money, prices, and the federal reserve

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Money, Prices, and the Federal Reserve

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Copyright c 2007 by The McGraw-HillCompanies, Inc. All rights reserved.

Chapter 10: Money, Prices, and the Federal Reserve Slide 2

Introduction

MoneyAny asset that can be used in making

purchasesExamples

CurrencyCoinsChecks

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Money and Its Uses

BarterThe direct trade of goods or services for

other goods or services

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Money and Its Uses

Medium of ExchangeAn asset used in purchasing goods and

services

Unit of AccountA basic measure of economic value

Store of ValueAn asset that serves as a means of holding

wealth

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Money and Its Uses

M1Sum of currency outstanding and balances

held in checking accounts

M2All the assets in M1 plus some additional

assets that are usable in making payments but at greater cost or inconvenience than currency or checks

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Components of M1 and M2, April 2005 (billions of dollars)

M1CurrencyDemand depositsOther checkable depositsTravelers’ checks

M2M1Savings depositsSmall-denomination time depositsMoney market mutual funds

1,354.6704.6318.5324.0

7.5

6,469.71,354.63,544.3

866.2704.6

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Commercial Banks and the Creation of Money

The Money Supply at ChristmasCurrency = 500Bank reserves = 500Reserve-deposit ratio = 0.20Money supply = 500 + 500/.20 =

500 + 2,500 = 3,000

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The Money Supply at ChristmasIf Xmas shoppers withdraw 100Money supply = 600 + 400/.20 =

600 + 2,000 = 2,600

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The Money Supply at ChristmasObservation

When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money supply by $5.

In general, when people make withdraws, the money supply contracts by a multiple of the withdrawal.

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The Federal Reserve System

Two Main ResponsibilitiesMonetary policyOversight and regulation of financial

markets

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The History and Structure of the Federal Reserve SystemFounded by the Federal Reserve Act of

1913The primary mission of the Fed is to

promote economic growth, low inflation, and stable financial markets.

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The Structure12 regional Federal Reserve banks

Assess economic conditions in their regions to assist in national policymaking

Provide service to the commercial banks in their districts

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The StructureBoard of Governors

Seven governorso Appointed by the president and confirmed by the

Senate to 14 year staggered terms

Chairman of the Board of Governorso Selected by the president from the governorso Serves a four year term

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The StructureFederal Open Market Committee (FOMC)

Members include:o The seven Fed governorso President of the New York Fedo Four presidents, chosen on a rotating basis, from the

remaining Federal Reserve BanksDetermines monetary policy

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Controlling the Money Supply: Open-Market OperationsThe primary function of the Fed is

monetary policy.The Fed controls the money supply by

changing the supply of bank reserves.

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Controlling the Money Supply: Open-Market OperationsOpen-market operations are the most

important method of changing the supply of bank reserves.

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Open-Market OperationsOpen-market purchases and open-market

sales

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Open-Market PurchaseThe purchase of government bonds from

the public by the Fed for the purpose of increasing the supply of bank reserves and the money supply

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Increasing The Money SupplyThe Fed purchases government bonds

from the public.The people deposit the funds they get from

their sale of bonds to the Fed.The increase in deposits increase bank

reserves.

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Increasing The Money SupplyThe increase in reserves will lead to an

expansion of the money supply as banks make more loans.

RecallThe change in the money supply is a multiple of

the change in reserves.

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Open-Market SaleThe sale by the Fed of government bonds

to the public for the purpose of reducing bank reserves and the money supply

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Reducing The Money SupplyThe Fed sells government bonds to the

public.The Fed presents the checks from the sale

of the bonds to the banks for payment.

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Reducing The Money SupplyThe bank’s reserves will fall when they

clear the checks.The money supply will fall by a multiple of

the decrease in reserves.

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ExampleIncreasing the money supply by open-

market operationsCurrency = 1,000 shekelsReserves = 200Reserve-deposit ratio = 0.2

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ExampleIncreasing the money supply by open-

market operationsMoney supply = 1,000 + 200/0.2 = 2,000 shekelsOpen market purchase = 100Reserves increase to 300Money supply = 1,000 + 300/0.2 = 2,500 shekels

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The Fed’s Role in Stabilizing Financial Markets: Banking PanicsSuppose:

Depositors lose confidence in their bank.They attempt to withdraw their funds.Bank may not have enough reserves (fractional)

to meet the depositors demand.The bank fails and further erodes depositor

confidence which triggers additional failures.

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The Fed’s Role in Stabilizing Financial Markets: Banking PanicsThe Fed to the rescue:

Instill confidenceDiscount lendingOpen Market Operations

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Economic NaturalistThe banking panics of 1930 - 1933 and the

money supplyOne-third of U.S. banks closedDepositors withdrew their fundsBanks raised the reserve-deposit ratio

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Key U.S. MonetaryStatistics, 1929-1933

Currency Reserve-deposit Bank Moneyheld by public ratio reserves supply

December 1929 3.85 0.075 3.15 45.9December 1930 3.79 0.082 3.31 44.1December 1931 4.59 0.095 3.11 37.3December 1932 4.82 0.109 3.18 34.0December 1933 4.85 0.133 3.45 30.8

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Economic NaturalistIn response to the panics of 1929-1933,

deposit insurance was established in 1934.Deposit insurance gives depositors an

incentive to keep their money in the banks.Deposit insurance reduces the incentive for

depositors to pay attention to the financial strength of their bank.

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What Do You Think?Why worry about the money supply?

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Money and Prices

VelocityA measure of the speed at which money

changes hands in transaction involving final goods and services

stockMoney GDP Nominal

stockMoney nstransactio of Value Velocity

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Money and Prices

VelocityA measure of the speed at which money

changes hands in transaction involving final goods and services

M x YP

supply)(money MGDP) (real x Y level) (price P (V)Velocity

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Money and Prices

Velocity in 2004M1 = $1,367.3 billionM2 = $6,428.4 billionNominal GDP = $11,734.3 billion

8.58 billion $1,367.3billion $11,734.3 V M1,

1.83 billion $6,428.4billion $11,734.3 V M2,

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Money and Prices

Money and Inflation in the Long RunRecall

MY x P V

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Money and Prices

Money and Inflation in the Long RunQuantity equation

M x V = P x YAssume V & Y are constant over the time

period

Y x P V x M

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Money and Prices

Money and Inflation in the Long RunIf the Fed increases M by 10%, then prices

must increase by 10%.High rates of money growth are associated

with high rates of inflation (too much money chasing too few goods).

Y x P V x M

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Money and Prices

What Do You Think?If high rates of money growth lead to

inflation, why do countries allow their money supplies to rise quickly?

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End ofChapter

money, prices, and the federal reserve

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