no click ho esntls ch15

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© 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O’Brien, 2e.

Fernando & Yvonn Quijano

Prepared by:

Chapter

15

Money, Banks, and the

Federal Reserve System



© 2009 Prentice Hall Business Publishing Essentials of Economics Hubbard/O’Brien, 2e. 2 of 43

McDonald’s Money

Problems in Argentina

15.1 Define money and discuss its

four functions.

15.2 Discuss the definitions of the

money supply used in the United

States today.

15.3 Explain how banks create money.

15.4 Discuss the three policy tools the

Federal Reserve uses to manage

the money supply.

15.5 Explain the quantity theory of money and use it to explain how

high rates of inflation occur.

LEARNING Objectives

Confidence and trust cannot betaken for granted. …households

and firms losing faith in an officialmoney can harm trade andeconomic activity in an economy.



C h a p t e r 1 5 : M o n e y ,

B a n k s , a n d t h e F e d e r a l R e s e r v e S y s t e m


Money Assets that people aregenerally willing to accept inexchange for goods and services or for payment of debts.

Asset Anything of value owned by aperson or a firm.

Learning Objective 15.1

What Is Money and Why Do We Need It?



C h a p t e r 1 5 : M o n e y ,





Commodity money A good usedas money that also has valueindependent of its use as money.

Barter and the Invention of Money

The Functions of Money Anything used as money—whether a deerskin, acowrie seashell, cigarettes, or a dollar bill—shouldfulfill the following four functions:

• Medium of exchange • Unit of account

• Store of value

• Standard of deferred payment



C h a p t e r 1 5 : M o n e y ,





Medium of Exchange

The Functions of Money

Money serves as a medium of exchange when sellers arewilling to accept it in exchange for goods or services.

Unit of Account

In a barter system, each good has many prices.

Store of Value

Money allows value to be stored easily: If you do not use all

your accumulated dollars to buy goods and services today,you can hold the rest to use in the future.

Standard of Deferred Payment

Money is useful because it can serve as a standard of

deferred payment in borrowing and lending.



C h a p t e r 1 5 : M o n e y ,





What Can Serve as Money?

Five criteria make a good suitable to use as a medium of exchange:

1 The good must be acceptable to (that is, usable by)most people.

2 It should be of standardized quality so that any twounits are identical.

3 It should be durable so that value is not lost byspoilage.

4 It should be valuable relative to its weight so thatamounts large enough to be useful in trade can beeasily transported.

5 The medium of exchange should be divisible becausedifferent goods are valued differently.



C h a p t e r 1 5 : M o n e y ,






Commodity money meets the criteria for a medium of exchange.

Commodity Money

It can be inefficient for an economy torely on only gold or other precious metalsfor its money supply.

Fiat Money



C h a p t e r 1 5 : M o n e y ,

B a n k s , a n d t h e F e

d e r a l R e s e r v e S y s t e m





Federal Reserve System Thecentral bank of the United States.

Fiat money Money, such as paper currency, that is authorized by acentral bank or governmental bodyand that does not have to be

exchanged by the central bank for gold or some other commoditymoney.

Commodity Money



C h a p t e r 1 5 : M o n e y ,





Money without a Government? TheStrange Case of the Iraqi Dinar

Making the

Connection

Many Iraqis continued to use currency with Saddam’s picture

on it, even after he was forced from power.



C h a p t e r 1 5 : M o n e y ,




How Is Money Measured in the United States Today?


M1: The Narrowest Definition of the Money Supply

M1 The narrowest definition of themoney supply: The sum of currencyin circulation, checking accountdeposits in banks, and holdings of traveler’s checks.



C h a p t e r 1 5 : M o n e y ,






M1 includes:

1 Currency , which is all the paper money and coins thatare in circulation, where “in circulation” means not held

by banks or the government

2 The value of all checking account deposits at banks

3 The value of traveler’s checks (although this last

category is so small—less than $7 billion in April 2008—

we will ignore it in our discussion of the money supply)




C h a p t e r 1 5 : M o n e y ,







Figure 15-1

Measuring the Money

Supply, April 2008



C h a p t e r 1 5 : M o n e y

, B a n k s , a n d t h e F e




Do We Still Need the Penny?Making

the

Connection

Unfortunately, these cost the government more than

a penny to produce.








M2: A Broader Definition of Money

M2 A broader definition of the money supply:M1 plus savings account balances, small-denomination time deposits, balances in money

market deposit accounts in banks, andnoninstitutional money market fund shares.

Don’t Let This Happen to YOU!Don’t Confuse Money with Income or Wealth


i Obj i 1 2








M2: A Broader Definition of Money

There are two key points about the money supply to keep in mind:

1 The money supply consists of both currency andchecking account deposits.

2 Because balances in checking account deposits areincluded in the money supply, banks play an importantrole in the process by which the money supply increasesand decreases. We will discuss this second point further in the next section.

What about Credit Cards and Debit Cards?

Many people buy goods and services with creditcards, yet credit cards are not included in definitionsof the money supply.


L i Obj ti 15 2







Solved Problem 15-2 The Definitions of M1 and M2


Suppose you decide to withdraw $2,000from your checking account and use themoney to buy a bank certificate of deposit

(CD). Briefly explain how this will affectM1 and M2.

L i Obj ti 15 3







How Do Banks Create Money?


Bank Balance Sheets

Don’t Let This Happen to YOU!

Know When a Checking Account Is an Asset and When It Is a Liability

Figure 15-2

Balance Sheet for Wachovia

Bank, December 31, 2007

L i Obj ti 15 3









Bank Balance Sheets

Reserves Deposits that a bank keeps as cash in itsvault or on deposit with the Federal Reserve.

Required reserves Reserves that a bank is legallyrequired to hold, based on its checking accountdeposits.

Required reserve ratio The minimum fraction of deposits banks are required by law to keep asreserves.

Excess reserves Reserves that banks hold over andabove the legal requirement.

L i Obj ti 15 3









Using T-Accounts to Show How a Bank Can Create Money

Learning Objecti e 15 3





d e r a l R e s e r v e S y s t

e m





Learning Objective 15 3






e m











e m





BANK INCREASE IN CHECKING ACCOUNT DEPOSITS

Wachovia $1,000

PNC + 900 (= 0.9 x $1,000)

Third Bank + 810 (= 0.9 x $900)

Fourth Bank + 729 (= 0.9 x $810)

. + •

. + •

. +

Total Change in Checking Account

Deposits =$10,000







e m




The Simple Deposit Multiplier

Simple deposit multiplier The ratioof the amount of deposits created bybanks to the amount of new reserves.

RR

1 multiplier depositSimple

1Change in checking account deposits Change in bank reserves x RR







e m


Solved Problem 15-3 Showing How Banks Create Money


PNC BankAssets Liabilities

Reserves +$5,000 Deposits +$5,000

PNC Bank

Assets Liabilities

Reserves +$5,000 Deposits +$5,000Loans +$4,500 Deposits +$4,500

PNC Bank

Assets Liabilities

Reserves +$500 Deposits +$5,000Loans +$4,500

Wachovia Bank

Assets Liabilities

Reserves +$4,500 Deposits +$4,500







e m




The Simple Deposit Multiplier versus the Real-World

Deposit Multiplier

1 Whenever banks gain reserves, they make newloans, and the money supply expands.

2 Whenever banks lose reserves, they reduce their loans, and the money supply contracts.

We can summarize these important conclusions:







e m


The Federal Reserve System


Bank Balance Sheets

Fractional reserve banking system Abanking system in which banks keep lessthan 100 percent of deposits as reserves.

Bank run A situation in which manydepositors simultaneously decide towithdraw money from a bank.

Bank panic A situation in which manybanks experience runs at the same time.







e m



The 2001 Bank Panic in ArgentinaMaking

the

Connection

The Argentine central bank was

unable to stop the bank panic of

2001.







e m




The Organization of the Federal Reserve System

Figure 15-3

Federal Reserve Districts










How the Federal Reserve Manages the Money Supply

Monetary policy The actions the FederalReserve takes to manage the money supply andinterest rates to pursue economic objectives.

To manage the money supply, the Fed uses threemonetary policy tools:

1 Open market operations

2 Discount policy

3 Reserve requirements











Open Market Operations

Federal Open Market Committee (FOMC) TheFederal Reserve committee responsible for openmarket operations and managing the moneysupply in the United States.

Open market operations The buying and sellingof Treasury securities by the Federal Reserve inorder to control the money supply.











Discount Policy

Discount loans Loans the Federal Reservemakes to banks.

Discount rate The interest rate the FederalReserve charges on discount loans.

Reserve Requirements

When the Fed reduces the required reserve

ratio, it converts required reserves intoexcess reserves.




C h a p t e r 1 5 : M o n e y ,






Putting It All Together: Decisions of the Nonbank Public,

Banks, and the Fed

Using its three tools—open market operations,the discount rate, and reserve requirements—theFed has substantial influence over the money

supply, but that influence is not absolute.

Two other actors—the nonbank public andbanks—also influence the money supply.




C h a p t e r 1 5 : M o n e y ,




ea g Objec e 5 5

Connecting Money and Prices: The Quantity Equation

In the early twentieth century, Irving Fisher, aneconomist at Yale, formalized the connectionbetween money and prices using the quantity

equation:

M × V = P × Y

The Quantity Theory of Money




C h a p t e r 1 5 : M o n e y ,




g j

Connecting Money and Prices: The Quantity Equation

Velocity of money The average number of times eachdollar in the money supply is used to purchase goods andservices included in GDP.

M

Y x P V

Quantity theory of money A theory of the connectionbetween money and prices that assumes that the velocity

of money is constant.





C h a p t e r 1 5 : M o n e y ,




g j

The Quantity Theory Explanation of Inflation

We can transform the quantity equation from:

Growth rate of the money supply + Growth rate of velocity= Growth rate of the price level (or inflation rate) + Growth

rate of real output

Y x P V x M

to:





C h a p t e r 1 5 : M o n e y ,




g j


The growth rate of the price level is just the inflation rate,so we can rewrite the quantity equation to help usunderstand the factors that determine inflation:

If Irving Fisher was correct that velocity is constant, thenthe growth rate of velocity will be zero. This allows us torewrite the equation one last time:

Inflation rate = Growth rate of the money supply +

Growth rate of velocity − Growth rate of real output


Inflation rate = Growth rate of the money supply −

Growth rate of real output




C h a p t e r 1 5 : M o n e y ,



g j


This equation leads to the following predictions:

1 If the money supply grows at a faster rate thanreal GDP, there will be inflation.

2 If the money supply grows at a slower rate thanreal GDP, there will be deflation. (Recall thatdeflation is a decline in the price level.)

3 If the money supply grows at the same rate asreal GDP, the price level will be stable, and therewill be neither inflation nor deflation.





C h a p t e r 1 5 : M o n e y ,



g j

High Rates of Inflation

Very high rates of inflation—in excess of hundredsor thousands of percentage points per year —areknown as hyperinflation.

Economies suffering from high inflation usuallyalso suffer from very slow growth, if not severerecession.





C h a p t e r 1 5 : M o n e y ,




High Inflation in Argentina

Figure 15-4Money Growth and Inflation in Argentina




C h a p t e r 1 5 : M o n e y ,



The German Hyperinflationof the Early 1920s

Making the

Connection

During the hyperinflation of the1920s, people in Germany used

paper currency to light their stoves.



C h a p t e r 1 5 : M o n e y ,



An Inside LOOK at

Policy

Using Reserve Requirements to SlowBank Lending in China

China Lifts Bank Reserves in Bid to Cool Growth

Fixing the value of the yuan against the U.S. dollar has effectively fueled the growth in

China’s bank reserves.



C h a p t e r 1 5 : M o n e y ,


K e y T e r m s

AssetBank panic

Bank run

Commodity money

Discount loansDiscount rate

Excess reserves

Federal Open Market

Committee (FOMC)

Federal Reserve System

Fiat money

Fractional reserve bankingsystem

M1M2

Monetary policy

Money

Open market operationsQuantity theory of money

Required reserve ratio

Required reserves

Reserves

Simple deposit multiplier

Velocity of money

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