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?

The Functions of Money

• Medium of exchange: buy stuff with money

No need to barter

• Unit of account: post prices/keep books in money terms

• Standard of deferred payment: need money to pay debts• Store of value

Hold money on chance prices of other assets fall

What Can Serve as Money?

Criteria for an asset to be a medium of exchange:

1 It must be acceptable to most people.

2 It should be of standardized quality.

3 It should be durable.

4 It should be valuable relative to its weight.

5 It should be divisible.

Currency is fine… “fiat money”

Checking account balances are just as good.

Electronic “money” is even better.

Precious metals serve when confidence falters.Commodity money.

M1: The Narrowest Definition of the Money Supply

M1 includes means of payment:

1 Currency: paper money and coins in circulation.

• “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

How Is Money Measured in the United States Today?

1 Because balances in checking accounts are in the money supply, banks play an important role in the way money supply increases and decreases.

What about Credit Cards and Debit Cards?You haven’t paid until you write a check to your bank.

M1: The Narrowest Definition of the Money Supply

How Is Money Measured in the United States Today?

Figure 25-1Measuring the Money Supply, July 2009

The Federal Reserve uses two different measures of the money supply: M1 and M2.M2 includes all the assets in M1, as well as the additional assets shown in panel (b).

How Do Banks Create Money in a Fractional Reserve Banking System?

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

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.

Banks buy interest yielding assets with deposits they don’t keep in reserves:• Gov’t securities, loans to households and firms

How Do Banks Create Money?

A Bank’s Balance Sheet

How Do Banks Create Money?

How Do Banks Create Money?

How Do Banks Create Money?

Bank Balance Sheets

Balance 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. 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.

How Do Banks Create Money?

BANK

INCREASE IN CHECKING 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

How Do Banks Create Money?

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

Change in bank reserves = RR x Change in deposits

The Simple Deposit Multiplier versus the Real-World Deposit Multiplier:• Not everything that one bank lends gets deposited in other banks.

– Much leaks out as currency holdings rather than deposits.• And banks may not lend to full extent the can…they hold excess reserves.

Real world deposit multiplier is less than the simple multiplier.

The Functions of a Modern Central BankThe Banker’s Bank:

Lender of last resort in crises• Bank run: When many depositors rush to withdraw money at the

same time...They “run” to get to the cashier.• Silent run: Major creditors don’t turn over their loans to a bank.• Bank panic: Many banks

experience runs at the same time.Operates clearing system for interbank

payments.Oversees financial intermediaries - ensure their soundness. - ensure public confidence

The Government's Bank:– Manages government transactions.– Controls availability of money and credit.

The Federal Reserve SystemThe Organization of the Federal Reserve System

Federal Reserve Districts

How the Federal Reserve Manages the Money SupplyMonetary policy The actions the Federal Reserve takes to manage the money supply and interest rates in pursuit of economic objectives.

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

1 Open market operations: Fed buys and sells gov’t securities

• Federal Open Market Committee (FOMC) sets target federal funds rate.

• “Federal funds” are reserves that banks borrow and lend to each other.

• Fed buys bonds to increase the supply of reserves and lower the fed funds rate.

2 Discount policy: Fed lends to banks @ discount rate

injects reserves into banking system directly

3 Reserve requirements: lowering reserve requirement converts required reserves to excess reserves that banks can lend

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

Multiple Creation of Money and CreditFed buys something … MB up

A bondA bank IOU

Seller deposits proceed in Bank AMoney supply increases

Bank A’s deposits @ Fed upBank A now has more reserves

Bank A holds reserves against its new deposit (required + excess)

Bank A makes loan to customerBorrower now has more deposits Money has just been created

Borrower buys somethingSeller holds onto currency and deposits the rest in its Bank B

Bank B’s deposits @ Fed up:

The Fed’s Balance Sheet Owns Owes .Gold, Forex Federal Reserve Notes

• Currency in CirculationVault Cash ReservesBank IOUs Bank Deposits @ Fed

(Discount loans) Bank A Bank B :Securities Gov’t Deposits

Gov’t Bonds MBSs Miscellaneous

Monetary Base High Powered= MB Money = H = MB

Note: MB = Currency + Bank Reserves = Cu + RMs = Currency + Demand Deposits = Cu + D

Connecting Money and Prices: The Quantity Equation

M × V = P × Y

The Quantity Theory of Money

Velocity of money The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.

MY x PV

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:

Inflation rate = Growth rate of the money supply + Growth rate of velocity − Growth rate of real output

or

If velocity is constant, then the growth rate of velocity is zero. This allows us to rewrite the equation one last time:

Inflation rate = Growth rate of the money supply − Growth rate of real output

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

High Inflation in Argentina

Money Growth and Inflation in Argentina

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.

K e y T e r m s

AssetBank panicBank runCommodity moneyDiscount loansDiscount rateExcess reservesFederal Open MarketCommittee (FOMC)Federal Reserve SystemFiat moneyFractional reserve banking

system

M1M2Monetary policyMoneyOpen market operationsQuantity theory of moneyRequired reserve ratioRequired reservesReservesSimple deposit multiplierVelocity of money