1. Money and Monetary Policy

2. EQ:
What assets are considered “money”? What are the functions of money? The types of money?

3. What Money Is and Why It’s Important
Without money, trade would require barter, the exchange of one good or service for another.
Every transaction would require a double coincidence of wants—the unlikely occurrence that two people each have a good the other wants.
Most people would have to spend time searching for others to trade with—a huge waste of resources.
This searching is unnecessary with money, the set of assets that people regularly use to buy g&s from other people.
As in previous chapters, “g&s” = goods & services.
“Double coincidence of wants” simply means that two people have to want each other’s stuff.
Students find the following example amusing:
I’m an economics professor, but I’m a consumer, too. Suppose I want to go out for a beer. Under a barter system, I would have to search for a bartender that was willing to give me a beer in exchange for a lecture on economics. As you might imagine, I would have to spend a LOT of time searching. (On the plus side, this would prevent me from becoming an alcoholic.)
But thanks to money, I can go directly to my favorite pub and get a cold beer; the bartender doesn’t have to want to hear my lecture, he only has to want my money. 2

4. The 3 Functions of Money
Medium of exchange: an item buyers give to sellers when they want to purchase g&s
Unit of account: the yardstick people use to post prices and record debts
Store of value: an item people can use to transfer purchasing power from the present to the future
Money is a medium of exchange. That just means you use money to buy stuff.
Money is a unit of account. The price or monetary value of virtually everything is measured in the same units—dollars (in the U.S., or substitute your country’s currency if you’re located outside the U.S.). Imagine how hard it would be to plan your budget or comparison shop if sellers each used their own system of measuring prices.
Money is a store of value. Money holds its value over time, so you don’t have to spend it immediately upon receiving it. 3

5. The 2 Kinds of Money
Commodity money: takes the form of a commodity with intrinsic value
Examples: gold coins, cigarettes in POW camps
Fiat money: money without intrinsic value, used as money because of govt decree
Example: the U.S. dollar
Intrinsic value means the commodity would have value even if it weren’t being used as money.
In the film “The Shawshank Redemption,” prisoners use cigarettes as money.
Fiat money is worthless—except as money. Yet, people are happy to accept your dollars (or euros or yen or whatever) because they know that they will be able to spend them elsewhere. 4

6. The Money Supply
The money supply (or money stock): the quantity of money available in the economy
What assets should be considered part of the money supply? Two candidates:
Currency: the paper bills and coins in the hands of the (non-bank) public
Demand deposits: balances in bank accounts that depositors can access on demand by writing a check
The definition of currency in the textbook does not include “(non-bank)”. I added it to avoid confusion later, when students are asked to think about what happens to the money supply when a consumer decides to deposit a $50 bill into his or her checking account. 5

7. Measures of the U.S. Money Supply
M1: currency, demand deposits, traveler’s checks, and other checkable deposits.
M1 = $1.9 trillion (February 2011)
M2: everything in M1 plus savings deposits, small time deposits, money market mutual funds, and a few minor categories.
M2 = $8.9 trillion (February 2011)
Source: Federal Reserve, Board of Governors, Statistical Release H.6.
The latest H.6 release can be found at:
The distinction between M1 and M2 will often not matter when we talk about “the money supply” in this course. 6

8. Central Banks & Monetary Policy
Central bank: an institution that oversees the banking system and regulates the money supply
Monetary policy: the setting of the money supply by policymakers in the central bank
Federal Reserve (Fed): the central bank of the U.S. 7

9. The Structure of the Fed
The Federal Reserve System consists of:
Board of Governors (7 members), located in Washington, DC
12 regional Fed banks, located around the U.S.
Federal Open Market Committee (FOMC), includes the Bd of Govs and presidents of some of the regional Fed banks The FOMC decides monetary policy.
Janet Yellin
Chair of FOMC, Jan 2014– present
In subsequent chapters (including the chapter immediately following this one), students will learn that the Federal Reserve’s monetary policy can have huge effects on many macroeconomic variables, like inflation, interest rates, unemployment, and even stock price indexes and exchange rates.
As chair of the FOMC, Ben Bernanke is in the news quite frequently. 8

10. What is the Federal Reserve?

11. What role do banks play in the monetary system and how do banks “create money”?

12. Bank Reserves
In a fractional reserve banking system, banks keep a fraction of deposits as reserves and use the rest to make loans.
The Fed establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits.
Banks may hold more than this minimum amount if they choose.
The reserve ratio, R
= fraction of deposits that banks hold as reserves
= total reserves as a percentage of total deposits
Segue from last slide:
The Fed controls the money supply and regulates banks. Banks clearly play an important role in the money supply because bank deposits are part of the money supply (recall that M1 includes checking account deposits, and M2 also includes savings account deposits).
In the interests of parsimony, I have combined the definitions of “fractional reserve banking system” and “reserves,” as shown in the first bullet point. I believe it is sufficient to convey the meaning of both terms. 11

13. Bank T-Account
T-account: a simplified accounting statement that shows a bank’s assets & liabilities.
Example:
FIRST NATIONAL BANK
Assets
Liabilities
Reserves $ 10
Loans $ 90
Deposits $100
Deposits are liabilities to the bank because they represent the depositors’ claims on the bank.
Loans are an asset for the bank because they represent the banks’ claims on its borrowers.
Reserves are an asset because they are funds available to the bank.
Banks’ liabilities include deposits, assets include loans & reserves.
In this example, notice that R = $10/$100 = 10%. 12

14. 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 % reserve banking system: banks hold 100% of deposits as reserves, make no loans 3. Fractional reserve banking system 13

15. Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
Suppose R = 10%. FNB loans all but 10% of the deposit:
FIRST NATIONAL BANK
Assets
Liabilities
Reserves $100
Loans $ 0
Deposits $100 10 90
The notion that banks create money by making loans is a new and perhaps awkward idea for students. The following slide may help.
Depositors have $100 in deposits,
borrowers have $90 in currency. 14

16. Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
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 that does not have an offsetting effect on the money supply
Students more easily accept the idea that banks create money when they see that banks do not create wealth.
A fractional reserve banking system creates money, but not wealth. 15

17. Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
Borrower deposits the $90 at Second National Bank.
SECOND NATIONAL BANK
Assets
Liabilities
Reserves $ 90
Loans $ 0
Deposits $ 90
Initially, SNB’s T-account looks like this: 9 81
If R = 10% for SNB, it will loan all but 10% of the deposit. 16

18. Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
SNB’s borrower deposits the $81 at Third National Bank.
THIRD NATIONAL BANK
Assets
Liabilities
Reserves $ 81
Loans $ 0
Deposits $ 81
Initially, TNB’s T-account looks like this:
$ 8.10
$72.90
If R = 10% for TNB, it will loan all but 10% of the deposit. 17

19. Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
The process continues, and money is created with each new loan.
In this example, $100 of reserves generates $900 of new money.
Original deposit =
FNB lending =
SNB lending =
TNB lending =
. . . $
$ 90.00
$ 81.00
$ 72.90
Total money supply =
$ (original deposit) 18

20. The Money Multiplier
Money 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 deposit creates $900 of money 19

21. ACTIVE LEARNING 1 Banks and the money supply
While cleaning your apartment, you look under the sofa cushion and 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?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. ACTIVE LEARNING 1 Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the money supply could increase?
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.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. ACTIVE LEARNING 1 Answers
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?
Answer: $0
If your bank makes no loans from your deposit, currency falls by $50, deposits increase by $50, money supply does not change.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. A More Realistic Balance Sheet
Assets: Besides reserves and loans, banks also hold securities.
Liabilities: Besides deposits, banks also obtain funds from issuing debt and equity.
This and the next few slides correspond to the section “Bank Capital, Leverage, and the Financial Crisis of 2008–2009,” new to the 6th edition.

27. Vocabulary Income-money earned Wealth-value of assets
Asset-any item that can be converted to cash
Liquid asset -asset that can be converted to cash quickly
Illiquid asset-asset that can not be converted quickly w/o significant loss of value
Liability-a debt or financial obligation
Financial Assets/liabilities-
Loan – agreement between a lender and borrower
Bonds- IOU issued by a borrower w/ a promise to pay by a certain date
Stock- Ownership in a company
Interest Rate- the percentage rate that a borrower must pay for taking out a loan (the cost of borrowing)

28. Interest Rate
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29. What’s in an interest rate?
The cost of borrowing (borrower) Or
Earnings/profit (saver)
Interest rates are controlled by money supply and demand, monetary policy

30. EQ:
How does the Federal Reserve control the money supply?

31. The Fed’s Tools of Monetary Control
Fractional Reserve Banking -Reserve Requirement (unlikely change)
OMOs (Open Market operations) – buying and selling of bonds
Adjusting discount rate (interest rate the Fed charges banks to borrow money)
Banks seldom do this, they usually just borrow from other banks, the Fed funds rate is cheaper that the discount rate

32. How the Fed Influences Reserves
Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.
If the Fed buys a government bond from a bank, it pays by depositing new reserves in that bank’s reserve account.
with more reserves, the bank can make more loans, increasing the money supply.
To decrease bank reserves and the money supply, the Fed sells government bonds.

33. List of the Primary Government Securities Dealers Reporting to the Government Securities Dealers Statistics Unit of the Federal Reserve Bank of New York
BNP Paribas Securities Corp. Banc of America Securities LLC Barclays Capital Inc. Bear, Stearns & Co., Inc. Cantor Fitzgerald & Co. Citigroup Global Markets Inc. Countrywide Securities Corporation Credit Suisse Securities (USA) LLC Daiwa Securities America Inc. Deutsche Bank Securities Inc. Dresdner Kleinwort Wasserstein Securities LLC. Goldman, Sachs & Co. Greenwich Capital Markets, Inc. HSBC Securities (USA) Inc. J. P. Morgan Securities Inc. Lehman Brothers Inc. Merrill Lynch Government Securities Inc. Mizuho Securities USA Inc. Morgan Stanley & Co. Incorporated UBS Securities LLC.

34. How the Fed Influences Reserves
The Fed makes loans to banks, increasing their reserves.
Traditional method: adjusting the discount rate—the interest rate on loans the Fed makes to banks—to influence the amount of reserves banks borrow
New method: Term Auction Facility—the Fed chooses the quantity of reserves it will loan, then banks bid against each other for these loans.

35. The Story of how Banks create Money!!

38. Goal of the Fed
Speed up the Economy and increase employment by buying government bonds, therefore increasing the money supply
remember the Phillip’s Curve?
High Inflation = low unemployment
Keep inflation under control
Maintain steady economic growth

39. Problems Controlling the Money Supply
If households hold more of their money as currency, banks have fewer reserves, make fewer loans, and money supply falls.
If banks hold more reserves than required, they make fewer loans, and money supply falls.
Yet, Fed can compensate for household and bank behavior to retain fairly precise control over the money supply. 38

40. 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.
Changes in the fed funds rate cause changes in other rates and have a big impact on the economy. 39

41. Fed Funds Rate…

43. Types of Monetary Policy
Contractionary
(Decrease Money Supply)
Monetary policy designed to counteract the effects of inflation and return the economy to full employment.
Expansionary
(Increase Money Supply)
Monetary policy designed to counteract the effects of recession and return the economy to full employment.

44. Despicable Me and Monetary Policy

45. FRQ Test Tomorrow!!!

47. How does the money supply affect inflation and nominal interest rates?

48. Supply and Demand of Money
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49. Shifters of Money Supply
Reserve Ratio-
Discount Rate
OMO- Fed buy or sell bonds

50. 49

51. Hyperinflation
Hyperinflation is generally defined as inflation exceeding 50% per month.
Prices rise when the government prints too much money.
Excessive growth in the money supply always causes hyperinflation. 50

52. Hyperinflation in Zimbabwe
Hyperinflation in Zimbabwe
Large govt budget deficits led to the creation of large quantities of money and high inflation rates.
date
Zim$ per US$
Aug 2007
245
Apr 2008
29,401
May 2008
207,209,688
June 2008
4,470,828,401
July 2008
26,421,447,043
Feb 2009
37,410,030
Sept 2009
355
This slide corresponds to a new FYI box in the 6th edition.
Greg Mankiw’s blog has a nice collection of articles on this topic. To see them, visit
and enter “Zimbabwe” in the search box.
Source of exchange rate data on this slide:
Sign posted in public restroom

53. The Market for Loanable Funds

55. The Fisher Effect Rearrange the definition of the real interest rate:
Rearrange the definition of the real interest rate:
Real interest rate
Nominal interest rate
Inflation rate + =
The real interest rate is determined by saving & investment in the loanable funds market.
Money supply growth determines inflation rate.
So, this equation shows how the nominal interest rate is determined. 54

56. The Fisher Effect Real interest rate Nominal interest rate
Real interest rate
Nominal interest rate
Inflation rate + =
In the long run, money is neutral, so a change in the money growth rate affects the inflation rate but not the real interest rate.
So, the nominal interest rate adjusts one-for-one with changes in the inflation rate.
This relationship is called the Fisher effect after Irving Fisher, who studied it. 55

57. Fiscal and Monetary Policy Review
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