1. 1 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System CHAPTER 13 Money, Banks, and the Federal Reserve System Fernando Quijano Prepared by:

2. 2 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System A “money” An asset 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 a “Money”, and Why Do We Need It? Define money and discuss its four functions. 13.1 LEARNING OBJECTIVE

3. 3 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System Commodity money A good used as money that also has value independent of its use as money. Barter and the Invention of Money The Four Functions of a “Money” Anything used as money—whether a deerskin, a cowrie seashell, cigarettes, or a dollar bill—should fulfill the following four functions: 1. medium of exchange 2. unit of account 3. store of value 4. standard of deferred payment Define money and discuss its four functions. 13.1 LEARNING OBJECTIVE What is a “Money”, and Why Do We Need It?

4. 4 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System 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 dollars 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. Define money and discuss its four functions. 13.1 LEARNING OBJECTIVE What is a “Money”, and Why Do We Need It?

5. 5 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System What Makes a Good Medium of Exchange? Five criteria make an asset suitable for use as a medium of exchange: 1.The asset 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. Define money and discuss its four functions. 13.1 LEARNING OBJECTIVE

6. 6 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System What Kinds of Money Do We Have? Federal Reserve System (the “Fed”) The central bank of the United States. 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. Define money and discuss its four functions. 13.1 LEARNING OBJECTIVE Commodity money has value independent of its use as money. Commodity Money Fiat Money

7. 7 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System How Is Money Measured in the United States Today? M1 The narrowest definition of the money supply: The sum of currency in circulation, checking account deposits in banks, and holdings of traveler’s checks. Discuss the definitions of the money supply used in the United States today. 13.2 LEARNING OBJECTIVE The M1 nominal money supply is made up of: 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 3.The value of all traveler’s checks (this category is very small so we usually ignore it)

8. 8 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System The M1 and M2 Nominal Money Supply How Is Money Measured in the United States Today? Figure 13-1 Measuring the Money Supply, July 2009 The Federal Reserve uses two different measures of the money supply: M1 and M2.M2 includes all the assets in M1, as well as the additional assets shown in panel (b). Discuss the definitions of the money supply used in the United States today. 13.2 LEARNING OBJECTIVE

9. 9 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System M2 A broader definition of the money supply: It includes M1 plus savings account balances, small-denomination time deposits, balances in money market deposit accounts in banks, and noninstitutional money market fund shares. How Is Money Measured in the United States Today? Discuss the definitions of the money supply used in the United States today. 13.2 LEARNING OBJECTIVE

10. 10 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System There are two key points about the money supply to keep in mind: 1.The money supply consists of both currency and checking account deposits. 2.Because balances in checking account deposits are included in the money supply, banks play an important role in the process by which the way money supply increases and decreases. We will discuss this second point further in the next section. What about Credit Cards and Debit Cards? Many people buy goods and services with credit cards, yet credit cards are not included in definitions of the money supply. How Is Money Measured in the United States Today? Discuss the definitions of the money supply used in the United States today. 13.2 LEARNING OBJECTIVE

11. 11 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System How Do Banks Create Money? Bank Balance Sheets Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Federal Reserve. Required reserves (RES) Reserves that a bank is legally required to hold, based on its checking account deposits. Required reserve ratio (RES/DEP) The minimum fraction of deposits banks are required by law to keep as reserves. Excess reserves (ER) Reserves that banks hold over and above the legal requirement. Total reserves = required reserves + excess reserves Explain how banks create money. 13.3 LEARNING OBJECTIVE

12. 12 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System How Do Banks Create Money? Bank Balance Sheets Figure 13-2 Balance Sheet for Bank of America, December 31, 2008 Explain how banks create money. 13.3 LEARNING OBJECTIVE The items on a bank’s balance sheet of greatest economic importance are its reserves, loans, and deposits. Notice that the difference between the value of Bank of America’s total assets and its total liabilities is equal to its stockholders’ equity. As a consequence, the left side of the balance sheet always equals the right side.

13. 13 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money Explain how banks create money. 13.3 LEARNING OBJECTIVE

14. 14 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money Explain how banks create money. 13.3 LEARNING OBJECTIVE

15. 15 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System How Do Banks Create Money? Using T-Accounts to Show How a Bank Can Create Money Explain how banks create money. 13.3 LEARNING OBJECTIVE

16. 16 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System How Do Banks Create Money? BANKINCREASE IN CHECKING ACCOUNT DEPOSITS Bank of America$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 Using T-Accounts to Show How a Bank Can Create Money Explain how banks create money. 13.3 LEARNING OBJECTIVE

17. 17 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System How Do Banks Create Money? The “Simple” Money Multiplier Simple Money Multiplier The ratio of the amount of deposits created by banks to the amount of new reserves. Explain how banks create money. 13.3 LEARNING OBJECTIVE

18. 18 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System How Do Banks Create Money? The Simple Multiplier compared to the Real-World Multiplier 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. We can summarize these important conclusions: Explain how banks create money. 13.3 LEARNING OBJECTIVE

19. 19 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System The Federal Reserve System Fractional reserve banking system A banking system in which banks keep less than 100 percent of deposits as reserves. 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. Discuss the three policy tools the Federal Reserve uses to manage the money supply. 13.4 LEARNING OBJECTIVE

20. 20 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System The Federal Reserve System The Establishment of the Federal Reserve System Discount (window) loans Loans the Federal Reserve makes to banks. Discount (window) rate The interest rate the Federal Reserve charges on discount loans. Discuss the three policy tools the Federal Reserve uses to manage the money supply. 13.4 LEARNING OBJECTIVE

21. 21 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System The Federal Reserve System The Twelve Regions of the Federal Reserve System Figure 13-3 Federal Reserve Districts The United States is divided into 12 Federal Reserve districts, each of which has a Federal Reserve bank. The real power within the Federal Reserve System, however, lies in Washington, DC, with the Board of Governors. Discuss the three policy tools the Federal Reserve uses to manage the money supply. 13.4 LEARNING OBJECTIVE

22. 22 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System The Federal Reserve System Monetary policy The actions the Federal Reserve takes to manipulate the money supply or the interest rate to pursue macroeconomic objectives. To manipulate the nominal money supply, the Fed uses its three monetary policy tools: 1. open market operations 2. discount (window) policy 3. reserve requirements Discuss the three policy tools the Federal Reserve uses to manage the money supply. 13.4 LEARNING OBJECTIVE The Monetary Policy Tools of the Fed

23. 23 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System The Federal Reserve System TOOL # 1: Open Market Operations Federal Open Market Committee (FOMC) The Federal Reserve committee responsible for open market operations and managing the money supply in the United States. Open market operations The buying and selling of Treasury securities by the Federal Reserve in order to control the money supply. Discuss the three policy tools the Federal Reserve uses to manage the money supply. 13.4 LEARNING OBJECTIVE How the Federal Reserve Manages the Nominal Money Supply

24. 24 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System Discuss the three policy tools the Federal Reserve uses to manage the money supply. 13.4 LEARNING OBJECTIVE The Federal Reserve System TOOL # 2: Discount Window Policy By lowering the discount rate, the Fed can encourage banks to take additional loans and thereby increase their reserves. With more reserves, banks will make more loans to households and firms, which will increase checking account deposits and the money supply. TOOL # 3: Reserve Requirements When the Fed reduces the required reserve ratio, it converts required reserves into excess reserves. How the Federal Reserve Manages the Nominal Money Supply

25. 25 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System The Federal Reserve System Discuss the three policy tools the Federal Reserve uses to manage the money supply. 13.4 LEARNING OBJECTIVE The “Shadow Banking System” and the Financial Crisis of 2008 Securitization Comes to Banking Security A financial asset—such as a stock or a bond—that can be bought and sold in a financial market. Securitization The process of transforming loans or other financial assets into securities.

26. 26 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System The Federal Reserve System The Financial Crisis of 2008 The Fed’s Response Discuss the three policy tools the Federal Reserve uses to manage the money supply. 13.4 LEARNING OBJECTIVE As banks and other financial firms sold assets and cut back on lending to shore up their financial positions, the flow of funds from savers to borrowers was disrupted. The resulting credit crunch significantly worsened the recession that had begun in December 2007. Although the recession continued into 2009, the extraordinary actions of the Treasury and Fed appeared to have stabilized the financial system. Still, by mid-2009, the flow of funds from savers to borrowers had not yet returned to normal levels, and economists and policymakers were debating the wisdom of some of the Fed’s actions.

27. 27 of 43 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 13: Money, Banks, and the Federal Reserve System K e y T e r m s Asset Bank panic Bank run Commodity money Discount window loans Discount window rate Excess reserves (ER) Federal Open Market Committee (FOMC) Federal Reserve (the Fed) Fiat money Fractional reserve banking system M1 M2 Monetary policy A “Money” Open market operations Required reserve ratio (RES/DEP) Required reserves (RES) Reserves (Total = RES + ER) Securitization Security Simple deposit multiplier KEY TERMS