McGraw-Hill/Irwin ©2009 The McGraw-Hill Companies, All Rights Reserved

Chapter 9

The Financial System, Money, and Prices

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Learning Objectives

1. Discuss the three functions of money and how money is measured

2. Analyze how the lending behavior of commercial banks affects the money supply

3. Understand the central bank control of the money supply and its relation to inflation in the long run

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Money Money is any asset that can be used in making

purchases Examples include coins and currency, checking

account balances, and traveler's checks Shares of stock are not money

Money has three principal uses1. Medium of exchange2. Unit of account3. Store of value

Money makes barter unnecessary Barter is trading goods directly

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Measuring Money Definitions of money range from narrow to broad

M1 ($B) $1,364.7Currency $758.1

Demand deposits 292.5

Other checkable deposits 307.9

Traveler's checks 6.2

M2 ($B) $7,498.7M1 $1,364.7

Savings deposits 3,903.4

Small-denomination time notes 1,224.4

Money market mutual funds 1,006.1

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Commercial Banks Create Money Republic of Gorgonzola begins with no banking system Government issues 1 million guilders Banks are created to store cash

Payments are made by withdrawing cash or writing checks

Without interest, banks earn profits by charging depositors fees

Citizens prefer bank deposits to cash for making transactions

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Consolidated Bank Balance Sheet – Part 1 All guilders (g) are deposited

Bank reserves are cash or similar assets held by banks Used to meet depositors' withdrawals and payments Gorgonzola's banks have 100% reserves

100% reserve banking is when banks' reserves equal 100% of their deposits

Assets LiabilitiesCurrency 1,000,000 g Deposits 1,000,000 g

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Bank Reserves Cash in a bank's vault is not part of the money supply Unavailable for payments Bank deposits available for use in transactions are

part of the money supply Depositing a $100 bill in your checking account

does not change the money supply Bankers realize that inflows and outflows from vaults

leave some guilders unused Only 10% of deposits are needed for transactions 90% can be lent to borrowers for a fee -- interest

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Consolidated Bank Balance Sheet – Part 2 Currency held in the vault is the bank reserves

The reserve – deposit ratio is bank reserves divided by total deposits

Fractional reserve banking system holds less bank reserves than deposits The reserve – deposit ratio is less than 100%

Assets LiabilitiesCurrency 100,000 g Deposits 1,000,000 gLoans 900,000 g

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Consolidated Bank Balance Sheet – Part 3 Farmers borrow 900,000 guilders to buy supplies Farmers spend the 900,000 guilders which are then

deposited in the banks

Bank deposits are the entire money supply Loan of 900,000 guilders increased the money

supply by 900,000 guilders Banks are again holding excess reserves on deposits

of 1,900,000 guilders

Assets LiabilitiesCurrency 1,000,000 g Deposits 1,900,000 gLoans 900,000 g

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Consolidated Bank Balance Sheet – Part 4 With deposits of 1,900,000 guilders and a reserve –

deposit ratio of 10%, banks want only 190,000 guilders in reserves Currently holding 1,000,000 guilders Loan 810,000 guilders

Loan are spent and re-deposited Excess reserves are created and re-loaned

Assets LiabilitiesCurrency 1,000,000 g Deposits 2,710,000 gLoans 1,710,000 g

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Consolidated Bank Balance Sheet – The End Expansion of loans and deposits stops when reserves

are 10% of deposits 1,000,000 guilders available as reserves Deposits stabilize at 10,000,000 guilders

Beginning with 1,000,000 guilders in cash, the money supply is now 10,000,000 guilders

Assets LiabilitiesCurrency 1,000,000 g Deposits 10,000,000 gLoans 9,000,000 g

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Money Creation With 10% reserves, each guilder supports 10 guilders

in deposits The general case of money creation with fractional

reserve banking is

Solving for bank deposits we get

Bank reservesBank deposits = Desired reserve-deposit ratio

Bank reservesDesired reserve-deposit ratioBank deposits =

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Money Supply with Currency and Deposits Gorgonzola residents hold 500,000 guilders as

currency Deposit 500,000 guilders in the banks Reserve-deposit ratio = 10% Bank deposits = 500,000 / 0.10 = 5,000,000 guilders Money supply = 500,000 cash + 5,000,000 deposits

= 5,500,000 guilders

Money supply = Currency held by public +

Bank reservesDesired reserve-deposit ratio

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Bank Panics, 1930 - 1933 One-third of the banks closed Increased the severity of the Great Depression Difficult for small businesses and consumers to get

credit Money supply decreased

With no federal deposit insurance, people held cash Feared banks would close and they would lose their

deposits Holding cash reduced banks' reserves

Lower reserves decreases the money supply by a multiple of the change in reserves

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Bank Panics, 1930 - 1933 Banks increased their reserve – deposit ratio Further decreased the money supply

DateCurrency Held by

Public ($B)

Reserve – Deposit Ratio

Bank Reserves

($B)

Money Supply

($B)12 / 1929 3.85 0.075 3.15 45.912 / 1930 3.79 0.082 3.31 44.112 / 1931 4.59 0.092 3.11 37.312 / 1932 4.82 0.109 3.18 34.012 / 1933 4.85 0.133 3.45 30.8

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Deposit Insurance Congress created deposit insurance in 1934 Deposits of less than $100,000 will be repaid even if

the bank is bankrupt Decreases incentive to withdraw funds on rumors

No significant bank panics since 1934 With less risk, depositors pay less attention to whether

banks are making prudent investments In the 1980s, many savings and loan associations

went bankrupt Cost the taxpayers hundreds of billions of dollars

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The Federal Reserve System The Fed is the central bank of the US Responsible for monetary policy and the oversight

and regulation of financial markets Monetary policy is deciding and managing the size of

the nation's money supply Money supply is controlled indirectly

Open-market purchase of government bonds from the pubic by the Fed increases bank reserves and the money supply

Open-market sale of government bonds by the Fed to the public decreases reserves and money supply

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Open Market Operations When the Fed purchases a bond from the public Fed pays bond holder with new money

Receipts are deposited and this leads to a multiple expansion of the money supply

When the Fed sells a bond to the public Bondholder pays with checking funds

Bank reserves decrease and this leads to a multiple contraction of the money supply

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Increasing the Money Supply An economy has 1,000 shekels in currency and bank

reserves of 200 shekels Reserve-deposit ratio = 0.2 Money supply = 1,000 + (200 / 0.2) = 2,000 shekels

Central bank pays 100 shekels for a bond held by the public Assume that all 100 shekels are deposited Money supply = 1,000 + (300/ 0.2) = 2,500 shekels 100 shekel increase in reserves leads to a 500

shekel increase in the money supply

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Money and Prices In the long run, the amount of money circulating and

the level of prices are closely linked Sustained high inflation rates occur with a

comparably high growth rate of the money supply

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Velocity of Money (V) Velocity is the speed money changes hands in

transaction for final goods and services

Nominal GDP is the price level (P) times real GDP (Y) M is the money supply

Velocity = Nominal GDPMoney supply

V = PY M

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Velocity in the US, 2007 M1 = $1,364.2 billion M2 = $7,447.1 billion Nominal GDP = $13,843.0 billion Using M1, velocity is 10.15

Using M2, velocity is 1.86

Velocity is determined by a number of factors including technology such as ATMs and debit cards

V = $13,843.01,364.2 = 10.15

V = $13,843.07, 447.1 = 1.86

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Money and Inflation in the Long Run Quantity equation states MV = PY Restatement of the velocity definition The quantity equation relates the money supply to price

levels Suppose velocity and real GDP are constant

The quantity equation becomes

An increase in the money supply by a given percentage would increase prices by the same percentage

V and Y, respectively

M V = P Y

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Approximating a Percentage Change

M V = P Y% change in (M V) = % change in (P Y)

The percentage change in a product is the sum of the percentage changes in each variable

Consequently % change in M + % change in V ≈

% change in P + % change in Y If the M grows 4% per year and V grows 1% per year,

nominal GDP (P Y) grows approximately 5% per year If Y grows 3% per year, then the percentage change

in price is approximately 2% per year

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The Financial System, Money, and PricesD

iver

sific

atio

n Money

Reserves

Financial System

Banks

Bonds

Stocks

Federal Reserve System

Open Market Operations

Quantity Equation