Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 43 Use basic AD-AS framework to analyze business cycles Basic AD-AS framework:No long run growth, no inflation. Recession: AD shifts left, Y down, P down. Y below potential Y. Adjust back to potential Y: SRAS shifts right: b/c wage rate down (two reasons) Expansion: Similar to recession, led by AD. Y and P are usually positive related. Supply shock and stagflation: SRAS Learning Objective 13.1 What we learned in last class:

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 43 Dynamic AD-AS framework LRAS shifts to the right continually. During most years, AD will be shifting to the right. Except that high inflation is expected, SRAS shifts to the right. Use Dynamic AD-AS frame work to explain inflation. Oil shocks may not cause recession AD decline in 2001 and slow recovery. Learning Objective 13.1 What we learned in last class:

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 44 Money, Banks, and the Federal Reserve System 13.1Define money and discuss its four functions. 13.2Discuss the definitions of the money supply used in the United States today. 13.3Explain how banks create money. 13.4Discuss the three policy tools the Federal Reserve uses to manage the money supply Explain the quantity theory of money and use it to explain how high rates of inflation occur. Learning Objectives Confidence and trust cannot be taken for granted. …households and firms losing faith in an official money can harm trade and economic activity in an economy.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 43 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. Barter and the Invention of Money Barter economies: double coincidence of wants. Commodity money A good used as money that also has value independent of its use as money. By making exchange easier, money allows for specialization and higher productivity Learning Objective 13.1 What Is Money and Why Do We Need It?

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 43 What Is Money and Why Do We Need It? Learning Objective 13.1 Medium of Exchange The Functions of Money Money serves as a medium of exchange when sellers are willing to accept it in exchange for goods or services. Unit of Account In a barter system, each good has many prices. Store of Value Money allows value to be stored easily: If you do not use all your accumulated dollars to buy goods and services today, you can hold the rest to use in the future. Standard of Deferred Payment Money is useful because it can serve as a standard of deferred payment in borrowing and lending.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 43 What Is Money and Why Do We Need It? Learning Objective 13.1 What Can Serve as Money? Five criteria make a good suitable to use as a medium of exchange: 1 The good must be acceptable to (that is, usable by) most people. 2 It should be of standardized quality so that any two units are identical. 3 It should be durable so that value is not lost by spoilage. 4 It should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported. 5 The medium of exchange should be divisible because different goods are valued differently.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 43 What Is Money and Why Do We Need It? Learning Objective 13.1 What Can Serve as Money? Commodity money meets the criteria for a medium of exchange. Problem: Quality standard, Inconvenience for transaction. Control for money supply. It can be inefficient for an economy to rely on only gold or other precious metals for its money supply. Commodity Money

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 43 What Is Money and Why Do We Need It? Learning Objective 13.1 What Can Serve as Money? Fiat money Money, such as paper currency, that is authorized by a central bank or governmental body and that does not have to be exchanged by the central bank for gold or some other commodity money. Federal Reserve System The central bank of the United States. Legal tender and acceptance by households and firms: Households and firms believe dollar will not lose much value during the time they hold them. (Zimbabwe case again) Fiat Money

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 43 Learning Objective 13.1 Money without a Government? The Strange Case of the Iraqi Dinar Making the Connection Many Iraqis continued to use currency with Saddam’s picture on it, even after he was forced from power.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 43 How Is Money Measured in the United States Today? Learning Objective 13.2 M1: The Narrowest Definition of the Money Supply M1 The narrowest definition of the money supply: The sum of currency in circulation, checking account deposits in banks, and holdings of traveler’s checks.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 43 Learning Objective 13.2 M1: The Narrowest Definition of the Money Supply M1 includes: 1 Currency, which is all the paper money and coins that are in circulation, where “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 (although this last category is so small—less than $7 billion in May 2007— we will ignore it in our discussion of the money supply) How Is Money Measured in the United States Today?

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 43 Learning Objective 13.2 M2: A Broader Definition of Money M2 A broader definition of the money supply: M1 plus savings account balances, small- denomination time deposits, balances in money market deposit accounts in banks, and noninstitutional money market fund shares. Don’t Let This Happen to YOU! Don’t Confuse Money with Income or Wealth How Is Money Measured in the United States Today?

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 43 Learning Objective 13.2 M1: The Narrowest Definition of the Money Supply How Is Money Measured in the United States Today? FIGURE 13.1 Measuring the Money Supply, May 2007

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 43 Learning Objective 13.2 Do We Still Need the Penny? Making the Connection Unfortunately, these cost the government more than a penny to produce.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 43 Learning Objective 13.2 There are two key points about the money supply to keep in mind: 1 The money supply consists of both currency and checking account deposits. 2 Because balances in checking account deposits are included in the money supply, banks play an important role in the process by which the money supply increases and decreases. We will discuss this second point further in the next section. What about Credit Cards and Debit Cards? Many people buy goods and services with credit cards, yet credit cards are not included in definitions of the money supply. How Is Money Measured in the United States Today?

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 43 Solved Problem 13-2 The Definitions of M1 and M2 Learning Objective 13.2 Suppose you decide to withdraw $2,000 from your checking account and use the money to buy a bank certificate of deposit (CD). Briefly explain how this will affect M1 and M2.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 43 How Do Banks Create Money? Learning Objective 13.3 Bank Balance Sheets Don’t Let This Happen to YOU! Know When a Checking Account Is an Asset and When It Is a Liability FIGURE 13.2 Balance Sheet for Wachovia Bank, December 31, 2006

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 43 How Do Banks Create Money? Learning Objective 13.3 Bank Balance Sheets Reserves Deposits that 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.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 43 How Do Banks Create Money? Learning Objective 13.3 Using T-Accounts to Show How a Bank Can Create Money

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 43 How Do Banks Create Money? Learning Objective 13.3 Using T-Accounts to Show How a Bank Can Create Money

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 43 How Do Banks Create Money? Learning Objective 13.3 Using T-Accounts to Show How a Bank Can Create Money

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 43 How Do Banks Create Money? Learning Objective 13.3 Using T-Accounts to Show How a Bank Can Create Money

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 43 How Do Banks Create Money? Learning Objective 13.3 Using T-Accounts to Show How a Bank Can Create Money BANKINCREASE IN CHECKING ACCOUNT 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

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 43 How Do Banks Create Money? Learning Objective 13.3 The Simple Deposit Multiplier Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 43 Solved Problem 13-3 Showing How Banks Create Money Learning Objective 13.3 PNC Bank AssetsLiabilities Reserves+$5,000Deposits+$5,000 PNC Bank AssetsLiabilities Reserves+$5,000Deposits+$5,000 Loans+$4,500Deposits+$4,500 PNC Bank AssetsLiabilities Reserves +$500Deposits+$5,000 Loans+$4,500 Wachovia Bank AssetsLiabilities Reserves+$4,500Deposits+$4,500

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 43 How Do Banks Create Money? Learning Objective 13.3 The Simple Deposit Multiplier versus the Real-World Deposit Multiplier 1 Whenever banks gain reserves, they make new loans, and the money supply expands. 2 Whenever banks lose reserves, they reduce their loans, and the money supply contracts. We can summarize these important conclusions: In the real world the real deposit multiplier is smaller than the simple deposit multiplier: Cash holding, and excess reserves.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 43 What we learned in last class: Learning Objective 13.4 The definition of money (compared with assets). Barter economies and commodity money. Money makes specialization possible and easier. Functions of money: Medium of exchange, unit of account, store of value, standard of deferred payment What can serve as money: acceptable, standardized, durable, valuable, divisible Commodity money vs. fiat money problems of commodity money fiat money is backed up by the central bank: legal tender and acceptance by firms and household.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 28 of 43 What we learned in last class: Learning Objective 13.4 M1 and M2, the narrowest vs. broader. Don’t Confuse Money with Income or Wealth Bank balance sheets: assets and liabilities reserves, required reserves and excess reserves, required reserves ratio. the bank system generates money Simple Deposit multiplier: no excess reserves and cash holding. In the real world: Smaller deposit multiplier.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 43 The Federal Reserve System Learning Objective 13.4 Bank Balance Sheets Fractional reserve banking system A banking system in which banks keep less than 100 percent of deposits as reserves. Bank run A situation in which many depositors simultaneously decide to withdraw money from a bank. Bank panic A situation in which many banks experience runs at the same time.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 30 of 43 Learning Objective 13.4 The 2001 Bank Panic in Argentina Making the Connection The Argentine central bank was unable to stop the bank panic of 2001.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 31 of 43 The Federal Reserve System Learning Objective 13.4 The Organization of the Federal Reserve System FIGURE 13.3 Federal Reserve Districts

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 32 of 43 The Federal Reserve System Learning Objective 13.4 How the Federal Reserve Manages the Money Supply Monetary policy The actions the Federal Reserve takes to manage the money supply and interest rates to pursue economic objectives. To manage the money supply, the Fed uses three monetary policy tools: 1 Open market operations 2 Discount policy 3 Reserve requirements

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 33 of 43 The Federal Reserve System Learning Objective 13.4 How the Federal Reserve Manages the Money Supply Open Market Operations Federal Open Market Committee (FOMC) The Federal Reserve committee responsible for open market operations and managing the money supply in the United States. Open market operations The buying and selling of Treasury securities by the Federal Reserve in order to control the money supply.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 34 of 43 The Federal Reserve System Learning Objective 13.4 How the Federal Reserve Manages the Money Supply Discount Policy Discount loans Loans the Federal Reserve makes to banks. Discount rate The interest rate the Federal Reserve charges on discount loans. Reserve Requirements When the Fed reduces the required reserve ratio, it converts required reserves into excess reserves.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 35 of 43 The Federal Reserve System Learning Objective 13.4 Putting It All Together: Decisions of the Nonbank Public, Banks, and the Fed Using its three tools—open market operations, the discount rate, and reserve requirements—the Fed has substantial influence over the money supply, but that influence is not absolute. Two other actors—the nonbank public and banks—also influence the money supply.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 36 of 43 Learning Objective 13.5 Connecting Money and Prices: The Quantity Equation In the early twentieth century, Irving Fisher, an economist at Yale, formalized the connection between money and prices using the quantity equation: M × V = P × Y The Quantity Theory of Money

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 37 of 43 Learning Objective 13.5 Connecting Money and Prices: The Quantity Equation Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services included in GDP. Quantity theory of money A theory of the connection between money and prices that assumes that the velocity of money is constant. The Quantity Theory of Money

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 38 of 43 Learning Objective 13.5 The Quantity Theory Explanation of Inflation We can transform the quantity equation from: Growth rate of the money supply + Growth rate of velocity = Growth rate of the price level (or inflation rate) + Growth rate of real output to: The Quantity Theory of Money

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 39 of 43 Learning Objective 13.5 The Quantity Theory Explanation of Inflation The growth rate of the price level is just the inflation rate, so we can rewrite the quantity equation to help us understand the factors that determine inflation: If Irving Fisher was correct that velocity is constant, then the growth rate of velocity will be zero. This allows us to rewrite the equation one last time: Inflation rate = Growth rate of the money supply + Growth rate of velocity − Growth rate of real output The Quantity Theory of Money Inflation rate = Growth rate of the money supply − Growth rate of real output

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 40 of 43 Learning Objective 13.5 The Quantity Theory Explanation of Inflation This equation leads to the following predictions: 1 If the money supply grows at a faster rate than real GDP, there will be inflation. 2 If the money supply grows at a slower rate than real GDP, there will be deflation. (Recall that deflation is a decline in the price level.) 3 If the money supply grows at the same rate as real GDP, the price level will be stable, and there will be neither inflation nor deflation. The Quantity Theory of Money

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 41 of 43 Learning Objective 13.5 The Quantity Theory Explanation of Inflation The useful insight on the long run relationship between money supply and inflation: In the long run, inflation results from the money supply growing at a faster rate than real GDP. The Quantity Theory of Money

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 42 of 43 Learning Objective 13.5 High Rates of Inflation Very high rates of inflation—in excess of hundreds or thousands of percentage points per year—are known as hyperinflation. (Zimbabwe, Argentina, Brazil….). How it comes? Dynamic AD-AS framework can not explain. It is the government’s faults !! Financing gov’t expenditures by increasing money supply !! Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession. The Quantity Theory of Money

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 43 of 43 Learning Objective 13.5 The Quantity Theory of Money High Inflation in Argentina FIGURE 13.4 Money Growth and Inflation in Argentina

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 44 of 43 An Inside LOOK Using Reserve Requirements to Slow Bank Lending in China China Lifts Bank Reserves in Bid to Cool Growth Fixing the value of the yuan against the U.S. dollar has effectively fueled the growth in China’s bank reserves.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 45 of 43 Learning Objective 13.4 The German Hyperinflation of the Early 1920s Making the Connection During the hyperinflation of the 1920s, people in Germany used paper currency to light their stoves.