1. McGraw-Hill/Irwin © 2009 The McGraw-Hill Companies, All Rights Reserved Chapter 9 The Financial System, Money, and Prices

2. 9-2 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21- All Learning Objectives 1.Discuss the three functions of money and how money is measured 2.Analyze how the lending behavior of commercial banks affects the money supply 3.Understand the central bank control of the money supply and its relation to inflation in the long run

3. 9-3 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 4 Money Money is any asset that can be used in making purchases Examples include coins and currency, checking account balances, and traveler's checks Shares of stock are not money Money has three principal uses 1.Medium of exchange 2.Unit of account 3.Store of value Money makes barter unnecessary Barter is trading goods directly

4. 9-4 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21- All Measuring Money Definitions of money range from narrow to broad M1 ($B) $1,364.7 Currency$758.1 Demand deposits292.5 Other checkable deposits307.9 Traveler's checks6.2 M2 ($B) $7,498.7 M1$1,364.7 Savings deposits3,903.4 Small-denomination time notes1,224.4 Money market mutual funds1,006.1

5. 9-5 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 5 Commercial Banks Create Money Republic of Gorgonzola begins with no banking system Government issues 1 million guilders Banks are created to store cash Payments are made by withdrawing cash or writing checks Without interest, banks earn profits by charging depositors fees Citizens prefer bank deposits to cash for making transactions

6. 9-6 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 5 Consolidated Bank Balance Sheet – Part 1 All guilders (g) are deposited Bank reserves are cash or similar assets held by banks Used to meet depositors' withdrawals and payments Gorgonzola's banks have 100% reserves 100% reserve banking is when banks' reserves equal 100% of their deposits AssetsLiabilities Currency1,000,000 gDeposits1,000,000 g

7. 9-7 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 5 Bank Reserves Cash in a bank's vault is not part of the money supply Unavailable for payments Bank deposits available for use in transactions are part of the money supply Depositing a $100 bill in your checking account does not change the money supply Bankers realize that inflows and outflows from vaults leave some guilders unused Only 10% of deposits are needed for transactions 90% can be lent to borrowers for a fee -- interest

8. 9-8 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 5 Consolidated Bank Balance Sheet – Part 2 Currency held in the vault is the bank reserves The reserve – deposit ratio is bank reserves divided by total deposits Fractional reserve banking system holds less bank reserves than deposits The reserve – deposit ratio is less than 100% AssetsLiabilities Currency100,000 gDeposits1,000,000 g Loans900,000 g

9. 9-9 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 5 Consolidated Bank Balance Sheet – Part 3 Farmers borrow 900,000 guilders to buy supplies Farmers spend the 900,000 guilders which are then deposited in the banks Bank deposits are the entire money supply Loan of 900,000 guilders increased the money supply by 900,000 guilders Banks are again holding excess reserves on deposits of 1,900,000 guilders AssetsLiabilities Currency1,000,000 gDeposits1,900,000 g Loans900,000 g

10. 9-10 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 5 Consolidated Bank Balance Sheet – Part 4 With deposits of 1,900,000 guilders and a reserve – deposit ratio of 10%, banks want only 190,000 guilders in reserves Currently holding 1,000,000 guilders Loan 810,000 guilders Loan are spent and re-deposited Excess reserves are created and re-loaned AssetsLiabilities Currency1,000,000 gDeposits2,710,000 g Loans1,710,000 g

11. 9-11 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 5 Consolidated Bank Balance Sheet – The End Expansion of loans and deposits stops when reserves are 10% of deposits 1,000,000 guilders available as reserves Deposits stabilize at 10,000,000 guilders Beginning with 1,000,000 guilders in cash, the money supply is now 10,000,000 guilders AssetsLiabilities Currency1,000,000 gDeposits10,000,000 g Loans9,000,000 g

12. 9-12 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 5 Money Creation With 10% reserves, each guilder supports 10 guilders in deposits The general case of money creation with fractional reserve banking is Solving for bank deposits we get Bank reserves Bank deposits = Desired reserve-deposit ratio Bank reserves Desired reserve-deposit ratio Bank deposits =

13. 9-13 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 5 Money Supply with Currency and Deposits Gorgonzola residents hold 500,000 guilders as currency Deposit 500,000 guilders in the banks Reserve-deposit ratio = 10% Bank deposits = 500,000 / 0.10 = 5,000,000 guilders Money supply = 500,000 cash + 5,000,000 deposits = 5,500,000 guilders Money supply = Currency held by public + Bank reserves Desired reserve-deposit ratio

14. 9-14 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 1 Bank Panics, 1930 - 1933 One-third of the banks closed Increased the severity of the Great Depression Difficult for small businesses and consumers to get credit Money supply decreased With no federal deposit insurance, people held cash Feared banks would close and they would lose their deposits Holding cash reduced banks' reserves Lower reserves decreases the money supply by a multiple of the change in reserves

15. 9-15 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 1 Bank Panics, 1930 - 1933 Banks increased their reserve – deposit ratio Further decreased the money supply Date Currency Held by Public ($B) Reserve – Deposit Ratio Bank Reserves ($B) Money Supply ($B) 12 / 1929 3.850.0753.1545.9 12 / 1930 3.790.0823.3144.1 12 / 1931 4.590.0923.1137.3 12 / 1932 4.820.1093.1834.0 12 / 1933 4.850.1333.4530.8

16. 9-16 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 1 Deposit Insurance Congress created deposit insurance in 1934 Deposits of less than $100,000 will be repaid even if the bank is bankrupt Decreases incentive to withdraw funds on rumors No significant bank panics since 1934 With less risk, depositors pay less attention to whether banks are making prudent investments In the 1980s, many savings and loan associations went bankrupt Cost the taxpayers hundreds of billions of dollars

17. 9-17 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 6 The Federal Reserve System The Fed is the central bank of the US Responsible for monetary policy and the oversight and regulation of financial markets Monetary policy is deciding and managing the size of the nation's money supply Money supply is controlled indirectly Open-market purchase of government bonds from the pubic by the Fed increases bank reserves and the money supply Open-market sale of government bonds by the Fed to the public decreases reserves and money supply

18. 9-18 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 6 Open Market Operations When the Fed purchases a bond from the public Fed pays bond holder with new money Receipts are deposited and this leads to a multiple expansion of the money supply When the Fed sells a bond to the public Bondholder pays with checking funds Bank reserves decrease and this leads to a multiple contraction of the money supply

19. 9-19 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 6 Increasing the Money Supply An economy has 1,000 shekels in currency and bank reserves of 200 shekels Reserve-deposit ratio = 0.2 Money supply = 1,000 + (200 / 0.2) = 2,000 shekels Central bank pays 100 shekels for a bond held by the public Assume that all 100 shekels are deposited Money supply = 1,000 + (300/ 0.2) = 2,500 shekels 100 shekel increase in reserves leads to a 500 shekel increase in the money supply

20. 9-20 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 6 Money and Prices In the long run, the amount of money circulating and the level of prices are closely linked Sustained high inflation rates occur with a comparably high growth rate of the money supply

21. 9-21 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 6 Velocity of Money (V) Velocity is the speed money changes hands in transaction for final goods and services Nominal GDP is the price level (P) times real GDP (Y) M is the money supply Velocity = Nominal GDP Money supply V = PY M

22. 9-22 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 6 Velocity in the US, 2007 M1 = $1,364.2 billion M2 = $7,447.1 billion Nominal GDP = $13,843.0 billion Using M1, velocity is 10.15 Using M2, velocity is 1.86 Velocity is determined by a number of factors including technology such as ATMs and debit cards V = $13,843.0 1,364.2 = 10.15V = $13,843.0 7, 447.1 = 1.86

23. 9-23 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 6 Money and Inflation in the Long Run Quantity equation states MV = PY Restatement of the velocity definition The quantity equation relates the money supply to price levels Suppose velocity and real GDP are constant The quantity equation becomes An increase in the money supply by a given percentage would increase prices by the same percentage V and Y, respectively M V = P Y

24. 9-24 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - 6 Approximating a Percentage Change M V = P Y % change in (M V) = % change in (P Y) The percentage change in a product is the sum of the percentage changes in each variable Consequently % change in M + % change in V % change in P + % change in Y If the M grows 4% per year and V grows 1% per year, nominal GDP (P Y) grows approximately 5% per year If Y grows 3% per year, then the percentage change in price is approximately 2% per year

25. 9-25 © The McGraw-Hill Companies, Inc., 2009 McGraw-Hill/Irwin LO 21 - All The Financial System, Money, and Prices DiversificationDiversification MoneyMoney ReservesReserves Financial System BanksBanks BondsBonds StocksStocks Federal Reserve System Open Market Operations Quantity Equation