the monetary system date lecture # 11. 11 in this chapter, look for the answers to these questions:...

The Monetary System

Date

Lecture #

11

22

In this chapter, look for the answers to these questions:

• What is money?

• What assets are considered “money”? What are the functions of money? The types of money?

• What is the Federal Reserve?

• What role do banks play in the monetary system? How do banks “create money”?

• How does the Federal Reserve control the money supply?

33

What Money Is and Why It’s Important

Without money, trade would require barter, the exchange of one good or service for another.

Every transaction would require a double coincidence of wants—the unlikely occurrence that two people each have a good the other wants.

44

Problem with Double Coincidence of Wants

I have

I want

You have

You want

We cannot trade!

55

What Money Is and Why It’s Important

Most people would have to spend time searching for others to trade with—a huge waste of resources.

This searching is unnecessary with money, the set of assets that people regularly use to buy g&s from other people.

66

Solution with Money

I have

I want

You have

You want

77

What Used to Be Used as Money? Gold, silver, other precious metals

Diamonds and other precious stones

Pearls, shells, ivory, feathers, fur, silk

Salt, spices

Alcohol, cigarettes, marijuana, cocaine

88

Four Properties of Money

Nonperishable, durable and easy to store

Portable

Easily divisible

Scarce and hard to counterfeit

99

The 3 Functions of Money

Medium of exchange: an item buyers give to sellers when they want to purchase g&s

Unit of account: the yardstick people use to post prices and record debts

Store of value: an item people can use to transfer purchasing power from the present to the future

1010

Very Brief History of Money

1200 B.C.: Cowrie Shells

The first use of cowries was in China.

Cowrie shells were widely available in the shallow waters of the Pacific and Indian Oceans.

The cowrie is the most widely and longest used currency in history.

1111

Very Brief History of Money

1000 B.C.: First Metal Money and Coins

Bronze and Copper cowrie imitations were manufactured by China at the end of the Stone Age and could be considered some of the earliest forms of metal coins.

1212

Very Brief History of Money

500 B.C.: Modern Coinage

Outside of China, the first coins developed out of lumps of silver.

They soon took the familiar round form of today, and were stamped with various gods and emperors to mark their authenticity.

These early coins first appeared in Lydia, which is part of present-day Turkey, but the techniques were quickly copied and further refined by the Greek, Persian, Macedonian, and later the Roman empires.

1313

Very Brief History of Money

118 B.C.: Leather Money

Leather money was used in China in the form of one-foot-square pieces of white deerskin with colorful borders.

This could be considered the first documented type of banknote.

1414

Very Brief History of Money

806: Paper Currency

The first known paper banknotes appeared in China.

In Europe, the concept of banknotes was first introduced during the 13th century by travelers such as Marco Polo, with proper banknotes appearing 1661 in Sweden.

1515

Very brief history of money

The Gold Standard

Gold was officially made the standard of value in England in 1816.

1930s: the end of Gold Standard

1944: return to Gold Standard (Bretton Woods International Monetary Agreement)

1971: The “Nixon Shock” – end of Gold Standard

1616

Origin of the Word “Dollar”

The word dollar is much older than the American unit of currency.

It is an Anglicized form of "thaler", (pronounced taler, with a long "a"), the name given to coins first minted in 1519 from locally mined silver in Joachimsthal (Jáchymov) in Bohemia.

Thaler is a shortened form of the term by which the coin was originally known - Joachimsthaler.

1717

The 2 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 govt decree

Example: the U.S. dollar

1818

Contaminated Currency

In 1994, the U.S. 9th Circuit Court of Appeals determined that in Los Angeles, out of every four banknotes, on average more than three are tainted by cocaine or another illicit drug.

In a study reported in Forensic Science International, A.J. Jenkins, the author reports the analysis of ten randomly collected one-dollar bills from five cities, and tested for cocaine, heroin, 6-acetylmorphine (also called "6-AM"), morphine, codeine, methamphetamine, amphetamine and phencyclidine (PCP).

Results demonstrated that 92% of the bills were positive for cocaine while heroin was detected in seven bills.

Forensic scientists have said that around 80% of all British banknotes contain traces of drugs.

Similar contaminations have been found on euro banknotes from Ireland, Spain, and Germany.

1919

The Money Supply

The money supply (or money stock):the quantity of money available in the economy

What assets should be considered part of the money supply? Two candidates: Currency: the paper bills and coins in the

hands of the (non-bank) public Demand deposits: balances in bank accounts

that depositors can access on demand by writing a check

2020

Measures of the U.S. Money Supply M1: narrowest and most liquid measure of money currency, demand deposits,

traveler’s checks, and other checkable deposits.

M1 = $2.7 trillion (February 2014)

M2: a boarder measure

everything in M1 plus savings deposits, small denomination time deposits (less than $100,000), money market mutual funds, and a few minor categories.

M2 = $11.1 trillion (February 2014)

When we talk about “the money supply” in this course you should

think about it as M1.

2121

Central Banks & Monetary Policy

Central bank: an institution that oversees the banking system and regulates the money supply

Monetary policy: the setting of the money supply by policymakers in the central bank

Federal Reserve (Fed): the central bank of the U.S.

2222

The Structure of the FedThe Federal Reserve System consists of: Board of Governors

(7 members), located in Washington, DC

12 regional Fed banks, located around the U.S.

Federal Open Market Committee (FOMC), includes the Bd of Govs and presidents of some of the regional Fed banks The FOMC decides monetary policy.

Ben S. BernankeChair of FOMC,

Feb 2006 – Jan 2014

2323

New Chairman of the Fed

Janet YellenChair of FOMC,

Feb 2014 – present

1st Woman serving as a Chair of the Fed.She graduated from Fort Hamilton High School in the Bay Ridge section of Brooklyn.She graduated summa cum laude from Pembroke College (Brown University) with a degree in economics in 1967.Received her Ph.D. in economics from Yale University in 1971.Yellen is considered by many on Wall Street to be a "dove" (more concerned with unemployment than with inflation) as opposed to a “hawk”.Yellen is a Keynesian economist.

2424

Bank Reserves

In a fractional reserve banking system, banks keep a fraction of deposits as reserves and use the rest to make loans.

The Fed establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits.

Banks may hold more than this minimum amount if they choose.

The reserve ratio, R= fraction of deposits that banks hold as reserves= total reserves as a percentage of total deposits

2525

Bank T-Account T-account: a simplified accounting statement

that shows a bank’s assets & liabilities.

Example: FIRST NATIONAL BANK

Assets Liabilities

Reserves $ 10

Loans $ 90

Deposits $100

Banks’ liabilities include deposits, assets include loans & reserves.

In this example, notice that R = $10/$100 = 10%.

2626

Banks and the Money Supply: An Example

Suppose $100 of currency is in circulation.

To determine banks’ impact on money supply, we calculate the money supply in 3 different cases:

1. No banking system

2. 100% reserve banking system: banks hold 100% of deposits as reserves, make no loans

3. Fractional reserve banking system

2727

Banks and the Money Supply: An Example

CASE 1: No banking system

Public holds the $100 as currency.

Money supply = $100.

2828

Banks and the Money Supply: An Example

CASE 2: 100% reserve banking system

Public deposits the $100 at First National Bank (FNB).

FIRST NATIONAL BANK

Assets Liabilities

Reserves $100

Loans $ 0

Deposits $100

FNB holds 100% of deposit as reserves:

Money supply = currency + deposits = $0 + $100 = $100

In a 100% reserve banking system, banks do not affect size of money supply.

2929

Banks and the Money Supply: An Example

CASE 3: Fractional reserve banking system

Depositors have $100 in deposits, borrowers have $90 in currency.

Money supply = C + D = $90 + $100 = $190 (!!!)

FIRST NATIONAL BANK

Assets Liabilities

Reserves $100

Loans $ 0

Deposits $100

Suppose R = 10%. FNB loans all but 10% of the deposit:

10

90

3030

Banks and the Money Supply: An Example

How did the money supply suddenly grow?

When banks make loans, they create money.

The borrower gets $90 in currency—an asset counted in the

money supply $90 in new debt—a liability that does not have

an offsetting effect on the money supply

CASE 3: Fractional reserve banking system

A fractional reserve banking system creates money, but not wealth.

3131

Banks and the Money Supply: An Example

CASE 3: Fractional reserve banking system

If R = 10% for SNB, it will loan all but 10% of the deposit.

SECOND NATIONAL BANK

Assets Liabilities

Reserves $ 90

Loans $ 0

Deposits $ 90

Borrower deposits the $90 at Second National Bank.

Initially, SNB’s

T-account looks like this:

9

81

3232

Banks and the Money Supply: An Example

CASE 3: Fractional reserve banking system

If R = 10% for TNB, it will loan all but 10% of the deposit.

THIRD NATIONAL BANK

Assets Liabilities

Reserves $ 81

Loans $ 0

Deposits $ 81

SNB’s borrower deposits the $81 at Third National Bank.

Initially, TNB’s

T-account looks like this:

$ 8.10

$72.90

3333

Banks and the Money Supply: An Example

CASE 3: Fractional reserve banking system

The process continues, and money is created with each new loan.

Original deposit =FNB lending =

SNB lending = TNB lending =

...

$

100.00$

90.00$

81.00$

72.90...

Total money supply =$

1000.00

In this example, $100 of reserves

generates $1000 of money.

3434

The Money Multiplier

Money multiplier: the amount of money the banking system generates with each dollar of reserves

The money multiplier equals 1/R.

In our example, R = 10% money multiplier = 1/R = 10$100 of reserves creates $1000 of money

A C T I V E L E A R N I N G 1

Banks and the money supply

While cleaning your apartment, you look under the sofa cushion and find a $50 bill (and a half-eaten taco). You deposit the bill in your checking account.

The Fed’s reserve requirement is 20% of deposits.

A. What is the maximum amount that the money supply could increase?

B. What is the minimum amount that the money supply could increase?

A C T I V E L E A R N I N G 1

Answers

If banks hold no excess reserves, then money multiplier = 1/R = 1/0.2 = 5

The maximum possible increase in deposits is 5 x $50 = $250

But money supply also includes currency, which falls by $50.

Hence, max increase in money supply = $200.

You deposit $50 in your checking account.

A. What is the maximum amount that the money supply could increase?

A C T I V E L E A R N I N G 1

Answers

Answer: $0

If your bank makes no loans from your deposit, currency falls by $50, deposits increase by $50, money supply does not change.

You deposit $50 in your checking account.

A. What is the maximum amount that the money supply could increase? Answer: $200

B. What is the minimum amount that the money supply could increase?

3838

A C T I V E L E A R N I N G 2

Banks and the money multiplier

A. What is Bank of Kopeka’s reserve ratio? B. Assume there is a reserve requirement and the

Bank of Kopeka is exactly in compliance with that requirement. Assume the same is true for all other banks. Lastly, assume people hold only deposits and no currency.

What is the money multiplier?

3939

A C T I V E L E A R N I N G 2

Answers

B. Money Multiplier = 1/R = 1/0.1 = 10

A. Bank of Kopeka reserve ratio is $2,000/$20,000 = 0.1 = 10%

4040

A C T I V E L E A R N I N G 2

Banks and the money multiplier

A. What is Bank of Kopeka’s reserve ratio? B. Assume there is a reserve requirement and the

Bank of Kopeka is exactly in compliance with that requirement. Assume the same is true for all other banks. Lastly, assume people hold only deposits and no currency.

What is the money multiplier?

4141

A More Realistic Balance Sheet

Assets: Besides reserves and loans, banks also hold securities.

Liabilities: Besides deposits, banks also obtain funds from issuing debt and equity.

Bank capital: the resources a bank obtains by issuing equity to its owners Also: bank assets minus bank liabilities

Leverage: the use of borrowed funds to supplement existing funds for investment purposes

4242

A More Realistic Balance Sheet

MORE REALISTIC NATIONAL BANK

Assets Liabilities

Reserves $ 200

Loans $ 700

Securities $ 100

Deposits $ 800

Debt $ 150

Capital $ 50

Leverage ratio: the ratio of assets to bank capital

In this example, the leverage ratio = $1000/$50 = 20

Interpretation: for every $20 in assets, $ 1 is from the bank’s owners, $19 is financed with borrowed money.

4343

Leverage Amplifies Profits and Losses

In our example, suppose bank assets appreciate by 5%, from $1000 to $1050. This increases bank capital from $50 to $100, doubling owners’ equity.

Instead, if bank assets decrease by 5%, bank capital falls from $50 to $0.

If bank assets decrease more than 5%, bank capital is negative and bank is insolvent.

Capital requirement: a govt regulation that specifies a minimum amount of capital, intended to ensure banks will be able to pay off depositors and debts.

4444

Leverage and the Financial Crisis

In the financial crisis of 2008–2009, banks suffered losses on mortgage loans and mortgage-backed securities due to widespread defaults.

Many banks became insolvent:In the U.S., 27 banks failed during 2000–2007, 166 during 2008–2009.

Many other banks found themselves with too little capital, responded by reducing lending, causing a credit crunch.

4545

The Government’s Response

To ease the credit crunch, the Federal Reserve and U.S. Treasury injected hundreds of billions of dollars’ worth of capital into the banking system.

This unusual policy temporarily made U.S. taxpayers part-owners of many banks.

The policy succeeded in recapitalizing the banking system and helped restore lending to normal levels in 2009.

4646

The Fed’s Tools of Monetary Control Earlier, we learned

money supply = money multiplier × bank reserves

The Fed can change the money supply by changing bank reserves or changing the money multiplier.

4747

How the Fed Influences Reserves Open-Market Operations (OMOs):

the purchase and sale of U.S. government bonds by the Fed.

If the Fed buys a government bond from a bank, it pays by depositing new reserves in that bank’s reserve account. With more reserves, the bank can make more loans, increasing the money supply.

To decrease bank reserves and the money supply, the Fed sells government bonds.

4848

How the Fed Influences Reserves The Fed makes loans to banks, increasing their

reserves. Traditional method: adjusting the discount rate

—the interest rate on loans the Fed makes to banks—to influence the amount of reserves banks borrow

New method: Term Auction Facility—the Fed chooses the quantity of reserves it will loan, then banks bid against each other for these loans.

The more banks borrow, the more reserves they have for funding new loans and increasing the money supply.

4949

How the Fed Influences the Reserve Ratio

Recall: reserve ratio = reserves/deposits,which inversely affects the money multiplier.

The Fed sets reserve requirements: regulations on the minimum amount of reserves banks must hold against deposits.

Reducing reserve requirements would lower the reserve ratio and increase the money multiplier.

Since 10/2008, the Fed has paid interest on reserves banks keep in accounts at the Fed. Raising this interest rate would increase the reserve ratio and lower the money multiplier.

5050

Problems Controlling the Money Supply

If households hold more of their money as currency, banks have fewer reserves, make fewer loans, and money supply falls.

If banks hold more reserves than required, they make fewer loans, and money supply falls.

Yet, Fed can compensate for household and bank behavior to retain fairly precise control over the money supply.

5151

Bank Runs and the Money Supply A run on banks:

When people suspect their banks are in trouble, they may “run” to the bank to withdraw their funds, holding more currency and less deposits.

Under fractional-reserve banking, banks don’t have enough reserves to pay off ALL depositors, hence banks may have to close.

Also, banks may make fewer loans and hold more reserves to satisfy depositors.

These events increase R, reverse the process of money creation, cause money supply to fall.

5252

Bank Runs and the Money Supply During 1929–1933, a wave of bank runs and

bank closings caused money supply to fall 28%.

Many economists believe this contributed to the severity of the Great Depression.

Since then, federal deposit insurance has helped prevent bank runs in the U.S.

In the U.K., though, Northern Rock bank experienced a classic bank run in 2007 and was eventually taken over by the British government.

5353

The Federal Funds Rate

On any given day, banks with insufficient reserves can borrow from banks with excess reserves.

The interest rate on these loans is the federal funds rate.

The FOMC uses OMOs to target the fed funds rate.

Changes in the fed funds rate cause changes in other rates and have a big impact on the economy.

The Fed Funds rate and other rates, 1970–2011

1970 1975 1980 1985 1990 1995 2000 2005 20100

5

10

15

20 Fed Funds

Prime

3 Month T-Bill

Mortgage

(%)

5555

Monetary Policy and the Fed Funds Rate

To raise fed funds rate, Fed sells govt bonds (OMO).

This removes reserves from the banking system, reduces supply of federal funds,

causes rf to rise.

rf

FD1

S2

3.75%

F2

S1

F1

3.50%

The Federal Funds marketFederal

funds rate

Quantity of federal funds

S U M M A RY

• Money serves three functions: medium of exchange, unit of account, and store of value.

• There are two types of money: commodity money has intrinsic value; fiat money does not.

• The U.S. uses fiat money, which includes currency and various types of bank deposits.

S U M M A RY

• In a fractional reserve banking system, banks create money when they make loans. Bank reserves have a multiplier effect on the money supply.

• Because banks are highly leveraged, a small change in the value of a bank’s assets causes a large change in bank capital. To protect depositors from bank insolvency, regulators impose minimum capital requirements.

S U M M A RY

• The Federal Reserve is the central bank of the U.S., is responsible for regulating the monetary system.

• The Fed controls the money supply mainly through open-market operations. Purchasing govt bonds increases the money supply, selling govt bonds decreases it.

• In recent years, the Fed has set monetary policy by choosing a target for the federal funds rate.