1. 1 Frank & Bernanke 3 rd edition, 2007 Ch. 10: Money, Prices, and the Federal Reserve

2. 2 What Is Money? Does Bill Gates have a lot of money? Does Bill Gates have a lot of money? Does LeBron James make a lot of money? Does LeBron James make a lot of money? Anything accepted by a community in exchange of goods and services and for settlements of debts. Anything accepted by a community in exchange of goods and services and for settlements of debts.

3. 3 Functions of Money Unit of account Unit of account Increase in variety of goods requires a common unit to quote and compare prices. Increase in variety of goods requires a common unit to quote and compare prices. 3 goods: 2 prices 3 goods: 2 prices 4 goods: 6 prices 4 goods: 6 prices 5 goods: 24 prices 5 goods: 24 prices N goods: (n-1)! Prices N goods: (n-1)! Prices Money had to be invented. Money had to be invented.

4. 4 Functions of Money Medium of exchange Medium of exchange Barter requires double coincidence of wants. Barter requires double coincidence of wants. Exchange makes both parties better-off. Exchange makes both parties better-off. Money had to be invented. Money had to be invented.

5. 5 Functions of Money Store of Value Store of Value Postponing consumption by storing wealth in an asset for future use. Postponing consumption by storing wealth in an asset for future use. Today we have many different assets for wealth storage. Today we have many different assets for wealth storage. Depending on the ability of these assets to be easily converted to cash (liquidity) these assets are near or far to “money.” Depending on the ability of these assets to be easily converted to cash (liquidity) these assets are near or far to “money.”

6. 6 Financial Assets Savers Can Hold Currency Currency Checking account Checking account Savings account Savings account Certificate of Deposit Certificate of Deposit Foreign currency Foreign currency Bonds Bonds Stocks Stocks Options on stocks, bonds, foreign currency Options on stocks, bonds, foreign currency Futures on commodities, foreign currency Futures on commodities, foreign currency

7. 7 Assets According to Liquidity Currency Currency Checking Account Checking Account Savings Account Savings Account Money Market Mutual Fund Money Market Mutual Fund Bonds Bonds

8. 8 Measuring Money http://research.stlouisfed.org/publications/mt/page16.pdf In billions of dollars

9. 9 Measuring Money

10. 10 Components of M1 and M2, July 2002 (billions of dollars) M1 Currency Demand deposits Other checkable deposits Travelers’ checks M2 M1 Savings deposits Small-denomination time deposits Money market mutual funds 1,197.8 615.1 303.8 270.3 8.6 5,641.2 1,197.8 2,552.8 920.8 969.8

11. 11 Banks and the Creation of Money When depositors put money in the bank, the bank turns around and loans part of the money to others. When depositors put money in the bank, the bank turns around and loans part of the money to others. Both the depositor and the borrower have funds to spend. Both the depositor and the borrower have funds to spend. Money has been created. Money has been created.

12. 12 Banks and the Creation of Money We will show the changes in assets and liabilities of a bank in response to deposit and loan activities. We will show the changes in assets and liabilities of a bank in response to deposit and loan activities. Deposits into checking accounts are liabilities of a bank. Deposits into checking accounts are liabilities of a bank. Cash is an asset. Cash is an asset. Assets = Liabilities for a Balance Sheet to be in balance. Assets = Liabilities for a Balance Sheet to be in balance.

13. 13 Creation of Money Ally deposits $1000 into her checking account with First National. Ally deposits $1000 into her checking account with First National. First National holds only 10% as reserves and loans the rest to Billy. First National holds only 10% as reserves and loans the rest to Billy. Billy buys a snow blower for $900 from Carl. Billy buys a snow blower for $900 from Carl. Carl deposits $900 with Second National. Carl deposits $900 with Second National. Second National loans how much to Deyna if it also holds 10% as reserves? Second National loans how much to Deyna if it also holds 10% as reserves?

14. 14 Creation of Money If this process goes on for thirty rounds, how much checking deposits will be in the banking system? If this process goes on for thirty rounds, how much checking deposits will be in the banking system? 1000 + 1000(.9) + 1000(.9)(.9)+…+1000(.9)^ 30 1000 + 1000(.9) + 1000(.9)(.9)+…+1000(.9)^ 30 1000 + 900 + 810 + … + 0.04 1000 + 900 + 810 + … + 0.04 1000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10] 1000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10]

15. 15 Creation of Money The banking system used the initial deposit of $1000 as the reserves and multiplied it by (1/reserve ratio) to create checking deposits for the economy. The banking system used the initial deposit of $1000 as the reserves and multiplied it by (1/reserve ratio) to create checking deposits for the economy. What would be the deposits created by the same $1000 deposit, if the banks kept 5% as the reserve ratio? What would be the deposits created by the same $1000 deposit, if the banks kept 5% as the reserve ratio?

16. 16 Narrow Money, M1 M1 is defined as currency outside of the banks plus bank deposits. M1 is defined as currency outside of the banks plus bank deposits. Monetary Base is defined as Currency + Reserves. Monetary Base is defined as Currency + Reserves.

17. 17 Measuring Money What was the amount of currency in January 2005? What was the amount of bank deposits in January 2005? What was the reserve ratio in January 2005?

18. 18 What was the amount of currency in January 2006, December 2006? What was the amount of bank deposits in January 2005, December 2006? What was the reserve ratio in January 2005, December 2006?

19. 19 Banks and the Creation of Money Summary Summary Bank reserves/bank deposits = desired reserve-deposit ratio Bank reserves/bank deposits = desired reserve-deposit ratio Bank deposits = bank reserves/desired reserve-deposit ratio Bank deposits = bank reserves/desired reserve-deposit ratio

20. 20 Banks and the Creation of Money The Money Supply with Both Currency and Deposits The Money Supply with Both Currency and Deposits CB provides 1 million in cash to residents CB provides 1 million in cash to residents Residents choose to hold 500,000 as currency Residents choose to hold 500,000 as currency Deposit 500,000 in the banks Deposit 500,000 in the banks Reserve-deposit ratio = 10% Reserve-deposit ratio = 10% Bank deposits = 500,000/.10 = 5,000,000 Bank deposits = 500,000/.10 = 5,000,000

21. 21 Banks and the Creation of Money The Money Supply with Both Currency and Deposits The Money Supply with Both Currency and Deposits Money supply = currency + bank deposits 5,500,000 = 500,000 + 5,000,000 Money supply = currency + bank deposits 5,500,000 = 500,000 + 5,000,000 Money is increased by 4,500,000 when the residents hold 500,000 in bank deposits Money is increased by 4,500,000 when the residents hold 500,000 in bank deposits

22. 22 Banks and the Creation of Money The Money Supply at Christmas The Money Supply at Christmas Currency = 500 Currency = 500 Bank reserves = 500 Bank reserves = 500 Reserve-deposit ratio = 0.20 Reserve-deposit ratio = 0.20 Money supply = 500 + 500/.20 = 500 + 2,500 = 3,000 Money supply = 500 + 500/.20 = 500 + 2,500 = 3,000

23. 23 Banks and the Creation of Money The Money Supply at Christmas The Money Supply at Christmas If Xmas shoppers withdraw 100 If Xmas shoppers withdraw 100 Money supply = 600 + 400/.20 = 600 + 2,000 = 2,600 Money supply = 600 + 400/.20 = 600 + 2,000 = 2,600

24. 24 Banks and the Creation of Money The Money Supply at Christmas The Money Supply at Christmas Observation Observation When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money supply by $5. When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money supply by $5. In general, when people make withdraws, the money supply contracts by a multiple of the withdrawal. In general, when people make withdraws, the money supply contracts by a multiple of the withdrawal.

25. 25 The Federal Reserve System The Central Bank of the United States. The Central Bank of the United States. The Fed is responsible for monetary policy. The Fed is responsible for monetary policy. Amount of money supplied to the system. Amount of money supplied to the system. Affects interest rates, inflation, unemployment and exchange rates. Affects interest rates, inflation, unemployment and exchange rates. The Fed oversees and regulates the financial markets. The Fed oversees and regulates the financial markets.

26. 26 The Fed Fed was established in 1913 in the hopes of eliminating banking panics of the 19th century by providing credit to the financial markets. Fed was established in 1913 in the hopes of eliminating banking panics of the 19th century by providing credit to the financial markets. In order to disperse power 12 regional Federal Reserve Banks were formed. In order to disperse power 12 regional Federal Reserve Banks were formed. The seven members of the Board of Governors are appointed by the President for 14-year terms every other year. The seven members of the Board of Governors are appointed by the President for 14-year terms every other year.

27. 27 Monetary Policy Federal Open Market Committee (FOMC) is the group that sets the monetary policy. Federal Open Market Committee (FOMC) is the group that sets the monetary policy. Fed Chairman (4-year term) plus governors, plus NY Fed President, plus 4 Presidents of Fed banks comprise FOMC. Fed Chairman (4-year term) plus governors, plus NY Fed President, plus 4 Presidents of Fed banks comprise FOMC. FOMC meets eight times a year. FOMC meets eight times a year.

28. 28 Controlling the Money Supply Open-Market Operations: buying and selling of financial assets. Open-Market Operations: buying and selling of financial assets. Buying government bonds from the public increases bank reserves, hence money supply. Buying government bonds from the public increases bank reserves, hence money supply. Selling bonds decreases money supply. Selling bonds decreases money supply. Discount window lending: Lending to banks increases bank reserves. Discount window lending: Lending to banks increases bank reserves. Changing reserve requirements: Raising reserve-deposit ratio decreases money supply. Changing reserve requirements: Raising reserve-deposit ratio decreases money supply. New Tools: http://stlouisfed.org/publications/re/2009/a/pages/presidents-message.html New Tools: http://stlouisfed.org/publications/re/2009/a/pages/presidents-message.html http://stlouisfed.org/publications/re/2009/a/pages/presidents-message.html

29. 29 Open-Market Operation Suppose an economy has $100 currency, $100 reserves and 0.1 as reserve-deposit ratio. Suppose an economy has $100 currency, $100 reserves and 0.1 as reserve-deposit ratio. What is the money supply? What is the money supply? If the Central Bank purchased $5 worth of bonds, what will be the money supply? If the Central Bank purchased $5 worth of bonds, what will be the money supply? If the CB sold $10 worth of bonds, what will be the money supply? If the CB sold $10 worth of bonds, what will be the money supply?

30. 30 The Federal Reserve System Example Example Increasing the money supply by open- market operations Increasing the money supply by open- market operations Currency = 1,000 Currency = 1,000 Reserves = 200 Reserves = 200 Reserve-deposit ratio = 0.2 Reserve-deposit ratio = 0.2

31. 31 The Federal Reserve System Example Example Increasing the money supply by open- market operations Increasing the money supply by open- market operations Money supply = 1,000 + 200/0.2 = 2,000 Money supply = 1,000 + 200/0.2 = 2,000 Open market purchase = 100 Open market purchase = 100 Reserves increase to 300 Reserves increase to 300 Money supply = 1,000 + 300/0.2 = 2,500 Money supply = 1,000 + 300/0.2 = 2,500

32. 32 The Federal Reserve System Controlling the Money Supply: Discount Window Lending Controlling the Money Supply: Discount Window Lending Banks can borrow reserves from the Fed. Banks can borrow reserves from the Fed. Discount window lending Discount window lending The lending of reserves to commercial banks The lending of reserves to commercial banks

33. 33 The Federal Reserve System Controlling the Money Supply: Discount Window Lending Controlling the Money Supply: Discount Window Lending The discount rate The discount rate The interest rate charged on these loans The interest rate charged on these loans Discount lending will increase reserves and the money supply. Discount lending will increase reserves and the money supply.

34. 34 Primary Credit Rate http://research.stlouisfed.org/publications/mt/page9.pdf

35. 35 The Federal Reserve System Controlling the Money Supply: Changing Reserve Requirements Controlling the Money Supply: Changing Reserve Requirements The Fed sets the reserve-deposit ratio The Fed sets the reserve-deposit ratio Called the reserve requirement Called the reserve requirement A reduction in the reserve requirement would allow the money supply to increase. A reduction in the reserve requirement would allow the money supply to increase. An increase in the reserve requirement may reduce the money supply. An increase in the reserve requirement may reduce the money supply.

36. 36 http://www.federalreserve.gov/monetarypolicy/default.htm

37. 37 The Federal Reserve System The Fed’s Role in Stabilizing Financial Markets: Banking Panics The Fed’s Role in Stabilizing Financial Markets: Banking Panics Suppose: Suppose: Depositors lose confidence in their bank. Depositors lose confidence in their bank. They attempt to withdraw their funds. They attempt to withdraw their funds. Bank may not have enough reserves (fractional) to meet the depositors demand. Bank may not have enough reserves (fractional) to meet the depositors demand. The bank fails and further erodes depositor confidence which triggers additional failures. The bank fails and further erodes depositor confidence which triggers additional failures.

38. 38 The Federal Reserve System The Fed’s Role in Stabilizing Financial Markets: Banking Panics The Fed’s Role in Stabilizing Financial Markets: Banking Panics The Fed to the rescue: The Fed to the rescue: Instill confidence Instill confidence Discount lending Discount lending Open Market Operations Open Market Operations

39. 39 The Great Depression The Fed did not prevent the Great Depression. The Fed did not prevent the Great Depression. Both currency held by the public and reserve- deposit ratio rose, reducing money supply. Both currency held by the public and reserve- deposit ratio rose, reducing money supply. The Fed increased the reserves but not enough. The Fed increased the reserves but not enough. Lack of enough reserves forced bank bankruptcies. Lack of enough reserves forced bank bankruptcies. One-third of U.S. banks closed One-third of U.S. banks closed

40. 40 Frank, R. H. and Ben S. Bernanke, Principles of Macroeconomics, 2 nd ed. (McGraw-Hill, 2004), p. 273.

41. 41 The Federal Reserve System In response to the panics of 1929-1933, deposit insurance was established in 1934. In response to the panics of 1929-1933, deposit insurance was established in 1934. Deposit insurance gives depositors an incentive to keep their money in the banks. Deposit insurance gives depositors an incentive to keep their money in the banks. Deposit insurance reduces the incentive for depositors to pay attention to the financial strength of their bank. Deposit insurance reduces the incentive for depositors to pay attention to the financial strength of their bank.

42. 42 Money and Price Level In the long run, prices adjust to pressures in the economy. In the long run, prices adjust to pressures in the economy. The “quantity theory of money” captures the long-run relationship. The “quantity theory of money” captures the long-run relationship. MV = PY

43. 43 Quantity Theory M is money stock, like M1 or M2. M is money stock, like M1 or M2. V is velocity, the number of times money stock exchanges hands in creating the nominal GDP. V is velocity, the number of times money stock exchanges hands in creating the nominal GDP. P is price level, like 1.00 or 1.26 (price index) P is price level, like 1.00 or 1.26 (price index) Y is real GDP. Y is real GDP. PY is nominal GDP. PY is nominal GDP.

44. 44 Long Run Inflation In the long-run, the economy will operate at full-employment; so Y will not change if there is no growth. If there is growth, then Y is predictable: Y is known. In the long-run, the economy will operate at full-employment; so Y will not change if there is no growth. If there is growth, then Y is predictable: Y is known. Velocity is also thought predictable in the long-run. Velocity is also thought predictable in the long-run. Therefore, any growth in money supply will be reflected in inflation. Therefore, any growth in money supply will be reflected in inflation.

45. 45 Money and Prices Velocity Velocity The speed at which money circulates The speed at which money circulates

46. 46 Money and Prices Velocity Velocity The speed at which money circulates The speed at which money circulates

47. 47 Money and Prices Velocity in 2001 Velocity in 2001 M1 = $1,177.9 billion M1 = $1,177.9 billion M2 = $5,449.1 billion M2 = $5,449.1 billion Nominal GDP = $10,082.2 billion Nominal GDP = $10,082.2 billion

48. 48 Money and Prices Money and Inflation in the Long Run Money and Inflation in the Long Run Recall Recall

49. 49 Money and Prices Money and Inflation in the Long Run Money and Inflation in the Long Run Quantity equation Quantity equation M x V = P x Y M x V = P x Y Assume V & Y are constant over the time period Assume V & Y are constant over the time period

50. 50 Money and Prices Money and Inflation in the Long Run Money and Inflation in the Long Run If the Fed increases M by 10%, then prices must increase by 10%. If the Fed increases M by 10%, then prices must increase by 10%. High rates of money growth are associated with high rates of inflation (too much money chasing too few goods). High rates of money growth are associated with high rates of inflation (too much money chasing too few goods).

51. 51 Inflation and Money Growth in Latin America, 1995-2001