Chapter 21 Money and Central Banking Introduction to Economics (Combined Version) 5th Edition

What Is Money? Money is any asset that serves as  a store of value,  a unit of account, and  a medium of exchange. Introduction to Economics (Combined Version) 5th Edition

Components of the Money Stock Introduction to Economics (Combined Version) 5th Edition

The Equation of Exchange M = money stock (M1 or M2) V = velocity of circulation of money (how many times per year each unit of the money stock is used to purchase final goods) P = price level (e.g., consumer price index) Q = real GDP MV = PQ Introduction to Economics (Combined Version) 5th Edition

Money: A Balance Sheet View Introduction to Economics (Combined Version) 5th Edition  Currency in the hands of the public is an asset of households and firms, and a liability of the Fed.  Currency held as vault cash by banks is not part of the money stock.  The remainder of the money stock consists of bank deposits, which are an asset of households and firms, and a liability of banks.  Currency plus banks' reserve deposits constitute the monetary base.

Effects of a Loan Introduction to Economics (Combined Version) 5th Edition  This diagram shows the effects of a bank loan on the money stock.  Instead of complete balance sheets, it uses T-accounts, which show only items that change as the result of the loan.  The loan causes an increase in bank assets and consumer liabilities.  At the same time, it produces an increase in bank deposits, which are consumer assets and bank liabilities.

Effects of a Loan with Cash Withdrawal Introduction to Economics (Combined Version) 5th Edition  This figure shows the T-account effects of a loan, when the borrowing withdraws part of the loan proceeds as cash.  The end result is an increase in the money stock (bank deposits plus currency in circulation) and a decrease in total bank reserves.

The Money Multiplier  In equation form, we can state the relationship between the money stock (currency in circulation plus bank deposits) and the monetary base (total currency plus bank reserve deposits at the central bank) as follows: Money stock = Monetary base X [(1+CUR)/(RES+CUR)]  RES = the target reserve ratio (amount of reserves banks want to hold for each dollar of deposits)  CUR = desired currency ratio (the amount of currency that the public chooses to hold per dollar of bank deposits)  The expression (1+CUR)/(RES+CUR) on the right-hand side of the equation is known as the money multiplier. The money multiplier gives the total quantity of money that can be created for each dollar of the monetary base. Introduction to Economics (Combined Version) 5th Edition

Instruments of Monetary Policy  Open market operations are purchases and sales of government securities by the Fed.  Changes in interest rates  Discount rate charged by the Fed on reserves it loans to commercial banks  Deposit rate paid by the Fed on reserve deposits of commercial banks  Changes in required reserve ratios  Purchases and sales of foreign assets Introduction to Economics (Combined Version) 5th Edition The Federal Reserve building in Washington, D.C.

Effects of an Open Market Purchase Introduction to Economics (Combined Version) 5th Edition  These T-accounts show the effects of a $1,000,000 open market purchase of securities by the Fed.  The immediate result is an increase in commercial bank reserves, bank deposits, and the money stock.  Later (not shown here), banks can use the new reserves as a basis for new loans, leading to further expansion of the money stock.