introduction to macroeconomics chapter 26 money, banking and the federal reserve
TRANSCRIPT
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Introduction to Macroeconomics
Chapter 26
Money, Banking and
the Federal Reserve
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Money, Banking, & the Federal Reserve
1. Barter Economy
2. Characteristics of Money
3. Definition of Money
4. Fractional Reserve Banking
5. How Banks Create Money
6. Federal Reserve Policy Tools
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1. Barter Economy Transaction Costs
Barter - direct trade of one good for another
Transaction Costs:– double coincidence of wants– problem of divisibility– negotiating relative values
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2. Characteristic of Money General Characteristics
• Medium of Exchange - item generally acceptable as payment for goods and services. Avoids double coincidence of wants.
• Store of Value - money can be accumulated without deterioration or loss. No problem with divisibility.
• Unit of Account - money is a standard unit for quoting prices and establishing relative values. Reduces negotiation costs.
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2. Characteristics of Money Commodity Money
• Characteristics:– scarce relative to other commodities– stable in supply– portable– divisible– durable
• Problems:– opportunity cost– debasing (Gresham’s Law)– can’t directly control supply
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2. Characteristics of Money Representative Money
Paper money that can be exchanged for a specific commodity, like silver or gold.
Advantages:• Lower opportunity cost• Eliminates debasing
Problems:• Depends on value of underlying commodity• Counterfeiting
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2. Characteristics of Money Fiat Money
Paper money that is solely money because the government says it is
Generally not backed by a valuable commodity such as god but is backed by the “full faith and credit of the government”
Advantages:• No opportunity cost• Not dependent on value of a commodity
Disadvantages• No restraint in printing money
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3. Definitions of Money Categorized by Liquidity
Liquidity - how easily money can be used to make purchases
• Monetary Base - currency held by public + currency held in bank vaults (reserves)
• M1 = currency held by public plus checking deposits
• M2 = M1 + savings deposits + small (less than $100,000) time deposits (CDs)
• M3 = M2 + large (more than $100,000) time deposits
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3. Definitions of Money M1
Source: Federal Reserve, H-6 Statistical Release, Table 4, September 2001.
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3. Definitions of Money M2
Source: Federal Reserve, H-6 Statistical Release, Table 5, September 2001.
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4. Fractional Reserve Banking
• Banks hold reserves (cash in their vault) that are only a fraction of their demand deposits (e.g., checking and savings accounts)
• Banks make a profit by charging a higher interest rate for loans than is paid for deposits.
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4. Fractional Reserve Banking Risks
Risks:
• Bank runs
• Bank failures because of bad loans
Institutions to reduce risks:
• FDIC deposit insurance
• Federal Reserve System bank regulations
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4. Fractional Reserve Banking Key Measurements
Demand Deposits (D) - total of checking and savings account
Required Reserve Ratio (r) - fraction of D established by Federal Reserve
Required Reserves, RR = r * D
Total Reserves = cash in bank vaults
Excess Reserves = Total Reserves - RR
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5. How Banks Create Money Money Multiplier
• Money Multiplier = 1 / r
• Maximum Possible Increase in Money Supply= Initial change in monetary base
x money multiplier
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5. How Banks Create Money Money Multiplier at Work
Cash Held by
individuals (C)
Cash in Bank Vault (R)
Total Demand Deposits
(D)
Required Reserves
(RR = r * D)
Excess Reserves (R – RR)
M1 Money Supply (C + D)
Federal Reserve Holds $100 Cash 0 0 0 0 0 0
Fed buys $100 T-Bill from individual A 100 0 0 0 0 100
Individual A deposits $100 in checking account
0 100 100 20 80 100
Bank loans excess reserves to person B 80 20 100 20 0 180
B deposits cash in checking account 0 100 180 36 64 180
Bank loans excess reserves to person C 64 36 180 36 0 244
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6. Federal Reserve Policy Tools The Federal Reserve System
C om m erc ia l b an ksan d o th er d ep os ito ry
in s titu tion s
2 5 F ed era l R eserveB ran ch B an ks
1 2 F ed era l R eserve B an ks O p en M arke t C om m itteeBoard of G overn ors p lu s 5 Fed eral
Reserve Ban k p resid en ts, altern atin gterm s, New York always rep resen ted
F ed era l A d visory C ou n c il12 com m ercial b an kers
for 12 d istricts
F ederal R eserveB oard of G overnors
7 m em b ers ap p oin tedb y th e P resid en t
Created by act of Congress in 1913
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6. Federal Reserve Policy Tools Policy Options
• Open Market Operations - buy and sell T-Bills
• Discount Rate - interest rate charged by Fed for overnight loans to banks
• Required Reserve Ratio
• Stock Market Margin Requirements
• Moral Persuasion
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6. Federal Reserve Policy Tools Open Market Operations
Open Market Operation - purchase or sale of government securities (T-bills) on the open market
• T-Bill Par Value: cash-in value when T-Bill matures
• Interest Rate - difference between par value of T-Bill and and purchase price
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6. Federal Reserve Policy Tools Expansionary Policy
• Objective: Lower Interest Rate
• Fed buys T-Bills (increase in money supply)
• Market price of T-Bills increase
• Difference between market price and par value declines.
• Result: Lower interest rate
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6. Federal Reserve Policy Tools Open Market Operations
Purchase T-Bills Sell T-Bills
From Bank
From Public
From Bank
From Public
Change in Monetary Base + + - -
Initial Change in Money Supply n/c + n/c -
Max Change in Money Supply 1 / r 1 / r - 1 / r - 1 / r
Bond Prices + + - -
Interest Rate - - + +
Investment / Aggregate Demand + + - -
+ represents increase, - represents decrease
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6. Federal Reserve Policy Tools Summary of Policy Options
Expansionary Policy
Contractionary Policy
Objectives:
Interest rate Lower Higher
Money Supply Higher Lower
Policies:
Open market operation Buy T-Bills Sell T-Bills
Discount rate Reduce Increase
Required reserves Reduce Increase
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6. Federal Reserve Policy Tools Money and the Unemployment Rate
0
50
100
150
200
250
Jan-18
Jan-23
Jan-28
Jan-33
Jan-38
Jan-43
Jan-48
Jan-53
0
5
10
15
20
25
30
Un
em
plo
ym
en
t ra
te, p
erc
en
t
Ratio: Reserves-to-Required Reserves
Unemployment Rate
Monetary Base