mba macroeconomics lecturer: jack wu the monetary system

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MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

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Page 1: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

MBA MACROECONOMICSLECTURER: JACK WU

The Monetary System

Page 2: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Money

Money is the set of assets in an economy that people regularly use to buy goods and services from other people.

Page 3: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Functions of Money

Money has three functions in the economy: Medium of exchange Unit of account Store of value

Page 4: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Liquidity

Liquidity Liquidity is the ease with which an asset can be

converted into the economy’s medium of exchange.

Page 5: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Kinds of Money

Commodity money takes the form of a commodity with intrinsic value. Examples: Gold, silver, cigarettes.

Fiat money is used as money because of government decree. It does not have intrinsic value. Examples: Coins, currency, check deposits.

Page 6: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Money in the Economy

Currency is the paper bills and coins in the hands of the public.

Demand deposits are balances in bank accounts that depositors can access on demand by writing a check.

Page 7: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Money Supply

M1 _ M1A _ M1BM2

Page 8: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Federal Reserve

The Federal Reserve (Fed) serves as the nation’s central bank. It is designed to oversee the banking system. It regulates the quantity of money in the economy.

Page 9: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Federal Open Market Committee

The Federal Open Market Committee (FOMC) Serves as the main policy-making organ of the Federal

Reserve System. Meets approximately every six weeks to review the

economy.

Page 10: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Monetary Policy

Monetary policy is conducted by the Federal Open Market Committee. Monetary policy is the setting of the money supply by

policymakers in the central bank The money supply refers to the quantity of money

available in the economy.

Page 11: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Open-Market Operations

Open-Market Operations The money supply is the quantity of money available

in the economy. The primary way in which the Fed changes the money

supply is through open-market operations. The Fed purchases and sells U.S. government bonds.

Page 12: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Open-Market Operations: continued

Open-Market Operations To increase the money supply, the Fed buys

government bonds from the public. To decrease the money supply, the Fed sells

government bonds to the public.

Page 13: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Banks and Money Supply

Banks can influence the quantity of demand deposits in the economy and the money supply.

Reserves are deposits that banks have received but have not loaned out.

In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.

Reserve Ratio The reserve ratio is the fraction of deposits that

banks hold as reserves.

Page 14: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Money Creation

When a bank makes a loan from its reserves, the money supply increases.

The money supply is affected by the amount deposited in banks and the amount that banks loan. Deposits into a bank are recorded as both assets and

liabilities. The fraction of total deposits that a bank has to keep as

reserves is called the reserve ratio. Loans become an asset to the bank.

Page 15: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

T-Account

T-Account shows a bank that… accepts deposits, keeps a portion

as reserves, and lends out

the rest. It assumes a

reserve ratio of 10%.

Page 16: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

T-Account: First National Bank

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00

Page 17: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Money Creation: continued

When one bank loans money, that money is generally deposited into another bank.

This creates more deposits and more reserves to be lent out.

When a bank makes a loan from its reserves, the money supply increases.

Page 18: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Money Multiplier

How much money is eventually created in this economy?

The money multiplier is the amount of money the banking system generates with each dollar of reserves.

Page 19: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

The Money Multiplier

Assets Liabilities

First National Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00

Assets Liabilities

Second National Bank

Reserves$9.00

Loans$81.00

Deposits$90.00

Total Assets$90.00

Total Liabilities$90.00

Money Supply = $190.00!

Page 20: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Money Multiplier:continued

The money multiplier is the reciprocal of the reserve ratio:

M = 1/RWith a reserve requirement, R = 20% or 1/5,The multiplier is 5.

Page 21: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Tools of Money Control

The Fed has three tools in its monetary toolbox: Open-market operations Changing the reserve requirement Changing the discount rate

Page 22: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Open-Market Operations

Open-Market Operations The Fed conducts open-market operations when it

buys government bonds from or sells government bonds to the public: When the Fed buys government bonds, the money supply

increases. The money supply decreases when the Fed sells

government bonds.

Page 23: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Reserve Requirements

Reserve Requirements The Fed also influences the money supply with reserve

requirements. Reserve requirements are regulations on the

minimum amount of reserves that banks must hold against deposits.

Page 24: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Change the Reserve Requirement

Changing the Reserve Requirement The reserve requirement is the amount (%) of a bank’s

total reserves that may not be loaned out. Increasing the reserve requirement decreases the money

supply. Decreasing the reserve requirement increases the money

supply.

Page 25: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Change Discount Rate

Changing the Discount Rate The discount rate is the interest rate the Fed charges

banks for loans. Increasing the discount rate decreases the money supply. Decreasing the discount rate increases the money supply.

Page 26: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Problems in Controlling Money Supply

The Fed’s control of the money supply is not precise.

The Fed must wrestle with two problems that arise due to fractional-reserve banking. The Fed does not control the amount of money

that households choose to hold as deposits in banks.

The Fed does not control the amount of money that bankers choose to lend.

Page 27: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Money Growth and Inflation

Page 28: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Recall Inflation

Inflation is an increase in the overall level of prices.

Hyperinflation is an extraordinarily high rate of inflation.

Hyperinflation is inflation that exceeds 50 percent per month.

Hyperinflation occurs in some countries because the government prints too much money to pay for its spending.

Page 29: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Classical Theory of Inflation

The quantity theory of money is used to explain the long-run determinants of the price level and the inflation rate.

Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange.

When the overall price level rises, the value of money falls.

Page 30: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Money Supply

The money supply is a policy variable that is controlled by the Fed. Through instruments such as open-market operations,

the Fed directly controls the quantity of money supplied.

Page 31: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Money Demand

Money demand has several determinants, including interest rates and the average level of prices in the economy

People hold money because it is the medium of exchange. The amount of money people choose to hold depends

on the prices of goods and services.

Page 32: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Equilibrium

In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.

Page 33: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Copyright © 2004 South-Western

Quantity ofMoney

Value ofMoney, 1/P

Price Level, P

Quantity fixedby the Fed

Money supply

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4

Equilibriumvalue ofmoney

Equilibriumprice level

Moneydemand

A

Page 34: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Copyright © 2004 South-Western

Quantity ofMoney

Value ofMoney, 1/P

Price Level, P

Moneydemand

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4

M1

MS1

M2

MS2

2. . . . decreasesthe value ofmoney . . .

3. . . . andincreasesthe pricelevel.

1. An increasein the moneysupply . . .

A

B

Page 35: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Quantity Theory of Money

The Quantity Theory of Money How the price level is determined and why it might

change over time is called the quantity theory of money. The quantity of money available in the economy

determines the value of money. The primary cause of inflation is the growth in the

quantity of money.

Page 36: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Nominal and Real

Nominal variables are variables measured in monetary units.

Real variables are variables measured in physical units.

Page 37: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Classical Dichotomy

According to Hume and others, real economic variables do not change with changes in the money supply. According to the classical dichotomy, different

forces influence real and nominal variables.Changes in the money supply affect nominal

variables but not real variables.The irrelevance of monetary changes for real

variables is called monetary neutrality.

Page 38: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Velocity of Money

The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

V = (P Y)/M

Where: V = velocityP = the price levelY = the quantity of outputM = the quantity of money

Page 39: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Quantity Equation

Rewriting the equation gives the quantity equation:

M V = P YThe quantity equation relates the quantity of

money (M) to the nominal value of output (P Y).

Page 40: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Quantity Equation

The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: the price level must rise, the quantity of output must rise, or the velocity of money must fall.

Page 41: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Quantity Theory of Money

The Equilibrium Price Level, Inflation Rate, and the Quantity Theory of Money The velocity of money is relatively stable over

time. When the Fed changes the quantity of money, it

causes proportionate changes in the nominal value of output (P Y).

Because money is neutral, money does not affect output.

Page 42: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Discussion Question 1

You take $100 you had kept under your mattress and deposit it in your bank account. If this $100 stays in the banking system as reserves and if banks hold reserves equal to 10% of deposits, by how much does the total amount of deposits in the banking system increase? By how much does the money supply increase?

Page 43: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Discussion Question 2

The economy of Elmendyn contains 2,000 $1 bills.

If people hold all money as currency, what is the quantity of money?

If people hold all money as demand deposits and banks maintain 100% reserves, what is the quantity of money?

If people hold equal amounts of currency and demand deposits and banks maintain 100% reserves, what is the quantity of money?

Page 44: MBA MACROECONOMICS LECTURER: JACK WU The Monetary System

Discussion Question 2: continued

If people hold all money as demand deposits and banks maintain a reserve ratio of 10%, what is the quantity of money?

If people hold equal amounts of currency and demand deposits and banks maintain a reserve ratio of 10%, what is the quantity of money?