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The Financial
System, Money
and Prices
Xi Wang
UMSL, Summer 2015
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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Slide
2Learning Objectives
1. Describe the role of financial intermediaries
2. Differentiate between bonds and stocks
Explain how their prices relate to interest rates
3. Explain how the financial system improves the
allocation of savings to productive uses
4. Discuss the three functions of money and how
money is measured
5. Analyze how the lending behavior of commercial
banks affects the money supply
6. Understand the central bank control of the money
supply and its relation to inflation in the long run
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
What is Money? Everyday language: Money means “income” or “wealth”.
In Economics: Money is any asset that can be used in making
purchases
Examples
Currency
Coins
Checking Account Deposits
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3
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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4
The Financial System
Financial markets are where households invest their current
savings and accumulated past savings (Wealth) by
purchasing financial assets or physical assets.
Financial Asset: is a paper claim (stocks, bonds, loans, etc)
that entitles the buyer to future income from the seller
A loan is a financial asset that is owned by the lender
(typically, banks). It is a bank’s asset and your (borrower)
liability.
Physical Asset: is a claim on a tangible object (house,
machinery, etc) that gives the owner the right to dispose of
the object as he or she wishes (rent it or sell it).
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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5
How Does the Financial System
Allocate Savings?A successful economy typically has a well
functioning financial system that allocates its
savings towards the most productive investments.
Financial Markets provide information to savers
about the most productive (highest rate of return)
investments
Financial Markets help savers to diversify
(investing in several assets with unrelated or
independent risks) so as to share the risks of
individual investment projects while at the same
time funding such risky but worthwhile projects.
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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6
Types of Financial Assets - Loans
Loan - is a lending agreement between a particular
lender and a particular borrower. Due to large
information-gathering transaction costs, large
borrowers like the government and large corporations
issue (sell) bonds. Loans are also harder to resell
because they are not as standardized as bonds
Bond – is a legal IOU issued by the borrower. The seller
of the bond (borrower) promises to pay a fixed sum of
interest (called coupon payments) each year and to
repay the principal amount (called face-value) at
maturity. The interest rate on the bond is called its
coupon rate.
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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7
Types of Financial Assets - Bonds
The coupon rate that a newly issued bond must
promise so as to be attractive to savers depends
on:
The term of a bond – length of time until maturity.
The longer the term the higher the coupon rate.
Credit Risk – the risk that the borrower will go
bankrupt and hence default. High risk bonds pay
higher coupon rates as in high-yield junk bonds.
Tax Treatment - Municipal bonds are federal tax
free and so offer a lower coupon rate.
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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8
Types of Financial Assets - Bonds
Bondholders are free to sell their bonds any time before maturity in the bond market. So you can buy used bonds in the bond market – an organized market for bonds run by professional bond traders.
The market value of a particular bond at any time is called its price. The price of a bond may be equal to, greater than or less than the face-valueof the bond, depending on how the bond coupon rate compares with the prevailing market interest rates.
We will see later that bond prices are inversely related to market interest rates
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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9
Types of Financial Assets: Loan-
Backed SecuritiesLoan-Backed Securities: are assets created by
pooling individual loans and selling shares in
that pool – a process called securitization.
These have become extremely popular over
the past two decades.
Mortgage-Backed securities are a special kind
of the above where individual home
mortgages are pooled and sold as shares to
investors.
Securitization has also been widely applied to
auto, student and credit card loans.
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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10
Types of Financial Assets – Loan-
Backed SecuritiesThese Loan-Backed Securities trade on
financial markets like bonds.
They are often preferred by investors because
they provide more diversification and liquidity
as compared to individual loans.(Why? This is a
interesting statement)
However, with so many loans packaged
together, it can often be difficult to assess risks
and evaluate the “true” quality of the
underlying assets – as was painfully obvious
during the financial crisis of 2007-08.
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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11
Types of Financial Assets - Stocks
Stock: is a share in the ownership of a company. It
is a financial asset from the owner’s point and a
liability from the company’s point of view.
Stockholders receive regular payments called
dividends (a share of the company’s profits) for
each share of stocks they own.(May not be
constant)
Stockholders also receive returns in the form of
capital gains when price of their stock increases.
Stock prices are determined by the demand and
supply of the stock at stock exchanges.
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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12
Types of Financial Assets - Stocks
Why does Microsoft allow you to buy
ownership of their company? Why don’t Bill
gates and Paul Allen (the two founders) sell
bonds for their investment needs and keep
100% ownership with themselves?
Risk aversion – few individuals are risk tolerant
enough to internalize the risks involved in
owning a large company like Microsoft.
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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13
Types of Financial Assets - Stocks
While stocks have historically yielded higher
real interest rates (7% for stocks and 2% for
bonds) they are riskier than bonds because, by
law, a company must repay its lenders before
paying out dividends to shareholders. Also, in
the event of default due to bankruptcy the
physical and financial assets after liquidation
goes to bondholders while stock shareholders
typically get nothing.
Loosely speaking – A bond is a promise; a
stock is a hope!
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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14
Types of Financial Assets – Bank
DepositsBank deposit: is a claim on the bank by the
depositor; the bank is obliged to give your
cash back on demand. So bank deposits are
often called demand deposits. It is your
financial asset and a liability for the bank.
On any given day a bank only keeps a
fraction of its deposits as reserves (cash on
hand) in the bank. It loans out the remaining
money to investors.
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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15Financial Intermediaries
A Financial Intermediary is an institution that
extends credit to borrowers using funds raised
from savers. Examples – banks, Savings and
Loan, and Credit unions, Mutual Funds, Pension
Funds and Life Insurance Funds.
Banks and other financial intermediaries specialize in
evaluating the quality of borrowers
Principle of Comparative Advantage
They have lower cost of evaluating opportunities than an individual would
They pool the savings of many individuals to make large loans
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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16
Advantages of Banking
Banks gather information, evaluate potential
investments, and direct savings to higher-
return, more productive investments
Service provided to depositors
Banks provide access to credit for small
businesses and homeowners
May be the only source of credit for some investments
When banks make loans, they earn interest
which, in turn, is paid by the bank to its
depositors
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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17Advantages of Banking
Having bank deposits makes payments easier
Checks
ATMs
Debit card
Checks and debit cards are safer than cash(what do I mean by
safe?)
Banks provide a record of your transactions
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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Slide
18
Banks and the South Korean Miracle
In the 1960s South Korea’s banking system was a mess. Nominal interest rates were low and inflations rates were high. Savers preferred physical assets – real estate and gold. Businesses found it difficult to finance their projects.(Why people choose not to save?Interest rate, yes?)
In 1965 South Korean government reformed the banking system by raising interest rates. National savings rate more than doubled. The rejuvenated banking system financed the great investment boom that followed.
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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19
Japanese Banking Crisis of the
1990sJapan’s real estate and stock prices soared
during the boom of the 1980s. Japanese
banks made loans to real estate developers
and they also bought stocks of companies.
When property and stock values fell in the
1990s, Japanese banks fell into severe trouble
Property values decreased and some loans on real estate went into
default
Banks held stocks in companies and the stock values decreased with
recession
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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20
Japanese Banking Crisis of the
1990sIn Japan, banks were the main way saving
was translated into investment
Not so well developed stock and bond markets
Small- and medium-sized businesses suffered from credit shortages
Credit shortages prolonged the recession as businesses struggled to
fund new projects
The recession of the 1990s was fueled by the
virtual breakdown on the banking sector.
The government’s response was too slow.
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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Slide
21
Bond Prices and Market Interest Rates
Bonds can be sold before their maturity date
Market price of the bond depends on the relationship between the
coupon rate and the interest rate in financial markets
A two-year government bond with principal
$1,000 is sold for $1,000, 1/1/09
Coupon rate is 5%; $50 will be paid 1/1/10; $1,050 will be paid 1/1/11
If you want to sell the bond on 1/1/10, what will
the price be? Depends on the prevailing
market interest rate.
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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22
Offer for sale: a government bond with payment of $1,050 due in one year
The competition: Interest rate is 6%; a $1000 invested in a savings account will yield $1,060 in one year
Price of the used bond will be less than $1,000(Savings account amount) (1.06) = $1,050
Used bond price = $991
Bond prices and interest rates are inversely related
Bond Prices and Market Interest Rates
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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23Stock Prices
Price of stock is expected to be $80 in 1 year;
Dividends will be $1 and the current Savings
Market Interest rate is 6%. What is the most you
will be willing to pay for this stock now?
(Price paid now) (1.06) = $81. So Stock price
now = $76.42.
Value would be higher if Dividend were higher
Expected capital gains were higher
Interest rate were lower
Stock prices and r are negatively related.
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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24Riskiness and Stock Prices
Most investors dislike risk and require a higher
rate of return on risky assets.
The difference between the required rate of
return to hold risky assets and the rate of return
on safe assets is called Risk Premium
In the previous example suppose a 10% return
is required as risk premium
So Stock price now = $81/1.10 = $73.64
Risk aversion increases the return required of a
risky stock and lowers the selling price
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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25
Rise and Fall of the US Stock Market
Standard & Poor's 500 index rose 60% between
1990 and 1995
More than doubled 1995 – 2000
Lost 40% of its value Jan 2001 – Jan 2003
Returned to Jan 2000 level by Jan 2008
Current Stock Prices depend on the
expectations of buyers of stock about
Future dividends: (+)vely related
Future stock prices (capital gains): (+)vely related
Required Rate of Return = r on safe assets + Risk
Premium: (-)vely related
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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Rise and Fall of the US Stock Market
An increase in stock prices could be the result of
Increased optimism about future dividends and/or
capital gains
A fall in the Required Rate of Return
In the 1990s, optimism was high
Strong dividends
Promise of new technologies
Risk premium declined
Increased diversification through mutual funds may have
reduced perceived risk of holding stocks
Investors may have underestimated risk
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
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Rise and Fall of the US Stock Market
Optimism and risk premium trends reversed
after 2000
Many high-tech firms turned out to be less profitable
than expected
Corporate accounting scandals of 2002 – illegally
inflated profits
The 2000-01 recession
Terrorist attack in US
In 2003 when the economy began to grow
more rapidly, stock prices began to recover.
MB MC
Copyright c 2004 by The McGraw-Hill
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Money: Three Principal
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Money is any asset that can be used in making
purchases
Examples include coins and currency, checking
account balances, and traveler's checks
Shares of stock are not money
Money has three principal uses
1. Medium of exchange
2. Unit of account
3. Store of value
Barter is trading goods directly
MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
Money: Definitions M1 is the sum of currency held outside
banks, traveler’s checks, and balances held
in checking accounts by individuals and
businesses
M2 is M1 plus some additional assets that
are useable in making payments but at
greater cost (including inconvenience) than
currency or checks.
E.g., Savings deposits, small-denomination (< $100,000) time
deposits and Money Market Mutual funds.
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MB MC
Copyright c 2004 by The McGraw-Hill
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Components of M1 and M2,
Jan 2008 (billions of dollars)T
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M1
Currency
Demand deposits
Other checkable deposits
Travelers’ checks
M2
M1
Savings deposits
Small-denomination time deposits
Money market mutual funds
1,364.7
758.1
292.5
307.9
6.2
7,498.7
1,364.7
3,903.4
1,224.4
1,006.1
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Copyright c 2004 by The McGraw-Hill
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Are these Money?
Checks, credit cards, debit cards?
These are themselves not money.
The bank deposits that they take the
money from is the actual money.
The cards are just a form of ID, sort of
like your driver’s license.
Similarly, currency inside the bank
(bank reserves) is not money.
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MB MC
Copyright c 2004 by The McGraw-Hill
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Commercial Banks and the
Creation of Money
Virtual Republic begins with no commercial banking system.
The Government of Virtual Republic, through its Central Bank issues 1 million guilders (currency) Money Supply = 1 m guilders
Lack of security, so people want to place their 1 million guilders in a bank A Commercial Bank is set up
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MB MC
Copyright c 2004 by The McGraw-Hill
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Consolidated Balance Sheet of
Virtual Commercial Bank (Initial)T
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Assets
Currency 1,000,000 guilders
Liabilities
Deposits 1,000,000 guilders
Citizens open accounts and deposit 1 million guilders
• Deposits are liabilities for the bank
• The guilders are an asset for the bank
• Guilders are the bank’s reserves
• Reserves = deposits: 100 percent reserve banking
Reserves are not part of the money supply
Deposits are part of the money supply
For simplicity assume that all guilders are deposited
in the commercial banks.
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Commercial Banks and
the Creation of Money Bank Reserves - Cash or similar assets held by
commercial banks for the purpose of meeting
depositor withdrawals and payments
100% Reserve Banking - Banks hold 100% of
their deposits (liabilities) as reserves
Reserve-Deposit ratio - Reserves/Deposits
Fractional Reserve Banking System - Banks may
also hold a fraction of the deposits as reserves
and loan out the rest to individuals and
businesses; reserve-deposit ratio < 100%
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MB MC
Copyright c 2004 by The McGraw-Hill
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Consolidated Balance Sheet of Virtual
Commercial Bank after One Round of LoansT
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Assets
Currency (= Reserves) 100,000 guilders
Loans to citizens 900,000 guilders
Liabilities
Deposits 1,000,000 guilders
Fractional Reserve Banking System
• Bankers agree they only need a reserve to deposit ratio of
10%
• Required reserves = 100,000 guilders, 10% of deposits
• Loan out the excess reserves of 900,000 guilders
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Copyright c 2004 by The McGraw-Hill
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Consolidated Balance Sheet of Virtual
Commercial Bank After Loans Are Re-depositedT
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Assets
Currency (=Reserves) 1,000,000 guilders
Loans to citizens 900,000 guilders
Liabilities
Deposits 1,900,000 guilders
People prefer bank deposits to holding cash
• Reserves = 1,000,000 G; Deposits = 1,900,000 G
• Money supply = 1,900,000 G
• Actual Reserve-Deposit ratio = 10/19 = 52.6%
• Required Reserve to deposit ratio = 10%
• Required Reserves = 10% of 1,900,000 = 190,000 G
• Excess Reserves = 1,000,000 - 190,000 = 810,000 G
• Banks can loan the 810,000 guilders
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Copyright c 2004 by The McGraw-Hill
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Consolidated Balance Sheet of Virtual
Commercial Bank After Two Rounds of
Loans and Re-deposits
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Assets
Currency (= reserves) 1,000,000 guilders
Loans to farmers 1,710,000 guilders
Liabilities
Deposits 2,710,000 guilders
Loan proceeds are deposited
• Reserves = 1,000,000 guilders
• Deposits = 2,710,000 guilders
• Money supply = 2,710,000 guilders
• Actual Reserve to deposit ratio = 36.9%
• Excess reserves = 729,000 guilders
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Copyright c 2004 by The McGraw-Hill
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Final Consolidated Balance Sheet of
Virtual Commercial BanksT
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Assets
Currency (= reserves) 1,000,000 guilders
Loans to farmers 9,000,000 guilders
Liabilities
Deposits 10,000,000 guilders
Observations
• Lending will continue until the actual reserve to deposit ratio
= required reserve to deposit ratio = 10%
• When loans = 9,000,000 guilders
•Deposits = 10,000,000 guilders
•Reserves = 1,000,000 guilders
•Reserve to deposit ratio = 10%
•No excess reserves
• The money supply = 10,000,000 guilders
MB MC
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Commercial Banks and the Creation
of Money: Observations The use of a fractional-reserve banking system
allows the money supply to grow as a multiple of the reserves. With a 10% reserve-deposit ratio, 1 guilder in reserve can support 10 guilders in deposits.
Bank reserves/bank deposits = desired reserve-deposit ratio
Bank deposits = bank reserves/desired reserve-deposit ratio
If desired reserve-deposit ratio is 5% and bank reserves are $1000, bank deposits will equal $1000/0.05 = $20,000
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Copyright c 2004 by The McGraw-Hill
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Money Supply with Currency and
Deposits Virtual Republic residents choose to hold half,
i.e., 500,000 guilders as currency and deposit 500,000 guilders in the bank
Reserve-deposit ratio = 10%
Bank deposits = 500,000/.10 = 5,000,000
Money supply with currency held = currency + bank deposits = 5,500,000
Money Supply without any Currency held = 1,000,000/0.1 = 10,000,000 guilders
Money supply is reduced by 10,000,000 -5,500,000 = 4,500,000 guilders when the residents hold 500,000 guilders in currency
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Copyright c 2004 by The McGraw-Hill
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Does money Supply Rise or Fall at
Christmas
Suppose banks hold $500 billion in reserves and
the public hold $500 billion in cash
Reserve-deposit ratio = 0.20
Money supply = $500 + (500 / 0.20) = $3,000
As Christmas approaches, consumers reduce
bank deposits by $100 billion
Banks have $400 billion in reserves; public holds $600 billion cash
Money supply = $600 + ($400 / 0.20) = $2,600
Reducing bank deposits reduces the money
supply
MB MC
Copyright c 2004 by The McGraw-Hill
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The Federal Reserve
System Two Main Responsibilities of the Fed Monetary policy
Oversight and regulation of financial markets
Monetary policy is deciding and managing the size of the nation's money supply
The Federal Open market Committee (FOMC) controls money supply by Open Market Operations – the purchase and sale of government bonds by the Fed that leads to a change in bank reserves and hence the money supply.
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Copyright c 2004 by The McGraw-Hill
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The Federal Reserve
System Increasing The Money Supply - Open Market Purchase
The Fed purchases government bonds from the public.
The people deposit the funds they get from their sale of
bonds.
The increase in deposits increase bank reserves.
The money supply increases by a multiple of the increase in
reserves.
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MB MC
Copyright c 2004 by The McGraw-Hill
Companies, Inc. All rights reserved.
The Federal Reserve
System Reducing The Money Supply - Open Market Sale
The Fed sells government bonds to the public.
The Fed presents the checks from the sale of the bonds to the
banks for payment.
The bank’s reserves will fall when they clear the checks
The money supply will fall by a multiple of the decrease in
reserves.
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MB MC
Copyright c 2004 by The McGraw-Hill
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Example of Open Market Purchase
Currency = 1,000 guilders
Reserves = 200 guilders
Reserve-deposit ratio = 0.2
Money supply = 1,000 + 200/0.2 = 2,000 guilders
Open Market Purchase = 100 guilders
New Money Supply = 1,000 + 300/0.2 = 2,500 guilders
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MB MC
Copyright c 2004 by The McGraw-Hill
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Money and Prices
Most nations that that have experienced high and sustained
inflation have had unusual increases in their money supply.
In the short run inflation can arise from other sources. But in the
long run inflation is almost always caused by too much money
chasing too few goods.
Indeed, in the long run, money supply is directly proportional to
prices.
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MB MC
Copyright c 2004 by The McGraw-Hill
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Money and Prices Velocity
The speed at which money circulates – the number of times a
year the typical dollar changes hands.
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stockMoney
GDP Nominal
stockMoney
nstransactio of Value Velocity
M
x YP
supply)(money M
GDP) (real x Y level) (price P (V)Velocity
MB MC
Copyright c 2004 by The McGraw-Hill
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Money and Prices
Velocity in 2007
M1 = $1,364.2 billion
M2 = $7,447.1 billion
Nominal GDP = $13,843.0 billion
Velocity is determined by a number of factors including technologies such as ATMs and debit cards
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10.15 billion $1,364.2
billion $13,843.0 V M1,
1.86 billion $7,447.1
billion $13,843.0 V M2,
MB MC
Copyright c 2004 by The McGraw-Hill
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Money and Inflation in the Long
Run
Recall:
Quantity equation
M x V = P x Y
Assuming V & Y are constant over the
time period
Then P is directly proportional to M.
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M
Y x P V
MB MC
Copyright c 2004 by The McGraw-Hill
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Money and Prices
If high rates of money growth lead to inflation, why do countries allow their money supplies to rise quickly?
Huge Govt. Budget deficits
If the govt. cannot tax or borrow from the public, it finances the deficit by printing money.
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End of Chapter
Summary