1 Money, Prices, & the Federal Reserve Chapter 10

2 Chapter 10 Learning Objectives. You should be able to: Describe the three functions of money. List the components of M1 and M2. Explain how banks create money. Define a bank panic and discuss the role of the FDIC in preventing bank panics. Describe the structure of the Fed. List the three tools of monetary policy and explain how they operate. Write down the quantity equation and explain its economic significance.

3 Functions of Money Medium of exchange. Unit of account. Store of wealth.

4 Components of M2 and M1 Components of M1Components of M2 Savings deposits (48%) Checking accounts (49%) Small-denomination time deposits (15%) Currency (50%) M1 (28%) Money market mutual funds (16%) Traveler’s checks (1%) M1 (21%) McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

5 The Money Multiplier Banks lend a portion of their deposits keeping the balance as reserves. Reserves are vault cash and the bank’s deposits at the Fed.

6 The reserve ratio is the ratio of reserves to deposits a bank keeps as a reserve against cash withdrawals.

7 The required reserve ratio is the percentage of their deposits banks are required to hold by the Fed. If banks choose to hold an additional amount, this is called the excess reserve ratio.

8 An Example of the Creation of Money The first 7 rounds of the money creation process is illustrated on the following table. Assume a deposit of $10,000 and a reserve ratio of 20 percent. Assume that all new money remains in the banking system, none is held as currency.

9 An Example of the Creation of Money

10 Determining How Many Demand Deposits Will Be Created To find the total amount of deposits that will eventually be created, multiply the original deposited amount by 1/r, where r is the reserve ratio.

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13 Determining How Many Demand Deposits Will Be Created If the original deposit is $100 and the reserve ratio is 10 percent, then: Money multiplier = 1/.10 =10 Multiply original deposit by the multiplier: 10 X $100 = $1,000

14 Equation 10.2 Money Supply = Currency held by public + Bank Reserves/Desired reserve-deposit ratio

15 Financial Panics The financial history of the world is filled with stories of financial upheavals and monetary problems. In the 1800s, local banks in the U.S. were allowed to issue their own notes, which often became worthless.

16 Anatomy of a Financial Panic Financial systems are based on trust that expectations will be fulfilled. Banks borrow short and lend long. If people lose faith in banks, the banks cannot keep their promises.

17 Government Policy to Prevent Panic To prevent panics, the U.S. government has guaranteed the obligations of various financial institutions. The most important guaranteeing program is the Federal Deposit Insurance Corporation (FDIC).

18 Government Policy to Prevent Panic Financial institutions pay a small premium for each dollar of deposit to the FDIC. The FDIC puts the money into a fund used to bail out banks experiencing a run on deposits.

19 The Benefits and Problems of Guarantees A lack of deposit guarantees act as an effective restraint or discipline on bank lending policies. When deposits are guaranteed, some banks may make risky loans knowing that the depositors will not leave. Moral hazard problem.

20 Federal Reserve System Passed through Congress narrowly in December 1913 Regional banks to disperse power and allay fears of monopoly capitalism Lender of last resort (discount loans only)

21 Federal Reserve Districts

22 Federal Reserve Bank of New York

23 Board of Governors 7 members. 14 year non-renewable terms, one opens up every second January. Chairman has 4 year renewable term.

24 New Fed Chair Ben Bernanke Appointed by President Bush on October 24, Takes office February 1, 2006.

25 Federal Open Market Committee 12 members 7 members of Board of Governors + 5 Federal Reserve Bank Presidents (always including the President of the FRBNY) Meets every 6-8 weeks in Washington to determine course of monetary policy

26 Fed Funds Rate Rate of interest that banks charge one another for short-term loans. Determined by supply of and demand for reserves Fed adjusts the supply of reserves through open market operations.

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28 Most Important Tool of Monetary Policy Open market operations: the purchase or sale of Treasury securities by the Fed Sell Treasury securities: contractionary. Buy Treasury securities: expansionary.

29 Two Other Tools of Monetary Policy Changing reserve requirements. Changing the discount rate.

30 Quantity Equation MV=PQ

31 Money Growth and Inflation

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