Download Ch. 10

Frank & Bernanke
3rd edition, 2007
Ch. 10: Money,
Prices, and the
Federal Reserve
1
What Is Money?
Does Bill Gates have a lot of money?
 Does LeBron James make a lot of money?
 Anything accepted by a community in
exchange of goods and services and for
settlements of debts.

2
Functions of Money

Unit of account
Increase in variety of goods requires a
common unit to quote and compare prices.
 3 goods: 2 prices
 4 goods: 6 prices
 5 goods: 24 prices
 N goods: (n-1)! Prices


Money had to be invented.
3
Functions of Money

Medium of exchange
Barter requires double coincidence of wants.
 Exchange makes both parties better-off.
 Money had to be invented.

4
Functions of Money

Store of Value
Postponing consumption by storing wealth in
an asset for future use.
 Today we have many different assets for
wealth storage.
 Depending on the ability of these assets to be
easily converted to cash (liquidity) these
assets are near or far to “money.”

5
Financial Assets Savers Can Hold


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Currency
Checking account
Savings account
Certificate of Deposit
Foreign currency
Bonds
Stocks
Options on stocks, bonds, foreign currency
Futures on commodities, foreign currency
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Assets According to Liquidity
Currency
 Checking Account
 Savings Account
 Money Market Mutual Fund
 Bonds

7
Measuring Money
In billions of dollars
http://research.stlouisfed.org/publications/mt/page16.pdf
8
Measuring Money
9
Components of M1 and M2,
July 2002 (billions of dollars)
M1
1,197.8
Currency
615.1
Demand deposits
303.8
Other checkable deposits
270.3
Travelers’ checks
8.6
M2
5,641.2
M1
1,197.8
Savings deposits
2,552.8
Small-denomination time deposits
920.8
Money market mutual funds
969.8
10
Banks and the Creation of Money
When depositors put money in the bank,
the bank turns around and loans part of
the money to others.
 Both the depositor and the borrower have
funds to spend.
 Money has been created.

11
Banks and the Creation of Money
We will show the changes in assets and
liabilities of a bank in response to deposit
and loan activities.
 Deposits into checking accounts are
liabilities of a bank.
 Cash is an asset.
 Assets = Liabilities for a Balance Sheet to
be in balance.

12
Creation of Money
Ally deposits $1000 into her checking
account with First National.
 First National holds only 10% as reserves
and loans the rest to Billy.
 Billy buys a snow blower for $900 from
Carl.
 Carl deposits $900 with Second National.
 Second National loans how much to
Deyna if it also holds 10% as reserves?

13
Creation of Money
If this process goes on for thirty rounds,
how much checking deposits will be in the
banking system?
 1000 + 1000(.9) +
1000(.9)(.9)+…+1000(.9)^30
 1000 + 900 + 810 + … + 0.04
 1000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10]

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Creation of Money
The banking system used the initial
deposit of $1000 as the reserves and
multiplied it by (1/reserve ratio) to create
checking deposits for the economy.
 What would be the deposits created by the
same $1000 deposit, if the banks kept 5%
as the reserve ratio?

15
Narrow Money, M1
M1 is defined as currency outside of the
banks plus bank deposits.
 Monetary Base is defined as Currency +
Reserves.

16
Measuring Money
•What was the amount of currency in January 2005?
•What was the amount of bank deposits in January 2005?
•What was the reserve ratio in January 2005?
17
•What was the amount of currency in
January 2006, December 2006?
•What was the amount of bank deposits in
January 2005, December 2006?
•What was the reserve ratio in
January 2005, December 2006?
18
Banks and the Creation of
Money

Summary
Bank reserves/bank deposits = desired
reserve-deposit ratio
 Bank deposits = bank reserves/desired
reserve-deposit ratio

19
Banks and the Creation of
Money

The Money Supply with Both Currency
and Deposits
CB provides 1 million in cash to residents
 Residents choose to hold 500,000 as
currency
 Deposit 500,000 in the banks
 Reserve-deposit ratio = 10%
 Bank deposits = 500,000/.10 = 5,000,000

20
Banks and the Creation of
Money

The Money Supply with Both Currency
and Deposits
Money supply = currency + bank deposits
5,500,000 = 500,000 + 5,000,000
 Money is increased by 4,500,000 when the
residents hold 500,000 in bank deposits

21
Banks and the Creation of
Money

The Money Supply at Christmas
Currency = 500
 Bank reserves = 500
 Reserve-deposit ratio = 0.20
 Money supply = 500 + 500/.20 = 500 + 2,500
= 3,000

22
Banks and the Creation of
Money

The Money Supply at Christmas
If Xmas shoppers withdraw 100
 Money supply = 600 + 400/.20 = 600 + 2,000
= 2,600

23
Banks and the Creation of
Money

The Money Supply at Christmas

Observation
 When
the reserve-deposit ratio = 0.20, every $1
reduction in reserves may reduce the money
supply by $5.
 In general, when people make withdraws, the
money supply contracts by a multiple of the
withdrawal.
24
The Federal Reserve System
The Central Bank of the United States.
 The Fed is responsible for monetary
policy.

Amount of money supplied to the system.
 Affects interest rates, inflation, unemployment
and exchange rates.


The Fed oversees and regulates the
financial markets.
25
The Fed
Fed was established in 1913 in the hopes
of eliminating banking panics of the 19th
century by providing credit to the financial
markets.
 In order to disperse power 12 regional
Federal Reserve Banks were formed.
 The seven members of the Board of
Governors are appointed by the President
for 14-year terms every other year.

26
Monetary Policy
Federal Open Market Committee (FOMC)
is the group that sets the monetary policy.
 Fed Chairman (4-year term) plus
governors, plus NY Fed President, plus 4
Presidents of Fed banks comprise FOMC.
 FOMC meets eight times a year.

27
Controlling the Money Supply

Open-Market Operations: buying and selling of
financial assets.

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Buying government bonds from the public increases
bank reserves, hence money supply.
Selling bonds decreases money supply.
Discount window lending: Lending to banks
increases bank reserves.
Changing reserve requirements: Raising
reserve-deposit ratio decreases money supply.
New Tools:
http://stlouisfed.org/publications/re/2009/a/pages/presidents-message.html
28
Open-Market Operation
Suppose an economy has $100 currency,
$100 reserves and 0.1 as reserve-deposit
ratio.
 What is the money supply?
 If the Central Bank purchased $5 worth of
bonds, what will be the money supply?
 If the CB sold $10 worth of bonds, what
will be the money supply?

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The Federal Reserve System

Example

Increasing the money supply by openmarket operations
 Currency
= 1,000
 Reserves = 200
 Reserve-deposit ratio = 0.2
30
The Federal Reserve System

Example

Increasing the money supply by openmarket operations
 Money
supply = 1,000 + 200/0.2 = 2,000
 Open market purchase = 100
 Reserves increase to 300
 Money supply = 1,000 + 300/0.2 = 2,500
31
The Federal Reserve System

Controlling the Money Supply: Discount
Window Lending
Banks can borrow reserves from the Fed.
 Discount window lending

 The
lending of reserves to commercial banks
32
The Federal Reserve System

Controlling the Money Supply: Discount
Window Lending

The discount rate
 The

interest rate charged on these loans
Discount lending will increase reserves and
the money supply.
33
Primary Credit Rate
http://research.stlouisfed.org/publications/mt/page9.pdf
34
The Federal Reserve System

Controlling the Money Supply: Changing
Reserve Requirements

The Fed sets the reserve-deposit ratio
 Called
the reserve requirement
A reduction in the reserve requirement
would allow the money supply to increase.
 An increase in the reserve requirement may
reduce the money supply.

35
http://www.federalreserve.gov/monetarypolicy/default.htm
36
The Federal Reserve System

The Fed’s Role in Stabilizing Financial
Markets: Banking Panics

Suppose:
 Depositors
lose confidence in their bank.
 They attempt to withdraw their funds.
 Bank may not have enough reserves (fractional)
to meet the depositors demand.
 The bank fails and further erodes depositor
confidence which triggers additional failures.
37
The Federal Reserve System

The Fed’s Role in Stabilizing Financial
Markets: Banking Panics

The Fed to the rescue:
 Instill
confidence
 Discount lending
 Open Market Operations
38
The Great Depression




The Fed did not prevent the Great Depression.
Both currency held by the public and reservedeposit ratio rose, reducing money supply.
The Fed increased the reserves but not enough.
Lack of enough reserves forced bank
bankruptcies.
 One-third
of U.S. banks closed
39
MONETARY STATISTICS DURING GREAT DEPRESSION
Currency
rr
Reserves
M1
Dec-29
3.85
0.075
3.15
45.9
Dec-30
3.79
0.082
3.31
44.1
Dec-31
4.59
0.095
3.11
37.3
Dec-32
4.82
0.109
3.18
34.0
Dec-33
4.85
0.133
3.45
30.8
Frank, R. H. and Ben S. Bernanke, Principles of Macroeconomics, 2nd
ed. (McGraw-Hill, 2004), p. 273.
40
The Federal Reserve System
In response to the panics of 1929-1933,
deposit insurance was established in 1934.
 Deposit insurance gives depositors an
incentive to keep their money in the banks.
 Deposit insurance reduces the incentive for
depositors to pay attention to the financial
strength of their bank.

41
Money and Price Level
In the long run, prices adjust to pressures
in the economy.
 The “quantity theory of money” captures
the long-run relationship.

MV = PY
42
Quantity Theory
M is money stock, like M1 or M2.
 V is velocity, the number of times money
stock exchanges hands in creating the
nominal GDP.
 P is price level, like 1.00 or 1.26 (price
index)
 Y is real GDP.
 PY is nominal GDP.

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Long Run Inflation
In the long-run, the economy will operate
at full-employment; so Y will not change if
there is no growth. If there is growth, then
Y is predictable: Y is known.
 Velocity is also thought predictable in the
long-run.
 Therefore, any growth in money supply will
be reflected in inflation.

44
Money and Prices

Velocity

The speed at which money circulates
Value of transactio ns Nominal GDP
Velocity 

Money stock
Money stock
45
Money and Prices

Velocity

The speed at which money circulates
P (price level) x Y (real GDP) P x Y
Velocity (V) 

M (money supply)
M
46
Money and Prices

Velocity in 2001
M1 = $1,177.9 billion
 M2 = $5,449.1 billion
 Nominal GDP = $10,082.2 billion

$10,082.2 billion
M1, V 
 8.56
$1,117.9 billion
$10,082.2 billion
M2, V 
 1.85
$5,499.1 billion
47
Money and Prices

Money and Inflation in the Long Run

Recall
P xY
V
M
48
Money and Prices

Money and Inflation in the Long Run

Quantity equation
M

xV=PxY
Assume V & Y are constant over the time
period
M xV  P x Y
49
Money and Prices

Money and Inflation in the Long Run
If the Fed increases M by 10%, then prices
must increase by 10%.
 High rates of money growth are associated
with high rates of inflation (too much money
chasing too few goods).

M xV  P x Y
50
Inflation and Money Growth in
Latin America, 1995-2001
51