CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 1 of 31 PowerPoint Lectures for Principles of Economics, 9e By Karl E. Case, Ray C. Fair & Sharon M. Oster ; ;

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 2 of 31

© 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 25 PART V THE CORE OF MACROECONOMIC THEORY The Money Supply and the Federal Reserve System Fernando & Yvonn Quijano Prepared by:

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 4 of An Overview of MoneyWhat Is Money?Commodity and Fiat MoniesMeasuring the Supply of Money in the United States The Private Banking SystemHow Banks Create MoneyA Historical Perspective: GoldsmithsThe Modern Banking SystemThe Creation of MoneyThe Money MultiplierThe Federal Reserve SystemFunctions of the Federal ReserveThe Federal Reserve Balance SheetHow the Federal Reserve Controls theMoney SupplyThe Required Reserve RatioThe Discount RateOpen Market OperationsThe Supply Curve for MoneyLooking Ahead CHAPTER OUTLINE The Money Supply and the Federal Reserve System 25 PART V THE CORE OF MACROECONOMIC THEORY

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Money has taken many forms. What is money today? What happens when the bank lends the money we’re deposited to someone else? How does the Fed influence the quantity of money? What happens when the Fed creates too much money?

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Medium of Exchange A medium of exchange is an object that is generally accepted in exchange for goods and services. In the absence of money, people would need to exchange goods and services directly, which is called barter. Barter requires a double coincidence of wants, which is rare, so barter is costly. What is Money?

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 7 of 23 Three Properties of Money 2.Money Serves as a unit of account: Unit of account is the property of money that prices are quoted in terms of money. Money provides a convenient measuring rod when prices for all goods are quoted in money terms. Money can be used to compare the relative value of goods, making it easier to carry out economic transactions.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 8 of 23 Three Properties of Money 3.Money serves as a store of value: Store of value is the property of money that it preserves value until it is used in an exchange. From the time you receive a payment until the time you make a payment, you can use money to store value. However, money is an imperfect store of value, particularly in an inflationary economy, when the real value of a nominal amount of money decreases.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 9 of 31 An Overview of Money Commodity and Fiat Monies Commodity monies are those items used as money that also have an intrinsic value in some other use. Cigarettes have long been used as money in prisons. fiat, or token, money Items designated as money that are intrinsically worthless. Most governments monopolize the printing of money by declaring it to be legal tender, money that a government has required to be accepted in settlement of debts. The government also promises that it will not print so much that the money will lose its purchasing power. Currency debasement is the decrease in the value of money that occurs when its supply is increased rapidly.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 10 of 31 Dolphin Teeth as Currency” The article discusses the use of dolphin teeth as currency in the Solomon Islands. Dolphin teeth are being used as a means of payment and a store of value. Note that even with a currency like dolphin teeth there is a concern about counterfeit currency, namely fruit-bat teeth. Tooth decay is also a problem..

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Characteristics of Money It must be widely accepted. It must have a value: weight ratio. It must be divisible to settle debts of different denominations. It must not be easily produced, counterfeited or based in value. 11 of 31

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 12 of 31 An Overview of Money Measuring the Supply of Money in the United States M1, or transactions money Money that can be directly used for transactions. M1: Transactions Money M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 13 of 31 An Overview of Money Measuring the Supply of Money in the United States near monies Close substitutes for transactions money, such as savings accounts and money market accounts. M2: Broad Money M2, or broad money M1 plus savings accounts, money market accounts, and other near monies. M2 ≡ M1 + Savings accounts + Money market accounts + Other near monies

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 14 of 31 An Overview of Money Measuring the Supply of Money in the United States There are no rules for deciding what is money and what is not. This poses problems for economists and those in charge of economic policy. Beyond M2

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 15 of 31 An Overview of Money The Private Banking System financial intermediaries Banks and other institutions that act as a link between those who have money to lend and those who want to borrow money. A Historical Perspective: Goldsmiths run on a bank Occurs when many of those who have claims on a bank (deposits) present them at the same time.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 16 of 31 A Historical Perspective: Goldsmiths The first bankers were Goldsmiths functioned as warehouses where merchant stored gold for safekeeping. Upon receiving the gold, a goldsmith would issue a receipt to the depositor. After a time, these receipts themselves began to be traded for goods, and were backed 100 percent by gold. Such a system of banking known as “cloakroom banking”حجرةالايداع How Banks Create Money

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster The second major stage was reached when the public developed greater confidence with the system. Then, Goldsmiths realized that they could lend out some of this gold without any fear of running out. Now there were more claims than there were ounces of gold. When this happened, the banks had become ‘Manufactures of money’ and had moved from cloakroom banking to ‘ Fractional reserve Banking’ المصرفية الاحتياطية الجزئية 17 of 31

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster The Five Oldest Bank in the World Bank of New York (now Bank of New York Mellon) New York, New York (Founded 1784). The Bank of Scotland (now Halifax Bank of Scotland) Edinburgh, Scotland (Founded 1695) Hoare & Co. London, England (Founded 1672) Berenberg Bank Hamburg, Germany (Founded 1590) The Oldest Bank in the World: Banca Monte dei Paschi di Siena Siena, Italy (Founded 1472) 18 of 31

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 19 of 31 How Banks Create Money The Modern Banking System A Brief Review of Accounting Assets − Liabilities ≡ Net Worth, or Assets ≡ Liabilities + Net Worth Federal Reserve Bank (the Fed) The central bank of the United States.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 20 of 31 How Banks Create Money The Modern Banking System A Brief Review of Accounting The balance sheet of a bank must always balance, so that the sum of assets (reserves and loans) equals the sum of liabilities (deposits and net worth).  FIGURE 25.1 T-Account for a Typical Bank (millions of dollars)

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 21 of 31 How Banks Create Money The Modern Banking System A Brief Review of Accounting reserves The deposits that a bank has at the Federal Reserve bank plus its cash on hand. required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Federal Reserve.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 22 of 31 How Banks Create Money The Creation of Money excess reserves The difference between a bank’s actual reserves and its required reserves. excess reserves ≡ actual reserves − required reserves When someone deposits $100 in a bank, and the bank deposits the $100 with the central bank, the bank has $100 in total reserves.  FIGURE 25.2 Balance Sheets of a Bank in a Single-Bank Economy

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 23 of 31 How Banks Create Money The Creation of Money In panel 1, there is an initial deposit of $100 in bank 1. In panel 2, bank 1 makes a loan of $80 by creating a deposit of $80. A check for $80 by the borrower is then written on bank 1 (panel 3) and deposited in bank 2 (panel 1). The process continues with bank 2 making loans and so on. In the end, loans of $400 have been made and the total level of deposits is $500.  FIGURE 25.3 The Creation of Money When There Are Many Banks

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 24 of 31 How Banks Create Money The Money Multiplier The money multiplier is the multiple by which deposits can increase for every dollar increase in reserves. In the example above, the required reserve ratio is 20%. Each dollar increase in reserves could cause an increase in deposits of $5 when there is no leakage out of the system. An additional $100 of reserves result in additional deposits of $500.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 25 of 31 The Central Bank performs important functions for banks including: *Clearing interbank payments. *Regulating the banking system. *Assisting banks in a difficult financial position. *Managing exchange rates and the nation’s *foreign exchange reserves. *Control of mergers between banks. *Examination of banks to ensure that they are financially sound. *Setting of reserve requirements for all financial institutions.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 26 of 31 The Federal Reserve System Functions of the Federal Reserve Clearing Interbank Payments The Fed does it. This function of clearing interbank payments allows banks to shift money around virtually instantaneously. All they need to do is wire the Fed and request a transfer, and the funds move at the speed of electricity from one computer account to another. Other Duties of the Fed lender of last resort One of the functions of the Fed: It provides funds to troubled banks that cannot find any other sources of funds.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 27 of 31 How the Federal Reserve Controls the Money Supply If the Fed wants to increase the supply of money, it creates more reserves, thereby freeing banks to create additional deposits by making more loans. If it wants to decrease the money supply, it reduces reserves. Three tools are available to the Fed for changing the money supply: (1) changing the required reserve ratio, (2) changing the discount rate, and (3) engaging in open market operations.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 28 of 31 How the Federal Reserve Controls the Money Supply The Required Reserve Ratio TABLE 25.2 A Decrease in the Required Reserve Ratio from 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars) Panel 1: Required Reserve Ratio = 20% Federal ReserveCommercial Banks AssetsLiabilitiesAssetsLiabilities Government$200$100Reserves $100$500Deposits securities $100CurrencyLoans$400 Note: Money supply (M1) = Currency + Deposits = $600. Panel 2: Required Reserve Ratio = 12.5% Federal ReserveCommercial Banks AssetsLiabilitiesAssetsLiabilities Government$200$100Reserves $100$800Deposits securities $100CurrencyLoans (+ $300) $700(+ $300) Note: Money supply (M1) = currency + deposits = $900.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 29 of 31 How the Federal Reserve Controls the Money Supply The Required Reserve Ratio Decreases in the required reserve ratio allow banks to have more deposits with the existing volume of reserves. As banks create more deposits by making loans, the supply of money (currency + deposits) increases. The reverse is also true: If the Fed wants to restrict the supply of money, it can raise the required reserve ratio, in which case banks will find that they have insufficient reserves and must therefore reduce their deposits by “calling in” some of their loans. The result is a decrease in the money supply.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 30 of 31 How the Federal Reserve Controls the Money Supply The Discount Rate discount rate The interest rate that banks pay to the Fed to borrow from it. moral suasion The pressure that in the past the Fed exerted on member banks to discourage them from borrowing heavily from the Fed.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 31 of 31 How the Federal Reserve Controls the Money Supply The Discount Rate TABLE 25.3 The Effect on the Money Supply of Commercial Bank Borrowing from the Fed (All Figures in Billions of Dollars) Panel 1: No Commercial Bank Borrowing from the Fed Federal ReserveCommercial Banks AssetsLiabilitiesAssetsLiabilities Securities$160$80Reserves $80$400Deposits $80CurrencyLoans$320 Note: Money supply (M1) = currency + deposits = $480. Panel 2: Commercial Bank Borrowing $20 from the Fed Federal ReserveCommercial Banks AssetsLiabilitiesAssetsLiabilities Securities$160$100Reserves (+ $20) $100$500Deposits (+ $300) Loans$20$80CurrencyLoans (+ $100) $420$20Amount owed to Fed (+ $20) Note: Money supply (M1) = currency + deposits = $580.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Goals of Monetary Policy Maximum employment, stable prices, and moderate long-term interest rates In the long run, these goals are in harmony and reinforce each other, but in the short run, they might be in conflict. Key goal is price stability. Price stability is the source of maximum employment and moderate long-term interest rates. Monetary Policy Objectives and Framework

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Means of Achieving the Goals By keeping the growth rate of the quantity of money in line with the growth rate of potential GDP, the Fed is expected to be able to maintain full employment and keep the price level stable. How does the Fed operate to achieve its goals? Monetary Policy Objectives and Framework

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Operational “Stables Prices” Goal The Fed also pays close attention to the CPI excluding fuel and food—the core CPI. The rate if increase in the core CPI is the core inflation rate. The Fed believes that the core inflation rate provides a better measure of the underlying inflation trend and a better prediction of future CPI inflation. Monetary Policy Objectives and Framework

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Operational “Maximum Employment” Goal Stable price is the primary goal but the Fed pays attention to the business cycle. To gauge/measure the overall state of the economy, the Fed uses the output gap—the percentage deviation of real GDP from potential GDP. A positive output gap indicates an increase in inflation. A negative output gap indicates unemployment above the natural rate. The Fed tries to minimize the output gap. Monetary Policy Objectives and Framework

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 36 of 31 How the Federal Reserve Controls the Money Supply Open Market Operations open market operations The purchase and sale by the Fed of government securities in the open market; a tool used to expand or contract the amount of reserves in the system and thus the money supply.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 37 of 31 How the Federal Reserve Controls the Money Supply Open Market Operations Two Branches of Government Deal in Government Securities The Treasury Department is responsible for collecting taxes and paying the federal government’s bills. The Fed is not the Treasury. Instead, it is a quasi- independent agency authorized by Congress to buy and sell outstanding (preexisting) U.S. government securities on the open market.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 38 of 31 How the Federal Reserve Controls the Money Supply Open Market Operations The Mechanics of Open Market Operations TABLE 25.4 Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars) Panel 1 Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities$100$20Reserves $20$100Deposits $5$0Debts $80CurrencyLoans$80$5Net Worth Note: Money supply (M1) = Currency + Deposits = $180. Panel 2 Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities (  $5) $95$15Reserves (  $5) $15$95Deposits (  $5) $0 Debts $80CurrencyLoans$80Securities (+ $5) $5 Net Worth Note: Money supply (M1) = Currency + Deposits = $175. Panel 3 Federal ReserveCommercial BanksJane Q. Public AssetsLiabilitiesAssetsLiabilitiesAssetsLiabilities Securities (  $5) $95$15Reserves (  $5) $15$75Deposits (  $25) Deposits (  $5) $0 Debts $80CurrencyLoans (  $20) $60Securities (+ $5) $5 Net Worth Note: Money supply (M1) = Currency + Deposits = $155.

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 39 of 31 How the Federal Reserve Controls the Money Supply Open Market Operations The Mechanics of Open Market Operations ■An open market purchase of securities by the Fed results in an increase in reserves and an increase in the supply of money by an amount equal to the money multiplier times the change in reserves. ■An open market sale of securities by the Fed results in a decrease in reserves and a decrease in the supply of money by an amount equal to the money multiplier times the change in reserves. We can sum up the effect of these open market operations this way:

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster Open Market Operations 40 of 31 ContractionaryExpansionary Sell BondsBuy Bonds Cash reserves fallCash reserves increase Bank deposits fallBank deposits increase Credit difficult & expensive Credit easier and cheaper Aggregate demand falls Aggregate demand rises Income fallsIncome increases

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 41 of 31 How the Federal Reserve Controls the Money Supply The Supply Curve for Money If the Fed’s money supply behavior is not influenced by the interest rate, the money supply curve is a vertical line. Through open market operations, the Fed can have the money supply be whatever value it wants.  FIGURE 25.5 The Supply of Money

CHAPTER 25 The Money Supply and the Federal Reserve System © 2009 Pearson Education, Inc. Publishing as Prentice Hall Principles of Economics 9e by Case, Fair and Oster 42 of 31 barter commodity monies currency debasement discount rate excess reserves Federal Open Market Committee (FOMC) Federal Reserve Bank (the Fed) fiat, or token, money financial intermediaries legal tender lender of last resort liquidity property of money M1, or transactions money M2, or broad money medium of exchange, or means of payment money multiplier REVIEW TERMS AND CONCEPTS moral suasion near monies Open Market Desk open market operations required reserve ratio reserves run on a bank store of value unit of account 1. M1 ≡ currency held outside banks + demand deposits + traveler’s checks + other checkable deposits 2. M2 ≡ M1 + savings accounts + money market accounts + other near monies 3. Assets ≡ liabilities + capital (or net worth) 4. Excess reserves ≡ actual reserves − required reserves 5. Money multiplier ≡