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

What Money Is and Why Its ImportantWithout 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.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.0

The 3 Functions of MoneyMedium of exchange: an item buyers give to sellers when they want to purchase g&sUnit 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

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The 2 Kinds of MoneyCommodity money: takes the form of a commodity with intrinsic valueExamples: gold coins, cigarettes in POW campsFiat money: money without intrinsic value, used as money because of govt decreeExample: the U.S. dollar0

The Money SupplyThe money supply (or money stock): the quantity of money available in the economyWhat assets should be considered part of the money supply? Two candidates:Currency: the paper bills and coins in the hands of the (non-bank) publicDemand deposits: balances in bank accounts that depositors can access on demand by writing a check0

Measures of the U.S. Money SupplyM1: currency, demand deposits, travelers checks, and other checkable deposits. M1 = $1.4 trillion (June 2008)M2: everything in M1 plus savings deposits, small time deposits, money market mutual funds, and a few minor categories. M2 = $7.7 trillion (June 2008)The distinction between M1 and M2 will usually not matter when we talk about the money supply in this course.0

Central Banks & Monetary PolicyCentral bank: an institution that oversees the banking system and regulates the money supplyMonetary policy: the setting of the money supply by policymakers in the central bankFederal Reserve (Fed): the central bank of the U.S. 0

The Structure of the FedThe Federal Reserve System consists of:Board of Governors (7 members), located in Washington, DC12 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. Bernanke Chair of FOMC, Feb 2006 present0

Bank ReservesIn 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 0

Bank T-accountT-account: a simplified accounting statement that shows a banks assets & liabilities.Example:Banks liabilities include deposits, assets include loans & reserves. In this example, notice that R = $10/$100 = 10%.0

FIRST NATIONAL BANKAssetsLiabilitiesReserves$ 10Loans $ 90Deposits$100

Banks and the Money Supply: An ExampleSuppose $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 system2.100% reserve banking system: banks hold 100% of deposits as reserves, make no loans3.Fractional reserve banking system 0

Banks and the Money Supply: An ExampleCASE 1: No banking systemPublic holds the $100 as currency. Money supply = $100. 0

Banks and the Money Supply: An ExampleCASE 2: 100% reserve banking systemPublic deposits the $100 at First National Bank (FNB). FNB holds 100% of deposit as reserves: Money supply = currency + deposits = $0 + $100 = $100In a 100% reserve banking system, banks do not affect size of money supply. 0

FIRST NATIONAL BANKAssetsLiabilitiesReserves$100Loans $ 0Deposits$100

Banks and the Money Supply: An ExampleCASE 3: Fractional reserve banking systemMoney supply = $190 (!!!) Depositors have $100 in deposits, Borrowers have $90 in currency.Suppose R = 10%. FNB loans all but 10% of the deposit:10900

FIRST NATIONAL BANKAssetsLiabilitiesReserves$100Loans $ 0Deposits$100

Banks and the Money Supply: An ExampleHow 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) CASE 3: Fractional reserve banking systemA fractional reserve banking system creates money, but not wealth. 0

Banks and the Money Supply: An ExampleCASE 3: Fractional reserve banking systemIf R = 10% for SNB, it will loan all but 10% of the deposit. Suppose borrower deposits the $90 at Second National Bank (SNB).Initially, SNBs T-account looks like this: 9810

SECOND NATIONAL BANKAssetsLiabilitiesReserves$ 90Loans $ 0Deposits$ 90

Banks and the Money Supply: An ExampleCASE 3: Fractional reserve banking systemIf R = 10% for TNB, it will loan all but 10% of the deposit.The borrower deposits the $81 at Third National Bank (TNB).Initially, TNBs T-account looks like this: $ 8.10$72.900

THIRD NATIONAL BANKAssetsLiabilitiesReserves$ 81Loans $ 0Deposits$ 81

Banks and the Money Supply: An ExampleCASE 3: Fractional reserve banking systemThe process continues, and money is created with each new loan. In this example, $100 of reserves generates $1000 of money.0

Original deposit =FNB lending =SNB lending = TNB lending = . . .$100.00$90.00$81.00$72.90. . .Total money supply =$1000.00

The Money MultiplierMoney multiplier: the amount of money the banking system generates with each dollar of reservesThe money multiplier equals 1/R. In our example, R = 10% money multiplier = 1/R = 10$100 of reserves creates $1000 of money0

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 find a $50 bill (and a half-eaten taco). You deposit the bill in your checking account. The Feds 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 = 5The maximum possible increase in deposits is 5 x $50 = $250But 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: $0If 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: $200B.What is the minimum amount that the money supply could increase?

The Feds 3 Tools of Monetary Control1.Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.To increase money supply, Fed buys govt bonds, paying with new dollars. which are deposited in banks, increasing reserveswhich banks use to make loans, causing the money supply to expand. To reduce money supply, Fed sells govt bonds, taking dollars out of circulation, and the process works in reverse.0

The Feds 3 Tools of Monetary Control1.Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed.OMOs are easy to conduct, and are the Feds monetary policy tool of choice. 0

The Feds 3 Tools of Monetary Control2.Reserve Requirements (RR): affect how much money banks can create by making loans. To increase money supply, Fed reduces RR. Banks make more loans from each dollar of reserves, which increases money multiplier and money supply.To reduce money supply, Fed raises RR, and the process works in reverse. Fed rarely uses reserve requirements to control money supply: Frequent changes would disrupt banking.0

The Feds 3 Tools of Monetary Control3.The Discount Rate: the interest rate on loans the Fed makes to banksWhen banks are running low on reserves, they may borrow reserves from the Fed. To increase money supply, Fed can lower discount rate, which encourages banks to borrow more reserves from Fed. Banks can then make more loans, which increases the money supply. To reduce money supply, Fed can raise discount rate. 0

The Feds 3 Tools of Monetary Control3.The Discount Rate: the interest rate on loans the Fed makes to banksThe Fed uses discount lending to provide extra liquidity when financial institutions are in trouble, e.g. after the Oct. 1987 stock market crash. If no crisis, Fed rarely uses discount lending Fed is a lender of last resort.0

The Federal Funds RateOn 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. Many interest rates are highly correlated, so changes in the fed funds rate cause changes in other rates and have a big impact in the economy.0

The Fed Funds Rate and Other Rates, 1970-2008(%)0510152019701975198019851990199520002005

Monetary Policy and the Fed Funds RateTo 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.The Federal Funds market0

Problems Controlling the Money SupplyIf 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. 0

Bank Runs and the Money SupplyA 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 dont 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. 0

Bank Runs and the Money SupplyDuring 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. 0

CHAPTER SUMMARYMoney includes currency and various types of bank deposits. 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. *

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

This chapter is shorter and less difficult than average. Students find most of the material very straightforward.

It contains one analytically challenging topic: the process of money creation in the banking system.

A good idea might be to proceed somewhat quickly through most of the chapter, spending more time on money creation in the banking system, t-accounts, and the money multiplier.

The fifth edition contains more discussion of the Federal Funds rate. Ive added some slides near the end of this PowerPoint file on the Federal Funds rate: The first covers the material in the textbook. The second slide shows time-series data on the Fed Funds rate and other key rates, to establish the importance of the Fed Funds rate. The third slide uses a supply-demand diagram of the federal funds market to show how the Fed can raise the federal funds rate using open market operations.*As in previous chapters, g&s = goods & services.

Double coincidence of wants simply means that two people have to want each others stuff.

Students find the following example amusing:

Im an economics professor, but Im a consumer, too. Suppose I want to go out for a beer. Under a barter system, I would have to search for a bartender that was willing to give me a beer in exchange for a lecture on economics. As you might imagine, I would have to spend a LOT of time searching. (On the plus side, this would prevent me from becoming an alcoholic.)

But thanks to money, I can go directly to my favorite pub and get a cold beer; the bartender doesnt have to want to hear my lecture, he only has to want my money.

*Money is a medium of exchange. That just means you use money to buy stuff.

Money is a unit of account. The price or monetary value of virtually everything is measured in the same units dollars (in the U.S., or substitute your countrys currency if youre located outside the U.S.). Imagine how hard it would be to plan your budget or comparison shop if sellers each used their own system of measuring prices.

Money is a store of value. Money holds its value over time, so you dont have to spend it immediately upon receiving it.

*Intrinsic value means the commodity would have value even if it werent being used as money.

In the film The Shawshank Redemption, prisoners use cigarettes as money.

Fiat money is worthless except as money. Yet, people are happy to accept your dollars (or euros or yen or whatever) because they know that they will be able to spend them elsewhere. *The definition of currency in the textbook does not include (non-bank). I added it to avoid confusion later, when students are asked to think about what happens to the money supply when a consumer decides to deposit a $50 bill into his or her checking account. *Source: Federal Reserve, Board of Governors, Statistical Release H.6.

The latest H.6 release can be found at:http://www.federalreserve.gov/releases/h6/Current/**In subsequent chapters (including the chapter immediately following this one), students will learn that the Federal Reserves monetary policy can have huge effects on many macroeconomic variables, like inflation, interest rates, unemployment, and even stock price indexes and exchange rates.

As chair of the FOMC, Ben Bernanke is in the news quite frequently. *Segue from last slide: The Fed controls the money supply and regulates banks. Banks clearly play an important role in the money supply because bank deposits are part of the money supply (recall that M1 includes checking account deposits, and M2 also includes savings account deposits).

In the interests of parsimony, I have combined the definitions of fractional reserve banking system and reserves, as shown in the first bullet point. I believe it is sufficient to convey the meaning of both terms. *Deposits are liabilities to the bank because they represent the depositors claims on the bank.

Loans are an asset for the bank because they represent the banks claims on its borrowers.

Reserves are an asset because they are funds available to the bank. ****The notion that banks create money by making loans is a new and perhaps awkward idea for students. The following slide may help. *Students more easily accept the idea that banks create money when they see that banks do not create wealth. *******Reserve requirements were introduced & defined on the slide titled Bank Reserves, immediately following The Structure of the Fed.

Reserve requirements are not a good tool for monetary policy:

To make the money supply grow over time, the Fed would have to continually reduce reserve requirements. This is neither possible they cannot be reduced below 0 nor desirable if reserves are too low, then banks will have liquidity problems, and bank runs (discussed later in the chapter) might become fashionable again.

To reduce the money supply using reserve requirements, banks wouldnt be able to make as many loans, which would make the banking industry less profitable and could cause it to contract. *Why might banks run low on reserves? On any given day, it might turn out that depositors make higher-than-expected withdrawals, or the bank makes more loans than expected. *Indeed, the Fed is a lender of last resort and usually doesnt make discount loans to banks on demand. The Fed is not in the business of giving banks cheap money to subsidize their profits. **The prime rate (the rate banks charge on loans to their best customers) and the 3-month Treasury Bill rate are very highly correlated with the Fed Funds rate.

The mortgage rate shown is the 30-year fixed rate. It is less correlated with the Federal Funds rate, but this is to be expected: Fed Funds are overnight loans between banks, while mortgages are 30-year loans to consumers.

source: FRED databasehttp://research.stlouisfed.org/fred2/*This graph is not in the textbook, so it is not supported with material in the study guide or test bank. Therefore, you may wish to omit this slide from your presentation. But I hope you will consider keeping it. It is uses a simple supply-demand diagram to illustrate something described verbally in the text: how the Federal Reserve targets the federal funds rate.

The demand for federal funds comes from banks that find themselves with insufficient reserves, perhaps because they made too many loans or had higher-than-expected withdrawals.

The supply of federal funds comes from banks that find themselves with more reserves than they want, perhaps because they had lower-than-expected withdrawals or because few customers took out loans.

The federal funds rate adjusts to balance the supply of and demand for federal funds.

The Federal Reserve can use OMOs to target the fed funds rate. Whenever the rate starts to fall below the Feds target, the Fed sells government bonds in the open market in order to pull reserves out of the banking system, which raises the rate as shown in this diagram. If the rate rises above the Feds target, the Fed buys govt bonds in the open market, injecting reserves into the banking system, and pushing the rate down.

For the Fed, OMOs are quick, easy, and effective, so the Fed can keep the fed funds rate very close to the target. ***