12 CHAPTER MONEY. Objectives After studying this chapter, you will able to Define money and describe its functions Explain the economic functions

12

CHAPTER

MONEY

Objectives

After studying this chapter, you will able to Define money and describe its functions

Explain the economic functions of banks and other depository institutions

Describe some financial innovations that have changed the way we use money today

Explain how banks create money

Explain the effects of the quantity of money on the price level and real GDP, and explain the quantity theory of money

Money Makes the World Go Around

Money has taken many forms; what is money now?

What do banks do, and can they create money?

What happens if the amount of money grows rapidly?

What is Money?

Money is any commodity or token that is generally acceptable as a means of payment.

A means of payment is a method of settling a debt.

Money has three other functions:

Medium of exchange

Unit of account

Store of value

What is Money?

Medium of Exchange

A medium of exchange is an object that is generally accepted in exchange for goods and services.

In the absence of money, people would need to exchange goods and services directly, which is called barter.

Barter requires a double coincidence of wants, which is rare, so barter is costly.

Unit of Account

A unit of account is an agreed measure for stating the prices of goods and services.

What is Money?

Store of Value

As a store of value, money can be held for a time and later exchanged for goods and services.

Money in the United States Today

Money in the United States consists of:

Currency

Deposits at banks and other depository institutions

Currency is the general term for bills and coins.

What is Money?

The two main official measures of money in the United States are M1 and M2.

M1 consists of currency outside banks, traveler’s checks, and checking deposits owned by individuals and businesses.

M2 consists of M1 plus time deposits, savings deposits, and money market mutual funds and other deposits.

What is Money?

Figure 12.1 illustrates the composition of these two measures in 2001 and shows the relative magnitudes of the components of money.

What is Money?

The items in M1 clearly meet the definition of money; the items in M2 do not do so quite so clearly but still are quite liquid.

Liquidity is the property of being instantly convertible into a means of payment with little loss of value.

Checkable deposits are money, but checks are not– checks are instructions to banks to transfer money.

Credit cards are not money. Credit cards enable the holder to obtain a loan quickly, but the loan must be repaid with money.

Depository Institutions

A depository institution is a firm that accepts deposits from households and firms and uses the deposits to make loans to other households and firms.

The deposits of three types of depository institution make up the nation’s money:

Commercial banks

Thrift institutions

Money market mutual funds


Commercial Banks

A commercial bank is a private firm that is licensed to receive deposits and make loans.

A commercial bank’s balance sheet summarizes its business and lists the bank’s assets, liabilities, and net worth.

The objective of a commercial bank is to maximize the net worth of its stockholders.


To achieve its objective, a bank makes risky loans at an interest rate higher than that paid on deposits.

But the banks must balance profit and prudence; loans generate profit, but depositors must be able to obtain their funds when they want them.

So banks divide their funds into two parts: reserves and loans.

Reserves are the cash in a bank’s vault and deposits at Federal Reserve Banks.

Bank lending takes the form of liquid assets, investment securities, and loans.


Thrift Institutions

The thrift institutions are:

Savings and loan associations

Savings banks

Credit unions


A savings and loan association (S&L) is a depository institution that accepts checking and savings deposits and that makes personal, commercial, and home-purchase loans.

A savings bank is a depository institution owned by its depositors that accepts savings deposits and makes mainly mortgage loans.

A credit union is a depository institution owned by its depositors that accepts savings deposits and makes consumer loans.


Money Market Mutual Funds

A money market fund is a fund operated by a financial institution that sells shares in the fund and uses the proceeds to buy liquid assets such as U.S. Treasury bills.


The Economic Functions of Depository Institutions

Depository institutions make a profit from the spread between the interest rate they pay on their deposits and the interest rate they charge on their loans.

This spread exists because depository institutions

Create liquidity

Minimize the cost of obtaining funds

Minimize the cost of monitoring borrowers

Pool risk

Financial Regulation, Deregulation, and Innovation

Financial Regulation

Depository institutions face two types of regulations:

Deposit insurance

Balance sheet rules


Deposits at banks, S&Ls, savings banks, and credit unions are insured by the Federal Deposit Insurance Corporation (FDIC).

This insurance guarantees deposits in amounts of up to $100,000 per depositor.

This guarantee gives depository institutions the incentive to make risky loans because the depositors believe their funds to be perfectly safe; because of this incentive balance sheet regulations have been established.


There are four main balance sheet rules:

Capital requirements

Reserve requirements

Deposit rules

Lending rules


Deregulation in the 1980s

The 1980s were marked by considerable financial deregulation, when federal legislation and rule changes lifted many of the restrictions on depository institutions, removing many of the distinctions between banks and others, and strengthening the control of the Federal Reserve over the system.


Deregulation in the 1990s

In 1994 the Riegle-Neal Interstate Banking and Branching Efficiency Act was passed, which permits U.S. banks to establish branches in any state. It led to a wave of mergers.


Financial Innovation

The 1980s and 1990s have been marked by financial innovation—the development of new financial products aimed at lowering the cost of making loans or at raising the return on lending.

Financial innovation occurred for three reasons:

The economic environment--high inflation

Massive technological change

Avoidance of regulation


Deregulation, Innovation, and Money

The combination of deregulation and innovation has produced large changes in the composition of money, both M1 and M2.

How Banks Create Money

Reserves: Actual and Required

The fraction of a bank’s total deposits held as reserves is the reserve ratio.

The required reserve ratio is the fraction that banks are required, by regulation, to keep as reserves. Required reserves are the total amount of reserves that banks are required to keep.

Excess reserves equal actual reserves minus required reserves.


Creating Deposits by Making Loans in a One-Bank Economy

When a bank receives a deposit of currency, its reserves increase by the amount deposited, but its required reserves increase by only a fraction (determined by the required reserve ratio) of the amount deposited.

The bank has excess reserves, which it loans. These loans can only end up as deposits in our one and only bank, where they boost deposits without changing total reserves, which creates money.


Figure 12.2 illustrates how one bank create money by making loans.


The Deposit Multiplier

The deposit multiplier is the amount by which an increase in bank reserves is multiplied to calculate the increase in bank deposits.

The deposit multiplier = 1/Required reserve ratio.


Creating Deposits by Making Loans with Many Banks

With many banks, one bank lending out its excess reserves cannot expect its deposits to increase by the full amount loaned; some of the loaned reserves end up in other banks.

But then the other banks have excess reserves, which they loan.

Ultimately, the effect in the banking system is the same as if there was only one bank, so long as all loans are deposited in banks.


Figure 12.3 illustrates money creation with many banks.

Money, Real GDP, and the Price Level

The Short-Run Effects of a Change in the Quantity of Money

An increase in the quantity of money increases aggregate demand.

The AD curve shifts rightward. Real GDP increases and the price level rises.


Figure 12.4 illustrates the effects of an increase in the quantity of money starting from below potential GDP.


The Long-Run Effects of a Change in the Quantity of Money

In the long run, real GDP equals potential GDP.

An increase in the quantity of money at full employment increases real GDP and raises the price level.

The money wage rate rises, which decreases short-run aggregate supply and decreases real GDP but raises the price level.

In the long run, an increase in the quantity of money leaves real GDP unchanged but raises the price level.


Figure 12.5 illustrates the effects of an increase in the quantity of money starting from potential GDP.


The Quantity Theory of Money

The quantity theory of money is the proposition that, in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.

The quantity theory of money is based on the velocity of circulation and the equation of exchange.

The velocity of circulation is the average number of times in a year a dollar is used to purchase goods and services in GDP.


Calling the velocity of circulation V, the price level P, real GDP Y, and the quantity of money M

V = PY/M.

Figure 12.6 on the next slide graphs the velocity of circulation for M1 and M2 for 1961–2001.



The equation of exchange states that

MV = PY

The quantity theory assumes that velocity and potential GDP are not affected by the quantity of money.

So

P = (V/Y)M

Because (V/Y) does not change when M changes, a change in M brings a proportionate change in P.


That is, the change in P, P, is related to the change in M, M, by the equation:

P = (V/Y)MDivide this equation by

P = (V/Y)M

and the term (V/Y) cancels to give

P/P = M/M

P/P is the inflation rate and = M/M is the growth rate of the quantity of money.


The Quantity Theory and the AS-AD Model

The quantity theory of money can be interpreted in terms of the AS-AD model.

In the long run, real GDP equals potential GDP and according to the AS-AD model, an increase in the quantity of money brings an equal percentage rise in the price level.

The AS-AD model also makes clear why the quantity theory is a long-run theory.

In the short run, an increase in the quantity of money brings an increase in real GDP and a smaller than proportionate increase in the price level.


Historical Evidence on the Quantity Theory of Money

Historical evidence shows that U.S. money growth and inflation are correlated, more so in the long run than the short run, which is broadly consistent with the quantity theory.


Figure 12.7 graphs money growth and inflation in the United States from 1931 to 2001.

Part (a) shows year-to-year changes.


Part (b) shows decade average changes.


International Evidence on the Quantity Theory of Money

International evidence shows a marked tendency for high money growth rates to be associated with high inflation rates.

Figure 12.8 shows the evidence.


Correlation, Causation, and Other Influences

Correlation is not causation; money growth and inflation could be correlated because money growth causes inflation, or because inflation causes money growth, or because a third factor causes both.

But the combination of historical, international, and other independent evidence gives us confidence that in the long run, money growth causes inflation.

In the short run, the quantity theory is not correct; we need the AS-AD model.

THE END

12

CHAPTER

MONEY

Documents

12 CHAPTER MONEY. Objectives After studying this chapter, you will able to Define money and describe its functions Explain the economic functions