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 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. What Is Money and Why Do We Need It? 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

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 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.

Chapter 13: Money, Banks, and the Federal Reserve System © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 43 Money without a Government? The Strange Case of the Iraqi Dinar 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. 4 of 43 M1: The Narrowest Definition of the Money Supply M1 includes means of payment: 1Currency: 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 How Is Money Measured in the United States Today? 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.

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 M1: The Narrowest Definition of the Money Supply How Is Money Measured in the United States Today? M2: A Broader Definition of 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. 6 of 43 How Do Banks Create Money in a Fractional Reserve Banking System? 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. Banks buy interest yielding assets with deposits they don’t keep in reserves: Gov’t securities, loans to households and firms

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 How Do Banks 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. 8 of 43 How Do Banks 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. 9 of 43 How Do Banks 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. 10 of 43 How Do 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

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 How Do Banks Create Money? Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves. Change in bank reserves = 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.

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 The Federal Reserve System The Organization of the Federal Reserve System 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. 13 of 43 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: 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. 2 Discount policy: Fed lends to discount rate  injects reserves into banking system directly 3 Reserve requirements: lowering reserve requirement converts required reserves to excess reserves 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. 14 of 43 Connecting Money and Prices: The Quantity Equation M × V = P × Y The Quantity Theory of Money Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.

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 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: Inflation rate = Growth rate of the money supply + Growth rate of velocity − Growth rate of real output or 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

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 High Rates of Inflation Very high rates of inflation—in excess of hundreds or thousands of percentage points per year—are known as hyperinflation. Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession.

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 The Quantity Theory of Money High Inflation in Argentina 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. 18 of 43 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.

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 K e y T e r m s Asset Bank panic Bank run 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