What Is Money and Why Do We Need It? Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts. Asset Anything of value owned by a person or a firm. The Functions of Money • Medium of exchange: buy stuff with money No need to barter • Unit of account: post prices/keep books in money terms • Standard of deferred payment: need money to pay debts Store of value Hold money on chance prices of other assets fall

Precious metals serve when confidence falters. What Can Serve as Money? Criteria for an asset to be a medium of exchange: 1 It must be acceptable to most people. 2 It should be of standardized quality. 3 It should be durable. 4 It should be valuable relative to its weight. 5 It should be divisible. Currency is fine… “fiat money” Checking account balances are just as good. Electronic “money” is even better. Precious metals serve when confidence falters. Commodity money.

How Is Money Measured in the United States Today? M1: The Narrowest Definition of the Money Supply M1 includes means of payment: Currency: paper money and coins in circulation. “in circulation” means not held by banks or the government 2 The value of all checking account deposits at banks 3 The value of traveler’s checks 1 Because balances in checking accounts are in the money supply, banks play an important role in the way money supply increases and decreases. What about Credit Cards and Debit Cards? You haven’t paid until you write a check to your bank.

How Is Money Measured in the United States Today? M1: The Narrowest Definition of the Money Supply Figure 25-1 Measuring the Money Supply, July 2009 The Federal Reserve uses two different measures of the money supply: M1 and M2.M2 includes all the assets in M1, as well as the additional assets shown in panel (b).

Money is an asset, like stocks and bonds and real estate Money is an asset, like stocks and bonds and real estate. Unlike these other assets, however, money pays no interest and promises no yield. Why, then, do people hold money as a store of value? A) You need money to buy stuff B) You need money to pay off your debts C) It’s good to hold some of your wealth in money, particularly if you think the prices of other asset will fall. D) All of the above

How Banks Create Money in a Fractional Reserve Banking System Legal Reserves Funds a bank keeps as cash in its “vault” or on deposit with the Federal Reserve. Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits. Required reserve ratio The minimum fraction of deposits banks are required by law to keep as reserves. Excess reserves Reserves that banks hold over and above the legal requirement. Banks buy interest yielding assets with deposits they don’t keep in reserves: Gov’t securities, loans to households and firms

Balance Sheet for a Large Bank, December 31, 2010

How Banks Create Money If the required reserve ratio is 10%, Wachovia now has $900 in excess reserves

PNC now has excess reserves of $810. It can extend a loan and create a deposit of $810.

How Banks Create Money BANK INCREASE IN CHECKING 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

d. What is the maximum possible increase in deposits in the banking system if all banks lend to the limit and no currency is held by the public?

Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves. Change in required reserves for a bank and for the banking system = RR x Change in deposits The Simple Deposit Multiplier versus the Real-World Deposit Multiplier: Not everything that one bank lends gets deposited in other banks. Much leaks out as currency holdings rather than deposits. And banks may not lend to full extent the can…they hold excess reserves. Real world deposit multiplier is less than the simple multiplier.

The deposit multiplier we just developed and the expenditure multiplier we studied before are the same thing. A) True B) False

The deposit multiplier we just developed and the expenditure multiplier we studied before are the same thing. A) True B) False False: The deposit multiplier multiplies an injection of additional reserves into the banking system into a larger increase in bank loans, bank deposits and Money Supply (Currency + Deposits). The expenditure multiplier multiples an increase in autonomous spending into a larger increase in total output, total income, and total spending.

The Functions of a Modern Central Bank The Banker’s Bank: Lender of last resort in crises Bank run: When many depositors rush to withdraw money at the same time...They “run” to get to the cashier. Silent run: Major creditors don’t turn over their loans to a bank. Bank panic: Many banks experience runs at the same time. Operates clearing system for interbank payments. Oversees financial intermediaries - ensure their soundness. - ensure public confidence The Government's Bank: Manages government transactions. Controls availability of money and credit.

The Federal Reserve System Board of Governors: Seven Governors nominated by Pres- ident and confirmed by Senate for 14 year terms. The Chair has a renewable 4 year term. The Organization of the Federal Reserve System Federal Reserve Districts Federal Open Market Committee: Board of Governors + District Bank Presidents meet 8 times a year to set policy. All presidents attend the FOMC meetings but they take turns voting (FRBNY guy always votes).

Which of the following people vote on monetary policy at the Federal Open Market Committee (FOMC) meetings? The seven members of the Federal Reserve’s Board of Governors. The president of the Federal Reserve Bank of New York. Four presidents from Federal Reserve banks other than the president of the Federal Reserve Bank of New York (rotating basis). All of the above.

How the Federal Reserve Manages the Money Supply Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates in pursuit of economic objectives. To manage the money supply, the Fed uses three monetary policy tools: 1 Open market operations: Fed buys and sells gov’t securities Federal Open Market Committee (FOMC) sets target federal funds rate. “Federal funds” are reserves that banks borrow and lend to each other. Fed buys bonds to increase the supply of reserves and lower the fed funds rate: BEST – BUY EASE SELL TIGHTEN. 2 Discount policy: Fed lends to banks @ discount rate  injects reserves into banking system directly 3 Reserve requirements: lowering reserve requirement converts required reserves to excess reserves that banks can lend Two other actors—the nonbank public and banks—also influence the money supply.

Multiple Creation of Money and Credit The Fed’s Balance Sheet Owns Owes . Gold, Forex Federal Reserve Notes Currency in Circulation Vault Cash Reserves Bank IOUs Bank Deposits @ Fed (Discount loans) Bank A Bank B : Securities Gov’t Deposits Gov’t Bonds MBSs Miscellaneous Monetary Base High Powered = MB Money = H = MB Note: MB = Currency + Bank Reserves = Cu + R Ms = Currency + Demand Deposits = Cu + D Fed buys something … MB up A bond A bank IOU Seller deposits proceeds in Bank A Money supply increases Bank A’s deposits @ Fed increase Bank A now has more reserves Bank A holds reserves against its new deposit (required + excess) Bank A makes loan to customer Borrower now has more deposits ... Money has just been created Borrower buys something Seller holds onto currency and deposits the rest in its Bank B Bank B’s deposits @ Fed increase :

The Fed uses three monetary policy tools The Fed uses three monetary policy tools. Which of the following is not one of those tools? Open market operations. Discount policy. Reserve requirements. Federal funds rate setting.

The “Shadow Banking System” and the Financial Crisis The banks we have been discussing are commercial banks, who accept funds from depositors and lend those funds to borrowers. In the past 20 years, important developments have occurred in the financial system: Banks have begun to resell many of their loans rather than keep them until they are paid off. Financial firms other than commercial banks, e.g., less-regulated investment banks, MMMFs, hedge funds, have become sources of credit to businesses. Banks have faced increased competitive pressure. Banks and these non-bank financial firms increasingly rely on very short-term liabilities, e.g., overnight repurchase agreements, to finance their long-term, income-earning assets, e.g., loans. Loans (mortgage loans, student loans, credit card loans,...) have been bundled together with shares in these bundles sold off as securities (securitization). Securitization The process of transforming loans or other financial assets into securities.

The Process of Securitization (a) Securitizing a loan (b) The flow of payments on a securitized loan

As the trigger of the crisis, problems in the U. S As the trigger of the crisis, problems in the U.S. housing market led to a myriad of troubles in the financial system: Mortgage-backed securities lost value; their investors suffered heavy losses. Many investment banks and other financial firms without deposit insurance that had borrowed short term and invested long term had to sell their holdings of securities  fire sale. In 2008, the failure of the investment bank Lehman Brothers set off a panic  securitization and interbank lending nearly ground to a halt. A wave of withdrawals from money market mutual funds disabled their role as buyers of corporate commercial paper. As banks and other financial firms sold assets and cut back on lending to shore up their financial positions – deleveraging – the flow of funds from savers to borrowers was disrupted and the resulting credit crunch significantly worsened the recession.

A “Global Saving Glut” The best of times Capital Inflows Escalating House Prices Easy Money Policy Eager Home Buyers Ambitious Mortgage Brokers Developer Clout Innovative Banks Rating Agencies Securitization MBSs Bank Regulators Gov’t Sponsored Enterprises

The best of times Capital Inflows Escalating House Prices Easy Money Policy Eager Home Buyers Ambitious Mortgage Brokers Developer Clout Innovative Banks Rating Agencies Securitization MBSs Bank Regulators Gov’t Sponsored Enterprises

Deleveraging – Debt Deflation Macroeconomic Linkages and Vicious Spirals Unleashed Demand – Jobs – Wages – Income – Spiral House Price – Foreclosure Spiral Deleveraging – Debt Deflation Spiral Government Revenue – Cutback Spiral Global Repercussion Spiral Macroeconomic Linkages and Feedbacks

Responses: No Bank Left Behind Lender of Last Resort / Spender of Last Resort Tax Rebate $124 bil. Fed Fund Rate Cuts Fannie/Freddie $200 bil. Bear-Stearns $29 bil. AIG $174 bil. Fed “Facilities” Primary Dealer Credit Facility (PDCF) $58 bil. Treasury Security Loan Facility (TSLF) $133 bil. Term Auction Facility (TAF) $416 bil. Asset- Backed Commercial Paper Funding Facility (CPFF) $1,777 bil. Money Market Investor Funding Facility (MMIFF) $540 bil. More Fed Fund Rate Cuts … Hold At ~0% Fed Purchases of Long-Term Securities: GSEs & MBSs $600 bil. Term Asset-Backed Securities Loan Facility (TALF) $200 bil. Emergency Economic Stabilization Act/TARP $700 bil. Government Loans Government Equity Stimulus Package $787 bil. aka The American Recovery and Reinvestment Act TARP II Stress Tests

M × V = P × Y Connecting Money and Prices: The Quantity Equation The Quantity Theory of Money Connecting Money and Prices: The Quantity Equation M × V = P × Y Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.

The Quantity Theory Explanation of Inflation We can transform the quantity equation from: to: Growth rate of the money supply + Growth rate of velocity = Growth rate of the price level (or inflation rate) + Growth rate of real output If velocity is constant, then the growth rate of velocity is zero. This allows us to rewrite the equation one last time: Inflation rate = Growth rate of the money supply − Growth rate of real output

3% 6% 9% 18%

Making the Connection The German Hyperinflation of the Early 1920s During the hyperinflation of the 1920s, people in Germany used paper currency to light their stoves.

K e y T e r m s Asset M1 Bank panic M2 Bank run Monetary policy Commodity money Discount loans Discount rate Excess reserves Federal Open Market Committee (FOMC) Federal Reserve System Fiat money Fractional reserve banking system M1 M2 Monetary policy Money Open market operations Quantity theory of money Required reserve ratio Required reserves Reserves Simple deposit multiplier Velocity of money