Parkin-Bade Chapter 25 - University Of Maryland

Parkin-Bade Chapter 25 - University Of Maryland

Chapter 8 MONEY, THE PRICE LEVEL, AND INFLATION Part 1 In this chapter: Define money and its functions Describe the economic functions of banks Describe the structure and functions of the Federal Reserve System (the Fed) Explain how the banking system creates money

Explain what determines the quantity of money and the nominal interest rate Explain how the quantity of money influences the price level and the inflation rate Average Inflation Rate Versus Average Rate of Money Growth for Selected Countries, 19972007 What is Money? Money is an asset that is generally acceptable as a means of payment . and used to repay debt and pay taxes.

It can be a commodity(gold) or a token (paper money) Money has three functions: - Medium of exchange - Unit of account - Store of value Medium of Exchange A medium of exchange - accepted in exchange for goods and services you can buy stuff. Without a medium of exchange, people would

need to exchange goods and services directly, which is called barter. Barter requires a double coincidence of wants, which is rare, so barter is costly. Unit of Account and Store of Value A unit of account - a measure for stating prices of goods and services. This table illustrates how money simplifies comparisons. A store of value - Money is an asset - you can hold your wealth as money.

What is Money? Official Measures of Money The two main official measures of money in the United States are M1 and M2. M1 consists of currency and travelers checks and checking deposits owned by individuals and businesses. M2 consists of M1 plus time deposits, saving deposits, money market mutual funds, and other deposits. What is Money? The figure illustrates the

composition of M1 and M2. It also shows the relative magnitudes of the components. Is M2 Really Money? All the items in M1 are means of payment, so they are money. Saving deposits in M2 are not means of payments - but, they are liquid assets. Liquidity is the property of being quickly

convertible into a means of payment with little loss of value. What is Money ? Credit Cards Are Not Money? A credit card transaction is a loan which must be repaid with money. Question: US population about 323 million people. Currency in circulation about $1400 billion, mostly $100 bills.

$4,300 per person. Where is this money? Depository Institutions A depository institution is a business firm that takes deposits from households, firms and governments and makes loans to other households, firms and governments. Types of Depository Institutions

Commercial banks (included in M1) Thrift institutions (included in M1) Credit unions (included in M1) Money market mutual funds (included in M2). They sell shares that act as a deposit but are not defined as a deposit. What Depository Institutions Do focus on banks The goal of any bank is to maximize profits. To do this, the interest rate at which it lends must exceed the interest rate it pays on

deposits. Spread - borrow at 2% and lend at 4%. The spread is 4% - 2% = 2% Banks must balance profit and prudence: Loans generate profit, but Depositors must be able to obtain their funds on demand (when they Bank balance Sheet

Sources and uses of funds in all U.S. commercial banks in June 2014. This is a consolidated balance sheet information for the banking system. How would you present this data in a T-account format?

Depository Institutions Are Regulated Depository institutions engage in risky business they can fail. To reduce the risk of failure, depository institutions are required to: Hold reserves and hold owners capital equal to or greater than ratios set by regulation. Additionally, deposits are guaranteed up to $250,000 per depositor per bank by the FDIC Federal Deposit Insurance Corporation.

The Federal Reserve System The Federal Reserve System (the Fed) is the central bank of the United States. A central bank is the public authority that regulates a nations depository institutions and controls the quantity of money. The Feds goals are to keep inflation low and maintain full employment the dual mandate To achieve its goals, the Fed adjust the federal funds rate which is the interest rate that banks charge each other on overnight loans of

reserves. Structure of the Federal Reserve System The key elements in the structure of the Fed are The Board of Governors The regional Federal Reserve banks The Federal Open Market Committee The Federal Reserve System The Board of Governors

Has seven members appointed by the president of the United States and confirmed by the Senate. 14 years - terms are staggered so that one position becomes vacant every 2 years. The president appoints one member to a (renewable) four-year term as chairman. The Federal Reserve System The Federal Reserve Banks

12 regions. The Federal Reserve System The Federal Open Market Committee The Federal Open Market Committee (FOMC) is the main policy-making group in the Federal Reserve System. It consists of the 7 members of the Board of Governors, the president of the Federal Reserve Bank of New York, and 4 of the 11 presidents of the other regional Federal Reserve banks serving on a rotating basis.

The FOMC meets every six weeks to formulate monetary policy. The Federal Reserve System The Feds Balance Sheet The largest and most important asset is U.S. government securities and in recent years, mortgage-backed securities. The most important liabilities are Federal Reserve notes in circulation (currency) and bank reserve deposits at the Fed. The sum of currency and bank reserves is called

the monetary base. The Federal Reserve System Major Assets Major Liabilities 1/current/h41.htm The Federal Reserve System

The Feds Traditional Policy Tools To achieve its objectives, the Fed uses three main policy tools: Open market operations. Discount loans which the book refers to as "last resort" loans. Required reserve ratio. The Conduct of Monetary Policy

Open Market Operations The purchase or sale of government securities by the Fed from or to a commercial bank or the public. When the Fed buys securities, it pays for them with newly created reserves held by the banks. When the Fed sells securities, they are paid for with reserves held by banks. So open market operations increase and decrease bank reserves and the monetary base. An Open Market Purchase Fed buys $100 million in securities from BoA.

Pays for the securities by increasing BoAs reserves. The open market purchase increases bank reserves. Reserves and the Monetary base increase. An Open Market Sale Fed sells $100 securities to BoA The open market sale

decreases bank reserves. Reserves and the Monetary Base decrease. Discount or Last Resort Loans to Banks The Fed is the lender of last resort, which means the Fed stands ready to lend reserves to depository institutions that are short of reserves. Fed Discount Loan to BoA

BoA Borrows $100m from the Fed Bank of America $100 Reserves and the Monetary Base increase. Required Reserve Ratio All banks must meet a required reserve ratio which is set by the Fed. Currently set at 10% applied to checking

account deposits. If checking account deposits = $1,000,000 bank must hold $100,000 as reserves. The Fed rarely changes the required reserve ratio. How Banks Create Money Banks create new deposits when they make loans. New deposits are new money. Therefore, banks create money when they make loans.

Recall M1 = currency + checking deposits Required Reserves, Actual Reserves, Excess Reserves and Desired Reserves A banks actual reserves consists of currency in its vault and its reserve deposit at the Fed. If the required reserve ratio is 10% and banks desire to hold an additional 2%, the desired reserve ratio is 12% - they hold the extra 2% to be prudent. The desired reserve ratio is the ratio of the banks reserves to total deposits that a bank plans to

hold. Reserves in excess of the desired level are called excess reserves. How Banks Create Money Desired Currency Holding People hold some fraction of their money as currency (cash) Increase in the desire to hold currency reduces reserves in the banking system and reduces the ability to make loans and create money. This leakage of reserves into currency is called

the currency drain. We will not focus on this. How Banks Create Money The money creation process begins with an increase in reserves and the monetary base. The Fed conducts an open market purchase in which it buys securities from banks. The Fed pays for the securities with reserves. Reserves and the monetary base increase.

How Banks Create Money Banks now have more reserves but the same amount of deposits, so they have excess reserves. Excess reserves = Actual reserves desired reserves. Banks make loans with excess reserves. Expansionary Monetary Policy An Open Market Purchase An open market purchase of $100 million of government

securities from Bank of America increases reserves on the balance sheet of Bank of America. The monetary base increases. The new reserves are all excess reserves. The bank has the ability to lend out all of its excess reserves, in this case, $100 million. Money Creation by the Banking System

Open Market Purchase of $100 million; No Currency Drain; Desired Reserve Ratio = Required Reserve Ratio = 10%; Bank Increase in Deposits Millions $ Increase in Loans Millions $

$0 $100 $100 $90 $10 Third Bank

$90 $81 $9 Fourth Bank $81 $72.9

$8.1 Fifth Bank $72.9 $65.61 $7.29 .

$65.61 $59.05 $6.56 BoA Second Bank Increase in Reserves Millions $

- . . . . .

. . . Banking System $1,000 $1,000

$100 Deposits in the banking system and the money supply increase by a multiple of the initial $100 million increase in the monetary base as a result of the open market purchase by the Fed. The Money Multiplier The money multiplier is the ratio of the change in the quantity of money (M) to the change in the M) to the change in the monetary base (M) to the change in the MB) . In the previous example, the Fed increased the monetary base by $100 million and the quantity of

money increased by $1,000 million - the money multiplier is 10. The quantity of money created depends on the desired reserve ratio and the currency drain ratio. The smaller these ratios, the larger is the money multiplier. The Money Multiplier

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