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Chapter 13 14 Money Banking The Federal
Reserve Monetary Policy
Principles of MacroEconomics Econ101
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In this Lecture..

• Money Defined
• Measurements of the Money Supply
• The Money Creation Process
• The Federal Reserve
• Monetary Policy

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Money 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.

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Functions 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.

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Why 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.

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What Gives Money Its Value?

• Our money today has value because of its general
  acceptability.

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Measuring 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.
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Measuring 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.
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Self-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.

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The 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.

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How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create
Money
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How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create
Money
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How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create
Money
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How Do Banks Create Money?
Using T-Accounts to Show How a Bank Can Create
Money
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The 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)
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Self-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

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The 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.
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Structure 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
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Federal 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.

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Self-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.

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Tools for Controlling the Money Supply

• Open Market Operations
• Required Reserve Ratio
• Discount Policy

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Open 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

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Open Market Operations
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Required 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
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Discount 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

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• 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.
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Borrowing 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.

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Fed Monetary Tools and Their Effects on the Money
Supply
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Self-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.