money and money supply - class1

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Saving, Investment,and the Financial System Premium

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N. Gregory Mankiw

Macroeconomic

s

Principles of

Sixth dition

!"


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##

In this chapter,

look for the answers to these questions:

What assets are considered money? What arethe functions of money? The types of money?

What is the Federal Reserve?

What role do banks play in the monetarysystem? How do banks create money?

How does the Federal Reserve control the

money supply?


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$$

Money

the set of assets in an economy that people

reularly use to buy oods and services from

other people


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%%

What Money Is and Why Its Important

Without money! trade would re"uire barter!the e#chane of one ood or service for another$

%very transaction would re"uire a double

coincidence of wants&the unlikely occurrence

that two people each have a ood the other wants$

'ost people would have to spend time searchinfor others to trade with&a hue waste of

resources$ This searchin is unnecessary with money!

the set of assets that people reularly use to buyoods ( services from other people$


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&&

The 3 Functions of Money

Medium of exchange) an item buyers ive to sellerswhen they want to purchase oods ( services

*n the absence of money! there will be hue number of

prices$ +umber of prices ,

money! the number of prices will be same as the

number of oods

Unit of account) the yardstick people use to post

prices and record debts

Store of value) an item people can use to transferpurchasin power from the present to the future


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""

The 2 Kinds of Money

Commodity money)

takes the form of a commoditywith intrinsic value

%#amples) old coins!ciarettes in -.W camps

Fiat money)

money without intrinsic value!

used as money because ofovt decree

%#ample) the /$0$ dollar


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''

The Money Supply

The money supply 1or money stock2)the "uantity of money available in the economy

What assets should be considered part of themoney supply? Two candidates)

Currency) the paper bills and coins in the

hands of the 1non3bank2 public

Demand deposits) balances in bank accounts

that depositors can access on demand bywritin a check


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((

Measures of the U.S. Money Supply

M1) currency ( demand deposits!

'4 , 54$6 trillion 1February 78442

M) everythin in '4 plus time deposits!

'9 , 5:$6 trillion 1February 78442


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))

Central an!s " Monetary #olicy

Central bank) an institution that oversees thebankin system and reulates the money supply

Monetary policy) the settin of the moneysupply by policymakers in the central bank

Federal !eserve "Fed#) the central bank of the/$0$


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!*!*

The Structure of the Fed

The Federal Reserve 0ystem

consists of) $oard of %overnors

1; members2!located in Washinton! d of ovs andpresidents of some of the reional Fed banksThe F.'= decides monetary policy$

Ben S. BernankeChair of FOMC,

Feb 2006 present


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!!!!


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!#!#

Clic!er $uestion

>en >ernanke@$ Has a beard$

>$ *s reyin$

=$ *s the =hairman of the Federal .pen 'arket=ommittee$


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!$!$

an! %eser&es

*n a fractional reserve banking system!

banks keep a fraction of deposits as reservesand use the rest to make loans$

The =entral >ank establishes reserve

re(uirements! reulations on the minimumamount of reserves that banks must hold aainstdeposits$

>anks 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 percentae of total deposits


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!%!%

an! T'(ccount

)*account) a simplified accountin statement

that shows a bankAs assets ( liabilities$ %#ample)

F+!S) ,-)+',-. $-,/

-ssets .iabilities

Reserves 5 48

Boans 5 68

anksA liabilities include deposits!assets include loans ( reserves$

*n this e#ample! notice that R, 548C5488 , 48D$


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!&!&

an!s and the Money Supply) (n *+ample

0uppose 5488 of currency is in circulation$To determine banksA impact on money supply!we calculate the money supply in 9 different cases)

1$ +o bankin system

&$ 488D reserve bankin system)

banks hold 488D of deposits as reserves!

make no loans

$ Fractional reserve bankin system


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!(!(


C-S0 ) Fractional reserve bankin system


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#*#*



*f R, 48D for 0+>! it will loan all but 48D of the

deposit$

S0C',D ,-)+',-. $-,/

-ssets .iabilities

Reserves 5 68

Boans 5 8

orrower deposits the 568 at 0econd +ational >ank$

*nitially! 0+>As

T3account

looks like this)

6

:4


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#!#!



*f R, 48D for T+>! it will loan all but 48D of the

deposit$

)+!D ,-)+',-. $-,/

-ssets .iabilities

Reserves 5 :4

Boans 5 8

As borrower deposits the 5:4 at Third +ational

>ank$

*nitially! T+>As

T3account

looks like this)

5 :$48

5;7$68


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####


C-S0 ) Fractional reserve bankin systemThe process continues! and money is created with

each new loan$

.riinal deposit ,

F+> lendin ,

0+> lendin ,T+> lendin ,$$$

5488$88

568$88

5:4$88

5;7$68$

$$

In this

example,$100 of

reserves

generates$1000 of

money


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#$#$

The Money Multiplier

*t refers to the factor by which money supplye#pands based on a iven monetary base$ *n

other words! it refers to the mathematical

relationshipbetween the monetary baseand

money supplyof an economy$

'oney multiplier e#plains the increase in the

amountof money in circulationbased on the

banksG abilityto lend moneyout of theirdepositorsG funds$
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#%#%

The Money Multiplier

The money multiplier e"uals 4CR$ *n our e#ample!

R, 48D

money multiplier , 4CR, 48

5488 of reserves creates 54888 of money


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#&

an!an!deposits

deposits

currency

currency


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#'#'

Credit creation -y -an!in, system

>alance sheet of >ankin system

Biabilities @ssets

>ank @

-rimary deposits 488 Boans 68

Reserves 48 >ank >

+ew deposits 68 loans :4

Reserves 6

>ank =

+ew deposits :4 loans ;7$6 ) Reserves :$4

Total deposits )

of bankin system 4888 total assets 4888


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#(

Credit Creation


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$*

#u-lic


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$!$!

!s

$ank

A i


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$#

Assumptions Fractional reserve banking system

Demand deposit only

,o excess reserves

,o cash leakage


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$&$&

2ublic !s

$ank

First !ound

!s3&44


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$'

Second %oundSecond %ound


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%*

Third %oundThird %ound

)hi d ! d


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%!%!

2ublic

!s

$ank

)hird !ound

!s3&44

!s3154

!s311&35

!s3154

!s311&354

)hi d ! d


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2ublic

!s

$ank

)hird !ound

!s3&44

!s3154

!s311&354

!s3154

!s311&354

!s367374


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/th %ound/th %ound

,th ! d


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2ublic

!s

$ank

,th!ound

!s3&44

!s3154

!s311&354

!s3154

!s311&354

!s367374

!s36737

4!s38343

3

3

3

,th ! d


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2ublic

!s3

$ank

,th!ound

!s3&44

!s3154

!s311&354

!s3154

!s311&35

!s367374

!s36737!s38343

3

3

3


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CreditCreation4st round ) Rs$7887nd round ) Rs$4J8

9rd round ) Rs$447$J8

Kth round ) Rs$:K$K8

Jth round ) Rs$L9$98

Lth round ) $

;th round ) $


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Credit Creation

Total?


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Calculation of Credit Creation

>ank multiplier , 4Re"uired reserve ratio

Total deposit increment, initial deposit # bankin multiplier

!s3

$ank


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!s3

$ank


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, 47JD

>ank multiplier ,4

Re"uired reserve ratio

, K


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Total deposit increment

, initial deposit # bankin multiplier

Total deposit increment

, Rs$788 # K, Rs$:88

The ma#imum amountof deposit created

is Rs +00


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A C T I V E L E A R N I N G 0


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A C T I V E L E A R N I N G 0an!s and the money supply



While cleanin your apartment! you look under thesofa cushion and find a 5J8 bill 1and a half3eaten

taco2$ Mou deposit the bill in your checkin account$

The FedAs reserve re"uirement is 78D of deposits$

-3 What is the ma#imum amount that themoney supply could increase?

$3 What is the minimum amount that themoney supply could increase?


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A C T I V E L E A R N I N G 0


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A C T I V E L E A R N I N G 0(nsers



@nswer) 58

*f your bank makes no loans from your deposit!

currency falls by 5J8! deposits increase by 5J8!

money supply does not chane$

Mou deposit 5J8 in your checkin account$-3 What is the ma#imum amount that the

money supply could increase?

@nswer) 5788

$3 What is the minimum amount that themoney supply could increase?


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Clic!er $uestion

*n a 488D reserve bankin system! the moneymultiplier is

@$ 8$

>$ 48$

=$ 4$


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( More %ealistic alance Sheet


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( More %ealistic alance Sheet

M'!0 !0-.+S)+C ,-)+',-. $-,/

-ssets .iabilities

Reserves 5 788

Boans 5 ;88

0ecurities 5 488


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1e&era,e (mplies #rots and 1osses

M'!0 !0-.+S)+C ,-)+',-. $-,/

-ssets .iabilities

Reserves 5 788

Boans 5 ;88

0ecurities 5 4J8


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1e&era,e and the Financial Crisis

*n the financial crisis of 788:N7886! banks

suffered losses on mortae loans and mortae3

backed securities due to widespread defaults$

'any banks became insolvent)

*n the /$0$! 7; banks failed durin 7888N788;!4LL durin 788:N7886$


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1e&era,e and the Financial Crisis

'any other banks found themselves with too little

capital! because the market bean to e#pect that

their profits would be poor$ =onse"uently! the

value of their stock was bid down$

*n order to reconcile their balance sheets! banksresponded by reducin lendin$ This caused a

credit crunch$

The -e,innin, of a credit crunch


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The -e,innin, of a credit crunch

M'!0 !0-.+S)+C ,-)+',-. $-,/

-ssets .iabilities

Reserves 5 788

Boans 5 J88

0ecurities 5 488


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The o&ernments %esponse

To ease the credit crunch! the Federal Reserve

and /$0$ Treasury inOected hundreds of billions of

dollarsA worth of capital into the bankin system$

This unusual policy temporarily made /$0$

ta#payers part3owners of many banks$


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4o the Fed In5uences


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4o the Fed In5uences%eser&es *f the Fed buys a bond! the bank swaps its bond

for an e"uivalent amount in currency$

The bond canAt be broken up and loaned out! but

the e"uivalent amount in currency can$

0ome of the currency is retained as reserves! the

rest is loaned out and e#pands accordin to the

money multiplier$

This is how the Fed can increase the moneysupply by swappin its cash for a bond held by a

bank$

4o the Fed In5uences


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4o the Fed In5uences%eser&es The Fed makes loans to banks! increasin their

reserves$ Traditional method) adOustin the discount rate

&the interest rate on loans the Fed makes tobanks&to influence the amount of reservesbanks borrow

+ew method) !erm "#tion Faility&the Fedchooses the "uantity of reserves it will loan! then

banks bid aainst each other for these loans$ The more banks borrow! the more reserves they

have for fundin new loans and increasin themoney supply$

4 th F d I 5 th % % ti


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4o the Fed In5uences the %eser&e %atio

Recall) reserve ratio , reservesCdeposits!

which inversely affects the money multiplier$

The Fed sets reserve re(uirements) reulations

on the minimum amount of reserves banks must

hold aainst deposits$Reducin reserve re"uirements would lower thereserve ratio and increase the money multiplier$

0ince 48C788:! the Fed has paid interest onreserves banks keep in accounts at the Fed$

Raisin this interest rate would increase the

reserve ratio and lower the money multiplier$

# -l C t lli th M S l


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#ro-lems Controllin, the Money Supply

*f households hold more of their money ascurrency! banks have fewer reserves!make fewer loans! and money supply falls$

*f banks hold more reserves than re"uired!

they make fewer loans! and money supply falls$

Met! Fed can compensate for householdand bank behavior to retain fairly precise control

over the money supply$

an! %uns and the Money


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ySupply @ run on banks)

When people suspect their banks are in trouble!they may run to the bank to withdraw their funds!holdin more currency and less deposits$

/nder fractional3reserve bankin! banks donAthave enouh reserves to pay off @BB depositors allat once! hence banks may have to close$



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ySupply This can happen even if the bank is not bankrupt!

meanin that the assets are e"ual in value to theliabilities$ The problem is that many of the assetsare in illi(uidform! such as loans that canAt becalled in instantaneously$ These assets canAt beconverted to cash "uickly enouh to satisfy thedemand for withdrawals$



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ySupply >anks that fear runs may make fewer loans and

hold more reserves to satisfy depositors$

These events increase R! reverse the process ofmoney creation! cause money supply to fall$



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ySupply


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Clic!er $uestion

Reducin R! the reserve re"uirement

@$ 'akes monetary policy more powerful andreduces the likelihood of a bank run$

>$ 'akes monetary policy less powerful andreduces the likelihood of a bank run$

=$ 'akes monetary policy less powerful andincreases the likelihood of a bank run$


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Monetary #olicy and the Fed Funds %ate


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o e a y o cy a d e ed u ds a e

To raise fed funds

rate! Fed sellsovt bonds 1.'.2$

This removesreserves from the

bankin system!reduces supply offederal funds!

causes rf to rise$

rf


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S U M M - ! ;

'oney serves three functions) medium ofe#chane! unit of account! and store of value$

There are two types of money) commoditymoney has intrinsic valueU fiat money does not$

The /$0$ uses fiat money! which includescurrency and various types of bank deposits$

2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, ecept !or use asper"itted in a license distributed with a certain product or service or otherwise on a password#protected website !or classroo" use.

S U M M - ! ;


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S U M M - ! ;

*n a fractional reserve bankin system! bankscreate money when they make loans$ >ankreserves have a multiplier effect on the moneysupply$

>ecause banks are hihly leveraed! a smallchane in the value of a bankAs assets causes alare chane in bank capital$ To protect

depositors from bank insolvency! reulatorsimpose minimum capital re"uirements$

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S U M M - ! ;


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S U M M - ! ;

The Federal Reserve is the central bank of the/$0$! is responsible for reulatin the monetarysystem$

The Fed controls the money supply mainlythrouh open3market operations$ -urchasinovt bonds increases the money supply! sellinovt bonds decreases it$

*n recent years! the Fed has set monetary policyby choosin a taret for the federal funds rate$

money and money supply - class1

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