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CHAPTER 14: Money. In this chapter we will . . . Define money and describe its function. Explain the economic functions of banks and other financial institutions. Explain how banks create money. Define money by its functions. Means of Payment
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In this chapter we will . . . • Define money and describe its function. • Explain the economic functions of banks and other financial institutions. • Explain how banks create money.
Define money by its functions • Means of Payment • A means of payment is a method for settling a debt. • Medium of Exchange • A medium of exchange is something that is generally accepted in exchange for goods and services. • Without money, people would have to exchange goods for goods, or barter.
Unit of Account • A unit of account is an agreed measure for stating the prices of goods and services. • This simplifies value comparisons and decision making about purchases, because all prices are expressed using a uniform measure, i.e. one yardstick. • Store of Value • A store of value is something that can be held and exchanged later for goods and services.
What is Money? Money in the United States Today Money in the US now is multi-function -- it serves all those functions. • Currency is the bills and coins that we use. • Demand [‘checkable’] Deposits are also money because they can be converted into currency and used to settle debts by check or transfer.
M1= • 1) M1 consists of currency and travelers’ checks plus checkable deposits. • Includes accounts held by individuals and businesses, but does not include currency held by banks, or currency and checking deposits owned by the U.S. government • Official Measures of Money Currency+ Demand Deposits + Travelers’ checks
What is Money? Official Measures of Money: M2 consists of M1 plus saving deposits and some time deposits. M3 consists of M2 plus large-scale time deposits and other term deposits
M2= 2) M2 consists of M1 plus saving deposits and time deposits M1+ Savings Accounts • The difference between M1and M2 has to do with the liquidity of an asset. • Liquidity is a measure of how easily and quickly something is convertible into a means of payment [i.e. M1] with little loss of value.
By lending money at interest rates higher than the interest rates they have to pay depositors. • Financial Intermediaries are firms that take deposits from households and firms and make loans to other households and firms • How do financial intermediaries earn profits?
How do financial intermediaries make a profit? • Most importantly, by their ‘spread’ -- the difference between the interest they pay depositors and the interest they charge borrowers. • They also, increasingly, charge for other services [e.g. payment services, ATMs, etc] they provide for customers.
Types of Financial Intermediaries • Commercial Banks • A commercial bank is a firm that receives deposits and makes loans. • Savings and Loan Associations • An S&L is a financial intermediary that receives checking deposits and savings deposits and that makes personal, commercial, and home-purchase loans.
Savings Banks and Credit Unions • A savings bank (mutual savings bank) is owned by its depositors. It accepts deposits and makes mostly home purchase loans. • A credit union is owned by its depositors [who all belong to a defined social or economic group]. It accepts deposits and makes mostly consumer loans. • Money Market Mutual Funds • A money market mutual fund is a financial institution that obtains funds by selling shares and uses these funds to buy highly liquid assets.
Economic Functions of Financial Intermediaries • Facilitate investment and business by borrowing short and lending long • minimize the cost of borrowing • minimize the cost of monitoring borrowers • pool risk • provide payment servicesfor customers
Assets = Some Basic Accounting • A balance sheet lists assets, liabilities, and net worth. • Assets are what the bank owns • Liabilities are what the bank owes • Net Worth is the value of the bank to its owners. • Fundamental Accounting Relationship Liabilities + Net Worth
T - Account for a bank Assets: Liabilities: • Cash • Demand Deposits • U.S. Government Treasury Bills • Time Deposits • Loan from Fed • U.S. Government Bonds • Loans Net Worth : XXXX XXXX
Assets: Liabilities: Assets: Liabilities: Examples of T-Accounts: • Consider the following bank: Demand Deposits $100 Cash $100 Net Worth $100 Loans $100 $200 $200 • If an individual deposits $100 into this bank, what happens to the T-account? Demand Deposits $200 Cash $200 Net Worth $100 Loans $100 $300 $300
Assets: Liabilities: Examples of T-Accounts: • Define reserves as the cash held by the bank plus what the bank has at the Federal Reserve. Hence, Demand Deposits $200 Reserves $200 Net Worth $100 Loans $100 $300 $300 • Suppose you hire a financial consultant. How will she evaluate the performance of your bank?Are you maximizing profits? • No, because reserves are assets that do not earn interest or any other kind of income.
Assets: Liabilities: Examples of T-Accounts: • Since holding reserves does not maximize profits, suppose you loan out the amount of the reserves? Demand Deposits $200 Loans $300 Net Worth $100 $300 $300 • Ok, but now . . . what happens if someone writes a check? • Your bank can’t honor the withdrawal as you don’t have funds available to “cash” the check.
This illustrates an important point. Banks must be prudentin the way they use deposits, balancing security for the depositor against profits for the bank and its owners. • The number of bank failures prior to and during the Great Depression suggests banks made decisions in the direction of maximizing profits at the expense of liquidity. • The Government decided to regulate banks so as to ensure a minimum level of liquidity. • Reserve requirements are rules setting out the minimum percentages of deposits that must be held as reserves.
RequiredReserves ExcessReserves • Reserves = + . RequiredReserveRatio RequiredReserves DemandDeposits = X Reserve requirements definitions: • The required reserve ratio - is the ratio of reserves to deposits that banks are required to hold.
Before regulation Assets: Liabilities: After regulation: reserve ratio = 10% Assets: Liabilities: • Suppose the government sets a reserve ratio of 10%. How does this impact our bank’s T-account? Demand Deposits $200 Reserves $200 Net Worth $100 Loans $100 $300 $300 Demand Deposits $200 Required Reserves $20 Net Worth $100 Excess Reserves $180 Loans $100 $300 $300
After regulation: reserve ratio = 10% Assets: Liabilities: After regulation: reserve ratio = 10% Assets: Liabilities: Demand Deposits $200 Required Reserves $20 Net Worth $100 Excess Reserves $180 Loans $100 $300 $300 • What will your financial advisor tell you to do? - The advice will be to turn the excess reserves into an interest earning asset. Demand Deposits $200 Reserves $20 Net Worth $100 Loans $280 $300 $300
Before deposit Assets: Liabilities: After deposit of $100 . Assets: Liabilities: • Consider our individual bank. Suppose someone deposits $100 into their account. What happens? Demand Deposits $200 Required Reserves $20 Net Worth $100 Loans $280 $300 $300 Demand Deposits $300 Required Reserves $30 Net Worth $100 Excess Reserves $90 Loans $280 $400 $400
Money = Can the bank create money? • Yes, because if it now loans out the excess reserves, it will create new demand deposits and money is defined as . . . DemandDeposits Currency +
We have a fractional reserves banking system. • Fractional reserves banking system means that any new demand deposit in the system implies additional demand deposits (and money) can be created by banks lending the excess reserves created by the deposit. • Suppose someone deposits $100,000 into a bank. The reserve requirement ratio is 25%. What will happen?
Required Reserve Ratio and Money Creation • If the required reserve ratio is 25%, for every $4 of deposits there must be $1 of reserves. • Turning this around, for every $1 of reserves, there can be up to $4 of deposits. • I.e., each $1 of reserves can support up to 1/(required reserve ratio) of deposits.
Required Reserve Ratio and Money Creation • I.e., each $1 of reserves can support up to 1/(required reserve ratio) of deposits. • Looking ahead, this suggests that control of the total reserves in the system can be a powerful tool to influence the total money supply in the system -- this is what Central Banks like the Federal Reserve do, and it turns out they can do it to a large extent even if there is no required reserve ratio.
Deposit $100,000 Reserve $25,000 Loan $75,000 $25,000 $75,000 $100,000 Deposit $75,000 Reserve $18,750 Reserve $18,750 Loan $56,250 Loan $56,250 $43,750 $131,250 $175,000 Deposit $56,250 The Multiple Creation of Bank Deposits The sequence The running tally Reserves Loans Deposits
Deposit $56,250 Reserve $14,063 Loan $42,187 $57,813 $173,437 $231,250 Deposit $42,187 Reserve $10,547 Loan $31,640 $68,360 $205,077 $273,437 and so on... $100,000 $300,000 $400,000 The sequence The running tally Reserves Loans Deposits $43,750 $131,250 $175,000
Total in themoney supply Total in demand deposits = 1 = Initial inDemand Deposits * reserve ratio 1 = * (+100,000) .25 = 4 * (+100,000) Total in themoney supply = +$ 400,000 • The initial demand deposit of +$100,000 resulted in demand deposits (and thus money) in the banking system changing by +$400,000
The deposit multiplier in the United States differs from our model economy’s for several reasons: 1) The actual reserve ratio is smaller than the 25 percent used here. 2) Banks sometimes choose to hold some excess reserves. 3) Not all loans made by banks return to other banks in the form of reserves. 4) Banks sometimes hold assets other than loans [e.g. buy equipment, new offices]
Money, Real GDP, andthe Price Level The Short-Run Effects of a Change in the Quantity of Money Let’s study how a change in the quantity of money effects the economy by using the aggregate supply-aggregate demand model. Consider an increase in the quantity of money: this will change Aggregate Demand -- why and how?
SAS AD0 AD1 0 Short-Run Effects ofChange in Quantity of Money LAS 140 130 Price level (GDP deflator, 1992 = 100) 120 110 107 100 6.6 6.8 7.0 7.2 7.4 7.6 Real GDP (trillions of 1992 dollars)
SAS2 SAS1 AD2 AD1 0 Long-Run Effects ofChange in Quantity of Money LAS 140 130 Price level (GDP deflator, 1992 = 100) 121 113 110 100 6.6 6.8 7.0 7.2 7.4 7.6 Real GDP (trillions of 1992 dollars)
Money, Real GDP, andthe Price Level 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. • This theory is based upon the velocity of circulation and the equation of exchange.
Money, Real GDP, andthe Price Level The Quantity Theory of Money The velocity of circulation is the average number of times a dollar of money is used annually to buy FINAL goods and services, i.e. part of GDP. It is very different from the number of times on average a dollar changes hands -- that is much larger, because so many transactions involve intermediates, old goods, or purely financial transactions [like buying stocks or bonds].
Money, Real GDP, andthe Price Level GDP equals the price level (P) times real GDP (Y), or: GDP = PY
Money, Real GDP, andthe Price Level Make the quantity of money M, and the velocity of circulation V is determined by: V = PY/M
Money, Real GDP, andthe Price Level The equation of exchange states that the quantity of money (M) multiplied by the velocity of circulation (V) equals GDP, or This is an identity -- it must be true by definition. MV=PY
Money, Real GDP, andthe Price Level We can convert the equation of exchange into the quantity theory of money by making two assumptions: 1) The velocity of circulation is not influenced by the quantity of money. 2) Potential GDP is not influenced by the quantity of money.
Assuming this is true, the equation of exchange tells us that a change in the quantity of money causes an equal proportional change in the price level. [In reality, velocity is NOT constant -- it varies with nominal interest rates, the opportunity cost of holding money. This is not a big problem with the theory, unless nominal interest rates are very high or very variable -- e.g. in a hyperinflation (very rapid inflation). What happens to velocity if money loses its value quickly?]
Money, Real GDP, andthe Price Level The Quantity Theory can be shown by using the equation of exchange to solve for the price level. P = (V/Y)M
Money, Real GDP, andthe Price Level In the long run, real GDP equals potential GDP, so the relationship between the change in the price level and the quantity of money is:
Money, Real GDP, andthe Price Level Dividing this equation by an earlier one, P = (V/Y)M, gives us
Money, Real GDP, andthe Price Level This equation shows that the proportionate change in the price level equals the proportionate change in the quantity of money, in the long run, IF velocity and potential GDP don’t change. This gives us the quantity theory of money: In the long run, the percentage increase in the price level equals the percentage increase in the quantity of money.
Money, Real GDP, andthe Price Level The AS-AD model predicts the same kind of outcome as the quantity theory of money. It also predicts a less precise relationship between the quantity of money and the price level in the short run than in the long run.
Money, Real GDP, andthe Price Level Historical Evidence on the Quantity Theory of Money • The data are broadly consistent with the quantity theory of money, but the relationship is not precise. • The relationship is much stronger in the long run than in the short run.
