Chapter 13: Money, Banks, and the Federal Reserve System Today (Tuesday, April 7): 1.Money 1.Nature of money: (fiat vs. commodity money, double coincidence of wants) 2.Functions of money 3.Measurement of money 2.Banks 1.How banks make money 2.Reserve requirement and money multiplier 3.The Federal Reserve System 1.Monetary policy 2.The quantity theory of money

Money

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? 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. Commodity money A good used as money that also has value independent of its use as money.

Medium of Exchange 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 Dinnars 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. The Functions of Money

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.

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.

How Is Money Measured Today? M1: The Narrowest Definition of the Money Supply 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 M1 plus savings account balances, small-denomination time deposits, balances in money market deposit accounts in banks, and noninstitutional money market fund shares. M2: A Broader Definition of Money

Many people buy goods and services with credit cards, yet credit cards are not included in definitions of the money supply. What about Credit Cards and Debit Cards? 2008 M1 = Million KD M2 = Million KD

Banks

FIGURE 13.2 Balance Sheet for Wachovia Bank, December 31, 2006 Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Central Bank. 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. Fractional reserve banking system A banking system in which banks keep less than 100 percent of deposits as reserves.

How Do Banks Create Money? Learning Objective 13.3 Using T-Accounts to Show How a Bank Can Create Money

How Do Banks Create Money? Learning Objective 13.3 Using T-Accounts to Show How a Bank Can Create Money

How Do Banks Create Money? Learning Objective 13.3 Using T-Accounts to Show How a Bank Can Create Money

How Do Banks Create Money? Learning Objective 13.3 Using T-Accounts to Show How a Bank Can Create Money

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

Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves. 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.

The 2001 Bank Panic in Argentina Making the Connection The Argentine central bank was unable to stop the bank panic of 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.

The Federal Reserve System

Monetary policy The actions the Central Bank takes to manage the money supply Open Market Operations Open Market Committee (OMC) The CB committee responsible for open market operations and managing the money supply in the country. Open market operations The buying and selling of Treasury securities by the CB in order to control the money supply. Discount Policy Discount loans Loans the CB makes to banks. Discount rate The interest rate the CB charges on discount loans. Reserve Requirements When the CB reduces the required reserve ratio, it converts required reserves into excess reserves.

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

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

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

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

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

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. Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession. The Quantity Theory of Money

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.

Recall, there are many policies that can applied to change a GDP gap or to generally change the real GDP and the price level. One of these policies is the Fiscal Policy. The other policy is monetary policy. Monetary policy: policy by the central Bank to adjust and control the quantity of money in circulation (money supply) through different tools to influence GDP growth, the general price level and other macroeconomics variables.

To understand the operation of the monetary policy, we need to understand the definition and function of money, commercial banks, and the central bank.

Q: What is money ? Money: anything that is generally accepted as a means of payment (in the exchange of goods & services) First: Money To understand the operation of the monetary policy, we need to understand the definition and function of money, commercial banks, and the central bank.

Functions of Money: 1- Medium of exchange 2- Unit of account 3- Store of value 4- Standard of deferred payment

(1) Narrow definition: financial assets that are the most liquid : M1 = currency in circulation (coins & papers in the hands of the public ) + Demand deposits (+ traveler's checks) (2) Broad definition: M2 = M1 + Saving and time deposits (in commercial banks (3) Broad definition: M3 = M2 + time deposits in other financial institutions Q: What is meant by quantity of money (money supply)? And how to measure it ?

Note: part of the quantity of money is held by commercial banks as demand and time deposits. In Kuwait (2000): M1: KD m M2: KD m M3: KD m

Functions of Commercial Banks 1- Accepting deposits 2- Lending money 3- Other banking services 4- Money creation Second: Commercial Banks

Required reserve ratio Required reserve ratio (RRR): percentage of deposits that is required by the central bank to keep as reserves. Example: if RRR=10%, of an initial deposit = KD100 Required reserves = 100 * 10% =10 ( الاحتياطى القانوني ) Excess reserves = = 90 ( الاحتياطى الفائض ) Note: If the bank was able to lend KD 60 of its excess reserves, what is the total reserve this bank has ? Total Reserve = Required reserves + Excess reserves = = 40

Money creation is based on the process of deposits & loans and the RRR. To explain this process we assume: 1- All Commercial Banks will apply the RRR 2- All banks will lend their excess reserves 3- No currency leakage out of the banking system Money Creation

A 90B Required Reserves Excess Reserve DepositsBank E D C Example: RRR= 10%, an initial deposit = KD 100

Money Multiplier (Deposit expansion multiplier): M m = 1 RRR The multiplier: maximum possible change in total deposits out of any new deposit created by a multi-bank system. Potential money creation = initial deposit x M m

Q: What will happen to the effect M m when : A: there is a leakage (money drain) from the banking system? B: Banks were not able to lend all their excess reserves? C: Banks fail to apply the RRR?

Example1: IF RRR= 20%, and an initial deposit = KD 7000 was deposited at Alnoor Bank. What is the maximum Value of loans can this bank lend ? What is the maximum value of loans can the banking system create out of this deposit ? Alnoor Required Reserves Excess Reserve Deposits Since M m = 1/20% = 5 Total loans (by the banking system) = 5600 x 5 = Answer :

Example2: IF RRR= 10%, and a commercial bank has deposits = KD 50,000 and total reserves = KD 7000 What is the value of excess reserves this bank has ? Required reserves = deposit x RRR = 50,000 x (10/100) = 5000 Excess reserves = Total reserves - Required reserves = 7000 – 5000 = 2000 Answer :

Third: Central Bank Functions of the Central Bank 1- Issuing the national currency 2- Banker’s Bank (maintain cash deposits, reserves, transferring funds and checks between banks, imposes regulations on banks, lender of last resort). 4- Implementing monetary policy (through monitoring and controlling money supply) 3- Government bank (handling payroll accounts, financial consultant & representative)

Tools of Monetary Policy 1- Discount rate: the interest rate that the central bank charges the commercial banks. 3- Open market operation: the purchase and sale of government securities (bonds) by the central bank 2- Required reserve ratio.

Note: To understand how these tools can affect macro economic activities, we first view the impact of changes in money supply. Factors affecting demand for money: Factors affecting investment and consumption expenditure such as: income, interest rate, expectation..etc. Factors affecting supply of money: Factors affecting saving decisions and central bank policy such as: income, interest rate, macroeconomic conditions

Now assuming all factors constant except interest rate, then money demand is inversely related to interest rate, while money supply is positively related to interest rate Qm i Md Ms i q

Qm i Md Ms i q If the central bank increases the money supply lower interest rate stimulate consumption and investment expenditure, i.e increases AE (other things equal) Ms 2 i2i2 q2q2 Note: This is an expansionary monetary policy that can be applied to increase AE (e.g in case of a deflationary gap)

Qm i Md Ms i q If the central bank reduces the money supply raise interest rate reduced consumption and investment expenditure, i.e reduce AE (other things equal) Ms 2 i2i2 Note: This is a contractionary monetary policy that can be applied to reduce AE (e.g in case of an inflationary gap) q2q2

First: If an economy is facing a deflationary gap, the central bank can increase money supply, i.e applying an expansionary monetary policy An expansionary monetary policy tools: 1- Reducing discount rate : reduce interest rate stimulate consumption & investment expenditure increase AE

An expansionary monetary policy tools: 2- Reducing RRR : increase money supply lower interest rate stimulate consumption & investment expenditure increase AE 3- Buying government securities : increase money supply lower interest rate stimulate consumption & investment expenditure increase AE

Second: If an economy is facing an inflationary gap, the central bank can reduce money supply, i.e applying a contractionary monetary policy a contractionary monetary policy tools: 1- increasing the discount rate : increase interest rate lower consumption & investment expenditure lower AE

A contractionary monetary policy tools: 2- Raising RRR : reduce money supply raise interest rate reduce consumption & investment expenditure reduce AE 3- Selling government securities : lower money supply raise interest rate reduce consumption & investment expenditure reduce AE

Possible obstacles to effective fiscal & monetary policies: 1- Possible time lags in policy implementation (more for fiscal policy) 2- Possible crowding out effect (as the government borrows to finance the deficit, interest rates increases and crowds out investment expenditure 3- Possible fiscal & monetary coordination problems

4- Lack of full control over some domestic and international economic variables. (e.g lack of control over international money movement, investors & consumers expectations, social & political changes) 5- Limitations of accurate economic forecasting of dynamic economic variables. Q: What policies should be applied in case of stagflation?