TM 13-1 Copyright © 1998 Addison Wesley Longman, Inc. What is Money? Money is any commodity or token that is generally acceptable as the means of payment. A means of payment is a method of settling a debt.

TM 13-2 Copyright © 1998 Addison Wesley Longman, Inc. What Money Does? functions of Money 1) Medium of exchange 2) Unit of account 3) Store of value

TM 13-3 Copyright © 1998 Addison Wesley Longman, Inc. Measures of Money? Official Measures of Money 1) M1 consists of currency and traveler’s checks plus checking deposits. Includes accounts held by individuals and businesses, but does not include currency held by banks, or currency and checking deposits owned by the U.S. government

TM 13-4 Copyright © 1998 Addison Wesley Longman, Inc. Measures of Money? Official Measures of Money 2) M2 consists of M1 plus saving deposits and time deposits

TM 13-5 Copyright © 1998 Addison Wesley Longman, Inc. Measures of Money? Official Measures of Money 3) M3 consists of M2 plus large-scale time deposits and term deposits

TM 13-6 Copyright © 1998 Addison Wesley Longman, Inc. Two Measures of Money

TM 13-7 Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries Financial intermediaries are firms that take deposits from households and firms and makes loans to other households and firms.

TM 13-8 Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries Four Types of Financial Intermediaries 1) Commercial banks 2) Savings and loan associations 3) Savings banks and credit unions 4) Money market mutual funds

TM 13-9 Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries Commercial Banks A commercial bank is a firm, licensed by the Comptroller of the Currency or by a state agency to receive deposits and make loans.

TM Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries Commercial Banks Their balance sheet is described by the following formula: Liabilities + Net Worth = Assets

TM Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries Reserves and Loans Banks divide their funds into two parts: Reserves are cash in a bank’s vault plus its deposits at Federal Reserve banks Loans

TM Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries Three Types of Assets Held by Banks 1) Liquid assets are U.S. government Treasury bills and commercial bills 2) Investment securities are longer-term U.S. government bonds and other bonds 3)Loans are commitments of fixed amounts of money for agreed- uponperiods of time

TM Copyright © 1998 Addison Wesley Longman, Inc. Financial Intermediaries (FI) The Economic Functions of FI 1)Creating Liquidity 2) Minimizing the cost of borrowing 3) Minimizing the cost of monitoring borrowers 4) Pooling Risk

TM Copyright © 1998 Addison Wesley Longman, Inc. How Banks Create Money Reserves: Actual and Required The reserve ratio is the fraction of a bank’s total deposits that are held in reserves. The required reserve ratio is the ratio of reserves to deposits that banks are required, by regulation, to hold. Excess reserves are actual reserves minus required reserves.

TM Copyright © 1998 Addison Wesley Longman, Inc. How Banks Create Money Creating Deposits by Making loans in a One-Bank Economy Let’s see an example of how banks create money.

TM Copyright © 1998 Addison Wesley Longman, Inc. Reserves$100Deposits$400 Loans$300 Total$400Total$400 Creating Money at the One-and-Only Bank Balance sheet on January 1 Assets (millions of dollars) Liabilities (millions of dollars)

TM Copyright © 1998 Addison Wesley Longman, Inc. Reserves$101Deposits$401 Loans$300 Total$401Total$401 Creating Money at the One-and-Only Bank Balance sheet on January 2 Assets (millions of dollars) Liabilities (millions of dollars)

TM Copyright © 1998 Addison Wesley Longman, Inc. Reserves$101Deposits$404 Loans$303 Total$404Total$404 Creating Money at the One-and-Only Bank Balance sheet on January 3 Assets (millions of dollars) Liabilities (millions of dollars)

TM Copyright © 1998 Addison Wesley Longman, Inc. How Banks Create Money The Deposit Multiplier

TM Copyright © 1998 Addison Wesley Longman, Inc. How Banks Create Money Creating Deposits by Making Loans with Many Banks Let’s see how the banking system creates money

TM Copyright © 1998 Addison Wesley Longman, Inc. The Multiple Creation of Bank Deposits The sequenceThe running tally ReservesLoansDeposits

TM Copyright © 1998 Addison Wesley Longman, Inc. The Multiple Creation of Bank Deposits The sequenceThe running tally Deposit $100,000 ReservesLoansDeposits

TM Copyright © 1998 Addison Wesley Longman, Inc. The Multiple Creation of Bank Deposits The sequenceThe running tally Deposit $100,000 ReservesLoansDeposits $25,000 $75,000$25,000 $75,000$100,000 Loan $75,000 Reserve $25,000

TM Copyright © 1998 Addison Wesley Longman, Inc. The Multiple Creation of Bank Deposits The sequence Deposit $100,000 Loan $75,000 Deposit $75,000 Reserve $25,000 The running tally ReservesLoansDeposits $25,000 $75,000$25,000 $75,000$100,000

TM Copyright © 1998 Addison Wesley Longman, Inc. The Multiple Creation of Bank Deposits The sequenceThe running tally Deposit $100,000 ReservesLoansDeposits $25,000 $75,000$25,000 $75,000$100,000 Loan $75,000 Deposit $75,000 Reserve $25,000 Loan $56,250 Reserve $18,750 $43,750$131,250$175,000

TM Copyright © 1998 Addison Wesley Longman, Inc. The Multiple Creation of Bank Deposits The sequence Deposit $56,250 The running tally ReservesLoansDeposits

TM Copyright © 1998 Addison Wesley Longman, Inc. The Multiple Creation of Bank Deposits The sequenceThe running tally ReservesLoansDeposits $43,750$131,250$175,000 Deposit $56,250 Loan $42,187 Reserve $14,063 $57,813$173,437$231,250

TM Copyright © 1998 Addison Wesley Longman, Inc. The Multiple Creation of Bank Deposits The sequenceThe running tally ReservesLoansDeposits Deposit $56,250 Loan $42,187 Reserve $14,063 Deposit $42,187 $43,750$131,250$175,000 $57,813$173,437$231,250

TM Copyright © 1998 Addison Wesley Longman, Inc. The Multiple Creation of Bank Deposits The sequenceThe running tally ReservesLoansDeposits $68,360$205,077$273,437 Loan $31,640 Reserve $10,547

TM Copyright © 1998 Addison Wesley Longman, Inc. The Multiple Creation of Bank Deposits The sequenceThe running tally ReservesLoansDeposits $68,360$205,077$273,437 Loan $31,640 Reserve $10,547 and so on... $100,000$300,000$400,000

TM Copyright © 1998 Addison Wesley Longman, Inc. The Fed controls the money supply by adjusting the reserves of the banking system.

TM Copyright © 1998 Addison Wesley Longman, Inc. The Fed controls the money supply by adjusting the reserves of the banking system. These reserves are controlled by three tools available to the Fed.

TM Copyright © 1998 Addison Wesley Longman, Inc. 1) Required reserve ratios

TM Copyright © 1998 Addison Wesley Longman, Inc. 1) Required reserve ratios 2) Discount rate

TM Copyright © 1998 Addison Wesley Longman, Inc. 1) Required reserve ratios 2) Discount rate 3) Open market operations

TM Copyright © 1998 Addison Wesley Longman, Inc. Required Reserve Ratios The Fed determines a required reserve ratio for each type of deposit. In 1997, banks were required to keep 3 percent of checking deposits up to $49 million and 10 percent of deposits in excess of $49 million. Other deposits had no reserve requirement.

TM Copyright © 1998 Addison Wesley Longman, Inc. Discount Rate The discount rate is the interest rate at which the Fed stands ready to lend reserves to commercial banks.

TM Copyright © 1998 Addison Wesley Longman, Inc. Open Market Operations Open market operations are the purchase or sale of government securities by the Federal Reserve System on the open market.

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level We are going to study the effect the money supply has on real GDP, the price level, and the inflation rate.

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level The Short-Run Effects of a Change in the Quantity of Money Let’s study how a change in the quantity of money effects these factors by examining the aggregate supply-aggregate demand model.

TM Copyright © 1998 Addison Wesley Longman, Inc. Short-Run Effects of Change in Quantity of Money Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100)

TM Copyright © 1998 Addison Wesley Longman, Inc. Short-Run Effects of Change in Quantity of Money Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) AD LAS SAS AD 1

TM Copyright © 1998 Addison Wesley Longman, Inc. Short-Run Effects of Change in Quantity of Money Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) AD LAS SAS AD 1

TM Copyright © 1998 Addison Wesley Longman, Inc. Short-Run Effects of Change in Quantity of Money Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS SAS AD 1

TM Copyright © 1998 Addison Wesley Longman, Inc. Long-Run Effects of Change in Quantity of Money Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100)

TM Copyright © 1998 Addison Wesley Longman, Inc. Long-Run Effects of Change in Quantity of Money Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS AD 1 SAS 1

TM Copyright © 1998 Addison Wesley Longman, Inc. Long-Run Effects of Change in Quantity of Money Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS 113 AD 1 SAS 1 AD 2

TM Copyright © 1998 Addison Wesley Longman, Inc. Long-Run Effects of Change in Quantity of Money Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS 113 AD 1 SAS 1 AD 2

TM Copyright © 1998 Addison Wesley Longman, Inc. Long-Run Effects of Change in Quantity of Money Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS 113 AD 1 SAS 1 AD 2 SAS 2

TM Copyright © 1998 Addison Wesley Longman, Inc. Long-Run Effects of Change in Quantity of Money Real GDP (trillions of 1992 dollars) Price level (GDP deflator, 1992 = 100) LAS 113 AD 2 SAS 2

TM Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain how banks create money Explain why the quantity of money is an important economic magnitude Explain the quantity theory of money

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level The Quantity Theory of Money The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level. This theory is based upon the velocity of circulation and the equation of exchange.

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level The Quantity Theory of Money The velocity of circulation is the average number of times a dollar of money is used annually to buy goods and services that make up GDP.

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level GDP equals the price level (P) times real GDP (Y), or: GDP = PY

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level Make the quantity of money M, and the velocity of circulation V is determined by: V = PY/M

TM Copyright © 1998 Addison Wesley Longman, Inc. The Velocity of Circulation in the United States: 1930–1996

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP, or MV=PY

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level We can convert the equation of exchange into the quantity theory of money by making two assumptions: 1)The velocity of circulation is not influenced by the quantity of money. 2)Potential GDP is not influenced by the quantity of money.

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level Assuming this is true, the equation of exchange tells us that a change in the quantity of money causes an equal proportional change in the price level.

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level This can be shown by using the equation of exchange to solve for the price level. P = (V/Y)M

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level In the long run, real GDP equals potential GDP, so the relationship between the change in the price level and the quantity of money is:

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level Dividing this equation by an earlier one, P = (V/Y)M, gives us

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level This equation shows that the proportionate change in the price level equals the proportionate change in the quantity of money. This gives us the quantity theory of money: In the long run, the percentage increase in the price level equals the percentage increase in the quantity of money.

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level The AS-AD model predicts the same outcome as the quantity theory of money. It also predicts a less precise relationship between the quantity of money and the price level in the short run than in the long run.

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level Historical Evidence on the Quantity Theory of Money The data are broadly consistent with the quantity theory of money, but the relationship is not precise. The relationship is stronger in the long run than in the short run.

TM Copyright © 1998 Addison Wesley Longman, Inc. Money Growth and Inflation in the United States

TM Copyright © 1998 Addison Wesley Longman, Inc. Money Growth and Inflation in the United States

TM Copyright © 1998 Addison Wesley Longman, Inc. Money Growth and Inflation in the World Economy

TM Copyright © 1998 Addison Wesley Longman, Inc. Money Growth and Inflation in the World Economy

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level Correlation, Causation, and Other Influences The evidence shows that money growth and inflation are correlated.

TM Copyright © 1998 Addison Wesley Longman, Inc. Money, Real GDP, and the Price Level Correlation, Causation, and Other Influences This does not represent causation. Does money growth cause inflation, or does inflation cause money growth? Does some other factor cause inflation (deficit spending)?