The big picture marcoeconomics 12e parkin chapter 08

This chapter defines money, introduces the Federal Reserve, explains the money creation process, and then concentrates on the long run effects the quantity theory of changes in the quant

T h e B i g P i c t u r e

Where we have been:

Chapters 6 and 7 focused on the markets for labor and capital, both real resources used in the production of real GDP This chapter now shifts gears to study money and how money impacts markets Because Chapter 8 is the first chapter on money, it introduces a lot of new material The discussion of the market for money relates back to the supply and demand model in Chapter 3

Where we are going:

Chapter 8 is the first of two chapters that examine money and the economy This chapter defines money, introduces the Federal Reserve, explains the money creation process, and then concentrates on the long run effects (the quantity theory) of changes in the quantity of money Chapter 14 returns to these topics to study monetary policy Chapter 8 also is the 3rd of 4 chapters that cover the economy in the long run The next chapter looks at the

exchange rate and balance of payments

N e w i n t h e Tw e l f t h E d i t i o n

An At Issue feature discusses fractional reserve requirements and the history of supporters of 100 percent reserve banking The data and figures in the chapter are updated to reflect 2014 data The section “What Do Depository Institutions Do” has been slightly modified to more clearly define commercial bank assets The Economics In The News feature has a 2014 article about banks preparing for deposit outflows in 2015 with the Fed relaxing quantitative easing The Worked Problem at the end of the chapter gives data about the amount of currency, checkable deposits, savings deposits, time deposits, and money market mutual funds and other deposits in June 2014 The students are asked to calculate of M1, M2, the monetary base, the currency drain and banks’ reserve ratio, and the M1 and M2 money multipliers To include the new Worked Problem without

lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications These problems are in the MyEconLab and are called Extra Problems

8 MONEY, THE PRICE LEVEL, AND

C h a p t e r

19

Money, the Price Level, and Inflation

• Money is anything that is used as a means of payment

• Banks play a major role in creating money but this process is ultimately controlled

by the Federal Reserve

• In the short run, equilibrium in the money market determines the nominal interest rate

• In the long run, an increase in the growth rate of the quantity of money leads to a higher inflation rate

I What Is Money?

The contrast between money in economics and money in everyday language It

can be helpful to emphasize that “money” is a technical term in economics that has a precise meaning and that differs from its looser usages in everyday language For

example, an economist would not say “Bill Gates makes a lot of money.” Rather, the economist would say “Bill Gates earns a large income.” An interesting exercise is to have students think of statements containing the word “money” that make complete sense in normal language but that misuse the word in its precise economic sense, and to get them

to explain why

payment A means of payment is a method of settling a debt Money has three

functions:

• Medium of exchange

• Unit of account

• Store of value

Medium of Exchange

A medium of exchange is any object that is generally accepted in exchange for goods and services Money acts as a medium of exchange As a result, money eliminates the

need for barter, which is the exchange of goods and services directly for other goods

and services

The defining characteristic of money Adam Smith wrote, “Money is a commodity or

token that everyone will accept in exchange for the things they have to sell.” Most people have interpreted this statement as defining money as the medium of exchange That interpretation is wrong Smith is defining money as the means of payment Money is a commodity or token that everyone will accept as payment for the things they have to sell When Michael Parkin was a young economist, he had the enormous good fortune to meet Anna Schwartz, Milton Friedman, and a group of other leading monetary economists It was during the late 1960s when the monetarist debate was alive and well and people were still arguing about whether the demand for money was interest inelastic (as the monetarists claimed) or almost perfectly elastic (as the Keynesians claimed) Anna made a remark that for Michael was one of those defining moments She said money is the means of payment Nothing else performs this function It is unique to money Many things serve as a medium

of exchange, unit of account, or store of value, but money alone serves as the means of payment—the means of settling a debt so that there is no remaining obligation between the parties to a transaction

Get the class involved in figuring out what money is To involve the students in the

process of determining what money is, after noting its definition and three functions, ask

them what they think should be counted as money List the suggestions on the board

before commenting on them Coins and currency will certainly be mentioned Usually each class has a few members who have read the text and will suggest checkable deposits

Almost always you will obtain some not-so-excellent answers, ranging from gold to shares

of stock to credit cards

The point of this exercise is to obtain these incorrect answers because they give you a

chance to discuss why these items are not money Without ridiculing the wrong answers,

you might point out that students rarely pay for books by giving the bookstore shares of

IBM stock and asking for change in AT&T stock By being involved and having to think, the students emerge with a stronger grasp of why money is measured as it is

Unit of Account

Money serves as a unit of account, which is an agreed measure for stating the prices of goods and services

Store of Value

Money serves as a store of value because it can be held and exchange later for goods and services

During the Great Depression there was deflation so the real return on money was positive Thus, many people held money as an asset and did not immediately use it to spend on goods and services This is the idea behind Keynes’ concern that people were stuffing money in their mattresses instead of spending it Concerns about deflation have been revived in recent years Japan has had deflation on and off for the past decade and many other countries have very low rates of inflation One of the more interesting suggestions by Fed economists in thinking how to avoid the problem of money serving so well as a store of value is to have money which expires like a coupon It is not clear whether such a form of money is feasible from a political or psychological point of view, but the suggestion is

interesting

Money in the United States Today

• Money consists of currency (the notes and coins held by individuals and

businesses) and deposits at banks and other depository institutions Deposits are also money because they can be converted into currency and because they are used

to settle debts

individuals and businesses

funds and other deposits M2 is much larger than M1, $11,423 billion versus $2,857 billion in June, 2014 M2 includes liquid assets that are not means of payment

Liquidity is the property of being instantly convertible into a means of payment with

little loss in value The assets in M2 are generally quite liquid

• Checks are not money—they are instructions to transfer money from one person’s deposits to another person’s deposits Credit cards are not money—they are IDs that allow an instant loan

Fiat money Pull out a dollar bill, wave it at the class and ask, “What backs our currency?”

You should get someone to state gold Tell them, “Yes, I have heard about all the gold

stored in Fort Knox, but none of it is there for a trade-in value We went off the gold

standard with Nixon If you look closely at the bill you’ll find your backing, “In God we trust,” That’s it! The dollar has value because of your faith that someone else will accept it for something else you want Alternatively (or additionally) take a green piece of paper and cut it to the same size as a dollar bill Then take the paper into class along with a dollar bill Ask the students why one piece of paper has value and the other does not Is there anything intrinsically more valuable about the dollar bill? If not, why won’t someone in class exchange his or her old wrinkled piece of green paper with writing on it for the nice new piece you offer?

II Depository Institutions

• A firm that takes deposits from households and firms and makes loans to other

households and firms is called a depository institution There are three types of

depository institutions whose deposits are money: commercial banks, thrift

institutions, and money market mutual funds

Commercial Banks

• A commercial bank is a firm that is licensed to receive deposits and make loans In

2014 there are about 6,800 commercial banks but that number has been trending

downward The deposits of commercial banks account for 50 percent of M1 and 71

percent of M2

• Banks accept deposits and then divide these funds into reserves (cash in the vault

plus its deposits at the Federal Reserve), liquid assets (such as Treasury bills and

commercial bills), securities (such as U.S government bonds and mortgage-backed securities), and loans (made primarily to corporations for purchases of capital

equipment and to households to finance homes, consumer durable goods, and credit cards) Loans are the riskiest of a bank’s assets As a percentage of deposits, on June

30, 2014 cash assets were 28.0 percent, securities were 27.6 percent, and loans

were 75.4 percent (The percentages sum to more than 100 percent because

deposits are just one source of funds; borrowing and the banks’ own capital are

other sources of funds and are equal to about 50 percent of deposits.)

Because of concerns about the financial crisis and bank runs, banks increased their

reserves from the more typical 0.6 percent of deposits in June 2008 to 14.3 percent in June,

2010 and to 28.0 percent in June, 2014

Thrift Institutions

The thrift institutions are savings and loan associations, savings banks, and credit

unions

Money Market Mutual Funds

A money market mutual fund is a fund operated by a financial institution that sells

shares in the fund and holds liquid assets such as U.S Treasury bills and short-term

commercial bills

The Economic Functions of Depository Institutions

• Depository institutions make a profit from the spread on the interest rate at which

they lend over the interest rate they pay on deposits The spread reflects four

services provided by depository institutions:

• Create Liquidity: Most assets are less liquid than liabilities, so depository

institutions turn less-liquid funds into more liquid funds

A bank run is a liquidity crisis in the sense that banks can have the deposits backed by

assets such as mortgage loans, but the assets are less liquid than the deposits This

scenario should be familiar to anyone who has seen It’s a Wonderful Life with Jimmy

Stewart As suggested by the movie, bank runs were a big problem in the 1930s and many economists believe they made the Great Depression much worse than other recessions

Indeed, banks runs were feared by the Federal Reserve during the financial crisis of 2008

and this fear likely accounted one reason why the Fed responded so strongly to the crisis

• Lower the Cost of Borrowing Obtaining Funds: Depository institutions lower

transaction costs of matching borrowers and lenders

• Lower the Cost of Monitoring Borrowers: Depository institutions lower transaction costs by specializing in monitoring risky loans

• Pool Risk: The costs of defaults on loans are spread across all depositors, instead

of being borne by individual lenders

What do banks do? Students usually have bank accounts, but often they have never fully

thought through what banks do, how they do it, or what the differences are between banks and other deposit-taking institutions, so what tends to strike instructors as rather dry

descriptive material can be interesting to students It is worth being explicit about the fact,

which students tend to be very aware of, that in practice commercial banks earn income not only by the spread between their deposit and lending rates, but also by charging fees for their services The text focuses on the role of depository institutions as a source of credit creation; for most students, like most customers, their most important function is actually facilitating the payment process, and a little discussion on that (and how relatively cheap it is) can also engage students

Financial Innovation

• The development of new financial products is called financial innovation Some

innovation has been a response to economic circumstances such as high inflation and high interest rates in the 1970s Others, such communications networks which have spread the use of credit cards, are the result of advances in technology Still others, such as sub-prime mortgages, were developed during the 2000s

III The Federal Reserve System

The central bank of the United States is the Federal Reserve System A central bank is

a bank’s bank and a public authority that regulates a nation’s depository institutions and

controls the quantity of money The Fed conducts the nation’s monetary policy, which

means that it adjusts the quantity of money in circulation By adjusting the quantity of

money, the Fed can change interest rates

Conspiracy theory of the Fed Some students will have heard about a “conspiracy

theory of the Fed.” This theory, advanced by the ignorant, the misinformed, or the

deceitful, is that the commercial banks own the Fed, which is run solely to benefit the

banks to ensure that they earn large profits Point out that commercial banks do indeed

own the Fed—they own all the stock issued by the Fed But Fed stock is not like shares in

General Electric or Microsoft The dividend on the Fed’s stock is fixed at 6 percent of the

purchase price, and the stock cannot be sold in a marketplace So this stock is a lousy

investment

What privileges come with the stock? Commercial banks elect six of the nine directors of

their Federal Reserve Regional bank; each commercial bank has the same number of votes regardless of the amount of stock it owns But the directors of the regional banks are

hardly key players in the Federal Reserve System Essentially, the most important task

they perform is nominating a president for the regional bank The regional banks’

presidents are important The directors, however, do not get much freedom in this choice

because their nominee must be approved by the Board of Governors, which does not

hesitate to veto anyone considered unacceptable

Regional bank presidents gain their power from sitting on the FOMC But there they are a

minority because the voting members of the FOMC consist of five regional bank presidents and seven members of the Board of Governors Because the board members are appointed

by the president and approved by the Senate, the government thus wields the ultimate

power in the Federal Reserve The regional bank presidents must be approved by the

publicly appointed board members and the board members constitute a majority on the

FOMC

The Structure of the Fed

• The Board of Governors has seven members, including the chairman (currently Ben Bernanke)

• There are 12 regional Federal Reserve banks

• The Federal Open Market Committee (FOMC) is the main policy-making group of

the Fed It is comprised of the members of the Board of Governors and the Presidents

of the regional Federal Reserve Banks The Board of Governors, the President of the Federal Reserve Bank of New York, and, on a rotating basis, the presidents of four

other regional Federal Reserve Banks, vote on monetary policy In practice, the

chairman has the largest influence on policy

The Fed’s Balance Sheet

• The Fed’s two main assets are U.S government securities and loans to depository

institutions

• The Fed’s two main liabilities are Federal Reserve notes (currency) and banks’

deposits

The Economics in Action detail discusses how the Fed’s balance sheet changed

dramatically as a result of the financial crisis in 2008 U.S government securities soared

from less than $1,000 billion to approximately $2,500 billion and currency from less than

$1,000 trillion to approximately $1,300 trillion Banks now hold almost $3,000 billion

reserves The monetary base quadrupled in size!

• The monetary base is the sum of coins, Federal Reserve notes, and depository

institution deposits at the Fed The major parts of the monetary base, Federal

Reserve notes and depository institution deposits, are liabilities of the Federal

Reserve Changes in the monetary base lead to changes in the quantity of money

The Fed’s Policy Tools

• Required Reserve Ratios: The minimum percentage of deposits that depository

institutions must hold as reserves are the required reserve ratios The Fed sets

the required reserve ratio A decrease leads to an increase in the quantity of money and an increase leads to an increase in the quantity of money

• Last Resort Loans: The Fed is the lender of last resort, which means that if

depository institutions are short of reserves, they can borrow from the Fed The

interest rate charged on these loans is the discount rate In 2008 the Fed changed

its policy and encouraged depository institutions to borrow from it A decrease in the discount rate leads to an increase in the quantity of money and an increase in the discount rate leads to a decrease in the quantity of money

• Open Market Operation: An open market operation is the purchase or sale of

government securities by the Federal Reserve System in the open market The Fed does not directly purchase bonds from the federal government because it would appear that the government was printing money to finance its expenditures An open market purchase leads to an increase in the money supply

IV How Banks Create Money

Creating Deposits by Making Loans

When a bank makes a loan, it makes a deposit to finance the loan Because deposits are money, the bank has created money For example, if you use a credit card to buy $50 at Walgreens, loans to you increase and Walgreens deposits increase The increase in deposits increases the quantity of money Three factors limit the amount of deposits that the

banking system can create:

• The monetary base: Banks have a desired amount of reserves they want to hold and people have a desired amount of currency The monetary base sets a limit on the sum of these two Both of these desired holdings depend on the quantity of money, and so the monetary base limits the amount of money that can be created

Alternatively, the monetary base limits the amount of the banking systems’

reserves

• Desired reserves: A bank’s actual reserves are the coin and currency in its vault

and its deposits at the Federal Reserve The fraction of a bank’s total deposits that

are held in reserves is called the reserve ratio The desired reserve ratio is the

ratio of reserves to deposits that banks want to hold Actual reserves minus desired

reserves are excess reserves Excess reserves can be loaned and can thereby

create money

• Desired currency holding: The other use of the monetary base involves the public’s holding it as currency When banks create new money by creating new deposits, the public wants to hold some of this money as currency As a result, currency leaves the banking system when banks increase their loans, which limits the overall increase in

loans The currency drain is the ratio of currency to deposits.

• Banks use excess reserves to make loans In the process, banks create money

• For each dollar deposited, a bank keeps a fraction as reserves and lends out the rest When a bank makes a loan, it creates a new deposit (new money) equal to the value of the loan After the loan is spent by the borrower, the new money eventually ends up back as a new deposit in a bank As new deposits are made, the process of money creation begins again, albeit with a smaller amounts each time because banks keep a fraction of each deposit in the form of reserves

• The total of amount of new money created by the entire banking system depends on the fraction of the deposits that banks loan at each step in the process

The Money Creation Process

• The monetary base increases and banks have excess reserves Banks lend the

excess reserves and thereby create new deposits, that is, create new money

• The new money is used to make payments Some of the new money remains in the banking system as deposits and some of it is drained out of the banking system via the currency drain

• The funds that stay within the banking system are reserves for the banks Because deposits have increased, banks’ desired reserves have increased But the actual

reserves have increased by more than desired reserves, so banks still have excess

reserves to loan Banks lend these excess reserves and the process continues

• Eventually the money creation process comes to a stop when the sum of additional currency holdings plus additional desired reserves equals the initial increase in the

monetary base and banks’ reserves

• The money multiplier is the ratio of the change in the quantity of money to the

change in the monetary base It determines the change in the quantity of money

that results from a given change in the monetary base A change in the monetary

base has a multiplied effect on the quantity of money because banks’ loans are

deposited in other banks where they are loaned once again The formula for the

money multiplier is derived in the Mathematical Note to the chapter (see the end of these lecture notes)

A money creation experiment The process through which banks “create money” can

be a dark and mysterious secret to the students Indeed, even though the text contains a

superb description of the process, students still manage to end up confused

The first prerequisite to students understanding the process is that they be comfortable

with balance sheets shown in the form of T-accounts, and it is well worth spending time on them to make sure students understand what they are and what they show This will be the first time some students have ever had to interpret a balance sheet, and it is key that they understand that assets are what are owned, liabilities are what are owed, by the institution for which the balance sheet is constructed; and that the two sides must balance

Mark Rush (our study guide author and supplements czar) tackles the problem of getting

students to understand bank money creation head-on by (again) involving the class in a

demonstration Prepare by decorating a piece of green paper with currency-like symbols

(For instance, Mark draws a seal and around it writes “In Rush We Trust.” You may write the same slogan, but substituting your name for his probably will be more effective; an

alternative is to use “play money.”) Label this piece of paper a “$100 bill.”

In class use one of the students by handing him the bill Tell him that he has decided to

deposit it in his bank and ask him his bank’s name On the chalkboard draw a balance

sheet for the bank with deposits of $100, reserves of $10, and loans of $90 Tell the

students that the required reserve ratio is 10 percent, so this bank currently has no excess reserves Now, instruct the student to deposit the money in his bank, which coincidentally

happens to be run by the student next to him Show the class what happens to the balance sheet and how the bank now has excess reserves of $90

Clearly the “banker” will loan these reserves to the next student in the class, who wants a

$90 dollar loan so she can take a bus ride to some nearby dismal location (Being located

in Gainesville, Florida, Mark picks on the city of Stark, home to Florida’s electric chair and a town with an apt name.) When the loan takes place, rip the $100 bill so that only about

nine tenths of it is given as the loan This student pays the money to Greyhound—

coincidentally the next student Ask the name of Greyhound’s bank and draw an initial

balance sheet for this bank identical to the initial balance sheet of the first bank

Greyhound deposits the money in the bank—the next student in the row

Work with the balance sheets to show what happens to the first bank and what happens to the second bank Clearly the first one no longer has excess reserves but the second bank now has $81 of excess reserves ($90 of additional deposits minus $9 of required reserves) The second bank will make a loan, which you can act out with more students in the class, again ripping off nine tenths of the remaining bill Work through the point where the

second loan winds up deposited in a third bank and then stop to take stock At this point the quantity of money has increased by $90 in the second bank and $81 in the third, for a total increase—so far—of $171 The students will see that this loaning and reloaning process is not yet over and that the quantity of money will increase by still more Moreover (and more important) the students will grasp how banks “create money.”

An Economics in the News detail defines, describes, and analyzes QE2, that is, the second round of quantitative easing the occurred in 2011