Principles of Economics Session 12

Topics To Be Covered Definition of Money Categories of Money The Federal Reserve System Money Multiplier Supply and Demand for Money Equilibrium of the Money Market Monetary Policy

Definition of Money Money is the set of assets in the economy that people regularly use to buy goods and services from other people. It serves three functions: Medium of exchange Unit of account Store of value

Three Functions of Money A medium of exchange is anything that is readily acceptable as payment. A unit of account is the yardstick people use to post prices and record debts. A store of value is an item that people can use to transfer purchasing power from the present to the future.

Barter Barter is 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. Money eliminates this problem. Money as a means of payment, or medium of exchange, is more efficient than barter.

Categories of Money Commodity Money Commodity money takes the form of a commodity with intrinsic value. For example: Gold, silver, cigarettes. Fiat Money Fiat money is used as money because of government decree. It does not have intrinsic value. For example: Coins, currency, check deposits.

Money in the U.S. Economy Measure Amount in 2000 What’s Included M1 $1,103 billion Currency Traveler’s checks Demand deposits Other checkable deposits M2 $4,778 billion Everything in M1 Saving deposits Small time deposits Money market mutual funds M3 $5,505 billion Everything in M2 Large time deposits

The Central Bank Generally, the central bank of a country serves the following functions: It oversees the banking system. It acts as a banker’s bank, making loans to banks and as a lender of last resort. It conducts monetary policy by controlling the money supply. The Chinese central bank is the People’s Bank of China and the American one is the Federal Reserve System.

The Fed’s Organization The Federal Reserve System (Fed) consists of : The Board of Governors The Regional Federal Reserve Banks The Federal Open Market Committee

The Fed’s Organization The Fed is run by a Board of Governors, which has seven members appointed by the President and confirmed by the Senate. Among the seven members, the most important is the chairman. The chairman directs the Fed staff, presides over board meetings, and testifies about Fed policy in front of Congressional Committees.

The Fed’s Organization The Fed also includes 12 regional reserve banks. Each regional reserve bank consists of nine directors—three appointed by the Board of Governors and six elected by the commercial banks in the district. The directors appoint the district president which is approved by the Board of Governors.

The Fed’s Organization The Federal Open Market Committee (FOMC) is made up of the following voting members: The chairman and the other six members of the Board of Governors. The president of the Federal Reserve Bank of New York. The presidents of the other regional Federal Reserve banks (four votes on a yearly rotating basis).

The Fed’s Organization FOMC serves as the main policy-making organ of the Federal Reserve System. FOMC meets approximately every six weeks to review the economy. FOMC conducts the monetary policy

Fed’s Tools of Monetary Control The Fed has three tools in its monetary toolbox: Open-market operations Changing the reserve requirement Changing the discount rate

Open-Market Operations The Fed conducts open-market operations when it buys government bonds from or sells government bonds to the public: When the Fed buys government bonds, the money supply increases. The money supply decreases when the Fed sells government bonds.

Changing the Reserve Requirement The reserve requirement is the amount (%) of a bank’s total reserves that may not be loaned out. Increasing the reserve requirement decreases the money supply. Decreasing the reserve requirement increases the money supply.

Changing the Discount Rate The discount rate is the interest rate the Fed charges banks for loans. Increasing the discount rate decreases the money supply. Decreasing the discount rate increases the money supply.

Money Creation Banks can influence the quantity of demand deposits in the economy and the money supply. In a fractional reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest. When a bank makes a loan from its reserves, the money supply increases.

Money Creation The money supply is affected by the amount deposited in banks and the amount that banks loan. Deposits into a bank are recorded as both assets and liabilities. The fraction of total deposits that a bank has to keep as reserves is called the reserve ratio (R). Loans become an asset to the bank.

Money Creation First Bank This T-Account shows a bank that: accepts deposits keeps a portion as reserves lends out the rest. It assumes a reserve ratio of 10%. Assets Liabilities Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities

Money Creation When one bank loans money, that money is generally spent. And the recipient deposits it into another bank. This creates more deposits and more reserves to be lent out. When a bank makes a loan from its reserves, the money supply increases.

Money Creation Money Supply = $190.00 First Bank Second Bank Assets Liabilities Assets Liabilities Reserves $10.00 Loans $90.00 Deposits $90.00 Deposits $100.00 Reserves $9.00 Loans $81.00 Total Assets $100.00 Total Liabilities $100.00 Total Assets $90.00 Total Liabilities Money Supply = $190.00

Money Creation Original deposit = $ 100.00 First lending = $ 100.00 First lending = $ 90.00 [=0.9 x $100.00] Second lending = $ 81.00 [=0.9 x $90.00] Third lending = $ 72.90 [=0.9 x $81.00] ……………………………………………………….

The Money Multiplier The money multiplier is the amount of money the banking system generates with each dollar of reserves.

Supply and Demand for Money In the money market, interest rates are determined by the supply and demand for money. The central bank can change the interest rate level because it controls the supply of money.

Supply and Demand for Money Interest Rate Ms Md Equilibrium Interest rate Money

The Demand for Money (The Liquid Preference) Portfolio of holding financial wealth: stocks, bonds or money. Holding wealth in currency or checking deposits means loss of potential income from interest on bonds and dividends on stocks.

The Demand for Money The market rate of interest is the opportunity cost of holding money. As interest rates rise, the opportunity cost of holding money rises, and the public demands less money. So the demand curve is downward sloping. Macroeconomic variables that change the demand for money are price level and real GDP.

Demand for Money and the Price Level Interest Rate Md2 Ms When the price level rises, the demand for money increases. Md1 r2 r1 Money

Demand for Money and the Real GDP Interest Rate Md2 Ms When real GDP rises, the demand for money increases. Md1 r2 r1 Money

The Demand for Money Generally, the motives of people holding money can be roughly classified into two categories. Transaction demand for money Speculative demand for money

The Demand for Money Transaction demand for money The needs or desires of individuals or firms to make purchases on short notice without incurring excessive costs. Speculative demand for money An attitude that holding money over short periods is less risky than holding stocks or bonds.

The Transaction Demand for Money The transactions demand for money (L1) is based on the desire to facilitate transactions. It mainly depends on the income (Y), so its function is:

The Speculative Demand for Money The speculative demand for money (L2) is based on the desire to make wise decisions to invest in securities such as bonds. It mainly depends on the interest, so its function is:

Bond Prices and Interest Rates Bonds are promises to pay money in the future. The price of a bond one year from now is the promised payment divided by 1 plus the interest rate.

Bond Prices and Interest Rates For example, a bond that promises to pay $106 a year, with an interest rate is 6% per year, would cost today: In other words, if you can invest at 6% per year, you would be willing to pay $100 today for a $106 promised payment next year.

Interest Rates and Bond Prices Bond prices change in the opposite direction from changes in interest rates: Interest Rate Promised Payment Interest Rate Promised Payment $106 6% $106 4% If the interest rate rose to 8%, how much would you like to pay? $98.15.

Interest Rates and Bond Prices When interest rates rise, investors need less money to obtain the same promised payments in the future, so the price of bonds falls. Therefore, bonds’ prices are inversely related to interest rates.

The Speculative Demand for Money When the interest is high, the bond price is low. Usually people will guess that the bond price is to rise, so they purchase bonds, thus having less money in hand. high interest rates Low bond prices Purchasing bonds Less money in hand

The Speculative Demand for Money When the interest is low, the bond price is high. Usually people will expect that the bond price is to fall, so they sell the bonds they own. Consequently they have more money in hand. Low interest rates High bond prices Selling bonds More money in hand

Demand for Money L1=L1(Y) m r m r L2=L2(r) L=L1+ L2

Equilibrium of the Money Market When the money market is at equilibrium, the demand for money (L) should be equal to the supply of money (m). The money supply is controlled by the central bank.

Equilibrium of the Money Market When money demand and supply equal, the money market is at equilibrium r1 E m

Central Bank and Interest Rates The central bank can influence the interest rate through changing the money supply. An increase in the money supply leads to a lower interest rate. A decrease in the money supply leads to a higher interest rate.

Central Bank and Interest Rates m3 m1 m2 L r3 E r1 r2 m

Monetary Policy Monetary policy is the range of actions taken by the Federal Reserve to influence the level of GDP or the rate of inflation.

Monetary Policy The central bank can influence the output by changing the money supply. When the central bank increase the money supply, the interest rate goes down. With the decrease of interest rate, the investment increases. Since increase is part of GDP, the total output increases.

Money supply increases Investment spending rises Monetary Policy Money Investment Output Ms2 AE2 Y2 r1 r1 r2 r2 AE1 Md I2 Ms1 I1 Y1 Open market purchase Money supply increases Interest rates fall Investment spending rises GDP increases

Limitations of Monetary Policy If the economy has reached the level of potential output, namely, the full-employment output, the expansionary monetary policy won’t work effectively. Initially, monetary expansion leads to output above full employment. The demand for money increases, leading to a higher interest rate. The increase of interest rate will decrease the investment, which will return the GDP back to the full-employment level.

Limitations of Monetary Policy Potential GDP Md2 Ms2 AE2 Y2 r1 r1 r2 r2 AE1 Md1 I2 Ms1 I1 Money Investment Output

Assignment Review Chapter 25 and 26. Answer questions on P491 and 513. Search for information on China’s monetary policies in the recent years. Preview Chapter 29 and 30.

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