Frank & Bernanke 2ndFrank & Bernanke 2nd

Ch. 10: Money, Prices, and the Ch. 10: Money, Prices, and the Federal ReserveFederal Reserve

What Is Money?What Is Money?

Does Bill Gates have a lot of money?Does Bill Gates have a lot of money?Does LeBron James make a lot of money?Does LeBron James make a lot of money?Anything accepted by a community in Anything accepted by a community in

exchange of goods and services and for exchange of goods and services and for settlements of debts.settlements of debts.

Functions of MoneyFunctions of Money

Unit of accountUnit of account Increase in variety of goods requires a Increase in variety of goods requires a

common unit to quote and compare prices.common unit to quote and compare prices.3 goods: 2 prices3 goods: 2 prices4 goods: 6 prices4 goods: 6 prices5 goods: 24 prices5 goods: 24 pricesN goods: (n-1)! PricesN goods: (n-1)! Prices

Money had to be invented.Money had to be invented.

Functions of MoneyFunctions of Money

Medium of exchangeMedium of exchangeBarter requires double coincidence of wants.Barter requires double coincidence of wants.Exchange makes both parties better-off.Exchange makes both parties better-off.Money had to be invented.Money had to be invented.

Functions of MoneyFunctions of Money

Store of ValueStore of ValuePostponing consumption by storing wealth in Postponing consumption by storing wealth in

an asset for future use.an asset for future use.Today we have many different assets for Today we have many different assets for

wealth storage.wealth storage.Depending on the ability of these assets to be Depending on the ability of these assets to be

easily converted to cash (liquidity) these easily converted to cash (liquidity) these assets are near or far to “money.”assets are near or far to “money.”

Financial Assets Savers Can HoldFinancial Assets Savers Can Hold

CurrencyCurrency Checking accountChecking account Savings accountSavings account Certificate of DepositCertificate of Deposit Foreign currencyForeign currency BondsBonds StocksStocks Options on stocks, bonds, foreign currencyOptions on stocks, bonds, foreign currency

Futures on commodities, foreign currencyFutures on commodities, foreign currency

Assets According to LiquidityAssets According to Liquidity

CurrencyCurrencyChecking AccountChecking AccountSavings AccountSavings AccountMoney Market Mutual FundMoney Market Mutual FundBondsBonds

Measuring MoneyMeasuring Money

http://research.stlouisfed.org/publications/mt/page16.pdf

In billions of dollars

Measuring MoneyMeasuring Money

Banks and the Creation of MoneyBanks and the Creation of Money

When depositors put money in the bank, When depositors put money in the bank, the bank turns around and loans part of the bank turns around and loans part of the money to others.the money to others.

Both the depositor and the borrower have Both the depositor and the borrower have funds to spend.funds to spend.

Money has been created.Money has been created.

Banks and the Creation of MoneyBanks and the Creation of Money

We will show the changes in assets and We will show the changes in assets and liabilities of a bank in response to deposit liabilities of a bank in response to deposit and loan activities.and loan activities.

Deposits into checking accounts are Deposits into checking accounts are liabilities of a bank.liabilities of a bank.

Cash is an asset.Cash is an asset.Assets = Liabilities for a Balance Sheet to Assets = Liabilities for a Balance Sheet to

be in balance.be in balance.

Creation of MoneyCreation of Money

Ally deposits $1000 into her checking Ally deposits $1000 into her checking account with First National.account with First National.

First National holds only 10% as reserves First National holds only 10% as reserves and loans the rest to Billy.and loans the rest to Billy.

Billy buys a snow blower for $900 from Billy buys a snow blower for $900 from Carl.Carl.

Carl deposits $900 with Second National.Carl deposits $900 with Second National.Second National loans how much to Second National loans how much to

Deyna if it also holds 10% as reserves?Deyna if it also holds 10% as reserves?

Creation of MoneyCreation of Money

If this process goes on for thirty rounds, If this process goes on for thirty rounds, how much checking deposits will be in the how much checking deposits will be in the banking system?banking system?

1000 + 1000(.9) + 1000(.9)(.9)+…1000 + 1000(.9) + 1000(.9)(.9)+…+1000(.9)^+1000(.9)^3030

1000 + 900 + 810 + … + 0.041000 + 900 + 810 + … + 0.041000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10]1000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10]

Creation of MoneyCreation of Money

The banking system used the initial The banking system used the initial deposit of $1000 as the reserves and deposit of $1000 as the reserves and multiplied it by (1/reserve ratio) to create multiplied it by (1/reserve ratio) to create checking deposits for the economy.checking deposits for the economy.

What would be the deposits created by the What would be the deposits created by the same $1000 deposit, if the banks kept 5% same $1000 deposit, if the banks kept 5% as the reserve ratio?as the reserve ratio?

Narrow Money, M1Narrow Money, M1

M1 is defined as currency outside of the M1 is defined as currency outside of the banks plus bank deposits.banks plus bank deposits.

Monetary Base is defined as Currency + Monetary Base is defined as Currency + Reserves.Reserves.

Measuring MoneyMeasuring Money

•What was the amount of currency in January 2005?•What was the amount of bank deposits in January 2005?•What was the reserve ratio in January 2005?

The Federal Reserve SystemThe Federal Reserve System

The Central Bank of the United States.The Central Bank of the United States.The Fed is responsible for monetary The Fed is responsible for monetary

policy.policy.Amount of money supplied to the system.Amount of money supplied to the system.Affects interest rates, inflation, unemployment Affects interest rates, inflation, unemployment

and exchange rates.and exchange rates.The Fed oversees and regulates the The Fed oversees and regulates the

financial markets.financial markets.

The FedThe Fed

Fed was established in 1913 in the hopes Fed was established in 1913 in the hopes of eliminating banking panics of the 19th of eliminating banking panics of the 19th century by providing credit to the financial century by providing credit to the financial markets.markets.

In order to disperse power 12 regional In order to disperse power 12 regional Federal Reserve Banks were formed.Federal Reserve Banks were formed.

The seven members of the Board of The seven members of the Board of Governors are appointed by the President Governors are appointed by the President for 14-year terms every other year.for 14-year terms every other year.

Monetary PolicyMonetary Policy

Federal Open Market Committee (FOMC) Federal Open Market Committee (FOMC) is the group that sets the monetary policy.is the group that sets the monetary policy.

Fed Chairman (4-year term) plus Fed Chairman (4-year term) plus governors, plus NY Fed President, plus 4 governors, plus NY Fed President, plus 4 Presidents of Fed banks comprise FOMC.Presidents of Fed banks comprise FOMC.

FOMC meets eight times a year.FOMC meets eight times a year.

Controlling the Money SupplyControlling the Money Supply

Open-Market Operations: buying and selling of Open-Market Operations: buying and selling of financial assets.financial assets. Buying government bonds from the public increases Buying government bonds from the public increases

bank reserves, hence money supply.bank reserves, hence money supply. Selling bonds decreases money supply.Selling bonds decreases money supply.

Discount window lending: Lending to banks that Discount window lending: Lending to banks that increases bank reserves.increases bank reserves.

Changing reserve requirements: Raising Changing reserve requirements: Raising reserve-deposit ratio decreases money supply.reserve-deposit ratio decreases money supply.

Primary Credit RatePrimary Credit Rate

http://research.stlouisfed.org/publications/mt/page9.pdf

Open-Market OperationOpen-Market Operation

Suppose an economy has $100 currency, Suppose an economy has $100 currency, $100 reserves and 0.1 as reserve-deposit $100 reserves and 0.1 as reserve-deposit ratio.ratio.

What is the money supply?What is the money supply? If the Central Bank purchased $5 worth of If the Central Bank purchased $5 worth of

bonds, what will be the money supply?bonds, what will be the money supply? If the CB sold $10 worth of bonds, what If the CB sold $10 worth of bonds, what

will be the money supply?will be the money supply?

The Great DepressionThe Great Depression

The Fed did not prevent the Great The Fed did not prevent the Great Depression.Depression.

Both currency held by the public and Both currency held by the public and reserve-deposit ratio rose, reducing reserve-deposit ratio rose, reducing money supply.money supply.

The Fed increased the reserves but not The Fed increased the reserves but not enough.enough.

Lack of enough reserves forced bank Lack of enough reserves forced bank bankruptcies.bankruptcies.

MONETARY STATISTICS DURING GREAT DEPRESSIONCurrency rr Reserves M1

Dec-29 3.85 0.075 3.15 45.9Dec-30 3.79 0.082 3.31 44.1Dec-31 4.59 0.095 3.11 37.3Dec-32 4.82 0.109 3.18 34.0Dec-33 4.85 0.133 3.45 30.8

Frank, R. H. and Ben S. Bernanke, Principles of Macroeconomics, 2nd ed. (McGraw-Hill, 2004), p. 273.

Money and Price LevelMoney and Price Level

In the long run, prices adjust to pressures In the long run, prices adjust to pressures in the economy.in the economy.

The “quantity theory of money” captures The “quantity theory of money” captures the long-run relationship.the long-run relationship.

MV = PY

Quantity TheoryQuantity Theory

M is money stock, like M1 or M2.M is money stock, like M1 or M2.V is velocity, the number of times money V is velocity, the number of times money

stock exchanges hands in creating the stock exchanges hands in creating the nominal GDP.nominal GDP.

P is price level, like 1.00 or 1.26 (price P is price level, like 1.00 or 1.26 (price index)index)

Y is real GDP.Y is real GDP.PY is nominal GDP.PY is nominal GDP.

Long Run InflationLong Run Inflation

In the long-run, the economy will operate In the long-run, the economy will operate at full-employment; so Y will not change if at full-employment; so Y will not change if there is no growth. If there is growth, then there is no growth. If there is growth, then Y is predictable: Y is known.Y is predictable: Y is known.

Velocity is also thought predictable in the Velocity is also thought predictable in the long-run.long-run.

Therefore, any growth in money supply will Therefore, any growth in money supply will be reflected in inflation.be reflected in inflation.