1. The Role of Money in the Macro Economy Chapter 13

2. What is Money? The stock of financial assets that can easily be used to make market transactions and that serves as a medium of exchange, a unit of account, and a store of value. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 2

3. Measures of the U.S. Money Supply Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3 MEASUREDESCRIPTION VALUE (JAN 2008) SEAS. ADJ. (BIL. $) C: CURRENCY Coins held outside the Treasury, the Federal Reserve banks, and depository institutions, as well as paper money—Federal Reserve notes 758.0 M1: C PLUS: Checkable deposits Deposits in checking accounts (demand deposits) 292.5 Travelers’ checks Checks that can be used as cash issued by nondepository institutions such as American Express 6.2 Other checkable deposits Negotiable orders of withdrawal (NOWs) and automatic transfer service (ATS) account balances 307.9 Total M11,364.6

4. Measures of U.S. Money Supply MEASUREDESCRIPTION VALUE (JAN 2008) SEAS. ADJ. (BIL. $) Total M11,364.6 M2: M1 PLUS: Money market mutual fund shares Shares of funds that invest in short-term financial assets and have check-writing privileges 1,006.1 Savings accounts Interest-bearing accounts with no checking privileges 3,903.2 Small time deposits Accounts of less than $100,000, such as certificates of deposit, that have fixed maturities and penalties for early withdrawal 1,224.5 Total M2 7,498.3 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 4

5. Depository Institutions Depository institutions are institutions that accept deposits from individuals and organizations, against which depositors can write checks on demand for their market transactions and that use these deposits to make loans. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 5

6. Fractional Reserve Banking A banking system in which banks are required to keep only a fraction of their deposits as reserves. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6

7. Reserve Requirement Required reserves kept in banks’ vaults or as deposits at the Federal Reserve divided by demand deposits or the fraction of deposits banks are required to keep as reserves. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 7

8. Simple Deposit Multiplier The amount by which the money supply can be increased in a fractional reserve banking system, which equals (1/rr), where rr is the reserve requirement. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8

9. Money multiplier The money multiplier,mm—which is usually smaller than the simple deposit multiplier, d— reflects individuals’ decisions to hold some of their assets in cash rather than deposit them in a checking account and banks’ decisions to hold excess reserves. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9

10. The Central Bank (Federal Reserve) The central bank in the United States that implements monetary policy and helps regulate and operate the country’s financial system. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 10

11. Federal Reserve Created in 1913 to help provide stability to the country’s financial system Implements monetary policy and helps regulate and operate the country’s financial system 12 Federal Reserve District Banks in major cities across the country Functions as an independent organization with government oversight Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 11

12. Federal Open Market Committee (FOMC) The Federal Reserve body that has the primary responsibility for conducting monetary policy The FOMC has 12 members: the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and four other Federal Reserve Bank presidents who serve one-year terms on a rotating basis Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 12

13. THE MONETARY SYSTEM13 Banks and the Money Supply: An Example Suppose $100 of currency is in circulation. To determine banks’ impact on money supply, we calculate the money supply in 3 different cases: 1.No banking system 2.100% reserve banking system: banks hold 100% of deposits as reserves, make no loans 3.Fractional reserve banking system

14. THE MONETARY SYSTEM14 Banks and the Money Supply: An Example CASE 1: No banking system Public holds the $100 as currency. Money supply = $100.

15. THE MONETARY SYSTEM15 Banks and the Money Supply: An Example CASE 2: 100% reserve banking system Public deposits the $100 at First National Bank (FNB). FIRST NATIONAL BANK AssetsLiabilities Reserves$100 Loans $ 0 Deposits$100 FNB holds 100% of deposit as reserves: Money supply = currency + deposits = $0 + $100 = $100 In a 100% reserve banking system, banks do not affect size of money supply.

16. THE MONETARY SYSTEM16 Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system Money supply = $190 (!!!) Depositors have $100 in deposits, Borrowers have $90 in currency. FIRST NATIONAL BANK AssetsLiabilities Reserves$100 Loans $ 0 Deposits$100 Suppose R = 10%. FNB loans all but 10% of the deposit: 10 90

17. THE MONETARY SYSTEM17 Banks and the Money Supply: An Example How did the money supply suddenly grow? When banks make loans, they create money. The borrower gets – $90 in currency (an asset counted in the money supply) – $90 in new debt (a liability) CASE 3: Fractional reserve banking system A fractional reserve banking system creates money, but not wealth.

18. THE MONETARY SYSTEM18 Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system If R = 10% for SNB, it will loan all but 10% of the deposit. SECOND NATIONAL BANK AssetsLiabilities Reserves$ 90 Loans $ 0 Deposits$ 90 Suppose borrower deposits the $90 at Second National Bank (SNB). Initially, SNB’s T-account looks like this: 9 81

19. THE MONETARY SYSTEM19 Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system If R = 10% for TNB, it will loan all but 10% of the deposit. THIRD NATIONAL BANK AssetsLiabilities Reserves$ 81 Loans $ 0 Deposits$ 81 The borrower deposits the $81 at Third National Bank (TNB). Initially, TNB’s T-account looks like this: $ 8.10 $72.90

20. THE MONETARY SYSTEM20 Banks and the Money Supply: An Example CASE 3: Fractional reserve banking system The process continues, and money is created with each new loan. Original deposit = FNB lending = SNB lending = TNB lending =... $100.00 $90.00 $81.00 $72.90... Total money supply =$1000.00 In this example, $100 of reserves generates $1000 of money.

21. THE MONETARY SYSTEM21 The Deposit Multiplier Deposit multiplier: the amount of money the banking system generates with each dollar of reserves The money multiplier equals 1/R. In our example, R = 10% money multiplier = 1/R = 10 $100 of reserves creates $1000 of money

22. A C T I V E L E A R N I N G 1 Banks and the money supply 22 While cleaning your apartment, you look under the sofa cushion find a $50 bill (and a half-eaten taco). You deposit the bill in your checking account. The Fed’s reserve requirement is 20% of deposits. A. What is the maximum amount that the money supply could increase? B. What is the minimum amount that the money supply could increase?

23. A C T I V E L E A R N I N G 1 Answers 23 If banks hold no excess reserves, then money multiplier = 1/R = 1/0.2 = 5 The maximum possible increase in deposits is 5 x $50 = $250 But money supply also includes currency, which falls by $50. Hence, max increase in money supply = $200. You deposit $50 in your checking account. A. What is the maximum amount that the money supply could increase?

24. A C T I V E L E A R N I N G 1 Answers 24 Answer: $0 If your bank makes no loans from your deposit, currency falls by $50, deposits increase by $50, money supply does not change. You deposit $50 in your checking account. A. What is the maximum amount that the money supply could increase? Answer: $200 B. What is the minimum amount that the money supply could increase?

25. Tools of Monetary Policy Open market operations Discount rate Reserve Requirements Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 25

26. Open Market Operations The major tool of Fed monetary policy that involves the buying and selling of government securities on the open market in order to change the money supply and influence interest rates. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 26

27. Expansionary Monetary Policy By buying U.S. government securities in the open market, the Federal Reserve aims to increase the rate of growth of real GDP by increasing the amount of bank reserves in the system and lowering the federal funds and other interest rates. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 27

28. Contractionary Monetary Policy By selling U.S. government securities on the open market, the Federal Reserve aims to decrease the rate of growth of real GDP by decreasing the amount of bank reserves in the system and raising the federal funds and other interest rates. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 28

29. THE MONETARY SYSTEM29 The Fed’s 3 Tools of Monetary Control 1. Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.  To increase money supply, Fed buys govt bonds, paying with new dollars. …which are deposited in banks, increasing reserves …which banks use to make loans, causing the money supply to expand.  To reduce money supply, Fed sells govt bonds, taking dollars out of circulation, and the process works in reverse.

30. THE MONETARY SYSTEM30 The Fed’s 3 Tools of Monetary Control 1. Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.  OMOs are easy to conduct, and are the Fed’s monetary policy tool of choice.

31. Discount rate The interest rate the Federal Reserve charges banks that borrow reserves at the Fed’s discount window. Increasing the rate signals contractionary monetary policy and lowering the rate signals expansionary monetary policy. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 31

32. THE MONETARY SYSTEM32 The Fed’s 3 Tools of Monetary Control 3. The Discount Rate: the interest rate on loans the Fed makes to banks  When banks are running low on reserves, they may borrow reserves from the Fed.  To increase money supply, Fed can lower discount rate, which encourages banks to borrow more reserves from Fed.  Banks can then make more loans, which increases the money supply.  To reduce money supply, Fed can raise discount rate.

33. THE MONETARY SYSTEM33 The Fed’s 3 Tools of Monetary Control 3. The Discount Rate: the interest rate on loans the Fed makes to banks  The Fed uses discount lending to provide extra liquidity when financial institutions are in trouble, e.g. after the Oct. 1987 stock market crash.  If no crisis, Fed rarely uses discount lending – Fed is a “lender of last resort.”

34. THE MONETARY SYSTEM34 The Federal Funds Rate On any given day, banks with insufficient reserves can borrow from banks with excess reserves. The interest rate on these loans is the federal funds rate. The FOMC uses OMOs to target the fed funds rate. Many interest rates are highly correlated, so changes in the fed funds rate cause changes in other rates and have a big impact in the economy.

35. Reserve Requirement Proportion of demand deposits that banks must hold in the form of reserves. Raising the reserve requirement signals contractionary monetary policy while lowering the reserve requirement signals expansionary monetary policy. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 35

36. THE MONETARY SYSTEM36 The Fed’s 3 Tools of Monetary Control 2. Reserve Requirements (RR): affect how much money banks can create by making loans.  To increase money supply, Fed reduces RR. Banks make more loans from each dollar of reserves, which increases money multiplier and money supply.  To reduce money supply, Fed raises RR, and the process works in reverse.  Fed rarely uses reserve requirements to control money supply: Frequent changes would disrupt banking.

37. Equilibrium in the Money Market Equilibrium in the money market determines the level of interest rates which in turn influences the level of aggregate expenditure and the equilibrium level of real output. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 37

38. Supply of Money Nominal money supply (MS) is the money supply (M1), controlled by the Federal Reserve, which is defined in dollar terms. Real money supply (MS/P) is the nominal money supply divided by the price level, which expresses the money supply in terms of real goods and services and which influences behavior. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 38

39. Factors Affecting the Real Money Supply Real interest rate Nominal money supply Price level Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 39

40. Increase in Real Money Supply Either an increase in the nominal money supply (MS) by the Federal Reserve or a decrease in the price level (P) will cause the real money supply function to shift from RLMS1 to RLMS2. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 40 r M/P RLMS 1 RLMS 2 (M s /P) 1 (M s /P) 2

41. Demand for Money The demand for money, in real terms, is a function of the real interest rate and the level of real income. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 41

42. Increase in Real Money Demand A change in the interest rate, all else held constant, causes a movement along a given money demand curve (RLMD1). A change in income or other autonomous factors influencing money demand shifts the curve from RLMD1 to RLMD2. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 42 r M/P r1r1 r2r2 A BC RLMD 1 RLMD 2 M/P 1 M/P 2 M/P 3

43. Equilibrium in the Money Market Equilibrium in the money market occurs at that interest rate where the quantity of money demanded equals the quantity of money supplied. At any other rate, there will be market disequilibrium, where the imbalance between demand and supply will set forces into motion that bring the market back to equilibrium. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 43

44. Equilibrium in Action – Change in Supply Beginning at the original equilibrium (point A), an increase in the real money supply from RLMS 1 to RLMS 2 causes the interest rate to fall from r 1 to r 2 to restore equilibrium in the money market (point B). Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 44 r M/P RLMS 1 RLMS 2 RLMD 1 r1r1 r2r2 AA׳A׳ B M/P 1 M/P 2

45. Equilibrium in Action – Change in Demand Beginning at the original equilibrium at point A, an increase in the demand for money due to an increase in real income from Y 1 to Y 2 results in an increase in the interest rate from r 1 to r 2 to restore equilibrium at point B. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 45 r M/P RLMD 1 (Y 1 ) RLMD 2 (Y 2 ) RLMS r1r1 r2r2 A A׳A׳ B

46. The Equation of Exchange Equation of exchange – the quantity of money times velocity of money equals price level times the quantity of real goods sold. MV = PQ lM = Quantity of money lV = velocity of money lP = price level lQ = real output lPQ = the economy’s nominal output

47. The Equation of Exchange Velocity of money – the number of times per year, on average, a dollar goes around to generate a dollar’s worth of income.

48. Velocity Is Constant The first assumption of the quantity theory is that velocity is constant. Its rate is determined by the economy’s institutional structure.

49. Velocity Is Constant If velocity remains constant, the quantity theory can be used to predict how much nominal GDP will grow. Nominal GDP will grow by the same percent as the money supply grows.

50. Real Output Is Independent of the Money Supply The second assumption of the quantity theory is that real output (Q) is independent of the money supply. Q is autonomous – real output is determined by forces outside those in the quantity theory.

51. Real Output Is Independent of the Money Supply The quantity theory of money says that the price level varies in response to changes in the quantity of money. With both V and Q unaffected by changes in M, the only thing that can change is P. %  M  %  P

52. The commercial banks in Zap have Reserves $250 million Loans $1,000 million Deposits $2,000 million Total assets $2,500 million If the banks have no excess reserves, calculate the banks’ desired reserve ratio. It A arrives to Zap with 20 millions which she deposits in a bank. How much does the immigrant’s bank lend initially Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 52

53. The banks’ desired reserves equal their reserves, $250 million, divided by their deposits, $2,000 million, which is 12.5 percent. With a desired reserve ratio of 12.5 percent, the bank keeps $20 million × 0.125 = $2.5 million on reserve. It then lends the rest, so it lends $20 million - $2.5 million, which is $17.5 million. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 53

54. Quantecon is a country in which the quantity theory of money operates. The country has a constant population, capital stock, and technology. In year 1, real GDP was $400 million, the price level was 200, and the velocity of circulation was 20. In year 2, the quantity of money was 20 percent higher than in year 1. What was a.The quantity of money in year 1? b.The quantity of money in year 2? c.The price level in year 2? d.The level of real GDP in year 2? e.The velocity of circulation in year 2? Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 54

55. The quantity of money in year 1 is $4000 million. Because the equation of exchange tells us that MV = PY, we know that M = PY/V. Then, with P = 200, Y = $400 million, and V = 20, M = $4000 million. The quantity of money is $4800 million. Money grows by 20 percent, which is $800 million. The price level is 240. Because the quantity theory of money holds and because the factors that influence real GDP have not changed, the price level rises by the same percentage as the increase in the quantity of money, which is 20 percent. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 55

56. Real GDP is $400 million. Because the factors that influence real GDP have not changed, real GDP is unchanged. The velocity of circulation is 20. Because the factors that influence velocity have not changed, velocity is unchanged. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 56

57. In Quantecon described in problem 8, in year 3, the quantity of money falls to one fifth of its level in year 2. a.What is the quantity of money in year 3? b.What is the price level in year 3? c.What is the level of real GDP in year 3? d.What is the velocity of circulation in year 3? Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 57

58. The quantity of money is $960 million. From the previous problem, the quantity of money in year 2 was $4800 million. Therefore the quantity of money in year 3 is $4800 million/5 = $960 million. The price level is 48. Because the quantity theory of money holds and because the factors that influence real GDP have not changed, the price level falls by the same percentage as the decrease in the quantity of money, which is 80 percent. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 58

59. Real GDP is $400 million. The factors that influence real GDP have not changed, so real GDP is unchanged. The velocity of circulation is 20. Because the factors that influence velocity have not changed, velocity is unchanged. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 59

60. 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. The quantity theory of money is based on the velocity of circulation and the equation of exchange. The velocity of circulation is the average number of times in a year a dollar is used to purchase goods and services in GDP.

61. The Quantity Theory of Money Calling the velocity of circulation V, the price level P, real GDP Y, and the quantity of money M: V = PY ÷ M The equation of exchange states that MV = PY. The equation of exchange becomes the quantity theory of money if M does not influence V or Y. So in the long run, the change in P is proportional to the change in M.

62. The Quantity Theory of Money Expressing the equation of exchange in growth rates: Money growth rate + = Inflation rate + Rate of velocity change Real GDP growth Rearranging: Inflation rate = Money growth rate + Rate of velocity change  Real GDP growth In the long run, velocity does not change, so Inflation rate = Money growth rate  Real GDP growth

63. The Quantity Theory of Money Evidence on the Quantity Theory of Money U.S. evidence is consistent with the quantity theory of money. The inflation rate fluctuates in line with money growth rate minus real GDP growth rate.

64. The Quantity Theory of Money International evidence shows a marked tendency for high money growth rates to be associated with high inflation rates. Figure 9.11(a) shows the evidence for 134 countries from 1990 to 2005.

65. Figure 9.11(b) shows the evidence for 104 countries from 1990 to 2005. There is a general tendency for money growth and inflation to be correlated, but the quantity theory does not predict inflation precisely. The Quantity Theory of Money