Frank & Bernanke 2nd Ch. 10: Money, Prices, and the Federal Reserve

What Is Money? Does Bill Gates have a lot of money? Does Bill Gates have a lot of money? Does LeBron James make a lot of money? Does LeBron James make a lot of money? Anything accepted by a community in exchange of goods and services and for settlements of debts. Anything accepted by a community in exchange of goods and services and for settlements of debts.

Functions of Money Unit of account Unit of account Increase in variety of goods requires a common unit to quote and compare prices. Increase in variety of goods requires a common unit to quote and compare prices. 3 goods: 2 prices 3 goods: 2 prices 4 goods: 6 prices 4 goods: 6 prices 5 goods: 24 prices 5 goods: 24 prices N goods: (n-1)! Prices N goods: (n-1)! Prices Money had to be invented. Money had to be invented.

Functions of Money Medium of exchange Medium of exchange Barter requires double coincidence of wants. Barter requires double coincidence of wants. Exchange makes both parties better-off. Exchange makes both parties better-off. Money had to be invented. Money had to be invented.

Functions of Money Store of Value Store of Value Postponing consumption by storing wealth in an asset for future use. Postponing consumption by storing wealth in an asset for future use. Today we have many different assets for wealth storage. Today we have many different assets for wealth storage. Depending on the ability of these assets to be easily converted to cash (liquidity) these assets are near or far to “money.” Depending on the ability of these assets to be easily converted to cash (liquidity) these assets are near or far to “money.”

Financial Assets Savers Can Hold Currency Currency Checking account Checking account Savings account Savings account Certificate of Deposit Certificate of Deposit Foreign currency Foreign currency Bonds Bonds Stocks Stocks Options on stocks, bonds, foreign currency Options on stocks, bonds, foreign currency Futures on commodities, foreign currency Futures on commodities, foreign currency

Assets According to Liquidity Currency Currency Checking Account Checking Account Savings Account Savings Account Money Market Mutual Fund Money Market Mutual Fund Bonds Bonds

Measuring Money In billions of dollars

Measuring Money

Banks and the Creation of Money When depositors put money in the bank, the bank turns around and loans part of the money to others. When depositors put money in the bank, the bank turns around and loans part of the money to others. Both the depositor and the borrower have funds to spend. Both the depositor and the borrower have funds to spend. Money has been created. Money has been created.

Banks and the Creation of Money We will show the changes in assets and liabilities of a bank in response to deposit and loan activities. We will show the changes in assets and liabilities of a bank in response to deposit and loan activities. Deposits into checking accounts are liabilities of a bank. Deposits into checking accounts are liabilities of a bank. Cash is an asset. Cash is an asset. Assets = Liabilities for a Balance Sheet to be in balance. Assets = Liabilities for a Balance Sheet to be in balance.

Creation of Money Ally deposits $1000 into her checking account with First National. Ally deposits $1000 into her checking account with First National. First National holds only 10% as reserves and loans the rest to Billy. First National holds only 10% as reserves and loans the rest to Billy. Billy buys a snow blower for $900 from Carl. Billy buys a snow blower for $900 from Carl. Carl deposits $900 with Second National. Carl deposits $900 with Second National. Second National loans how much to Deyna if it also holds 10% as reserves? Second National loans how much to Deyna if it also holds 10% as reserves?

Creation of Money If this process goes on for thirty rounds, how much checking deposits will be in the banking system? If this process goes on for thirty rounds, how much checking deposits will be in the banking system? (.9) (.9)(.9)+…+1000(.9)^ (.9) (.9)(.9)+…+1000(.9)^ … … [1/(1-.9)] = 1000 [1/.1] = 1000 [10] 1000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10]

Creation of Money The banking system used the initial deposit of $1000 as the reserves and multiplied it by (1/reserve ratio) to create checking deposits for the economy. The banking system used the initial deposit of $1000 as the reserves and multiplied it by (1/reserve ratio) to create checking deposits for the economy. What would be the deposits created by the same $1000 deposit, if the banks kept 5% as the reserve ratio? What would be the deposits created by the same $1000 deposit, if the banks kept 5% as the reserve ratio?

Narrow Money, M1 M1 is defined as currency outside of the banks plus bank deposits. M1 is defined as currency outside of the banks plus bank deposits. Monetary Base is defined as Currency + Reserves. Monetary Base is defined as Currency + Reserves.

Measuring Money What was the amount of currency in January 2005? What was the amount of bank deposits in January 2005? What was the reserve ratio in January 2005?

The Federal Reserve System The Central Bank of the United States. The Central Bank of the United States. The Fed is responsible for monetary policy. The Fed is responsible for monetary policy. Amount of money supplied to the system. Amount of money supplied to the system. Affects interest rates, inflation, unemployment and exchange rates. Affects interest rates, inflation, unemployment and exchange rates. The Fed oversees and regulates the financial markets. The Fed oversees and regulates the financial markets.

The Fed Fed was established in 1913 in the hopes of eliminating banking panics of the 19th century by providing credit to the financial markets. Fed was established in 1913 in the hopes of eliminating banking panics of the 19th century by providing credit to the financial markets. In order to disperse power 12 regional Federal Reserve Banks were formed. In order to disperse power 12 regional Federal Reserve Banks were formed. The seven members of the Board of Governors are appointed by the President for 14-year terms every other year. The seven members of the Board of Governors are appointed by the President for 14-year terms every other year.

Monetary Policy Federal Open Market Committee (FOMC) is the group that sets the monetary policy. Federal Open Market Committee (FOMC) is the group that sets the monetary policy. Fed Chairman (4-year term) plus governors, plus NY Fed President, plus 4 Presidents of Fed banks comprise FOMC. Fed Chairman (4-year term) plus governors, plus NY Fed President, plus 4 Presidents of Fed banks comprise FOMC. FOMC meets eight times a year. FOMC meets eight times a year.

Controlling the Money Supply Open-Market Operations: buying and selling of financial assets. Open-Market Operations: buying and selling of financial assets. Buying government bonds from the public increases bank reserves, hence money supply. Buying government bonds from the public increases bank reserves, hence money supply. Selling bonds decreases money supply. Selling bonds decreases money supply. Discount window lending: Lending to banks that increases bank reserves. Discount window lending: Lending to banks that increases bank reserves. Changing reserve requirements: Raising reserve-deposit ratio decreases money supply. Changing reserve requirements: Raising reserve-deposit ratio decreases money supply.

Primary Credit Rate

Open-Market Operation Suppose an economy has $100 currency, $100 reserves and 0.1 as reserve-deposit ratio. Suppose an economy has $100 currency, $100 reserves and 0.1 as reserve-deposit ratio. What is the money supply? What is the money supply? If the Central Bank purchased $5 worth of bonds, what will be the money supply? If the Central Bank purchased $5 worth of bonds, what will be the money supply? If the CB sold $10 worth of bonds, what will be the money supply? If the CB sold $10 worth of bonds, what will be the money supply?

The Great Depression The Fed did not prevent the Great Depression. The Fed did not prevent the Great Depression. Both currency held by the public and reserve-deposit ratio rose, reducing money supply. Both currency held by the public and reserve-deposit ratio rose, reducing money supply. The Fed increased the reserves but not enough. The Fed increased the reserves but not enough. Lack of enough reserves forced bank bankruptcies. Lack of enough reserves forced bank bankruptcies.

Frank, R. H. and Ben S. Bernanke, Principles of Macroeconomics, 2 nd ed. (McGraw-Hill, 2004), p. 273.

Money and Price Level In the long run, prices adjust to pressures in the economy. In the long run, prices adjust to pressures in the economy. The “quantity theory of money” captures the long-run relationship. The “quantity theory of money” captures the long-run relationship. MV = PY

Quantity Theory M is money stock, like M1 or M2. M is money stock, like M1 or M2. V is velocity, the number of times money stock exchanges hands in creating the nominal GDP. V is velocity, the number of times money stock exchanges hands in creating the nominal GDP. P is price level, like 1.00 or 1.26 (price index) P is price level, like 1.00 or 1.26 (price index) Y is real GDP. Y is real GDP. PY is nominal GDP. PY is nominal GDP.

Long Run Inflation In the long-run, the economy will operate at full-employment; so Y will not change if there is no growth. If there is growth, then Y is predictable: Y is known. In the long-run, the economy will operate at full-employment; so Y will not change if there is no growth. If there is growth, then Y is predictable: Y is known. Velocity is also thought predictable in the long-run. Velocity is also thought predictable in the long-run. Therefore, any growth in money supply will be reflected in inflation. Therefore, any growth in money supply will be reflected in inflation.