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1 of 43Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e.

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CHAPTER13

Money, Banks,and theFederal Reserve System

In 2008, Zimbabweans were suffering shortages of fuel, food,

and other basic goods. A key problem was that the government’s

mismanagement had caused the Zimbabwean dollar to lose most of

its value.


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CHAPTER13

13.1 What Is Money, and Why Do We Need It?

Define money and discuss its four functions.

13.2 How Is Money Measured in the United States Today?

Discuss the definitions of the money supply used in the United States today.

13.3 How Do Banks Create Money?Explain how banks create money.

13.4 The Federal Reserve SystemDiscuss the three policy tools the Federal Reserve uses to manage the money supply.

13.5 The Quantity Theory of MoneyExplain the quantity theory of money and use it to explain how high rates of inflation occur.

Chapter Outline andLearning ObjectivesMoney, Banks,

and theFederal Reserve System


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Money Assets that people are generally willing to accept in exchange for goods and services or for payment of debts.

Asset Anything of value owned by a person or a firm.

What Is Money, and Why Do We Need It? Define money and discuss its four functions.

13.1 LEARNING OBJECTIVE

Money is not income, and money is not wealth.- Wealth is equal value of assets minus value of debts

National income is also not the same as national money supply.


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• Barter is the direct exchange of goods and services for other goods and services.

• A barter system requires a double coincidence of wants for trade to take place. Money eliminates this problem.

• As a medium of exchange, or means of payment, money is generally accepted by buyers and sellers as payment for goods and services.

Barter and the Invention of Money


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What Is Money, and Why Do We Need It?

The Functions of Money

Anything used as money—whether a deerskin, a cowrie seashell, cigarettes, or a dollar bill—should fulfill the following four functions:

• Medium of exchange

• Unit of account

• Store of value

• Standard of deferred payment




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Medium of Exchange


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

Unit of AccountIn a barter system, each good has many prices.

Money provides a consistent way of quoting prices.




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Store of Value

Money allows value to be stored easily: If you do not use all your dollars to buy goods and services today, you can hold the rest to use in the future.

Money transports purchasing power from one time period to another

Standard of Deferred PaymentMoney is useful because it can serve as a standard of deferred payment in borrowing and lending.



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What Can Serve as Money?

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



Acceptability -- people must be willing to accept it as a means of payment and in settlement of a debtDurability -- must last a reasonable length of time before deteriorating Divisibility -- to function as money an asset must be capable of division into smaller units to accommodate transactions of differing value


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Portability / Convenience -- to function as money an asset must be portable and easy to use, it must be light, small to carry around and easy to transfer ownershipUniformity -- money of the same value must be of uniform quality / standardized qualityHard for Individuals to Produce Themselves -- it must be hard to forge


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What Can Serve as Money?

Fiat money: money without intrinsic value that is used as money because of government decree. Something that serves as money but has no other important uses, e.g., Coins, currency and checkable deposits (current account)



Commodity money

• A good used as money that also has value independent of its use as money.

• Money that takes the form of a commodity with intrinsic value. Something that performs the function of money and also has alternative, non-monetary uses, e.g., gold, silver, cigarettes.

• For hundreds of years gold could be used directly to buy things, but it also had other uses ranging from jewelry to dental fillings.


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mHow Is Money Measured in the United States Today?M1: The Narrowest Definition of the Money Supply



M1 – the narrowest definition of money supply, consists of currency outside banks plus checking accounts plus traveler’s checks

• Currency held outside banks – includes coins and paper money in the hands of public

• Checking accounts – balances can be withdrawn by using check

• Traveler’s check – issued in specific denominations, these are treated as cash

• M1 = currency held outside banks + checking accounts + traveler’s check


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Do We Still Need the Penny?Making

theConnection

(Unfortunately,) these often cost the government more than a cent to produce.

YOUR TURN: Test your understanding by doing related problem 2.8 at the end of this chapter.




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M2: A Broader Definition of Money

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

How Is Money Measured in the United States Today?




M2 – A broader definition of money supply, itincludes all of the components of M1 plus timedeposits and savings deposits • Time deposits (fixed deposits) – interest-earning

deposits with a specified maturity, which are subject to penalty for early withdrawal

• Savings deposits – interest-earning deposits with no specific maturity

• M2 = M1 + time deposits + saving deposits


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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 and checking account deposits.

2. Because balances in checking account deposits are included in the money supply, banks play an important role in the process by which the way money supply increases and decreases.

What about Credit Cards and Debit Cards?

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

How Is Money Measured in the United States Today?




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The Definitions of M1 and M2

Suppose you decide to withdraw $2,000 from your checking account and use the money to buy a bank certificate of deposit (CD). Briefly explain how this will affect M1 and M2.

YOUR TURN: For more practice, do related problems 2.4 and 2.5 at the end of this chapter.

Solved Problem 13-2 Discuss the definitions of the money supply used in the United States today.



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M3 = M2 + deposits with non-bank financial institution (e.g., deposits of finance companies and post office saving)


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Central bank : • An institution designed to oversee the banking system and

regulate the quantity of money in the economy Financial institution : • Privately owned institutions that serve the general public• Intermediaries that stand between savers from whom they

accept deposits ; and investors to whom they make loans

Structure of Banking System


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1. Banker to commercial banks (banker’s bank) 2. Banker for the government 3. Controller of money supply 4. Lender of last resort 5. Others

Functions of Bank Negara Malaysia


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How Do Banks Create Money?

Bank Balance Sheets

Reserves Deposits that a bank keeps as cash in its vault or on deposit with the Central Bank. Deposits that banks have received but have not loaned out.

Required reserves Reserves that a bank is legally required to hold, based on its checking account deposits.

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

Excess reserves Reserves that banks hold over and above the legal requirement.

Explain how banks create money.



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Bank Balance Sheets

Figure 13-2Balance Sheet for Bank of America, December 31, 2008



The items on a bank’s balance sheet of greatest economic importance are its reserves, loans, and deposits. Notice that the difference between the value of Bank of America’s total assets and its total liabilities is equal to its stockholders’ equity. As a consequence, the left side of the balance sheet always equals the right side.


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




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BANK INCREASE IN CHECKING ACCOUNT DEPOSITSBank of America $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





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The Simple Deposit Multiplier

Simple deposit multiplier The ratio of the amount of deposits created by banks to the amount of new reserves.

RR1 multiplierdeposit Simple

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

Don’t Let This Happen to YOU!Don’t Confuse Assets and Liabilities





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• If single deposit multiplier = 10, total increase in bank reserves = $1,000 x 10 = $10,000

• The higher the reserve ratio (RR), the smaller the multiplier.


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How Do Banks Create Money?The Simple Deposit Multiplier versusthe Real-World Deposit Multiplier

1. Whenever banks gain reserves, they make new loans, 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:



• Money supply can only increase if the bank loans out

• If bank keeps everything as reserves (100% , or 1.00),

Money multiplier = 1/1 = 1

• Banks make new loans whenever they gain reserves. If bank loses reserves, they reduce outstanding loan and deposits – money supply declines.


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The Federal Reserve System

Fractional reserve banking system A banking system in which banks keep less than 100 percent of deposits as reserves.

Bank run A situation in which many depositors simultaneously decide to withdraw money from a bank.

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

Discuss the three policy tools the Federal Reserve uses to manage the money supply.



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The Establishment of the Federal Reserve System

Discount loans Loans the Central Bank makes to banks.

Discount rate The interest rate the Central Bank charges on discount loans.




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How the Central Bank Manages the Money Supply

Monetary policy The actions the Central Bank takes to manage the money supply and interest rates to pursue macroeconomic objectives.

To manage the money supply, the Central Bank uses three monetary policy tools:

1. Open market operations

2. Discount policy

3. Reserve requirements




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How the Federal Reserve Manages the Money Supply

Open Market Operations

Open market operations The buying and selling of government securities by the Central Bank in order to control the money supply.




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How the Central Bank Manages the Money Supply

Discount Policy

By lowering the discount rate, the Central Bank can encourage banks to take additional loans and thereby increase their reserves. With more reserves, banks will make more loans to households and firms, which will increase checking account deposits and the money supply.

Reserve Requirements

When the Central Bank reduces the required reserve ratio, it converts required reserves into excess reserves.


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The Federal Reserve System Discuss the three policy tools the Federal Reserve uses to manage the money supply.


The “Shadow Banking System” andthe Financial Crisis of 2007–2009

Securitization Comes to Banking

Security A financial asset—such as a stock or a bond—that can be bought and sold in a financial market.

Securitization The process of transforming loans or other financial assets into securities.


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The “Shadow Banking System” andthe Financial Crisis of 2007–2009

Figure 13-4The Process of SecuritizationPanel (a) shows how in the securitization process banks grant loans to households and bundle the loans into securities that are then sold to investors. Panel (b) shows that banks collect payments on the original loans and, after taking a fee, send the payments to the investors who bought the securities.



(a) Securitizing a loan (b) The flow of payments on a securitized loan


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The Financial Crisis of 2007–2009



As banks and other financial firms sold assets and cut back on lending to shore up their financial positions, the flow of funds from savers to borrowers was disrupted. The resulting credit crunch significantly worsened the recession that had begun in December 2007.


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High Rates of Inflation

Very high rates of inflation—in excess of hundreds or thousands of percentage points per year—are known as hyperinflation.

Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession.

The Quantity Theory of Money Explain the quantity theory of money and use it to explain how high rates of inflation occur.



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The German Hyperinflation of the Early 1920s

Makingthe

Connection

During the hyperinflation of the 1920s, people in Germany used paper currency to light their stoves.


Explain the quantity theory of money and use it to explain how high rates of inflation occur.


The total number of marks—the German currency—in circulation rose from 115 million in January 1922 to 1.3 billion in January 1923 and then to 497 billion billion, or 497,000,000,000,000,000,000, in December 1923. Just as the quantity theory predicts, the result was a staggeringly high rate of inflation.

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