1 Frank & Bernanke 3 rd edition, 2007 Ch. 10: Money, Prices, and the Federal Reserve

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Frank & BernankeFrank & Bernanke33rdrd edition, 2007 edition, 2007

Ch. 10: Money, Ch. 10: Money, Prices, and the Prices, and the

Federal ReserveFederal Reserve

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What Is Money?What Is Money?

Does Bill Gates have a lot of money?Does Bill Gates have a lot of money?Does LeBron James make a lot of money?Does LeBron James make a lot of money?Anything accepted by a community in Anything accepted by a community in

exchange of goods and services and for exchange of goods and services and for settlements of debts.settlements of debts.

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Functions of MoneyFunctions of Money

Unit of accountUnit of account Increase in variety of goods requires a Increase in variety of goods requires a

common unit to quote and compare prices.common unit to quote and compare prices.3 goods: 2 prices3 goods: 2 prices4 goods: 6 prices4 goods: 6 prices5 goods: 24 prices5 goods: 24 pricesN goods: (n-1)! PricesN goods: (n-1)! Prices

Money had to be invented.Money had to be invented.

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Medium of exchangeMedium of exchangeBarter requires double coincidence of wants.Barter requires double coincidence of wants.Exchange makes both parties better-off.Exchange makes both parties better-off.Money had to be invented.Money had to be invented.

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Store of ValueStore of ValuePostponing consumption by storing wealth in Postponing consumption by storing wealth in

an asset for future use.an asset for future use.Today we have many different assets for Today we have many different assets for

wealth storage.wealth storage.Depending on the ability of these assets to be Depending on the ability of these assets to be

easily converted to cash (liquidity) these easily converted to cash (liquidity) these assets are near or far to “money.”assets are near or far to “money.”

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Financial Assets Savers Can HoldFinancial Assets Savers Can Hold

CurrencyCurrency Checking accountChecking account Savings accountSavings account Certificate of DepositCertificate of Deposit Foreign currencyForeign currency BondsBonds StocksStocks Options on stocks, bonds, foreign currencyOptions on stocks, bonds, foreign currency Futures on commodities, foreign currencyFutures on commodities, foreign currency

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Assets According to LiquidityAssets According to Liquidity

CurrencyCurrencyChecking AccountChecking AccountSavings AccountSavings AccountMoney Market Mutual FundMoney Market Mutual FundBondsBonds

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Measuring MoneyMeasuring Money

http://research.stlouisfed.org/publications/mt/page16.pdf

In billions of dollars

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1010

Components of M1 and M2,Components of M1 and M2,July 2002 (billions of dollars)July 2002 (billions of dollars)

M1

Currency

Demand deposits

Other checkable deposits

Travelers’ checks

M2

M1

Savings deposits

Small-denomination time deposits

Money market mutual funds

1,197.8

615.1

303.8

270.3

8.6

5,641.2

1,197.8

2,552.8

920.8

969.8

1111

Banks and the Creation of MoneyBanks and the Creation of Money

When depositors put money in the bank, When depositors put money in the bank, the bank turns around and loans part of the bank turns around and loans part of the money to others.the money to others.

Both the depositor and the borrower have Both the depositor and the borrower have funds to spend.funds to spend.

Money has been created.Money has been created.

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Banks and the Creation of MoneyBanks and the Creation of Money

We will show the changes in assets and We will show the changes in assets and liabilities of a bank in response to deposit liabilities of a bank in response to deposit and loan activities.and loan activities.

Deposits into checking accounts are Deposits into checking accounts are liabilities of a bank.liabilities of a bank.

Cash is an asset.Cash is an asset.Assets = Liabilities for a Balance Sheet to Assets = Liabilities for a Balance Sheet to

be in balance.be in balance.

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Creation of MoneyCreation of Money

Ally deposits $1000 into her checking Ally deposits $1000 into her checking account with First National.account with First National.

First National holds only 10% as reserves First National holds only 10% as reserves and loans the rest to Billy.and loans the rest to Billy.

Billy buys a snow blower for $900 from Billy buys a snow blower for $900 from Carl.Carl.

Carl deposits $900 with Second National.Carl deposits $900 with Second National.Second National loans how much to Second National loans how much to

Deyna if it also holds 10% as reserves?Deyna if it also holds 10% as reserves?

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If this process goes on for thirty rounds, If this process goes on for thirty rounds, how much checking deposits will be in the how much checking deposits will be in the banking system?banking system?

1000 + 1000(.9) + 1000(.9)(.9)+…1000 + 1000(.9) + 1000(.9)(.9)+…+1000(.9)^+1000(.9)^3030

1000 + 900 + 810 + … + 0.041000 + 900 + 810 + … + 0.041000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10]1000 [1/(1-.9)] = 1000 [1/.1] = 1000 [10]

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The banking system used the initial The banking system used the initial deposit of $1000 as the reserves and deposit of $1000 as the reserves and multiplied it by (1/reserve ratio) to create multiplied it by (1/reserve ratio) to create checking deposits for the economy.checking deposits for the economy.

What would be the deposits created by the What would be the deposits created by the same $1000 deposit, if the banks kept 5% same $1000 deposit, if the banks kept 5% as the reserve ratio?as the reserve ratio?

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Narrow Money, M1Narrow Money, M1

M1 is defined as currency outside of the M1 is defined as currency outside of the banks plus bank deposits.banks plus bank deposits.

Monetary Base is defined as Currency + Monetary Base is defined as Currency + Reserves.Reserves.

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•What was the amount of currency in January 2005?•What was the amount of bank deposits in January 2005?•What was the reserve ratio in January 2005?

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•What was the amount of currency in January 2006, December 2006?•What was the amount of bank deposits in January 2005, December 2006?•What was the reserve ratio in January 2005, December 2006?

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Banks and the Creation of Banks and the Creation of MoneyMoney

SummarySummaryBank reserves/bank deposits = desired Bank reserves/bank deposits = desired

reserve-deposit ratioreserve-deposit ratioBank deposits = bank reserves/desired Bank deposits = bank reserves/desired

reserve-deposit ratioreserve-deposit ratio

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The Money Supply with Both Currency The Money Supply with Both Currency and Depositsand DepositsCB provides 1 million in cash to residents CB provides 1 million in cash to residents Residents choose to hold 500,000 as Residents choose to hold 500,000 as

currencycurrencyDeposit 500,000 in the banksDeposit 500,000 in the banksReserve-deposit ratio = 10%Reserve-deposit ratio = 10%Bank deposits = 500,000/.10 = 5,000,000Bank deposits = 500,000/.10 = 5,000,000

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The Money Supply with Both Currency The Money Supply with Both Currency and Depositsand DepositsMoney supply = currency + bank deposits Money supply = currency + bank deposits

5,500,000 = 500,000 + 5,500,000 = 500,000 + 5,000,0005,000,000

Money is increased by 4,500,000 when the Money is increased by 4,500,000 when the residents hold 500,000 in bank depositsresidents hold 500,000 in bank deposits

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The Money Supply at ChristmasThe Money Supply at ChristmasCurrency = 500Currency = 500Bank reserves = 500Bank reserves = 500Reserve-deposit ratio = 0.20Reserve-deposit ratio = 0.20Money supply = 500 + 500/.20 = 500 + 2,500 Money supply = 500 + 500/.20 = 500 + 2,500

= 3,000= 3,000

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The Money Supply at ChristmasThe Money Supply at Christmas If Xmas shoppers withdraw 100If Xmas shoppers withdraw 100Money supply = 600 + 400/.20 = 600 + 2,000 Money supply = 600 + 400/.20 = 600 + 2,000

= 2,600= 2,600

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The Money Supply at ChristmasThe Money Supply at ChristmasObservationObservation

When the reserve-deposit ratio = 0.20, every $1 When the reserve-deposit ratio = 0.20, every $1 reduction in reserves may reduce the money reduction in reserves may reduce the money supply by $5.supply by $5.

In general, when people make withdraws, the In general, when people make withdraws, the money supply contracts by a multiple of the money supply contracts by a multiple of the withdrawal.withdrawal.

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The Federal Reserve SystemThe Federal Reserve System

The Central Bank of the United States.The Central Bank of the United States.The Fed is responsible for monetary The Fed is responsible for monetary

policy.policy.Amount of money supplied to the system.Amount of money supplied to the system.Affects interest rates, inflation, unemployment Affects interest rates, inflation, unemployment

and exchange rates.and exchange rates.The Fed oversees and regulates the The Fed oversees and regulates the

financial markets.financial markets.

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The FedThe Fed

Fed was established in 1913 in the hopes Fed was established in 1913 in the hopes of eliminating banking panics of the 19th of eliminating banking panics of the 19th century by providing credit to the financial century by providing credit to the financial markets.markets.

In order to disperse power 12 regional In order to disperse power 12 regional Federal Reserve Banks were formed.Federal Reserve Banks were formed.

The seven members of the Board of The seven members of the Board of Governors are appointed by the President Governors are appointed by the President for 14-year terms every other year.for 14-year terms every other year.

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Monetary PolicyMonetary Policy

Federal Open Market Committee (FOMC) Federal Open Market Committee (FOMC) is the group that sets the monetary policy.is the group that sets the monetary policy.

Fed Chairman (4-year term) plus Fed Chairman (4-year term) plus governors, plus NY Fed President, plus 4 governors, plus NY Fed President, plus 4 Presidents of Fed banks comprise FOMC.Presidents of Fed banks comprise FOMC.

FOMC meets eight times a year.FOMC meets eight times a year.

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Controlling the Money SupplyControlling the Money Supply

Open-Market Operations: buying and selling of Open-Market Operations: buying and selling of financial assets.financial assets. BuyingBuying government bonds from the public government bonds from the public increasesincreases

bank reserves, hence money supply.bank reserves, hence money supply. SellingSelling bonds bonds decreasesdecreases money supply. money supply.

Discount window lending: Lending to banks Discount window lending: Lending to banks increases bank reserves.increases bank reserves.

Changing reserve requirements: Raising Changing reserve requirements: Raising reserve-deposit ratio decreases money supply.reserve-deposit ratio decreases money supply.

New Tools: New Tools: http://stlouisfed.org/publications/re/2009/a/pages/presidents-message.htmlhttp://stlouisfed.org/publications/re/2009/a/pages/presidents-message.html

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Open-Market OperationOpen-Market Operation

Suppose an economy has $100 currency, Suppose an economy has $100 currency, $100 reserves and 0.1 as reserve-deposit $100 reserves and 0.1 as reserve-deposit ratio.ratio.

What is the money supply?What is the money supply? If the Central Bank purchased $5 worth of If the Central Bank purchased $5 worth of

bonds, what will be the money supply?bonds, what will be the money supply? If the CB sold $10 worth of bonds, what If the CB sold $10 worth of bonds, what

will be the money supply?will be the money supply?

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ExampleExample Increasing the money supply by open-Increasing the money supply by open-

market operationsmarket operationsCurrency = 1,000 Currency = 1,000 Reserves = 200Reserves = 200Reserve-deposit ratio = 0.2Reserve-deposit ratio = 0.2

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ExampleExample Increasing the money supply by open-Increasing the money supply by open-

market operationsmarket operationsMoney supply = 1,000 + 200/0.2 = 2,000Money supply = 1,000 + 200/0.2 = 2,000Open market purchase = 100Open market purchase = 100Reserves increase to 300Reserves increase to 300Money supply = 1,000 + 300/0.2 = 2,500Money supply = 1,000 + 300/0.2 = 2,500

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Controlling the Money Supply: Discount Controlling the Money Supply: Discount Window LendingWindow LendingBanks can borrow reserves from the Fed.Banks can borrow reserves from the Fed.Discount window lendingDiscount window lending

The lending of reserves to commercial banksThe lending of reserves to commercial banks

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Controlling the Money Supply: Discount Controlling the Money Supply: Discount Window LendingWindow LendingThe discount rateThe discount rate

The interest rate charged on these loansThe interest rate charged on these loans

Discount lending will increase reserves and Discount lending will increase reserves and the money supply.the money supply.

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Primary Credit RatePrimary Credit Rate

http://research.stlouisfed.org/publications/mt/page9.pdf

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Controlling the Money Supply: Changing Controlling the Money Supply: Changing Reserve RequirementsReserve RequirementsThe Fed sets the reserve-deposit ratioThe Fed sets the reserve-deposit ratio

Called the reserve requirementCalled the reserve requirement

A reduction in the reserve requirement A reduction in the reserve requirement would allow the money supply to increase.would allow the money supply to increase.

An increase in the reserve requirement may An increase in the reserve requirement may reduce the money supply.reduce the money supply.

3636http://www.federalreserve.gov/monetarypolicy/default.htm

3737


The Fed’s Role in Stabilizing Financial The Fed’s Role in Stabilizing Financial Markets: Banking PanicsMarkets: Banking PanicsSuppose:Suppose:

Depositors lose confidence in their bank.Depositors lose confidence in their bank.They attempt to withdraw their funds.They attempt to withdraw their funds.Bank may not have enough reserves (fractional) Bank may not have enough reserves (fractional)

to meet the depositors demand.to meet the depositors demand.The bank fails and further erodes depositor The bank fails and further erodes depositor

confidence which triggers additional failures.confidence which triggers additional failures.

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The Fed’s Role in Stabilizing Financial The Fed’s Role in Stabilizing Financial Markets: Banking PanicsMarkets: Banking PanicsThe Fed to the rescue:The Fed to the rescue:

Instill confidenceInstill confidenceDiscount lendingDiscount lendingOpen Market OperationsOpen Market Operations

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The Great DepressionThe Great Depression

The Fed did not prevent the Great Depression.The Fed did not prevent the Great Depression. Both currency held by the public and reserve-Both currency held by the public and reserve-

deposit ratio rose, reducing money supply.deposit ratio rose, reducing money supply. The Fed increased the reserves but not enough.The Fed increased the reserves but not enough. Lack of enough reserves forced bank Lack of enough reserves forced bank

bankruptcies.bankruptcies.One-third of U.S. banks closedOne-third of U.S. banks closed

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MONETARY STATISTICS DURING GREAT DEPRESSIONCurrency rr Reserves M1

Dec-29 3.85 0.075 3.15 45.9Dec-30 3.79 0.082 3.31 44.1Dec-31 4.59 0.095 3.11 37.3Dec-32 4.82 0.109 3.18 34.0Dec-33 4.85 0.133 3.45 30.8

Frank, R. H. and Ben S. Bernanke, Principles of Macroeconomics, 2nd ed. (McGraw-Hill, 2004), p. 273.

4141

The Federal Reserve SystemThe Federal Reserve System In response to the panics of 1929-1933, In response to the panics of 1929-1933,

deposit insurance was established in 1934.deposit insurance was established in 1934.Deposit insurance gives depositors an Deposit insurance gives depositors an

incentive to keep their money in the banks.incentive to keep their money in the banks.Deposit insurance reduces the incentive for Deposit insurance reduces the incentive for

depositors to pay attention to the financial depositors to pay attention to the financial strength of their bank.strength of their bank.

4242

Money and Price LevelMoney and Price Level

In the long run, prices adjust to pressures In the long run, prices adjust to pressures in the economy.in the economy.

The “quantity theory of money” captures The “quantity theory of money” captures the long-run relationship.the long-run relationship.

MV = PY

4343

Quantity TheoryQuantity Theory

M is money stock, like M1 or M2.M is money stock, like M1 or M2.V is velocity, the number of times money V is velocity, the number of times money

stock exchanges hands in creating the stock exchanges hands in creating the nominal GDP.nominal GDP.

P is price level, like 1.00 or 1.26 (price P is price level, like 1.00 or 1.26 (price index)index)

Y is real GDP.Y is real GDP.PY is nominal GDP.PY is nominal GDP.

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Long Run InflationLong Run Inflation

In the long-run, the economy will operate In the long-run, the economy will operate at full-employment; so Y will not change if at full-employment; so Y will not change if there is no growth. If there is growth, then there is no growth. If there is growth, then Y is predictable: Y is known.Y is predictable: Y is known.

Velocity is also thought predictable in the Velocity is also thought predictable in the long-run.long-run.

Therefore, any growth in money supply will Therefore, any growth in money supply will be reflected in inflation.be reflected in inflation.

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Money and PricesMoney and Prices

VelocityVelocityThe speed at which money circulatesThe speed at which money circulates

stockMoney

GDP Nominal

stockMoney

nstransactio of Value Velocity

4646


VelocityVelocityThe speed at which money circulatesThe speed at which money circulates

M

x YP

supply)(money M

GDP) (real x Y level) (price P (V)Velocity

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Velocity in 2001Velocity in 2001M1 = M1 = $1,177.9 billion$1,177.9 billionM2M2 = $5,449.1 billion = $5,449.1 billionNominal GDP = $10,082.2 billionNominal GDP = $10,082.2 billion

8.56 billion $1,117.9

billion $10,082.2 V M1,

1.85 billion $5,499.1

billion $10,082.2 V M2,

4848


Money and Inflation in the Long RunMoney and Inflation in the Long RunRecallRecall

M

Y x P V

4949


Money and Inflation in the Long RunMoney and Inflation in the Long RunQuantity equationQuantity equation

M x V = P x YM x V = P x Y

Assume Assume V & YV & Y are constant over the time are constant over the time periodperiod

Y x P V x M

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Money and Inflation in the Long RunMoney and Inflation in the Long Run If the Fed increases If the Fed increases MM by 10%, then prices by 10%, then prices

must increase by 10%.must increase by 10%.High rates of money growth are associated High rates of money growth are associated

with high rates of inflation (too much money with high rates of inflation (too much money chasing too few goods).chasing too few goods).

Y x P V x M

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Inflation and Money Growth in Inflation and Money Growth in Latin America, 1995-2001Latin America, 1995-2001

Documents

1 Frank & Bernanke 3 rd edition, 2007 Ch. 10: Money, Prices, and the Federal Reserve