CASE  FAIR  OSTER MACROECONOMICS PRINCIPLES OF E L E V E N T H E D I T I O N CASE  FAIR  OSTER PEARSON Prepared by: Fernando Quijano w/Shelly Tefft

10 The Money Supply and the Federal Reserve System CHAPTER OUTLINE An Overview of Money What Is Money? Commodity and Fiat Monies Measuring the Supply of Money in the United States The Private Banking System How Banks Create Money A Historical Perspective: Goldsmiths The Modern Banking System The Creation of Money The Money Multiplier The Federal Reserve System Functions of the Federal Reserve Expanded Fed Activities Beginning in 2008 The Federal Reserve Balance Sheet How the Federal Reserve Controls the Money Supply The Required Reserve Ratio The Discount Rate Open Market Operations Excess Reserves and the Supply Curve for Money Looking Ahead

An Overview of Money What Is Money? Money is a means of payment, a store of value, and a unit of account. A Means of Payment, or Medium of Exchange barter The direct exchange of goods and services for other goods and services. A barter system requires a double coincidence of wants for trade to take place. That is, to effect a trade, you have to find someone who has what you want and that person must also want what you have. medium of exchange, or means of payment What sellers generally accept and buyers generally use to pay for goods and services.

A Store of Value store of value An asset that can be used to transport purchasing power from one time period to another. liquidity property of money The property of money that makes it a good medium of exchange as well as a store of value: It is portable and readily accepted and thus easily exchanged for goods. The main disadvantage of money as a store of value is that the value of money falls when the prices of goods and services rise. A Unit of Account unit of account A standard unit that provides a consistent way of quoting prices.

E C O N O M I C S I N P R A C T I C E Don’t Kill the Birds! One of the more interesting examples of a commodity money is described by David Houston, an ethno-ornithologist. In the nineteenth century, elaborate rolls of red feathers harvested from the Scarlet Honeyeater bird were used as currency between the island of Santa Cruz and nearby Pacific Islands. Feathers were made into rolls of more than 10 meters in length and were never worn, displayed, or used. Their sole role was to serve as currency in a complex valuation system. Houston tells us that more than 20,000 of these birds were killed each year to create this “money,” adding considerably to bird mortality. Running the printing presses is much easier. Today, one of the few remaining uses of commodity monies is the use of dolphin teeth in the Solomon Islands. THINKING PRACTICALLY Why do red feather rolls and dolphin teeth make good commodity monies, whereas coconut shells would not?

Commodity and Fiat Monies commodity monies Items used as money that also have intrinsic value in some other use. fiat, or token, money Items designated as money that are intrinsically worthless. legal tender Money that a government has required to be accepted in settlement of debts. Aside from declaring its currency legal tender, the government usually does one other thing to ensure that paper money will be accepted: It promises the public that it will not print paper money so fast that it loses its value. currency debasement The decrease in the value of money that occurs when its supply is increased rapidly.

Measuring the Supply of Money in the United States M1: Transactions Money M1, or transactions money Money that can be directly used for transactions. M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits M1 is a stock measure—it is measured at a point in time. M1 at the end of December 2012 was $2,440.1 billion.

M2: Broad Money near monies Close substitutes for transactions money, such as savings accounts and money market accounts. M2, or broad money M1 plus savings accounts, money market accounts, and other near monies. M2 ≡ M1 + savings accounts + money market accounts + other near monies M2 at the end of December 2012 was $10,402.4 billion. M2 is sometimes more stable than M1. Beyond M2 One of the very broad definitions of money includes the amount of available credit on credit cards (your charge limit minus what you have charged but not paid) as part of the money supply. There are no rules for deciding what is and is not money. This poses problems for economists and those in charge of economic policy. However, for our purposes, “money” will always refer to transactions money, or M1.

The Private Banking System financial intermediaries Banks and other institutions that act as a link between those who have money to lend and those who want to borrow money. The main types of financial intermediaries are commercial banks, followed by savings and loan associations, life insurance companies, and pension funds. The Depository Institutions Deregulation and Monetary Control Act, enacted by Congress in 1980, eliminated many of the previous restrictions on the behavior of financial institutions.

How Banks Create Money A Historical Perspective: Goldsmiths The origins of the modern banking system date back to the fifteenth and sixteenth centuries, when gold was used as money but was also inconvenient to carry around. People began to place their gold with goldsmiths for safekeeping. The receipts issued to the depositor became a form of paper money. The receipts were backed 100 percent by gold. The goldsmiths found that people did not come often to withdraw gold. People simple exchanged their paper receipts. So the goldsmiths found “extra” gold sitting around that they could lend out, effectively changing from depositories to banklike institutions that had the power to create money. Without adding any more gold to the system, the goldsmiths increased the amount of money in circulation.

Goldsmiths-turned-bankers did face certain problems Goldsmiths-turned-bankers did face certain problems. Once they started making loans, their receipts outstanding (claims on gold) were greater than the amount of gold they had in their vaults at any given moment. In normal times, goldsmiths were safe, but once people started to doubt the safety of the goldsmith, they would be foolish not to demand their gold back from the vault. run on a bank Occurs when many of those who have claims on a bank (deposits) present them at the same time. Today’s bankers differ from goldsmiths—today’s banks are subject to a “required reserve ratio.” Goldsmiths had no legal reserve requirements, although the amount they loaned out was subject to the restriction imposed on them by their fear of running out of gold.

The Modern Banking System A Brief Review of Accounting Assets − Liabilities ≡ Net Worth or Assets ≡ Liabilities + Net Worth Assets are things a firm owns that are worth something. For a bank, these assets include the bank building, its furniture, its holdings of government securities, bonds, stocks, and so on. Most important among a bank’s assets, for our purposes at least, are the loans it has made. Other bank assets include cash on hand (sometimes called vault cash) and deposits with the U.S. central bank. Federal Reserve Bank (the Fed) The central bank of the United States. A firm’s liabilities are its debts—what it owes. A bank’s most important liabilities are its deposits. Deposits are debts owed to the depositors because when you deposit money in your account, you are in essence making a loan to the bank. Net worth represents the value of the firm to its stockholders or owners.

 FIGURE 10.1 T-Account for a Typical Bank (millions of dollars) The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth). reserves The deposits that a bank has at the Federal Reserve bank plus its cash on hand. required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Federal Reserve.

excess reserves ≡ actual reserves − required reserves The Creation of Money excess reserves The difference between a bank’s actual reserves and its required reserves. excess reserves ≡ actual reserves − required reserves  FIGURE 10.2 Balance Sheets of a Bank in a Single-Bank Economy In panel 2, there is an initial deposit of $100. In panel 3, the bank has made loans of $400. When loans are converted into deposits, the supply of money will increase.

 FIGURE 10.3 The Creation of Money When There Are Many Banks In panel 1, there is an initial deposit of $100 in bank 1. In panel 2, bank 1 makes a loan of $80 by creating a deposit of $80. A check for $80 by the borrower is then written on bank 1 (panel 3) and deposited in bank 2 (panel 1). The process continues with bank 2 making loans and so on. In the end, loans of $400 have been made and the total level of deposits is $500.

The Money Multiplier An increase in bank reserves leads to a greater than one-for-one increase in the money supply. Economists call the relationship between the final change in deposits and the change in reserves that caused this change the money multiplier. money multiplier The multiple by which deposits can increase for every dollar increase in reserves; equal to 1 divided by the required reserve ratio. In the United States, the required reserve ratio varies depending on the size of the bank and the type of deposit. For large banks and for checking deposits, the ratio is currently 10 percent, which makes the potential money multiplier 1/.10 = 10. This means that an increase in reserves of $1 could cause an increase in deposits of $10 if there were no leakage out of the system.

The Federal Reserve System  FIGURE 10.4 The Structure of the Federal Reserve System

Founded in 1913 by an act of Congress (to which major reforms were added in the 1930s), the Fed is the central bank of the United States. The Fed is a complicated institution with many responsibilities, including the regulation and supervision of about 6,000 commercial banks. The Board of Governors is the most important group within the Federal Reserve System. The Fed is an independent agency in that it does not take orders from the president or from Congress. Federal Open Market Committee (FOMC) A group composed of the seven members of the Fed’s Board of Governors, the president of the New York Federal Reserve Bank, and four of the other 11 district bank presidents on a rotating basis; it sets goals concerning the money supply and interest rates and directs the operation of the Open Market Desk in New York. Open Market Desk The office in the New York Federal Reserve Bank from which government securities are bought and sold by the Fed. The United States is divided into 12 Federal Reserve districts, each with its own Federal Reserve bank. The district banks are like branch offices of the Fed in that they carry out the rules, regulations, and functions of the central system in their districts and report to the Board of Governors on local economic conditions.

Functions of the Federal Reserve The Fed is the central bank of the United States. Central banks are sometimes known as “bankers’ banks.” From a macroeconomic point of view, the Fed’s crucial role is to control the money supply. The Fed also performs several important functions for banks, such as clearing interbank payments, regulating the banking system, and assisting banks in a difficult financial position. The Fed is also responsible for managing exchange rates and the nation’s foreign exchange reserves. It is often involved in intercountry negotiations on international economic issues. Besides facilitating the transfer of funds among banks, the Fed is responsible for many of the regulations governing banking practices and standards. lender of last resort One of the functions of the Fed: It provides funds to troubled banks that cannot find any other sources of funds.

Expanded Fed Activities Beginning in 2008 In March 2008, faced with many large financial institutions simultaneously in serious financial trouble, the Fed began to broaden its role in the banking system. No longer would it be simply a lender of last resort to banks, but would become an active participant in the private banking system. In the process of bailing out Fannie Mae and Freddie Mac, in September 2008, the Fed began buying securities of these two associations, called “federal agency debt securities.” In January 2009 the Fed began buying mortgage-backed securities, securities that the private sector was reluctant to hold because of their perceived riskiness. In September 2012 the Fed opted to buy mortgage-backed securities and long-term government bonds to the tune of $85 billion per month. Most of these purchases show up as an increase in excess reserves of commercial banks. There has been much political discussion of whether the Fed should be intervening in the private sector as much as it has been doing.

The Federal Reserve Balance Sheet TABLE 10.1 Assets and Liabilities of the Federal Reserve System, January 30, 2013 (Billions of Dollars) Assets Liabilities Gold $ 11 $ 1,156 Currency in circulation U.S. Treasury securities 1,710 1,645 Reserve balances Federal agency debt securities 75 71 U.S. Treasury deposits Mortgage-backed securities 966 180 All other liabilities and net worth All other assets 290 $3,052 Total Gold is trivial. Do not think that this gold has anything to do with money in circulation. U.S. Treasury securities are the traditional assets held by the Fed. The new assets of the Fed (since 2008) are federal agency debt securities and mortgage-backed securities. Currency in circulation accounts for about 38 percent of the Fed’s liabilities. Reserve balances account for about 54 percent of the Fed’s liabilities.

How the Federal Reserve Controls the Money Supply The money supply is equal to the sum of deposits inside banks and the currency in circulation outside banks. If the Fed wants to increase the supply of money, it creates more reserves, thereby freeing banks to create additional deposits by making more loans. If it wants to decrease the money supply, it reduces reserves. Three tools are available to the Fed for changing the money supply: Changing the required reserve ratio. Changing the discount rate. Engaging in open market operations.

The Required Reserve Ratio TABLE 10.2 A Decrease in the Required Reserve Ratio from 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars) Panel 1: Required Reserve Ratio = 20% Federal Reserve Commercial Banks Assets Liabilities Government $200 $100 Reserves $500 Deposits securities Currency Loans $400 Note: Money supply (M1) = Currency + Deposits = $600. Panel 2: Required Reserve Ratio = 12.5% $800 Loans (+ $300) $700 (+ $300) Note: Money supply (M1) = currency + deposits = $900.

Decreases in the required reserve ratio allow banks to have more deposits with the existing volume of reserves. As banks create more deposits by making loans, the supply of money (currency + deposits) increases. The reverse is also true: If the Fed wants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce their deposits by “calling in” some of their loans. The result is a decrease in the money supply.

The Discount Rate discount rate The interest rate that banks pay to the Fed to borrow from it. When banks increase their borrowing, the money supply increases. TABLE 10.3 The Effect on the Money Supply of Commercial Bank Borrowing from the Fed (All Figures in Billions of Dollars) Panel 1: No Commercial Bank Borrowing from the Fed Federal Reserve Commercial Banks Assets Liabilities Securities $160 $80 Reserves $400 Deposits Currency Loans $320 Note: Money supply (M1) = currency + deposits = $480. Panel 2: Commercial Bank Borrowing $20 from the Fed $100 Reserves (+ $20) $500 Deposits (+ $300) $20 Loans (+ $100) $420 Amount owed to Fed (+ $20) Note: Money supply (M1) = currency + deposits = $580. moral suasion The pressure that in the past the Fed exerted on member banks to discourage them from borrowing heavily from the Fed.

Open Market Operations open market operations The purchase and sale by the Fed of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply. When the Fed purchases a security, it pays for it by writing a check that, when cleared, expands the quantity of reserves in the system, increasing the money supply. When the Fed sells a bond, private citizens or institutions pay for it with their bank deposits, which reduces the quantity of reserves in the system. Two Branches of Government Deal in Government Securities The Treasury Department is responsible for collecting taxes and paying the federal government’s bills. To finance the deficit, (G - T) is the amount the Treasury must borrow each year. This means that the Treasury cannot print money to finance the deficit. The Fed is not the Treasury. It is a quasi-independent agency authorized by Congress to buy and sell outstanding (preexisting) U.S. government securities on the open market.

The Mechanics of Open Market Operations If the Fed sells some of its holdings of government securities to the general public, they will pay by writing checks drawn on their banks and payable to the Fed. TABLE 10.4 Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences between Those Panels and Panel 1. All Figures in Billions of Dollars) Panel 1 Federal Reserve Commercial Banks Jane Q. Public Assets Liabilities Securities $100 $20 Reserves Deposits $5 $0 Debts $80 Currency Loans Net Worth Note: Money supply (M1) = Currency + Deposits = $180. Panel 2 Securities (- $5) $95 $15 Reserves (- $5) Deposits (- $5) Deposits ($5) Securities (+ $5) Note: Money supply (M1) = Currency + Deposits = $175. Panel 3 $75 Deposits (- $25) Loans (- $20) $60 Note: Money supply (M1) = Currency + Deposits = $155. The final equilibrium position is shown in panel 3, where commercial banks have reduced their loans by $20 billion. This corresponds exactly to our earlier analysis of the money multiplier. The change in money ( -$25 billion) is equal to the money multiplier (5) times the change in reserves (-$5 billion).

The Mechanics of Open Market Operations We can sum up the effect of these open market operations this way: ■ An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves. ■ An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves. Open market operations are the Fed’s preferred means of controlling the money supply for several reasons. They can be used with some precision; are extremely flexible; and, have a fairly predictable effect on the money supply.

Excess Reserves and the Supply Curve for Money  FIGURE 10.5 The Supply of Money If the Fed’s money supply behavior is not influenced by the interest rate, the money supply curve is a vertical line. Through its three tools, the Fed is assumed to have the money supply be whatever value it wants.

Looking Ahead This chapter has discussed only the supply side of the money market. In the next chapter, we turn to the demand side of the money market. We will examine the demand for money and see how the supply of and demand for money determine the equilibrium interest rate.

R E V I E W T E R M S A N D C O N C E P T S barter commodity monies currency debasement discount rate excess reserves Federal Open Market Committee (FOMC) Federal Reserve Bank (the Fed) fiat, or token, money financial intermediaries legal tender lender of last resort liquidity property of money M1, or transactions money M2, or broad money medium of exchange, or means of payment money multiplier moral suasion near monies Open Market Desk open market operations required reserve ratio reserves run on a bank store of value unit of account 1. M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits 2. M2 ≡ M1 + savings accounts + money market accounts + other near monies 3. Assets ≡ Liabilities + Net Worth 4. Excess reserves ≡ actual reserves − required reserves 5. Money multiplier ≡