1. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko “The Economic Way of Thinking” 11 th Edition Chapter 16: The Supply of Money

2. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 2 of 42 Chapter 16 Outline Introduction Cigarettes as Money The Evolution of Money The Myth of Fiat Money The Nature of Money Today So How Much Money is Out There?

3. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 3 of 42 Chapter 16 Outline The Creation of Money What Can Be Created Can Be Destroyed Credibility and Confidence Banks Under Regulation: Legal Reserve Requirements The Fed as Monitor and Rule Enforcer

4. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 4 of 42 Chapter 16 Outline The Tools Used by the Fed The Discount Rate Open Market Operations But Who is Really in Charge? Appendix: What About Gold?

5. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 5 of 42 Introduction R. A. Radford –British Economist –WWII – POW –Prisoners created an economy –Cigarettes – Principal money or medium of exchange

6. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 6 of 42 Cigarettes as Money WWII POW’s created a monetary system –Why replace barter with money? –Why use cigarettes as money?

7. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 7 of 42 Cigarettes as Money Cigarettes were: –Generally accepted –Homogeneous and durable –Divisible into small units –Red Cross maintained a supply –Smokers create value

8. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 8 of 42 Cigarettes as Money Disadvantages of cigarettes –May not remain homogeneous Hand rolled vs. machine rolled Removal of tobacco from machine rolled to make hand rolled A heterogeneous money supply –Creates uncertainty –Reduces trading

9. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 9 of 42 Cigarettes as Money Gresham’s Law –Bad Money drives Good Money out of circulation 2 units of money have same nominal value If in reality one is more valuable –One with lower value will circulate –One with higher value will be hoarded

10. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 10 of 42 The Evolution of Money Money evolved to facilitate trade. Precious metals were the first accepted medium of exchange. Coin evolved to establish a standard measure.

11. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 11 of 42 The Evolution of Money The coins had greater value than the metal because it reduced transaction cost. The person minting the coin kept some of the metal as profit for minting – seignorage. What do you think? –Why put ridges on the edge of minted coins?

12. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 12 of 42 The Evolution of Money Goldsmiths – the first bankers. The goldsmiths issued receipts for metals deposited with them. The receipts were traded for goods. –The first paper money.

13. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 13 of 42 The Myth of Fiat Money Fiat –Latin for “let it be” or “let it become” Questions –Is the US dollar accepted as medium of exchange merely because the government decrees it so? –What gives the US dollar value?

14. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 14 of 42 The Nature of Money Today What do we use in the United States today as our medium of exchange? –Currency –Checkable deposits or demand deposits

15. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 15 of 42 The Nature of Money Today Which one accounts for the largest share of the US money supply? Currency and checkable deposits share two characteristics. –Accepted as a medium of exchange –Liabilities of the issuing institution

16. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 16 of 42 The Nature of Money Today Amount of money in an economic system –Expanded by institutions –Persuading people to hold and circulate its liabilities –Private and public institutions

17. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 17 of 42 So How Much Money is Out There? The Fed calculates M1 –Sum of currency in circulation + –Demand deposits + –Other checkable deposits + –Traveler’s checks

18. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 18 of 42 So How Much Money is Out There? M2 is –M1 + –Non-checkable deposits (<$100,000) + –Retail money market mutual funds Funds allowing initial investments <$50,000

19. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 19 of 42 So How Much Money is Out There? Changes in M1 and M2 result from –Public preferences on how to hold Money Money-like assets

20. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 20 of 42 So How Much Money is Out There? M3 = M2 + –Non-checkable deposits >$100,000 + –Mutual funds requiring >$50,000

21. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 21 of 42 So How Much Money is Out There? People at the Fed calculate the 3 M’s –Attempt to determine implications for the future

22. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 22 of 42 The Creation of Money Scenario: –You borrow $500 from your bank. –The $500 is deposited into your account. –You now have $500 in money. Since your money went up by $500, the money supply has increased by $500.

23. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 23 of 42 The Creation of Money Where did the money ($500) come from? –The bank created it. –You write a check for a $500 computer and the store accepts it as a medium of exchange. –The store deposits the check in its checking account. –The store’s bank will clear the check through the Federal Reserve’s check clearing system. –Your account balance will be reduced by $500 when the check clears.

24. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 24 of 42 The Creation of Money Questions –Does the total quantity of money change when your account balance is reduced by the $500? –Why was the bank able to create $500? Hint: Demand deposits are liabilities.

25. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 25 of 42 What Can Be Created Can Be Destroyed Question –What would be the impact of paying back the $500 loan?

26. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 26 of 42 What Can Be Created Can Be Destroyed Scenario: –You write a check to the bank for $575 (principal and interest). –Your account balance falls by $575. –The bank’s account increases by $75.

27. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 27 of 42 What Can Be Created Can Be Destroyed What happened to the $500? –The liability (demand deposit) and asset (loan) are removed from the bank’s books. –The money supply falls by $500.

28. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 28 of 42 Credibility and Confidence If not regulated, the only limit on a bank creating money is –The ability to maintain credibility. People must remain confident in a particular money –Or they will stop using it.

29. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 29 of 42 Banks Under Regulation: Legal Reserve Requirements Banks are not allowed –To have deposit liabilities –In excess of some multiple of reserves –Called a required reserve ratio Typically averages <10%

30. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 30 of 42 Banks Under Regulation: Legal Reserve Requirements Reserves earn no interest. Increasing the required reserve ratio for a bank will mean: –Lower excess reserves –Reduction in ability to make loans –Higher costs –Reduction in potential profit

31. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 31 of 42 The Fed as Monitor and Rule Enforcer Federal Reserve – central bank in US. –Created in 1913 –Government agency –12 district banks –Restrains lending activities of commercial banks –Controls the process of money creation

32. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 32 of 42 The Fed as Monitor and Rule Enforcer FDIC (1933) –Bank deposits insured by US government –Ended “bank runs” –With fewer “runs” – fewer bank failures

33. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 33 of 42 The Fed as Monitor and Rule Enforcer The Fed will loan additional reserves –Entire system is more flexible –And more resistance to crises and temporary dislocations

34. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 34 of 42 Tools Used by the Fed Authority to establish legal reserve requirements Altering the discount rate Open market transactions

35. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 35 of 42 The Discount Rate The interest rate the Fed charges banks for short term loans. Decrease or increase in discount rate –Increase or decrease nation’s money supply

36. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 36 of 42 Open Market Operations Open Market Operations – most common technique used by the Fed. –Fed buys US government bonds. Banks get dollars and M1 increases Interest rates fall –Fed sells US government bonds. Banks get bonds and M1 decreases Interest rates rise

37. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 37 of 42 Who Is Really in Charge? The Federal Open Market Committee (FOMC) –12 members 7 governors President of the NY Fed Presidents of 5 of the remaining 11 Fed banks chosen on a rotating basis

38. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 38 of 42 Who Is Really in Charge? Questions –Is the FOMC’s monetary policy effective? Does the FOMC set the appropriate goals? Does the FOMC achieve its goals?

39. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 39 of 42 Appendix: What About Gold? The value of money determined by –A limited supply –Confidence the supply will remain limited Gold Standard –Currency exchanged for gold at fixed ratio –Limited gold supply restricts increase in money supply

40. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 40 of 42 Once Over Lightly Money as a social institution. An item is money if exchangeable. Financial institutions liabilities and money supply. M1 – M2 – M3 Commercial banks / reserve requirements.

41. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 41 of 42 Once Over Lightly Fed reserve requirements, discount rate and open market operations. Money must be acceptable as an exchange and have limited availability.

42. © 2006 Prentice Hall Business Publishing The Economic Way of Thinking, 11/e Heyne/Boettke/Prychitko 42 of 42 End of Chapter 16