Chapter 31 - Money and the monetary system. In this chapter you will learn: What the main functions of money are and what makes something a good choice for money? How to explain the concept of fractionalreserve banking and the money multiplier? What role the central bank plays and what the Federal Reserve’s (Fed) dual mandate is?...
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Chapter 31
Money and the Monetary System
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• What the main functions of money are and
what makes something a good choice for
money
• How to explain the concept of
fractional-reserve banking and the money multiplier
• What role the central bank plays and what the
Federal Reserve’s (Fed) dual mandate is
• How the Fed conducts monetary policy
• How monetary policy affects interest rates, the
money supply, and the broader economy
What will you learn in this chapter?
• Moneyis the set of all assets that are regularly
used to directly purchase goods and services
1 Store of value:Money represents a certain amount of
purchasing power
2 Medium of exchange: Money can be used to
purchase goods and services.
good or service for another good or service.
3 Unit of account:Money provides a standard unit of
comparison.
What is money? Functions of money
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certain money better than others
• Stability of value:
– Early versions of money generally took the form of a
physical material that was durable and had intrinsic
value.
– Money does not need intrinsic value to maintain
stability.
• Convenience:
– Technology has allowed for the development of more
convenient forms of money.
coins
What makes for good money?
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• Any form of money that can be legally
exchanged into a fixed amount of an
underlying commodity is commodity-backed
money.
– The most common underlying commodity is gold.
• Money created by rule, without any
commodity backing it, is fiat money.
– U.S currency is backed only by the trust that the
government will keep the value of money relatively
constant.
Commodity-backed money versus fiat money
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• Paper money made it possible for banks to
create money through a process called
fractional-reserve banking.
• The primary way that banks earn money is
through lending a fraction of deposited funds
and collecting interest on those loans
that can be withdrawn by depositors at any time,
without advance notice.
Banks and the money-creation process
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on hand
amount of demand deposits at the bank to the
amount kept as cash reserves
–Required reservesis the amount that a bank is
legally required to keep on hand.
–Excess reserves is any additional amount that a
bank chooses to keep beyond the required
reserves.
Banks and the money-creation process
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The money creation process occurs through banks repeatedly
accepting deposits and lending out a fraction of the deposits.
Banks and the money-creation process
Original deposit of 1,000 gold coins
Total deposits = 1,000 gold coins + 900 gold coins = 1,900 gold coins
Deposit of
900 more gold coins
100 gold coins
held on reserve
(10% of original deposit)
900 gold coins loaned out (90% of original deposit)
One
Assets Liabilities
The bank loans out 90%
of its new deposits Assets Liabilities
The loan is deposited in
the bank
Assets Liabilities Bank makes its first loan Assets Liabilities
Original deposit
The above process increases money by $900
Banks and the money-creation process
Loan: $900 Required
$100 Deposit: $1,000
Loan: $900
New cash
deposit: $900
Required
$100
Cash: $1,000 Deposit: $1,000
Deposit: $1,900 Loans: $1,710
Required
$190 Deposit: $1,900
A simple way to account for a bank’s transactions is by using
T-account formatting to record changes in banks assets and
liabilities.
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A bank accepts a $1,000 deposit If the bank has
a reserve ratio of 20% and loans out the rest,
find the change in assets and liabilities
Active Learning: Money creation
Loans: $2,000
Required
reserves
$500 Deposit: $2,500
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repeated cycles of lending and depositing of
funds
• The money multiplieris the ratio of money
created by the lending activities of the banking
system to the money created by the central bank:
less than 100% of their deposits on reserves
Banks and the money-creation process
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Use the money multiplier equation to fill in the
blanks in the following table
Active Learning: The money multiplier
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available in the economy
– The money supply is managed by the Fed.
• The Fed classifies different types of money by
their liquidity
– The monetary base includes cash and bank
reserves, sometime referred to as hard money.
–M1includes cash plus checking account balances
–M2includes M1 plus savings accounts and other
financial instruments.
Measuring money
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Hard money M2
0
1
2
4
5
7
8
9
10
1984 1989 1994 1999 2004 2009
Trillions of U.S dollars
Hard money, M1, and M2 over time
• M1 indicates liquidity.
• M2 indicates savings.
• M2 is a measure of the money multiplier when compared to the monetary base.
M1
Each measure provides a distinct understanding
of the financial system
Measuring money
for managing the nation’s money supply and
coordinating the banking system
• In the U.S., the central bank is the Federal
Reserve, which has been mandated by Congress
to conduct monetary policy to perform two
essential functions:
1 Manage the money supply.
2 Act as a lender of last resort.
the central bank to manage the money supply
Managing the money supply
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The Federal Reserve System has a seven-member Board of Governors
and twelve regional banks that collectively act as the central bank of
the U.S.
Managing the money supply
San
Francisco
Dallas
Kansas City Chicago
St.
Louis
Atlanta Richmond
Cleveland Philadelphia
Boston NewYork Board of Governors, ashington D.C.
Minneapolis
W
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presidents serve on the Federal Open Market
Committee, or FOMC
– Carries full responsibility for setting the overall
direction of monetary policy and guiding the money
supply.
– Ensuring price stability : Enacting monetary policy that
meets the needs of the economy while keeping prices
constant over time.
– Maintaining full employment : Enacting monetary
policy that keeps the economy strong and stable.
Managing the money supply
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• The Fed achieves these mandates by managing
the money supply through three main tools
1 Thereserve requirementis the amount of money
banks must hold in reserve.
2 The discount window is the lending facility that
allows banks to borrow reserves from the Fed.
• The discount rateis the interest rate charged by the Fed
for loans through the discount window.
3 Open-market operations are sales or purchases of
government bonds by the Fed to or from banks
on the open market.
Tools of monetary policy
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• These transactions directly impact the money supply.
–Contractionary monetary policy is when money supply is
decreased to lower aggregate demand.
–Expansionary monetary policyis when money supply is
increased to raise aggregate demand.
• Open market operations also affect the inter-bank
lending market, the federal funds market.
– The federal funds rateis the interest rate at which banks
lend reserves to one another.
• The Fed affects the federal funds rate through
changes in the supply of reserves by conducting
contractionary and expansionary monetary policy.
Tools of monetary policy
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• The liquidity-preference model
refers to the idea that the quantity of money people want to hold is a function of the interest rate.
– This means the money demand curve slopes downward.
– The Fed sets the money supply, which means the money supply curve is set by monetary policy.
The economic effects of monetary policy
Monetary demand
Monetary supply
r*
Q*
Interest rate, r
Quantity of money
The liquidity-preference model
in the interest rate.
and lending, which can have significant impacts on the economy.
Interest rate, r
MD
MS*
Shifts in the money supply curve
The liquidity-preference model explains how the
Fed’s actions can change interest rates
The economic effects of monetary policy
MSc MSe
rc
r*
re
• Expansionary monetary policy results in a higher
quantity of money and
lower interest rates.
• Contractionary monetary policy results in a lower
quantity of money and
higher interest rates.
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For each of the following situations, indicate the
effect (increase or decrease) on the money
supply and interest rate
Active Learning: The money supply
Situation
Change in money supply Change in interest rate The Federal Reserve
conducts open-market
bond purchases.
The Federal Reserve sells
government bonds on the
open market.
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Expansionary monetary policy
AD2 Interest rate, r
Quantity of money
Money demand MS1
Q1
r1
Expansionary monetary policy
Y2 P2
Price level
Real GDP
LRAS
AD1 Y1
SRAS Expansionary monetary policy and the AD/AS model
P1 MS2
Q 2
r2
• During a recession, expansionary
monetary policy decreases the interest
rate.
• Cheaper to borrow and less rewarding
to save money.
• The aggregate demand curve shifts out.
• Price and output increase.
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Interest rate, r
Quantity of money
MD
MS 1
Q 1
Contractionary monetary policy
MS 2
Q 2
r2
Contractionary monetary policy
• During overheating, contractionary
monetary policy increases the interest
rate.
• More expensive to borrow and
encourages saving.
• The aggregate demand curve shifts in.
• Prices and output decrease.
r1
1
AD2
Contractionary monetary policy and the AD/AS model Price level
Real GDP
LRAS
P
Y1
SRAS
AD1 P
Y2
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• The Fed faces time lags
and imperfect
information.
before the Fed’s actions
make their impact.
policy could make
economic conditions
worse.
The economic effects of monetary policy
• The Fed does not have to wait for politicians to come
to a policy consensus
• The Fed is made up of
prominent economic policy-makers.
they fully understand the nuances of the overall economy.
Analyzing the use of monetary policy shows how
policy can work in ideal cases, but it is rare for the
world to work so cleanly
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during times of expansionary monetary policy
shortageof loanable funds, as the demand from
borrowers increases and the supply from savers
decreases
the world works:
1 The Federal Reserve determines the interest rate by
managing the supply and demand for money.
2 The market as a whole determines the interest rate
by the interaction of savers and borrowers.
Two interconnected markets
These two models are connected by the dynamics of the economy.
Two interconnected markets
Interest rate
Quantity of dollars
Market for loanable funds
Savings 2
Investment
Savings 1
r1
Q 1 Q 2
r2 MD
MS 2
Interest rate
Quantity of dollars
Q 1
r1
MS 1
Liquidity-preference model
r2
Q 2
• When the Fed acts to lower interest
rates, it spurs borrowing and increases
• Some of this increase in output is saved.
• Shifts the supply of loanable funds outward
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• The three main functions of money are a store
of value, a medium of exchange, and a unit of
account
• Money needs to have stability of value to be
convenient
• Banks create money by lending through the
fractional reserve banking
• The money multiplier is the ratio of money
created by the lending activities to the money
created by the central bank
Summary
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• The Fed classifies different types of money by
their liquidity
– M1 includes hard money plus checkable deposits.
– M2 includes M1 plus money in savings accounts
and CDs.
• The central bank maintains the money supply
and coordinates the banking system
• The Federal Reserve has a dual mandate:
– Ensure price stability.
– Maintain full employment.
Summary
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• Monetary policy includes changing the reserve
requirement, lending through the discount
window, and engaging in open-market
operations
• The liquidity-preference model explains that
the demand for money is a function of the
interest rate
• The Fed may want to engage in expansionary
or contractionary monetary policy depending
on the economic circumstances
Summary