deposit), and mutual funds McGraw-Hill/Irwin Colander, Economics 7
Money and Credit Credit cards are not money They are a short-term loan (usually with a higher than normal interest rate) A debit card is part of the monetary system because it serves the same function as a check since it allows you to spend money from your bank account 30-8
Why People Hold Money The transactions motive is the need to hold money for spending The precautionary motive is holding money for unexpected expenses and impulse buying The speculative motive is holding cash to avoid holding financial assets whose prices are falling 30-9
Time Value of Money The future value of money is: P (1 + r) n P = principal or amount of money r = interest rate n = number of years McGraw-Hill/Irwin Colander, Economics 10
Time Value of Money Calculate the future value of $100 with 5% interest, 10 years from now P (1 + r) n 100 (1 + 0.05) 10 = $162.89 McGraw-Hill/Irwin Colander, Economics 11
Present Value of Money The present value of money is: Amount of money (1 + r) n Present value of $100 a year from now 100 (1+0.10) 1 = $90.91 See Mr. Clifford Video McGraw-Hill/Irwin Colander, Economics 12
INTEREST RATES Colander, Economics 13
Interest Rates Interest rate: the price paid for use of a financial asset The long-term interest rate is the price paid for financial assets with long maturities, such as mortgages The market for long-term financial assets is called the loanable funds market 30-14
Interest Rates The short-term interest rate is the price paid for financial assets with short maturities Short-term financial assets are called money McGraw-Hill/Irwin Colander, Economics 15
Real Interest Rate Interest Rates and Inflation The percentage increase in purchasing power that a borrower pays (adjusted for inflation) Real interest rate = nominal interest rate - expected inflation McGraw-Hill/Irwin Colander, Economics 16
Interest Rates and Inflation Nominal Interest Rate The percentage increase in money that the borrower pays not adjusted for inflation Nominal interest rate = Real interest rate + expected inflation McGraw-Hill/Irwin Colander, Economics 17
Interest Rates and Inflation Example #1: You lend out $100 with 20% interest. Inflation is 15%. A year later you get paid back $120. What is the nominal and what is the real interest rate? The nominal interest rate is 20%. The real interest rate was 5%. In reality, you get paid back an amount with less purchasing power. McGraw-Hill/Irwin Colander, Economics 18
Interest Rates and Inflation Example #2: You lend out $100 with 10% interest. Prices are expected to increase 20%. In a year you get paid back $110. What is the nominal and what is the real interest rate? The nominal interest rate is 10%. The real rate was 10% In reality, you get paid back an amount with less purchasing power. McGraw-Hill/Irwin Colander, Economics 19
Loanable Funds McGraw-Hill/Irwin Colander, Economics 20
Loanable Funds Market The loanable funds market is the private sector supply and demand of loans It represents the money in commercial banks and lending institutions that is available to lend out to firms and households to finance expenditures (investment or consumption) This market shows the effect on the real interest rate (r) McGraw-Hill/Irwin Colander, Economics 21
Loanable Funds Market Demand for loanable funds: there is an inverse relationship between the real interest rate and the quantity of loans demanded At higher interest rates, households prefer to delay their spending and put their money in savings McGraw-Hill/Irwin Colander, Economics 22
Loanable Funds Market Supply of loanable funds: there is a direct relationship between the real interest rate and the quantity of loans supplied An increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out) McGraw-Hill/Irwin Colander, Economics 23
Loanable Funds Market Demand Shifters 1. Changes in perceived business opportunities 2. Changes in government borrowing 3. Budget deficit 4. Budget surplus Supply Shifters 1. Changes in private savings behavior 2. Changes in public savings 3. Changes in foreign investment 4. Changes in expected profitability McGraw-Hill/Irwin Colander, Economics 24
Draw the Graph: Increase in the Supply of Loanable Funds Real Interest Rate S 1 or S LF1 S 2 or S LF2 r 1 r 2 Q 1 Q 2 D 1 or D LF1 Q of Loanable Funds 30-25
Draw the Graph: Decrease in the Supply of Loanable Funds Real Interest Rate S 2 or S LF2 S 1 or S LF1 r 2 r 1 Q 2 Q 1 D 1 or D LF1 Q of Loanable Funds 30-26
Draw the Graph: Increase in the Demand for Loanable Funds Real Interest Rate S 1 or S LF1 r 2 r 1 D 2 or D LF2 Q 1 Q 2 D 1 or D LF1 Q of Loanable Funds 30-27
Draw the Graph: Decrease in the Demand for Loanable Funds Real Interest Rate S 1 or S LF1 r 1 r 2 D 1 or D LF1 Q 2 Q 1 D 2 or D LF2 Q of Loanable Funds 30-28
Loanable Funds Example The government increases deficit spending Draw the graph that illustrates this concept 30-29
Loanable Funds Example Government borrows from the private sector, increasing the demand for loans Real Interest Rate r 2 r 1 S 1 or S LF1 D 2 or D LF2 Real interest rates increase causing crowding out (of investment) Q 1 Q 2 D 1 or D LF1 Q of Loanable Funds 30-30
The Fed and Monetary Policy Colander, Economics 31
The Fed The Federal Reserve Bank (the Fed) is the U.S. central bank Federal Reserve notes are liabilities of the Fed that serve as cash A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms 30-32
Structure of the Fed Board of Governors 7 members appointed by the president and confirmed by the senate Oversees Regional Reserve Banks and Branches 12 regional Federal Reserve banks and 25 branches Federal Open Market Committee (FOMC) Board of Governors plus 5 Federal Reserve bank presidents Open Market Operations Provides Services FINANCIAL SECTOR GOVERNMENT 31-33
Six Duties of the Fed 1. Conducts monetary policy (influencing the supply of money and credit in the economy) 2. Supervises and regulates financial institutions 3. Lender of last resort to financial institutions 31-34
Six Duties of the Fed 4. Provides banking services to the U.S. government 5. Issues coin and currency 6. Provides financial services to commercial banks, savings and loan associations, savings banks, and credit unions McGraw-Hill/Irwin Colander, Economics 35
Monetary Policy Monetary policy: influencing the economy through changes in the banking system s reserves, which in turn, influences the money supply and credit availability in the economy 31-36
Monetary Policy If commercial banks need to borrow money, they can do so from the Fed If there s a financial panic and a run on banks, the central bank is there to make loans Can we go to the Fed to get a loan? No 31-37
Expansionary Monetary Policy Expansionary monetary policy is designed to counteract the effects of recession and return the economy to full employment It increases the money supply It decreases interest rates and it tends to increase both investment and output Also called the easy money policy M i I Y M=money supply i=interest rate I=investment Y=output 31-38
Draw the AS/AD Graph: Expansionary Monetary Policy Price level LRAS SRAS P 2 P 1 AD 2 AD 1 Y 1 Y 2 Real GDP 31-39
Contractionary Monetary Policy Contractionary monetary policy is designed to counteract the effects of inflation and return the economy to full employment It decreases the money supply It increases the interest rate, and it tends to decrease both investment and output Also called the tight money policy M i I Y M=money supply i=interest rate I=investment Y=output 31-40
Draw the AS/AD Graph: Contractionary Monetary Policy Price level LRAS SRAS P 1 P 2 AD 1 Y 2 Y 1 AD 2 Real GDP 31-41
1. Reserve requirement 2. Discount rate Tools of Monetary Policy 3. Open market operations These are the 3 shifters of the money supply These tools are used by the Fed to regulate the amount of money in circulation McGraw-Hill/Irwin Colander, Economics 42
The Reserve Requirement The reserve requirement is the percent of deposits that banks must hold in reserve (the percent they can NOT loan out) Banks keep some of the money in reserve and loan out their excess reserves Reserves and interest rates are inversely related 31-43
Reserve Requirement By changing the reserve requirement the Fed can increase or decrease the money supply If the Fed increases the reserve requirement it contracts the money supply banks have to keep more reserves and lend out less money (decreases the money multiplier) McGraw-Hill/Irwin Colander, Economics 44
Reserve Requirement If the Fed decreases the reserve requirement it expands the money supply banks have more money to lend out (increases the money multiplier) McGraw-Hill/Irwin Colander, Economics 45
Reserve Requirement If there is a recession, what should the Fed do to the reserve requirement? It should decrease the reserve ratio This means banks hold less money and have more excess reserves Banks create more money by loaning out excess reserves The money supply increases, interest rates fall, and AD increases McGraw-Hill/Irwin Colander, Economics 46
Reserve Requirement If there is inflation, what should the Fed do to the reserve requirement? Increase the reserve ratio This means banks hold more money and have less excess reserves Banks create less money The money supply decreases, interest rates increase, and AD decreases McGraw-Hill/Irwin Colander, Economics 47
The Discount Rate Discount rate: the interest rate the Fed charges for the loans it makes to commercial banks To increase the money supply, the Fed should decrease the discount rate To decrease the money supply, the Fed should increase the discount rate McGraw-Hill/Irwin Colander, Economics 48
Open Market Operations The primary way in which the Fed changes the amount of reserves in the system Open market operations occur when the Fed buys or sells government securities (bonds) To expand the money supply, the Fed buys bonds To decrease the money supply, the Fed sells bonds 31-49
Open Market Operations How are you going to remember this? Buy-BIG: Buying bonds increases the money supply Sell-SMALL: Selling bonds decreases the money supply McGraw-Hill/Irwin Colander, Economics 50
Open Market Operations There is an inverse relationship between bond prices and interest rates When the Fed buys bonds, the price of bonds rises and interest rates fall When the Fed sells bonds, the price of bonds falls and interest rates rise McGraw-Hill/Irwin Colander, Economics 51
Open Market Purchases An open market purchase is an expansionary monetary policy that tends to reduce interest rates and increase income When the Fed buys bonds, it deposits money in banks account with the Fed Bank reserves are then increased When banks loan out the excess reserves, the money supply increases 31-52
Open Market Sales An open market sale is a contractionary monetary policy that tends to raise interest rates and lower income When the Fed sells bonds, it receives checks drawn against banks The bank s reserves are reduced and the money supply decreases 31-53
The Federal Funds Market The federal funds rate is the interest rate that banks charge one another for one-day loans of reserves Federal funds are loans of excess reserves that banks make to one another (Often asked about on the AP exam) 31-54
The Federal Funds Market The Fed can increase or reduce reserves by buying or selling bonds By selling bonds, the Fed decreases reserves This causes the fed funds rate to increase (banks have less reserves to loan out) By buying bonds, the Fed increases reserves This causes the fed funds rate to decrease (banks have more reserves to loan out) McGraw-Hill/Irwin Colander, Economics 55
The Fed Funds Rate as an Operating Target If the federal funds rate is above the Fed s target range, it buys bonds to increase reserves and lower the Fed funds rate If the federal funds rate is below the Fed s target range, it sells bonds to decrease reserves and raise the Fed funds rate The current federal funds rate is 1.5% It can take as long as 12-18 months for a change in this rate to affect the entire economy McGraw-Hill/Irwin Colander, Economics 56
Quantitative Easing Quantitative easing is a monetary policy used by the Fed to buy government bonds to stimulate the economy The Fed might decide to purchase assets from commercial banks in order to increase the price of those assets, which increases the money supply and lowers interest rates May be used when inflation is low and open market operations are not working McGraw-Hill/Irwin Colander, Economics 57
The Money Market McGraw-Hill/Irwin Colander, Economics 58
The Money Market The market where the Fed and the users of money interact thus determining the nominal interest rate (i%) McGraw-Hill/Irwin Colander, Economics 59
The Money Market Money Demand (MD) comes from households, firms, government and the foreign sector The demand for money shows an inverse relationship between nominal interest rates and the quantity of money demanded McGraw-Hill/Irwin Colander, Economics 60
The Money Market The Money Supply (MS) is determined only by the Federal Reserve The money supply curve is vertical because it is determined by the Fed s (or central bank s) particular monetary policy McGraw-Hill/Irwin Colander, Economics 61
Draw the Graph: The Money Market Nominal Interest Rate (ir) i 1 MS NOTE: i=nominal interest rate I= Investment Be careful! MD or D M Q Quantity of Money or Q M1 M McGraw-Hill/Irwin Colander, Economics 62 62
The Demand for Money What happens to the quantity demanded of money when interest rates increase? Quantity demanded falls because individuals would prefer to have interest earning assets instead What happens to the quantity demanded when interest rates decrease? Quantity demanded increases There is no incentive to convert cash into interest earning assets McGraw-Hill/Irwin Colander, Economics 63
Shifters of Money Demand The Financial Sector and 1. Changes in price level 2. Changes in income 3. Changes in taxation that affects personal investment McGraw-Hill/Irwin Colander, Economics 64 64
Draw the Graph: Increase in Money Demand Nominal Interest Rate (ir) MS Scenario: The price level increases. i 2 i 1 MD 2 MD 1 Q Q M1 M (billions of dollars) McGraw-Hill/Irwin Colander, Economics 65 65
Draw the Graph: Decrease in Money Demand Nominal Interest Rate (ir) MS Scenario: The price level decreases. i 1 i 2 MD 1 MD 2 Q Q M1 M (billions of dollars) McGraw-Hill/Irwin Colander, Economics 66 66
Shifters of the Money Supply 1. Reserve requirement 2. Discount rate 3. Open market operations McGraw-Hill/Irwin Colander, Economics 67
Draw the Graph: Increase in Money Supply Nominal Interest Rate (ir) MS 1 MS 2 Scenario: The Fed buys bonds on the open market. i 1 i 2 Q M1 MD 1 Q M2 McGraw-Hill/Irwin Colander, Economics 68 68 Q M (billions of dollars)
Draw the Graph: Decrease in Money Supply Nominal Interest Rate (ir) MS 2 MS 1 Scenario: The Fed sells bonds on the open market. i 2 i 1 Q M2 MD 1 Q M1 McGraw-Hill/Irwin Colander, Economics 69 69 Q M (billions of dollars)
The Money Supply and AD How does this affect AD? An increase in the money supply leads to a decrease in interest rates, an increase in investment and therefore an increase in AD M i I AD McGraw-Hill/Irwin Colander, Economics 70
The Money Supply and AD How does this affect AD? Decreasing the money supply leads to an increase in interest rates, which decreases investment and AD M i I AD McGraw-Hill/Irwin Colander, Economics 71
Draw the Graphs: The Money Supply and AD The economy is in a recession. Using the AS/AD model and the money market, demonstrate an expansionary monetary policy to move the economy out of a recession. McGraw-Hill/Irwin Colander, Economics 72
Draw the Graphs: The Money Supply and AD The economy is in a recession. Using the AS/AD model and the money market, demonstrate an expansionary monetary policy to move the economy out of a recession. McGraw-Hill/Irwin Colander, Economics 73
Draw the Graphs: The Money Supply and AD The economy has rising inflation. Using the AS/AD model and the money market, demonstrate a contractionary monetary policy to move the economy out of an inflationary gap. McGraw-Hill/Irwin Colander, Economics 74
Draw the Graphs: The Money Supply and AD The economy has rising inflation. Using the AS/AD model and the money market, demonstrate a contractionary monetary policy to move the economy out of an inflationary gap. McGraw-Hill/Irwin Colander, Economics 75
How are AS/AD, Loanable Funds, and the Money Market Connected? If there is an expansionary monetary policy, what are the results? AD increases MS increases The supply of loanable funds increases McGraw-Hill/Irwin Colander, Economics 76
How are AS/AD, Loanable Funds, and the Money Market Connected? If there is a contractionary monetary policy, what are the results? AD decreases MS decreases The supply of loanable funds decreases McGraw-Hill/Irwin Colander, Economics 77
Putting it all Together: AS/AD, The Money Market, & Loanable Funds Market Interest Rate MS 1 i 1 Expansionary Monetary Policy: Increases AD Money Market MS 2 Expansionary monetary policy leads to Interest Rate r 1 Loanable Funds Market an increase in loanable funds S LF1 S LF2 i 2 r 2 D M QM 1 QM 2 Q of Money Q 1 Q 2 D LF Q of Loanable Funds McGraw-Hill/Irwin Colander, Economics 78
Putting it all Together: AS/AD, The Money Market, & Loanable Funds Market Interest Rate MS 2 i 2 Contractionary Monetary Policy: Decreases AD Money Market MS 1 Contractionary monetary policy leads to Interest Rate r 2 Loanable Funds Market an decrease in loanable funds S LF2 S LF1 i 1 r 1 D M QM 2 QM 1 Q of Money Q 2 Q 1 D LF Q of Loanable Funds McGraw-Hill/Irwin Colander, Economics 79
The Fed and the Creation of Money McGraw-Hill/Irwin Colander, Economics 80
Banks and the Creation of Money The first step in the creation of money: The Fed creates money by simply printing currency (really it is the Bureau of Engraving and Printing who prints the money the Fed orders) Currency is a financial asset to the bearer and a liability to the Fed 30-81
Banks and the Creation of Money The bearer deposits the currency in a checking account at the bank The form of money has changed from currency to a bank deposit 30-82
Banks and the Creation of Money The second step in the creation of money: The bank lends a fraction of the deposit The amount of money has expanded: Initial deposit + new loan The amount of money is multiplied 30-83
Reserves Reserves: currency and deposits a bank keeps on hand or at the Fed or central bank, to manage the normal cash inflows and outflows The required reserve ratio (RRR) is the percentage that banks are required to hold (set by the Fed) 30-84
Reserves The reserve ratio is the ratio of reserves to deposits a bank keeps and does not loan out (can include excess reserves) Reserve ratio = required reserve ratio + excess reserve ratio McGraw-Hill/Irwin Colander, Economics 85
Calculating the Money Multiplier 1/r is the simple money multiplier The simple money multiplier is the measure of the amount of money ultimately created per dollar deposited in the banking system, when people hold no currency 30-86
Calculating the Money Multiplier It tells us how much money will ultimately be created by the banking system from an initial inflow of money The higher the reserve ratio, the smaller the money multiplier, and the less money that will be created McGraw-Hill/Irwin Colander, Economics 87
Calculating the Money Multiplier When People Hold Currency The simple money multiplier reflects the assumption that only banks hold currency When firms and individuals hold currency, the money multiplier in the economy is: (1 + c) (r + c) 30-88
Calculating the Money Multiplier when People Hold Currency Where r is the percentage of deposits banks hold in reserve and c is the ratio of money people hold in currency to the money they hold as deposits McGraw-Hill/Irwin Colander, Economics 89
Determining How Many Demand Deposits Will Be Created Demand deposits: bank deposits that can be withdrawn at any time To find the total amount of deposits that will be created, multiply the original deposit by 1/r, where r is the reserve ratio 30-90
Determining How Many Demand Deposits Will Be Created A customer deposits $100 into a bank. What is the immediate impact on the money supply? No impact the money was already in the money supply so there is no change McGraw-Hill/Irwin Colander, Economics 91
Determining How Many Demand Deposits Will Be Created A customer deposits $100 into the bank. The reserve ratio is 10 percent (0.1). The amount of money ultimately created is: $100 x 1/0.1 = $1,000 New money created = $1,000 $100 = $900 McGraw-Hill/Irwin Colander, Economics 92
Determining How Many Demand Deposits Will Be Created New money created = $1,000 $100 = $900 Why is the new money created only $900 and not $1,000? Because the $100 deposit was already in the money supply This is due to our fractional reserve banking system: banks hold a portion of deposits and loan out the rest of the money If the Fed had created money through bonds this number would have been different ($1,000) McGraw-Hill/Irwin Colander, Economics 93
Change in Money Supply vs. Change in Loans The Fed buys bonds equal to $10 million and the required reserve ratio is 0.2. What is the maximum change in loans throughout the banking system? 1/r =1/0.2=5 5 *(10 million)=50 million Fed has to hold 20% though 50 million*(0.2)=10 million Total available for loans: 50 million -10 million =40 million McGraw-Hill/Irwin Colander, Economics 94
Change in Money Supply vs. Change in Loans The Fed buys bonds equal to $10 million and the required reserve ratio is 0.2. What is the maximum change in the money supply throughout the banking system? 1/r =1/0.2=5 5 *(10 million)=50 million McGraw-Hill/Irwin Colander, Economics 95
Sample Question: Bank Balance Sheet Assets Loans $15,000 Total reserves $ 5,000 Treasury bonds $10,000 Liabilities Demand deposits $20,000 Owner s equity $10,000 Total: $30,000 Total: $30,000 Owner s equity: money put into a business or bank; not held in reserves (This concept often shows up in the FRQs) McGraw-Hill/Irwin Colander, Economics 96
Sample Question: Bank Balance Sheet Assets Loans $15,000 Total reserves $ 5,000 Treasury bonds $10,000 Liabilities Demand deposits $20,000 Owner s equity $10,000 Total: $30,000 Total: $30,000 The reserve requirement is 10%. How much is the bank s required reserves? To answer, we will look at the demand deposits. $20,000 x.1 = $2,000 Is the bank holding excess reserves? If so, how much? Yes: $3,000 (Total reserves required reserves) McGraw-Hill/Irwin Colander, Economics 97
Sample Question: Bank Balance Sheet Assets Loans $15,000 Total reserves $ 5,000 Treasury bonds $10,000 Liabilities Demand deposits $20,000 Owner s equity $10,000 Total: $30,000 Total: $30,000 How much could the bank increase the money supply if it loaned out its excess reserves? $3,000 x 1/.1 = $30,000 Assume John deposits $1,000 into the bank. What is the initial change in the money supply? None the $1,000 was already in the money supply McGraw-Hill/Irwin Colander, Economics 98
Chapter Summary The financial sector is the market where financial assets are created and exchanged The financial sector channels flows out of the circular flow and back into the circular flow Every financial asset has a corresponding financial liability The economy has many interest rates The long-term rate is determined in the market for loanable funds, while the short-term rate is determined in the money market 30-99
Chapter Summary Money is a highly liquid financial asset that serves as a unit of account, a medium of exchange, and a store of wealth The measures of money are: M 1 is currency in the hands of the public, checking account balances, and traveler s checks M 2 is M 1 plus savings deposits, smalldenomination time deposits, and money market mutual fund shares Banks create money by loaning out deposits 30-100
Chapter Summary The simple money multiplier is 1/r The money multiplier tells you the amount of money ultimately created per dollar deposited in the banking system The money multiplier when people hold cash is (1+c)/(r+c) People hold money for the transactions motive, the precautionary motive, and the speculative motive 30-101
Monetary Policy 31 Chapter Summary Monetary policy influences the economy through changes in the banking system s reserves that affect the money supply and credit availability Expansionary monetary policy works as follows: M i I Y Contractionary monetary policy works as follows: M i I Y The Federal Open Market Committee (FOMC) makes the actual decisions about monetary policy 31-102
Monetary Policy 31 Chapter Summary When the Fed buys bonds, the price of bonds rises and interest rates fall. When the Fed sells bonds, the price of bonds falls and interest rates rise. A change in reserves changes the money supply by the change in reserves times the money multiplier The Federal funds rate is the rate at which one bank lends reserves to another bank It is the Fed s primary operating target 31-103