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Money, Prices, and the Federal ReserveMoney, Prices, and the Federal Reserve
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Introduction
MoneyAny asset that can be used in making
purchasesExamples
CurrencyCoinsChecks
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Money and Its Uses
Medium of ExchangeAn asset used in purchasing goods and
services
Unit of AccountA basic measure of economic value
Store of ValueAn asset that serves as a means of holding
wealth
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Money and Its Uses
Economic NaturalistPrivate money: Ithaca Hours and LETS
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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
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Money and Its Uses
M1Sum of currency outstanding and balances
held in checking accounts
M2All the assets in M1 plus some additional
assets that are usable in making payments but at greater cost or inconvenience than currency or checks
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Commercial Banks and the Creation of Money
AssumeRepublic of Gorgonzola
No banking systemGovernment issues 1 million guildersPeople want to place their 1 million guilders in a
bank
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Consolidated Balance Sheet of Gorgonzolan Commercial Banks (Initial)
AssetsCurrency 1,000,000 guilders
LiabilitiesDeposits 1,000,000 guilders
Citizens open accounts and deposit 1 million guilders• Deposits are liabilities for the bank• The guilders are an asset for the bank• Guilders are the bank’s reserves• Reserves = deposits: 100 percent reserve bankingReserves are not part of the money supplyDeposits are part of the money supply
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Commercial Banks and the Creation of Money
Bank ReservesCash or similar assets held by commercial
banks for the purpose of meeting depositor withdrawals and payments
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Consolidated Balance Sheet ofGorgonzolan Commercial Banks After One Round of Loans
AssetsCurrency (= reserves) 100,000 guilders
Loans to farmers 900,000 guilders
LiabilitiesDeposits 1,000,000 guilders
Fractional Reserve Banking System• Bankers agree they only need a reserve to deposit ratio of 10%• Required reserves = 100,000 guilders, 10% of deposits• Loan out the excess reserves of 900,000 guilders
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Consolidated Balance Sheet ofGorgonzolan Commercial Banks after Guilders Are Redeposited
AssetsCurrency (= reserves) 100,000 guilders
+ New reserves 900,000 guilders
Loans to farmers 900,000 guilders
LiabilitiesDeposits 1,000,000 guilders
+ New deposits 900,000 guilders
Loan proceeds are deposited• Reserves = 1,000,000 guilders• New Deposits = 900,000 guilders• Total Deposits = 1,900,000 guilders• Money supply = 1,900,000 guilders• Reserve to deposit ratio = 1/1.9 = 52.6%• For 1.9 m. deposits, only need 190 k. reserves• => excess reserves = 810 k.• Banks can loan the 810 k. guilders
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Consolidated Balance Sheet of Gorgonizolan Commercial Banks After Two Rounds of Loans and Redeposits
AssetsCurrency (= reserves)
1,000,000 guilders
Loans to farmers
1,710,000 guilders
LiabilitiesDeposits 2,710,000 guilders
Loan proceeds are deposited• Reserves = 1,000,000 guilders• Deposits = 2,710,000 guilders• Money supply = 2,710,000 guilders• Reserve to deposit ratio = 1/2.71 = 36.9%• => Excess reserves = 729 k. guilders, should loan out
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Final Consolidated Balance Sheet of Gorgonzolan Commercial Banks
AssetsCurrency (= reserves)
1,000,000 guilders
Loans to farmers
9,000,000 guilders
LiabilitiesDeposits 10,000,000 guilders
Observations• Lending will continue until the reserve to deposit ratio = 10%• When loans = 9,000,000 guilders
•Deposits = 10,000,000 guilders•Reserves = 1,000,000 guilders•Reserve to deposit ratio = 10%•No excess reserves
• The money supply = 10,000,000 guilders
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Commercial Banks and the Creation of Money
ObservationsThe use of a fractional-reserve banking
system allows the money supply to grow as a multiple of the reserves
In Gorgonzola, with a 10% reserve-deposit ratio, 1 guilder in reserve can support 10 guilders in deposit.
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Commercial Banks and the Creation of Money
SummaryBank reserves/bank deposits = desired
reserve-deposit ratioBank deposits = bank reserves/desired
reserve-deposit ratio
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Commercial Banks and the Creation of Money
The Money Supply with Both Currency and DepositsGorgonzola residents choose to hold
500,000 guilders as currencyDeposit 500,000 in the banksReserve-deposit ratio = 10%Bank deposits = 500,000/.10 = 5,000,000
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Commercial Banks and the Creation of Money
The Money Supply with Both Currency and DepositsMoney supply = currency + bank deposits
5,500,000 = 500,000 + 5,000,000
Money is reduced by 4,500,000 guilders when the residents hold 500,000 guilders in currency
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Commercial Banks and the Creation of Money
The Money Supply at ChristmasCurrency = 500Bank reserves = 500Reserve-deposit ratio = 0.20Money supply = 500 + 500/.20 =
500 + 2,500 = 3,000
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Commercial Banks and the Creation of Money
The Money Supply at ChristmasIf Xmas shoppers withdraw 100Money supply = 600 + 400/.20 =
600 + 2,000 = 2,600
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Commercial Banks and the Creation of Money
The Money Supply at ChristmasObservation
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.
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The Federal Reserve System
Two Main ResponsibilitiesMonetary policyOversight and regulation of financial
markets
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The Federal Reserve System
The History and Structure of the Federal Reserve SystemFounded by the Federal Reserve Act of
1913The primary mission of the Fed is to
promote economic growth, low inflation, and stable financial markets.
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The Federal Reserve System
The Structure12 regional Federal Reserve banks
Assess economic conditions in their regions to assist in national policymaking
Provide service to the commercial banks in their districts
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The Federal Reserve System
The StructureBoard of Governors
Seven governorso Appointed by the president to 14 year staggered
terms
Chairman of the Board of Governorso Selected by the president from the governorso Serves a four year term
Chapter 10: Money, Prices, and the Federal Reserve Slide 25
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The Federal Reserve System
The StructureFederal Open Market Committee (FOMC)
Members include:o The seven Fed governorso President of the New York Fedo Four presidents, chosen on a rotating basis, from the
remaining Federal Reserve Banks
Determines monetary policy
Chapter 10: Money, Prices, and the Federal Reserve Slide 26
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The Federal Reserve System
Controlling the Money Supply: Open-Market OperationsThe primary function of the Fed is
monetary policy.The Fed controls the money supply by
changing the supply of bank reserves.
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The Federal Reserve System
Controlling the Money Supply: Open-Market OperationsOpen-market operations are the most
important method of changing the supply of bank reserves.
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The Federal Reserve System
Increasing The Money SupplyThe Fed purchases government bonds
from the public.The people deposit the funds they get from
their sale of bonds to the Fed.The increase in deposits increase bank
reserves.
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The Federal Reserve System
Increasing The Money SupplyThe increase in reserves will lead to an
expansion of the money supply as banks make more loans.
RecallThe change in the money supply is a multiple of
the change in reserves.
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The Federal Reserve System
Reducing The Money SupplyThe Fed sells government bonds to the
public.The Fed presents the checks from the sale
of the bonds to the banks for payment.
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The Federal Reserve System
Reducing The Money SupplyThe bank’s reserves will fall when they
clear the checks.The money supply will fall by a multiple of
the decrease in reserves.
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The Federal Reserve System
Open-Market PurchaseThe purchase of government bonds from
the public by the Fed for the purpose of increasing the supply of bank reserves and the money supply
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The Federal Reserve System
Open-Market SaleThe sale by the Fed of government bonds
to the public for the purpose of reducing bank reserves and the money supply
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The Federal Reserve System
Open-Market OperationsOpen-market purchases and open-market
sales
Chapter 10: Money, Prices, and the Federal Reserve Slide 35
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The Federal Reserve System
ExampleIncreasing the money supply by open-
market operationsCurrency = 1,000 shekelsReserves = 200Reserve-deposit ratio = 0.2
Chapter 10: Money, Prices, and the Federal Reserve Slide 36
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The Federal Reserve System
ExampleIncreasing the money supply by open-
market operationsMoney supply = 1,000 + 200/0.2 = 2,000 shekelsOpen market purchase = 100Reserves increase to 300Money supply = 1,000 + 300/0.2 = 2,500 shekels
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The Federal Reserve System
Controlling the Money Supply: Discount Window LendingBanks can borrow reserves from the Fed.Discount window lending
The lending of reserves to commercial banks
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The Federal Reserve System
Controlling the Money Supply: Discount Window LendingThe discount rate
The interest rate charged on these loans
Discount lending will increase reserves and the money supply.
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The Federal Reserve System
Controlling the Money Supply: Changing Reserve RequirementsThe Fed sets the reserve-deposit ratio
Called the reserve requirement
A reduction in the reserve requirement would allow the money supply to increase.
An increase in the reserve requirement may reduce the money supply.
Chapter 10: Money, Prices, and the Federal Reserve Slide 40
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The Federal Reserve System
The Fed’s Role in Stabilizing Financial Markets: Banking PanicsSuppose:
Depositors lose confidence in their bank.They attempt to withdraw their funds.Bank may not have enough reserves (fractional)
to meet the depositors demand.The bank fails and further erodes depositor
confidence which triggers additional failures.
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The Federal Reserve System
The Fed’s Role in Stabilizing Financial Markets: Banking PanicsThe Fed to the rescue:
Instill confidenceDiscount lendingOpen Market Operations
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The Federal Reserve System
Economic NaturalistThe banking panics of 1930 - 1933 and the
money supplyOne-third of U.S. banks closedDepositors withdrew their fundsBanks raised the reserve-deposit ratio
Chapter 10: Money, Prices, and the Federal Reserve Slide 43
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Key U.S. MonetaryStatistics, 1929-1933
Currency Reserve-deposit Bank Moneyheld by public ratio reserves supply
December 1929 3.85 0.075 3.15 45.9
December 1930 3.79 0.082 3.31 44.1
December 1931 4.59 0.095 3.11 37.3
December 1932 4.82 0.109 3.18 34.0
December 1933 4.85 0.133 3.45 30.8
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The Federal Reserve System
Economic NaturalistIn 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 reduces the incentive for
depositors to pay attention to the financial strength of their bank.
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The Federal Reserve System
What Do You Think?Why worry about the money supply?
Chapter 10: Money, Prices, and the Federal Reserve Slide 46
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Money and Prices
VelocityThe speed at which money circulates
stockMoney
GDP Nominal
stockMoney
nstransactio of Value Velocity
Chapter 10: Money, Prices, and the Federal Reserve Slide 47
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Money and Prices
VelocityThe speed at which money circulates
M
x YP
supply)(money M
GDP) (real x Y level) (price P (V)Velocity
Chapter 10: Money, Prices, and the Federal Reserve Slide 48
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Money and Prices
Velocity in 2001M1 = $1,177.9 billionM2 = $5,449.1 billionNominal GDP = $10,082.2 billion
8.56 billion $1,117.9
billion $10,082.2 V M1,
1.85 billion $5,499.1
billion $10,082.2 V M2,
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Money and Prices
Money and Inflation in the Long RunRecall
M
Y x P V
Chapter 10: Money, Prices, and the Federal Reserve Slide 50
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Money and Prices
Money and Inflation in the Long RunQuantity equation
M x V = P x Y
Assume V & Y are constant over the time period
Y x P V x M
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Money and Prices
Money and Inflation in the Long RunIf 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).
Y x P V x M
Chapter 10: Money, Prices, and the Federal Reserve Slide 52
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Inflation and Money Growth in Latin America, 1995-2001
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Money and Prices
What Do You Think?If high rates of money growth lead to
inflation, why do countries allow their money supplies to rise quickly?
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