Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001)

1
Mankiw Brief Principles of Macroeconomics,
Second Edition (Harcourt, 2001)

• Ch. 10 The Monetary System

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Money Had To Be Invented

• As the number of products to be exchanged
  increases, the relative prices of these goods
  become impossible to remember and compare Unit
  of account.
• Barter required double coincidence of wants.
  Something had to be invented to make exchange
  easier Medium of exchange.
• Some people wanted to postpone their consumption
  to the future. Money allowed this Store of
  value.

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Unit of Account

• We use money to measure the value of goods and
  services.
• Suppose we had 4 goods and no money. How do we
  measure the price of each good?
• A in terms of B
• B in terms of C
• C in terms of D
• A in terms of C
• A in terms of D
• B in terms of D
• Money allows to quote prices in terms of currency
  only.

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Medium of Exchange

• By eliminating barter, this function of money
  increases efficiency in a society.
• As human societies started to engage in exchange,
  money had to be invented.
• Any technological change that reduces transaction
  costs increases the wealth of the society.
• Any technological change that allows people to
  specialize also increases wealth.

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Storing Value Assets

• Cash
• Checking Accounts
• Saving Accounts
• Mutual funds
• Stocks
• Bonds
• Real estate
• Paintings

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Store of Value

• All assets are stored value.
• Money, although without any return, is still
  desirable to hold because it allows purchases
  immediately.
• Other assets take time (transaction costs) to use
  as a payment for purchases.
• The more liquid an asset is, the less transaction
  cost it carries.
• Inflation erodes the value of money.

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What Makes An Asset Money

• The willingness of other people to accept it in
  return for debts and goods and services.
• The ease an asset can be transferred into cash
  liquidity.
• The higher the transaction cost, the farther is
  the asset from money.
• The expectation that the asset will have a
  relatively stable value.
• High inflation no one wants to hold cash.
• High return no one wants to part with it.

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Meaning of Money

• Money (money supply) any vehicle used as a means
  of exchange to pay for goods, services or debts.
• In todays society, any asset that can quickly be
  transferred into cash is considered money.
• The more liquid an asset is, the closer it is to
  money.
• In economics,money does not mean wealth nor does
  it mean income.

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Kinds of Money

• Metals, like gold, silver or copper, have served
  as money because they were durable, recognizable
  and transportable.
• In Micronesia, heavy stones serve as money.
  Exchanging ownership of stones allows people to
  transact sales of large items, like houses or
  fields.
• In order to diffuse confidence on the intrinsic
  weight of the precious metal, the state put
  stamps on coins.
• Eventually, the state put stamps on worthless
  paper and declared it fiat money.

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What Is Included in the Money Supply

• The medium of exchange function of money in the
  US is satisfied by currency, checking deposits,
  travelers checks and sometimes money market
  mutual funds.
• Banks make it quite easy for their customers to
  move funds from savings to checking accounts.
• Sometimes banks allow their customers to overdraw
  their checking accounts by extending a personal
  loan.
• Credit cards extend a short term loan to
  consumers.
• These loans have to be paid from the checking
  deposits.

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Measuring Money

• M1 Currency, demand deposits, travelers checks.
• M2 M1, saving deposits, small time deposits,
  retail MMMF.
• M3 M2, large time deposits, repos, Eurodollar
  deposits, institutional MMMF.
• MZM M2, institutional MMMF minus small time
  deposits.
• Growth rates of these aggregates do not always go
  hand in hand, making monetary policy difficult
  since signals are conflicting.

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Why Is There So Much Currency?

• The January 2001 average for currency is 535
  billion. M1 was 1102 billion.
• Source http//www.stls.frb.org/fred/data/monetary
  .html
• The population of the US is 283 million.
• It would imply that each person (man, woman and
  child) would be carrying 1890 on average!
• A substantial portion of US currency is overseas.
• Underground economy operates strictly on cash.

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Who Controls the Money Supply

• The primary institution that controls the money
  supply is the Central Bank.
• In the US, the Central Bank is called Federal
  Reserve System (the Fed).
• The banking system diffuses the money the Fed
  desires to provide. Their choices affect the
  amount of money in the system.
• The way people want to hold their liquid funds,
  in cash or in checking deposits, also affects the
  money supply.

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The Fed

• Woodrow Wilson signed the law establishing the
  Fed on Dec. 23, 1913 to establish stability to
  the financial system.
• In 1907, run on the 19th Ward Bank of New York
  City created a financial panic that led to
  bankruptcies, unemployment, recession.
• To have more local control, there are 12 Federal
  Reserve Banks.

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The Fed

• The Federal Reserve Board consists of 7 governors
  nominated by the President and confirmed by the
  Senate for 14-year terms.
• The chair of the Board is appointed for a 4-year
  term by the President.
• Monetary Policy is formed by the FOMC (Federal
  Open Market Committee).
• Voting FOMC members are the 7 governors,
  Presidents of New York Fed, and 4 other Fed
  Presidents on a rotating basis.

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Responsibilities of the Fed

• Monetary Policy
• FOMC determines how much money and credit should
  be available.
• Supervision and Regulation
• Supervise banks, bank holding companies, foreign
  bank offices in the US.
• Government Services
• It is the bank for the Federal Government.
• Depository Institution Services
• Distributes currency.
• Processes checks.
• Federal Reserve Communications System allows wire
  transfers of funds and securities among 7800
  depository institutions.
• Automated Clearinghouses allow electronic
  exchange of payments among depository
  institutions.

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Tools of Monetary Policy

• Open-market operations
• Buying US securities increases the money supply.
• Selling US securities decreases the money supply.
• Reserve Ratio
• Raising the reserve ratio decreases the money
  supply.
• Discount rate
• Lowering the discount rate allows banks to borrow
  more from the Fed and increase the money supply.

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The Role of Banks in Money Supply

1. The Fed buys 100 million worth of US securities
   from Anthony.
2. Anthony deposits the check he got from the Fed in
   his bank, First Bank.
3. First Bank now has excess reserves because it
   only has to keep 10 as required reserves.
4. First Bank gives a loan of 90 million to
   Beatrice.
5. Beatrice purchases Courtneys services.
6. Courtney deposits 90 million in Second Bank.

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The Role of Banks in Money Supply

• Finish the sequence.
• Develop a formula for calculating the increase
  (decrease) in money supply.
• Calculate how much money is created.
• Figure out what would happen if the banks did not
  loan out all of the excess reserves.
• Figure out what would happen if the reserve ratio
  were larger.
• Figure out what would happen if the banks took
  larger loans from the Fed.

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Money Creation
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Not All the Excess Reserves Are Loaned Out
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Larger Reserve Ratio
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Banks Borrowing More From the Fed
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Households Affect Money Supply, Too

• What happens if households decide to hold less
  demand deposits and more cash?
• As households withdraw some of their deposits,
  the banks will have to reduce their outstanding
  loans.
• This will affect other banks and they will all
  reduce their loan portfolio.
• Money supply shrinks.