Title: 1 of 29
1Chapter 13 14 Money Banking The Federal
Reserve Monetary Policy
Principles of MacroEconomics Econ101
2In this Lecture..
- Money Defined
- Measurements of the Money Supply
- The Money Creation Process
- The Federal Reserve
- Monetary Policy
3Money vs. Barter
- Money
- Any good that is widely accepted for purposes of
exchange and in the repayment of debt. - Barter
- Exchanging goods and services for other goods
and services without the use of money.
4Functions of Money
- Money as a Medium of Exchange
- Anything that is generally acceptable in
exchange for goods and services. - durable
- Store of value
- High in value in relation to weight..no cotton
- Scarce
- Money as a Unit of Account
- A common measure in which relative values are
expressed. - Money as a Store of Value
- The ability of an item to hold value over time.
5Why Do We Need Money?
- ..because by making exchange easier, money
allows for specialization and higher
productivity. - In a barter economy, before a trade can be made,
a trader must find another trader who is willing
to trade what the first trader wants (Double
Coincidence of Wants) and at the same time wants
what the first trader has.
6What Gives Money Its Value?
- Our money today has value because of its general
acceptability.
7Measuring the Money Supply M1
M1 The narrowest definition of the money
supply the sum of currency in circulation,
checking account balances in banks, and holdings
of travelers checks. It includes 1. All the
paper money and coins that are in circulation
meaning what is not held by banks or the
government. 2. The value of all checking account
balances at banks. 3. The value of travelers
checks.
8Measuring the Money Supply M2
M2 A broader definition of the money supply
M1 plus savings account balances,
small-denomination time deposits, balances in
money market deposit accounts in banks, and
non-institutional money market fund shares. Two
key points about the money supply to keep in mind
are 1. The money supply consists of both
currency and balances in checking accounts and
travelers checks. 2. Because balances in
checking accounts are included in the money
supply, banks play an important role in the
process by which the money supply increases and
decreases.
9Self-Test
- 1. Why (not how) did money evolve out of a barter
economy? - Money evolved because individuals wanted to make
trading easier (i.e., less time-consuming). In a
barter economy, this need motivated people to
accept the good with relatively greater
acceptability than all other goods. In time, the
effect snowballed, and finally the good with
initially relatively greater acceptability
emerged into a good that was widely accepted for
purposes of exchange. At this point, the good
became money. - 2. If individuals remove funds from their
checkable deposits and transfer them to their
money market accounts, will M1 fall and M2 rise?
Explain your answer. - No. M1 will fall, but M2 will not rise it will
remain constant. To illustrate, suppose M1 is
400 and M2 is 600. If people remove 100 from
checkable deposits, M1 will decline to 300. For
purposes of illustration, think of M2 as equal to
M1 money market accounts. The M1 component of M2
falls by 100, but the money market accounts
component rises by 100 so there is no net
effect on M2. Thus M1 falls and M2 remains
constant. - 3. How does money reduce the transaction costs of
making trades? - In a barter (moneyless) economy, a double
coincidence of wants will not occur for every
transaction. When it does not occur, the cost of
the transaction increases because more time must
be spent to complete the trade. In a money
economy, money is acceptable for every
transaction so a double coincidence of wants is
not necessary. All buyers offer money for what
they want to buy, and all sellers accept money
for what they want to sell.
10The Money Creation Process
- Reserves
- The sum of bank deposits at the Fed and vault
cash. - Required Reserve Ratio (r)
- A percentage of each dollar deposited that must
be held on reserve (at the Fed or in the banks
vault). - Required Reserves
- The minimum amount of reserves a bank must hold
against its checkable deposits as mandated by the
Fed. - Excess Reserves
- Any reserves held beyond the required amount.
The difference between (total) reserves and
required reserves.
11How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create
Money
12How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create
Money
13How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create
Money
14How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create
Money
15The Simple Deposit / Money Multiplier
BANK INCREASE IN CHECKING ACCOUNT DEPOSITS INCREASE IN CHECKING ACCOUNT DEPOSITS
Wachovia 1,000
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
Simple Deposit/Money Multiplier the ratio of the
amount of deposits created by banks to the amount
of new reserves. Change in checking account
deposits Change in bank reserves x (1/RR)
16Self-Test
- 1. If a banks deposits equal 579 million and
the required reserve ratio is 9.5 percent, what
dollar amount must the bank hold in reserve form? - .095 X 579 55 million
- 2. If the Fed creates 600 million in new
reserves, what is the maximum change in checkable
deposits that can occur if the required reserve
ratio is 10 percent? - 1/10 X .6 billion 6 billion
17The Federal Reserve System
The central bank of the United States,
established in 1913 as lender of last resort to
avoid bank panics and manage the money supply.
18Structure of the Federal Reserve System
- Board of Governors - The 7-member governing body
of the Federal Reserve System. - Federal Open Market Committee (FOMC) -The
12-member policymaking group within the Fed. The
committee has the authority to conduct open
market operations.
To view a presentation on the Fed click the
picture of Fed Headquarters select Structure
Tour
19Federal Open Market Committee (FOMC)
- The Federal Open Market Committee (FOMC) is the
major policymaking group within the Fed. - Authority to conduct open market operationsthe
buying and selling of government securitiesrests
with the FOMC. - The FOMC has 12 members the 7-member Board of
Governors and 5 Federal Reserve District Bank
presidents.
20Self-Test
- 1. What is the most important responsibility of
the Fed? The Fed controls the money supply. - 2. What does it mean to say the Fed acts as
lender of last resort? - Acting as the lender of last resort means the
Fed stands ready to lend funds to banks that are
suffering cash management, or liquidity,
problems.
21Tools for Controlling the Money Supply
- Open Market Operations
- Required Reserve Ratio
- Discount Policy
22Open Market Operations
- Open Market Operations
- The buying and selling of government securities
by the Fed.printing more money. - Open Market Purchase
- The buying of U.S. government securities by the
Fed - Open Market Sale
- The selling of U.S. government securities by
the Fed
23Open Market Operations
24Required Reserve Ratio
- The Fed rule that specifies the amount of
reserves a bank must hold to back up deposits. - Maximum change in checkable deposits (1/rr) x
?R (rrrequired reserve ratio R reserves)
? rr ? ? in checkable deposits excess reserves
? rr? ? in checkable deposits excess reserves
25Discount Policy
- Discount loans
- Loans the Federal Reserve makes to banks.
- Discount rate
- The interest rate the Federal Reserve charges on
discount loans. - Lower interest rate encourages banks to take on
loans. - Raising interest rate has reverse effect
26- The Fed Responds to the Terrorist Attacks of
September 11, 2001
The day after the terrorist attacks of September
11, 2001, the Fed made massive discount loans to
banks and succeeded in preventing a financial
panic. Alan Greenspan, pictured here, was the
chairman of the Fed at the time of the attacks.
27Borrowing Reserves
- Federal Funds Market
- A market where banks lend reserves to one
another, usually for short periods. - Why?
- To increase loan making ability
- To meet required reserve requirements
- Federal Funds Rate
- The interest rate in the federal funds market
the interest rate banks charge one another to
borrow reserves. - Affects short term treasury bills
- Affects interest rates on long term financial
assets, such as corporate bonds and mortgages.
28Fed Monetary Tools and Their Effects on the Money
Supply
29Self-Test
- 1. How does the money supply change as a result
of (a) an increase in the discount rate, (b) an
open market purchase, (c) an increase in the
required reserve ratio? - a. The money supply falls.
- b. The money supply rises.
- c. The money supply falls.
- 2. What is the difference between the federal
funds rate and the discount rate? - The federal funds rate is the interest rate that
one bank charges another bank for a loan. The
discount rate is the interest rate that the Fed
charges a bank for a loan. - 3. If bank A borrows 10 million from bank B,
what happens to the reserves in bank A? in the
banking system? - Reserves in bank A rise reserves in the banking
system remain the same (bank B lost the reserves
that bank A borrowed). - 4. If bank A borrows 10 million from the Fed,
what happens to the reserves in bank A? in the
banking system? - Reserves in bank A rise reserves in the banking
system rise because there is no offset in
reserves for any other bank.