1. MONEY AND PRICES IN THE LONG RUNV
MONEY AND PRICES IN THE LONG RUN
This is Part 10 in “Principles of Economics”.

2. 11
The Monetary System
This is Chapter 29 in “Principles of Economics” and Chapter 16 in “Principles of Macroeconomics”.

3. THE MEANING OF MONEY
Money is the set of assets that people commonly use to buy things.
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4. The Meaning of Money: The Functions of Money
Money has three functions in the economy:
Medium of exchange
Money is the item that buyers give to sellers when they want to purchase goods and services
Unit of account
Money is the yardstick people use to post prices and record debts
Store of value
Money is an item that people can use to transfer purchasing power from the present to the future
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5. The Meaning of Money: The Functions of Money
Every asset has some amount of liquidity.
Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange.
As money is the economy’s medium of exchange, it is the most liquid of all assets.
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6. The Meaning of Money: 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 government 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 they will be able to spend the currency.

7. The Meaning of Money: Money in the U.S. Economy
The quantity of money in an economy needs to be measured.
A basic measure, M1, is obtained by adding:
Currency: the paper bills and coins in the hands of the public
Demand deposits: balances in bank accounts that depositors can use as payment by writing a check.
And a few other less important things, such as travelers’ checks
Nowadays, M2 is more widely used.
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8. M1 and M2 in February 2018 $ Billions Currency 1,540.3
+ Traveler’s Checks
1.9
+ Demand Deposits
1,474.0
+ Other Checkable Deposits
597.9
= M1
3,614.0
+ Savings Deposits
9,121.9
+ Small-denomination Time Deposits
415.8
+ Retail Money Market Mutual Funds
706.6
= M2
13,858.3
Data downloaded on March 18, 2018.
Currency:
Traveler’s Checks:
Demand Deposits:
Other Checkable Deposits:
M1:
Savings Deposits:
Small-denomination Time Deposits:
Retail Money Market Mutual Funds:
M2:
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9. Video
What Is Money? Marginal Revolution University, YouTube, July 18, 2017
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10. THE FEDERAL RESERVE SYSTEM
The Federal Reserve (The Fed) serves as the central bank of the US.
It is designed to oversee the banking system.
It regulates the quantity of money in the economy.
This activity is called monetary policy.

11. The Federal Reserve System: Helicopter and Vacuum Cleaner
You can think of the Fed as printing money and dropping it from helicopters, thereby adding to the quantity of money in the economy
Conversely, you can think of the Fed as a giant vacuum cleaner that sucks money out of people’s wallets, thereby reducing the quantity of money

12. The Federal Reserve System: Helicopter and Vacuum Cleaner
The helicopter-and-vacuum view of the Fed is a bit too simple, however
The Fed really can increase or decrease the quantity of money
But it uses a process called open market operations to do so

13. The Federal Reserve System: Helicopter and Vacuum Cleaner
When the Fed wishes to increase the quantity of money in the economy, it prints money and buys financial assets—such as government bonds—on the open market
That’s the Fed acting as a money-dropping helicopter

14. The Federal Reserve System: Helicopter and Vacuum Cleaner
When the Fed wishes to decrease the quantity of money in the economy, it sells financial assets—such as the government bonds it may have bought in the past—on the open market, and burns the money it gets from the sale
That’s the Fed acting as a money-sucking vacuum

15. BANKS AND THE MONEY SUPPLY
Commercial banks can also increase or decrease the economy’s quantity of money
That is, banks too can also act like a money-dropping helicopter or a money-sucking vacuum

16. BANKS AND THE MONEY SUPPLY
Remember that the quantity of money consists of:
Currency: the paper bills and coins in the hands of the public
Demand deposits: balances in bank accounts that depositors can use as payment by writing a check.
Banks can control the quantity of money by controlling the quantity of demand deposits
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17. BANKS AND THE MONEY SUPPLY
When banks make new loans faster than borrowers repay old loans, the quantity of money in demand deposits increases and, therefore, the economy’s quantity of money increases
That is, banks can act like a money-dropping helicopter
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18. BANKS AND THE MONEY SUPPLY
When banks make new loans slower than borrowers repay old loans, the quantity of money in demand deposits decreases and, therefore, the economy’s quantity of money decreases
That is, banks can act like a money-sucking vacuum
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19. Banks and the Money Supply: Fractional-Reserve Banking
Silly example:
The Fed prints $10,000 and pays Alex, a caterer who provided food at a Fed function
M1 increases by $10,000. (Why?)
Alex deposits the $10,000 in Bank A
M1 is unchanged. (Why?)
Bank A’s reserves increase and it decides to make a $9,000 loan out of the new reserves.
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20. Banks and the Money Supply: Fractional-Reserve Banking
The recipient of Bank A’s loan buys a car from Barbara.
Barbara deposits $9,000 in her account at Bank B
M1 increases by $9,000. (Why?)
So far, the Fed’s printing of $10,000 has already increased M1 by $19,000.
And further increases in the money supply may follow when Bank B reacts to Barbara’s deposit the way Bank A reacted to Alex’s deposit.
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21. Banks and the Money Supply: Fractional-Reserve Banking
When one bank loans money, that money generally ends up as a deposit in a second bank.
This creates more deposits and more reserves to be lent out by the second bank.
When the second bank makes a loan from its reserves, the money supply increases again.
And the process continues …
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22. Banks and the Money Supply: The Money Multiplier
How much money is eventually created in this economy?
The money multiplier is the name given to the amount of money the banking system generates with each dollar of money created by the Fed.
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23. Banks and the Money Supply: The Money Multiplier
Reserve Ratio
The reserve ratio is the fraction of total deposits that banks hold as reserves.
The fraction of its total deposits that a bank is required by the Fed to keep as reserves is called the required reserve ratio.
When banks hold reserves in excess of the required reserves, those reserves are called excess reserves.
Reserves = Required Reserves + Excess Reserves
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24. Banks and the Money Supply: The Money Multiplier
The money multiplier is the reciprocal of the reserve ratio:
M = 1/R
With a reserve ratio of R = 20% or 1/5,
The multiplier is 5.
Example: In this case, if the Fed prints a fresh dollar bill and buys a government bond with it, the money supply may increase by as much as $5.00!
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25. Video
The Money Multiplier, Marginal Revolution University, YouTube, July 25, 2017
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26. THE FED’S TOOLS OF MONETARY CONTROL
Influences the quantity of reserves
Open-market operations
Fed lending to banks
Influences the reserve ratio
Reserve requirements
Paying interest on reserves

27. Fed’s Tools of Monetary Control
Open-market operations
Purchase and sale of U.S. government bonds by the Fed
To increase the money supply
The Fed buys U.S. government bonds
To reduce the money supply
The Fed sells U.S. government bonds
Used more often

28. Fed’s Tools of Monetary Control
Fed lending to banks
To increase the money supply
Discount window
At the discount rate
Term Auction Facility
To the highest bidder

29. Fed’s Tools of Monetary Control
The discount rate
Interest rate on the loans that the Fed makes to banks
Higher discount rate
Reduce the money supply
Smaller discount rate
Increase the money supply

30. Fed’s Tools of Monetary Control
Term Auction Facility
The Fed sets a quantity of funds it wants to lend to banks
Eligible banks bid to borrow those funds
Loans go to the highest eligible bidders
Acceptable collateral
Pay the highest interest rate

31. Fed’s Tools of Monetary Control
Reserve requirements
Regulations on minimum amount of reserves
That banks must hold against deposits
An increase in reserve requirement
Decrease the money supply
A decrease in reserve requirement
Increase the money supply
Used rarely – disrupt business of banking

32. Fed’s Tools of Monetary Control
Paying interest on reserves
Since October 2008
The higher the interest rate on reserves
The more reserves banks will choose to hold
An increase in the interest rate on reserves
Increase the reserve ratio
Lower the money multiplier
Lower the money supply

33. The Fed’s control of the money supply is not precise.
Fed’s Tools of Monetary Control: Problems in Controlling the Money Supply
The Fed’s control of the money supply is not precise.
The Fed must wrestle with two problems that arise due to fractional-reserve banking.
The Fed does not control the amount of money that households choose to hold as deposits in banks.
The Fed does not control the amount of money that bankers choose to lend.
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34. Fed’s Tools of Monetary Control: Problems in Controlling the Money Supply
If people lose confidence in the banking system and decide to withdraw cash from their bank accounts to hold as currency, the banks would be forced to cut back on lending
This would cause the money supply to decrease
This actually happened during the Great Depression of the 1930s.
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35. Fed’s Tools of Monetary Control: Problems in Controlling the Money Supply
If banks lose confidence in the economy they may be afraid to lend, fearing that in a bad economy borrowers would default on their loans.
So, banks may decide to make fewer loans and hold more reserves.
The rise in the reserve ratio would reduce the money multiplier and cause the money supply to decrease.
This actually happened during the Great Depression of the 1930s.
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36. Fed’s Tools of Monetary Control: Problems in Controlling the Money Supply
During the Great Depression both factors discussed in the two previous slides were in play
From 1929 to 1933, the US money supply fell by 28 percent, without the Federal Reserve taking any deliberate contractionary action
This emphasizes the point that the Fed’s control of the money supply is imprecise.
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37. Fed’s Tools of Monetary Control: The Federal Funds Rate
The Federal Funds Rate is the interest rate that banks charge for overnight loans to one another
When the federal funds rate rises or falls, other interest rates often move in the same direction
When interest rates change they affect the behavior of consumers and businesses.
This, in turn, has short-run effects on the economy
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38. The Fed Funds rate and other rates, 1970–2016
Mortgage
Prime
3 Month T-bill
By controlling the fed funds rate, the Fed indirectly affects many other interest rates that affect economic activity directly.
The prime rate (the rate banks charge on loans to their best customers; IRSTPI01USM156N) and the 3-month Treasury Bill rate (TB3MS) are very highly correlated with the Fed Funds rate.
The mortgage rate shown is the 30-year fixed rate (MORTGAGE30US). It is less correlated with the Federal Funds rate (DFF), but this is to be expected: Fed Funds are overnight loans between banks, while mortgages are 30-year loans to consumers.
source: FRED database
Image permalink:

39. Fed’s Tools of Monetary Control: The Federal Funds Rate
In recent years, the Fed has used its policy tools to control the Federal Funds Rate
From time to time the Fed announces a target level for the federal funds rate
The Fed then uses its monetary policy tools to push the federal funds rate to the target level
The theory of how the Fed can control interest rates and why it does so will be discussed further when we discuss the short run
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40. Monetary Policy and the Fed Funds Rate
Federal funds rate
The Federal Funds market rf F
To raise the fed funds rate, the Fed sells government bonds (open market operations). This removes reserves from the banking system, reduces supply of federal funds, causes the fed funds rate to rise. Conversely, buys bonds (with newly printed money) to reduce the fed funds rate.
Note that the fed funds rate and the money supply move in opposite directions. S2 S1 D1
1.75% F2 F1
1.50%
This graph is not in the textbook, so it is not supported with material in the study guide or test bank. Therefore, you may wish to omit this slide from your presentation. But I hope you will consider keeping it. It uses a simple supply-demand diagram to illustrate something described verbally in the text: how the Federal Reserve targets the federal funds rate.
The demand for federal funds comes from banks that find themselves with insufficient reserves, perhaps because they made too many loans or had higher-than-expected withdrawals.
The supply of federal funds comes from banks that find themselves with more reserves than they want, perhaps because they had lower-than-expected withdrawals or because few customers took out loans.
The federal funds rate adjusts to balance the supply of and demand for federal funds.
The Federal Reserve can use OMOs to target the fed funds rate. Whenever the rate starts to fall below the Fed’s target, the Fed sells government bonds in the open market in order to pull reserves out of the banking system, which raises the rate as shown in this diagram. If the rate rises above the Fed’s target, the Fed buys govt bonds in the open market, injecting reserves into the banking system, and pushing the rate down.
For the Fed, OMOs are quick, easy, and effective, so the Fed can keep the fed funds rate very close to the target.
Fed’s open market operation
Fed funds rate
Money supply
Buy bonds ↓ ↑
Sell bonds
Quantity of federal funds 40

41. Fed’s Tools of Monetary Control: The Federal Funds Rate
Downloaded from on March 18, 2018.

42. Fed’s Tools of Monetary Control: The Federal Funds Rate
Downloaded from on March 18, 2018.

43. The Federal Reserve’s Monetary Policy Tools: Videos
How the Fed Worked: Before the Great Recession, Marginal Revolution University, YouTube, March 13, 2018
How the Fed Works: After the Great Recession, Marginal Revolution University, YouTube, April 3, 2018
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44. Any Questions?