1. Money $ Money $ Money What is money?
Anything that performs these functions:
A medium of exchange
A unit of account
A store of value

2. Medium of Exchange
Anything used to determine value during the exchange of goods and services
Money makes these transactions easier
The alternative is barter

3. Allows us to compare the values of goods and services
Unit of Account
Allows us to compare the values of goods and services

4. Keeps its value over a period of time What threatens this?
Store of Value
Keeps its value over a period of time
What threatens this?
Inflation

5. Types of Money Commodity Money Representative Money Fiat Money
Something that is used as a medium of exchange that has value in its own right (gold, silver, cigarettes)
Representative Money
Commodity backed money
A bank note redeemable for a commodity (gold or silver)
Fiat Money
Something that has value because government says that it has value

6. What type of money is today’s U.S. dollar? Fiat Money
Types of Money
What type of money is today’s U.S. dollar?
Fiat Money

7. Measuring the Money Supply
M1 Money Supply (most liquid)
Includes currency in circulation, coins, travelers checks, and checkable/demand deposits (checking accts) **About 50/50 Currency and coins to Deposits

8. Measuring the Money Supply
M2 Money Supply
Includes M1 and “near moneys” -- savings deposits (savings accounts) and other interest bearing accounts like CD’s
M1 is about 20% of M2

9. The Goldsmiths and the Origins of Paper Money
Goldsmiths provided a place of storage for an individual’s gold and silver
They would charge a fee for this service
They would issue a receipt to the owner of the specie (gold and silver)

10. The Goldsmiths and the Origins of Paper Money
Receipts then began to be exchanged for goods and services
Why? The receipts were accepted as a medium of exchange
Voila! The first paper money!

11. The Goldsmiths and the Origins of Paper Money
Then some shrewd Goldsmith realized he could issue receipts in excess of the amount of gold he had. Why?
They rarely had to exchange receipts for gold!
Voila! The first bank loan!

12. The Monetary Role of Banks
About half of M1 money supply is bank deposits
What Banks Do
Uses its assets to finance the investments of borrowers
Not all assets are lent out
Some assets must be kept on hand to satisfy the demands of depositors that want to withdraw their funds (Reserves)

13. Fractional Reserve Banking System
The assets that a bank must keep in reserve is established by the Fed
This is known as the RESERVE RATIO or the RESERVE REQUIREMENT

14. It’s a Wonderful Banking System!
What would happen, if for some reason, all a bank’s depositors wanted their deposits at the same time?

15. It’s a Wonderful Banking System!
Is this a problem today?
Not likely. Why not?
The Federal Deposit Insurance Corporation (FDIC)
Insures bank deposits (of member banks) up to $250,000 (result of a new law President Obama signed in 2010)

16. It’s a Wonderful Banking System!
The insurance also eliminates the cause of bank runs

17. How Banks Create New Money
Let’s look at an initial $1000 cash deposit into a checking acct. (demand deposit)
First key point
This does NOT add anything NEW to the money supply
There is $1000 less currency and $1000 more in demand deposits – No net increase

18. How Banks Create New Money
Now let’s assume the bank has a 10% reserve requirement (rr)
The bank must keep $100 in reserve in its vaults (required reserves)
It can then lend out the $900 in excess reserves
This begins the process of money creation

19. How Banks Create New Money
How much NEW money will be created initially?
How much NEW money will be created in the end (total)?
The first step is to determine the money multiplier
***1/rr OR 1/reserve requirement***
Multiplier of 10

20. How Banks Create New Money
How much new money will be created initially?
$900
How much total new money will be created?
The initial new money times the multiplier
$900 X 10
In this instance, the $900 excess reserves is multiplied 10 times throughout the economy - $9000 in total NEW money

21. How Banks Create New Money
If a bank initially lent out $1000 in excess reserves, $10,000 in NEW money would be created
What if you were asked the change in demand deposits as a result of this?
The initial $1000 demand deposit would result in how much of a total change in demand deposits?
$10000

22. From the 2009 AP Test
3. Assume that the reserve requirement is 20 percent and banks hold no excess reserves.
(a) Assume that Kim deposits $100 of cash from her pocket into her checking account. Calculate each of the following.
(i) The maximum dollar amount the commercial bank can initially lend
(ii) The maximum total change in demand deposits in the banking system
(iii) The maximum change in the money supply

23. The Banking System Bank A Bank B Bank C Bank D Bank E Bank F Bank G
(1)
Acquired
Reserves
and Deposits
(2)
Required
(Reserve
Ratio = .2)
(3)
Excess
(1)-(2)
(4)
Amount Bank Can
Lend; New Money
Created = (3)
Bank A
Bank B
Bank C
Bank D
Bank E
Bank F
Bank G
Bank H
Bank I
Bank J
Bank K
Bank L
Bank M
Bank N
Other Banks
$100.00
80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
21.99
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
2.15
1.72
1.37
1.10
4.40
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
8.59
6.87
5.50
4.40
17.59
32-23
$400.00

24. The Monetary Multiplier= 1
required reserve ratio 1 = rr
Graphic
Example
New Reserves
$100
$80
Excess
Reserves
$20
Required
Reserves
$100
Initial
Deposit
$400
Bank System Lending
Money Created
32-24

25. The Federal Reserve System
Historical Background
Prior to 1913, the U.S. had a decentralized and unregulated banking system
This led to much economic instability, (fraud, different currencies, bank failures)

27. The Federal Reserve System
A financial crisis in 1907 led to the desire to create a centralized banking system with control over the money supply
In 1913 Congress passed and President Wilson signed, The Federal Reserve Act

28. The Federal Reserve System
The Federal Reserve Act (1913)
The Board of Governors
7 members
Appointed by the President, Confirmed by the Senate
14 year terms; staggered so one member is replaced every two years (above political pressure)

29. The Federal Reserve System
President chooses a board member to be the Chairman of the Fed (4 year term)
Janet Yellen (Since 2014)

30. Prior to Janet Yellen Alan Greenspan Ben Bernanke Chairman of the Fed
Ben Bernanke
Chairman of the Fed

31. The Fed - Basics

32. The Fed - Basics

33. The Fed - Basics Main Functions of The Fed
A bank to banks and to the Federal government
Regulate the banks in their district
Provide a safe and stable financial system
****Monetary Policy

34. The Fed - Basics Monetary Policy
Manipulation of the money supply in order to bring about the desired macroeconomic goals (expanding Real GDP, low inflation, low unemployment)

35. The Tools of the Fed Manipulate the Discount Rate
The interest rate the Fed charges to banks that want to borrow money from the Fed
Manipulate the Reserve Ratio
The percentage of reserves a bank is required to keep on hand as cash
Target a higher or lower FEDERAL FUNDS RATE --> by selling or buying government bonds (Open Market Operations)

36. The Federal Funds Rate
Banks keep some of their reserves in accounts at a Federal Reserve bank
Sometimes bank required reserves go lower than a bank wants or needs
Banks with excess reserves willingly lend deficient banks funds from their Federal Reserve accounts ($1 Million minimum)

37. The Federal Funds Rate
The interest rate that banks charge each other for these short-term, often overnight loans, is known as the FEDERAL FUNDS RATE
The Federal Reserve does NOT set the Fed Funds Rate but it does target a rate that they would like (0.25 to 0.50)
They influence the rate through their Open Market Operations

38. The Federal Funds Rate
The lower the Federal Funds Rate, the more it encourages banks to borrow from each other
The higher the Federal Funds Rate, the more it discourages banks to borrow from each other
The current Fed Funds target rate is really a range, from 0.25 to 0.50%

39. The Tools of the Fed Carry out Open Market Operations (OMO)
Buying and selling of government securities (bonds)
Executed by the Federal Open Market Committee (FOMC)
7 member Board of Governors, President of the New York Fed, 4 other bank presidents on a rotating basis

40. The Tools of the Fed Expansionary Monetary Policy
Aka – Easy Money Policy
Increasing the money supply (increasing excess reserves)
Lowers interest rates
To fight against recession
Stimulate AD (through Ig)

41. The Tools of the Fed Contractionary Monetary Policy
Aka – Tight Money Policy or Restrictive Policy
Decreasing the money supply (decreasing excess reserves)
Increases interest rates
To fight against inflation
To reduce AD (through Ig)

42. Tools of Monetary Policy
Expansionary Policy (Easy Money)
Contractionary Policy (Tight Money)
Open Market Operations
Discount Rate
Reserve Requirements
Federal Funds Rate
Target a

43. The Demand and Supply of Money

44. The Money Market Graph
Shows the relationship between the supply of money (Sm or Ms) and the demand for money (Dm or Md)
The Money Demand Curve
Impacted by Fiscal Policy
Changes in the Price Level can shift the Dm curve
– Higher PL the higher the demand for money
– Lower PL the lower the demand for money

45. The Money Market Graph Changes in Real GDP shift the Dm curve
Increases in Real GDP shift the Dm curve to the right
Decreases shift the curve to the left

46. The Money Market Graph The Money Supply curve
Impacted by Monetary Policy
Fed actions shift the curve depending on whether the money supply has been increased or decreased

47. The Demand and Supply of Money

48. What would happen to the money supply AND interest rates if the Fed
Targeted a reduction of the Federal Funds Rate
Raised the Discount Rate
Lowered the Reserve Requirement
Bought government securities on the open market
Targeted an increase the Federal Funds Rate
Sold government securities on the open market

49. Money Supply or Money Demand?
The rate of inflation declines (disinflation)
The Fed buys bonds
The reserve requirement is raised
There is economic growth (a rise in Real GDP)
The Fed targets an increase in the federal funds rate

50. Interest Rates and Bond Prices
Bonds are bought and sold in the open market based on supply and demand
They sell for a certain price and pay fixed interest rates
Suppose a $1000 bond pays an annual $50 in interest
That’s a 5% yield annually (5% interest rate)

51. Interest Rates and Bond Prices
Now, what happens interest rates rise to 7.5%
Would you want to purchase the old bond at 5% when you could get a new one at 7.5%?
What would make you be willing to purchase the $1000 old bond?
If it was sold for less than $1000

52. Interest Rates and Bond Prices
In fact, if you could buy the old bond for $667 and receive the fixed $50 interest you would be receiving 7.5% annually on your investment
THUS, WHEN INTEREST RATES RISE BOND PRICES DECLINE
WHEN INTEREST RATES DECLINE, BOND PRICES RISE

53. One Final Point
If the Fed buys $10,000 in government bonds, does the money supply initially increase by $10,000?
Yes it does!!!
Why?
Because the money in the vaults of Fed banks is not considered to be a demand deposit and is therefore not part of M1

54. One Final Point
So, there is a difference between you taking $1,000 cash and putting it into your checking account and the Fed making a $1,000 purchase of government bonds.
What is that difference?
The Fed purchase initially increases the M1 money supply by $1,000, the cash deposit does not

55. Practice Monetary Policy problems
2014 #2
2012 #1

56. Limitations of Monetary Policy
Hard to determine how much money growth of the money supply is optimal
Can’t always predict the exact results of a monetary action
Lag time before the actions of the Fed kick in
World events make things more complex
Congress may do things (Fiscal Policy) that conflict with the Fed

57. Practice
Complete
Connections: Countercyclical Monetary Policies (On the back of Countercyclical Fiscal Policies)
Examine the 2012 exam question on T-Accounts

58. The Monetarists
When Keynesian fiscal policy failed to deal with the stagflation of the 1970’s, some economists put forth the concept of MONETARISM
They believed that a steady growth of the money supply would assure economic growth and macroeconomic stability

59. The Monetarists
Monetarists call for a steady increase of the money supply (say at 3% a year) regardless of the status of the economy
They rejected an active monetary policy (an important distinction).
In other words, they didn’t feel that the supply of money should be expanded and contracted (Monetary Policy) to meet certain conditions because of its limitations
They are basically conservative, laissez-faire economists

60. The Monetarists
Milton Friedman was its leading advocate and he has become a conservative icon over the last 30+ years

62. The Equation of Exchange
The fundamental equation for monetarists is MV=PQ
M is the supply of money
V is the velocity of money (the average number of times a dollar is spent during a year – this is relatively stable they believe)
P is the price level
Q is the quantity of all goods and services produced

63. The Equation of Exchange
MV is the money supply multiplied by the number of times the money is spent throughout the year
PQ is basically nominal GDP
MV (Spending) equals the value of PQ (Output)

64. The Equation of Exchange
If V is relatively stable and predictable, INCREASING THE MONEY SUPPLY WILL INCREASE NOMINAL GDP

65. Decrease in Invest Demand

67. The Monetary Role of Banks
The T-account summarizes a banks financial position

68. Creating a Bank Transaction #1 Vault cash: cash held by the bank
Assets
Liabilities and Net Worth
Creating a Bank
Balance Sheet 1: Wahoo Bank
Cash
$250,000
Stock Shares
$250,000
32-68

69. Creating a Bank Transaction #2 Acquiring property and equipment
Assets
Liabilities and Net Worth
Acquiring Property and Equipment
Balance Sheet 2: Wahoo Bank
Cash
$10,000
Stock Shares
$250,000
Property
240,000
32-69

70. Creating a Bank Transaction #3 Commercial bank functions
Accepting deposits
Making loans
Assets
Liabilities and Net Worth
Accepting Deposits
Balance Sheet 3: Wahoo Bank
Cash
$110,000
Checkable
Deposits
$100,000
Property
240,000
Stock Shares
250,000
32-70

71. Creating a Bank Transaction #4
Assume the bank deposits all cash on reserve at the Fed
Assets
Liabilities and Net Worth
Depositing Reserves at the Fed
Balance Sheet 4: Wahoo Bank
Cash $0
Checkable
Deposits
Reserves
110,000
$100,000
Property
240,000
Stock Shares
250,000
32-71

72. Creating a Bank Transaction #5 Clearing a check
$50,000 check reduces reserves and checkable deposits
Clearing a Check
Assets
Liabilities and Net Worth
Balance Sheet 5: Wahoo Bank
Checkable
Deposits
Reserves
$60,000
$50,000
Property
240,000
Stock Shares
250,000
32-72

73. Financial Institutions
Institutions offering checkable deposits
Commercial banks
JP Morgan Chase
Bank of America
Wells Fargo
Credit unions
31-73

74. Crowding Out - Revisited
Initiated by Government deficit spending to pay for an _______________ fiscal policy.

75. The Loanable Funds Market
A market that brings together borrowers and lenders
There is a supply of loanable funds and a demand for those loanable funds

77. Shifts in the Demand for LF
Business and Consumer expectations
Optimistism leads to increased demand of LF
Pessimism leads to declining demand of LF
Government borrowing to finance an expansionary fiscal policy increases the demand for LF (Which leads to crowding out)

79. Shifts in the Supply of LF
Changes in private savings behavior
More savings increases the supply of LF
Less savings decrease the supply of LF
Changes in the flow of foreign investment in the U.S. (We will understand this when we study the international economy)