Principles of macroeconomics 10e by case fair oster ch10

Commodity and Fiat Monies Measuring the Supply of Money in the United States The Private Banking System How Banks Create Money A Historical Perspective: Goldsmiths The Modern Banking Sys

T E N T H E D I T I O N

The Money Supply

and the Federal Reserve System

An Overview of Money

What Is Money?

Commodity and Fiat Monies Measuring the Supply of Money in the United States The Private Banking System

How Banks Create Money

A Historical Perspective: Goldsmiths The Modern Banking System

The Creation of Money The Money Multiplier

The Federal Reserve System

Functions of the Federal Reserve Expanded Fed Activities Beginning in 2008 The Federal Reserve Balance Sheet

How the Federal Reserve Controls the Money Supply

The Required Reserve Ratio The Discount Rate

Open Market Operations Excess Reserves and the Supply Curve for Money

Looking Ahead

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Money is a means of payment, a store of value, and a unit of account

barter The direct exchange of goods and services for other goods and services

medium of exchange, or means of payment What sellers generally accept and buyers generally use to pay for goods and services

An Overview of Money

What Is Money?

A Means of Payment, or Medium of Exchange

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Which field of economic theory does not require that we know anything about money?

unit of account A standard unit that provides a consistent way of quoting prices

An Overview of Money

What Is Money?

A Store of Value

A Unit of Account

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Which of the following refers to the liquidity property of money?

a The fact that money makes a good medium of exchange

b The fact that money is portable and comes in convenient

denominations

c The fact that money is readily accepted and thus easily

exchanged for goods

d All of the above

Which of the following refers to the liquidity property of money?

a The fact that money makes a good medium of exchange

b The fact that money is portable and comes in convenient

denominations

c The fact that money is readily accepted and thus easily

exchanged for goods

d All of the above.

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commodity monies Items used as money that also have intrinsic value in some other use

fiat, or token, money Items designated as money that are intrinsically worthless

legal tender Money that a government has required to be accepted in settlement of debts

currency debasement The decrease in the value of money that occurs when its supply is increased rapidly

An Overview of Money

Commodity and Fiat Monies

In most countries commodity monies are not

used anymore, but the world is a big place

and there are exceptions

In the Solomon Islands, dolphin teeth are

being used as a means of payment and a

store of value

Note that even with a currency like dolphin

teeth there is a concern about counterfeit

currency, namely fruit-bat teeth, but also

tooth decay

Dolphin Teeth as Currency

E C O N O M I C S I N P R A C T I C E

Shrinking Dollar Meets Its Match in Dolphin Teeth

Wall Street Journal

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M1, or transactions money Money that can be directly used for transactions

M1 ≡ currency held outside banks + demand deposits +

traveler’s checks + other checkable deposits

An Overview of Money

Measuring the Supply of Money in the United States

M1: Transactions Money

near monies Close substitutes for transactions money, such

as savings accounts and money market accounts

M2, or broad money M1 plus savings accounts, money market accounts, and other near monies

M2 ≡ M1 + savings accounts + money market accounts +

other near monies

An Overview of Money

Measuring the Supply of Money in the United States

M2: Broad Money

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When you transfer $1,000 from your checking account to your savings account, this transaction will:

a Decrease both M1 and M2

b Decrease M1 and increase M2

c M1 will remain the same and M2 will increase

d M2 will remain the same and M1 will decrease

a Decrease both M1 and M2.

b Decrease M1 and increase M2

c M1 will remain the same and M2 will increase

d M2 will remain the same and M1 will decrease.

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There are no rules for deciding what is and is not money

This poses problems for economists and those in charge of economic policy

An Overview of Money

Measuring the Supply of Money in the United States

Beyond M2

An Overview of Money

The Private Banking System

The main types of financial intermediaries are commercial banks, followed by savings and loan associations, life insurance companies, and pension funds

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run on a bank Occurs when many of those who have claims on a bank (deposits) present them at the same time

How Banks Create Money

A Historical Perspective: Goldsmiths

Today’s bankers differ from goldsmiths—today’s banks are subject to

a “required reserve ratio.”

Goldsmiths had no legal reserve requirements, although the amount they loaned out was subject to the restriction imposed on them by their fear of running out of gold

Federal Reserve Bank (the Fed) The central bank of the United States.

How Banks Create Money

The Modern Banking System

A Brief Review of Accounting

reserves The deposits that a bank has at the Federal Reserve bank plus its cash on hand

required reserve ratio The percentage of its total deposits that a bank must keep as reserves at the Federal Reserve

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The balance sheet of a bank must always balance, so that the sum of assets (reserves and

loans) equals the sum of liabilities (deposits and net worth)

 FIGURE 10.1 T-Account for a Typical Bank (millions of dollars)

How Banks Create Money

The Modern Banking System

A Brief Review of Accounting

On the T-account of a bank:

a Reserves are on the liability side

b Deposits are an important liability

c Assets plus net worth equal liabilities

d Assets are usually greater than liabilities plus net worth

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On the T-account of a bank:

a Reserves are on the liability side

b Deposits are an important liability.

c Assets plus net worth equal liabilities

d Assets are usually greater than liabilities plus net worth

excess reserves ≡ actual reserves − required reserves

In panel 2, there is an initial deposit of $100

In panel 3, the bank has made loans of $400.

 FIGURE 10.2 Balance Sheets of a Bank in a Single-Bank Economy

How Banks Create Money

The Creation of Money

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In panel 1, there is an initial deposit of $100 in bank 1 In panel 2, bank 1 makes a loan of $80

by creating a deposit of $80 A check for $80 by the borrower is then written on bank 1 (panel 3)

and deposited in bank 2 (panel 1) The process continues with bank 2 making loans and so on.

In the end, loans of $400 have been made and the total level of deposits is $500

 FIGURE 10.3 The Creation of Money When There Are Many Banks

How Banks Create Money

The Creation of Money

required

1multiplier

How Banks Create Money

The Money Multiplier

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Assuming there are no leakages out of the banking system, a money multiplier equal to 10 means that:

a The reserve ratio equals 10

b An additional $10 of reserves create one dollar of deposits

c Each additional dollar of deposits creates $10 of reserves

d Each additional dollar of reserves creates $10 of additional deposits

a The reserve ratio equals 10.

b An additional $10 of reserves create one dollar of deposits

c Each additional dollar of deposits creates $10 of reserves

d Each additional dollar of reserves creates $10 of additional deposits.

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 FIGURE 10.4 The Structure of the Federal Reserve System

The Federal Reserve System

Federal Open Market Committee (FOMC) A group composed of the seven

members of the Fed’s Board of Governors, the president of the New York

Federal Reserve Bank, and four of the other 11 district bank presidents on a

rotating basis; it sets goals concerning the money supply and interest rates

and directs the operation of the Open Market Desk in New York

Open Market Desk The office in the New York Federal Reserve Bank from

which government securities are bought and sold by the Fed

The Federal Reserve System

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From a macroeconomic point of view, the Fed’s crucial role is to control the money supply

The Fed also performs several important functions for banks, such as clearing interbank payments, regulating the banking system, and

assisting banks in a difficult financial position

The Fed is also responsible for managing exchange rates and the nation’s foreign exchange reserves

It is often involved in intercountry negotiations on international economic issues

lender of last resort One of the functions of the Fed: It provides funds to troubled banks that cannot find any other sources of funds

The Federal Reserve System

Functions of the Federal Reserve

The Federal Reserve System

Expanded Fed Activities Beginning in 2008

When housing prices began to fall in late 2005, the stage was set for a worldwide financial crisis, which essentially began in 2008

There has been much political discussion of whether the Fed should have regulated more in 2003–2005 and whether it should be

intervening in the private sector as much as it has been doing

It is certainly the case that the Fed has taken a much more active role

in financial markets since 2008

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TABLE 10.1 Assets and Liabilities of the Federal Reserve System, June 30, 2010

(Billions of Dollars)

Gold $ 11 $ 945 Currency in circulation

U.S Treasury securities 777 970 Reserve balances

Federal agency debt securities 165 288 U.S Treasury deposits

Mortgage-backed securities 1,118 170 All other liabilities and net worth

All other assets 302 $2,373 Total

Total $2,373

The Federal Reserve System

The Federal Reserve Balance Sheet

If the Fed wants to increase the supply of money, it creates more reserves,

thereby freeing banks to create additional deposits by making more loans If it

wants to decrease the money supply, it reduces reserves

Three tools are available to the Fed for changing the money supply:

(1) Changing the required reserve ratio

(2) Changing the discount rate

(3) Engaging in open market operations

How the Federal Reserve Controls the Money Supply

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The preferred tool of the Federal Reserve for conducting monetary policy involves:

a Changes in the reserve requirement

b Changes in the discount rate

c Open market operations

d Government spending and taxation

a Changes in the reserve requirement.

b Changes in the discount rate

c Open market operations.

d Government spending and taxation

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TABLE 10.2 A Decrease in the Required Reserve Ratio from 20 Percent to 12.5 Percent

Increases the Supply of Money (All Figures in Billions of Dollars)

Panel 1: Required Reserve Ratio = 20%

Government $200 $100 Reserves Reserves $100 $500 Deposits

securities $100 Currency Loans $400

Note: Money supply (M1) = Currency + Deposits = $600.

Panel 2: Required Reserve Ratio = 12.5%

Government $200 $100 Reserves Reserves $100 $800 Deposits

securities $100 Currency Loans

(+ $300) $700 (+ $300)

Note: Money supply (M1) = currency + deposits = $900.

How the Federal Reserve Controls the Money Supply

The Required Reserve Ratio

The result is a decrease in the money supply

How the Federal Reserve Controls the Money Supply

The Required Reserve Ratio

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discount rate The interest rate that banks pay

to the Fed to borrow from it

How the Federal Reserve Controls the Money Supply

The Discount Rate

moral suasion The pressure that in the past the Fed exerted on member banks to discourage them from borrowing heavily from the Fed

TABLE 10.3 The Effect on the Money Supply of Commercial Bank Borrowing from the Fed (All

Figures in Billions of Dollars)

Panel 1: No Commercial Bank Borrowing from the Fed

Securities $160 $80 Reserves Reserves $80 $400 Deposits

$80 Currency Loans $320

Note: Money supply (M1) = currency + deposits = $480.

Panel 2: Commercial Bank Borrowing $20 from the Fed

Securities $160 $100 Reserves

(+ $20) Reserves(+ $20) $100 $500 Deposits(+ $300)

Loans $20 $80 Currency Loans

(+ $100) $420 $20 Amount owed to Fed (+ $20)

Note: Money supply (M1) = currency + deposits = $580.

How the Federal Reserve Controls the Money Supply

The Discount Rate

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open market operations The purchase and sale by the Fed of government securities in the open market;

a tool used to expand or contract the amount of reserves in the system and thus the money supply

How the Federal Reserve Controls the Money Supply

Open Market Operations

The Treasury Department is responsible for collecting taxes and paying the federal government’s bills

The Fed is not the Treasury It is a quasi-independent agency

authorized by Congress to buy and sell outstanding

(preexisting) U.S government securities on the open market

Two Branches of Government Deal in Government Securities

If the Fed wants to increase the money supply, it will:

a Increase the discount rate

b Increase the reserve requirement

c Buy government securities in the open market

d Print money

e Sell gold

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If the Fed wants to increase the money supply, it will:

a Increase the discount rate

b Increase the reserve requirement

c Buy government securities in the open market.

d Print money

e Sell gold

TABLE 10.4 Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the

Differences between Those Panels and Panel 1 All Figures in Billions of Dollars)

Panel 1

Assets Liabilities Assets Liabilities Assets Liabilities

Note: Money supply (M1) = Currency + Deposits = $180.

Panel 2

Assets Liabilities Assets Liabilities Assets Liabilities

Securities

( $5) $95 $15 Reserves( $5) Reserves( $5) $15 $95 Deposits( $5) Deposits($5) $0 $0 Debts

(+ $5) $5 $5 Net Worth

Note: Money supply (M1) = Currency + Deposits = $175.

Panel 3

Assets Liabilities Assets Liabilities Assets Liabilities

Securities

( $5) $95 $15 Reserves( $5) Reserves( $5) $15 $75 Deposits( $25 ) Deposits( $5) $0 $0 Debts

( $20) $60 Securities(+ $5) $5 $5 Net Worth

Note: Money supply (M1) = Currency + Deposits = $155.

How the Federal Reserve Controls the Money Supply

Open Market Operations

The Mechanics of Open Market Operations

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■ An open market purchase of securities by the Fed results in an increase in reserves and an increase

in the supply of money by an amount equal to the money multiplier times the change in reserves

■ An open market sale of securities by the Fed results in a decrease in reserves and a decrease

in the supply of money by an amount equal to the money multiplier times the change in reserves

We can sum up the effect of these open market operations this way:

How the Federal Reserve Controls the Money Supply

Open Market Operations

The Mechanics of Open Market Operations