Money, Prices, and the Federal Reserve Principles of Macroeconomics Dr. Gabriel X. Martinez Ave Maria University

Chapter 23: Money, Prices, and the Federal Reserve2 Introduction  Is Economics about Money?  What is Money?

Chapter 23: Money, Prices, and the Federal Reserve3 Introduction  Money –Any asset that is generally accepted in making purchases –Examples  Paper Currency, (worthless) Coins, and Checking Accounts  But also –Bronze, Silver, and Gold –Cows, Clams, and Cocoa Beans –At different times and in different places, foreign currency, boulders, even tulip bulbs have been accepted as money.

Chapter 23: Money, Prices, and the Federal Reserve4 Money and Its Uses  An asset is money if it is …  …A Medium of Exchange –If it is used in purchasing goods and services.  …A Unit of Account –If it is a basic measure of economic value.  …A Store of Value –If is serves as a means of holding wealth.

Chapter 23: Money, Prices, and the Federal Reserve5 Money and Its Uses  Why is barter inconvenient? –Double coincidence of wants.  Would a bartender accept an economics lecture? –Less specialization  People try to do everything by themselves.  How does money solve this problem? –Why is everyone willing to accept money? –What if people refuse to accept your “money”?

Chapter 23: Money, Prices, and the Federal Reserve6 Money and Its Uses  Is cash money?  Are checking accounts money?  Are savings accounts money?  Are 3-month certificates of deposit money?  Are 1-year, negotiable, CDs money?  Is a gold mine money?  Is a house money?

Chapter 23: Money, Prices, and the Federal Reserve7 Components of M1 and M2, July 2002 (billions of dollars) M1 Currency held by the public plus Demand deposits plus Other checkable deposits plus Travelers’ checks M2 M1 plus Savings deposits plus Small-denomination time deposits plus Money market mutual funds 1, , , ,

Chapter 23: Money, Prices, and the Federal Reserve8 Money and Its Uses  M1--- very liquid –Sum of currency outstanding and balances held in checking accounts  M2--- less liquid, but … –All the assets in M1 plus some additional assets that are usable in making payments but at greater cost or inconvenience than currency or checks

Chapter 23: Money, Prices, and the Federal Reserve9  How do non-cash assets that are also money (e.g., checking accounts) come into existence? Commercial Banks and the Creation of Money Palazzo Ducale di Venetia

Chapter 23: Money, Prices, and the Federal Reserve10  Republic of Venice –Central Bank issues 1 million guilders. Commercial Banks and the Creation of Money Colonna di San Todaro Basilica di San Marco Colonna di San Marco Source of pictures:

Chapter 23: Money, Prices, and the Federal Reserve11 Commercial Banks and the Creation of Money  People want to place their 1 million guilders in a bank  Why? Why do banks exist? –They are safer than your pocket or couch. –They are convenient (fund transfers, check- writing). –They may pay interest on your deposited funds. –They channel your savings to productive uses.

Chapter 23: Money, Prices, and the Federal Reserve12 Assets Currency1,000,000 guilders Liabilities Deposits1,000,000 guilders Central Bank issues 1 million guilders. Citizens open accounts and deposit 1 million guilders Deposits are liabilities for the bank The guilders are an asset for the bank Consolidated Balance Sheet of Venetian Commercial Banks (Initial)

Chapter 23: Money, Prices, and the Federal Reserve13  If a bank receives deposits and keeps them, those guilders are the bank’s reserves.  Bank Reserves –Cash or similar assets held by commercial banks for the purpose of meeting depositor withdrawals and payments  Suppose Reserves = deposits. Then we have 100% reserve banking. Commercial Banks and the Creation of Money

Chapter 23: Money, Prices, and the Federal Reserve14  Why keep Reserves? –Because if depositors want to withdraw some of their funds, the bank must have cash available.  Why not keep 100% Reserves? –Because a bank’s business is to lend out funds (i.e., its depositors’ savings).  How much should banks keep in Reserves? –The Central Bank’s requirement, –plus predicted withdrawals. Commercial Banks and the Creation of Money

Chapter 23: Money, Prices, and the Federal Reserve15 Commercial Banks and the Creation of Money ReservesDeposits Reserve/Deposit Ratio

Chapter 23: Money, Prices, and the Federal Reserve16  Reserves are not part of the money supply (they cannot be used for exchange with goods/services).  Deposits are part of the money supply (you can write checks on your checking deposits).  Remember checks are NOT money! Commercial Banks and the Creation of Money

The Process of Deposit Creation

Chapter 23: Money, Prices, and the Federal Reserve18 Assets Currency1,000,000 guilders Liabilities Deposits1,000,000 guilders Central Bank issues 1 million guilders. Citizens open accounts and deposit 1 million guilders Deposits are liabilities for the bank The guilders are an asset for the bank Consolidated Balance Sheet of Venetian Commercial Banks (Initial)

Chapter 23: Money, Prices, and the Federal Reserve19 Assets Currency (= reserves) 100,000 guilders Loans to farmers900,000 guilders Liabilities Deposits1,000,000 guilders Fractional Reserve Banking System Bankers agree they only need a reserve to deposit ratio of 10% R = r D = 0.1 D Required reserves = 100,000 guilders, 10% of deposits Lend the excess reserves of 900,000 guilders The Process of Deposit Creation Consolidated Balance Sheet of Venetian Commercial Banks After One Round of Loans

Chapter 23: Money, Prices, and the Federal Reserve20 $ Bank 1 Palazzo Ducale di Venetia Source ne.com/media/img _investors.jpg

Chapter 23: Money, Prices, and the Federal Reserve21 $ Bank 1 $ Bank 2 Palazzo Ducale di Venetia

Chapter 23: Money, Prices, and the Federal Reserve22 $ Bank 1 $ Bank 2 $ Bank 3

Chapter 23: Money, Prices, and the Federal Reserve23 $ Bank 1 $ Bank 2 $ Bank 3 $ Bank 4

Chapter 23: Money, Prices, and the Federal Reserve24 $ Bank 1 $ Bank 2 $ Bank 3 $ Bank

Chapter 23: Money, Prices, and the Federal Reserve Deposits Notice how the original deposit of 1000 has gotten multiplied. Because Deposits are part of money, the money supply has grown by $

Chapter 23: Money, Prices, and the Federal Reserve26 Assets Currency (= reserves) 100,000 guilders Loans to farmers900,000 guilders Liabilities Deposits1,000,000 guilders Fractional Reserve Banking System Bankers agree they only need a reserve to deposit ratio of 10% R = r D = 0.1 D Required reserves = 100,000 guilders, 10% of deposits Lend the excess reserves of 900,000 guilders The Process of Deposit Creation Consolidated Balance Sheet of Venetian Commercial Banks After One Round of Loans

Chapter 23: Money, Prices, and the Federal Reserve27 Assets Currency (= reserves)1,000,000 guilders Loans to farmers900,000 guilders Liabilities Deposits1,900,000 guilders Loan proceeds are redeposited Reserves = 100, ,000 = 1,000,000 guilders Deposits = 1,900,000 guilders Money supply = Deposits = 1,900,000 guilders Excess reserves = Reserves – 0.1 * Deposits Excess reserves = 1,000,000 – 0.1 * 1,900,000 Excess reserves = 1,000,000 – 190,000 = 810,000 Banks can lend the excess 810,000 guilders The Process of Deposit Creation Consolidated Balance Sheet of Venetian Commercial Banks After One Round of Loans

Chapter 23: Money, Prices, and the Federal Reserve28 Assets Currency (= reserves)190,000 guilders Loans to farmers900,000 guilders Loans to merchants810,000 guilders Liabilities Deposits 1,900,000 guilders Lend excess reserves Reserves = 190,000 guilders Deposits = 1,900,000 guilders Money supply = Deposits = 190,000 guilders Loans = 900, ,000 = 1,710,000 The Process of Deposit Creation Consolidated Balance Sheet of Venetian Commercial Banks After Two Rounds of Loans and Redeposits

Chapter 23: Money, Prices, and the Federal Reserve29 Assets Currency (= reserves)1,000,000 guilders Loans to farmers900,000 guilders Loans to merchants810,000 guilders Liabilities Deposits2,710,000 guilders Loan proceeds are redeposited Reserves = 190, ,000 = 1,000,000 guilders Deposits = 1,900, ,000 = 2,710,000 guilders Money supply = Deposits = 2,710,000 guilders Excess reserves = Reserves – 0.1 * Deposits Excess reserves = 1,000,000 – 271,000 = 729,000 Excess reserves = 729,000 guilders The Process of Deposit Creation Consolidated Balance Sheet of Venetian Commercial Banks After Two Rounds of Loans and Redeposits

Chapter 23: Money, Prices, and the Federal Reserve30 The Process of Deposit Creation DepositsReservesLoans 1,000,000100,000900,000 90,000810,000 81,000729,000 72,900656,100 65,610590,490 59,049531,441 53,144478, ,29647,830430,467 10,000,0001,000,0009,000,000 ……… Notice Reserves = 10% of D Also Reserves = original injection of Reserves by Central Bank = 1 million  D=10*  R

Chapter 23: Money, Prices, and the Federal Reserve31 The Process of Deposit Creation DepositsReservesLoans 1, ,0001,0009,000 ……… Notice Reserves = 10% of D Also Reserves = original injection of Reserves by Central Bank = 1000  D=10*  R

Chapter 23: Money, Prices, and the Federal Reserve32 Assets Currency (= reserves)1,000,000 guilders Loans to farmers9,000,000 guilders Liabilities Deposits10,000,000 guilders Observations Lending will continue to keep the reserve to deposit ratio = 10% When loans = 9,000,000 guilders Deposits = 10,000,000 guilders Reserves = 1,000,000 guilders Reserve to deposit ratio = 10% No excess reserves The money supply = 10,000,000 guilders The Process of Deposit Creation Final Consolidated Balance Sheet of Venetian Commercial Banks

Chapter 23: Money, Prices, and the Federal Reserve33  The use of a fractional-reserve banking system allows the money supply to grow as a multiple of the reserves.  In Venice, with a 10% reserve-deposit ratio, 1 guilder in reserve can support 10 guilders in deposit. –The CB creates currency, which is kept by banks as reserves. As long as banks have reserves, they can make loans, which are redeposited and become money. Commercial Banks and the Creation of Money

Chapter 23: Money, Prices, and the Federal Reserve34  Summary –R = r D –Bank reserves/bank deposits = desired reserve- deposit ratio –R / D = r –Bank deposits = bank reserves/desired reserve- deposit ratio –D = R / r Commercial Banks and the Creation of Money

Chapter 23: Money, Prices, and the Federal Reserve35  The Central Bank can control the amount of money in an economy by –Printing more (or fewer) dollar bills.  It gives them out by exchanging them for government bonds or by lending them to banks. –Changing the reserve requirement ( r ). Commercial Banks and the Creation of Money

Chapter 23: Money, Prices, and the Federal Reserve36 Exercise 23.2  Suppose banks’ desired reserve/deposit ratio is 10%, and the CB prints 1m guilders.  How does the money supply change? Since we are still assuming people don’t hold currency, the 1m guilders must be held as reserves by the banking system.Since we are still assuming people don’t hold currency, the 1m guilders must be held as reserves by the banking system. Without currency, money supply = deposits.Without currency, money supply = deposits. Deposits = (1/r)*ReservesDeposits = (1/r)*Reserves  Deposits = (1/r)*  Reserves  Deposits = (1/r)*  Reserves 10m = 10*1m = (1/0.10)*1m10m = 10*1m = (1/0.10)*1m

Chapter 23: Money, Prices, and the Federal Reserve37 Exercise 23.2  Suppose banks’ desired reserve/deposit ratio is 10%, and the CB prints 2m guilders.  How does the money supply change? Without currency, money supply = deposits.Without currency, money supply = deposits. Deposits = (1/r)*ReservesDeposits = (1/r)*Reserves  Deposits = (1/r)*  Reserves  Deposits = (1/r)*  Reserves 20m = 10*2m = (1/0.10)*2m20m = 10*2m = (1/0.10)*2m

Chapter 23: Money, Prices, and the Federal Reserve38 Exercise 23.2  Suppose banks’ desired reserve/deposit ratio is 5%, and the CB prints 1m guilders.  How does the money supply change? Deposits = (1/r)*ReservesDeposits = (1/r)*Reserves  Deposits = (1/r)*  Reserves  Deposits = (1/r)*  Reserves 20m = 20*1m = (1/0.05)*1m20m = 20*1m = (1/0.05)*1m

Money Supply with Both Currency and Deposits

Chapter 23: Money, Prices, and the Federal Reserve40  Money Supply = Currency + Deposits  Money Supply = Currency + R / r  Currency + Reserves = Central Bank Money –If the Central Bank prints $1000, all of it must be held either in Currency or in Reserves. Commercial Banks and the Creation of Money

Chapter 23: Money, Prices, and the Federal Reserve41  The Money Supply with Both Currency and Deposits –Suppose residents choose to hold 500,000 guilders as currency –If the CB issues 1 million guilders, people deposit 500,000 in the banks –Reserve-deposit ratio = 10% –Bank deposits = 500,000/0.10 = 5,000,000 Commercial Banks and the Creation of Money

Chapter 23: Money, Prices, and the Federal Reserve42  The Money Supply with Both Currency and Deposits –Money supply = currency + bank deposits 5,500,000 = 500, ,000,000  But before we found that currency = 0, 10,000,000 = ,000,000 10,000,000 = ,000,000 –The money supply is reduced by 4,500,000 guilders when the residents hold 500,000 guilders in currency Commercial Banks and the Creation of Money

Chapter 23: Money, Prices, and the Federal Reserve43  The Money Supply at Christmas –Currency = 500 –Bank reserves = 500 –Reserve-deposit ratio = 0.20 –Money supply = /.20 = ,500 = 3,000 Commercial Banks and the Creation of Money

Chapter 23: Money, Prices, and the Federal Reserve44  The Money Supply at Christmas –If Xmas shoppers withdraw 100 –Money supply = ( ) + (500 – 100)/0.20 = /0.20 = ,000 = 2,600 Commercial Banks and the Creation of Money

Chapter 23: Money, Prices, and the Federal Reserve45  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 withdrawals, the money supply contracts by a multiple of the withdrawal.  Fall in Money Supply = (1/r) x Withdrawal – increase in cash held by public Commercial Banks and the Creation of Money

Central Banks

Chapter 23: Money, Prices, and the Federal Reserve47 Central Banks  Two Main Responsibilities –Monetary policy –Oversight and regulation of financial markets

Chapter 23: Money, Prices, and the Federal Reserve48 Central Banks  Their primary mission is to promote low inflation, economic growth, and stable financial markets.  The Bank of England was founded in  The US Federal Reserve System,  Many Latin American countries founded central banks in the 1920s.

Chapter 23: Money, Prices, and the Federal Reserve49 The Federal Reserve System  The Fed’s Structure –12 regional Federal Reserve banks  Assess economic conditions in their regions to assist in national policymaking  Provide service to the commercial banks in their districts

Chapter 23: Money, Prices, and the Federal Reserve50 The Federal Reserve System  The Fed’s Structure –Board of Governors  Seven governors, Appointed by the president to 14 year staggered terms. The Chairman is selected by the president from the governors, and serves a four year term. –Federal Open Market Committee (FOMC)  Members include: –The seven Fed governors, President of the New York Fed, four presidents, chosen on a rotating basis, from the remaining Federal Reserve Banks  Determines monetary policy

Chapter 23: Money, Prices, and the Federal Reserve51 Central Banks  Controlling the Money Supply: Open-Market Operations –The primary function of Central Banks is monetary policy. –CBs control the money supply by changing the supply of bank reserves.

Chapter 23: Money, Prices, and the Federal Reserve52 Central Banks  Controlling the Money Supply: Open-Market Operations (OMOs) –Open-market operations are the most important method of changing the supply of bank reserves.  The “Market” in OMOs is the Market for Government or Central Bank Bonds. –The CB exchanges bonds for currency.

Chapter 23: Money, Prices, and the Federal Reserve53  Bond –A legal promise to repay a debt, usually including both the principal amount and regular interest payments. Central Banks Source: posters/WWI/catalog 11.htm

Chapter 23: Money, Prices, and the Federal Reserve54 Open Market Operations  Increasing The Money Supply –The Fed purchases US government bonds from the public. –The people deposit the funds they get from their sale of bonds to the Fed. –The increase in deposits increase bank reserves.

Chapter 23: Money, Prices, and the Federal Reserve55 Open Market Operations  Increasing The Money Supply –The increase in reserves will lead to an expansion of the money supply as banks make more loans. –Recall  The change in the money supply is a multiple of the change in reserves.

Chapter 23: Money, Prices, and the Federal Reserve56 Open Market Operations  Reducing The Money Supply –The CB sells government bonds to the public. –The CB presents the checks from the sale of the bonds to the banks for payment. –The bank’s reserves will fall when they clear the checks. –The money supply will fall by a multiple of the decrease in reserves.

Chapter 23: Money, Prices, and the Federal Reserve57 Open Market Purchase  Open-Market Purchase –The purchase of government bonds from the public by the CB for the purpose of increasing the supply of bank reserves and the money supply.

Chapter 23: Money, Prices, and the Federal Reserve58 Open Market Purchase Fed pays for BOND purchase with a check, which is deposited in a commercial bank New money becomes a part of the bank’s reserves Reserves are the basis for additional lending Additional lending increases the money supply D → L → D → L → D → L → …

Chapter 23: Money, Prices, and the Federal Reserve59 Open Market Sale  Open-Market Sale –The sale by the CB of government bonds to the public for the purpose of reducing bank reserves and the money supply

Chapter 23: Money, Prices, and the Federal Reserve60 Open Market Sale Fed receive a check (drawn on a commercial bank deposit) in exchange for the Bond. Open market sale reduces the supply of bank reserves Fewer reserves are available to back new loans Reduction in lending means that fewer dollars will be created.

Chapter 23: Money, Prices, and the Federal Reserve61 Open Market Operations  Suppose the CB wants to increase the money supply using open-market operations.  Currency = 1,000 shekels; Reserves = 200  Reserve-deposit ratio = 0.2  Money supply = 1, /0.2 = 2,000 shekels  What should the CB do?

Chapter 23: Money, Prices, and the Federal Reserve62 Open Market Operations  An Open Market Purchase increases Reserves and the Money Supply  Open market purchase = 100  Reserves increase to 300  Money supply = 1, /0.2 = 2,500 shekels

Chapter 23: Money, Prices, and the Federal Reserve63 Discount Lending  Controlling the Money Supply: Discount Window Lending –Banks can borrow reserves from the Fed. –Discount window lending  The lending of reserves to commercial banks. –The discount rate  The interest rate charged on these loans.

Chapter 23: Money, Prices, and the Federal Reserve64 The Reserve Requirement  Controlling the Money Supply: Changing Reserve Requirements –The Fed sets a minimum reserve-deposit ratio, 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.

Chapter 23: Money, Prices, and the Federal Reserve65 The Lender of Last Resort  The CB’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.

Chapter 23: Money, Prices, and the Federal Reserve66 The Lender of Last Resort  The CB’s Role in Stabilizing Financial Markets: Banking Panics –The CB to the rescue:  Instill confidence  Discount lending  Open Market Operations Depositors attempt to claim their funds during the 1907 Bank Panic. Source: Altanta Fed Bank Panic (1930) People lined up outside a New York City bank, trying to get in to get their money out. Source: Library of Congress.

Chapter 23: Money, Prices, and the Federal Reserve67 CurrencyReserve-depositBankMoney held by publicratioreservessupply December December December December December Key U.S. Monetary Statistics, Currency, reserves, and money supply are in billions of dollars. Note that as C, r, and R rise, MS falls. The process of Deposit Creation is choked.

Money and Prices

Chapter 23: Money, Prices, and the Federal Reserve69 Money and Prices  “Inflation is always and everywhere a monetary phenomenon” -- Milton Friedman  This is true in the long run and if inflation is very high.

Chapter 23: Money, Prices, and the Federal Reserve70 Money and Prices Price of 1 radio = 4 oranges

Chapter 23: Money, Prices, and the Federal Reserve71 Money and Prices Price of 1 radio = 6 oranges

Chapter 23: Money, Prices, and the Federal Reserve72 Money and Prices Price of 1 radio = 3 oranges

Chapter 23: Money, Prices, and the Federal Reserve73 Money and Prices  Assume an economy where dollar bills are used only once a year (“velocity” = 1); and where annual real GDP = 10 million houses.  Suppose M s =$10bn. What will P be?  MV = PY  $10bn x 1 = P x 10 million houses  P = $1 thousand / house

Chapter 23: Money, Prices, and the Federal Reserve74 Money and Prices  Now suppose M s =$20bn. What will P be?  MV = PY  $20bn x 1 = P x 10 million houses  P = $2 thousand / house  If M doubles, P doubles. M/P doesn’t change.  Why doesn’t this happen in the short run?  Because M affects P through the goods, money, and labor market, over time.

Chapter 23: Money, Prices, and the Federal Reserve75 Money and Prices  Velocity –The speed at which money circulates.  The number of times a dollar bill is used in one year.

Chapter 23: Money, Prices, and the Federal Reserve76 Money and Prices  Velocity –The speed at which money circulates  The number of times a dollar bill is used in one year.

Chapter 23: Money, Prices, and the Federal Reserve77 Money and Prices  Velocity in 2001 –M1 = $1,177.9 billion –Nominal GDP = $10,082.2 billion

Chapter 23: Money, Prices, and the Federal Reserve78 Money and Prices  Money and Inflation in the Long Run –Quantity equation M x V = P x Y It’s a definition, so it’s always true.

Chapter 23: Money, Prices, and the Federal Reserve79 Money and Prices  Money and Inflation in the Long Run –Assume V & Y are constant over the time period This is a definition, so it’s always true. This is a theory, so it may or may not be true.

Chapter 23: Money, Prices, and the Federal Reserve80 Money and Prices  Money and Inflation in the Long Run –Why should we assume V & Y are constant? –Y is determined by human capital, technology, etc.. This theory says economic growth is unrelated to the quantity of money. –V is determined by institutions, etc.. This theory says that the need for transactions (which use money) is also unrelated to the quantity of money. –So if we change M, we assume V or Y won’t change. Then assume they are constant.

Chapter 23: Money, Prices, and the Federal Reserve81 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 is chasing too few goods.

Chapter 23: Money, Prices, and the Federal Reserve82 Inflation and Money Growth in Latin America,

Chapter 23: Money, Prices, and the Federal Reserve83 Money and Prices  If high rates of money growth lead to inflation, why do countries allow their money supplies to rise so quickly? –In the case of Ecuador, because of the need for a lender of last resort! –The Central Bank had to print billions of sucres to try to save the banks from failing … which caused the economy, and the banks, to collapse.