$$$$ Money!!! $$$ Who is on the 1.$100 Bill 2.$50 Bill 3.$20 Bill 4.$10 Bill 5.$5 Bill 6.$2 Bill 7.Half Dollar 8.Dime 9.$1,000 Bill 10.$100,000 Bill 1.Franklin 2.Grant 3.Jackson 4.Hamilton 5.Lincoln 6.Jefferson 7.JFK 8.FDR 9.Cleveland 10. Wilson Bonus: E Pluribus Unum means. Out of Many, One 1 2 If there were no money, we would have to exchange goods and services directly for each other in a barter system Imagine taking a pig into a shoe store and trying to exchange it for a pair of tennis shoes What if the owner of the tennis shoes doesnt happen to want a pig or any portion of a pig? What if he does, but the pig is worth 5 pairs of tennis shoes and you only want one pair? What Would We Do Without Money? Money is much more convenient than barter, because everyone is willing to accept money as a medium of exchange for whatever it is that one might want to buy or sell It is also very easily divisible to the scale of what is being exchanged What Would We Do Without Money? What is Money? Money is anything that is generally accepted in payment for goods and services 5 Commodity Money - Something that performs the function of money and has alternative uses. Examples: Gold, silver, cigarettes, etc. Fiat Money- Something that serves as money but has no other important uses. Examples: Paper Money, Copper coins 3 Functions of Money 6 1. A Medium of Exchange Money can easily be used to buy goods and services without problems of barter 2. A Unit of Account Money acts as a measurement of value of goods and services 1 goat = $50 = 5 chickens OR 1 chicken = $10 3. A Store of Value Money allows you to store purchasing power for the future. It doesnt spoil! 7 How Much Money Is There? Depends on how you define money! Different measures of money vary by liquidity Liquidity - ease with which an asset can be accessed and converted into cash (liquidated) M1 (High Liquidity) - Coins, Currency, and checking accounts This is the most common definition of the money supply M2 (Medium Liquidity) - M1 plus savings deposits (money market accounts), time deposits (CDs = certificates of deposit), and Mutual Funds below $100K. Measuring the Money Supply 9 Current U.S. M1 Money Supply:$3.1 Trillion 10 Bonus! Money Velocity:5.9 What is our money backed by? Nothing. Until 1973, dollars could be redeemed for gold. Not anymore, thanks to Richard Nixon. Then what makes money effective? 1.Generally Accepted - Buyers and sellers have confidence that it others will accept it. 2.Scarce Cant be easily reproduced. 3.Portable and Dividable Must be easily transported and divided. The Purchasing Power of money is the quantity of real goods and services a unit of money can buy 11 12 Why I studied economics: The Money Market (Supply and Demand for Money) 13 The Demand for Money People must choose how to allocate their wealth between different kinds of assets: e.g. a house, stocks, bonds, bank accounts, and physical cash A persons demand for money refers to how much of her wealth she wishes to hold as money at any moment in time There are two types of money demand: transactions demand and asset demand Transactions demand refers to the desire to hold money in order to use it to make transactions (a.k.a. to buy stuff) Asset demand refers to the desire to hold cash as a store of value 14 The Demand for Money Holding wealth in the form of money is advantageous because it is very liquid, meaning it can be easily traded Holding money as cash comes at a cost, however the opportunity cost of interest that could have been earned by holding other types of assets like stocks and bonds instead Therefore there is a tradeoff between liquidity and interest The average interest rate in the economy and the quantity of money demanded are inversely related When interest rates are high, the opportunity cost of holding money is high meaning people will tend to hold less money, other things equal When interest rates are low, people will tend to hold more of their wealth as money 15 Nominal Interest Rate (ir) Quantity of Money (billions of dollars) 20% 5% 2% 0 D Money Inverse relationship between interest rates and the quantity of money demanded 16 The Demand for Money Shifts in the Money Demand Curve A change in the nominal interest rate causes a movement along the curve A change in money demand caused by something else will cause the entire curve to shift Money demand curve shifters include: 1.Changes in the Price Level A higher price level means that more money is needed to pay for goods and services 2.Changes in Real Income (Real GDP) An increase in income increases the demand for money because more money is needed to facilitate transactions 17 Shifts in the Money Demand Curve 3. Changes in Payments Technologies The advent of credit cards has significantly reduced the demand for money 4. Changes in the (Perceived) Riskiness of Non-Money Assets After a financial crisis, people tend to hold a lot more physical cash Why? 18 Quantity of Money (billions of dollars) 20% 5% 2% 0 D Money What happens if the price level increases? 19 The Demand for Money D Money2 Nominal Interest Rate (ir) Quantity of Money (billions of dollars) 20% 5% 2% 0 D Money What happens if real income decreases? 20 The Demand for Money Nominal Interest Rate (ir) 21 The Money Supply 200 D Money S Money The Fed is a nonpartisan quasi-governmental body that adjusts the money supply to manipulate the economy This is called Monetary Policy The U.S. money supply is controlled by the Board of Governors of the Federal Reserve System (The Fed) 22 The Supply of Money 20% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir) Monetary Policy 23 When the Fed adjusts the money supply to achieve macroeconomic goals If the Fed increases the money supply, interest rates will fall Increasing the Money Supply Increase in the money supply Decreases interest rate Increases Investment (I) Increases AD DMDM SMSM 10% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir) How does this affect the economy? 250 S M1 If the Fed decreases the money supply, interest rates will rise Decreasing the Money Supply DMDM SMSM 10% 5% 2% Quantity of Money (billions of dollars) Interest Rate (ir) 150 S M1 Decrease in the money supply Increases interest rate Decreases Investment (I) Decreases AD How does this affect the economy? Monetary Policy 26 Three Related Graphs: Money Market Investment Demand AD/AS On the Graph!!!! Investment DemandS&D of Money The Fed increases the money supply to stimulate the economy DMDM SMSM 10% 5% 2% Quantity M Interest Rate (i) 250 S M1 D Investment Quantity of Investment Spending 10% 5% 2% Interest Rate (i) AD/AS QeQe AD AS GDP R PL AD 1 Q1Q1 PL e PL 1 1.Interest Rate Decreases 2.Investment Increases 3.AD, GDP and PL Increase Investment DemandS&D of Money The Fed decreases the money supply to slow down the economy DMDM SMSM 10% 5% 2% Quantity M Interest Rate (i) 175 S M1 D Investment Quantity of Investment 10% 5% 2% Interest Rate (i) AD/AS QeQe AD AS GDP R PL AD 1 Q1Q1 PL e PL 1 1.Interest rates increase 2.Investment decreases 3.AD, GDP and PL decrease How the Government Manipulates the Economy 29 How the Fed Stabilizes the Economy 30 These are the three Shifters of Money Supply 3 Shifters of the Money Supply 1. Reserve Requirement 2. Discount Rate 3. Open Market Operations The Fed is now chaired by Janet Yellen. 31 32 I love this job. I swear. #1. The Reserve Requirement If you have a bank account, where is your money? Only a small percent of your money is in the safe. The rest of it has been lent out. This is called Fractional Reserve Banking The Fed sets the minimum amount that banks must keep in their safes this is called the reserve requirement (or reserve ratio) 33 Money Multiplier Reserve ratio 1 = The Money Multiplier 34 Example: Assume the reserve ratio in the US is 10% Harris deposits $1,000 into his checking account at the bank The bank must hold $100 (required reserves) The bank lends $900 out to Hari Hari deposits the $900 in his bank Haris bank must hold $90. It loans out $810 to Clark, who then deposits $810 into his bank SO FAR, Harriss initial deposit of $1000 caused the CREATION of another $1710 (Haris $900 + Clarks $810) 35 Example: The reserve ratio is.20. Tony discovers $3,000 cash in his backpack and decides to deposit it into the bank. What is the maximum amount by which the money supply could increase? Money Multiplier Reserve ratio 1 = Answer: Assuming consumers hold no cash, $12,000 (initial amount first lent out after Tonys deposit ($2,400), times the multiplier (5)) 36 The Money Multiplier In reality, people do not keep all of their money in the bank; they hold some of their money as physical currency Therefore, a deposit will not increase the money supply by the full amount of the money multiplier The money multiplier describes the maximum amount by which a deposit could increase the money supply, not necessarily the actual amount Using Reserve Requirement 1. In a recession, what can the Fed do? If theres inflation, what can the Fed do? Decrease the Reserve Ratio 1. Banks hold less money and have more excess reserves 2. Banks create more money by loaning out excess 3. Money supply increases, interest rates fall, AD goes up Increase the Reserve Ratio 1. Banks hold more money and have less excess reserves 2. Banks create less money 3. Money supply decreases, interest rates up, AD down #2. The Discount Rate The Discount Rate is the interest rate that the Fed charges commercial banks. Example: If Bank of America needs $10 million, they might borrow directly from the Fed at 3% interest. To increase the Money supply, the Fed should _________ the Discount Rate ( To decrease the Money supply, the Fed should _________ the Discount Rate DECREASE INCREASE 38 39 Where does the Fed get the money it lends out? From customer deposits? From the government? From foreigners? From people who accidentally left their wallets on bus stop benches? None of the above 40 #3. Open Market Operations The Fed buys or sells government bonds This is the most important and widely used monetary policy To increase the Money supply, the Fed should _________ government securities. To decrease the Money supply, the Fed should _________ government securities. How to remember this: Buy-BIG- Buying bonds increases money supply Sell-SMALL- Selling bonds decreases money supply BUY SELL 41 42 Where does the Fed get the money to buy government bonds? From the lemonade stand it operates in its spare time? From panhandling outside of subway stations? From selling Janet Yellens kidneys on the black market? Wrong on all counts! 43 Practice 1.If the reserve requirement is.5 and the Fed sells $10 million of bonds, what is the maximum change in money supply? 2.If the reserve requirement is.1 and the Fed buys $10 million bonds, what is the maximum change in money supply? 3.If the Fed decreases the reserve requirement from.50 to.20 what will happen to the money multiplier? 44 $20 million decrease $100 million increase Increase from 2 to 5 Federal Funds Rate 45 The interest rate banks charge each other for one-day loans of reserves. Fed uses open market operation to hit a so-called target rate The rate fluctuates due to market conditions but it is heavily influenced by monetary policy Federal Funds Rate 46 47 Banking 48 The Balance Sheet A balance sheet is a financial statement that records a firms assets (what it owns), and liabilities (what it owes) Total assets will always be equal to total liabilities on a balance sheet Types of assets on a banks balance sheet: 1.Cash reserves Required reserves the percentage of demand deposits that a bank must keep in its vaults Excess reserves any extra reserves a bank holds beyond the required reserves 2.Loans 49 The Balance Sheet Types of liabilities on a banks balance sheet: 1.Demand Deposits Customer deposits into checking accounts must be withdrawable on demand 2.Owners equity What is left over for the banks owners (shareholders) after all assets are sold and all liabilities are paid 50 AssetsLiabilities Required Reserves Loans Demand Deposits *Assume a required reserve ratio of.10 Owners Equity Total $90 $10 $100 $9 $91 $100 51 AssetsLiabilities Required Reserves Loans Demand Deposits *Assume a required reserve ratio of.10 Owners Equity Total $500 $0 $500 $50 $450 $500 52 AssetsLiabilities Required Reserves Loans Demand Deposits *Assume a required reserve ratio of.10 Owners Equity Total $200 $0 $200 $20 $150 $200 Excess Reserves $30 53 What is the reserve requirement? 0.10 54 Assume that Luis withdraws $5,000 cash from his checking account at Mi Tierra Bank. By how much will Mi Tierras total reserves change based on Luiss withdrawal? Reserves will decrease by $5,000 55 As a result of the withdrawal, what is the new value of excess reserves on the balance sheet of Mi Tierra Bank based on the reserve requirement of 0.10? Excess reserves are now $500 56 What is the initial effect of the withdrawal on the M1 measure of money supply? Explain. One point is earned for stating that the $5,000 withdrawal has no effect on the M1 measure of the money supply because it only changes the composition of M1 between cash and demand deposits. 57 Based on this banks balance sheet, what is the required reserve ratio? 0.20 58 Suppose the Fed purchases $5,000 worth of bonds from this bank. What will be the change in the dollar value of each of the following immediately after the purchase? i. Excess Reserves. ii. Demand Deposits Excess Reserves: $5,000 Demand Deposits: $0 59 Calculate the maximum amount that the money supply can change as a result of the $5,000 purchase of bonds by the Federal Reserve. $25,000 60 When the Federal Reserve purchases bonds, what will happen to the price of bonds in the open market? Explain. The price of bonds will increase. The purchase of bonds increases the money supply, which decreases the interest rate, which increases the price of existing bonds. 61 Suppose that instead of the purchase of bonds by the Federal Reserve, an individual deposits $5,000 in cash into her checking (demand deposit) account. What is the immediate effect of the cash deposit on the M1 measure of the money supply? The cash deposit will not immediately change the money supply. (It will only change the composition of M1 between cash and demand deposits) 62 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 $80 63 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 possible change in the money supply due to Kims deposit. $400 64 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 total change in demand deposits in the banking system $500